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In the bleak midwinter

January’s large-scale falls followed last year’s weak showing by the UK’s mid-tier stocks. After a number of years of excellent returns, 2007 was tough for UK mid-caps, with the FTSE 250 finishing down by 2.5 per cent.

Mid-caps had previously surfed the global wave of liquidity, with share prices boosted by rampant takeover activity. They were a popular hunting ground for private equity and corporate buyers.

Strong economic growth also served to buttress mid-caps but the party had to end at some point. Declining risk appetites in the aftermath of the implosion in the US sub-prime market led to a re-rating of mid-cap equities that dragged the FTSE 250 down by 6.6 per cent in the second half of 2007. Investors sought the relative comfort offered by large-cap stocks, preferring their perceived superior defensive qualities and more predictable earnings.

The key to the prospects of UK mid-caps lies with the fortunes of the broader UK economy. The mid-cap part of the market is dominated by domestically-focused companies. Industrial and consumer services firms have a far greater presence in the FTSE 250 than the FTSE 100, making the mid-cap index a handy barometer for the health of the UK economy.

This state of health is now in question. Weaker consumer sentiment, reflected in sluggish retail sales, tighter credit conditions and worries over a deteriorating housing market, are widely accepted as pointing to a downturn in the previously buoyant UK economy. Fourth-quarter GDP figures suggest that this slowdown is already under way, with quarterly growth of 0.6 per cent representing the lowest level of growth since the third quarter of 2006.

In this environment of uncertainty and heightened volatility, it is difficult to anticipate how the UK equity market and, in particular, mid-cap stocks may fare in the coming months. We share much of the market’s concern over the UK consumer.

Housing transactions are falling and may remain subdued for some time, which may have a material adverse impact on retail sales. Higher interest rates and taxes will hamper overall consumption patterns.

But there are mitigating factors that should not be overlooked – rising wages, supportive employment figures and an arguably understated economic boost from immigration.

Nor is it entirely clear what is happening on the high street. Disappointing Christmas trading by retailers such as Tesco, Next, Debenhams and Woolworths may have grabbed the news headlines but it is not all doom and gloom, with Morrisons, John Lewis, Sainsbury, HMV, Game and Boots enjoying strong trading over the festive period.

Large swathes of the stockmarket are already reflecting a recession but there has been a tension between apparent valuations and perceptions of operating and financial gearing. This will be another challenging year from a valuation perspective but if markets realise a recession is not happening in certain areas of the economy, then there may well be some major valuation anomalies to exploit.

One area where valuations seem to be overly downbeat is house building. Share prices have been very weak in recent months following stockmarket concerns over the possibility of a sharp fall in house prices but prevailing share prices discount a fall in property prices that is arguably far too pessimistic, even given the evidence of a significant decline in housing transactions.

These extreme valuations have seemingly registered with investors of late and the household goods sector of the FTSE 250, which largely comprises housebuilders, has been one of the bestperforming parts of the mid-cap market in 2008, with the likes of Bellway and Bovis Homes withstanding the broad market sell-off.

The outlook for the UK economy and stockmarket is decidedly opaque and the most uncertain it has been for many years. We expect our individual stockpicking approach to come to the fore in identifying the numerous opportunities that market gyrations will produce.

Tony Willis is head of UK equities at Lazard Asset Management

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