Best and Worst Sectors in 2022

Commodities/Natural Resources have been perfectly positioned (again) during this year’s economic upheaval, with manufacturing hubs struggling with demand post-Covid, the Russian invasion of Ukraine (heavily impacting both energy and grain supplies), and much sharper interest rate increases due to runaway inflation.

The reason for this is twofold.  Firstly, Commodities/Natural Resources see their prices inflate alongside inflation (usually), allowing the sector to be an effective hedge against the current high inflationary environment we face. Secondly, the reopening of major manufacturing hubs like China (albeit with sporadic regional lockdowns) and India has spurred demand for commodities and natural resources, forcing prices higher.

Although LatAm had a difficult November, as well as a tough 2021, over the course of the entire year the region’s performance has been the second-best.  There have been two key drivers.

The first is the sectors 27% weighting to financials.  Why is this a positive?  Since early 2021 Brazil and Mexico have pursued aggressive interest rate hiking cycles to fight inflation.  These hikes have taken their base rates from 2% in early 2021 to 13.75% and 10.50% respectively today. These huge rate rises drive up the profitability of the financial sector, chiefly because banks profit by charging a higher rate on loans than they pay to depositors - as interest rates rise, the gap between these two widens, increasing their profit margins.

The second driver for LatAm is its 24% weighting in basic materials, the sector that extracts and refines/processes raw materials such as chemicals, metals, minerals, forestry products and so on. This has been driven higher for the same reasons as the Natural Resources sector.

Beyond these two sectors, the rest of our top performers are all “cash equivalents” that offer minimal nominal returns. That is to say that these sectors haven’t necessarily performed brilliantly this year, but they have broadly maintained their nominal value amidst a broad-based sell-off of other assets.  Of course their real returns, after allowing for inflation, are negative.

Gilts and Tech Crushed

On the flip side this year, UK government debt had a stinker of a year, with the UK Index Linked Gilt sector taking the crown for the worst sector, and its sister-sector UK Gilts in 5^th spot. Supposedly ultra low-risk, gilts have had a torrid time this year for three key reasons.

The first is fundamental to bond sectors in general.  When interest rates rise (as they have done consistently this year, thanks to persistently high inflation), bond prices fall.

The second reason gilts have suffered so much is confidence.  Confidence in the UK government and economy fell, and overseas buyers of UK government bonds want to be paid more to buy these bonds.  The immediate reason was the short-lived plan of Truss and Kwarteng for a high spend/low tax economy, which markets saw as fanciful and risky to the quality of UK government debt.

This deterioration in investors trust in government bonds was perhaps most intense in the UK, but was by no means solely a UK phenomenon. Other peer nations saw similar issues, albeit less dramatically, as their debt to GDP ratios increased, economic growth stalled and the monetary levers available to relieve it were spinning in reverse to fight inflation.

The final reason was the use of derivatives by pension funds to juice the returns from their government bond holdings.  Some would say this was gambling.  This “strategy” meant that when gilt prices fell in September, it triggered selling by pension funds, and the liquidity problem reared its head – who will buy when I want to sell?  For a short while the answer was “no one”. 

The twin problems of lack of liquidity in government bonds, and wobbly defined-benefit pension funds, are ones which will persist for a while yet, and globally.

The decline in the two smaller company sectors (UK and Europe) is not a surprise.  With recessions building, these sectors get hit hard.  Plus they are relatively illiquid, so a little selling triggers indiscriminate price falls.  These sectors look cheap, but they can get cheaper.  At some point this will be where the greatest opportunities lie.

Technology is the 2^nd worst sector, and there is not much more that we can add to what we have said over the last 3-4 years.  It was (and remains) a very overvalued sector, and featured in many of the funds which have been smashed over the last year, such as the ARK funds, the flagship fund being down 65% this year.

NOTE

Sector performance 03/01/2022 to 20/12/2022.

All Investment Association sectors considered except for ETF’s.