Investors should beware looming volatility in UK mid-caps ahead of the forthcoming general election, according to Chris St John, manager of the AXA Framlington UK Mid Cap fund.
However, the fund manager maintains that any turbulence is likely to be short term in nature and will be using market dips to add further to his favourite stocks, rather than seeking shelter in other parts of the market.
Most polls and commentators are indicating a stalemate result between Labour and the Conservatives, meaning the host of fringe parties also fielding candidates will likely help build a coalition government, potentially involving complicated backroom deals or even a repeat election in the coming months.
Markets distaste for uncertainty will mean a tricky time for mid-caps, which tend to be more domestically focused than their larger peers and are currently sitting on high valuations, St John said while speaking at the FE UK Growth event earlier this week.
“Clearly the general election is now being focused on more and more. The outcome is very uncertain and so there is a great amount of uncertainty with the markets. It could be a lot like the Scottish referendum. It may take until two weeks before and they people will really start concentrating,” he said.
According to FE Analytics, both the FTSE 250 and the average fund in the IA UK All Companies sector took a hit in the run-up to and fallout from the Scottish independence referendum back in 2014, which prompted a sell-off in stocks.
Performance of index and sector from Sep to Nov 2014
Source: FE Analytics
The uncertainty of what a potential referendum on Europe in the event of a Conservative victory would mean, a punitive business environment in the event of a Labour win or the ‘unknown unknowns’ in the event of a complex coalition are the most often cited outcomes that could knock back markets.
St John believes that more simply businesses will avoid expansion and become more defensive financially, thereby decelerating market activity.
“Over the short term my main concern is that companies scale back, put investment on hold – I don't think that will be a surprise. It typically happens ahead of a general election when there is a lot of uncertainty,” he said.
“If you have battled to get your balance sheet into a really good position then it is logical to sit back on capital investment programmes and wait to see how the land lies.”
However, the manager believes his portfolio can weather a turbulent mid-cap market although there may be some headwinds if the pound weakens.
“I haven't typically invested in companies that are reliant on the UK government. Particularly 'green agenda' companies. When your business only stands up because of government subsidy then that is something that I wanted to steer clear from,” he said.
“If sterling goes down, we have some companies that get a hurt a little bit but there are plenty that would do well too in that environment.”
In this event he says he would rather sell down large-caps such Dixons and buy further into his top mid-cap holdings.
“I haven’t really built up cash because I have 7 per cent in FTSE 100, which is plenty of liquid investments. If I start to get the collywobbles in certain areas then I will act but that will only be to free up capital to invest more in core holdings that may get hit unfairly on a short-term basis.”
Mid-caps appear to be losing some appeal more broadly after a strong run since the bottom of the financial crisis led them to sell-off in 2009. As the graph below shows, the FTSE 250 has gained 188.64 per cent over the past six years, 23 percentage points more than the FTSE Small Cap index and significantly more than the FTSE 100.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
Alex Savvides, manager of the £300m JOHCM UK Dynamic fund, on the other hand, has been selling down mid-caps in favour of small and AIM stocks. For the first time since Savvides took over the fund at the height of financial crisis in June 2008 his mid-cap exposure is at its lowest.
St John says mid-caps are looking expensive, trading at a premium to their long run average P/E of 14, at about 16 times earnings. But he says due to gilts’ very low yields the market is still attractive.
“If you look at earnings yield relative to gilts that the FTSE 250 has never looked cheaper but in my mind the tail is starting to wag the dog with arguments like that. Clearly your comparative – gilts – is being distorted significantly by quantitative easing. However, the FTSE 250 is yielding 3 per cent.”
“However, companies tend to be in good health and the end markets of those companies tend to be in good health. Balance sheets are strong but you can’t get away from the fact that it is at a premium.”
The AXA Framlington UK Mid Cap fund is a top decile performer over three years, having returned 84.42 per cent while the average IA UK All Companies fund has returned 49.08 per cent and the FTSE All Share ex ITs has gained 76.84 per cent.
Performance of fund, sector and index over 3yrs
Source: FE Analytics