Long ReadAug 30 2022

An uncertain mixture of threats

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An uncertain mixture of threats
(Pixabay/Pexels)

I am pretty sure we have all seen a film, cartoon or play in our lifetime with the stereotypical scene of a dark cave with a boiling cauldron and three witches brewing a potion or poison.

If memory serves, eye of newt and toe of frog, wool of bat and tongue of dog, were just some of the ingredients used in Shakespeare’s Macbeth.

The reason I mention it is because it was recently used by a fund manager to explain the uncertain mix of threats facing the global economy. Inflation, fears over recession, rising interest rates, monetary stimulus being withdrawn, geopolitics and China’s slowdown are just some of the events in the brewing cauldron.

The new economic cycle

We are now in a period where the pendulum has swung in the direction of macro concerns driving markets. Investors seem focused on data points and top-down news flow. Company-specific fundamentals seem to have taken a back seat in the early days of this new economic cycle.

Take the UK for example: inflationary cost pressures are hitting hard – but not for everyone. Strong demand and limited supply continue to underpin the UK housing market, along with a healthy job market with low unemployment. Millions of investors can also lean on their savings built up during Covid-19 for the uncertain times ahead.

Performance across the market spectrum

From a market perspective, a 4.3 per cent return from UK large caps has seen them significantly outperform many other markets year to date; this is courtesy of the FTSE 100 having a value tilt – its defensive nature, global revenues and exposure to the mining and energy sectors.

By contrast, UK mid and small caps have been battered in 2022, down 16.3 and 12.3 per cent respectively. But are we now reaching the point where valuations are simply too attractive to ignore?

Time to buy?

The pessimistic voice on one shoulder is telling me it is still too early. The Bank of England has openly said it thinks the UK is going into a long and protracted recession.

UK real wages are falling at a record rate, and consumer confidence is at the lowest in history. When energy prices kick in this autumn, any remaining disposable income will go out the window for millions of British households. But continued high inflation could still result in further rate rises into an already very weak economy. 

The optimist tells me a lot of this is already priced in and that a number of companies, particularly in the mid-cap space, have suffered from an indiscriminate sell-off and are now trading on attractive P/Es with a large amount of cash on their balance sheets.

UK mid caps are now not only cheap relative to large caps and other global markets – the FTSE 250 has been trading below its long-term average of 14, with its 12-month forward P/E ratio currently estimated at 13 times.

Having seen cyclical and value companies flourish to the detriment of quality growth businesses in the first few months of 2022, ASI UK Mid Cap Equity manager Abby Glennie says she has started to see more positive share price moves in recent weeks as commodity costs have started to fall and there are early signs that the labour market could be cooling off.

The hope being that this feeds through to lower inflation and less pressure to raise rates – benefiting quality growth companies, which retain those strong balance sheets I mentioned earlier.  Even if consolidation does occur, this will allow certain mid caps to take advantage.

It is a similar story for UK small caps, which have already demonstrated tremendous resilience throughout the uncertainties of Brexit and Covid.

A recent research update from Franklin Templeton says UK small caps are currently pricing in a lot of downgrades, with investor sentiment swinging to pessimism – as a result the team are finding opportunities in four specific market areas: digital economy, decarbonisation, consumer brands and content and IP creation.

A lot of this all boils down to balance sheet strength – these companies have the ability to tap into opportunities in uncertain times. For example, the Liontrust UK Micro Cap fund only invests in companies that are profitable at the time of their initial investment.

Good examples are companies like corporate training business Mind Gym and online music retailer Gear4Music, where their respective owners invested in their business during uncertain times to generate long-term growth.

History shows us that small and mid caps historically lead recoveries in markets – we also must remember that when you read about the history of recessions, the market can spend 12-15 months falling and then unwind all that negative performance in two or three months. An allocation to these areas might mean some more pain now but a lot less in the future.

Three funds to consider:

AXA Framlington UK Mid Cap 

Managed by Chris St John, the AXA Framlington UK Mid Cap fund targets UK companies that are benefiting from structural tailwinds. St John will look for companies that are high quality (both financially and in terms of their management teams) that can show sustained profitability, and that exhibit future growth potential. He is also pragmatic about including select opportunities from the smaller companies space.

IFSL Marlborough Special Situations

Manager Eustace Santa Barbara looks to build a well-diversified portfolio of 150 stocks to minimise risk. Relatively small positions are taken initially, with winners run aggressively as their story unfolds. The fund has evolved as it has grown over the years and now invests in small and medium-sized companies. Long-term performance has been exceptional.

TB Amati UK Smaller Companies

This fund is managed by a highly experienced quintet of small-cap specialists. The portfolio of 65-70 companies focuses on structural growth businesses, which the managers say can add value in the under-researched small and mid-cap part of the market. Valuation is important, and the managers love to buy cheap businesses when they can, but they think it is much more important to find the right companies first.

Darius McDermott is managing director of Chelsea Financial Services & FundCalibre