Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why European Small Caps Are Surging While Economies Stutter
Transcript
- Lucas: European small caps are beating large caps by the widest margin in two years, and almost nobody is talking about it. Luna: Really? Because all I hear is worry about Eurozone growth stalling and the geopolitical headlines out of Eastern Europe and the Middle East. Lucas: Right, and that's exactly why this is interesting. Let me give you the numbers. The VGK, which is the broad European stock ETF, is up about 1.8 percent in the last five trading days. That's a solid week. But if you look under the hood, it's the small and mid-cap exposure that's really driving it. Luna: Is there a specific small-cap ETF we can point to? Lucas: There isn't a perfect single ticker for the whole region, but the iShares MSCI EMU Small-Cap ETF, ticker SCZ, has been on a tear. Up about 3.5 percent over the same period. Compare that to the broad EZU, the Eurozone large-cap ETF, which is up 2.1 percent. That's a meaningful spread. Luna: So investors are rotating into smaller companies even as the macro picture looks fragile. That feels like a bet on domestic demand over export-driven giants. Lucas: Exactly. Large European companies — think your big automotive exporters or industrial conglomerates — they're heavily exposed to global trade and China demand. And right now, China's economy is still sputtering. Plus, the trade-weighted dollar has strengthened to 119.3, which makes European exports more expensive outside the eurozone. Luna: The dollar at nearly 119 on the trade-weighted index is a headwind for any European company that sells in dollars or competes with dollar-based rivals. Lucas: Correct. Meanwhile, small caps tend to be more domestically focused — they sell within their own country or region. So if the Eurozone economy isn't collapsing, they benefit from that base level of activity. And right now, the data shows Eurozone real GDP grew at a 2 percent annualized rate in the first quarter, up from just 0.5 percent in the previous quarter. That's not booming, but it's a clear improvement. Luna: Two percent annualized isn't anything to write home about, but it's a lot better than the stagnation people feared six months ago. Lucas: Exactly. And the ECB has now paused rate hikes. The market expects rates to stay on hold through at least the summer. That's a tailwind for smaller companies because they tend to carry more floating-rate debt than large caps. When rates stop rising, their interest expense stops climbing. Luna: So the reasoning is: rates peak, domestic demand holds up, small caps get a double boost from lower rate sensitivity and a better local economy. But does the data actually show that playing out across countries? Lucas: Let's look at two specific ETFs. The German market ETF, EWG, is up 1.6 percent over the past week. That's decent. But the Italian ETF, EWI, is up only 0.5 percent. Italy's economy still has structural fragilities — higher debt, weaker banks. The small-cap rotation is happening more in core Europe than in peripheral countries. Luna: That makes sense. Germany's small and mid-cap sector includes a lot of hidden champions — family-owned manufacturing firms that are highly profitable. Italy's small caps are more in services and retail, which are more cyclical. Lucas: Right. And the French ETF, EWQ, is up 1 percent. Spain, EWP, up 0.4 percent. So there's a clear gradient: the stronger the underlying economy, the bigger the small-cap lift. But I want to stress that this is still a rotation, not a stampede. The question is whether it can sustain if a geopolitical shock hits. Luna: And that's where I get skeptical. We're seeing headlines about the Iran war fueling inflation worries, consumer sentiment hitting record lows in the US, and the new Fed chair, Kevin Warsh, being sworn in this Friday. If the Fed keeps tightening, that could strengthen the dollar further and hurt European exports all over again. Lucas: That's the bear case. But here's the counterargument: the dollar strengthening actually makes European assets cheaper for foreign buyers. And we've already seen the euro slip to 1.16 against the dollar, down from 1.17 last week. A weaker euro is a tailwind for European stocks when measured in dollar terms, which tends to attract global capital. Luna: So the rotation could have legs if foreign investors start buying European small caps as a value play. Lucas: Precisely. Small-cap valuations in Europe are still cheap relative to large caps. The price to earnings ratio on the MSCI Europe Small Cap index is around 13. Large caps are closer to 15. And with the ECB on hold, there's less risk of a valuation multiple compression from higher rates. Luna: Thirteen times earnings is not demanding, especially if earnings stabilize. But I want to push back a little: a lot of those small companies are not very liquid. If a real crisis hits, you could see a sharp sell-off because there aren't many buyers. Lucas: That's a fair point. Small-cap ETFs have wider bid-ask spreads during stress. But the market isn't pricing in a crisis right now. The VGK is up, the European financials are steady, and credit spreads haven't blown out. The market seems to be saying: we can handle a slow-growth environment as long as there's no recession. Luna: So the thesis rests on the Eurozone avoiding a recession. Q1 GDP data was better, but that's backward-looking. The PMI data for May comes out next week. If that disappoints, this rotation could reverse quickly. Lucas: Absolutely. The May PMIs are the next big catalyst. If they show the services sector holding up while manufacturing stabilizes, that would be very supportive for small caps. If they drop sharply, then all bets are off. Luna: For a listener who wants to act on this, what's the simplest way to get European small-cap exposure? Lucas: The easiest is probably the iShares MSCI EMU Small-Cap ETF, SCZ. It covers eurozone small caps. If you want UK exposure too, there's the Vanguard FTSE All-World ex us Small-Cap ETF, VSS, but that's global. The biggest risk to watch is liquidity: don't go all in at once. Add positions in tranches to manage volatility. Luna: And keep an eye on the euro-dollar exchange rate. If the euro drops below 1.15, that might indicate deeper problems that hit small caps harder. Lucas: Good call. The euro at 1.16 right now is fairly weak but not crisis-level. If it breaks below 1.12, that's a different story. But for now, the market is saying that European small caps are worth a look. The rotation is real, but it's conditional. Luna: Conditional on no recession, no major geopolitical escalation, and the ECB staying patient. That's a lot of conditions. Lucas: It is. But in a world where large-cap growth stocks are priced for perfection, small-cap value in Europe offers a margin of safety. Not every trade has to be a home run — sometimes singles add up. Luna: Alright, let's see if the PMIs deliver next week. Thanks Lucas. Lucas: You got it. We'll check back in a couple of weeks.