Markets are rallying not because corporate earnings growth is surprising to the upside but because a majority of market participants have been persuaded that the world is becoming a less, not more risky place.
Fears around the big questions of 2012 – would the fiscal cliff provoke a US recession? Would the Chinese economy experience a hard landing? Would the euro currency bloc begin to break apart? – have begun, rightly in my view, to dissipate.
US data has not been uniformly strong, but the overall picture is one where economic traction is beginning to reassert itself and where the US housing market in particular, after years of torpor, has begun to grow again.
With US consumer debt service cost as a percentage of disposable income at its lowest since records began in 1980 and interest rates likely to remain at current levels into 2015, we expect the housing market recovery has much further to run.
This has profound implications for US consumer confidence and spending. In addition, we expect the discovery of huge US shale oil and gas reserves to be very positive for growth in the longer term.
Much reduced energy costs will significantly improve US industrial competitiveness.
First-quarter growth data for China may have disappointed slightly, but growth of 7 per cent – 8 per cent for that economy, particularly if it is increasingly driven by consumption rather than production – should provide a useful impetus for the global economy.
Finally, while the eurozone as a whole looks unlikely to grow, the serene performance of equity and bond markets in the face of the collapse and bailout of the Cypriot banking system and protracted formation of a new Italian government is testament to the success that the eurozone authorities have had in persuading the market that their "lender of last resort" message is more than just rhetoric.
How have UK mid and small caps performed against this backdrop? The answer is rather well.
Mid and small caps saw double-digit returns in the first quarter, outpacing the FTSE All Share.
Performance of indices in 2013
Source: FE Analytics
In this environment, our focus has been primarily on stock selection rather than on major shifts in sector allocation.
We have reduced our exposure to mining and oil, reflecting the weakness of commodities prices generally, and have taken profits among some of the industrial names where ratings have expanded materially, but have increased our weighting to financials in response to positive prospects for asset managers and an improving environment for specialist lenders.
Our thematic biases have remained essentially unchanged – we continue to look for structural growth opportunities, for strong total return stories and for a range of special situations.
By structural growers, we mean businesses that we believe have the opportunity to deliver above-average rates of growth over an extended time horizon, driven by dynamics which are either intrinsic to the company itself (a compelling and differentiated product or service) or through exposure to a strongly growing niche market, rather than being a function of wider economic growth.
In this basket, we continue to like Telecom Plus, a multi-utility reseller with significant headroom for growth arising from its current low market share; Perform Group, which monetises sports rights across a range of web-based channels; and Rightmove, the dominant property portal.
Total return stories are companies delivering good if unspectacular rates of earnings growth accompanied by a high and rising dividend yield.
In a still uncertain world where high but dependable yields are hard to access, companies that can deliver, within their total return (earnings growth plus rating expansion plus dividend) a high proportion of that return through the relative certainty of the dividend component will continue to perform well.
Holdings with these characteristics include Greene King and Talk Talk.
Finally, in a low-growth world, special situations are a key focus. These are stocks whose investment case rests on self-help and/or a range of helpful developments in end-markets.
Good examples which we have written about in the past are housebuilders – two we like are Barratt Developments and Persimmon – and Ashtead, which lends equipment in the US construction market, helping companies operating in that sector to reduce their capital outlay.
Looking ahead, we remain optimistic. While a near-term correction in markets cannot be ruled out, particularly given the strength seen in recent months, we would expect markets to grind higher over the balance of this year.
UK interest rates remain historically low, while on-going quantitative easing creates a positive environment for UK equity investors.
We have also seen tentative signs of equity inflows picking up. UK small and mid cap equity market valuations look well underpinned: a 12-month prospective P/E ratio of around 13, earnings growth of around 7 per cent and a yield for the market of around 3 per cent suggest that double-digit total returns represent a sensible central case on a year-ahead view.
Daniel Nickols manages the Old Mutual UK Smaller Companies fund. The views expressed here are his own.