It’s been a hard slog for UK smaller companies over the past few years. A combination of declining asset values and net redemptions undermined the performance of open-ended UK smaller company funds, while the FTSE Small Cap UK index declined by around 35 per cent from September 2021 through to last October. Admittedly, UK small caps and mid-tier stocks still managed to outperform the overall market in 2023 and their fortunes have improved markedly since their last trough.
Anyone banking on a return to significant net inflows into this corner of the market would have paid close attention to this week’s inflation figures. That’s because companies at the lower end of the food chain suffer disproportionately from prolonged bouts of inflation and the rate hikes that come in their wake. The burden of higher input and labour costs falls heavily on these companies, while debt becomes more expensive to service. And although the headline inflation rate grabs the headlines, it is concerning that UK wage growth has strengthened even as the UK unemployment rate has edged up.
It could be argued that valuation anomalies among well-capitalised UK small caps will become more apparent once it is clear that the rate cycle has peaked. Despite the post-October rally, many of the minnows still trade at a sizeable global valuation discount, as opposed to the traditional premiums they command over their blue-chip counterparts.
It’s strange to think that prior to the inflationary surge, many young investors would have had no experience of the negative impact that long-term inflation can have on corporate valuations. By now, those negative effects would be well understood, but the fear is that unconventional monetary policy and the massive increase in sovereign debt have made it more difficult to tame inflationary pressures, challenging some long-held assumptions in the process and even undermining a key tool used in the construction of diversified portfolios.
One of the more vexing developments in the aftermath of the Global Financial Crisis has been the periodic breakdown in the negative correlation between bonds and equities. Indeed, the correlation has reversed from time to time and not only during the inflationary surge that commenced midway through 2021.
The theory runs that in a low-inflation environment, a negative correlation between equity and bond returns should be evident, but increased volatility in fixed-income markets has eroded confidence in how these two asset classes interact. This poses a challenge for fund managers and retail investors alike from a risk management perspective. The traditional 60/40 portfolio allocation has long been standard practice for the moderate risk investor, but we have witnessed a loss of faith in the viability of bonds as a hedge against a portfolio’s equity component. This partly explains why we have seen periodic spikes in bond yields as investors have pushed up term premiums, essentially as effective compensation for undiversified risk.
Certain economists, including former governor of the Bank of England, Mervyn King, have blamed the inflationary surge on the expansion of government balance sheets resulting from quantitative easing (QE) programmes and, lest we forget, the somewhat panicked response to Covid-19. But it seems a rather narrow focus given the varying forms of supply chain disruption brought about by the pandemic and the upward trajectory of wholesale energy and farm input prices following Russia’s invasion of Ukraine. That said, the UK’s M1 money supply (currency, demand deposits, and other liquid deposits) did increase rapidly between 2000 and 2022, but it doesn’t automatically follow that the adoption of conventional monetary policy in response to the pandemic would have resulted in a vastly different outcome given the external issues outlined above.
In any event, the core UK inflation rate, that which excludes volatile energy and food prices, is in downtrend, albeit moderately. Analysts at the Bank of England will be paying closer attention to services sector inflation as a barometer as to whether inflation will prove stickier for longer than anticipated. Any more favourable readings will improve sentiment towards UK equities, already buoyed by slightly better news on the admissions front. Analysts at HSBC (HSBA) recently made the point that the prolonged sell-off in UK stocks by pension funds is grinding to a halt, but mainly due to the fact that they have nothing left to sell. That’s hardly a ringing endorsement and it probably only affects FTSE 350 constituents. Advocates of mean reversion theory would be better advised to seek out opportunities within the small-cap universe, but they might want to do so quickly as the number of companies within this space has shrunk by around 30 per cent since 2018.
