UK small- and mid-cap funds have fared better than large-cap vehicles during spells of rising gilt yields over the last decade, data from FE Analytics shows.
This analysis follows a recent interview with Lazard’s Alan Custis, who told FE Trustnet that a rise in gilt yields and monetary policy tightening could cause a growth/value rotation towards the end of this year.
“To me, it feels like a re-run of last year again,” he said. “Bond yields have started to march up and this time perhaps for slightly better reasons than before – we are now in an actual tightening environment rather than anticipating the tightening environment, which was the case back then.”
Over the last decade, 10-year gilt yields have fallen by 72.94 per cent due to the Bank of England’s continuation of ultra-loose monetary policy following the 2008 financial crisis.
This has not been a constant decline, however, with yields having risen on an annual basis during 2009, 2013 and 2015.
Following higher-than-expected inflation and hawkish noises from the UK’s central bank, gilt yields have risen by 6.98 per cent year-to-date, having leapt by more than 25 per cent over the last month.
As such, we decided to look at the IA UK All Companies, IA UK Smaller Companies and IA UK Equity Income sector averages and see how they fared during previous periods of gilt yield rises.
During 2009, 2013, 2015 and year-to-date, the average IA UK Smaller Companies fund significantly outperformed the IA UK Equity Income and IA UK All Companies sectors.
When delving under the bonnet of the two latter sectors, the only funds to have achieved top or second-decile total returns during every one of these time frames were small- and mid-cap focused strategies, as shown in the below table.
Source: FE Analytics
Not only this, an average 98.32 per cent of funds in the IA UK Smaller Companies sector managed to beat the FTSE All Share index during these years, compared with 58.83 per cent in the IA UK Equity Income sector and 64.27 per cent in the IA UK All Companies sector.
Examples of IA UK Smaller Companies funds that have done particularly well during years when gilt yields have risen include M&G Smaller Companies, Investec UK Smaller Companies and Marlborough UK Micro Cap Growth.
Rob Morgan, pension and investment analyst at Rob Morgan, said: “If gilt yields are rising it usually means that inflation and/or interest rate expectations are on the increase.
“There can be a number of reasons for this but one is that the economy is doing well – and in that circumstance it is often domestically-orientated firms sensitive to the local economy that make the most progress.”
Jason Hollands, managing director at Tilney Group, added: “When the Bank of England raises interest rates, it’s usually a sign the economy is in good health and overheating and therefore they need to be less simulative.
“Obviously this is more accurately translated into small and mid caps because they are more domestic in nature.”
Given today’s unusual circumstances surrounding ongoing Brexit negotiations, though, Morgan and Hollands are sceptical that gilt yields are rising because of a strengthening UK economy.
Performance of index over 10yrs
Source: FE Analytics
“While this is the likely explanation for the correlation in the course of normal economic cycles, you shouldn’t necessarily expect it to always be the case,” Morgan pointed out.
“If interest rates rise for a bad reason – to guard against imported inflation primarily as a result of currency weakness for instance, and the economy is not doing that well, then smaller companies could struggle.
“I don’t actually think this is the case at the moment though and UK smaller companies do look reasonable value as a lot of people have written off the UK economy unfairly as a result of concerns over Brexit. I’m also not convinced interest rates, and gilt yields, will rise that much.”
Hollands also believes small and mid caps were oversold in the wake of the EU referendum as investors perceive them to be closely correlated with the UK economy.
However, he said another contributing factor to the strong performance of UK small and mid caps this year has been the strengthening of sterling compared to lows seen immediately after the vote for Brexit.
“It’s partly a reflection of a little bit of unwinding of some of the extreme reactions to the EU referendum and I don’t think it’s really driven by gilt yields,” the managing director said.
“Obviously we’re in a very different environment at the moment. we’re facing some headwinds from inflation outpacing wage growth as well as uncertainties around Brexit and wider political uncertainty.
“I don’t think the economy is racing ahead but there is no doubt the Bank of England are moving towards a more hawkish stance because I think they recognise they need to tackle inflation.”
Hollands is currently underweight gilts with a preference for equities, and deems the UK equity market to be fairly valued. While he is not significantly overweight the market area, he believes a lot of funds that invest further down the market cap spectrum have been sold off as a knee-jerk reaction.
“A lot of this is to do with fears about Brexit which we think are unmerited to the extent that the UK equity market is not the UK economy,” he reasoned. “Even mid caps in aggregate deliver half of their revenues outside of the UK.
“It is common to mistake the UK equity market as some kind of proxy play on the UK domestic economy.”
In a future article, FE Trustnet will look at the fund picks for investors looking to gain exposure to UK small and mid-caps.