SHORT-TERM TRENDS DON'T MATTER TOO MUCH UNLESS THEY TURN INTO LONG-TERM TRENDS. In the financial markets, there is a lot of “noise” or short-term events that really don’t deserve the attention they often receive. Whether
investors watch CNBC, Fox Business News, Bloomberg or read The Wall Street Journal, the latest blog, their favorite newsletter or the latest quarterly earnings release, long-term success depends partially on the ability to filter the short-term “noise”
from the important long-term trends that really determine what happens in the business world. This filtering is not an easy task.
At First Merchants Private Wealth Advisors, we constantly ask ourselves what events or circumstances will really matter in three or five or 10 years compared to what we’ll forget about in six months. This may mean ignoring the advice of “talking
heads” on TV and “expert” consultants or passing on some “hot” short-term investment, and instead focusing on those investments that will quietly build wealth or pay steady or increasing income to our clients. Over the
years, we have sometimes chosen a course different from what industry consultants have advocated, and it has served us well by avoiding some pitfalls or short-term trends that soon faded. At FMPWA, when we select equity investments, we are neither
value- nor growth-style investors. Instead, we focus on companies that enjoy strong, enduring profitability built on distinct and sustainable competitive advantages with consistent cash flow and a solid balance sheet to withstand challenging markets.
Further, we seek management teams that have demonstrated strong stewardship of shareholder capital. There are other ways to select stocks, but this approach has served us well and has provided our clients some protection during the downdrafts that
the market goes through regularly.
As in years past, we are not going to make specific market or economic predictions here but will instead briefly discuss some things we are watching that we feel will influence the economic and capital market environment over the next several years.
INFLATION AND INTEREST RATES
Unless you’ve been asleep under a log for the past year, you’ve likely noticed or heard about inflation ramping up as the global economy emerges from “the great shutdown.” While inflation was often described as being transitory
or temporary throughout the year, we don’t believe that description tells the full story. We believe the rate of inflation will eventually slow, but the current pressures pushing prices higher will not fade quickly. While some of the current
inflation pressures, indeed, are pandemic-related and temporary, other pressures could be with us for an extended period. We believe wages will remain at permanently higher levels and many other prices pushed higher by shortages will not return to
pre-pandemic levels. However, the longer-term forces that kept inflation low for over a decade (primarily demographics, technology and globalization) remain. The Fed is shifting gears with its decision to start reducing monthly bond purchases, but
it will remain cautious about future rate increases given the uncertainty surrounding the economy’s trajectory. Fed policymakers have also been commenting more on the recent inflation surge and how it may be “stickier” or longer
lasting than previously thought, which has pushed up the timeline for possible rate increases. As we mentioned in our review of 2021, the market has priced in a high probability of at least two rate hikes in 2022. Until recently, the market had been
anticipating no interest rate hikes until 2023. While we believe that short-term interest rates will increase modestly, we do not currently see longer-term rates increasing significantly in the next couple of years.
THE COURSE OF COVID-19
As we headed into the 2021 holiday season, the emergence of the omicron strain of the virus once again reminded us the pandemic is still with us and the global economic recovery hinges on the course of the pandemic. This virus will continue to affect
virtually every area that investors have traditionally focused on. While we believe that governments will be reluctant to impose lockdowns or other restrictions like those in 2020, we shouldn’t rule out the possibility of the virus once again
playing havoc with our lives. While we hope that vaccines and therapies will evolve to remain effective against variants, we certainly must be prepared for the possibility they won’t.
SUPPLY CHAIN TROUBLES AND SHORTAGES
Many companies made great strides over the last three decades in cutting costs through “just-in-time” inventory management and sourcing parts and manufacturing globally. However, restarting these global supply chains during a stubbornly persistent
pandemic has proven very difficult. The past two years have illustrated that supply chains are far more brittle than we may have suspected. Manufacturing has been disrupted in countries still reeling from COVID-19 and distribution has been snared
by a combination of factors including fewer truck drivers and dock workers. These problems will not correct quickly, may have lasting impact on the prices we pay, and will be influenced by the progression of the virus. Supply issues are increasing
the risks that inflation will only drop slowly, making the next several months uncomfortable for major central bank policymakers.
While confidence rebounded sharply earlier in 2021 with massive stimulus efforts and arrival of vaccines, broadening inflation fears and continuing virus concerns began to sap confidence later in 2021. This has raised doubts whether consumer consumption
will remain robust in coming quarters. Findings of a recent confidence survey asking about buying plans for durable goods indicated consumer conditions at the worst level in 50 years, reflecting widespread shortages and hefty price increases. Consumer
confidence is fickle but still a major determinant of economic growth. We must always be prepared for the arrival of a virus strain that is not effectively blunted by current vaccines or treatments, particularly one that could quickly reduce consumer
expenditures, especially in the service-related industries. On the plus side, consumer balance sheets and employment prospects generally remain quite healthy.
THE LABOR FORCE
A trained workforce is vital to a healthy growing economy. However, in many areas a shortage of new qualified workers entering the workforce and an increasing stream of retiring workers will continue to hamper the ability of many countries to grow over
the next decade. The general trend of aging populations in developed countries will remain a major headwind to growth and influence inflation for many years. Over longer periods, it is difficult for countries to post healthy economic growth rates
without a growing and educated workforce.
CORPORATE EARNINGS AND STOCK PRICES
We believe current corporate earnings and shifting expectations around future earnings growth are significant drivers of equity returns. If corporate earnings are expected to remain healthy in the next 12 months, and/or the results end up being better
than expected, then stocks can maintain recent gains. However, investors know that the rate of earnings growth must slow from the blistering pace of 2021. Earnings growth, the strength of the dollar and the level of interest rates will be key factors
to watch as corporations navigate through 2022 and 2023. Stock valuations are rich and will be especially susceptible to even minor disappointments in earning reports or unexpectedly rapid increases in interest rates.
Recent indicators confirm the global recovery has continued, but it has entered a slower and more difficult phase. U.S. GDP growth slowed sharply to just 2.1% in Q3 and debt troubles in China may force a contraction there. Recent growth in the euro zone
is welcome, but the latest rise in virus case numbers may hurt discretionary spending. The biggest brake on output is still coming from supply shortages, which could intensify rather than improve. Global industrial production already struggled to
grow in 2021 so, with headwinds from shortages unlikely to fade soon, consensus forecasts for GDP growth in 2022 may prove too optimistic. The pandemic highlighted our immense dependence on Asian output, and the very interconnected global economy
remains dependent not only on the virus but also on the continued tug-of-war between expanded globalization and nationalism or de-globalization. In addition to economic issues previously mentioned, there are longer-term societal and structural trends
that we continue to watch closely.
THE STRUCTURE OF MARKETS
The long-term trend of increased indexing has led to market concentration, less dispersion of returns, increased market correlation and possibly increased risk. In addition, due to the structure of markets, liquidity of many securities (although increased
in some ways through stimulus efforts) may not be sufficient in future times of market turmoil. Very low interest rates have pushed many investors into higher levels of risk exposure than what they will be comfortable with during the next major market
downturn. New asset classes such as cryptocurrencies or non-fungible tokens (NFTs) have attracted trillions of dollars and need to be very carefully evaluated before investing in them.
THE LEVEL OF DEBT
Whether it’s renewed concerns about China Evergrande and Chinese real estate markets, the fragile condition of the European banking system or the high debt loads of many governments and corporations, all investors should remember higher debt levels
can exacerbate troubles in the global debt and currency markets. If inflation eventually leads to higher interest rates, the ability of some government or corporate issuers to service their debt needs to be closely monitored. If interest rates move
up, that in and of itself will take some of the exuberance out of certain markets. There is a lot of truth to the statement that inflation doesn’t necessarily tank economies or markets, but high interest rates do. Due to this increase of debt,
the Fed can only increase rates so much without creating systemic risk.
THE CHANGING FACE OF ENERGY AND TRANSPORTATION
Energy markets will continue to evolve as the shift from fossil fuels to other sources takes place and as the methods of transportation more effectively use various power sources. The electric vehicle (EV) will undergo substantial changes over the next
decade but may be limited by deficiencies in our electric grid, the capabilities of energy storage or the shortage of rare earth minerals. While we see opportunities in green tech, clean air or carbon reduction solutions and other environmental, social
and governance (ESG) investment, finding the ones that will be the profitable survivors will prove challenging.
THE DRIVE TO DIGITIZE
Technology continues to change how we work and how businesses utilize sometimes scarce human resources. Technologies such as artificial intelligence, big data and cybersecurity will all disrupt numerous businesses while providing huge potential for others.
As with the energy arena, there will be winners and losers in this booming industry, and care must be taken to not overpay for even great businesses that have proven their abilities. We will also continue to look not only for tech companies that provide
these products and services but also for those companies that use this technology to maintain or improve their position in other industries.
In sum, 2022 will be a year of discovery—and volatility—as we figure out how to live in this new world and how to adapt to the existing and potential changes going on in so many areas of our lives. We will have to see what happens with inflation
and COVID-19. The past decade of low inflation and exceptional financial market returns has shaped the expectations of many investors, especially those who have recently begun investing. We would advise investors to temper their forward-looking return
expectations relative to the abnormal experience of the past decade.
While we remain cautiously optimistic, the last two years have reminded us how quickly things can change and how asset prices are influenced by myriad factors, many out of human control. The last two years have also shown the value of having carefully
considered, rock-solid long-term goals and objectives that provide stability and guidance during the storms. Our goal remains the same: to keep our eyes open and 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.