If inflation falls more quickly than expected in 2023, small and mid-caps shares and private equity and the investment trusts that invest in these areas are likely to recover the fastest.
Investment fund analysts at Stifel put across this view in a note suggesting that inflation may fall more quickly than many expect.
Inflation is already likely to have peaked in both the US and UK consumer price index, the analysts said.
"We can foresee a scenario where inflation falls quickly during 2023, and this view seems to have been given some support from the Bank of England’s comments about interest rates peaking and inflation falling, following the rise in UK interest rates to 4.0% last week.
"We are more confident in our view today, than back in November and indeed it may even be becoming quite consensual."
Reasons why inflation may fall faster than the current consensus forecast include power prices falling significantly, a sharp drop in the money supply, the effects of a higher inflation ‘starting-base’ likely to be fully reflected by April, recent weakening of the US dollar leading to lower UK commodity import prices such as oil, with weaker economies also traditionally dampening inflation.
Therefore, they set out potential implications for the performance of several investment fund sectors.
Small and mid-cap companies have tended to be relatively sensitive to interest rates - both as a result of levered structures and because of the predominance of high growth companies that are relatively sensitive to discount rates in the sector.
Over the year end October 2022, the NAV total return of the UK mid cap trust sector declined 28% and smaller companies 29%, with the average price discount to NAV of 13% and 11% respectively.
"We would expect the Small and Mid-Cap funds to be one of the fastest areas to recover if the environment changes to falling inflation and lower interest rates," the analysts said, pointing to some signs of this in the last three months, with the FTSE 250 index rising 14.4% and the FTSE Small Cap up 15.9%, with the average discount narrowing to 9%.
Small cap trusts include Smithson Investment Trust, Henderson Smaller Companies Investment Trust PLC (LSE:HSL), Herald Investment Trust (LSE:HRI) and Odyssean Investment Trust PLC (LSE:OIT).
The private equity investment trust sector is sensitive to higher interest rates given leverage and the implications of higher debt costs on company earnings, the analysts said, along with the risk of valuation writedowns as a result of the falls in valuations of comparable-listed small and mid-cap companies, given that managers use earnings multiples in their valuation processes.
"We think a recovery in valuations of comparable listed companies, should be helpful for the sector. Similarly, less pressure on levered financial structures after interest rates peak would be helpful for investor sentiment."
Discounts for investment trusts in the listed private equity sector are around 30% to 40%. Companies include 3i Group PLC (LSE:III), HgCapital Trust (LSE:HGT) and Pantheon International PLC (LSE:PIN).
For technology-focused trusts, such as Scottish Mortgage Investment Trust PLC (LSE:SMT), the past year has shown the sensitivity to changes in interest rates, but the recent expectation of a 'Fed pivot' thanks to weaker inflation "would likely propel the sector back into favour – especially with earlier stage, unprofitable growth companies", the Stifel team said.
As for the commodities and mining sector, the analysts think lower inflation "may remove some of the investor enthusiasm for this sector, potentially resulting in some premium erosion and widening of discounts in such a scenario".
In renewables, a lower inflation environment is expected to result in funds not enjoying see the same exceptional gains delivered in the past year.