UK small- and mid-cap stocks are showing signs of renewed appeal as investors eye the potential for stronger domestic growth and attractive valuations, according to UBS research.
The UK economy remains in a state of flux, with inflation unexpectedly rising to 3.6% in June, complicating the Bank of England’s path on interest rates.
Although the central bank is still expected to cut rates by a quarter of a percentage point to 4% in August, the wider economic backdrop is subdued.
Growth is fragile, with monthly GDP contracting slightly in May and purchasing managers’ indices hovering near the neutral 50 mark. Recession fears have eased, but economic momentum is uncertain.
Balancing act
UBS describes the current macroeconomic environment as “a balancing act” for the Bank of England, caught between sticky inflation and sputtering growth.
This uncertainty has translated into mixed earnings trends for UK companies. Overall, analysts have trimmed profit forecasts for 2025, with consensus expecting modest earnings per share growth of about 2% for the FTSE 100 and 15% for the FTSE 250.
The earnings outlook is uneven across sectors.
Commodity-related areas such as energy and materials are seeing notable earnings pressure after a strong 2024.
The more domestically focused and defensive sectors such as financials and utilities have more stable or improving earnings prospects.
Cautious resillience
UBS expects the upcoming second-quarter reporting season to show cautious resilience rather than outright weakness.
Valuations across UK equities remain attractive both compared with European peers and based on historical averages.
The FTSE 250 trades at a significant discount to the FTSE 100 and global mid-cap indices.
This discount is partly driven by the mid-caps’ heavy exposure to the UK economy, which is currently under strain, but UBS believes this creates a “sweet spot” for investors as UK growth stabilises.
UBS highlights a key trade idea: overweight the FTSE 250 relative to the FTSE 100.
Mid-cap companies tend to offer a better blend of valuation and growth potential, especially as they stand to benefit more directly from any domestic economic recovery.
Greater leverage
The FTSE 250’s higher weighting in financials and industrials also gives it greater earnings leverage to an improving UK economy compared to the more internationally focused FTSE 100, which is dominated by multinational companies with slower growth profiles.
Sentiment toward UK stocks has improved in July, buoyed by the FTSE 100’s recent record high above 9,000 and easing fears over interest rates.
Fund flows are turning positive, reflecting growing investor interest in UK equities after a period of scepticism.
UBS’s research suggests that while the UK market is not yet out of the woods, the environment is becoming more favourable for smaller and mid-sized companies.
Their valuation discount, combined with improving fundamentals, offers an opportunity to capture growth potential ahead of a broader economic recovery, the Swiss bank's analysts conclude.