Over the past year UK mid-caps have been one of the best performing asset classes from the point of view of a sterling investor. What has made the outperformance especially interesting is that it has been driven largely by sectors facing the domestic consumer. In recent months, the places to be have been financials, retailers, property, travel & leisure.
The question now is will it continue? The global outlook remains key and as leadership in global recovery turns from east to west, the US will become increasingly critical. In our view, the conditions for a self-sustaining recovery in the US are now in place. Whilst growth in the second quarter of the year will likely be a little softer than initially expected, the impact of fiscal tightening and a weak global economic backdrop has clearly been felt. However, moving in to the second half of 2013 and into 2014 gives reason for optimism.
The outlook for the consumer looks positive; employment numbers continue to modestly improve and consumer confidence is high. Elsewhere, manufacturing data appears to also be gaining momentum. The strong improvement in the housing market is driving stronger construction activity, whilst increasing house prices are positive for the wealth effect and, therefore, consumer spending.
Fiscal contraction, which really started in the second quarter, is estimated to reduce overall growth by about 1.75 per cent in 2013. However, this represents the high point and the drag on the economy will start to reduce in 2014 and beyond. Many economic forecasters are predicting growth to round out this year in the region of 2.5 per cent and to accelerate a little further in 2014, with consensus looking for 2.7 per cent.
We believe the underlying improvement in the US economy has to be positive in a global context and for equity markets. Elsewhere, a feature that is becoming increasingly apparent is that developed economy data has been improving, versus low expectations, whilst emerging market economic data has been deteriorating.
This is positive for economies like the UK, where GDP forecasts have been modestly revised up, and for the eurozone, where conditions remain weak but the pace of decline appears to have moderated. We need to remain mindful that a marked deterioration in emerging economies could be a significant risk to the outlook but we believe the global economy can cope with a modest slowing in the rate of emerging market growth against a backdrop of improving developed economic activity.
Overall, it feels to us that our thesis of around 3 per cent global real GDP remains intact. This should give nominal GDP in the region of 5 per cent to 6 per cent. In this environment we should expect to see modest corporate profit growth; we think mid-single-digits for the UK market as a whole and a little bit more for the mid cap area. Valuations are not expensive. The UK market is trading on around 12x one year forward earnings, with the mid cap index trading at around 14x. In our view, although the valuation multiple has been expanding the UK market is not expensive compared to its long term average of 13-14x and a premium for the mid cap index to the overall UK market is not unreasonable given its strong relative fundamentals; typically stronger earnings growth, better diversity and greater dynamism compared to the large cap index.
It’s been a very strong period of performance for UK mid-caps. However, if we are right on the global economic outlook and the relative strengthening of developed economies relative to emerging then the prospects for the UK mid-cap market continue to look attractive, in our view.
Richard Watts is manager of the Old Mutual Mid Cap fund