Inflation and interest rates in the UK are likely to start rising which means that damaged mid-caps are set to double in value while expensive large-caps will struggle, according to Stuart Mitchell (pictured). 
The FE Alpha Manager, who is managing partner and chief investment officer at S.W. Mitchell Capital, says there are “all sorts of value opportunities” in the market as the valuation disparity between global-facing and domestic-facing stocks continues to widen.
While the value versus growth debate seems to have reared its head again in recent months, Mitchell says the shape of his portfolios has remained the same since as far back as 2012.
While he admits his overweight in mid-caps has hurt portfolios this year due to weakening sterling and a flight to safety year, he hasn’t changed his view that market behaviour will soon shift dramatically.
Performance of indices in 2016
Source: FE Analytics
“It’s interesting how things change so quickly. We’re clawing back a lot of what we lost already. For us the difficult moment was Brexit as we have quite a lot of UK domestic exposure,” he admits.
It’s quite difficult in regards to Brexit because it wasn’t obvious – certainly in the short term – why the UK economy would be affected in any way. We knew there would be a currency hit but, on the other hand, it wasn’t obvious that there would be a particular impact on business in the short term.”
That said, the CIO says large companies are trading on valuations that he has never seen before in 30 years of working in the industry and that the differentiation between stocks is becoming more and more extreme.
“Our view is still very much that it’s all about domestic stocks. Keep away if you can from the big international companies because they’re just too expensive,” he warned.
“As long as you can believe that Europe will gradually recover, as long as you believe Brexit isn’t the beginning of something which will fracture Europe even further, we going to make a lot of money in these stocks. A lot of money.
“Interestingly it’s just starting to turn, it’s fascinating. We were surprised by how much further bond yields fell.
“With these so-called great international companies, we’ve been revising down our earnings expectations but the share prices are continuing to rise because, given the lack of German bond yield, it’s a haven of safety.
“It’s really starting to change now. German bond yields are back in positive territory again and there are all sorts of very important technical breaks which are happening. It’s happening in the UK bond market; inflation is starting to pick up again.”
He says that, if and when this happens, the UK will become a market area where domestic stocks double in value while expensive dividend-paying ‘stalwarts’ could be down by 5 to 10 per cent.
In an article published last week, Premier’s Simon Evan-Cook told FE Trustnet the popularity of growth equities over value over recent years is due to investors expecting a permanent deflationary environment.
“There are, however, some signs that the deflationary pendulum has reached the end of its swing and may be about to swoop back in the other direction. Or, at the very least, there are signs that investors are beginning to expect it to. The ‘other direction’, at least to begin with, means ‘reflation’. This is when factors like rising spending, consumption and credit growth force a spiral of rising prices,” he explained.
“As soon as the weight of expectation begins to switch from one to the other, volatility picks up, and market leadership changes.”
Mitchell says he has seen this switch many times before throughout his investment career and thinks there is a very good chance of it happening again soon. He says the next step will be bond yields continuing to rise and inflation steadily increasing.
As such, he thinks investors will finally stop prioritising safety over valuation – a pattern that he has witnessed since 2007 – and move towards allocating to broader and more diversified areas of the market.
Performance of indices since start of data
Source: FE Analytics
“You can think about it in terms of risk premium but, if you look at the share price of Nestle today, it basically implies you’re going to get a 1.5 per cent return from it. On the other hand, if you go to something like a really good quality bank such as Lloyds, it’s implying you will have a 15 per cent return,” the CIO continued.
“In the 30 years I have done this job I have never seen that before. That’s a risk premium which breaks all boundaries, I have never, ever seen it.
“It could be right in the sense that Europe goes into a catastrophic depression and the euro breaks up, that’s one explanation, and the only area that shows growth is the emerging world, but I’m not so sure. To us, that doesn’t look likely. But that is what the share price is telling you.”
Many investors have also resided themselves to a ‘lower for longer’ interest rate environment, which means the hunt for yield has taken precedence.
While investors initially piled into traditionally ‘safe’ fixed income assets for regular pay-outs, their popularity and subsequent fall in yield has meant dividend-paying ‘bond proxies’ have now gained favour among many income investors.
“Recessions after a financial crisis always last much, much longer than usual. There’s a process of deleveraging, it’s not their usual tactic of selling down the inventory after too much produce and therefore restoring the financial system,” Mitchell explained.
“But, if you study financial crises in the past, growth does come back eventually and maybe we’re seeing it already with inflation picking up.
“That will be the way we properly sort out the financial crisis. You can do it through austerity, but the way you really get rid of debt is with inflation. If we have inflation of 5 or 6 per cent in the UK - which we will do - for three or four years, you’ve taken 20 per cent off the debt just like that.
“I’m not so sure about the lower for longer environment. Maybe, but history will tell you something different. History will tell you that at some stage the economy will recover dramatically and at some stage quantitative easing will come back to bite you.
“All that money will eventually somehow end up in our own economy and you’ll see it in prices. But who knows.”
Another indicator Mitchell points out is that, while bond markets have indeed performed strongly year-to-date, their yields have gradually started to pick up over the last month.
As shown in the below graph, 10-year gilt yields have risen by 63.55 per cent since the start of August and, at time of writing, are at 1.2 per cent.
Performance of indices over 3months
Source: FE Analytics
“It’s interesting how bond markets are acting now. Something is really changing and if you look at share price action, the big international stocks which have done quite well recently are being absolutely hammered. Meanwhile, some of the stocks which we’ve been buying have started to do very, very well,” he pointed out.
“My guess is that people who have done quite well recently will receive a nasty surprise, it will be a very different market from what they might think. And they’ll dismiss it as just the junk rising and all that kind of thing. But of course, with a bit of inflation in the economy, the junk becomes the great stocks.
“That’s what I love about this job. People can go on about the golden stocks and of course the golden stocks become the junk. Before you know it, with slightly lower growth and some problems in emerging markets, those stocks have de-rated by half.”