In a year that has produced far more questions than answers, a few dynamics have nonetheless become clear: The economy is in transition, with roaring consumer prices and swelling interest rates posing the most immediate hazards. The Federal Reserve has redoubled its efforts to vanquish inflation, even at the risk of touching off a recession. Most apparent of all, investors’ nerves are being tested as the stresses weigh on stocks and bonds.
Of course, the biggest question is the one that can’t yet be answered: Will the Fed be able to pull off a much-hoped-for soft landing? Or to put it more simply, can policymakers squelch inflation without pancaking growth? The outcome of that precarious balancing act could determine how the markets fare the rest of the year.
The forces pressuring the economy are well known. A mix of pandemic-scrambled supply chains, altered consumer spending habits and repeated helpings of government stimulus pushed inflation to a series of 40-year highs. After a flat-footed start in which central bankers underestimated the inflationary threat, they’re pushing up interest rates at the most aggressive pace in decades. The central bank hoisted its benchmark rate by three-quarters of a percentage point in June, and is expected to do so again in July.
As interest rates have risen, so has fear of a recession. Economic growth projections have fallen considerably, while stocks slipped into a bear market in the worst first half of a year since 1970. Every sector weakened in the second quarter, with technology stocks clanking particularly hard — casualties of the pixelated economy and business-specific setbacks. Energy is the only sector sporting a gain for the year, although it also has softened of late. Meanwhile, the swift rise in interest rates pushed bonds into one of their worst-ever starts to a year.
Going forward, Capital Group economists believe there is a significant risk of inflation remaining elevated. Employment costs are increasing more rapidly than they have in the past two decades. And mortgage rates and apartment rents are climbing sharply. Nevertheless, it’s important to remember that equities have withstood repeated economic shocks over the past 15 years, including the pandemic-induced recession in early 2020. And regardless of when the market bottoms, stock prices can quickly shoot higher in the early days of a rebound.
Easy as they may be to miss, there are reasons for optimism. Employers continue to snap up workers, and the substantial effort that’s gone into building their workforces may make businesses reluctant to cut jobs in all but the grisliest of downturns. Even with inflation-warped consumer sentiment skidding to an all-time low, Americans continue to lead with their wallets. And though corporate operating margins may have peaked, they remain at historical highs. Thus far, companies have been able to pass on higher input costs to customers, and earnings expectations have risen throughout the year.
On a deeper level, market downturns have historically laid the foundation for subsequent advances. Drastically lower valuations can create buying opportunities in previously out-of-reach stocks. And the excesses that accumulate in extended market advances can be scrubbed away as investors refocus on fundamentals.
As important, broad-based declines have tended to reshuffle market leadership. The industries and companies that were the front runners of one market advance often give way to new standard bearers in the next. For example, tech has dominated over the past decade. Ongoing innovation bodes well for the sector, but the overreliance on a narrow band of attention-grabbing giants is unlikely to persist. Instead, the midsection of the market — sectors with long-term investment potential that may have been overshadowed previously — could come to the fore.
Capital Group analysts and portfolio managers are working to identify sectors with long-term promise and compelling valuations. For example, industrial automation companies stand to benefit as businesses emphasize “just-in-case” manufacturing over the freewheeling globalization of the past several decades.
In this story, Will Robbins, the principal investment officer of Capital Group Private Client Services, discusses some of the industries that he believes are well positioned, including travel-related businesses that are riding the furious pickup in Americans’ vacation plans.
Historically, bonds have been a source of refuge when stocks have slumped. But even high-quality bonds have been staggered by this year’s double whammy of blistering inflation and repeated interest rate hikes. At one point, the yield on the 10-year Treasury jumped to its highest point in more than a decade.
Inflation gnaws at the fixed payments that bonds provide, especially if rising consumer prices outpace yields and turn real returns negative. Rising rates can dampen the entire market. That’s because new bond issuances have higher yields — a direct result of those climbing rates — that reduce the value of older, lower-interest securities.
However, core fixed income still served many of its functions this year. High-quality bonds continued to provide income and were decidedly less volatile than stocks, particularly in the second quarter. Moreover, bonds generally didn’t decline nearly as much as equities, partly because of steady coupon payments.
Beyond that, rising interest rates can benefit bond investors in the long term. As older securities mature, the proceeds can be reinvested into newer, higher yielding offerings. After a years-long run of spectacularly low bond yields, there may be notably more income in the fixed income portion of investor portfolios.
Looking forward, fixed income may be well positioned to reward long-term investors. Historically, when yields have been at today’s levels, bonds have provided healthy returns in the ensuing five years. In this story, fixed income portfolio manager John Queen gives an in-depth explanation of the current environment and how he’s positioning his portion of client portfolios.