Navigating the UK Smaller Companies Effect
This week, we look at a realistic base case scenario for the coming year’s global economy, financial markets and the knowable attendant risks. The central thesis remains that the UK and its smaller-listed companies offer significant upside. But, as Maslow said, to a man with a hammer, everything looks like a nail.
First, the battle against inflation has been won, and rates will fall with setbacks along the way. However, it is unknown how quickly this will happen, mainly due to the continued strength of the US economy. The consensus is for a soft landing, something considered improbable only six months ago. What is clear is that the longer rates are at levels the Fed itself describe as restrictive, the greater the probability that something breaks. There are already emerging cracks in the banking sector.
China and Europe face recession. China suffers from the three Ds of debt, demographics, and deflation with the liquidation of its vast residential property developer China Evergrande last week, just the latest visible sign of this damaging trifecta. Meanwhile, German de-industrialisation caused by its disastrous energy policy has led the Eurozone into a significant slowdown, with financial and political consequences increasingly evident.
While the UK is not immune from these problems, its economy has a greater services focus and has proven more resilient than most estimates. Since the Brexit vote eight years ago, expectations regarding the UK’s economy have been low, capital flows into the UK have been weak, and UK assets have become cheap relative to peers and history. This is a positive setup for the UK smallcap investment opportunity.
Following a prolonged period of post-Brexit constitutional crises, this year’s general election will be a relatively low-key affair involving the transition of power from one technocratic centrist PM to another. The UK’s relationship with Europe will not feature in the campaign, and even the thorny issue of Northern Ireland is starting to be resolved. All this contrasts markedly with elections for the next US president and the EU parliament. Whoever wins the US election, 50% of the voters are unlikely to accept the result, while the European Parliament looks set to return a majority of Euro-sceptic MEPs.
More broadly, with increasing evidence of the passing peak of ESG, Western politicians have been forced to reconsider the vital trade-off between net zero and economic growth. The unexpected Uxbridge by-election result was sufficient for the main UK parties to backtrack on flagship green policies. Brussels, Berlin, and Paris required more forceful reminders from their farmers. But the result is the same: electorates have shifted the debate, forcing politicians to be more honest about the cost of net zero and the impact it has on its citizens. As Jean Claude Junker said, we know what needs to be done. We just don’t know how to get re-elected once we have done it.
As 2024 progresses, policy rates will fall, and yield curves can normalise. They have started to flatten and can begin to slope upwards again. The changing term structure of interest rates impacts asset classes differently. History suggests it increases market volatility and disperses returns, conducive to active stock picking, the value style, and smaller companies. It must be accepted that the memo on this has yet to reach the Magnificent Seven.
Nonetheless, such financial conditions will disproportionately favour UK assets, which global investors have hitherto regarded as value traps. As capital percolates into the UK, the most significant price action will be in the least liquid shares. The period after the dotcom bust in 2001 saw rates and market concentration fall with a sustained outperformance of the value style and smaller companies. The market performance in Q4 last year was a foretaste of what will come.
However, inevitably, there will be bumps along the road. Let’s look at the main known unknowns.
While the US economy can grow despite higher rates, it is terminal for some, such as indebted commercial real estate landlords. There is an emerging rerun of last year’s US regional banking difficulties, this time not based on bond values but on exposure to office blocks and apartment buildings. The concern is credit risk, not duration risk, which is a more challenging problem for regulators to contain. The S&L crisis in the 1990s took over a decade to tidy up.
The longer rates remain high, the more apparent it becomes that the only entity that can afford to borrow at such elevated levels is the US government, provided by its exorbitant privilege of issuing the world’s favoured pristine collateral; others are less fortunate. Without checks on the rate of sovereign debt issuance, global liquidity risks being sucked from the rest of the world into a rampant dollar—the so-called Dollar Milkshake Theory, threatening the return of the Dollar wrecking ball, the cause of so much damage in 2022.
While one cannot ignore rising geopolitical tensions or the human tragedies involved, the world’s hot and simmering cold wars are so far being regionally contained, the global economy is adapting effectively, and supply chains have coped. Container rates have spiked, lead times have extended, and some commodity prices have risen, but energy prices continue to ease. We can only hope that this remains the case and wider conflagration can be avoided.
The final known unknown is the emerging deflationary recession based on China’s looming structural problems. Last year saw the first net fixed capital divestment of foreign investors from China in twenty-five years, and its stock market remains incredibly weak. Emerging market investors are reluctant to put good money after bad, particularly after Russia’s invasion of Ukraine delivered them a zero on their Russian value bets. Meanwhile, last year Mexico overtook China as the US’s biggest export partner. China’s authorities are pulling all the levers at their disposal to reinvigorate its economy and mitigate the impact of falling asset prices, but this has, so far, been to negligible effect. Brian McCarthy, the former Head of Macro research at Carlyle Group, thinks China’s financial system is the biggest bubble and Ponzi scheme the world has ever witnessed, and China is going the way of Japan in the 1990s.
None of these risks needs to be terminal to a positive outturn for stock markets, particularly the UK smaller company segment. However, neither can they be ignored as obstacles to our base case of falling inflation, falling interest rates, normalising yield curves, and increased capital flows into the UK. Increased global equity allocations to the UK, a reversal of outflows into fixed-income as rates moderate and a recovery of new issue opportunities would deliver the long-awaited re-assertion of the smaller companies’ positive performance effect.
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