After a challenging 2016 for UK stocks some investors might be forgiven for eschewing mid-cap funds in favour of internally-focused large-cap, but AXA IM manager Chris St John and Jamie Hooper believe mid-caps will outperform in 2017. 
St John, manager of the AXA Framlington UK Mid Cap, and Hooper, who oversees AXA Framlington UK Growth, believe UK mid-caps were hit by a “perfect storm” last year that could be coming to an end.
Indeed, in 2016, mid-caps languished behind their larger peers for several reasons with the FTSE 250 index ending the year 12.41 percentage points lower than the FTSE 100.
Performance of indices in 2016
Source: FE Analytics
Hooper said: “It has been a perfect storm for the mid- and small-cap area because what we’ve had is unexpected political outcomes and with that came the decline in sterling.
“We’ve had a recovery in growth and inflation globally after many years of wondering whether we would get this post the financial crisis and then there has been a subtle shift in the way policy makers talk moving away from monetary policy to fiscal policy.
“As a consequence of that you had a very brutal and significant rotation in size, sectors, stocks and style. For once it was quite a good place to be in the larger cap area.”
St John added: “2016 was one of those wonderful years where nothing happened as predicted.
“Brexit had the biggest effect on UK equity funds because of the surprise because of the reaction banks had to it and because of the reaction the currency market had.”
Indeed, a reduction in the pound made dollar earners (typically found in the FTSE 100) that much more valuable versus domestic earners.
Performance of pound versus dollar since the EU referendum
Source: FE Analytics
“The tangible effect was the significant fall in the value of sterling relative to other currencies and that has implications for the value of sterling assets so you saw the mid-cap space – which is about 50 per cent UK earnings – selling off,” St John said.
“They were viewed as UK assets, priced in sterling, earning in sterling though only half of it was in UK sterling – but I think the perception is higher than that.
“As a consequence there was a translational effect which drove the FTSE 100 up and initially significantly downed the FTSE 250.”
As well as this, value stocks such as miners and oil companies improved last year on the back of rising commodity prices.
As the below graph shows, value stocks outperformed growth stocks in the UK last year by 17.22 percentage points – the first year it has outperformed since 2012 and only the third year since the financial crisis in 2008.
Performance of indices in 2016
Source: FE Analytics
As a result, miners, financials including the banks and oil companies all profited from this move upwards – most of which reside at the larger end of the market capitalisation spectrum.
Hooper said: “What we typically find is when value outperforms it is aggressive, it tends to be short and incredibly sharp.
“The market has favoured some of those big large cap sectors by way of upgrades, policy, starting valuations but I am not so sure they are going to be leading the charge from here – we think because markets are more finely balanced.”
However, on the whole, Hooper says there are positive signs for equity markets, with investor confidence relatively low at the moment along with an improving economic background.
“You have economic growth picking up globally and it seems to be quite synchronised at the moment,” the manager said.
“We’ve had earnings upgrades across the market predominantly driven by those large cap value companies that are sticking for the first time since the financial crisis.
“Meanwhile, if I look at things like fund flows and whether analysts are bullish or bearish, generally people are still a bit cautious on equities and you don’t get the sense that people are overly optimistic.”
One area that should benefit from this is the mid-cap space, where long-term investors have been rewarded for their patience.
St John said: “People tend to underestimate the power of compounding and the mid-cap market has been an area of the market where for a prolonged period of time that group of companies have managed to compound their earnings up at between 7 and 8 per cent per year.
As the below graph shows, mid-caps have outperformed their larger rivals over the long term, returning 44.31 percentage points more over the last decade.
Performance of indices over 10yrs
Source: FE Analytics
“So what you’ve seen over a prolonged period of time - clearly over any short time period the level of the market will be dictated by the capital flows more than the fundamentals – earnings and compounding earnings growth is what drives returns.
“There is one proviso which is the balance sheet of companies that you are investing has to be adequately capitalised so that the benefits of any growth accrue to the equity holders not the debt holders.”
Additionally, there are a lot of businesses out there that from a fundamental perspective will perform well this year because there are secular drivers alive and kicking that were there before Brexit and are there after Brexit as well, St John said.
“If you think about demographic changes and shifts in consumption, longevity, healthcare, the growth of the digital economy, industrial automation thematics were all alive and well before Brexit and will continue to be in the future and there are business that take advantage of that.
“Infrastructure spend looks like it is rising in the UK and abroad so companies that are selling into that are seeing increased demand. A number of industrial companies have come in recently and talked about improvements in their own markets.
“They’re not bullish these management teams because they have come from a global financial crisis and a long period that has been awful and they are very reluctant.
“There’s no great overexcitement about the trade industry, but a number of them are coming and in it seems that certain verticals are definitely getting better for them.”
He adds that as many have been through a difficult time they have “pared back their cost base, are much more efficient businesses and have worked out how to deal with operational gearing issues, so you could see quite an acceleration in the profit growth of some of those industrial companies”.