Is it time to look at European Small and Midcaps?

After a year of mixed performances in global equity markets, 2025 could be the year to consider European Small and Midcaps (SMIDs). Growth in the US is expected to moderate this year, driven by slowing domestic demand, a weaker labour market, and the potential for inflationary pressure if the US president elect, Donald Trump, follows through on his campaign promises.

Meanwhile, in Europe, inflation is expected to continue its downward trajectory, likely falling faster than the European Central Bank (ECB) had anticipated, which should, in turn, support real incomes. As a result, interest rates are set to decline further, which should stimulate economic activity and improve market sentiment. Equity market valuations, especially in European SMIDs, appear attractive and could offer significant upside potential as they are often more sensitive to positive changes in economic conditions and reduced interest rates.

External trade was one of the saviours of the European economy in 2024. However, in 2025, domestic consumption is anticipated to strengthen and become a key driver of growth, supported by the ECB’s interest rate cuts, with the terminal rate expected to reach 1.75% by July of this year¹. This is expected to boost purchasing power, and the savings accumulated by consumers during the prior higher interest rate period should provide further support for spending. This combination of factors is expected to drive European GDP growth to around 1% by the end of 2025, with a modest pick-up to 1.3% forecast for 2026².

However, there is likely to be some divergence in the performance of Eurozone countries. German growth is forecast to lag, with industrial production facing headwinds, particularly in the automobile sector, where competition is intensifying and demand for German electric vehicles remains sluggish. In contrast, France and Italy are projected to experience modest growth, while Spain is set to deliver one of the region’s strongest performances. Spain’s recovery is notable, as it was disproportionately affected by the global pandemic due to its heavy reliance on tourism, but it is now benefiting from a strong rebound in the sector. 

Global policy uncertainty and ongoing geopolitical tensions pose risks for all segments, including European SMIDs, which underperformed in 2022 and 2023 due to rising inflation, rapid interest rate hikes, supply chain disruptions, and negative market sentiment that collectively hampered growth. However, these risks may be more than priced in. The gap between the forward P/E for the S&P500 and the Stoxx600 indices indicates that Europe is particularly appealing as a value play, with an emphasis on quality deemed essential. With European SMIDs' earnings growth outpacing their large-cap counterparts since 2022, the fundamentals remain attractive, especially given their recent underperformance, which should support valuations.

With the conclusion of 2024, inflation has settled at a more manageable level, and the ECB – after cutting rates by 25 basis points in each of June, September, and October – is expected to continue easing. This shift towards a more neutral monetary policy, coupled with a rebound in economic momentum, enhances the appeal of European SMIDs, which are currently trading at significantly lower relative valuations.

Historical trends show that investing in SMIDs at an economic inflection point – when the economy shifts from contraction to expansion – has typically been a successful strategy. SMIDs tend to benefit exponentially from a reduction in interest rates for a number of reasons:

• Large-cap corporates can raise capital using equity or bonds, while SMIDs are much more reliant on bank finance, which is expensive in a high interest rate environment.
• Smaller companies tend to be more domestically focused, which means their performance is more closely tied to the growth of the domestic economy. 
• Riskier assets, as SMIDs are generally considered, become more attractive in a lower interest rate environment.
• Lower interest rates tend to kick-start corporate consolidation and M&A activity, as reduced borrowing costs make acquisitions more attractive, which can result in operational efficiencies and an increased market share, ultimately boosting valuations.

SMIDs often behave differently from large-cap stocks throughout economic cycles, making them a valuable tool for enhancing portfolio diversification. These companies are typically seen as the growth engines of an economy, expanding more rapidly than their larger counterparts as they scale their businesses.

Further diversification within the European SMID category across various sectors can also help mitigate risk. For instance, domestic players such as utilities, which are safe havens against global turmoil, generally offer stable earnings and lower growth, while providing regular dividends, which can be particularly appealing in a low interest rate environment. The financial sector tends to perform well when an economy expands, benefiting from increased lending activity, which tends to drive positive earnings growth. Similarly, consumer discretionary stocks outperform in a recovering economy, as they benefit from rising consumer confidence and increased spending.

A rising tide may not lift all boats, and hence, independent of the macro situation, we believe that a strong focus on stock selection within portfolios will be key.

Following a year of elections, 2025 is shaping up to be dominated by policy changes, and while the outlook for European SMIDs remains positive, these shifts present notable risks. Donald Trump will take office as president later this month, and despite inheriting a record budget deficit and rising interest payments, he has pledged to reduce income taxes, which is expected to further increase the national debt. Additionally, Trump has been clear about his intention to impose trade tariffs, which could drive up prices in the US, and create friction in global trade.

Trump's "America First" agenda will prioritise the economic strength of the US, potentially at the expense of international relations. Therefore, investing in European SMIDs that are multinational and leaders in their fields can offer an attractive upside. These companies, with significant exposure to the US market, are well-positioned to navigate the global environment effectively. Their diversified revenue streams and US market presence can provide additional growth opportunities and resilience against regional economic fluctuations.

For Europe, potential policy shifts present some challenges. To mitigate these, EU politicians are increasingly focusing on strategic autonomy as well as trying to address relative productivity and investment gaps. The recent Draghi report on European competitiveness highlighted weak productivity and underinvestment as key challenges, exacerbated by developments in the digital economy, artificial intelligence, rising protectionism, and more interventionist global industrial policies.

To close this competitive gap, Europe will need substantial investment, reduced fragmentation and regulation, and a unified industrial policy. Achieving this will require significant political commitment from EU leaders, particularly in countries such as France and Germany. If Germany relaxes its strict fiscal policies, it could significantly enhance economic growth. This increased fiscal flexibility could further support European SMIDs by improving market conditions and boosting domestic spending, creating a favourable environment for these equities to thrive. However, a loosening of the debt brake would occur gradually, with economic effects likely becoming evident from 2026 onward.

A potential positive development is that the odds of a ceasefire between Ukraine and Russia are higher this year. This outcome would ease political tensions, and the post-war reconstruction efforts could provide a boost to growth in the region, making peace in Ukraine a significant catalyst for Europe.

¹ Amundi Global Investment Views January 2025 
² Amundi 2025 Investment Outlook