Generally, the decades of globalisation were marked by abundant ‘supply’ of goods and services, often from low-cost economies. Whenever the economy slowed, central banks just injected extra ‘demand’, given that there was ample headroom in ‘supply’. During the 2008 financial crisis for example, the Bank of England was able to cut interest rates from 5.75% to 0.5% to engineer a recovery. Since 2008, the Bank of England has kept the economy going by adding yet more ‘demand’ using quantitative easing whenever necessary. All this has worked out well for investors, because ‘demand’ has been more than satisfied by ‘supply’, so inflation never took off.
An anxiety about our reliance on long-distance supply routes eventually initiated a change of trend. The logistical problems during the global pandemic further amplified these concerns. When Russia invaded Ukraine in early 2022, the application of sanctions underlined the risk of relying on remote suppliers yet further. Meanwhile, central banks injected yet more ‘demand’ during the pandemic to keep businesses from failing. The net effect is that ‘demand’ now exceeds ‘supply’, and inflation has returned. Insufficient ‘supply’ is a nightmare for central banks, as inflation forces them to suppress ‘demand’ to bring it into balance with ‘supply’, via a recession caused by increased interest rates.
During the first half of 2022, as the gravity of these implications became evident, the valuations of many bonds and equities began to fall away. Going forward, as ‘demand’ declines, we now expect corporates to begin running short of sales, with potential price wars as they seek to hang onto customers – economic recessions are normally associated with weakness in both corporate sales and margins. Cash-flow negative businesses are particularly vulnerable at such times, as any shortfall in sales and margins shortens the time before they run out of cash. Alongside, high indebted businesses also risk insolvency due to rising interest rates and falling profits.
Interestingly, listed small-cap companies may have the advantage during recessions especially if they are already generating surplus cash. By acquiring viable but formerly over-indebted businesses, debt-free, at knock-down prices from the receiver, they can boost their future cash surpluses. Sometimes these kinds of deals can deliver ‘transformational’ uplifts for small-caps.
The bottom line is that the UK’s heritage of inflation over the last century means that the UK stock market is distinctive in having a vibrant universe of quoted small and micro-caps. The key point is that immature businesses can sometimes sustain growth even when the global economy is in recession. Furthermore, as noted above, quoted small and micro-caps can sometimes generate transformative returns on top by acquiring businesses from the receiver.
With global interest rates rising, we believe that economic conditions will become tougher. But alongside we also believe that these economic trends could favour the Miton UK MicroCap Trust. Indeed, with the unsettled economic and market trends, we believe there are likely to be few assets that perform as well as UK-quoted small and micro-caps. Furthermore, given that so few institutions have weightings in UK-quoted small and micro-cap stocks, we believe that the new trend might be reflected in renewed capital allocations and outperformance that could surprise in terms of its scale and duration.