Capital Ideas^™

U.S. Midyear Outlook: From recession to recovery

In the opening weeks of 2020, investors had very few hints of the daunting events to come in this most unusual year. The U.S. economy was humming along nicely. Unemployment levels declined to 50-year lows. And the stock market hit record new highs almost like clockwork.

That was then. This is now.

Over three challenging months, coronavirus-induced lockdowns have wreaked havoc on the U.S. and global economies. Millions have filed for unemployment benefits. COVID-19 infections appear to have peaked in many places, but the risk of secondary outbreaks remain. Meanwhile, widespread civil unrest in many American cities has added a volatile new element to an already high level of uncertainty.

Despite all of this, many stocks are down on a year-to-date basis but not necessarily out, as many investors optimistically look ahead to an eventual recovery. Their hopes are underpinned by massive government stimulus measures and ultra-low interest rates. Some companies perceived to be benefiting from stay-at-home mandates — including e-commerce, video streaming and food delivery firms — have rallied in the face of the worst market and economic environment since the 2008–09 global financial crisis.

As Capital Group vice chairman and portfolio manager Rob Lovelace has noted in recent investors calls, there is a unique aspect of this downturn: It was self-imposed by governments in response to a global health crisis. As such, it is not difficult for investors to imagine an end to this chapter and look forward to a post-COVID recovery period, which may have already started.

“This is different than the 2008 financial crisis — we can see the other side of the valley,” says Lovelace, a portfolio manager of Capital Group Canadian Focused Equity Fund™ (Canada), “It’s hard to know how wide the valley is, but I believe we will end up in a better place two years from now.”
 

Positioning for a market recovery

Bear markets are painful, no doubt about it. And when you’re in the middle of a sharp decline like the one we saw in March, it feels like it’s never going to end. But it’s important to remember that during the post-World War II era, bull markets have been far more robust than bear markets, and they’ve lasted considerably longer as well.

While every market decline is unique, over the past 70 years the average bear market has lasted 14 months and resulted in an average loss of 33%. By contrast, the average bull market has run for 72 months — or more than five times longer — and the average gain has been 279%.

Moreover, returns have often been strongest right after the market bottoms, as investors learned in the last severe downturn. After the carnage of 2008, U.S. stocks finished 2009 with a 23% gain. Missing a bounce back can cost you, which is why it’s important to consider staying invested through even the most difficult periods.
 

Dividends and the downturn

Another important difference in this downturn is that prospects for some dividend-paying stocks have changed dramatically. During previous bear markets, dividend stocks in aggregate have generally helped to provide a cushion against rapidly falling equity prices. Not so this year as many previously reliable dividend-paying companies have suspended or cut those payments in a bid to preserve capital.

However, rather than avoiding income stocks altogether, investors should instead consider the fundamental strengths and weaknesses of each company with an eye toward dividend sustainability going forward, notes Joyce Gordon, a portfolio manager of Capital Group Capital Income Builder™ (Canada).

Indeed, select companies across various sectors — including Apple, Costco, Procter & Gamble and UnitedHealth — have actually increased their dividends this year. “The key is to be really selective in this environment,” Gordon says. “Not all dividend-payers are created equal. Companies with high debt levels and a deteriorating credit outlook are particularly unattractive, in my view.”
 

International outlook: Seek opportunities beyond borders

If you’re convinced that all the best stocks are in the U.S., then it’s time to take a closer look at the issue.

While it’s true that U.S. market indices have generated greater returns than international indices over the past decade, indices don’t tell the whole story. In fact, on a company-by-company basis, the picture changes drastically: The stocks with the best annual returns have been overwhelmingly located in non-U.S. markets.

That trend was even more pronounced in the first quarter of 2020. The list of investable companies with the best returns was dominated by Chinese firms. Not surprising, given that China was the first country to get hit by the COVID-19 outbreak, and among the first to emerge from lockdown. While one quarter is a very short time frame, the trend has broadly played out over other years as well, through generally smaller non-U.S. companies in fast-growing emerging markets.

Why? It’s all about opportunity set. There are roughly three times as many foreign stocks as domestic. So why fish in a smaller pond when there are great companies all over the world? When markets are uncertain, it’s important to have flexibility. Consider selecting global funds that give managers the ability to choose from among the best companies, no matter where they are located.
 

Fixed income outlook: Focus on core strength

Stock market turmoil has hammered home one crucial lesson: the importance of investment-grade bonds in a diversified portfolio. If you owned a core bond fund that provided capital preservation and diversification from equities when the stock market plummeted in the first quarter, then you probably feel pretty good about your decision.

From peak to trough, equities fell more than 30%, while core bond returns — as measured by the Bloomberg Barclays U.S. Aggregate Index — were close to flat. By contrast, many widely bond mandates, which rely more heavily on higher risk bonds, failed to perform these critical roles, and investment returns suffered.

“We talk all the time about the four roles of fixed income in a balanced portfolio. They are diversification from equities, income, inflation protection and capital preservation,” explains Mike Gitlin, Capital Group’s head of fixed income. “There is no fifth role for replicating equity risk across your entire bond portfolio. We believe investors should take measured risks in their equity portfolios and consider dedicating a portion of their bond portfolios to those four very important roles.”

If you didn’t follow that approach, you might think it’s too late to upgrade your bond portfolio. It isn’t, Gitlin notes. Even though U.S. government bond yields have fallen sharply, the market expects them to remain low. Easy monetary policy, low growth and near-term muted inflation prospects imply that significantly higher rates aren’t a major risk today.

The potential shock absorption that a quality-oriented core bond fund can help provide still matters. Stock market volatility may not be over. While many investors expect the global economy to recover eventually, the timing isn’t certain and, therefore, a solid dose of downside protection remains a vital part of any fixed income allocation.