Gervais Williams and Martin Turner, managers of the Miton UK MicroCap Trust look at the reasons behind the Great British Sell-Off and whether it provides an opportunity for micro-caps.

The effect of the US giants

Whilst there was a broadening of market participation in the global stock market rally in the final part of 2023, this new momentum softened again into the year end, and in the early part of 2024, US mega-cap outperformance has become the dominant theme again. US GDP accelerated in the final quarter because of extra spending under the terms of the Inflation Reduction Act, funded by an increased government deficit. The net effect was that US company results typically outpaced market expectations, with Nvidia’s share price in particular rising dramatically.

US stock market outperformance continues to weigh on the valuation of the UK stock market. During the globalisation decades, the low-beta nature of the UK market has led to its return and its valuation lagging other markets. Overseas investors withdrew capital, so they could participate in superior returns elsewhere. As the returns on the seven large US mega-caps – the so-called “Magnificent Seven” – have accelerated upwards over recent years, UK investors have also reduced their UK weightings. The chart overleaf details the scale of accelerating pace of recent UK OEIC redemptions.

UK Equity Funds annual flows

Source: Numis research

What has this meant for UK stocks, particularly micro-caps?

This adverse trend has weighed most heavily on UK-quoted small and micro-caps. Whilst local selling of UK mainstream stocks may have accelerated, large caps at least have the luxury of generating surplus cash, some of which they have been able to redirect into buying back their shares, thereby offsetting local redemptions. As a result, the return on FTSE 100 Index has largely kept pace with other global exchanges. UK small and micro-caps are typically investing for the future, so few are generating enough surplus cash to use to buy back stock.

What do we expect from here?

The current global economic outlook is mixed. Whilst elevated interest rates have dampened global demand, this has been offset by extra stimulus in the US. In the first half of 2023, the Federal Reserve loosened market liquidity to help address the growing issue of near-insolvency amongst a number of regional banks. This was followed by the injection of a substantial fiscal stimulus to the economy via the Inflation Reduction Act. As economic growth accelerated in the US as 2023 drew to a close, elevated interest rates without extra stimulus led to weakening economies In Europe and Asia.

Headwinds for 2024

While many stock markets may have appreciated over 2023, the headwinds for 2024 look more challenging. There is little economic momentum in Europe or Asia, suggesting that even with major interest rate cuts, these economies appear set to weaken in the near term, as the effect of any cuts will take time to feed through to the wider economy. Meanwhile, a larger US government deficit may help boost that economy, but it comes with additional bond issuance that may sap market liquidity.

Given current US economic growth, US mega-cap share prices have started 2024 well. But the longer global interest rates remain elevated, the greater the dampening impact on demand. When demand falls below supply, customers have pricing power and corporate margins can be vulnerable. This has already been seen amongst traded goods, with the prices of electronic goods and cars coming under downward pressure. In time, we can expect a similar trend in the service sectors, which importantly comprise a much larger part of the global economy.

A particular opportunity for micro-caps…

This will be a challenge for all businesses, both large and small, but larger companies are potentially more vulnerable. When demand weakens, large cap businesses can struggle to pick up additional sales elsewhere, at a rate fast enough to offset declining demand. In contrast, whilst some micro-caps may suffer, their immaturity means that those with resilient business models have a greater chance of keeping their businesses moving forward.

If the global downturn were to be more severe than expected, then quoted micro-caps with relatively strong balance sheets and the potential to raise additional capital might have an even greater chance of bucking the trend, by investing at a time when others are constrained. Return on capital at times of distress can generate much greater uplifts than normal, and can be transformational to quoted micro-cap returns.

…as UK prospects start to improve

Meanwhile, the prospects for UK investors may in fact be improving. January’s inflation rate fell to 4% from a peak 12 months earlier of over 10%, and is forecast to fall further over the next few months. As a result, UK interest rates, together with those of other European economies may be set to come down before those of the US. Such cuts, together with the Chancellor’s recent budget announcement regarding a ringfenced UK ISA, have the potential to reduce UK OEIC redemptions and could even bring in some new capital from overseas investors, if they start to recognise that the UK stock market, and UK small/micro-caps in particular, are standing on such low valuations.

We therefore believe that the upside potential of the UK stock market is much greater than appreciated, and that the best performing part of it is likely to be UK-quoted micro-caps. In time, even professional small cap investors who have little micro-cap exposure may find they need to participate, or else risk underperforming. Hence, we anticipate that UK micro-caps, when their recovery finally comes, might appreciate a lot faster than expected for a decade or more.