What’s on the horizon?

Are small and medium-sized stocks poised for a recovery in 2023? A bounce would certainly be welcome – while the FTSE 100’s positive performance last year saw the UK stock market grab headlines as one of few major exchanges to finish 2022 in the black, it was only larger company shares that gained ground. The FTSE 250, for example, dropped 19.7% over the year.

The measured tone struck by Bank of England Governor Andrew Bailey in remarks in recent days provides some cause for optimism. Mr Bailey isn’t ruling out further interest rate rises, but the Bank is now seeing inflationary pressures begin to moderate. That is potentially good news for small and medium-sized businesses in the UK, which tend to be more sensitive to higher borrowing costs – and more dependent on the domestic economy.

In this context, recent research from the investment companies analysis team at Stifel makes interesting reading. Even before Mr Bailey’s speech, Stifel was arguing that inflation might come down more quickly than expected over the next few months. Small and mid-cap shares, as well as funds exposed to them, could therefore recover quickly, the analyst argued.

That’s food for thought for advisers currently wondering about this year’s fund choices for clients’ ISAs – or about asset allocation more broadly. For those who buy the idea that small and mid-cap stocks are ready to accelerate, investment companies may offer value. Closed-ended funds exposed to these stocks fell even harder than the index last year, largely because the discount at which their shares trade relative to the value of the underlying assets widened markedly.

Some of that widening has already been unwound. Discounts averaging around 12% at investment companies with small and mid-cap exposure last October have since dropped to around 10%, reflecting better performance from this area of the market already this year. But there may be more value on the table, if gains can be sustained over the rest of the year.

Stifel also points to investment companies with private equity holdings as potentially offering value in this scenario. Unquoted company valuations are closely linked to comparable listed companies, so a recovery of small and mid-caps would help here. So too would a more optimistic interest rate outlook, since the private equity sector is even more sensitive to interest rate risk.

Indeed, arguably, the opportunity in the private equity sector is even more attractive – discounts, even at the most popular trust, broadened considerably last year as investors shifted into risk-averse mode. In some cases, discounts hit 30% or even 40%. Accordingly, there is even more headroom for attractive returns as market sentiment shifts.

None of this is guaranteed. The Bank of England remains nervous about what lies ahead – further interest rate rises are still very possible. Still, it feels as if the economic landscape is shifting subtly; some of the gloomiest forecasts for the inflation outturn in 2023 are beginning to look overblown. And if expectations of what is to come do now improve, so too will sentiment, particularly in areas most sensitive to the outlook.

Investment companies are not the only way to access small and mid-cap stocks, but they do have a strong track record in this area. It’s a good example of where specialist and experienced management can really add value. And a bargain basement valuation adds to the attraction.