Worst-performing fund sectors of 2022: time to buy or further pain to come?

Buying the dip is normally a smart move, but will it work out in 2023? Sam Benstead investigates. 

Investors had nowhere to hide this year, with all but seven of the 58 investment sectors losing money in the first 11 months of the year.

Rising interest rates ravaged valuations of high-growth stocks and bonds, while fears about slowing economic growth impacted the share prices of companies exposed to consumer spending. Geopolitics also had an impact, with European shares affected most by the war in Ukraine and tension between China and the US also dampening investor optimism.

• Find out about: High Yield Bonds | Fixed Income Investing | Investing in Bonds

The worst-performing fund sectors, according to Investment Association (IA) categories and data from FE FundInfo, were: UK Index-Linked Gilts (-30.9%); UK Smaller Companies (24.2%); Technology and Technology Innovations (-22.9%); European Smaller Companies (-21.7%) and UK Gilts (-20.2%).

The top sectors this year were: Commodity/Natural Resources (21.9%); Latin America (18.8%); Infrastructure (3.4%); India (2.5%) and Short Term Money Market (1%).

Popular sectors stuck in the middle of the rankings included Global Equities (-8.5%); UK All Companies (-7.4%) and North America (-6.1%).

The best returns in investing often come from bravely backing out-of-favour sectors that rebound – but are any of this year’s worst-performing sectors set to become next year’s best investment? We take a look.

Index-linked gilts and regular gilts

UK government bond prices collapsed in 2022 for two main reasons: higher interest rates due to inflation, and political changes.

When interest rates rise, any new gilts issued come with higher coupons. This makes existing gilts less attractive, causing their price to fall. The longer until a gilt matures, the more impactful the changing interest rates are on price.  

This is why index-linked gilts fell so much in 2022 – they have very long maturity dates as they are generally sold to professional investors, such as pension funds, which need to calculate and match their liabilities and assets well into the future.

Political changes also negatively impacted the gilt market, with rising government debt undermining confidence in the UK Treasury. Plans from Liz Truss when she was prime minister to cut taxes and increase spending, despite a growing budget deficit problem, also exacerbated the gilt market sell-off.

But things may be different in 2022. With interest rates expected to peak in early 2023, bond prices could benefit from interest rate cuts next year if inflation is contained. A change in government policy with the appointment of Jeremy Hunt as chancellor and Rishi Sunak as prime minister, who preach fiscal conservatism, has also been good for gilt prices.

Higher yields also help the gilt outlook. The “income” in fixed income has returned, which is tempting new buyers in search of yield and has helped boost bond prices over the past couple of months. Poor returns for bonds this year could therefore set the asset class up for strong returns next year. 

• The part of the bond market offering ‘rare’ 6%-plus income 
• What are gilts?
• What are index-linked bonds?

Fund managers are becoming more bullish on bonds following their price crash in 2022. Jupiter Asset Management’s Adam Darling, a bond fund manager, says that a recession next year does not mean the bond market will suffer.

He said: “Major Western central banks have started making noises that interest rate rises may slow or stop in early 2023. Frankly, given that I anticipate a global recession, which in itself will dampen inflation, I think we could see a rate cut or two before this time next year.

“This would be good news for bonds in general, in particular government bonds and investment grade bonds.”

Darling adds that it could be less of a boon for high yield, which is naturally a bit less exposed to interest rate movements due to the fact that such bonds behave more like equities. With high-yield bonds, the price of the bond is more sensitive to the economy or performance of the issuing company.

UK Smaller Companies

Small and mid-sized British stocks are sensitive to the UK economy. They are also negatively impacted by a weak pound as the cost of their imports rises, and they don’t tend to trade as much as large companies internationally, so they don’t benefit much from greater overseas profits when sterling weakens.

With the UK forecast to be in recession all of next year, according to the Bank of England, the outlook for smaller UK stocks looks tough.

However, stock markets are forward looking and price in bad news. In fact, Peter Hewitt, manager of the CT Global Managed Portfolio investment trust says stock markets look 12 months ahead, so shares could rally even as the economy battles slow growth and high inflation.

Speaking to interactive investor in our Insider Interview series, he said: “Once we hit a peak in inflation, which probably is not far off, and also interest rates reach their peak, we are actually probably going to be in a recession, or the recession is beginning to deepen a bit.

“But the stock market looks 12 months ahead, so it will judge that inflation is coming down a bit. I'm not saying it's going to come back to 2%, but it will be declining and so will interest rates.

“Both of those are good for the market and I think for mid and small-cap investment companies. Probably quite a number of their holdings might be having profit warnings or missing their earnings, profits and earnings estimates, but actually that's when you should be considering them.”

• Watch out interview with Peter Hewitt: How I pick investment trusts – and the ones I'm never selling
• Watch out interview with Peter Hewitt: Bargain trusts for 2023 – and Scottish Mortgage outlook

Hewitt says that Mercantile and Henderson Smaller Companies investment trusts are ways to profit from a possible rebound. The latter is a member of interactive investor’s Super 60 investment ideas.

Technology

Rising interest rates this year triggered a collapse in technology stock valuations, even as the underlying businesses performance stayed steady.

Higher interest rates give investors more options for their money. If last year government bonds offered you 1% annual returns, but now they offer 4%, then investing in technology stocks that are highly valued based on their future – not current – profits makes less sense.

The focus for technology stocks is now on whether earnings will keep growing next year. Ben Rogoff, who manages the £2.5 billion Polar Capital Technology Trust, says that valuations are now looking attractive in some parts of the technology market.

“A US recession may not be a foregone conclusion. Goldman Sachs recently said it sees only a 35% chance of this outcome in the next 12 months, significantly lower than the 63% average in a recent forecaster survey by TheWall Street Journal.

• These two regions are tipped as winners in 2023. Here’s how to profit
• Sentiment to China has never been so dire, top investor says
• China trust pulls IPO, blaming market conditions

“If a US recession is avoided and inflation/bond yields subside in 2023, the resulting rebound in growth equities could be meaningful. In our view, it is still too early to make this call with conviction, but after a significant valuation reset for technology growth stocks, the risk/reward appears more favourable than it has for some time.”

However, Morgan Stanley, the investment bank, has a price target of 3,900 for the S&P 500 index, suggesting a 1% decline from current levels. America’s most important stock market index is packed with technology stocks and trades at a valuation premium to other markets.

It said investors should instead embrace cheaper, income-paying stocks next year. “We think that this is an exceptional environment for generating high single-digit returns from high-quality assets, an opportunity that hasn’t presented itself for a long time,” the bank said.

European Smaller Companies

Morgan Stanley is more optimistic about European shares next year, but prefers big, income-paying European stocks over smaller companies, which are more vulnerable to interest rate rises.

It said: “We see a modest upside for European equities and expect a 6.3% total return in 2023 as low inflation leads to greater tolerance for high price-to-earnings ratios in Europe.

• Three big questions Scottish Mortgage investors now have answers to
• The investment trusts exposed to the cryptocurrency crash

“This should ultimately more than offset the 10% earnings decline we expect from weaker revenue growth.”

The bank says investors should focus on cheap “value” shares in Europe: financials and energy over higher growth names that are sensitive to the economy. “Banks and energy companies all have above-average dividend yields,” it said.