Investment Comment: Mid caps will give you maximum exposure to the UK’s recovery

WHILE boom times remain far off, UK households are spending and sentiment is improving. The latest good news is that the UK economy grew at its fastest pace in three years in the third quarter, with economic output up 0.8 per cent between July and September. Earlier this month the IMF also lifted its UK growth projections, while trimming its forecast for the global economy as a whole. The fledgling UK recovery is outpacing that of many other major economies.

And as this growth is driven by domestic demand, it logically follows that the area of the equity market most exposed to UK domestic consumption will benefit the most from the recovery – UK mid caps (or the FTSE 250 index).

Why mid caps specifically? They give investors the best chance to benefit from the economic upswing, because recovering conditions tend to benefit smaller companies first. The FTSE 250 generates half its sales in the UK, and has a 50 per cent sector weighting towards cyclical sectors – a large part of which is consumer discretionary. The FTSE 100, meanwhile, generates less than 25 per cent of its sales in the UK, and cyclical sectors make up just 25 per cent of the index.

Timing is everything, however. The mid cap space has already performed strongly this year, so clients often ask why we think there is still an upside from here. It’s a valid point. The FTSE 250 has performed well in 2013, and is trading at a 10 per cent premium to its own long-run average, based on 12 month forward price-to-earnings. However, based on historical comparisons for current economic growth forecasts, our House View tells us there is still room for an earnings growth upside next year. We forecast UK real economic growth of 1.5 per cent for 2013 and 2.3 per cent for 2014. But should the economic recovery prove stronger than forecast, the scope for earnings upgrades increases, as does the outlook for FTSE 250 returns.

In addition, the recovery is now underpinned by the introduction of forward guidance by the Bank of England. Maintaining the current ultra-loose monetary policy stance until the unemployment rate reaches a 7 per cent threshold is likely to result in higher growth and slightly higher inflation expectations – an environment that should benefit equities.

It is important, of course, that investors maintain a global view. We also believe that mid-cap companies will outperform large caps in the US over the next six to 12 months. The relationship between market composition and economics holds as true for the US as it does for the UK. The greater domestic sales exposure and more cyclical sector composition of US mid caps make them a purer way for investors to gain exposure to the US’s ongoing economic recovery.

At last we are seeing evidence of a self-sustaining recovery, albeit at an unspectacular pace. We would strongly encourage investors wishing to maximise their exposure to the UK’s welcome economic recovery to head for the UK mid cap space.

Caroline Winckles is a strategist at UBS Wealth Management UK.