LAST YEAR WE STARTED OUR COMMENTARY ON THE OUTLOOK FOR 2020 WITH THIS STATEMENT: “In this business of investing other’s hard-earned money, it is amazing how some things change nearly overnight and other things never seem to change. It is also amazing how wrong the forecasters usually are each year.” As all of you know, 2020 did not turn out as any of us expected. In early 2020, things were looking pretty good and hopes were high that the very long economic recovery and bull market might continue for another year. However, a little microscopic virus changed all that, sending us into one of the deepest recessions on record. As we look ahead into 2021 and beyond, we are again hopeful, but this time for a recovery from a brutal 2020 that once again reminded us of the downside of risk and fundamentally changed the world as we knew it.
As this is written in late 2020, there appears to be a light at the end of the tunnel as several new vaccines or therapies are expected to finally bring this wicked invisible enemy we call COVID-19 more under control. The U.S. economy was the envy of the world in early 2020 and we hope that underlying strength will help us pull out of the COVID crisis. However, we have to first navigate through several more months of how to live and work in a world restricted by the virus. While the stock market rallied in the fall of 2020 on positive health care news, declining unemployment and stimulus efforts, we all should know that the second part of the recovery will probably be the hardest. The virus and its effects may very well linger longer than any of us want and definitely longer than the most optimistic forecasts. The body blow the U.S. suffered will not be healed quickly. Small businesses and even larger ones serving customers in the restaurant, lodging and entertainment industries will struggle to adapt and survive, and many will falter in 2021. There are still large numbers of Americans struggling, and many of those were or are employed by small businesses who just are unable to withstand the pandemic. As we head into 2021, there are many uncertainties, just as there has been at EVERY point in recent history. COVID-19 has brought unprecedented uncertainty to investors, and further volatility cannot be ruled out. There are
multiple reasons for optimism but also a long list of problems, many of which have only been magnified by the pandemic. We do not intend to inundate you with forecasts but will instead point out issues that the investment team will be monitoring.
LOWER FOR LONGER
While inflation may creep slightly higher, we expect inflation to remain very modest for a very long time despite concerns of mounting debt loads and extraordinarily easy monetary policies. Interest rates that were low before the pandemic have fallen to new lows as investors expect the Federal Reserve and other central banks to remain on hold for not just months, but years. Chairman Jerome Powell has said, “We’re not even thinking about thinking about raising rates.” Even though interest rates have historically had a habit of surprising investors, we just do not believe the current environment will allow interest rates to rise significantly for an extended period. While low interest rates will provide support to stocks and the housing industry, extended low rates dampen income for millions of savers and retirees and create a headwind for pension funds and many financial institutions. Low rates mean that the typical 60% equity/40% bond investment portfolio will produce less income, and bonds will not provide as an effective hedge against stock declines as they have historically.
We believe the rising threat of COVID-19 will dampen growth through the first months of 2021, but then expect the U.S. to show very strong economic growth later in 2021 when the risk of the pandemic fades and consumers are likely to be eager to get out and spend again. However, the trauma of 2020 may lead many to continue to save a larger part of their income. There remains a chance of more fiscal stimulus being injected into the economy, especially if the virus surges over the winter months. While the odds of major fiscal stimulus is lessened by a divided government, the need for fiscal stimulus is largely a bipartisan issue as many across the nation are hurting.
Global economic growth, after a temporary rebound, will still remain dreadfully slow in following years in established economies due to demographic and other reasons. The European banking system will remain on life support, and the European Union will continue to wrestle with problems too numerous to mention. China’s growth may continue to slow, and the Japanese economy will struggle in the hope of emerging from three decades of being stuck in neutral. For this reason, we will continue to underweight international equity exposure but favor emerging markets over developed markets.
Employers cut some 22 million jobs in the early months of the pandemic, and like a light switch we were able to bring back 12 million jobs once the economy reopened. Recovering the next 10 million jobs, however, poses a far greater challenge – one that could take years. As many businesses rethink their business models, one common takeaway is they don’t need as many workers. As adjustments are made, the number of permanent job losses may increase. A recent Wall Street Journal survey found that more than half of the surveyed economists and CEOs do not expect the job market to fully recover until 2023 or later.
We remain an interconnected world, and global trade is extremely complicated with many issues to consider. It remains to be seen what changes in trade policies are made under new U.S. leadership, but it is safe to say that trade issues will continue to be an important issue for many years. Hopefully leaders can continue to push for intellectual property protections and fairness in all trade deals. Even though trade disputes may slow economic growth, at least here in the U.S. they are not expected to shave more than a few tenths off GDP growth or push the U.S. economy into a recession.
As we said last year, easy money policies around the world have certainly led to increased risks in the financial system. Low rates have caused investors to reach for yield, leading to stretched valuations in some assets while also encouraging both consumers and corporations to take on higher debt loads. Any economic or market downturn could be magnified as debt holders or ill-advised investors scramble as times turn against them. Central banks will find it incredibly difficult to unwind these programs as global markets have become “addicted” to the easy money policies.
LONG TERM TRENDS
We will also continue to look further out on the horizon than next quarter’s earnings to attempt to identify the long-term trends that can revolutionize economic or industrial sectors and determine long-term winners. In health care, the progress of vaccines and therapies will be monitored as well as what adjustments a divided Washington may try to make to health care policies. We continue to see health care as a sector that will show above average growth as advances are made in biotech and as the population ages. We also believe that many technology companies will bring forth advances in artificial intelligence, cloud utilization, energy evolution, self-driving cars and other technologies that will disrupt some companies and revolutionize others. We also will continue to evaluate emerging markets and innovative leaders that may emerge outside the developed markets. In 2021, the investment team at First Merchants will be watching these issues closely. The events of 2020 remind us again that there are things we can control and those we cannot. We also know that we have to separate the short-term “noise” from the significant news with long- term implications. One thing that will not change is that we will continue to focus on individual companies that have managements that have historically used shareholder capital efficiently, have high quality balance sheets, pay sustainable dividends, possess pricing power, and have strong cash flows and underlying earnings growth that can weather an economic slowdown. The second thing that remains the same is that diversification across asset classes is the best way to manage the risks in one’s portfolio. However, given the very low starting yields on bonds, investors may also need to seek alternative ways of diversifying their portfolios to realize attractive returns and income generation over the next several years.
While we remain cautiously optimistic about the prospects for the U.S. economy and the equity markets, we also want to stress that investors should expect subdued returns and bouts of volatility that might rock those investors without a solid and reasonable long-term financial plan. Numerous studies have shown that the average investor has done far worse than the average mutual fund has done, primarily due to jumping in and out of the market and not having a good long-term plan that puts emotion aside and instead focuses on long-term goals.
Our goal in all this is to do all we can to partner with our clients to provide comprehensive solutions and personal service in the pursuit of what we all want for ourselves and our families—a secure financial future.