UK mid-caps: an improving outlook

Sentiment towards Britain as an investment destination seems to be improving. Sterling is back above $1.30, while the mid-cap FTSE 250 stock index is at its highest since April 2022 and has outperformed the large-cap FTSE 100 over the last three months. Since the FTSE 250 is seen as the best gauge of domestic sentiment – nearly half of its constituents’ sales come from the UK, compared to around 20% for the FTSE 100 – that may imply views on the UK economy are becoming more optimistic. 

Hopes for an end to the incessant political drama of the past few years must be helping. I wasn’t impressed by the substance of the agenda unveiled in this week’s King’s Speech, which was a mix of woolly aspirations (talk of boosting growth without the concrete measures that are needed) and further state interference in matters of personal choice (the resurrection of Rishi Sunak’s anti-smoking law). However, what matters is sentiment, and many will welcome evidence that Britain now has a rather dour, statist government, rather than a three-ring circus. 

There should be enough relief and goodwill to give Labour a chance to come out with some solid proposals for fixing the housing and infrastructure crisis. So you can make a pretty convincing case of why this rally will continue. When a market as unloved as the UK begins to turn the corner, even small bits of good news are fodder for bulls.

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Are UK mid-caps set to shine?

The reason I struggle with a long-term, strategic argument for being bullish on UK mid-caps is the one I set out in March, around the time that the FTSE 250 seems to have picked up. The market has hollowed out. Good companies get bought because they are cheap. New ones don’t list. The mid-market gets smaller and potentially lower quality on average (what’s left is what buyers don’t want). I’m sceptical that the new listing rules will change that. 

So FTSE 250 trackers still don’t appeal to me that much. I’d rather look at the UK as a market where a lack of interest may create opportunities for picking stocks or whole sectors. On the income side of my portfolio, I’ve begun accumulating some of the larger infrastructure and renewable energy trusts. When interest rates were near zero, these traded at premiums to net asset value (NAV). Now they trade at sizeable discounts, partly because higher rates mean higher debt costs (which may reduce their returns, since they tend to use debt to part-fund investments) and partly because a 4% yield on a government bond has made them less compelling in comparison. 

There are obvious risks. Infrastructure trusts could be beneficiaries of a government that wants investors to help rebuild Britain, but also targets if they look like they are profiteering (I am cautious about water assets). Renewable funds have even more complications, including exposure to volatile power prices. Still, the largest trusts yield 4%-7% in infrastructure and 6%-8% in renewables (depending on dividend growth rates). At this point, they seem worth a look.

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