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  Insights

Market Volatility
Shifting economic conditions require flexibility and adaptability
Philip Winston
Portfolio Manager

This year’s market volatility has prompted me to revisit a truism: Flexibility is key when conditions change. Whether it’s in investing or anything else, those who do best aren’t necessarily the smartest or most opinionated. Rather, they’re the ones who adapt to circumstances. That is especially true in today’s evolving economic climate.


Volatility may linger throughout this year and could bring surprises, for good or ill. On the downside, history has shown that markets can drop further than you might expect. After a partial rebound from their initial punishing decline during the 2008 global financial crisis, markets suffered a second major leg down. The economic malaise of the 1970s went on far longer than many people expected. Conversely, negative events can reverse quickly, too: The October 1987 market crash felt devastating at the time, but share prices recovered so quickly that today the episode barely registers on graphs.


Whatever the immediate future holds, adaptability will likely remain essential. That’s because, in my view, we’re entering a new, lasting market environment that will not return to the conditions of the previous decade.


The nature of opportunity could change with market fundamentals.


What has changed? Low interest rates, muted inflation and globalization appear to be receding. The new landscape will feature higher interest rates, higher taxes, more regulations and more barriers to trade. Simply put, valuations may be lower, and earnings downgrades may be more common. The result, I believe, is that stock index returns may be lower in the next 10 years than they were in the preceding 10.


Inflation and interest rates are rising

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Sources: Bureau of Labor Statistics, Eurostat, Office for National Statistics, Federal Reserve, European Central Bank, Bank of England. Inflation rates are 12-month change in prices, measured on a monthly basis. Interest rates reflect the upper bound when a range of interest rates was targeted. As of September 30, 2022.

Inflation in the U.S. and Europe remains far above that of the past few decades. Though price hikes have eased slightly in the U.S., I think many cost pressures are embedded. Geopolitical tensions and trade disputes make overseas production more expensive. Many regions face resource, energy and food insecurity. Tight labor markets are adding to wage pressures.


As a result, profitability and margins may have peaked for many companies. I don’t think price-to-earnings ratios of the loftiest stocks will return to their recent heights. Historically speaking, the robust growth of recent years is highly exceptional and will likely be rarer for some time. With fewer growth opportunities, dividends will play a larger role in total returns, especially for companies that raise their payout ratios as earnings and cash flow rise.


However, none of this spells an end to investment opportunities. Far from it. There are opportunities in every market, and the best-run companies will still thrive. As difficult as times like this can be, down markets present a chance to buy promising businesses at attractive valuations. Diligent research and careful stock selection will be critical. So will the ability to keep an open mind, because the economic backdrop and the most promising sectors in coming years may veer meaningfully from those of the recent past.


To put this all another way, the new environment may reward those who can meet the challenge where it exists, not where they wish it was. In the words of British outdoorsman Alfred Wainwright, “There’s no such thing as bad weather, only unsuitable clothing.”


Resilience and inflation are important to my investment considerations.


I have always looked for solid and dependable businesses. Given the emerging challenges, I am even more drawn to some of their key attributes. Resilience — a company’s projected ability to maintain dependable growth over a long period — leads the list. The hallmarks of resilience include durable pricing power and earnings, sustainable cash flow and a commitment to increase dividends.


That has historically led me to stable, well-run businesses in sectors with built-in demand. At the moment, I think such opportunities can be found among utilities and defense companies in the U.S. and telecommunications businesses in Europe. Some pharmaceutical companies could also fit the bill.


Some of the trends mentioned above might favor specific industries. For example, many businesses may seek to rein in costs by boosting automation to offset wage and labor pressures. On the factory line, industrial robots can improve efficiency, precision and safety. In the office, many routine tasks can be handled by increasingly sophisticated software.


Efforts to relocate and diversify supply chains could lead to a renaissance in capital expenditures. That could give a lift to businesses addressing infrastructure needs. I think mining equipment and telecommunications are potential beneficiaries, as are companies that specialize in energy savings and efficiency.


These kinds of periods can be stressful, and for good reason. But I view a period like this as an opportunity. Adaptability and a good perspective can be powerful guides in volatile markets.



Philip Winston is an equity portfolio manager with 37 years of experience (as of 12/31/2021). He holds a PhD and a master’s degree in history from Cambridge University.


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