According to analysts, UK small-cap stocks could bounce back from years of lacklustre performance in the coming months as a combination of earnings growth and interest rate cuts boosts this segment of the market.
The smaller companies in the UK have had a rough time of it recently, with the FTSE Smallcap index down 8.4 per cent over the last two years, compared to a rise of around four per cent for the FTSE 100.
Flows into funds for UK companies have been even worse, with investors cumulatively pulling billions from UK-focused investment funds ever since Brexit.
“Within the UK, small caps and domestics have been more hurt by rising rates and falling activity,” explained Emmanuel Cau, Barclays head of European equity strategy.
Since domestically-focused businesses are more affected by the slowdown in UK economic activity, and higher interest rates have more of an impact on smaller companies that might be taking out more debt, this has left them suffering.
However, with the Bank of England set to cut rates in the summer, that might all be about to change.
“[Small caps] are currently trading at a 20 year low relative valuation to large caps, and with both activity picking up and rates likely to fall, they should be a key beneficiary of the market broadening out,” said Cau.
“Every UK small cap equity manager I’ve spoken to for the last four months has said when the interest rates start cutting, watch UK small caps, because historically, they have flown in a dropping interest rate environment,” said Jock Glover, strategic relationships director at Square Mile Investment Consulting & Research.
“Everyone says the UK is the cheapest market out there in terms of developed markets, and all the small cap managers are saying ‘Yeah, but we’re the cheapest we’ve ever been relative to the UK market,’ so you get that double whammy.
“When that elastic goes, suddenly the momentum traders will be jumping on it, Hargreaves will be selling out, it’ll all go because that’s the nature of markets,” he added.
Liberum strategist Joachim Klement calculated that the FTSE 250 would gain 2.8 per cent for every percentage point reduction in rates compared with a 1.8 per cent advance for the FTSE 100.
Meanwhile, analysts have begun raising earnings estimates for companies within the FTSE 250 and below, and managers are now ready for their bad luck to change.
Barclays’ Cau added that other factors beyond the upcoming rate cuts from the Bank of England could also assist small caps, with UK co-ordination with the EU appears to be improving across both parties, and the election potentially unwinding some of the risk premium placed on the UK.
Chris McVey, fund manager of the Octopus UK Multi Cap Income fund, also noted that for the first time in five years, small and mid caps companies in the UK are set to yield greater dividends than the FTSE 100 in 2025.
Bringing in dividend investors, who have traditionally been forced to go towards mega-cap companies like Shell for dividend payouts, could be a major boost for the smaller companies.
“As interest rates normalise, we predict investor appetite for small-caps will return, as people seek to benefit from the higher growth and opportunities provided by the asset class,” added McVey.