5 keys to investing in 2022

by Rob Lovelace, Vice Chair and President, Diana Wagner, Equity Portfolio Manager, Mike Gitlin, Head of Fixed Income, Capital Group

The wall of worry that markets and investors face every year only seems to be getting taller and wider heading into 2022. There are the known challenges: How long will inflation last? Will central banks raise rates? How will a slowing Chinese economy impact global growth?

There also are unknown shocks and surprises that likely await investors in the year ahead. But smart investors can take action to prepare for the unexpected. Here are five keys to staying on course in 2022 amid economic and geopolitical uncertainty:

1. Prepare for higher volatility

What a difference a year makes. At the start of 2021, investors cheered the approval of several COVID vaccines and the rollout of massive government stimulus to bolster economies and markets.

Heading into 2022, COVID case counts are soaring, inflation is hitting new highs and the U.S. Federal Reserve has indicated it could raise rates three times in the coming year.

While such developments can be unnerving, it’s important to keep them in perspective. “The pandemic will likely be with us a long time, if not forever, but over time I expect its impact on the economy and markets will diminish,” says Rob Lovelace, vice chair and president of Capital Group and portfolio manager on Capital Group Canadian Focused Equity FundTM (Canada).

Another likely source of volatility over the next 12 months: the upcoming U.S. midterm elections. Political uncertainty often has a noticeable impact on markets, but that impact has tended to be short term. “I don’t think this year will be any different,” says Chris Buchbinder, portfolio manager on Capital Group U.S. Equity FundTM (Canada). “There may be a few bumps in the road — and investors should brace for short-term volatility — but I don’t think the destination will change.”

Indeed, an analysis of more than 90 years of equity returns reveals that stocks tend to have lower average returns and higher volatility for the first several months of midterm election years. As results at the polls become more predictable, this trend often reverses, and markets have tended to return to their normal upward trajectory.

Uncertainty, whether political or economic, generates a lot of noise. Smart investors would be wise to look past the short-term highs and lows and stay the course.

Prepare for U.S. market volatility this U.S. midterm election year

The two lines show YTD returns in USD for midterm election years and other years, respectively. In U.S. midterm election years, the points on the line generally stay within a range of 0% and 2% until around October, when they start to rise for the remainder of the year. In all other years, the points on the line increase steadily through most of the year.

Sources: Capital Group, RIMES, Standard & Poor’s. The chart shows the average trajectory of equity returns throughout U.S. midterm election years compared to non-midterm election years. Each point on the lines represents the average year-to-date return of that particular month and day and is calculated using daily price returns from 1/1/31–11/30/21. Returns are in USD.

2. To fight inflation, add pricing power to your portfolio

Evidence is mounting that inflation will stick around in 2022. In November, the U.S. Consumer Price Index, a broad measure of inflation, rose at its fastest rate in nearly 40 years.

“Though inflation will likely normalize within a few years, I do expect COVID and related supply chain issues to dominate the inflation outlook over the next 12 months,” says U.S. economist Darrell Spence.

To blunt inflation’s impact, investors can seek companies with pricing power. Pricing power can help protect a company’s profit margins by passing rising costs along to customers.

High and stable margins can be an indication of pricing power. Companies with pricing power potential include consumer businesses with strong brand recognition, like beverage makers Keurig Dr Pepper and Coca-Cola; companies in industries with favourable supply and demand dynamics, like semiconductor and chip equipment makers Taiwan Semiconductor Manufacturing Company and ASML; and businesses that provide essential services, like health care giants Pfizer and UnitedHealth Group.

“I believe lingering inflation may be the biggest risk companies and investors face in 2022,” says equity portfolio manager Diana Wagner. “That’s why I am so focused on uncovering companies with pricing power.”

Pricing power can help companies fight inflation

The scatter gram plots a range of industries by their average gross profit margins for the five years ended September 30, 2021, and for standard deviation of gross margins for the same period. Standard deviation measures how varied or consistent the gross margins have been over the five years. Relatively high and consistent gross margins can be an indicator of pricing power. Among the industries identified as having such characteristics are pharmaceutical/biotech, beverages, semiconductors, household products, apparel and luxury goods, and media.

Sources: Capital Group, FactSet, MSCI. Reflects industries within the MSCI World Index. Average and standard deviation of gross margins are calculated for the five-year period ended 9/30/21. Average gross margin is net sales less the cost of goods sold and is shown as a percentage of net sales. Standard deviation is a common measure of absolute volatility that tells how returns over time have varied from the mean. A lower number signifies lower volatility.

3. Go global to tap into the digital revolution

Sure, U.S. stock markets have outpaced the rest of the world for much of the past decade, partly because many of the leaders of the digital revolution have been U.S. tech giants. But the outlook for international stock markets is brighter than it’s been in a long time, thanks to improving European economic growth and the expansion of the digital revolution beyond U.S. shores.

Indeed, the digital shift has moved far beyond the turf of Amazon, Google and Microsoft. Across nearly all industries, companies are adopting new technology to improve business and transform the way we live.

“I don’t think these opportunities are yet fully understood by the market,” says equity portfolio manager Greg Wendt. “In addition, there’s no question that valuations are lower for many international and emerging markets companies compared to their U.S. counterparts. That makes non-U.S. markets a very attractive hunting ground.”

Global spending on digital transformation is expected to rise from US$1.3 trillion in 2020 to US$2.4 trillion by 2024, according to Statista. Even old economy companies are investing heavily in technology to reinvent and revitalize their businesses through automation, cyber sales and machine learning.

In Europe, companies like food giant Nestlé and cosmetics leader L’Oréal have ramped up their digital adoption, nearly doubling e-commerce-related revenues as a percentage of total revenue in recent years. China is even further ahead in many ways: Companies like appliance maker Midea Group and restaurant firm Yum China have generated significantly stronger growth in e-commerce revenues.

Beyond big tech: The digital revolution spreads overseas

The graphic shows the percentage of total e-commerce sales made by companies in the United States, Europe and China in 2019 and the first half of 2021. E-commerce made up 9% of total sales for The Home Depot in 2019 and 14% in the first half of 2021. E-commerce made up 56% of total sales for Williams Sonoma in 2019 and 65% in the first half of 2021. E-commerce made up 9% of total sales for Nestlé in 2019 and 15% in the first half of 2021. E-commerce made up 16% of total sales for L’Oréal in 2019 and 27% in the first half of 2021. E-commerce made up 21% of total sales for the Midea Group in 2019 and 57% in the first half of 2021. E-commerce made up 61% of total sales for Yum China in 2019 and 85% in the first half of 2021.

Sources: Capital Group, company filings, company reports, FactSet. For The Home Depot and Williams Sonoma, the full-year period refers to the 12 months ending on January 30 to align with the company’s fiscal year (i.e., 1H:21 refers to the period between February 2021–July 2021). All other periods correspond with calendar years. As of July 31, 2021.

4. Strengthen your core bond allocation to help counter volatility

Does the prospect of rising rates bode poorly for core bond portfolios? Not necessarily, says Capital Group head of fixed income Mike Gitlin.

“The Fed’s intent to hike rates is well telegraphed, and with growth slowing, the central bank will likely move at a measured pace,” Gitlin says. “With that in mind, it still makes sense to maintain an allocation to core bonds.”

Indeed, core bonds held up well the last seven hiking periods. The core U.S. bond benchmark, the Bloomberg U.S. Aggregate Bond Index, declined in only two of those periods and averaged a nearly 4% return in USD. Those two periods, with low single-digit losses, were also a far cry from the double-digit corrections stocks often experience.

Core bond funds should provide a critical function in a balanced portfolio. First, they can offer diversification from equities. That is especially important at a time when the stock market is hitting new highs and volatility is rising.

Uncertainties, such as slowing global growth, an unknown COVID trajectory and a weaker Chinese economy, could result in heightened volatility. Active core bond managers can work to identify bonds with maturities that could hold up relatively well should rates drift higher.

Bonds have done well in rising rate environments

A bar chart showing the cumulative return in USD of the Bloomberg U.S. Aggregate Index in the last seven periods of rising rates, starting in 1983. It shows that the index return was positive in five of those periods, ranging from 2.0% to 10.2%. It was negative in two of the periods, ranging from –2.9% to –2.0%. The average for all periods was a positive return of 3.9%. It also indicates how much the federal funds rate rose in each of these periods, ranging from 1.44% to 4.25%.

Sources: Bloomberg Index Services Ltd., Morningstar. As of 11/30/21. Daily results for the index are not available prior to 1994. For those earlier periods, returns were calculated from the closest month-end to the day of the first hike through the closest month-end to the day of the final hike. Returns are in USD.

5. Diversification still matters, so maintain a balanced portfolio

Today, with valuations for most types of financial assets far from cheap and volatility rising, investors may be thinking of moving to cash. But they should remember that well-diversified portfolios like the one in the chart below would have held up well amid shifting market conditions.

The chart illustrates a hypothetical scenario representing three types of investors. Each year, a momentum-driven investor buys the top returning asset class from the previous year. A value-seeking investor buys the lowest returning asset class. A third investor sticks to a 60/40 balance between diversified stock and bond portfolios and rebalances at year-end. In nearly every multi-year holding period over the last 20 years, the balanced portfolio would have outpaced the other two, often by a wide margin.

Balanced portfolios would have outpaced other strategies over the last 20 years

The chart shows the cumulative total returns in USD of three hypothetical portfolios from January 1, 2009, through October 31, 2021. Total cumulative returns for the three strategies were as follows: Balanced, 230%; Ride the wave, 77%; Buy the dip, 61%.

Sources: Capital Group, Bloomberg Index Services Ltd., FTSE Russell, ICE Benchmark Administration Ltd., MSCI, Refinitiv Datastream, Standard & Poor's. As of October 31, 2021. "Buy the dip" strategy represents buying the prior year's worst performing asset class every year. "Ride the wave" strategy represents buying the prior year's best performing asset class every year. "Balanced portfolio" strategy represents maintaining a 60/40 split between U.S. large cap stocks and U.S. aggregate bonds. Asset classes included in the analysis: cash (Bloomberg 1–3 Month U.S. Treasury Bill Index), developed international stocks (MSCI EAFE Index), emerging markets stocks (MSCI Emerging Markets Index), foreign bonds (Bloomberg Global Aggregate Index), global commodities (S&P GSCI), gold (LBMA Gold), U.S. equity REITs (FTSE USA REIT), U.S. high-yield bonds (Bloomberg U.S. Corporate High Yield Index), U.S. aggregate bonds (Bloomberg U.S. Aggregate Index), U.S. large cap stocks (S&P 500 Index), U.S. small cap stocks (Russell 2000), U.S. taxable municipal bonds (Bloomberg Taxable Municipal Bond Index). Based in USD.

6. The bottom line for investors

“Looking at the year ahead, the risks are clear: Inflation is rising, central banks will likely raise rates and growth is slowing,” says Lovelace. “But I am optimistic about an environment that is ideally suited to selective investing grounded in bottom-up, fundamental research.”

Rob Lovelace is vice chair and president of The Capital Group Companies, Inc., chief executive officer of Capital Research and Management Company, and an equity portfolio manager. Rob has 35 years of investment experience (as of 12/31/2020), all with Capital Group. Earlier in his career, Rob covered global mining & metals companies as an equity investment analyst. He holds a bachelor’s degree in mineral economics (geology) from Princeton University. He also holds the Chartered Financial Analyst® designation.

Diana Wagner is an equity portfolio manager with 23 years of investment experience. She holds an MBA from Columbia Business School and a bachelor’s degree in art history from Yale University.

Michael C. Gitlin is a partner at Capital Fixed Income Investors, part of Capital Group, with primary responsibility for leading the fixed income business. He is chair of the Fixed Income Management Committee and also serves on the Capital Group Management Committee. He has 27 years of investment industry experience and has been with Capital Group for six years. He holds a bachelor’s degree from Colgate University. Mike is based in Los Angeles.

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