SMID is beautiful
120 Tuesday, 10 June 2025 10:31
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The restrictive monetary stance has come to an end in the euro area. As expected, the ECB cut rates by 25bps last week for the fourth time this year, bringing the deposit rate to 2%. The ECB has been one of the most aggressive central banks within developed markets, cutting interest rates by a cumulative 200bps in the past 12 months.
- On the dovish side, there were material downward revisions to the short-term inflation outlook, with headline inflation now seen at 1.6% YOY in 2026 and 2.0% YOY in 2027. These revisions were predominantly the result of the assumptions for energy prices and the euro exchange rate, and core inflation forecasts were left virtually unchanged.
- Moreover, another dovish element could be seen in the scenario analysis conducted by the staff to assess the effects of various outcomes in terms of trade policies between the US and the EU. In the event of a further increase in US tariffs, the effect on inflation is expected to be negative on the back of the adverse impact on economic growth.
- At this juncture, we do not rule out that the ECB will proceed with another cut this year, even though much will obviously depend on what happens on the trade front. The OIS curve also points to another rate cut before year-end and prices in a policy rate in the range of 1.5-1.75% by end-Q1 2026.
With regards to market implications, the ECB meeting was ultimately perceived as slightly hawkish, as Lagarde downplayed the significance of the expected inflation undershoot in 2026, due to it stemming mostly from the technical assumptions for energy prices and the euro exchange rate. Lagarde also stressed that the focus should be more on 2027, a horizon at which inflation is expected to be consistent with the 2% target. As a result, the higher repricing of rate expectations at the short end of the curve flattened the yield curve and further fuelled the EURUSD.
- Yet, beyond the short-term market reaction to the ECB meeting, the fact is that the restrictive monetary cycle in response to the succession of shocks constituted by Covid, the war in Ukraine, and the energy crisis has come to an end.
Small caps are set to be one of the largest beneficiaries of low interest rates/low energy prices. The ECB’s latest survey on enterprises’ access to finance in the EMU highlights that the pass-through of lower policy rates to SMEs’ financing conditions is still incomplete. The lag in the transmission of monetary policy to SMEs suggests that there is substantial room in the coming months for an easing of their financing conditions, which large firms are already experiencing.
From an equity market standpoint, we note that the sharp underperformance of small caps versus large caps in Europe has turned a corner. The monetary tightening cycle coupled with high energy prices between 2022 and 2024 was a critical headwind for the asset class, and we now see better prospects. From an overall standpoint, small-cap equity benchmarks in Europe have a bias towards energy-intensive sectors such as industrials and materials, which explains why they are more sensitive to energy prices. Small caps are also more domestically focused than large caps and are thus somewhat sheltered from trade wars. European small and mid-sized companies generate more than 60% of their revenues in Europe.
Over the past three months, European SMIDs have recorded one of their strongest periods of relative outperformance versus large caps on record (+7%). The German stimulus plan kicked off the recent SMID-cap rally versus large caps, but the interesting new aspect is that this outperformance continued despite April’s tariff scare and elevated volatility, thanks to the domestic nature of smaller caps. From a valuation standpoint, SMID caps remain very attractively valued versus large caps despite their recent outperformance, with the consumer and industrial sectors being among the most attractive. On a country basis, SMIDs in France, the UK, Denmark, and Belgium appear to be the most attractively valued, while Germany is closer to fair value but presents significant upside considering the stimulus plan that will be deployed in the coming years.
Week ahead: a relatively light macro agenda. The US CPI & PPI for May will be released.
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