Comment: Optimism rises as China, EU and US tides turn

So my congratulations to Jim Wood-Smith, equity strategist at Investec, for his contrarian optimism at The Scotsman investment evening last week.

Jim’s plea to stop seeing everything as a never-ending crisis was dramatically vindicated by markets. In a week that began with deep worries over the United States fiscal cliff, the eurozone crisis – yet again – and China’s slowdown, it was game, set and match to Jim as stock markets enjoyed one of their best weeks this year.

The FTSE-100 index broke through a resistance level of 5,800 to hit 5,827 for a gain of 215 points over the week, or 3.8 per cent, one of its best performances all year.

In the US, the S&P 500 index gained 3.2 per cent, while the Eurofirst 300 index rallied by more than 4 per cent.

What occasioned this upward burst, less one of optimism, of course, that’s off the table, but certainly one of hope? For most of this year markets have priced in deep apprehension over the course of economic and political events. America was staring into a debt abyss. German business activity looked to succumb to troubles in the eurozone. China seemed to be giving less support to global expansion.

What changed last week was that the outlook turned less negative. In China, the manufacturing purchasing managers index (PMI) for November rose from 49.5 to 50.4, the movement across the “boom-or-bust” line at 50, taken as a sign that China’s economy has turned a corner and is about to pick up speed. As Stephen Lewis, of Monument Securities puts it, these and other figures suggest Chinese gross domestic product (GDP) has established a new “normal” rate of growth of 7-8 per cent a year, rather more sedate than the 10 per cent which we came to take for granted.

In the eurozone, the “flash” November PMIs were slightly less weak than feared, contributing to a better feeling about global growth prospects. The manufacturing PMI, which arguably leads turning-points in the broader economy, turned up more strongly to stand at its highest since March.

In America, figures for housing starts are pointing sharply upwards. The October figure showed a 41 per cent year-on-year rise. The rate would have been higher, had it not been for preparations ahead of tropical storm Sandy. But that in itself should deliver a demand boost, with estimates of the cost of repairs and replacements ranging up to $450 billion (£280bn), equivalent to about 3 per cent of US GDP.

Meanwhile, there are signs of progress on talks over the US fiscal cliff. A budget settlement would probably be a big enough plus, says the normally saturnine Lewis, for global risk markets to outweigh the minus of soft US retail sales.

One resonant criticism made at The Scotsman investment evening related to the shortcomings – and quality – of the FTSE-100 index, heavily-weighted towards overseas mining shares. Beneath this lay a reminder – well illustrated in the presentations by Katherine Garret-Cox, of Alliance Trust, and Alan Porter, of Securities Trust of Scotland – of the importance of individual stock selection; don’t just buy the index.

It is too early yet to pronounce a recovery in the UK economy – we have the baleful warnings of Bank of England governor Sir Mervyn King that we are in for low growth with bumps and setbacks for the next few years ahead. But my sense is that the New Year will see a growing recognition of the importance of smaller companies as spurs to growth, and – hopefully – accompanying policy support. Alongside an unease that many of those giant FTSE-100 stocks may now have limited upside by way of share price, there is also a souring public mood about the tax‑ minimising practices of major global companies.

For these reasons, investor attention is likely to swing back to companies outwith the FTSE-100 – and with a renewed interest in smaller capitalisation stocks. Historically, smaller companies have long been associated with superior long-term returns – a perspective lost in the enveloping storm of the global banking crisis and a consequent stampede towards safety in size.

Characteristics of smaller companies that can turn in excellent share price returns include: consistency of returns on equity and capital; re-investment of profits to build the business, Aggreko being an outstanding example; talented management teams; solid balance sheets to ride out fluctuations in demand; and the ability to generate free cash flow.

For investors who want to lessen their exposure to the behemoths but who lack the time or aptitude to do the research, there are a number of investment trusts that specialise in smaller companies and which have an impressive record on stock selection.

Many have performed remarkably well over the past five stormy years. Heading the list is Standard Life Smaller Companies Investment Trust, managed by the legendary Harry Nimmo.

Others to consider are Dunedin Smaller Companies Trust and Invesco Perpetual UK Smaller Companies.