Stuck in the middle with U(K)

Over the past decade, there have been only three instances when mid-caps underperformed large-caps in the UK by more than 10%. Today is one of that trio. In the previous episodes of 2016 and 2020, buying on the dip would have been – with perfect hindsight – a profit-making tactical trade. However, this time it feels different.

Why is this of interest to a global macro Asset Allocation team?

In LGIM’s Asset Allocation team, our philosophy is rooted in the power of diversification to help our clients achieve their long-term goals – diversification in the form of different asset classes, different regions, and different macroeconomic drivers.

As such, we believe that – for clients with a domestic UK focus – small to mid-caps present a good source of long-term diversification in a multi-asset portfolio. This is due in part to the relative liquidity premium of owning non-large-cap equities. Additionally, UK mid-caps offer greater ‘true’ domestic exposure compared with the heavily international-focused large caps.[1]

Therefore, we need to be tuned in to large price movements to understand if they present a tactical opportunity to add to our longer-term, structural allocations.

What has happened this time?

After reaching a peak of outperformance in September 2021, the FTSE 250 UK mid-cap index has underperformed the large-caps of the FTSE 100 by 16.8% (to 14 February 22). Over the past 10 years, the only two other episodes when mid-caps have underperformed large-caps by such an extent were in June 2016 (-14.3%) and March 2020 (-16.8%).

These prior selloffs were concurrent with the exogenous shocks of Brexit and the first wave of COVID-19, which brought with them sudden changes in sentiment about the health of the UK economy. These both presented buying opportunities, in our view, as the reaction in both instances proved to be overdone when fundamentals and valuations remained supportive.

However, at the start of 2022 we have no such single catalyst. Instead, a combination of drivers are making this episode unique in recent history.

At the highest level, it’s been a story of strength in FTSE 100 index heavyweights like the energy, materials and banking sectors, which together account for almost one-third of the total FTSE 100 by index weight (compared with less than 7.5% for the FTSE 250). These cyclical, value sectors have driven half of the relative large-cap outperformance, benefiting from the post-COVID macroeconomic backdrop. Banks have been bolstered by rising rates, while higher inflation and commodity prices have supported the energy and materials sectors.

What are we going to do about it?

At first look, from a fundamentals perspective this would seem promising, as over the past 20 years our analysis suggests that a rising-rate environment has been supportive for mid-caps. However, this has typically been in a context of rates rising against a backdrop of growth – when smaller, domestically focused names are likely to outperform. Today, in contrast, these increases are the result of the Bank of England pivoting to try to temper inflation as we shift to later in the cycle.

We get a similar picture with regards to valuations. During the previous episodes of underperformance in 2016 and 2020, UK mid-cap equities moved to trade on a slight discount compared with large-caps on a forward price-to-earnings (P/E) measure. Today, however, while there has been a re-rating from a forward P/E ratio almost 1.5x that of large-caps, mid-caps continue to trade at a premium of 1.2x, remaining above the longer-run average of 1-1.1x.

Taking these elements into account, together with our view that sentiment is broadly neutral, UK mid-caps don’t yet look like a tactical buying opportunity to us. For now, we’ll watch closely for signs of easing pressure on the economy through channels such as lower commodity prices and improvements in supply-chain disruptions, coupled with a move cheaper in valuations, to start building a case that the selloff has been overdone.

Unless otherwise stated, information is sourced from LGIM internal analysis as at 14 February 2022.

[1] According to Morgan Stanley research, approximately 40% of FTSE 250 revenues come from the UK, compared with just 20% for the FTSE 100, with a further 25% derived from our closest neighbours in Europe. In comparison, the FTSE 100 has 25% from Asia Pacific and a further 20% North America. Data as at end 2019 but representative of broad trends.