With monetary policy and inflation moving in the right direction, undervalued smaller companies could benefit from a broad-based economic recovery.
What a tricky investment environment to navigate in these days. While selective US macro data such as the labour market remains surprisingly resilient, the Eurozone has reported a repeated loss of growth momentum lately, which is widening the divergence between the two economies, Add the uncertainties related to the upcoming US elections, the geopolitical tensions in the Middle East and risks of an intensifying trade war with China and you get higher equity volatility as a result.
Yet, many equity indices recently reached new record-highs, fuelled by the start of a new and globally synchronized interest rate cutting cycle. This backdrop opens new opportunities. In a way, the stars are increasingly aligned for small-cap companies in Europe to catch-up both with their bigger rivals as well as with global small caps. This is because declining inflationary pressures and looser monetary policy create a more favourable backdrop for a catch-up in the performance of smaller businesses.
Several forces are at work here. Supply chain disruption during the COVID-19 crisis disproportionately impacted smaller companies. Large firms were able to use their greater purchasing power to ensure the supply of necessary components. Now that supply chains are running smoothly again, the greater margin pressures felt by small caps has eased.
Equally, smaller businesses, which rely on shorter-term borrowing and tend to have less excess cash put aside, felt the effect of rising refinancing costs faster and more strongly than large corporations did. So with the monetary policy tide turning, they are set to benefit more dramatically from falling interest rates. And that tide looks to have truly turned.
Globally, 26 interest rate cuts were recorded during the month of September, the fourth-highest monthly figure this century, comparable to those in December 2008 (27 cuts) and March 2009 (28 cuts) during the great financial crisis. The expectation is that the ECB will continue to cut rates as inflation falls closer to its 2 % target.
Stepping back, it's worth noting where we are in the business cycle. While the global economy has so far avoided recession, it still appears to be gradually slowing. Indeed, LGT has recently raised its recession forecast probability from 20 % to 25 % for the Eurozone, while cutting back the recession risk for the US from 25 % to 20 %.
Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.
So far, the manufacturing PMIs remain largely in contraction territory. However, a recovery in the PMI for the manufacturing sector, even if it takes time to materialize, could act as a positive catalyst for small cap firms and their earnings growth prospects. A potentially successful soft landing of the US economy combined with the latest Chinese stimulus programs may act supportive in this regard over time. History suggests that above-average performance is possible, especially in the first year after the manufacturing PMI bottoms out.
The well-known investor, Sir John Templeton, said, "Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria." The current bull market was born out of pandemic pessimism, with phases of great scepticism regarding economic growth and inflation risks accompanying its development.
Based on investor positioning we are somewhere between optimism and euphoria - clearly in a late-cycle environment. This creates ideal conditions for potential rotations in the market, such as in this case from larger to smaller stocks.
In the early phase of pessimism and scepticism, investors tend to position themselves in large cap, higher quality stocks. This trend has been extremely pronounced in this cycle, and we think that the extreme crowding into a narrow market segment has started to fade. Even a slight rotation into small caps, with just 15 % of overall European market capitalisation, could make a big difference. However, should a recession scenario materialize, then history suggests larger and higher quality stocks would be better positioned to navigate through such an environment.
Fundamentally, however, looking at the European small caps valuation - or undervaluation - should be encouraging for investors. The MSCI Europe Small Caps Index is showing a price-earnings ratio (one of the most common valuation metrics) of roughly 14 times 12-month forward earnings. Over the past 20 years, valuations have only been noticeably more favourable during periods of great turmoil, like the global financial crisis in 2009, the European sovereign debt crisis in 2011, and during and after the COVID-19 pandemic. In retrospect, investing in European small caps would have been worthwhile at each of these times.
Circling back to our introduction, the global economic and geopolitical backdrop obviously remains very complex and challenging, with several risks looming. Such risks could be a pronounced industrial recession, new trade tariffs following the US elections, an escalation in the Middle East accompanied by higher oil prices and a relapse in inflation pressure, which would narrow the room for further rate cuts.
However, with our base case scenario of a US soft landing, abating inflation and more interest rate cuts to come in mind, small caps in Europe look set to benefit from attractive valuations and neglected investor interest. Hence, for risk-tolerant investors, current conditions may offer an opportunity to diversify their equity positions.
