July 5, 2022

Britain’s ‘Squeezed Middle’ (Caps)

by Dewi John.

There has been a strong disconnect between the FTSE 100 and 250 indices since the start of the year. The FTSE 100 is a developed market top-performer, whereas its mid-cap sibling is in line with much less impressive performance of European large caps (chart 1).

 

Chart 1: European, US and UK Indices’ Performance, Year-to-Date

Source: Refinitiv Lipper

 

I’ve scratched my head as to why European (predominantly large caps) and UK mids have marched in lockstep over the year, and don’t have an answer—the composition of each is quite different, for example. Drop me a postcard if you can explain it, but I’m shelving IT under “one of those things” for now.

 

Open for Business?

I’m going to take a slight detour from the FTSE 250 itself to look at the UK economy more broadly. This is because the UK’s growth prospects are highly relevant to the mid-cap index, as it has far more UK exposure than FTSE 100, so is more sensitive to what goes on in the domestic economy. Indeed, to a large degree, it is the domestic economy.

First, the bad news: UK consumer confidence is falling faster than OECD peers (chart 2), with growth predicted to be worse than all other OECD members apart from Russia. The unfolding trade dispute with the European Union over the Northern Ireland protocol is unlikely to brighten this picture.

 

Chart 2: Developed Market Consumer Confidence

Source: Refinitiv Datastream/Fathom Consulting

There is some longer-term good news, however—although, as we’ll see, this is heavily skewed to large cap. In some respects, the UK looks like a good place for business. The UK is an innovative country, ranking forth in Global Innovation index, ahead of many European peers (other methodologies score the UK lower, though this is probably the most authoritative).

But this comes with a heavy caveat, highlighted by the then Bank of England chief economist well before COVID hit. Exactly four years ago, Andy Haldane complained there was no mechanism for the transmission of productivity for all but the largest UK companies. “When it comes to innovation, the UK is a hub without spokes”, said Haldane—the hub being the heavy innovators, and the spokes the channels through which innovation spreads.

“Since 2008, productivity in the UK has essentially flat-lined”, he added. Even then he was of the opinion: “This is almost unprecedented in the modern era, a ‘lost decade’ and counting. The UK faces perhaps no greater challenge, economically and socially, than its productivity challenge”.

Indeed, the UK has been a laggard since at least the global financial crisis, as the Office of National Statistics pointed out the UK saw the largest proportional fall in the level of gross fixed capital formation (GFCF) of any G7 nation after the pre-financial crisis peak of Q1 2008, falling by 18% from peak-to-trough. Between Q1 1997 and Q2 2017, the UK had the lowest average GFCF as a percentage of GDP of any OECD nation.

In other words, the structural issues that Haldane pointed to four years ago have led to persistent lower growth—something unlikely to end while those structural issues are themselves not remedied.

 

COVID and Beyond

Largely in response to COVID, the government has injected almost £1 trillion into the economy—more than any other UK government at any other time. That, as an economist I used to work with never tired of saying, is a good night out by anyone’s estimate. This hasn’t acted to stimulate production above its sub-par trend, however. Things, if anything, have worsened since Haldane’s 2018 comments, with investment and productivity growth anaemic.

The Bank of England noted at the end of Q2 last year, “Over recent years, business investment in the UK has been weak”. Although it expected a recovery in investment post COVID, this has not materialised. So, with a recession looking increasingly likely, UK growth anaemic if not negative, and its consumers not even on life support but left in the hospital corridor on a gurney, those companies with strong domestic exposure (in relative terms, mid caps) don’t look a particularly rosy prospect.

 

Sector Selection

There is a stronger trade-off between inflation and employment in less open economies than their more open peers. With April’s CPI at 7.8%, these effects are exacerbated. The UK has become less open since Brexit, especially those that started with a greater domestic focus—which tends to mean those entities below the FTSE 100. To what extent can companies control costs or pass on cost increases, is therefore a question with increasing bottom line impact.

 

FTSE 250 ex-IT sector weights

Source: Refinitiv Workspace

 

Taking a snapshot of some of the biggest stocks in the three largest sectors:

Consumer cyclicals, at 22.7% of the index: Bellway is down about 35% YTD; M&S is down 42%; Inchcape is down 27%, and Travis Perkins is down 35%: all with big exposure to UK consumer.

Industrials, at 18.4%: engineer Weir Group is down 16% (with growing short interest noted); EasyJet is down 30%.

Financials, at 14.8%: this FTSE 250 sector is dominated by insurers, and asset and wealth managers, rather than the large banks in the FTSE 100. With profit margins that expand as rates climb, these operations generally benefit from higher rates. Insurance disrupters are burning cash at an alarming rate, so this is perhaps good for the traditional incumbents that inhabit the FTSE 250.

Another point of note is that dividend-reliant stocks do comparatively well in a rising-rate environment. FTSE 100 companies are expected to pay out about £80bn of the £90bn this year. Most to the rest, unsurprisingly, will come from the FTSE 250. However, it’s not all about blue-chip cash cows.

At the end of April, FTSE 250 dividend yield was about one percentage point lower than for the FTSE 100. However, a number of FTSE 250 companies pay out in the high single digits, particularly financial services companies. So, while UK mid caps overall are getting hammered, with little sign of respite, financials with robust dividend streams look to be an interesting part of the index.

 

A Bad Year for Active Managers

At the fund level, the biggest losers over the first five months of year have had the largest tilt to Consumer Services. Those suffering the smallest falls—none are in the black over the period—have been tilted towards industrials and financials.

Only two actively managed funds with more than 80% in mid caps had beaten the index over the first five months of the year, with some losing as much as 28%, compared with trackers’ losses of just above 12%. Despite this disparity, passive funds with the FTSE 250 as a benchmark has seen outflows of £763m YTD, while their active peers have suffered just £474m of negative flows.

 

Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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