Valuations are attractive, earnings growth remains strong, and the potential flow dynamics from the US are encouraging. Of course, the investment case is nuanced, and thorough analysis of stock dynamics remains crucial. Let’s take a closer look.

Why the UK?

President Trump has slapped a 10% tariff on all UK goods. While tariffs are never good, this rate is more favourable compared to the EU (currently 10% with the threat of 20%), Mexico/Canada (20%) and China (145%). At the same time, the UK has limited dependence on US trade compared to many other regions. In 2023, exports to the US accounted for 1.8% of GDP, compared to Ireland (18.5%), Germany (3.5%), and Canada (22.3%). Importantly, services are excluded from these tariffs. In 2023 the UK exported £126.3 billion worth of services to the United States, which accounted for 27% of all UK services exports [1].

The FTSE 100 Index is also a relatively defensive market. While it includes many companies that generate revenues overseas, particularly in the oil and gas sector, it is also home to giants in the utilities, tobacco, and fast-moving consumer goods space. This makes it an attractive destination for investors seeking shelter from US volatility.

Meanwhile, the FTSE 250 and UK small and mid-cap stocks are largely domestically focused, with small-caps generating around 50% of their revenues in the UK. While not immune, many small-cap operations have a degree of insulation against external pressures and uncertainty.

UK markets are also reasonably unique in offering income, which becomes a more appealing factor when markets are selling off globally. True, UK income had a tough March due to the dominance of energy names, which rebounded with oil prices. Banks, on the other hand, had a poor showing. Nonetheless, the prospect of a long-term income will remain appealing during periods of turmoil.

Ask Reeves

The UK government is working hard to support markets. Measures include adjustments to stamp duty, changes to ISA allocation away from cash towards stocks, and pension reforms to stimulate market activity. Disappointing growth outlook numbers have put further pressure on the government to act. The home-focused UK small and mid-cap stocks are well-placed to benefit from these measures. Pension allocations to UK small caps are already creating a virtuous cycle, where flows drive returns and returns drive additional flows.

Feel flows

These factors should help drive inflows as US investors look overseas, and UK and European investors increasingly invest in their own markets. This raises the question: is US exceptionalism over? Even before Trump’s actions, investors were already concerned about the weight of their US allocations. Valuations were rich. Since the start of the year, capital has exited US equities, and the market has underperformed all other geographies. Trump’s aggressive and erratic tariff policy has exacerbated the matter.

Of course, the US remains the largest economy in the world, with numerous dominant industries, notably tech. Indeed, last year 75% of the MSCI World Index performance was due to US stocks. However, we expect unsure investors to increasingly diversify both geographically and down the market cap scale, including UK small and mid-caps. Data shows big institutional capital has started to flow out of the US. We’ll watch to see if and when retail money follows suit.

It’s also interesting that in 2024, 50% of global equity returns came from just eight US stocks. Historical data suggests that starting from valuations seen earlier this year, the S&P 500 may generate no returns over the next decade.

Details, details

Direct tariff exposure is important for many companies. That said, the potential fallout from slumping GDP or recession, alongside secondary factors like deteriorating global trading conditions, are critical for measuring a company’s outlook and earnings risks.

We conducted thorough analysis on each stock in our UK small-cap portfolio, measuring both the direct and indirect impact of tariffs. Of the top 10 holdings, we believe eight have no tariff exposure and two have very limited exposure. Among stocks 11-20, seven have no tariff exposure, two have manageable exposure, and one might struggle, although it is better placed than its peers.

Growing earnings

The earnings power of UK small caps remains a compelling factor. In 2024, the asset class delivered high single-digit returns without a re-rating, propelled by robust earnings growth.

Our analysis following the tariff announcement indicates that while pressures may evolve as the year progresses, we do not foresee a significant risk to earnings growth.

It's also important to note that while UK small caps are more domestically focused, they are not a direct reflection of the UK economy. Despite the Bank of England forecasting GDP growth of 0.75% annualised this year, our portfolio’s earning growth is expected to reach 16% [2].

Attractive valuations

There has been some price/earnings compression between markets due to the US sell-off. Nonetheless, the UK remains undervalued relative to its historical norms and is significantly cheaper than other geographies. Given the potential upside, we believe that now is an opportune time to pick up bargains in robust companies.

Final thoughts…

Markets will likely remain volatile for the coming months. Against this backdrop, UK small and mid-caps present a unique and compelling investment opportunity. Favourable valuations and strong earnings growth create the potential for significant returns. The asset class is also ripe for flows as investors seek to diversify away from the US or markets exposed to the US and global trade. Meanwhile, UK government measures to stimulate growth should help drive domestically focused small and mid-caps.

So, while Trump will continue to dominate the international headlines, we believe investors who turn their attention homewards could be well-placed to reap rewards. Call it a reverse Trump trade.

Next steps…

We’ve been investing in smaller companies since the late 1990s. If you’re considering reviewing your portfolio and exploring opportunities within UK small caps, visit our website to learn more about our expertise.