World financial markets managed modest growth in the fourth quarter and posted strong gains for the year despite lingering macroeconomic issues. The pace of global growth remained a concern, but signs of continued recovery in the U.S., improving demand in China and gradual steps toward closer fiscal union in the Eurozone increased investor confidence.

Actions by major central banks to support economic growth mitigated fears of a Eurozone collapse and a U.S. recession. Despite these positive developments, trepidation took hold of U.S. markets near the end of the year, as the re-election of President Barack Obama provided little clarity on how Congress would address the mountain of expiring tax breaks and new spending cuts set to take effect in 2013. A lack of confidence that politicians would be able to resolve the issue in a timely manner kept markets in check, with the MSCI World Index only adding 2.5% during the quarter. Returns for non-U.S. and emerging market stocks were better, while U.S. stock markets declined slightly. Nevertheless, it was a good year overall for global stocks: each index posted gains in the range of 16 to 19%.

Although expectations of accommodative monetary policies by global central banks improved investors’ willingness to take on risk, fixed-income securities continued to see demand throughout the year. The ongoing search for stronger yields in the current low-interest-rate environment benefited corporate high-yield bonds, which rose 15.8% in 2012. Investment-grade debt and municipal bonds posted modest gains, and even Treasuries delivered a positive return for the year.

In the fourth quarter, a lack of clarity surrounding key macroeconomic issues upheld demand for the perceived safety of bonds. The low rate environment continued to benefit corporate high-yield bonds, which rose 3.3%. Municipal and investment-grade securities each gained 0.2% while Treasuries declined slightly.

Growth trends persist despite uncertainty

Many equity investors appear to be waiting on the sidelines as leaders in the developed world address structural weaknesses in their economies. However, our portfolio managers have identified several long-term growth trends that could lead to a period of strong economic expansion once near-term issues are resolved.

Most notable is the rapid expansion of the middle class in the developing markets. The number of middle-class consumers is increasing most rapidly in China and India, but Latin America and Africa are also contributing to this trend. The rise in households with disposable income sufficient to purchase discretionary goods and services will be a strong driver of future economic growth and is expected to heighten demand for a variety ofconsumer goods as well as health care and financial services. In addition to creating opportunities for businesses headquartered in the emerging markets, this development has changed the way multinational companies are positioning themselves for future growth. Competitive companies with well-established franchises and the flexibility to look beyond stagnant home markets in the developed world are shifting their focus to target dynamic markets in Asia, Latin America and Africa. The implications for the global economy are significant. As shown in Figure 3, in 2010 the emerging markets accounted for 32% of global consumer expenditures. This number is expected to rise to nearly 50% by 2025.

Investment opportunities aren’t limited to the developing world. Advanced drilling technology has made previously inaccessible stores of North American natural gas available to energy producers, resulting in a potentially abundant supply of domestic energy. These vast resources are transforming the U.S. energy industry and fueling expectations that the country will become a major producer and could achieve energy independence within the next 10 years. Cheaper energy and labor prices are prompting many global companies to build or expand operations in the U.S. Eventually, these developments have the possibility of providing an engine of growth for the economy, improving hiring and leading to a renaissance in the U.S. industrial sector. Additionally, lower input costs from cheaper natural gas pricing are helping domestic companies that operate in energy-intensive industries such as chemicals and materials. Oil-service and transportation companies are also expected to benefit from this trend.

A resurgence of the U.S. housing market is another area of interest for many of our portfolio managers. The Federal Reserve targeted this sector in its third round of quantitative easing with the purchase of mortgage-backed securities. Although housing only accounts for roughly 2% of U.S. gross domestic product, a turnaround in this area could have a wide-reaching impact on the broad economy, as shown in Figure 4. Construction, materials and equipment companies would benefit from new building activity, which should also create jobs. A pickup in hiring, combined with new homeowners’ purchases of furnishings, services and appliances, would advance consumer spending, fueling demand and supporting higher employment in the retail and services sectors. All of these developments could help consumers feel more optimistic about the economy and make them less likely to delay large or discretionary purchases.

Though Europe continues to struggle with fiscal challenges, many companies based there have expanded their reach to exploit the demand from the emerging markets and other, healthier economies. Because these high-quality, globally competitive companies are not dependent on their domestic markets for growth, our portfolio managers believe that many of them present unique value to long-term investors. Health care companies that happen to be domiciled in Europe, for example, will benefit from increased demand for state-of-the-art treatments and therapies by new consumers in the emerging world as well as customers in established markets in the U.S. and elsewhere. Many of the consumer-oriented companies in Europe are focusing their growth on the developing world and stand to benefit from the upturn in spending as those markets expand. Last, demand for more and better nutrition offers opportunities for companies that improve efficiency in the food chain, from advanced seed production to fertilizer to convenient packaged foods.

Opportunities for long-term investors

Although it may feel counterintuitive to increase risk exposure when there are still macroeconomic uncertainties looming on the horizon, it is during such times that market opportunities arise for long-term investors. Market valuations currently remain below historical averages. Our portfolio managers have been using bottom-up analysis to identify well-managed companies with strong fundamentals that are exposed to some of the growth trends highlighted above.

If the past year is any indication, world leaders should continue to make incremental progress in their efforts to resolve fiscal imbalances as central banks remain supportive of global growth with accommodative policies.

Regardless of the impact that U.S. deficit reduction and Eurozone fiscal unification efforts will have on the broader economy, our portfolio team will continue to employ a bottom-up approach to identify well-managed companies with strong fundamentals. We believe high-quality businesses with the ability to target long-term global trends will be extremely well positioned once developed economies work through current structural weaknesses and global growth sustainably accelerates.

A company’s management team is an important starting point for us when we make investment decisions. We benefit from our long-standing industry reputation, which allows us ample access to company management. Our research capabilities enable us to identify innovative and talented corporate managers who can weather difficult economic climates and seize opportunities for prudent growth and expansion.

Though uncertainty is likely to persist, recent improvements suggest the global economy is moving in the right direction. At this stage, durable growth trends present compelling opportunities for long-term investors. 

The thoughts expressed herein are current as of December 31, 2012, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with an Investment Counselor. © 2013 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.