State Street SPDR ETFs: European small-cap equities - are doves preparing for takeoff?

7 juni 2024

Yesterday, the European Central Bank (ECB) cut interest rates and the Swiss National Bank and Riksbank have already begun loosening monetary conditions. Meanwhile, economic growth in Europe was better than feared in Q1, alleviating recession worries. This European version of a soft landing may allow small caps to fare well over the coming months given their sensitivity to rates and economic conditions.

Achieving a Delicate Balance

Yesterday’s long-awaited rate cut may have been baked into expectations, but given the restrictiveness of the Federal Reserve (Fed), an element of uncertainty remains — hence the rate cut could now provide a tailwind to rate-sensitive small-cap stocks. Within Europe, markets expect that the Bank of England is likely to keep rates at the current level at least until August.

Krzysztof Janiga, Senior Equity Strategist at State Street SPDR ETFs:

'The beginning of rate cuts, however, is less important than the trajectory that follows. As the year progresses, central banks in Europe may have a cleaner path to continue easing as growth remains lower than in the US. But that growth, while still soft, has been improving in Q1 as Germany avoided recession, GDP growth in France came in at +0.2%, and Spain at +0.7%1.

In the UK, a recessionary period ended with GDP jumping by 0.6% quarter on quarter — the strongest growth since the end of lockdown. All of these growth numbers exceeded expectations. While these are not stellar growth rates, European economies may be achieving a delicate balance between growth and disinflation, a potentially favourable backdrop for small-cap equities.'

Valuations Remain Appealing

Despite relatively strong performance in May and the recent rate cut, price-to-earnings (P/E) multiples for European small caps remain attractive on an absolute basis and relative to the MSCI Europe Index. The MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index trade at a discount of 17% and 14%, respectively, compared to the long-term average. Moreover, the MSCI Europe Small Cap Index trades at a 7% lower P/E compared to MSCI Europe, while historically, small caps traded at a 3% premium on average.

Cyclical Sector Composition

The MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index both overweight Industrials and Real Estate. Industrials makes up 25% of the index and the sector is supported by multiple structural tailwinds including defence spending, investment in infrastructure including green transition or energy security, as well as broad reshoring efforts.

Real Estate is another significant overweight; while the sector has been battered, it may now be well supported by disinflation, the economic slowdown supporting lower rates, the structural housing shortage in Europe, and undemanding valuations. The MSCI Europe Small Cap Value Weighted Index also overweighs Financials, which accounts for 22% and benefits from a high interest rate environment as consumers remain relatively resilient. Another overweight is Materials, an interesting sector given the recent surge in commodity prices. 

On the other side, the index underweights Consumer Staples and Health Care — both defensive sectors. Therefore small caps are a higher risk-reward exposure not only because of the size but also due to the sector composition.

Country Composition

From a regional standpoint, European small caps are overweight the United Kingdom (30% of both the MSCI Europe Small Cap and the MSCI Europe Small Cap Value Weighted Indices) as well as Nordic countries. The Euro area accounts for only 40% of the MSCI Europe Small Cap Index, which is a significant underweight compared to both the MSCI Europe Index (52%) and the MSCI Europe Small Cap Value Weighted Index (47%).

Perhaps the most important distinction between small and large caps lies in the domestic bias of smaller companies which derive approximately 60% of their revenue within Europe, while the corresponding number for the MSCI Europe is 42%. This makes small caps potentially better positioned to capture the benefits of reshoring efforts.