Analysts say UK small-cap stocks could recover from years of lackluster performance in the coming months as a combination of earnings growth and interest rate cuts boost this segment of the market.
Smaller companies in the UK have not had an easy time of it recently: the FTSE Smallcap Index has lost 8.4 percent in the last two years, while the FTSE 100 has risen by around four percent.
Even worse were the inflows into funds for British companies: since Brexit, investors have withdrawn billions in total from UK-focused investment funds.
“In the UK, small caps and domestic companies have been hit harder by rising interest rates and falling activity,” said Emmanuel Cau, head of European equity strategy at Barclays.
As domestically focused companies are more affected by the slowdown in the UK economy and higher interest rates place a greater burden on smaller companies, which may take on more debt, they are suffering.
However, with the Bank of England set to cut interest rates this summer, this could soon change.
“(Small caps) are currently trading at a 20-year low relative to large caps. With increasing activity and likely falling interest rates, they are likely to be among the main beneficiaries of the market expansion,” Cau said.
“Every UK small-cap equity manager I have spoken to over the last four months has said to look out for UK small caps when interest rates cut because historically they have risen sharply in a falling interest rate environment,” said Jock Glover, director of strategic relations at Square Mile Investment Consulting & Research.
“Everyone says the UK is the cheapest market compared to developed markets and all the small cap managers say, ‘Yeah, but compared to the UK market we’re cheaper than we’ve ever been.’ So that’s a double whammy.
“When that rubber breaks, the momentum traders will suddenly jump up, Hargreaves will sell, everything will disappear, because that’s the nature of the markets,” he added.
Liberum strategist Joachim Klement has calculated that the FTSE 250 would gain 2.8 percent for every percentage point interest rate cut, while the FTSE 100 would gain 1.8 percent.
Meanwhile, analysts have started to raise their earnings forecasts for companies in the FTSE 250 and below, and managers are now ready to turn their losing streak around.
Barclays’ Cau added that factors other than the Bank of England’s impending rate cuts could also benefit small caps. For example, the UK’s bipartisan alignment with the EU appears to be improving and the election could lead to a weakening of risk premiums for the UK.
Chris McVey, fund manager of the Octopus UK Multi Cap Income Fund, also pointed out that small and mid-cap companies in the UK will pay higher dividends than the FTSE 100 in 2025 for the first time in five years.
Attracting dividend investors who have traditionally had to rely on large corporations such as Shell for dividend payments could provide a significant boost for smaller companies.
“As interest rates normalize, we predict investor interest in small caps will return as people look to capitalize on the higher growth and opportunities presented by this asset class,” McVey added.
