Mid-caps should bounce back next year following a down year in 2016, according to Royal London’s Derek Mitchell, providing there is an uptick in spending on infrastructure.
So far this year, mid-caps have underperformed their larger rivals, with the effect of Brexit hitting medium-sized domestic-focused stocks more than the larger global companies within the FTSE 100.
In the aftermath of the EU referendum, the pound plummeted, immediately providing a headwind to mid-caps, while investors chose to invest in more global-facing large cap names.
This was caused by an aversion to risk, led by investor uncertainty over how the result would impact the economy, but despite this period of weakness, many believe mid-caps should rebound and outperform their larger peers next year.
Performance of the dollar, FTSE 100 and FTSE 250 since the EU Referendum
Source: FE Analytics
Since the referendum, the dollar has risen more than 11 per cent against the pound and the FTSE 100 has followed a similar pattern, rising almost 13 per cent as many of its constituents have overseas earnings.
The more domestic-focused mid-caps, however, have struggled gaining just 5.2 per cent since the vote, as investors feared that many companies within the index would be hit by a weaker pound.
Mitchell (pictured) says this hit to the value of sterling should keep mid-caps underperforming for the rest of the year, with little sign that the pound will pick up.
“Clearly Brexit has come and gone and it’s had a very big impact on the market,” he said.
“Broker consensus is for sterling to dollar to be around the 1.20 level. We’ve stabilised in the 1.30s at the moment but there are some forecasts out there of a possible fall to 1.10 - so in that environment, pressure would certainly remain on mid-cap stocks and would favour the large caps.”
This year, mid-caps are expected to underperform their larger rivals for only the fifth year in the last 18 years, and Mitchell says FTSE 250 are currently suffering from a negative perception.
“Obviously I fear that 2016 will be another year of underperformance by the mid cap index but that’s still only five years out of the previous 18 and for me this just shows that – other than in years or periods of stress – I would expect the mid-caps to continue to outperform the FTSE 100.”
Nevertheless, this trend has hurt funds with a high weighting to mid-caps.
FE data shows, for example, that all 12 funds in the IA UK All Companies sector that are benchmarked against the FTSE 250 are sitting in the third or fourth quartile in 2016 so far.
Performance of funds versus sector and index in 2016
Source: FE Analytics
The best performer in the space has been Allianz UK Mid Cap, yet its returns year-to-date of 5.03 per cent leave it 1.48 percentage points and 6.09 percentage points, respectively, behind the sector average and the FTSE All Share.
However, Mitchell – manager of the Royal London UK Mid-Cap Growth fund (which has lost of 0.65 per cent this year) – says all is not lost for mid-caps. Though he does indeed think they will underperform for the remainder of this year, he expects a significant boost from infrastructure in 2017.
He says if the government spends more on infrastructure, many of the cyclical (and domestically orientated) companies within the mid-cap sector could be in line for a boost.
“A lot depends on where we are with regards to infrastructure. If it follows through then there is a clear lead for cyclicals, and that clearly has a more positive impact on mid-caps than large caps,” he said.
Some believe that the early signs of Theresa May’s reign are positive for this, with fiscal policy to increase infrastructure among her key objectives.
Michael Stanes, investment director at Heartwood Investment Management, said last month: “Early indications suggest that Prime Minister May is heeding those calls to take up fiscal arms. In various speeches, she has spoken of the need to end the budget surplus targets; increase infrastructure spending via Treasury-backed bonds; support house building; and deliver an industrial strategy.”
Royal London’s Mitchell said that there are a number of companies within the FTSE 250 that would immediately benefit from an increase in fiscal spending, as well as those that will indirectly benefit.
“There’s certainly chat that in the autumn statement there might be some further incentives coming to the housebuilders,” he said.
“There’s companies directly involved in infrastructure spend - the likes of Keller, Balfour Beatty and Atkins – which is in my fund - and selected industrials as well should benefit from a pick-up in economic activity.”
It’s not just in the UK where infrastructure spending could boost mid-caps, as Mitchell says he expects this trend to be a “global phenomenon”.
“We’re focusing solely here on the UK – but this is a global phenomenon. Both US presidential hopefuls have talked openly about picking up infrastructure spend and it’s going to happen elsewhere as well.”
“That, to my mind, would clearly benefit mid-caps and if it were to transpire I would expect mid-caps to do better - given their greater cyclical nature - than large caps in 2017.”
Performance vs sector and FTSE 250 over five years
Source: FE Analytics
Mitchell’s £350m fund has outperformed its sector and the FTSE 250 index over the last three and five years, returning 123 per cent over a five-year period.
It currently includes the likes of engineering firm Atkins, utility infrastructure firm Pennon and cement-maker Sagar in its top ten holdings, meaning it could benefit greatly from an uptick in infrastructure spending.
Mitchell said: “A strong message from me is not let’s give up on mid-caps – yes this year is going to be a struggle but I would expect that when normal service is resumed that they will do better than their larger brethren.”
There are a number of others who agree with this sentiment such as LGIM’s Justin Onuekwusi, who currently has his highest weighting to UK mid-caps on record.
“We now believe that a fiscal injection from the UK government is on the cards,” Onuekwusi said.
“The size of that is uncertain, but that is bound to benefit mid-cap stocks over large cap stocks. It is bound to benefit the domestic economy more than your big mega-caps with global exposure.”