Weekly ETF Brief

Thriving through turbulence: European small caps surge

Despite prevailing uncertainty, the MSCI Europe Small Cap and MSCI Europe Small Cap Value Weighted Indices have delivered stellar gains so far this year. European small caps remain well positioned, in our view, benefitting from increased fiscal spending, monetary easing, and relative tariff insulation. Meanwhile, undemanding valuations combined with a robust earnings growth suggest continued momentum remains plausible.

6 agosto 2025 tempo di lettura 5 min

Krzysztof Janiga, CFA

Senior Equity ETF Strategist

Outperforming in a tariff-driven market

Performance has been remarkable in the first seven months of 2025 not only in absolute terms, but also because small cap indices did not experience significantly larger drawdowns during the first week of April as markets roiled from US tariff announcements. The MSCI Europe Small Cap Value Weighted Index has surged 17% year to date, outpacing the large cap benchmark by 8 percentage points. Small caps’ domestically focused profile has provided greater level of resilience against the trade-related headwinds, and their interest rate sensitivity has proven advantageous in a disinflationary environment

European small-caps earnings and valuations

In our view, European small caps continue to appear attractive on an absolute basis and relative to the MSCI Europe Index, even after their recent outperformance. As of 31 July, the MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index traded respectively at 7% and 4% discounts to their average price-to-earnings FY1 multiples, while the MSCI Europe Index traded at a 3% premium.

European small caps offer a rare combination of undemanding valuation and robust projected-earnings growth. Analysts have downgraded earnings-per-share equity estimates around the world this year, but European Small Caps saw only mild downgrades. The MSCI Europe Small Caps Index is expected to increase its earnings by 13% year over year in 2025 compared to the 17% forecast at the beginning of the year. MSCI Europe, which tracks large and mid-cap stocks, is expected to deliver a modest 2% earnings-per-share (EPS) growth this year, down from the 8% expected at the start of 2025.¹

Europe’s improving macro outlook

Europe has become an increasingly attractive place to invest in relative to the US this year. The economic growth forecasts for 2025 and 2026 between the US and Western Europe have narrowed from 0.9% & 1.0% at the beginning of the year to just 0.4% and 0.3%, respectively, as of end of July.²Higher uncertainty in the US, and expected Europe tailwinds from Germany’s landmark fiscal spending plan, have driven this convergence.

Inflation, a key concern of investors over the last couple of years, is abating in Europe,and President Trump’s 15% tariffs are more likely to hinder growth, rather than spark inflation in Europe. In the US, those trade measures may not only hinder growth but also put upward pressure on the CPI (Consumer Price Index). Unemployment across European economies remains low, reducing the probability of a widespread tariff-driven consumer crisis.

Geopolitical risk remains elevated and escalation tends to have a negative effect on risk on small caps in general. On the other hand, any sign of potential resolution of the Russian war in Ukraine may serve as a positive catalyst.

Small caps’ cyclical sector composition

Three elements that distinguish small caps from their larger counterparts are size, cyclicality, and home bias. Companies in the MSCI Europe Small Cap Index have a median market capitalisation of $1.3B USD vs. $13.7B USD in the MSCI Europe Index.3 Cyclicality is detectable in the sector composition. The MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index are overweight in Industrials, a key beneficiary of the expected increase in fiscal spending and European rearmament. There is also an overweight towards Consumer Discretionary, yield-sensitive Real Estate, and Materials, while Financials and more defensive sectors such as Consumer Staples and Healthcare are underrepresented relative to the MSCI Europe. Small caps are a higher risk-reward exposure, not only because of size, but also because of their sector composition.

Country exposures

Key country differences between European small and large cap indices include small caps’ overweights in the UK and Sweden. The largest underweights are in France, Switzerland, and Germany.

Home bias matters more in a tariff-driven market

Companies within the MSCI Europe Small Cap Value Weighted and the MSCI Europe Small Cap indices generate approximately two-thirds of their revenue within Europe, while the corresponding number for the MSCI Europe is only 46%. A more domestic profile was not necessarily a desirable trait for European exposures in 2023 and 2024 as the US economy decisively outpaced the old continent, US dollar was strong and political uncertainty was higher in Europe than in the US.

All of that changed in 2025 as economic growth converged, and geopolitical headwinds turned into economic tailwinds once European NATO members, led by Germany, ramped up military spending with a strong preference for local purchases. These factors have boosted Europe's outlook versus the US and made domestic small caps more attractive than globally oriented large caps.

US reliance may be less desirable after the 15% tariff Trump’s administration set. MSCI Europe’s constituents derive 24% of their revenue from the US in aggregate. The two small cap indices generate only 11 to 12%.

European currencies including the euro, pound, Swiss franc, and Swedish krona have all sharply appreciated against the US dollar, amplifying the cross-regional difference in stock returns in single currency terms. From here, stronger currencies are a challenge, but they are less of a headwind for more domestically focused companies than for internationally oriented large caps.

Footnotes

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