Weaker but still strong data from the United States and the combination of moderate inflation with better-than-expected growth in Europe create an attractive entry point for Small Cap on both sides of the Atlantic.
He writes it Francesco LomartireHead of SPDR ETFs for Southern Europe underlining that “with levels of valuation of Large Cap Once elevated, the market rally began to broaden with investors looking for opportunities across all sectors and market capitalization segments. The Small Cap “may be well positioned to take advantage of this trend, given attractive multiples, recovery potential, cyclical sector composition and a greater focus on the domestic market in a context of deglobalisation. Although there are some common characteristics, Small Cap exposures are never the same. As a result, each geographic area is exposed to specific risks and opportunities.”
US Small and Mid Caps: Accommodative Signals and Long-Term Resilience
At this stage of the cycle, inflation data “they will continue to influence thehe performance of Small Caps. US Small Caps suffered a sharp decline in April, when the higher-than-expected CPI led to increasingly restrictive forecasts and an increase in yields. Since then, we have seen a rebound driven by several dovish signals, including: 1) the May Federal Reserve (Fed) meeting, which was less restrictive than feared; 2) weaker than expected Q1 US GDP growth at an annualized rate of 1.6% and 3) slowing wage growth to 0.2%. While rising CPI remains a key risk for equity markets, including Small Caps, recent data suggests the possibility of a more accommodative outcome than markets are currently anticipating.”
US GDP growth “it has slowed down, but the data for the 1st quarter did not put an end to the narrative on the exceptional nature of the United States, where growth continues to be much higher than in other countries in the developed world, driven by consumption which, thanks to the labor market, is remained extraordinarily resilient in the face of restrictive monetary policy. The economic expansion in the United States has been chronically underestimated, leading to continuous upward upgrades of forecasts GDP for 2023 and 2024″.
Moderate wage growth, combined with low unemployment, “It's an optimal scenario for Small Caps. Monthly wage growth of 0.2% along with productivity gains could allow the Fed to make an accommodative turn in July or September, while the extraordinarily low unemployment rate of 3.9% supports domestic consumption. In the long term, the resilience of the labor market is fundamental to the prosperity of the most national and cyclical Small and Mid Caps.”
The small and mid-cap indices – explains the expert – “generate between 76% and 79% of their revenues within the United States, while for the S&P 500® Index this value is equal to 59%. This makes the Russell 2000, MSCI USA Value Weighted and S&P MidCap 400 indices the most direct tools for accessing exceptional US growth. But every strategy has a profile particular:
- in the index S&P MidCap 400 more traditional companies occupy a greater weight. For example, the sector with the greatest weight is Industrials, an interesting aspect if we consider the rise in the ISM data. In the long term, public spending resulting from the Infrastructure Investment and Jobs Act, the CHIPS and Science Act, the Inflation Reduction Act and extensive efforts to reorganize supply chains (so-called “reshoring”) will likely favor small and medium-sized businesses. Cap with characteristics more oriented towards the domestic market and the industrial sector.
- The Russell 2000 Index It is overweight biotech companies and software stocks, which are often in an early stage of development. In our opinion this means that the index has a higher risk-reward profile.
- The MSCI USA index Small Cap Value Weighted, on the other hand, is more oriented towards financial stocks, which represent more than a quarter of the index.
The common feature of the three indexes is an allocation more cyclical and less tied to the technology sector, which could be a positive factor if a hard landing can be avoided and the market rally continues to broaden.
European Small Caps: opportunities from imminent rate cuts and improved growth
The European Small Cap landscape “has shown notable improvements in both absolute and relative terms over the course of 2024. Inflation in Europe is slowing more convincingly than in the United States, making June rate cuts the baseline scenario in 'Eurozone and the UK. Riksbank and SNB have already started the reduction process, providing a leverage effect for risky assets. The easing in Sweden is of particular importance, given that the debt maturity schedule is structurally short.”
Although disinflation is a highly desired but yet to be achieved goal, “the improvement in the investment scenario that had not been previously observed comes from better than expected economic activity. Germany avoided recession in the 1st quarter and GDP growth in France (+0.2%) and Spain (+0.7%) over the same period exceeded estimates. In the United Kingdom, the recession ended with a 0.6% increase in GDP on a quarterly basis: the highest growth since the end of the lockdown. All in all, economic activity is likely to remain much more muted than in the United States. However, the rate cuts on the horizon, the improvements in the economic outlook and the absence of recession are in our opinion creating favorable conditions for European Small Caps”.
Small Caps in Europe trade at economical multiples advantageous not only with respect to Large Caps, but also their history. The price-to-earnings (P/E) ratio at 13.0x is in the second-lowest decile over the past 10 years. During this period, on average, the MSCI Index Europe Small Cap traded at a P/E level 9% higher than the MSCI Europe Index. It is currently trading at a discount of 7%, one of the lowest levels in the last 10 years. These levels may represent an attractive entry point, as rate cuts are imminent and European economies are holding up better than expected.
The indexes MSCI Europe Small Cap and MSCI Europe Small Cap Value Weighted they generate 66% and 69% of their revenues in Europe respectively, so they have more national exposure than the MSCI Europe index, where that value is 42%. From a regional point of view, the Small Cap indices overweight the United Kingdom and Sweden, while the most significant underweights concern France and Switzerland.
Perhaps – explains Lomartire – the most important difference concerns the sectoral composition, with industrials accounting for almost a quarter of Small Cap exposure. This sector is supported by favorable long-term trends, including the green transition, energy security and the reorganization of supply chains. Another major overweight is Real Estate, a battered sector that could see a recovery now that the fight against inflation has been won and central banks in Europe are clearly more inclined to cut interest rates. The underweight in the healthcare and consumer staples sectors makes European Small Caps a riskier exposure from a sector perspective.
Global Small Caps from Developed Countries: A diversified exposure with attractive valuations
The MSCI World Small Cap Index it groups together both US Small Caps (which represent 60% of the exposure) and European Small Caps (which represent 18%). This helps balance the risks and opportunities associated with each region. The third highest weight is Japan, which accounts for 12% of the index, double its weight in the MSCI World Index. Although the weakening of the Yen has boosted stock performance over the past two years, negotiations in 2024 “Shunto” have led to strong wage growth, which represents a positive factor for Small Caps which have a greater focus on the domestic market. Furthermore, the Tokyo Stock Exchange reforms are expected to increase efficiency among listed companies.
As CPI levels gradually moderate around the world and the outlook outside the United States improves as well, “the opportunity opens up to adopt sstrategies that focus on recovery. Valuations remain attractive, both on an absolute basis and relative to the MSCI World Index. Finally, with regards to the potential broadening of performance, the MSCI World Small Cap index is less concentrated than the MSCI World index: the weight of the first 10 components is 1.9% versus 21.5% respectively”.
Emerging Markets Small Caps: More Direct Access to Economic Growth
Emerging Market (EM) economies continue to perform better than the developed world, but equity returns in these markets have been unsatisfactory, dragged down by Chinese stocks which face numerous challenges, including strict regulation of the sector technology, geopolitical tensions and weaker-than-expected economic growth. While Chinese stocks have rebounded over the course of the year, geopolitical and regulatory risks remain.”
The MSCI EM Small Cap Index “offers a simple solution to overcome these risks and obstacles, being heavily underweight China, which represents only 8% (versus 27% for the MSCI EM Index). On the other hand, India, the fastest growing economy, accounts for 27%. Rapid growth and the need to diversify supply chains make India an attractive destination for foreign capital, which is likely to flow into the country in the medium term in various forms. The second most important overweight is Taiwan, with 22% of the index. While geopolitical risks need to be monitored carefully, Taiwan remains indispensable in the semiconductor supply chain. The third highest overweight is South Korea, a technology powerhouse that offers access to a wide range of high-quality companies.”
Country breakdown was the main reason why the MSCI EM Small Caps Index outperformed the MSCI EM Index nohe last few years and we expect it will continue to be a positive factor until there is a sustainable improvement in China's geopolitical and regulatory landscape.
Furthermore, small caps in emerging countries “generate a larger share of their revenues domestically, allowing them to benefit more directly from their relatively strong emerging economies. The MSCI EM Small Cap Index is well diversified: the top 10 companies represent only 3% (versus 25% for the MSCI EM Index). Furthermore, state-owned companies, which may be less efficient, account for only 8%, as opposed to 23%. in the MSCI Emerging Market index”.
