Big middle sharpens hunger for risk

Mid caps are at the forefront of the British equity market rally, but performance is unlikely to be as robust as previously and despite an appetite for risk, high-quality stocks are desirable.

British equity markets have started the year strongly, with mid-cap stocks leading the advance. The FTSE Mid-250 index had risen by over 12% by late February, compared with a gain of just over 6% by the FTSE 100. The sector has thus already recouped more than half of last year’s performance deficit versus large caps.

Given this development, it is worth noting that the mid-cap sector was the harbinger of an aggressive and sustained wider rally in both 2003 and 2009. Domestic cyclicals such as pubs, bus and rail operators led the way in 2003, as share prices in these companies responded positively to the Bank of England’s base rate cuts.

By contrast, corporates that had been affected by the dearth of liquidity during the credit crunch drove the 2009 mid-cap upturn, as funding from banks, bond markets and equity markets picked up.

The industrials sector saw the sharpest gains, although investors also snapped up financially-exposed, consumer-facing stocks. In both cases, fund managers who had scurried for havens, such as utility companies, and those with visible revenue streams and strong balance sheets, lagged as risk appetite revived. (Trends continues below)

The performance of mid-caps in early 2012 appears similar to that seen in previous rallies. However, there are important differences. The most obvious is the limited prospect of economic growth significantly beating investors’ expectations this year given that austerity programmes are in place across Europe.

”A maker of precision measuring tools saw significant earnings downgrades alongside its results. Yet owing to a positive outlook the shares still posted strong gains”

In addition, most of the evidence points to spare capacity in the economy. And unemployment will not fall significantly during the initial stages of any recovery. Most emerging economies, meanwhile, appear to be growing at a slower rate than previously. This is a trend that the markets view as positive, since it allows policymakers to apply monetary and fiscal stimuli, while inflationary pressures could be abating globally, which again increases the scope for monetary easing.

Moreover, the slowdown in industrial activity towards the end of 2008 was so abrupt that the rebound was equally extreme and drove the sharp stockmarket rally of 2009. By contrast, the slowdown in economic activity that took place in the late summer and autumn of 2011 was not as bad as in 2008. Hence, the economic and stockmarket rebound is likely to be muted compared with that seen in the spring of 2009.

Was risk rally justified and can it continue?
Markets generally move on the expectation of bad news, yet paradoxically they often greet the eventual negative outcome with indifference. If the eurozone slides into recession in 2012, it is possible that investors will perceive the development as cathartic.

This would be particularly true if a contraction in the eurozone were accompanied by more positive developments in other parts of the globe, such as signs of a recovery in the American housing market and encouraging data from the manufacturing and services sectors.

However, the sustainability of any stockmarket rally depends on confidence. Investors have been heartened by the new leadership at the European Central Bank and its wide-ranging long-term refinancing operation (LTRO) in December. This programme, which involves three-year loans to Europe’s banks, has helped to remove the medium-term insolvency threat facing the region’s financial institutions.

Threats to investor confidence?
The rally could continue if the news from the fourth quarter earnings season is unchanged from that of late autumn 2011, and if earnings downgrades are mainly restricted to known weak areas.

The market has already shown its willingness to look through what it sees as ’the final downgrade’. Thus Renishaw, a maker of precision measuring tools, saw significant earnings downgrades alongside its results. Yet owing to a positive outlook the shares still posted strong gains.

It will also be interesting to see if stocks can deliver genuine, positive earnings surprises. Several of our mid-cap holdings saw downgrades during the second half of 2011, largely by sell-side analysts who injected a large dose of generic caution into their estimates.

AZ Electronic Materials is an example of this trend. This specialist technology company produces chemicals used in the manufacture of Apple’s iPad and iPhone, and management maintains the guidance issued before last summer, when the economic outlook was more upbeat.

In addition to the challenging economic outlook, geopolitical risks, ranging from Iran to Syria to North Korea, and later in the year, the American presidential election, could hurt equity markets. However, valuations appear sufficiently compelling to allow these concerns to remain on the back burner.

The outlook for mid caps
It is likely that mid-caps will continue to outperform if markets were to rally further, on the premise that the eurozone crisis will be contained, and that 2012 will see the nadir of global growth.

Moreover, the precedent of previous upturns shows that the most “distressed” areas are nearly always the ones that rise sharply once the rally is underway. We seek stocks that are viewed by the market as distressed or risky, but which are likely to be higher-quality stocks and hence less dangerous.

This fits our overall strategy of buying stocks for the long term. During any continued rally, these stocks would provide outsized returns, but would have a relatively low-risk profile.

Simon Haines is the manager of the Threadneedle Mid 250 fund.