UK mid-caps face signs of economic slowdown and pressure from a long period of outperformance
Investors in UK equities are being reminded of the quip from one of Bill Clinton’s election strategists, as they struggle for clear signals on the underlying economic health of the British economy amid the noise of the EU referendum campaign.
While Brexit risk has been something of a shadow over the FTSE 250 this year, the mid-cap benchmark’s prospects also depend on the state of the economy given the reliance its member companies have on the UK.
The benchmark’s 250 constituents earn 50 per cent of their revenue from the UK, compared with around 20 per cent for the FTSE 100, according to recent analysis from Credit Suisse.
With recent opinion polls suggesting a growing likelihood that UK voters will choose to stay in the EU at the June 23 poll, May has been a bright month for the index, taking it up 2.4 per cent.
That has not been enough to erase its losses for the year. The FTSE 250 is down 1.2 per cent since January, lagging the more internationally focused FTSE 100, which is up 0.3 per cent over the same period.
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While the risk of an exit from the EU has been a constant for the FTSE 250 all year, it is not the only story in town for investors weighing up stocks with a reliance on the UK. There is now a growing sense among investors that an underlying slowdown in the economy is worth paying attention to.
“Economic tailwinds which were helping the UK last year have eased as the referendum has approached,” says James Illsley, portfolio manager of JPMorgan’s UK Equity Core Fund.
“The rate of improvement on indicators that we look at, including those tracking consumer spending, has slowed, although they are still showing improvement. That reflects changes in the real economy, from effects including the impact on take-home discretionary incomes due to the bottoming-out in energy costs.”
Britain’s economic growth slowed in the first quarter, slipping to 0.4 per cent from the 0.6 per cent in the final three months of 2015. That reflects, in part, a slowdown in corporate capital expenditure as the referendum loomed.
However, the weaker pace also reflects a decline in household expenditure, which economists doubt is defined by Brexit risk, and could point toward deeper challenges faced by the economy.
“The UK could well be looking at the start of a natural economic slowdown, which relates to the withdrawal of stimulus measures, on which the recent period of sustained growth has depended,” warns Koon Chow, strategist at Union Bancaire Privée.
“The drop in consumer spending should not relate to specific political risk factors. There was a similar effect in the US, when it was being weaned off quantitative easing. In some ways, the prospect of Brexit and the wider disruption it would cause leaves the market with a sense of eerie calm into the vote, widening the scope for reaction afterwards. Turbulence is likely as the economy returns to the fore, but it will be more violent should the Leave campaign win.”
Such an outcome is looking less likely according to the polls, which have shown recent growth in support for the Remain camp, creating hopes of what Investec Securities called a “Bremain-bounce” for UK assets.
When dealing room calenders flip from June into July, Britain will either be free of the threat of Brexit or facing the start of a drawn-out withdrawal from the EU.
Either way, the underlying condition and the prospects of the UK economy will move back to the forefront of investors’ attention.
That will occur after a long period of relative strength for the UK mid-cap index.
Since the start of 2009, the FTSE 250 has outperformed the FTSE 100 by 92 per cent. That relative strength reflects the sustained recovery of the UK economy and also came as tumbling commodity prices took a toll on the resource-heavy blue-chip index.
This trend prompted fund managers to increase their exposure to UK mid-caps. Any signs that the domestic economy is faltering, especially after the commodities rout has shown signs of bottoming out, could prompt the unwinding of such trades.
JPMorgan’s Mr Illsley is clear on his intentions as the calendar flips over from May to June, and onwards beyond the vote.
His fund will continue to take a “bottom-up” approach to managing risk, aiming to minimise political and macro threats via its blend of stocks. It currently has financials as its main weighting, taking up 23 per cent of the fund from March 2016.
Even if the current shape of the polls proved right on June 23, the long, strong run higher for the FTSE 250 could leave it ready to revisit the days when it moved in lockstep with the FTSE 100.
If more clouds appear over the UK’s economic outlook, it could prove to be a brave bet that the mid-cap index will continue to outperform.
SOURCE: Financial Times
