Investment Strategies

Market Outlook 2022: Beware "Distortion Complacency"

Charles Paikert New York November 17, 2021

Market Outlook 2022: Beware

One of the largest investment houses in the US explained its thinking about the most effective way to allocate capital in an economy where COVID-19 has caused major distortions.

Note to asset managers gearing up for 2022: Embrace capital allocation and avoid portfolio complacency brought on by pandemic-induced distortions.

Investors are paying too little attention to how companies allocate capital, according to T Rowe Price's chief investment officer David Giroux.

“Capital allocation prowess has become an increasingly important source of competitive advantage,” Giroux explained at the firm’s annual Global Market Outlook press briefing. “Slower economic growth and lower interest rates have meant there is more capital than ever for firms to deploy.”

However, because capital allocation isn’t exciting, most companies have very few experts in the field or on the board. Compounding the problem, the topic is also overlooked by investors and the media.

Study in allocation contrasts: GE and Danaher
General Electric and its abysmal stock performance for the past decade was cited as the poster child for “unparalleled poor capital allocation.” By contrast, Danaher Corporation allocated capital much more wisely, Giroux said, more than doubling organic growth by shifting from cyclical tools and controls to become a tech innovator and leader in life science tools and medical products.

Structural changes in the global economy have sparked the increase of free cash flow and incremental debt capacity. In addition, materially lower interest costs have allowed firms to safely have more debt in their capital structure.

“The returns that firms generate on this capital are becoming an increasing driver of long-term shareholder returns,” Giroux noted. “Firms that deploy capital well are expected to grow materially faster than their peers, [will] likely experience valuation multiple expansion, and benefit all stakeholders over the long term.”

How equity markets became distorted
Investors in 2022 also have to guard against becoming complacent and accepting the current state of equity markets as normal, according to T Rowe Price's global equity portfolio manager David Eiswert.

Three key global events have distorted equity markets, Eiswert asserted at the press briefing: COVID-19 behavior, monetary and fiscal policy, and China reform and policy change.

Investors need to “cross the chasm” leading into a post-COVID world and embrace a much different reality that lends itself to active management, Eiswert argued. “Pandemic distortions have created ample room for idiosyncratic stock picking,” he said.

The labor market, for example, has been profoundly impacted by COVID, with heightened child care and workplace issues.  Similarly, COVID has distorted supply chains and digital commerce.

What’s more, the US Federal Reserve’s decision to flood the system with a massive amount of money has distorted both monetary and fiscal policy, Eiswert noted. Also, China has faced skepticism from investors in the wake of Premier Xi Jinping’s economic crackdown and saber-rattling.

Change is coming
“It’s really important for investors to understand how this environment will change,” Eiswert said.

COVID behavior is likely to moderate, he said, with workers returning to the labor force and supply chain functions improving, driving economic stabilization. T Rowe Price also believes that inflation is peaking now and will be lower next year, although higher than before COVID. This trend, according to the outlook, will lead to a steepening yield curve and positive momentum for financial firms.

Despite the current optics, Chinese reform is coming from “a position of strength,” Eiswert maintained. “They are fixing the roof while the sun is shining.”

The current upheaval in China is actually part of a regulatory cycle that is likely to fade in the next two or three quarters, according to Eiswert. “Near-term volatility should be viewed as an investment opportunity, not something to avoid,” he said.

The “massive distortions” in global equity markets will fade away, Eiswert argued, giving active investors in all equity classes an opportunity to benefit. “Business is getting better,” he said. “It will be bad for speculators and good for stock pickers.”

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