(Bloomberg) -- The outlook for Britain’s smaller stocks is improving more quickly than that of their blue-chip peers, with a brighter economic backdrop set to boost profits. 

Analysts are raising earnings estimates for the domestically focused FTSE 250 faster than for the FTSE 100 as recession worries ease and inflation cools, according to data compiled by Bloomberg.

Investors are taking note. The post-pandemic underperformance of domestic UK stocks has opened up a near-record gap between relative earnings expectations and valuations to larger peers. That means stronger company results could reignite these smaller, cheaper names.

“The backdrop has changed but the valuation hasn’t, and that creates a really exciting window of opportunity for small- and mid-caps in the UK,” said Georgina Hamilton, a fund manager at Polar Capital. “We’ve had some pretty tumultuous years, but now we’re seeing the biggest swing in sentiment since Brexit.”

The domestic index — comprising mainly financial firms, retailers and industrial companies — has lagged amid anemic economic growth and political turmoil. The FTSE 250 has declined about 4% since the end of 2020, while the large-cap index — home to the likes of Shell Plc and Unilever Plc — has rallied a whopping 24% to trade near record highs.

Mid-caps’ 12-month forward earnings estimate has increased 9% since last summer, while the index has only gained about 4% over that period. The stark gap has made these stocks among the cheapest in two decades relative to the FTSE 100.

“We think the UK offers one of the best entry points in its history,” said Goldman Sachs Group Inc. strategists including Guillaume Jaisson and Sharon Bell. “Given its attractive valuation and strong earnings, we argue that the FTSE 250 has some space to rebound.”

A lot hinges on a turnaround in macro growth, with latest data showing that the UK economy expanded for a second month in February following a shallow recession at the end of last year.

The Goldman team found that the FTSE 250’s performance relative to the FTSE 100 is closely correlated with the Purchasing Managers’ Index, a measure of business activity. With the reading showing signs of improvement, the FTSE 250 is poised for a “catch-up trade,” they said.

Bets are also growing that the Bank of England will reduce interest rates earlier than the Federal Reserve, with swaps data pointing to August as the heavy favorite for a cut as UK inflation cools faster than in the US. 

This could benefit smaller stocks more than large caps, according to Liberum strategist Joachim Klement. He calculates that the FTSE 250 would gain 2.8% for every percentage point reduction in rates compared with a 1.8% advance for the FTSE 100.

Judging by its recent performance, it would be some feat for the FTSE 250 to pull ahead. Until 2020, the gauge outperformed in 12 of 17 years by an annual average of 13 percentage points. It has since faltered in a post-Covid world as stronger global growth propelled the FTSE 100’s firms, while an upcoming UK general election adds to political risk.

Moreover, strategists remain bullish about the FTSE 100’s prospects. The equity strategy team at Deutsche Bank AG sees the index providing the biggest upside to European stocks more broadly as its cheaper, more value-oriented constituents rally along with an improving economy.

Yet there are other factors working in favor of smaller stocks, including a pickup in domestic corporate mergers. Data compiled by Bloomberg showed that buyers — both foreign and domestic — have announced $17.8 billion of acquisitions of listed companies in the UK this year, compared with just $2.9 billion in the same period of 2023.

Share buybacks have also provided a catalyst. This was the best-performing strategy for FTSE 350 firms in Bloomberg’s factors to watch analysis in the past year.

“Mechanically, valuations should tick higher as buybacks increase, but if the bounce in profitability can be maintained at the same time, then it could draw more investors back to the UK,” Barclays Plc strategist Emmanuel Cau said.

--With assistance from Michael Msika and Alexandra Muller.

©2024 Bloomberg L.P.