The past few years have been a whirlwind for equities: after the blistering post-pandemic rally of 2021, investors had to adjust to higher inflation and a hawkish U.S. Federal Reserve (Fed), leading to a painful sell-off in 2022.

As markets have returned to rally mode over the last six months with inflation and interest rates stabilizing, investors may be tempted to think “2021 is back.” While many equity indexes have reached, or exceeded, 2021 heights, market leadership is markedly different today. In this article, we examine the regime shifts within equities and offer some secular themes that may help investors navigate the volatility.

Two Crises and Their Impact on Equities

Let’s start by reaching further back in history. The decade following the Global Financial Crisis (GFC) of 2008–09 was defined by largely experimental U.S. monetary policy. It was a period that ushered in zero percent rates in response to the worst global market crisis since the Great Depression. The Fed cut interest rates to stimulate the U.S. economy to allow households and businesses to recover.

Fast forward to 2020 and the onset of the COVID-19 pandemic, which led to a shutdown of the global economy. This time, the Fed implemented its post-GFC playbook in a much bigger way, infusing the economy with monetary and fiscal support that was significantly larger than in 2008. Combining the effects of pandemic-related supply chain disruptions, war in Ukraine, and unprecedented consumer stimulus, we found ourselves in an entirely new economic and monetary policy regime, primarily marked by sticky inflation, higher rates, and higher volatility.

In the decade following the GFC, low rates and subdued inflation resulted in an environment conducive for risk asset performance broadly—“a rising tide lifting all boats.” The period from 2012−2020 provided attractive broad equity market performance, resulting in an average annual return for the S&P 500^® Index for the period of 15.3%.

But we think it’s instructive to segment that broad market performance by earnings power—that is, companies that reported positive earnings (“earners”) versus those that reported negative earnings, during that time (“non-earners”). Figure 1 shows that the “rising tide” of 2012–2020 was supportive of both categories, with a modest advantage to the earners.

Why Innovation and Quality Stocks Can Potentially Thrive in a Higher-Rate World

But the second time frame in Figure 1, one that encompasses the end of the low-rate era, tells a different story. Following a series of interest-rate increases by major central banks, business financing costs are meaningfully higher. Today’s higher-rate environment has punished vulnerable businesses with weaker balance sheets. The differential between companies with positive and negative earnings has widened significantly since the Fed began its rate-raising campaign in 2021.

Not all earners and non-earners are created equal, however. While it may seem like holding a portfolio of earners, and avoiding non-earners, is a winning formula, we believe a more active approach is prudent. Seeking out companies with positive earnings should be complemented by an assessment of relative value, i.e., whether a stock is too expensive versus comparable equities, as well as an assessment of a company’s ability to generate stable or growing free cash flows.

We should look at non-earners with a similar level of scrutiny. Not all non-earning companies are bad from an investment standpoint. In fact, those companies prioritizing investing back in their businesses in the form of research and development (R&D), at the expense of current earnings, historically have outperformed those who spent at lower levels. We have found that the highest R&D intensity companies—those that spend the most on R&D relative to revenues—historically have superior revenue growth, earnings growth, and long-term performance versus the broader market.¹

While companies taking advantage of unprecedented technological innovation in areas like biotechnology and artificial intelligence (AI) are growing substantially faster than the broader market and offer the potential for outsized returns, the new higher-rate regime also necessitates a focus on quality, in our view—seeking out companies with higher-return metrics and lower leverage.

Furthermore, an equal blend of innovation (as defined by top decile R&D intensity companies), free cash flow yield, and quality (as defined by top-decile return on equity, return on assets, return on invested capital, and a bottom 50% standing in terms of debt/equity leverage), over a long period of time has been a winning combination, outperforming the MSCI All Country World Index (Figure 2). This combination has historically made for a portfolio well suited to different interest-rate and economic environments.

A Final Word

The current backdrop of higher interest rates, persistent inflation, and periodic volatility has seen the re-emergence of equity market dispersion—that is, widely differing performances among sectors. In addition, we believe that disruption—from factors such as major leaps in technology or forward-thinking business models—is here to stay, and investing in equities requires more selectivity than in the past. More displacement is coming from AI and other new technologies, so we believe equity investing needs to focus on identifying the winning disruptors and those well positioned to increase their dominance by leveraging innovation.

In our view, active management is critical to identify companies that can be long-term winners in this environment, while avoiding those with vulnerabilities. An active equity portfolio that can navigate changing regimes, focusing on blending true innovators and quality value stocks, while avoiding vulnerable businesses, can be the key to generating alpha over the long term.