Trying to time markets is indeed a ‘fool’s errand’. Various industry studies have shown that over lengthy timeframes, market-timed portfolios routinely underperform. It’s a mug’s game. But let’s have a go, anyway – or, at the very least, muse on prospects for the FTSE 250.
The index has lost 8.4 per cent of its value over the past five years and is now 22.1 per cent adrift of its last high-water mark in August 2021. The capitalisation-weighted index is more domestically focused than the top-tier benchmark, so is generally more reactive to domestic economic trends over the medium to long-term. So, news that UK gross domestic product increased by 0.2 per cent in the second quarter and by 0.5 per cent in June should have dispelled some of the bearish sentiments that have suppressed valuations. Things are rarely that simple, however.
Even though the index is more indicative of domestic economic performance, its constituents are not immune to wider effects. And indicators of the global trade cycle are clearly recessionary. The S&P US Manufacturing PMI remained in negative territory in July, signalling a further, albeit slower, decline in operating conditions. European and UK manufacturing PMIs are also firmly negative. Meanwhile, June statistics from the International Air Transport Association show that global air cargo decreased by 3.4 per cent – that’s set against the continuing recovery in air passenger numbers. Industry is feeling the pinch.
The macro environment is being reflected in industrial input pricing. Iron ore prices have declined due to expected steel output cuts, while aluminium and copper prices have pulled back amid expectations of faltering Chinese demand as the country’s real estate market faces a renewal of its debt crisis.
Potentially the most consequential developments, at least in terms of the FTSE 250, have been the stronger-than-expected UK wage growth numbers for June, together with the increase in unemployment numbers and an accompanying drop-off in vacancies. These will be viewed as contradictory signals, but they will certainly inform the deliberations of the Bank of England's (BoE) monetary policy committee (MPC) when it sits down in September.
Wage growth (excluding bonuses) hit a record 7.8 per cent in the second quarter, exacerbated by the national minimum wage and living wage increases. This has stoked fears of an intensifying wage-price spiral, thus placing further pressure on the BoE to keep raising rates.
Any such move would be negative where equities are concerned, and somewhat at odds with unfolding sentiment given that gilt yields had been in retreat in the run-up to the data announcement, and mortgage lenders had been cutting fixed-term rates. The expectation was that we were approaching the apex of the current interest rate cycle – not the first time that this assumption has held sway.
Even with inflation cooling in July, the MPC will still need to determine the extent to which employers will be pressured to keep pay awards in line with inflation, a difficult assessment given the structural problems in the UK labour market post-Covid-19. It’s a real balancing act. Some commentators have suggested interest rate rises should be paused, given there is usually a lag between increased borrowing costs and their economic impact, so the second-quarter GDP data needs to be viewed in that context.
Nobody wants to see dole queues, but nothing dampens wage inflation more rapidly than the threat of job losses. And that threat will be monitored closely by regulators, who are being pulled in two directions by the need to keep a cap on prices, while avoiding a recession. If the latter imperative is eventually prioritised over the former, then we may see the UK base rate peak at 5.5 per cent. Such a scenario could be viewed as an inflection point by investors looking to exploit the historical price/earnings (PE) discounts on offer amongst the FTSE 250 constituents. That’s because the domestically focused index has historically outperformed the wider UK market in the periods immediately following a peak in interest rates. Analysts at Martin Currie make the point that the index’s 12-month forward PE stands at 11 times next year’s earnings, effectively “at the bottom end of the long-term range” and at a 20 per cent discount to the average multiple over the long run.
It’s worth adding that while the index's value has been under pressure, the FTSE 250 offers a forward dividend yield of 3.8 per cent, so it has delivered a total return of 14.2 per cent over the past three years according to FactSet. Even given conflicting signals and depressed index valuations, speculative exposure to the mid-cap index does not appear to be an outlandish proposition.
