Activating Equity Portfolios for Higher Rates and Inflation

Passive equity investing has retained its dominance and outflows from active portfolios have continued amid the market and macro shocks of the past year. But in a world of structurally higher inflation and interest rates, there are good reasons for equity investors to consider active portfolios for equity allocations.

Companies and markets are still digesting the uncertainties that were unleashed in 2022. We believe these changes warrant a rethink of the rationale behind passive portfolios, which continued to see net inflows last year. While passive funds are generally cheaper and have a role to play in allocations, active portfolios offer benefits that are worth paying up for—especially in times of dramatic change. Here are some evolving conditions that we believe reinforce the case for skilled active management in the years ahead.

    1. Inflation (and Potential Recession) Will Create New Winners and Losers—we’re only in the early innings of the earnings reset triggered by higher inflation and rates. During the first stage of this regime change in 2022, the first order effect of inflation was higher rates, which triggered a compression of stock valuations across the entire market. This year, we think earnings growth will play a greater role in stock performance.

      Don’t expect this process to play out neatly. Inflation and a potential recession will affect companies in different ways, which may lead to a wider dispersion of equity returns, in our view. Long gone are the days of virtually free financing and the “growth at any price” mindset. Instead, a higher cost of capital will necessitate corporate discipline, as well as an active approach to identify those companies with pricing power, earnings and profit margin sustainability, lower debt and company-specific business momentum. Taken together, these trends may lead to persistently lower correlations of stock returns, which are currently well below the median since the 2008 global financial crisis (Display). Lower stock correlations mean trading patterns of individual stocks are more pronounced, which tends to offer better conditions for skilled active managers to outperform and can help reduce overall portfolio risk.