2021 4th Quarter Client Letter
By Will Klein, CFA
Quarterly Investment Commentary
Baldwin Brothers clients benefitted from peaks in economic growth, inflation, and earnings growth over this past year. Economists estimate US real GDP grew 5.6% last year, reaching growth rates we have not seen since the 1970s. Consumer Price Index (CPI) inflation climbed to 6.8% in the most recent November report, which marked the highest US inflation rate in over 30 years. Strong growth and hot inflation bolstered corporate profits, leading analysts to believe the S&P 500 index earnings per share climbed over 70% in 2021.
Many define 2021 as a peak-everything environment. This was a boon to equity investors; US stocks, represented by the S&P 500 index, returned 28.7% over 2021. International developed equities, represented by the MSCI EAFE Index, returned 11.9% in dollar terms. Emerging market (EM) stocks were more challenged; the MSCI EM index returned -2.5% in dollar terms, as Chinese regulatory crackdowns and lower EM vaccination rates weighed on market sentiment. However, that had a limited impact on diversified equity portfolios.
While equities delivered strong returns, fixed income markets struggled against climbing inflation. The Barclays US Agg, the most widely used core US bond index, returned -1.5% over 2021. However, that did not derail diversified portfolios. A 60% MSCI All Country World Index / 40% Barclays Global Agg asset allocation index (a useful proxy for a traditional balanced portfolio) returned 9.2% over 2021, moderately exceeding its 7.1% 20-year compound annual growth rate.
Our US equity investments delivered strong returns over 2021, and our asset allocation framework insulated portfolios from headwinds in more challenged markets. For instance, our focus on domestic equities limited client exposure to the bear market in Chinese stocks as Beijing cracked down on tech companies. All the while, our decision to favor shorter duration fixed income insulated portfolios from extreme inflation and interest rate volatility.
Today, we believe this peak-everything environment is ending: We expect the macro and market environment will revert towards more normal mid-cycle conditions over 2022, as the effects of fiscal and monetary stimulus wane and we finish lapping 2020’s pandemic-impacted year-over-year growth and earnings comparisons. We are also optimistic this inflationary heatwave will break soon. While tight housing markets and strong hiring demand could continue to drive inflation longer term, extreme cost pressures in categories like autos and oil, which propelled inflation to multi-decade highs over recent months, could fade this coming year. So while inflation could remain elevated in the near term, we think peak inflation may already be behind us.
Markets could become more discerning should growth, inflation, and earnings tail off; however, investors will still have to contend with big macro trends such as tight labor markets. Our focus on identifying investments geared to environmental and social drivers could put us on the right side of that trend. For instance, we’ve historically researched firms’ approaches to hiring and retaining talent as part of our equity investment process. That could pay off if portfolio companies do a better job of retaining talent while competitors struggle with employee attrition.
While we feel peak-everything conditions are fading, we anticipate this cycle will continue to burn hotter and faster than the 2008-2020 economic cycle. Recent monetary policy announcements underscore that trend. Last November, the Fed began tapering its $120 billion in monthly Treasury and mortgage bond purchases, signaling the beginning of the end for the extraordinary monetary policy accommodations it introduced in March 2020. Last December, Fed Chair Jerome Powell announced plans to double the rate of that taper from $15B/month to $30B/month. That accelerated timeline puts the Fed on track to wind down asset purchases as soon as this coming March. This is significant because Fed decision makers have signaled they could raise rates as soon as they wind down bond purchases if inflation remains extreme. Powell’s recent move puts a rate hike in play roughly two years after the Fed cut rates to zero in March 2020. Putting that timeline in context, it took the Fed seven years to hike rates after first cutting them to zero in 2008.
Tighter monetary policy is not the only risk investors face coming into 2022. While economic momentum, financial conditions, and corporate fundamentals remain strong, endemic COVID outbreaks, fragile commodity markets, and US/China tensions could complicate that backdrop. Those risks underscore the need for diligent portfolio construction today.
The Baldwin team continues to balance our emphasis on today’s opportunities with our strategic commitment to capital preservation. That informs our equity research, where we are focused on finding companies we believe can thrive through the business cycle. It also informs our asset allocation and manager research frameworks, where we continue to emphasize diversification and building partnerships with asset managers we believe align with our clients’ objectives and values. Taken together, we remain focused on building portfolios to help you achieve your long-term goals.