If 2021 could be summed up in a single word, it might be “higher.” Markets and economic growth continued their rocket recoveries from the COVID-19 shock that knocked them off their feet in 2020. But with that good news came a troubling side effect: Inflation ticked steadily upward to hit an almost four-decade high. In an effort to tame inflationary pressures, the Federal Reserve appears ready to begin raising interest rates faster than expected.

As a result, bond indexes essentially held their breath. That seeming placidity belied the markets’ complexity, however, and set the table for what could be another dynamic year. We sat down with Capital Group Private Client Services portfolio managers John Queen and Mark Marinella, along with Capital Group fixed income analysts Vikas Malhotra and Theo Pan, to discuss this market.

Last year was a quietly dramatic year in the fixed income world. Where is the market now, and where do you think it’s going?

John Queen: The story of the year really was about how we came out of 2020, using massive fiscal and monetary stimulus to drive the economy amid the ongoing, rolling shutdowns related to COVID-19.

The stimulus helped asset prices. Equity markets and home values not only held up, but went up. Savings grew quite a bit because people couldn’t spend due to the shutdowns. It’s a sharp contrast to the Global Financial Crisis, when there was real, ongoing wealth destruction. So there’s been this weird but rapidly growing economy where jobs were fast to come back but workers weren’t.

Of course, inflation rates went up early in the year and have remained much higher than the Fed’s target. The markets reflected that. The yield curve significantly flattened, which suggests the market is starting to price in the end of the stimulus and potentially higher interest rates.

Mark Marinella: You might ask how the economy can continue to grow at the pace we’ve seen in the last couple of quarters as stimulus wound down, but there are two things to consider.

Historically, the U.S. consumer tends to spend nearly 100 percent of any additional income provided in the form of things like tax rebates and stimulus checks. But for a while in this pandemic, it was something like 60 pennies of every dollar. They saved and paid down debt with the other 40%, and this “dry powder” could function like a stimulant going forward, since consumers will likely go back to spending.

The second thing is that, while there may or may not be any new stimulus on the horizon, a lot of those hundreds of billions of dollars that were earmarked for various projects and programs have yet to be put in place. Money is still being dripped into the economy.

Queen: It’s been a really unusual market. You’ve seen lots of ebbs and flows as people try to figure out where it’s going. And it certainly hasn’t been figured out yet.

Mark, your focus is on municipal bonds. How are things in that corner of the market?

Marinella: Muni bonds have done really well, not only on their own but in comparison to the taxable market. There’s a tremendous amount of demand. According to Lipper data, as of year-end 2021 we had surpassed the highest level of flows into muni bond funds since it’s been tracked, back to 1992.

I expect the market will continue to do quite well. I’m expecting new issuance to stay relatively steady in 2022. But with coupons, maturities, puts, calls and bonds being taken out of the market, the net amount of issuance could actually be down. It was down in 2021, as it has been down for the last five years. As a result, there are essentially fewer bonds at the end of 12 months at the same time that record inflows are coming in.

With inflation at a decades-high level, it’s front of mind for everyone. What does it mean for fixed income?

Queen: Inflation grew rapidly as we went through 2021. The Fed isn’t calling it “transitory” anymore and recently announced it would taper the bond buyback program and could raise rates earlier than anticipated.

Now we’re trying to figure out what “earlier rate hikes” could mean. Normally, it would mean the front end of the yield curve would go up, but since the Fed’s announcement, markets have been pretty volatile. That’s not surprising, given the incredibly unusual combination of things going on. This isn’t in any way a typical business cycle.

The inflation-protected bond market seems to believe the Fed will get inflation back down over time. We expect to have a 3%-plus annual inflation rate over the next three to five years. But it goes back toward that average of 2% that the Fed has sought as you go out to 10 years.

Marinella: In times past, you’d hear about demand-pull inflation, where too much money was chasing goods, and cost-push inflation, which we saw in the ’70s, when cost-of-living adjustments fed into higher costs, creating an inflationary spiral. I think today we have at least a drizzle of both.

Historically, inflation’s a really difficult thing to stop once it gets started. You have to get at it with some meaningful measures because expectations tend to drive everything. If people think prices are going to be higher, they’re going to spend and they’re going to push prices higher still.

Queen: By tapering, the Fed is reducing the liquidity it’s putting into the system. But I think there are a lot of inflationary pressures that will be more persistent than they originally suggested. In a sense, there are a lot more funds that aren’t in the system. There are savings at the consumer level, and companies have levered up low interest rates, and low spreads are offering incredibly attractive financing. In other words, even as the Fed stops adding liquidity, there is more waiting in the wings as the economy continues to open.

And I think labor has an opportunity now — I don’t mean just unions but labor generally. After decades of receiving a declining share of economic growth, anybody who works suddenly has some negotiating power. I think we could see a wage spiral.

Snarled supply chains have been partly blamed for rising prices. What’s causing those delays?

Vikas Malhotra: Ports are processing 15% to 20% more TEUs, which are 20-foot equivalent units — basically, containers — than they were in 2019. There’s more demand for physical goods, and they would probably be processing more if they could handle the volume.

From my research and conversations with management, it seems you can’t point your finger to one problem. They tried running the ports on a 24-hour cycle, but labor and management couldn’t agree on wages for graveyard shifts. They need space for the containers that trucks aren’t picking up in a timely manner. Warehouses are backed up. It’s a myriad of problems that compound one another.

Given all those factors, how are you positioning portfolios?

Queen: We want to be careful not to get out over our skis. We’re taking a little credit risk, a little inflation protection and a limited exposure to rising interest rates. We want to make sure we’re still hedging equity volatility while looking for opportunities to reduce the impacts of rising rates and rising inflation.

I think Treasury Inflation-Protected Securities — TIPS — will continue to provide some hedge against inflation expectations and could do well because they’re not pricing in the full level of inflation that we believe will continue to feed through.

Marinella: Munis are highly correlated to U.S. Treasury rates over time. If there’s inflation, if there’s a Fed that’s transitioning away from easy policy, then it’s going to be hard for muni bonds not to follow. We want to be protective of shareholders, so we are largely less exposed to rising interest rates.

In terms of selection, it’s pretty rare for this group to come out of a room and say, “We want to buy sectors A, B and C.” We really don’t manage portfolios that way. We apply a fundamental framework of security selection based upon underlying credit fundamentals and specific security structure.

For example, if I look at the portfolios I manage, I have a good amount of PAC bonds, a kind of single-family housing mortgage bond. It’s not because we decided that we’ve got to own housing; it has everything to do with the structure of PAC bonds, which the muni market hasn’t seemed to value correctly. When value is presented to us, we end up having a concentration in the related sector. If I look at my portfolios, the concentration is in PAC bonds. It’s not in “single-family housing.”

Theo, Vikas, as analysts you’re constantly searching for new opportunities. Where are you seeing bright spots?

Theo Pan: Railroads. They have just been a fantastic investment in the sense that they have been reliably defensive. They’ve been so over every meaningful period of spread widening in the past 20 years. I think that defensive nature is oftentimes underpriced by the market, especially when spreads are tight. They have tremendous pricing power. They tend to be a beneficiary in an inflationary environment, as we’re seeing now. So it’s generally a great place to be.

Malhotra: One area is public transit. Liquidity is something that I think a lot more about for those agencies because they’re not generating the same revenue and they’re relying a lot more on their balance sheets. But that is factored into the price. We’re looking at areas where maybe the fundamentals are weaker, but we think that we’re getting more than compensated for that risk.

And some have received a tremendous amount of federal aid. The New York Metropolitan Transportation Authority is getting $10.5 billion from the infrastructure plan. That gives it a much longer runway than it would’ve otherwise had.

What I’ve learned is not to be too entrenched in one mindset and to be fairly adaptive, but also to lean on that fundamental framework that we spend a lot of time building out.

In what other ways has the pandemic changed your role as an analyst?

Pan: Another difference is the inability to do the site visits with my equity counterparts that we would do day in, day out prior to the pandemic.

I remember going to hump yards for different railroads across the U.S. and seeing how they implemented precision scheduling, physically seeing the railcars being moved around and the locomotives in storage. Some insights you can only get from meeting the team on the ground.

On the other hand, we still have phenomenal access to management. I’ve participated in many more management meetings as a result of the virtual environment. If I want to meet with the supply chain in China, I don’t need to hop on a plane these days.

This has been an enlightening and far-ranging discussion. Given the breadth of last year’s challenges, is there anything you want to add?

Queen: A client said to me recently, “A friend of mine who’s a big investor just went to 40% cash. What do you think about that?” I said, “I think cash is a really expensive option.”

If he’s right and the markets tank in the next month or so, it’s a brilliant move. But if that doesn’t happen, he’ll have missed out on market appreciation by being in cash for a potentially extended period of time. He’ll likely lose money. Alternatives where you try to protect yourself can be expensive options.

That’s why you stay with a plan. Really, that’s why you own bonds — so you can own equities. Hedging against equity volatility can help you stay invested in the equity market, which is where you’re going to gain your appreciation over the long period.