Midyear Outlook

Moderated by Will McKenna, featuring Noriko Chen and Pramod Atluri

Will McKenna (WM): Hello, and welcome to the Capital Ideas webinar series. I'm your host, Will McKenna. I want to thank everybody for joining us today. It's great to have you with us. I know we were having some technical problems getting this event off the ground. So, I appreciate your patience and sticking with us. Apologies for that.

Our topic today is Capital Group's Midyear Outlook, and it's certainly been a momentous first half of the year. We've seen high inflation, rising interest rates lead to a bear market in equities, and really the most topsy-turvy bond market we've seen literally in decades. Now today we're going to dig into all those challenges, as well as talk about where we're seeing opportunities in the year ahead and, most importantly, what it means for your portfolios. And we've got veteran equity and bond managers Noriko Chen and Pramod Atluri here to help us make sense of it all.

Now, before I introduce them, let me cover a couple of quick housekeeping details. If you look in the Resources section of your webinar player, you're going to find everything you need, including slides, CE credit. Go ahead and open those links now so you have access to them. You'll also find our Midyear Outlook report, which is hot off the presses, and I would encourage you to download it and share it as you see fit. We love getting your questions. I want to thank those of you who sent your questions in advance. I've got them right here next to me. We're going to try to answer as many as we can, and if you do have any tech problems, let us know in the same Q&A window.

Now, let me introduce our speakers. Noriko Chen is an equity portfolio manager on New Perspective and EuroPacific Growth Fund, among other strategies. She also serves on the Capital Group Management Committee. Noriko has 31 years' experience, been with Capital for 23 years. Earlier in her career as an analyst, Noriko covered Asian infrastructure, building materials and construction companies, as well as oil, gas and refining companies. So very interesting mix of old economy industries. I think one of the quotes in our Midyear Outlook is, "You can't build a new economy without old industries." Noriko got her bachelor's degree in economics from Williams College and is based in our San Francisco office.

Pramod Atluri is a fixed income portfolio manager. He's the PIO, principal investment officer, on The Bond Fund of America. He has 18 years' experience, been with Capital for six years. Prior to joining us, Pramod had a similar role at Fidelity, and even earlier in his career, he was a management consultant at McKinsey. He got his MBA from Harvard Business School and a bachelor's from the University of Chicago, and he is based here in Los Angeles.

Noriko and Pramod, many thanks for joining us. Great to have you. Let's go ahead and jump right in now. Pramod, I'd like to start with you because, as a bond manager, you're very focused on inflation rates, central banks, the big issues of the day. So why don't you kick us off with your outlook for inflation and interest rates. How far do you think the Fed is going to have to go to bring inflation back down?

Pramod Atluri (PA): Sure. Thanks, Will, and thanks all of you for joining us today. That is really the million dollar or more like trillion dollar question. The Fed is in a really tough predicament. Inflation is high, too high. The last three inflation prints were around eight-and-a-half percent, and we expect the next one to remain probably in that same range. That is way too high, and the longer it stays there, the more it gets entrenched in the economy and the harder it'll be to stamp it out.

The tricky thing about inflation today is that it's not the inflation that we're used to. When supply and demand are roughly in balance, inflation is much easier to deal with. When the economy runs too hot, demand grows faster than supply and inflation heats up. Then the Fed just taps on the brakes a little bit to bring everything back in line, and inflation pressures ease, or at least that's the theory. But today we're dealing with something a little different. Today we're dealing with a massive disruption in the supply of goods and labor. There are many reasons for this. Supply chain disruptions are a huge factor, which continue even to this day, as China is only now reemerging from another COVID lockdown. But the disruptions from the Russia-Ukraine conflict are also playing a large role. Today, supply is meaningfully below demand. So, small changes in demand may not lead to large falls in inflation because it's just so far away from balanced. This makes predictions very tricky today.

In our view, the Fed likely needs to raise rates well into restrictive territory. So if neutral is something like two-and-a-half percent in the Fed funds rate, we're currently pricing in that the Fed will get to three-and-a-half to four percent in the next year. Now that certainly feels restrictive, and we are certainly seeing a significant impact from these tighter financial conditions in the economy today. The question is whether this is enough and, unfortunately, we won't know for certain until we see how inflation trends over the next few months. But my own view is that as the market prepares for a recession this year and next, we may have already seen the highs in yields. Yields have fallen almost 50 basis points in just the past two weeks as investors start to price in a recession. So, could we back up a bit again? Yes, but I think it's very possible we already saw the highs in yields for this cycle.

WM: OK. Great. And restrictive territory, very interesting your perspective, and I know the possibility of recession is very much on the minds of our audience. We're going to get to that a little later and whether you think this is going to tip us into recession anytime soon. Noriko, let's bring you into the conversation. Obviously, it's been a momentous six months in the markets, and, you know, we're now in bear market territory. Similar question, what's your outlook on global equity markets from here?

Noriko Chen (NC): Thank you, Will and thank you, everyone, for joining us today. So, yes, tough question. I've been through Japan's bubble bursting, the Asian financial crisis, the tech bubble bursting, the GFC [Insert onscreen definition: GFC: global financial crisis], and I have to say, you know, it just doesn't get any easier when going through one of these extremely tough periods. What we do start to understand better though is that there are similarities in the cycles. So, for example, the main drivers of this bubble bursting included tighter monetary conditions that then impacted liquidity, you know, very high starting valuations, and we had and continue to have several imbalances that Pramod just mentioned. And we just heard from Pramod on tighter monetary conditions, and my mantra is, you know, don't fight the Fed. I think the Fed has been very clear that they are going to tighten directionally from here to tame inflation and, of course, the market is very concerned about over-tightening and putting us into a recession.

Our analysts will say that tighter fiscal and monetary policy will not show up in the numbers for a while due to a lag, which means that it may take another six to nine months for the market to bottom, and on the imbalances, you know, we've had an imbalance in demand and supply of things we needed during COVID. We essentially pulled forward sales for several industries due to work-from-home and going virtual. You know, think of everything that you did in your homes, from getting more tech-enabled to work-from-home, not just for yourself but for every person in your household. You know, we worked out on new Pelotons, ate a lot more cereal than you ever did before, binge-watched a lot of Netflix. But the corporates did the same thing. They focused on getting more digital in terms of their operations, which is great for them strategically, but also means that for many manufacturers they bought a lot more inventory for the short term in case things shut down again, and for some industries and services, we ended up losing almost two years of potential revenue that's just not going to come back.

And while originally not COVID-related, we also do have an imbalance in energy, where major suppliers were not investing to increase supply due to top-down issues like the need to be less hydrocarbon dependent. This situation is being exacerbated due to the invasion of Ukraine, and as a former oil and gas analyst I see a very tight market for the next several years and have repositioned my portfolios to reflect that.

You know, as one of our PMs who covered banks during the past two decades pointed out, this period is actually quite similar to Y2K right before the dot-com bust. So as a reminder, the fear on disruptions caused by Y2K from a technology perspective led us to worry incessantly about it for a while. You know the Fed injected liquidity while they were raising rates, and everyone was triple ordering in case things shut down on January 1st, 2000. And then Y2K came and went, and nothing happened (laughs). You know when I talk to my kids about it, they say, "What were you thinking?" But the Fed started withdrawing liquidity, rates continued to rise and purchasing managers took a long time to run down their inventory. Many indicators turned negative quickly, and the dot-com companies, many of which were generating no cashflow, had to burn less cash, reduce capex [Insert onscreen definition: Capex: capital expenditure], stop buying electronic equipment and let people go. And some went bust. So, you know, again (laughs) we see a lot of similarities to today.

So, what's my outlook going forward? I think, you know, regardless of if we have a recession or not, I'm now working under the assumption that global growth is slowing and some costs will be structurally higher for a while, including energy. But on the positive side, corporate balance sheets are much better this time around and are in generally good shape, and we're seeing market valuations adjust to the reality of a softer macro environment with lower growth. So, trailing P/Es have already contracted from a recent peak of 35 times for the S&P to around 20 times now. And 17 times is the long-term average.

WM: Okay. Great. And thank you for setting that context. Interesting analogy to Y2K, and I can certainly relate during the pandemic period to watching more Netflix, riding a Peloton, eating more cereal. So, that hits home. Great start. What I'd like to do now is put our first poll question in front of our audience, which is essentially this, and this become a bit of a tradition for us. If you look at the lighthouse on the cover of our Outlook, we want to ask you where in the world is this? And if you want to guess where it's from, let us know in the comments. We'll reveal the answer at the end of the event.

Let's stick with you, Noriko. I want to dig into some more detail in terms of investment opportunities and risks, as you both see them, but Noriko, you know, we've seen this big rotation away from the high-flying growth in tech stocks. Do you think that's going to be a lasting shift in market leadership or are those kinds of growth-oriented companies going to bounce back relatively quickly in your view?

NC: Yeah. Thanks, Will. You know, I think there's going to be a shift for the next few years in market leadership. So, as you can see from prior bear market cycles, you have the bear market period of over, you know, 18 months or so, and then there's still another several years before the market returns to prior levels. So it can take many years for the market to digest to kind of new economic realities. And as I mentioned before, we started off this bubble bursting with very high stock valuations, primarily due to the infotech, EV and some biotech companies that had gotten very expensive due to lower or to minimal earnings. The valuation framework switched to an EV to sales. So, EV is economic value.

So it's market cap plus liabilities, plus cash, EV to sales from price earnings. And at the end of last year stocks with an elevated EV to sales ratio were a much larger percentage of the market. So, for example, you know, companies with an EV to sales of over 10 times accounted for an astounding 30 percent at the market peak, and an additional eight percent were valued at over 20 times EV to sales. So while valuations have come down for many of these companies, it still hasn't come down enough to reflect the company's actual fundamentals.

For energy, as I mentioned before, we had supply issues prior to the invasion due to the lack of capex going into upstream development, and as most cash flow is being allocated to dividends (partially because we were asking for them), and paying down debt and now into renewables. You know, when we talked to the energy companies, and we saw several recently at our yield meetings in New York, it doesn't seem like their strategy is going to change significantly, which means that energy may be structurally undersupplied until we get through this rocky energy transition which, again, could take another decade, if not longer, and this shift in energy transition is inflationary.

You know, so, overall, I think this is increasingly going to be a stock picker's market, as earnings growth slows, since the challenge will be to find companies that can continue to grow earnings above single-digit percentages, but that's also why the infotech companies are not off the table or even far down the chart. I think, structurally, you know, there are many companies in the technology space that have resilient business models and will generate a ton of free cash flow. Not that many companies will be able to do that over a longer period of time, and I believe that many of the tech management teams are already focused on making their companies more profitable. For the ones who aren't, they're starting to be a bit more disciplined around capital allocation, and we're also starting to see some cost reductions, including layoffs, as well.

WM: Okay. So, interesting transition in the tech space. Very helpful. Pramod, let's talk about opportunities you're seeing in the bond market. There's really no way to sugarcoat it. The sell-off this year has been pretty dramatic, among the worst we've seen, I guess, in decades. So I think our audience's big question here is, what should I do now? Is this the time to buy or sell bonds in my portfolios?

PA: Yeah, that is really the big question. I think what investors need to understand is that while the fall has been very quick, the climb back from here is likely to be slow and steady. So, fixed income, particularly investment-grade fixed income [Insert onscreen definition: Investment grade: bonds rated BBB and above] is extremely high quality, and the beautiful thing about bonds is that, at the end of the day, when bonds mature, you get your money back. The losses that we've seen year-to-date have been historic. I think we're maybe around negative 12 percent for the Bloomberg Aggregate Index, plus or minus, at the lows, but I think we'll probably recover all of these losses in the next two to three years. And there's additional upside if we're right that the economy will slow and inflation falls over the next year or two.

In The Bond Fund of America, we've gone from selling to buying now. We want to capture these yields, these much more attractive yields, and at the same time we think that bonds may resume their role as a portfolio diversifier and as a hedge against equity volatility now that the market is better priced-in a more hawkish Fed and the economy continues to slow.

So it's my view that investors looking at their portfolio should view the negative returns in bonds as a really great opportunity today because bonds mature, and those returns will all come back and more. It's just a matter of time. There will still be volatility over the next couple months as inflation remains elevated and we look for peak inflation, but sometime over the next few months I really think investors should be looking to add to bonds and, in particular, high-quality bonds.

WM: Okay. That's great overview. Thank you for that. And Noriko, what are some of the major investment themes that you're focused on these days, given the environment that we're in?

NC: So maybe I'll start off with health care first. As a former premed student in college, you know, I definitely gravitate to health care, but I do think it continues to be very interesting. We know that many of the large caps were trading at steep discounts to the S&P in prior years due to growth concerns between fiscal year '25 through '30 from patent cliffs, with about 140 billion in revenues for the industry expected to go away during this period. But given that 50 percent of biopharma large cap revenues historically have come from M&A, our analysts have been very active in assessing whether future M&A can help solve the issue. And the time I think is ripe for M&A. You know, large cap pharma balance sheets are in pretty good shape and can be leveraged. The biotech market has also been extremely difficult, with many newly listed companies realizing that they don't have the cash to get through the next 12 to 18 months.

So now there's an acknowledgement that they need to partner with the large cap or be acquired. And the list of interesting mid-size targets is somewhat limited. So we're not going to be surprised to see some decent size deals this year. And just in the past few months alone we've seen Regeneron acquire Checkmate, GSK acquired Sierra, Pfizer acquired Arena.

But I think the next chart on semis is also very clear. You know, there's a huge TAM, or a total addressable market, for semiconductors. If you think about how EVs need more semiconductors, you know, our phones, everything. Computers, power computing, everything requires more semiconductors, more chips. But the market is clearly currently worried that we have reached the peak of the current cycle.

So I think some of these concerns are justified due to the imbalance points I discussed earlier about all of that advance ordering and inventory building. And I think it will continue to take some time to work down the double counting and ordering. But while this may take some months to work itself out, I think fundamentally this is a good business. And the semi cap equipment business is actually even better. And then finally the last chart is on smart industrials. But I do think smart industrials are also interesting as they're focused on enabling the ESG environment, social governance and energy transition through mainly developing products that reduce the emission of carbon dioxide.

You know, I also think these companies, or ones that you can't just buy as concept stocks though, you need to make sure that they're operationally strong with strong R&D capacity, diverse supply chains and markets, and decent margins and profitability because higher input costs are likely here to stay. So this is a good potential space to fish from, but you need to really do the work to understand which companies will grow at attractive margins and profitability.

WM: Okay. Great. So research very important in some of these areas, picking the right companies to partner with. Good overview of some of the opportunity areas. Pramod, let's hear from you about some of the opportunities that you're seeing across the different bond market subsectors. Any attractive opportunities today, whether that's in corporates, mortgages, high yield, TIPS, munis. Go down the list.

PA: Sure. I think one age-old truth is that with great volatility comes great opportunity. We've definitely seen a lot of volatility in the markets today. So one area that I would focus on is as the market has begun pricing in a much more hawkish Fed and the economy shows signs of slowing, as I said before, we're starting to lock in some of the yields that we're seeing here. Where earlier in the year we had been underweight duration, so underweight yields as we thought yields were going to rise.

Now we're much closer to neutral and are looking to capture these higher yields, which look attractive if growth continues to slow and inflation falls in the coming months and years. We've also changed the profile of the bonds that we own. So earlier in the year, we were owning 30-year, 10- and 30-year bonds and underweight the front part of the curve with the idea that as the Fed hikes rates it really pushes up one-, two-, three-, four- five-year yields. Well now that so much is priced into the market, those yields now look much more attractive to us.

And so we have started to reverse our curve positioning and are starting to prefer the bonds that are at the front and belly of the curve. And with the upside potentially that if the Fed is able to become a little bit more dovish, if inflation does fall, that there's extra return that we can generate from those bonds. More than just the yield that they deliver.

Mortgages are an interesting asset class because valuations had reached very, very extreme levels because the Fed had been buying so many of them during their quantitative easing program. Now that the Fed has gone from easing to hiking and to tightening, mortgages have really cheapened up quite a bit. And they've gotten to a point now where they're starting to look attractive over a multi-year view.

So that is a sector that we are looking at very closely. The one issue that we still have with mortgages is that when volatility rises and is high, mortgages tend to not do so well. And right now volatility is high, and we think it might continue to be high for a little bit longer. But with a longer term view — six months, a year, two years — our expectation is that volatility is likely to fall, and therefore mortgages present a really interesting opportunity.

In TIPS, treasury inflation-protected securities, that's also a fascinating market. This is an area where one might think that since inflation is so high that TIPS must have been doing fantastic. And it's true, TIPS have done quite well, but different TIPS, short-maturity TIPS versus long-maturity TIPS have done very differently. And the reason is because when you buy a short-maturity TIP, a one-year bond or a two-year bond, what you're really capturing there are the high inflation prints that we're seeing in the market today. And so those are the bonds that we really like in the portfolio because we believe that inflation is likely to stay high for an extended period of time. And we want to make sure that we can use TIPS.

Longer TIPS, 10-year TIPS, 30-year TIPS, while you are capturing those high inflation prints, those long-maturity TIPS are much more dominated by inflation expectations. What is inflation going to average over the next five, 10, 30 years? And when you buy those TIPS, what you're also getting is the likelihood of a potential recession that comes and that might pull down inflation. And so as recession fears grow, we're nervous about owning too many long-maturity TIPS. Because while you might capture the high inflation prints of today, it might be overwhelmed by recessionary fears over the longer term.

The last thing I'd say is on corporate bonds one can now find really solid high-quality corporate bonds, even with just a five-year maturity, with yields of four-and-a half to five percent. Now that looks really attractive in my view. But the problem is that if we are moving into a recession, those could still get a little bit cheaper. So given our conservative outlook and the increasing chance of a recession, we're continuing to stay up in quality and may look to add credit a little bit more down the line when it fully prices in the risk of recession. But make no mistake, I think bonds are a buy somewhere around here, particularly high-quality bonds. There may be some volatility in the next few months, but the risk of a recession is only growing larger. And I believe that'll be reflected in demand for bonds as the year progresses.

WM: That's a great overview. Thank you, Pramod, of all those different areas of the market. Noriko, I want to turn to you. We are getting some questions about supply chains. Obviously, we've seen lots of problems there. They continue to be an issue. I know you recently wrote an article on Capital Ideas that touched on supply chain issues and this whole idea of are we entering a period of deglobalization or, as I think you like to call it, re-globalization? Can you talk about this issue? What are the investment implications of it? What industries, types of companies might actually benefit from this trend?

NC: Sure Will. So I think the fragility of global supply chains exposed during the pandemic surprised most people and continues to be a challenge, although less so than before. Globalization has long been characterized by developed market countries offshoring production to lower cost locations. And then even better to countries that had good potential consumer markets like China. But now, companies are recognizing the need to build redundancies into their supply lines, which will have varied impacts on countries, companies and industries.

So, some have argued that this could lead to a less globalized world or deglobalization. And it is true that we're unlikely to have one true global market. But I think that's already been the case for a few years now with Brexit. And I think this is more of the start of an era of re-globalization in which more countries are brought into global trade where supply chains and trade are reorganized rather than reduced.

And I would expect most companies with a significant percentage of their manufacturing base in greater China to diversify to other countries. But it doesn't mean they will just bring manufacturing home. You know there are some things that we shouldn't be making in, for example, the U.S. because of the economics. Just think of most kind of lower price point products. But there are some things that do make sense, like semiconductors. The reinvestment to other countries, including Mexico, Indonesia, Southeast Asia, Eastern Europe is likely to be positive for those countries.

Some of it will come at a cost to profitability for some companies as new investment locations may not have some of the skilled workers or might be not as low cost or have additional infrastructure, including logistics and a solid supply chain yet. But this should lead to new investing opportunities for those who can identify companies that will benefit from changes in global trade patterns. And that's why, you know, I'm pretty excited about the opportunities that we're seeing for both NPF and EUPAC [Insert onscreen definitions: NPF: New Perspective Fund; EUPAC: EuroPacific Growth Fund].

WM: Very interesting point that you see supply chains being reorganized rather than reduced. And perhaps made more regional, building out some of those redundancies. Yes, the implications for companies, it may create a little bit more cost to have that redundancy in their supply chain, but a lot of opportunities there as well. Speaking of, kind of our words, Pramod, we're seeing some questions come in about recession. You guys touched on this earlier. Everybody seems to be focused on the possibility we're headed for a recession this year or early next. What's your own view and how does that inform your investment decisions?

PA: Yeah, I think everyone is right to focus on the risk of a recession. So here are some data points. Real GDP in the first quarter was negative one-and-a-half percent. In the second quarter, the Atlanta Fed GDP now is forecasting GDP growth of zero percent. And it's been trending down every day as we continue to get economic data that is weakening. So just by the definition of two consecutive negative quarters of GDP, we're flirting with it right now. Now, ultimately, we don't think we're in a recession just yet and that growth will rebound a bit in the second half. But we're talking more like growth of zero to one percent for all of 2022. And our outlook for 2023 is for growth to continue to slow as the impact of tighter financial conditions and the Fed rate hikes continue to impact the economy.

CEO confidence has fallen, consumer confidence is near record lows. Retail spending is weakening, housing activity is weakening, and inventories are piling up. Volatility and inflation are linked together right now. The higher and more persistent inflation is, the more hawkish the Fed will be and the more volatility there will be. And we think inflation is likely to remain high for at least a little bit longer before hopefully trending down. All of this is leading us in The Bond Fund of America to remain very cautiously positioned. We know that investors buy bonds because they want something to hold up when times are tough. So given our outlook, we want to maintain a high-quality portfolio until valuations get more attractive.

WM: Any views from your fellow economists and managers around the world as it relates to some of the other markets that are depicted on this chart beyond the U.S., Pramod?

PA: Yeah. I think our economists have been very, very conservative when it comes to China. We've seen that economy as being weak for quite some time. And while the government has been very recently looking to take some actions to boost the economy, it's been more to stem some of the decline rather than to boost it in stimulus like we've seen in the past. The outlook for Europe is actually quite risky at the moment. They're dealing with inflation and growth risk that are even more concerning than the U.S., given their proximity to the Russia-Ukraine conflict and how much energy makes up in their basket of inflation goods. So Europe is starting to look, we're starting to get a little bit more nervous in Europe than we are in the U.S.

And so really when you go around the world, what we're seeing is that as interest rates were all too low, inflation is a global phenomenon. And now we are going into a period where global monetary policy is all hiking at the same time. I think this amount of coordinated monetary policy tightening is pretty unprecedented, especially in modern times.

WM: Yeah, absolutely. Well, great perspective on that. Thank you. I'd like to shift gears for a minute and help take our audience inside The Capital System. And many of you in the audience know it well, but I think we can provide you with a deeper view and take you perhaps behind the scenes a little bit. Noriko, I might start with you here. Would love to hear some examples from your experience about the Capital System. How it works, what makes it unique in your view? For example, I know you were part of a recent what we call a “smile” retreat. It'd be great to hear about that. What is a smile retreat? Take us inside that trip. Any insights that came from it?

NC: Yes. Thanks, Will. So the Capital System is one where we collaborate with each other, and it's not just something we talk about, but it's built into our investment framework and our process. Structurally, our funds are set up so we have multiple portfolio managers and the research portfolio. And that helps us in times like this when we have different investment styles in our funds. It also means that we're okay getting into a room or at an onsite to discuss tough topics, and results in us really kind of pressure testing various views.

You know, I know I'm not going to be right half of the time, so I want to understand what my other colleagues are thinking. At our smile retreat, so smile stands for SMID-cap investment lens. It's our SMID-cap group. We went through several topics, including lessons learned, acorns to oaks and 10-year trends. But it's good to take yourself away from screens, particularly when they're red, to think a bit more high level and long term.

And during these volatile periods, we also spend time on holdings that have been less impactful for the funds. Small or sole holdings. Now the Capital System is also about prioritizing our investors and our clients. So we also recently discussed selling some companies to generate tax losses to offset any gains we have this year. And everyone helps out. I was at a smaller offsite in New York for a few days two weeks ago. It was just 16 of us. And my favorite session was the bull and bear discussion. So all 16 of us paired up with someone and took opposing sides of a company or a theme — including for example, energy transition, cruise lines, meta (laughs).

It was such a great discussion, and everyone was really engaged, but it really helped people understand the risk to their companies better when they had to advocate for the other side. You know, if only we could get our news and media outlets to do the same thing. But what this really does is build trust. And when we build trust, we can make more courageous investment decisions that can significantly impact our funds over the long term.

WM: That's fantastic. Can you take us maybe one step further into your discussion? You referenced it, how we think about harvesting tax losses and going through that process. Give us a little more detail around that.

NC: Sure. So what the PIOs [Insert onscreen definition: PIO: principal investment officer] will do is provide a list of both long-term and short-term tax losses. And so we look at that list and the idea is we really want and we have an understanding of what the gains are, so we want to offset the gains for the financial year. And we basically work through every single one of those companies to see if we can kind of harvest tax losses.

And you know, we will tell the analyst that if they like the company, they can buy it back in a month, which is also a great way to test people's convictions. But again, this is a way for us to be able to manage some of the gains that you really want to offset in a year like this year.

WM: Okay. That's very helpful. Pramod, let's come to you because in the fixed income team, the Capital System may look a little different. Can you take us into that world and express, you know, how does the Capital System work through the process we're seeing in fixed income and any stories that bring the process to life?

PA: Sure. So the markets have certainly been volatile, and that's made navigating markets a challenge. It's incredibly difficult to focus on any given sector when everything is moving around so quickly. Now, luckily for us, Capital Group and The Bond Fund of America has benefited tremendously from our multi-manager system. This was absolutely critical for us in 2020, and even in markets today, as every sector of the market is swinging wildly from cheap to rich to everything in between. I don't think it would've been possible for a single manager to navigate each of those markets and capture the opportunities presented.

Now, with our approach, we have a team of analysts and portfolio managers in different areas investing in the fund directly. So, take for example 2020. As treasuries swung wildly in 2020, our rates analysts and rates PMs were able to move from long duration to short duration and from owning short-maturity bonds to long-maturity bonds.

At the same time as mortgages swung from super cheap to super rich once the Fed started buying in their quantitative easing program, our multi-manager approach allowed each of us to divide and conquer. And if we're each able to focus and navigate our corner of the market effectively, the whole portfolio becomes far more nimble and effective. Our system is simply designed for these types of volatile markets.

WM: That's fantastic. Great context for us to now pivot and talk about some of the portfolio implications for each of you. Noriko, let's start with you on the equity side of the shop. Obviously, your responsibilities in New Perspective, EuroPacific Growth Fund and — apologies to our audience — not everyone has access to those strategies, but I think your comments will be relevant for them as well. Maybe take us through each of those strategies. Start with New Perspective. How are you thinking about your portfolios and how you're positioning them there?

NC: Yeah, well, I can speak to all of my portfolios kind of with my comments. But, as you probably have guessed from my prior commentary, you know, I have reduced some holdings in some companies where I thought they would not have cash flow for the foreseeable future. But I have added to some kind of infotech and technology companies that may not be profitable but are generating solid operating cash flow. I've added to energy across the board. I've trimmed some of my other commodities, including iron ore. I have added to health care and reduced some of the biotechs that would not be profitable for a while.

You know, the message is, again, not about selling all technology. It's really about being more focused on valuations during this period. And with energy, I think many of the U.S. energy companies are already priced at pretty high valuations, so I think there's more value to the ones outside of the U.S. While China may still be a bit weak this year as they remain largely closed due to COVID policies, I think there are other countries that have been doing better, including India, Indonesia and, until recently, Brazil.

You know, and even India, which would be under pressure from higher energy costs as it imports about 70 percent of its energy. But it doesn't rely as much on China for GDP growth. And our banks analyst this morning gave us a pretty optimistic update on the economic cycle where the banks, both private and public, are much healthier than in the past and have the capacity to lend. And the government is planning a big infrastructure spending program.

You know Indonesia and Brazil, emerging markets that are leveraged to commodities, particularly oil, should be net gainers from structurally high energy prices. And the same goes for Australia as well as Canada.

WM: Is this a time fair to say where you're maybe concentrating your number of holdings and sharpening your portfolio? Give the audience a sense of, you know, how many holdings might you have in those strategies you're responsible for?

NC: Yeah. I typically hold more companies than other portfolio managers. And almost all of my holdings tend to be co-owned with our analysts. So I'm usually, you know, higher than average. And you're right, during this period we focus a lot more on valuations, which companies and we'll segment them. You know, we just had a number of calls over the past several weeks on, you know, which companies are not going to be profitable for the next five years, which ones are not profitable but also not gaining share, which ones have strong operating cash flow. I think you know we've already reduced any companies that have leveraged quite some time ago, so that's not an issue as much. But it's really kind of just making sure that we're comfortable with the valuations of the companies that we hold.

WM: Got it. Pramod how about for you? I know earlier we talked about and you kind of went through in great detail your perspective on the various opportunities across different bond market sectors. But when you think about your responsibilities on Bond Fund, as well as in the multi-asset strategies — AMBAL, IFA [Insert onscreen definitions: AMBAL: American Balanced Fund; IFA: The Income Fund of America] — how are you thinking about those portfolios or a broader kind of 60/40 kind of portfolio in this kind of environment?

PA: Yeah. So as we talked about earlier, there are a lot of different areas where we're starting to see some value. And so, you know, I think of myself as a gradual contrarian. And as interest rates rise and they get to a point where I think a lot is priced in, that's an area where I start to add duration. When corporate bond spreads almost double from where they were just six months ago, that's an area where we go, where I like to go from kind of an underweight position to more neutral or a little bit overweight. So as things get to be priced in, that's the direction I move into. Now the issue as we talked about is that we still have a pretty conservative view of the direction of the economy. And so there's only so far that we want to go so that we protect against equity volatility. Which is kind of the primary reason that one holds a bond fund in their portfolio.

So we are moving in the direction, and I myself am moving in the direction of risk as that gets priced in, but we're keeping a lot of room for it. Now Will, one thing you mentioned was 60/40 portfolios, and maybe I'll just take a minute to talk about that because that's a question I've gotten a lot over the past several months. The year-to-date time period has been one where, as everyone knows, bonds have suffered significant losses as inflation rose much further and faster than anyone expected. And this rapid change in yield forced a repricing in all asset classes and led to an environment where losses in bonds led to losses everywhere else. And so what that shows is that bonds didn't go up when equities fell, and in fact when bonds fell equities fell, so they went in the same direction. Which, you know, doesn't feel great if you're an investor in a 60/40 portfolio.

Now, to be fair to the 60/40 portfolios, investors in those portfolios did better than those that had 100 percent in equities. Because while bonds fell, equities fell a little bit further. And so it did do what it was intended to do, which is to reduce the volatility of the overall portfolio, but it still disappointed a lot of investors. But as we talked about earlier today, the big negative total returns that we've seen in bonds are an opportunity. And if we're right about that we're about to see peak CPI inflation, and as growth is starting to weaken, I think we're getting to a point where now bonds are going to start going back to a traditional role.

Where now, when bad things happen in the economy and growth slows, bonds may actually go up in value as risky assets go down. So that negative correlation, which is kind of what you want to see in a 60/40 portfolio, I think is on the cusp of reasserting itself. So whether it's a 60/40 portfolio or investors who have their own allocation of stocks and bonds, I think bonds — the bond portion — is likely to start working once again in their favor as we navigate the coming slowdown. And bonds should be a portfolio diversifier and a hedge against further equity volatility.

WM: Okay, great point. So in your view bonds may be taking on/coming back to their more traditional role of having that negative correlation to stocks from here. Very helpful to think about. Okay we're coming, we're rounding toward home here. And, you know, one of the popular questions we've been getting on these webinars from our audience is what are the kind of more interesting books that our portfolio managers are reading? And we've had a couple of great suggestions over the last couple of webinars from some of our managers like Mark Casey or Cheryl Frank. And the question to the two of you, is any summer reading — books or podcasts or other media — that you might suggest for our audience today? Why don't I start with you Pramod?

PA: Sure. So I am in the middle of a real thriller. It's a page-turner; it's a thriller. It goes through highs and lows; it brings your emotions up and down. It's called 21st Century Monetary Policy by Ben Bernanke (laughs). And what it does is it walks through kind of what's happened over the last 70 years in monetary policy. And for anyone who has been in the markets, you might get PTSD looking back on some of the crises that we've been through and how the Fed's navigated it. But the interesting thing about this book is he starts talking about the future and how the world has changed and how monetary policy and the Fed might have to change with it. So 21st Century Monetary Policy by Ben Bernanke.

WM: That's an absolute page-turner, I agree. If you must be seen out on the beach with that book this summer, everybody will have it. Make sure you get a copy. Noriko, I understand you're a real podcast fan. Share with us any great tips you have for podcasts and/or books in your travels?

NC: Yeah, sure. I have an hour-and-a-half commute every day, so I do a lot of podcasts. And the ones that I listen to pretty regularly include The Daily [Wire] and Colossus' Invest Like the Best, Patrick O'Shaughnessy. And I think those are great podcasts. The last one for the Invest Like the Best was about factories of the future. But really just interesting topics. And I'm also part of a number of diversity, equity and inclusion committees at Capital. And for a number of these committees and groups we've been trying to kind of educate ourselves better on other ethnicities and other particularly minority groups. And I read some great books with our book clubs, including Caste by Isabel Wilkerson. But the next book that I'm reading right now is called Asian American Dreams by Helen Zia. But she's been an Asian American activist, one of the earliest ones in the United States, for the past 40 years and is an amazing writer.

WM: That's fantastic. And so some DEI options there. And we'll make sure we clarify that. I love seeing that cover for our audience. Invest Like the Best, which is a great podcast, Patrick O'Shaughnessy. Our very own Carl Kawaja was featured on one episode some time ago. It's a really good one.

Okay guys, let's do this. Why don't we turn to our two or three key messages that you'd like our audience to take away from the call today? Pramod, why don't you start us off.

PA: Sure. I guess the two or three things I would like the listeners to leave with is one — inflation is high. It's higher than anyone wants it to be, but it's likely to persist for a little while before it starts to settle down. And so anyone who is sitting on a high cash portion in their portfolio is currently losing eight percent because of inflation. So one, understand that cash is a big drag on your portfolio. Two, as inflation peaks in the coming months and investors look ahead to slowing growth and possible recession, bonds will likely resume their role as a diversifier that will provide ballast and reduce volatility. And then three, with yields close to around four, four to five percent for high-quality bonds with additional upside as the economy slows and inflation falls, the outlook for bonds hasn't looked this good in years.

WM: That's excellent. A simple one, two, three. Noriko over to you. Take us home.

NC: Yeah so, you know, it's a tough period so continue to hang in there. I think as Pramod said, you know, it could take a while longer before the market kind of bottoms. But, and as he said earlier, you know, Buffet said, “Be fearful when others are greedy and greedy when others are fearful." While I think, you know, others are getting fearful now, we're not there yet, but it's almost time to get more focused on investing or being, you know, greedy. And again, I think that this will continue to be a stock picker's market. It is a stressful period between this, COVID, the invasion, and higher gas and food prices closer to home. So try to find something that will help you de-stress. It could be activity, sports, comedy, cooking, anything. So please take care of your health and thank you for all you do for Capital.

WM: Okay great. Good life advice there too. It's a stressful period. Make sure you're taking care of yourself and your mindset. Also, in your view a stock picker's market, probably not a shock coming from Capital Group, but this does feel like one of those periods. Very helpful guys. Well, the moment you've all been waiting for, we're going to reveal the location of the cover image from our Outlook cover. Sam, can I get a drum roll please? All right, well that's the extent of our special effects on this program. This is a lighthouse that appears on the Faroe Islands, which as I understand are kind of halfway between Scotland and Iceland. And it's the, I'm not going to even try to pronounce it. I think it's Mykines, not Mykonos, which is in Greece where many of you like my friend Chuck may be traveling this summer for vacation, but Mykines in the Faroe Islands.

And famous for the bird pictured here. Spoiler alert or pro tips, not a penguin. But it is a puffin, which is a bird that can fly. Looks like a penguin. Thank you for that.

Before we do go, I want to remind everybody about our next event, which is all-weather investing amid the storm. We've got a couple of great speakers there, and that event is scheduled for Thursday, July 28th, at our usual 11:00 a.m. start time. Please add to your calendar, and obviously we'll work hard to make sure we iron out any of the technical issues that were part of this event.

And I do want to thank all of you in the audience for your engagement over this series, your great questions over time. It's really because of you that Capital has been voted number one for thought leadership for the past three years in a row. Finally, let me thank Noriko and Pramod for your great insights. Really fun to have you today. I hope all of you in the audience found this as interesting as I did. Don't forget to take advantage of the additional resources in the event, including the Midyear Outlook report. Thanks again and enjoy the rest of your day.

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