Fidelity International: Shift in global dynamics an opportunity for mid-caps
George Efstathopoulos, Portfolio Manager, Fidelity International, comments:
'In recent decades, markets have predominantly been influenced by globalisation and the outperformance of large-cap stocks, particularly in the United States. However, recent trends suggest a potential shift as global policy divergence grows and regional dynamics gain significance.
The rise of tariffs and protectionism is hastening regionalisation, prompting a significant restructuring of supply chains and a move towards onshoring. In this context, domestically focused revenue generation emerges as an attractive theme, with mid-cap companies presenting unique advantages in this evolving landscape.
This trend is particularly evident outside the US, where the moderation of inflation is enabling central banks to adopt a more accommodative approach, signalling a potential turning point for mid-cap stocks. Furthermore, several evolving dynamics are proving advantageous for mid-caps on a global scale.
At present, the valuation gaps between mid-cap and large-cap stocks are historically wide, suggesting that mid-caps may be undervalued. Additionally, mid-caps are positioned to benefit from domestic industrial policies, infrastructure projects, and capital expenditure cycles, which align well with current economic trends.
While mid-caps globally present an attractive opportunity, certain markets are experiencing additional tailwinds that could accelerate and sustain this theme. These markets are undergoing multi-decade, if not generational, shifts in dynamics, offering compelling investment opportunities.
Japan's economic landscape is experiencing substantial shifts, signalling an end to the extended period of stagnation characterised by low growth, low inflation, and low interest rates. The situation is changing, with wage-driven inflation leading to increased domestic demand, which is transforming consumption behaviours after decades of economic inertia.
Japan's mid-cap stocks offer a compelling investment opportunity; they are largely insulated from JPY volatility, making them a stable choice. Additionally, mid-caps are closely aligned with the domestic economy, which is currently undergoing reflation spurred by positive real wage growth.
This favourable economic climate is reflected in improving fundamentals, as demonstrated by rising Return on Equity and profit margins among mid-cap companies. The narrative of structural corporate reform also seems to be benefiting mid-caps, evident in the significant increase in dividend yield.
Germany's fiscally conservative government is moving away from austerity and embracing substantial fiscal stimulus. In this environment, German mid-cap stocks, which are more cyclical, are poised to benefit from the transition from late to early economic cycles. These companies have a stronger correlation with PMIs, given their heavy industrial focus, and seem to have reached a low point.
Unlike large caps, mid-caps generate more revenue not only domestically but also across Europe, making them less susceptible to US-driven trade tariffs and competition from China. Furthermore, mid-caps are more responsive to short-term interest rates, and with the European Central Bank on an easing trajectory, further easing is anticipated in the coming quarters. This environment is favourable for mid-caps, whose earnings are more sensitive to GDP growth compared to large caps.
China is probably the only market globally where we see easing across monetary, fiscal, and regulatory policies. With a notably high savings rate, China’s mid-cap stocks could benefit significantly if policymakers choose to stimulate domestic consumption, the second engine of China's dual circulation economy. This is particularly timely as the first growth engine of exports faces increasing challenges amid escalating global trade tensions.
While earnings in the offshore market have been improving, the rest of China's equity market has been relatively uneventful. However, this could change with further fiscal expansion. In a world increasingly characterised by trade protectionism, it would be advantageous for China to boost domestic demand, rather than rely solely on exports. This strategy would not only mitigate tariff impacts but also help rebalance the economy and tackle deflationary pressures, fostering more sustainable growth.
Unlike offshore tech stocks, which can be sensitive to fluctuations in US Treasury yields and trade policies, onshore mid-caps are typically more attuned to the Chinese consumer. By using its fiscal capabilities to combat deflation and rebalance the economy, China can cultivate sustainable domestic growth, positioning onshore mid-caps as prime beneficiaries.
As the equity market regime established after the Global Financial Crisis - characterised by globalisation and large-cap dominance - encounters disruption, the emphasis on domestically generated revenue is becoming increasingly appealing. This approach is especially pertinent in countries experiencing notable economic transitions, such as Germany, Japan, and China. By seeking opportunities in mid-cap stocks within these regions, investors can engage with the shifting dynamics and opportunities arising from these changes, potentially achieving favourable returns in a fragmented global landscape.'
