WHETHER LOOKING AT the health of an individual, an organization or a civilization, in the wake of treatment comes a focus on the progress of recovery and side effects. The market story in 2020 was defined by the onset of the pandemic
and the decisive, unprecedented actions and innovations from humankind necessary to treat and adapt: lockdowns, vaccines, remote work technology and financial stimulus, to name a few. In 2021, the story shifted to the ongoing, uneven recovery and
to the side effects of such unprecedented economic “treatments.” While much of the side effects from snarled supply chains and pandemic-specific stimuli may fade with time, other by-products will prove longer lasting – for better
or worse.
Despite the challenges and uncertainty of emerging side effects, innovation and economic value creation have pushed forward globally and here at home. Final readings of economic growth in 2021 will likely confirm that this was the strongest year of economic
growth in the U.S. in decades. Financial markets have reflected this strength and resilience and rewarded investors staying the course with a long-term perspective.
One of the side effects that has received the most attention – given its pervasive impact and the uncertainty of its future path – is inflation. In 2021, the breadth and magnitude of inflation reached levels not seen in decades. As of October,
the Consumer Price Index registered a 6.2% increase year over year, the highest mark since 1990. Certain segments of the market – like energy and new and used cars – saw some of the largest gains, but inflation caused by the lack of key
inputs, like labor and semiconductors, have touched nearly every industry.
The catalyst for rising prices has been two-sided: overwhelming, stimulus-supported demand on one side has outpaced the recovery of a global supply chain still struggling to come back online amid intermittent COVID-19 variant waves and lockdowns. Furthermore,
with many service segments like international travel directly impacted by COVID trends, the swell in demand was funneled to the smaller goods sector that typically accounted for only a quarter of U.S. consumption pre-crisis. Vaccination has advanced
globally, which is encouraging for a normalization in service spending but remains far from complete.
Looking at financial market returns in the context of recovery and inflation, 2021 was a difficult year for fixed income markets. Surging economic growth and inflation pushed interest rates higher from the ultra-low levels of 2020 when the Federal Reserve
slashed short-term rates to zero. Rising rates negatively impact bond prices, though they also improve future income potential. At the same time, the rising prices of goods and services meant eroding purchasing power for those receiving fixed payments
that didn’t adjust with inflation. However, the underperformance of fixed income is not unusual in times of economic recovery as fixed income tends to shine in times of volatility and economic drawdowns. The table below gives a look at how various
asset classes performed in 2021, both before inflation (nominal return) and after inflation (real return).
The flip side for financial markets is that asset classes whose returns are leveraged to the state of economic growth and inflation, namely equities and real assets like commodities and real estate, broadly performed exceptionally well in 2021. Surging
demand drove both volume and price growth in commodities, and corporations have generally been able to pass on rising input costs to consumers to maintain their profit margins. In fact, even though
corporate profit margins just before the pandemic were near all-time highs, nearly two out of three S&P 500 companies reported better profit margins as of the third quarter of 2021 than they did before the pandemic, reflecting the strong demand environment
and their ability to pass on cost increases. Robust corporate profits have in turn helped to push equity markets higher this year and provide protection against the side effects of treatment, including inflation’s ability to erode purchasing
power.
A disciplined, long-term investment perspective doesn’t imply staying stagnant though; the optimal investment strategy needs to adjust as your financial goals and constraints shift, and it needs to be adaptable to structural shifts in the economic
and market landscape. The pandemic era has served as a crucible of innovation and change, and a sound long-term investment strategy should be forward looking to the implications for financial markets. At First Merchants Private Wealth Advisors, we
seek to help clients navigate these times of change, whether that change relates to their personal financial situations or to the effects of broader market shifts. If you are experiencing a change in your personal financial picture or have questions
on how the changing landscape may affect that picture, please don’t hesitate to reach out.
KEY THEMES
CORPORATE EARNINGS GROWTH DROVE ROBUST EQUITY RETURNS
Stock market valuations stood at precarious levels coming in to 2021. After years of declining interest rates and expanding liquidity, more money has been poured into equity markets as one of the few avenues able to provide a return that keeps pace with
inflation. In 2021, equity markets saw record net inflows and yet equity valuations actually declined (the chart at left breaks down the sources of total return for the S&P 500). Instead, corporate earnings growth far and away exceeded expectations
and fueled equity returns.
In fact, at the start of the year, the aggregate earnings for the S&P 500 constituents in 2021 was forecast to grow by a robust 23%. The index is now on pace to more than double that mark with 48% profit growth over 2020 (pending fourth quarter earnings
results). That upside was fueled by the rapid rollout of vaccines, sustained stimulus-supported demand, and the pricing power of corporations to pass on labor and input cost increases.
EMPLOYMENT GAINING MOMENTUM BUT LABOR SHORTAGES REMAIN A PAIN POINT
Labor markets remain a bit of a puzzle at the end of 2021. The total number of people employed by the U.S. economy has improved dramatically from pandemic lows but remains several million below pre-crisis levels as shown in the chart above. And yet, employers
across the economy are struggling to find enough workers to keep pace with demand.
The balance of power in the labor market has tilted from employers to workers. Job openings are plentiful, with about 10 job openings for every seven job seekers, according to the Bureau of Labor Statistics. Improved remote work technology has reduced
geographic limitations and broadened available job opportunities. Significant stimulus savings and strong financial market returns have provided flexibility for job seekers to pursue better pay and working conditions or even to switch career paths
altogether. As a result, quit rates are at record levels with 4.4 million employees quitting their jobs in September, compared to a 20-year monthly average of less than 2.7 million.
Some of this elevated turnover will fade with time, but the effects from a reduced workforce might be long lasting. Roughly 3.4 million people who have left the labor force since the pandemic are over the age of 55, many of whom may not return to work.
In turn, shortages are putting upward pressure on wages and pushing companies to invest more in automation to meet demand.
RATES ON THE RISE
After starting the year at very depressed levels, interest rates have gradually drifted higher as sustained high inflation readings and growing momentum in employment have brought forward rate hike expectations. The strong pace of economic growth, improving
job gains and rising prices are indications that the U.S. economy is no longer in need of the extraordinary accommodative monetary policy employed by the Federal Reserve to counteract the shock from the pandemic. In response, the Federal Reserve has
begun to take its foot off the gas pedal by tapering its monthly bond purchases, which should be completed by mid-2022. If job gains and inflation continue to keep pace, the Fed will next consider beginning to step on the brakes with rate hikes. The
market has priced in a high probability of at least two rate hikes in 2022.
