Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Small Caps Are Suddenly Beating Large Caps
Transcript
- Lucas: If you've been watching European markets this week, you might have noticed something unusual. Small-cap stocks are suddenly outperforming large caps across the Eurozone, and that hasn't happened in over two years. Luna: I did see it. The VGK — the Vanguard FTSE Europe ETF — is up about two and a half percent in five days. But the Germany ETF, EWG, is up over four percent. That's a big gap. Lucas: Right, and what's driving that is a subtle but real shift in how ECB rate cuts are landing. For the past year, the cuts were mostly helping large corporations that could refinance bonds at lower rates. Small companies don't have that luxury — they borrow from banks, and bank rates were sticky. Luna: So what changed? Lucas: Honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. But to answer your question: what changed is that the ECB's latest cut, combined with a signal from Lagarde last week that she's open to an early exit from tightening, finally got banks to lower their lending rates to small businesses. Luna: Yeah, it's the transmission mechanism finally working. I saw the ECB's bank lending survey from last month — it showed that loan rates to small and medium enterprises dropped by about thirty basis points in June. That's the first real decline in two years. Lucas: Exactly. And that matters because small caps in the Eurozone are disproportionately domestic. They don't have the dollar revenue that large exporters like BMW or LVMH have. So they've been getting hit from two sides: high borrowing costs and a strong dollar hurting their big-cap peers. Now one of those headwinds is fading. Luna: But the dollar is still strong. The trade-weighted dollar index is at 120.9 — that's down a hair from 121.06 a week ago, but it's still near multi-decade highs. How are small caps ignoring that? Lucas: Because they don't have to care. A small Italian manufacturer that sells only in the Eurozone doesn't care if the dollar is strong. In fact, a strong dollar might even help them indirectly if it hurts their German large-cap competitors. What they care about is their cost of capital and domestic demand. Luna: And domestic demand is still uneven. The Eurozone consumer confidence number improved last month, but it's still below pre-pandemic levels. Plus, the labor force participation rate in the US fell to its lowest in fifty years — that's a global signal that people are dropping out. Lucas: True, but let's look at where the outperformance is coming from geographically. The German ETF, EWG, is up four point one percent in five days. That's the biggest mover among the big Eurozone country ETFs. Italy, EWI, is up three point four percent. Spain, EWP, is up only one point seven. So it's not uniform. Luna: Why is Spain lagging? Lucas: Two reasons. First, Spanish banks have been slower to pass on rate cuts — their lending rates to SMEs dropped only ten basis points in June, compared to thirty in Germany. Second, Spain's economy is more exposed to tourism and services, which are still recovering unevenly. Germany's small caps are more industrial and have benefited from the recent pickup in manufacturing PMIs. Luna: So the rotation is real, but it's a German small-cap story more than a Eurozone-wide one. Lucas: For now, yes. But look at the UK — the EWU ETF is up three point one percent, and the UK has a lot of small-cap financial and consumer services companies that are seeing lower borrowing costs too. The Bank of England hasn't cut as aggressively as the ECB, but the expectation of cuts is already priced in. Luna: You mentioned earnings revisions earlier. Is there data backing up the rotation? Lucas: Yes. According to a recent note from Goldman Sachs, earnings revisions for Eurozone small caps turned positive in June for the first time in eight months. For large caps, they're still negative. The gap is about five percentage points. That's the kind of fundamental catalyst that can sustain a rotation. Luna: But small caps are more sensitive to economic growth. If the Eurozone economy slows further, won't they get hit harder? Lucas: They will, but the real GDP growth rate for the Eurozone just came in at two point one percent annualized for the first quarter. That's up from zero point five percent in the previous quarter. So the economy is accelerating, not slowing. That helps small caps more than large caps. Luna: Right, because large caps have already priced in a global slowdown. Small caps are more tied to local GDP. Lucas: Exactly. And there's another factor: the ECB's signal that it might stop hiking or even cut further. Lagarde left the door open to an early exit last week, and that's a huge deal for small firms that have been squeezed by high rates. If the ECB cuts again in September, the rotation could accelerate. Luna: But what about the flip side? If the dollar weakens, large-cap exporters could rebound and steal the spotlight back. Lucas: That's the risk. The dollar index has already edged down from 121.06 to 120.9. If it breaks below 120, you could see a rotation back into large caps. But the dollar is still strong by historical standards, and the Fed is not cutting anytime soon. So I think the small-cap rally has more room to run. Luna: How should investors play this? Is it as simple as buying a small-cap ETF like the iShares MSCI Europe Small-Cap ETF? Lucas: That's one way, but you have to be selective. Within small caps, look for companies with low dollar exposure and high domestic revenue. Also, avoid sectors that are still struggling with high debt — like real estate. The Southern European REITs we talked about in episode 82 are doing well, but that's a different story. Luna: What about currency-hedged ETFs? If the euro strengthens, that could eat into returns for US investors. Lucas: Good point. The euro has been flat at 1.14 against the dollar, so it's not a big factor right now. But if the ECB cuts and the Fed holds, the euro could weaken, which would actually help US investors. I'd avoid hedging for now. Luna: So bottom line: the small-cap rotation is real, driven by ECB rate cuts finally reaching small businesses, and it has fundamental support from improving earnings revisions and GDP growth. But it's not uniform — Germany is leading, Spain is lagging, and a weaker dollar could reverse it. Lucas: That's the summary. And the key number to watch is the ECB's September meeting. If they signal another cut, the rotation has legs. If they pause, we might be in for a consolidation. Luna: And for listeners who want to track this, which ETFs or indices should they follow? Lucas: The STOXX Europe Small 200 Index is the benchmark. For ETFs, the iShares MSCI Europe Small-Cap ETF, ticker IEUS, is the most liquid. And of course, the country-level ETFs we mentioned: EWG for Germany, EWU for UK, EWI for Italy. Watch the relative performance versus the VGK or the FEZ. Luna: Last thing: any individual stocks that epitomize this shift? Lucas: I'd look at companies like HelloFresh in Germany — it's a small-cap that's been beaten down but has strong domestic demand. Or Lindt & Spruengli in Switzerland — technically a mid-cap, but it has pricing power and low dollar exposure. But always do your own research. Luna: Good advice. So we'll keep watching the data. Thanks, Lucas. Lucas: Thanks, Luna. That's the European Economy Podcast for July 6th. We'll be back tomorrow.