Growth funds face their nightmare scenario but investors don’t need to worry yet

Headlines about higher inflation and higher interest rates caused by an energy crisis are making some investors wary. The last time this happened, in 2022-23, the market's most popular stocks and funds took a major performance hit.

Many investors will own growth stocks even if they don’t realise it. Popular technology or AI companies such as Meta, Nvidia or Apple are all examples of ‘growth stocks’.

Growth stocks are limited to the tech sector, but these tech giants are a premier example. This type of company is expected to grow sales and earnings at a faster rate than the average stock on the market. In order to do this, they usually don’t pay dividends because they reinvest the profits in themselves to grow. In the pre-pandemic decade when borrowing costs and inflation rates were low, these companies were able to load up on cheap debt and fuel their rapid expansion.

The S&P 500 has a high concentration of these stocks. In the past 20 years, it’s made over 710%, over 100% more than the global MSCI ACWI benchmark.

Big tech funds were the best performers during that era, including Amundi MSCI Semiconductors, Polar Capital Global Technology, iShares S&P 500 Information Technology Sector ETF, Allianz Technology Trust and Scottish Mortgage.

Except for one blip. From 2022 to 2023, the S&P 500 fell over 15% during the year and all of the funds listed above saw a collapse in their annual returns. Scottish Mortgage lost almost 40% from the start of 2022 to the end of 2023 and WisdomTree Cloud Computing ETF lost almost 30%.

The fall was a result of Russia's invasion of Ukraine, which triggered a global energy shortage and sent UK inflation soaring to over 10%. In response, central banks raised interest rates to generational highs in a bid to combat the crisis.

Referred to as ‘higher for longer’ this macroeconomic backdrop is the anthesis of growth funds, and today economists and fund managers are signaling a possible return to this environment because of the Strait of Hormuz remaining shut, at least, headline inflation remaining higher from oil.

So far, the US has already seen one interest rate hike this year, and the market is pricing in at least another 0.25 percentage point bump before we put up the Christmas tree. The Bank of England is expected to follow suit soon, as inflation rose from 2.8% at the beginning of the summer to 3.1% by August.

But the situation now is still a long way off the 5% borrowing costs and inflation we had four years ago. Karen Ward JPMAM's EMEA chief market strategist points out that core inflation isn't flashing a warning sign yet. So investors aren’t yet facing the need to dump their growth-er names just because there’s a 2022 echo going on.

Long-term investors will have heard the phrase ‘history rarely repeats itself, but it does rhyme’. When applied to markets, it means that the driving forces behind the rise and falls are never exactly the same, so the winners and losers tend to not be the same either. But the human nature of investors involved in the trades and events driving these cycles means that there is knowledge to be learned from the past.

Cycles are a normal function of markets and one type of asset cannot remain permanently on top all the time. Understanding why you’ve bought something and how it might react to certain macro factors might can help understand why they’re raining on its parade right now, but it could be worth riding out short-term pain for longer term comfort.