European small caps: Positioned for domestic recovery and rate tailwinds

• The Eurozone economy is picking up momentum, supported by fiscal expansion and accommodative monetary policy.

• Small caps are more domestically exposed, with around 65% of revenue generated within Europe, making them primary beneficiaries of improving local growth.

• Lower interest rates disproportionately benefit small caps, as higher leverage and greater floating-rate exposure allow financing costs to decline more quickly, directly supporting earnings and cash flow.

• Earnings momentum is strengthening, with small caps projected to grow EPS around 17% in 2026, outpacing both the broader European market and US equities.

• Valuations reflect a compelling “double discount”, trading below historical averages and at a discount to both US equities and European large caps despite stronger growth. We estimate potential upside of approximately 36% by end of 2027.

• Active management can add value, as the under-researched small-cap universe offers greater scope for disciplined stock selection and risk control. We recommend BNP Paribas Europe Small Cap Classic Cap EUR as a preferred vehicle to access this opportunity.

European small caps are starting to look mispriced.

The Eurozone economy is improving, the ECB has already delivered meaningful rate cuts, and domestic demand is showing early signs of life. Small caps typically benefit more than large caps in this environment because they are more exposed to the local economy and more sensitive to financing costs. With earnings momentum building and valuations still undemanding versus richly priced global equities, the risk-reward looks unusually attractive.

Related article: Europe Outlook 2026: Access growth at a reasonable price

The European economy: The recovery is gaining traction

The Eurozone’s GDP troughed in 2023. Since then, growth has gradually recovered to around 1.5% in 2025 and is expected to remain broadly stable through 2026–2027. Momentum strengthened into year-end, with fourth-quarter GDP rising 0.3% quarter-on-quarter, ahead of expectations.

The UK, which represents a meaningful share of the European equity market, is showing a similar pattern. Full-year GDP growth reached 1.3%, improving on 2024. More importantly, forward-looking indicators across both the Eurozone and the UK point to firmer momentum heading into early 2026.

Chart 1: Economic growth momentum is picking up

The key is not the absolute growth rate, which remains moderate, but the direction and breadth of improvement.

Three forces are driving this shift.

1. Fiscal policy is reviving manufacturing

For much of the post-pandemic period, manufacturing was a drag on growth. That dynamic is now reversing. Higher public spending on infrastructure and defence is lifting industrial demand. In February 2026, Eurozone manufacturing returned to expansion and reached a 44-month high, suggesting fiscal stimulus is feeding through to the real economy.

This does not signal a rotation away from services. Services activity remains in expansion. Rather, the region is moving toward a more balanced recovery, with both goods and services contributing.

The UK shows a similar improvement. The composite PMI rose to 53.9 in February, its highest level in nearly two years and firmly above the 50 expansion threshold. Manufacturing has re-entered expansion and has remained there since November, reinforcing the view that the recovery is broadening across sectors.

Chart 2: The region’s growth now driven by both manufacturing and service

2. Real incomes are improving

With inflation easing to around 1.7%, real household incomes are expected to rise by roughly 1.5%. European households also maintain high savings buffers. Around one-third of financial assets are held in cash and deposits, compared with about 17% in the US, amounting to approximately EUR14 trillion sitting in bank accounts.

Consumers remain cautious, but this substantial savings buffer provides a firm foundation for spending as confidence improves, which forms an additional pillar of support for domestic demand, alongside fiscal expansion.

3. Monetary conditions remain supportive

Since June 2024, the European Central Bank has cut rates by a cumulative 200 basis points, bringing policy rates to 2%. In parallel, the Bank of England has lowered rates from 5.25% to 3.75%, a 150-basis-point reduction. With inflation under control, policy can remain accommodative. Lower financing costs ease debt burdens, support investment, and improve capital allocation conditions.

Taken together, the Eurozone is not experiencing a boom. But it is entering a more durable and balanced expansion phase, and for markets, trajectory matters more than speed.

Why small caps are the main beneficiary

European small caps are structurally more exposed to domestic growth. Approximately 65% of their revenue is generated within Europe, compared with roughly 45% for the broader index. Improvements in fiscal spending, manufacturing activity, and consumer resilience therefore translate more directly into small-cap earnings.

Chart 3: Small cap has larger domestic revenue exposure

They are also less vulnerable to currency headwinds. A stronger euro typically weighs on multinational exporters, but small caps are more domestically anchored. Their localised revenue and cost bases can even benefit from currency appreciation through lower imported input costs and improved purchasing power.

Interest-rate sensitivity provides an additional lever. Small caps tend to carry higher leverage and a larger share of floating-rate or shorter-maturity debt. Rate cuts therefore flow through more quickly to lower interest expenses. As policy eases, financing costs typically decline faster for small caps than for large caps, directly supporting earnings and cash flow.

Chart 4: M&A activities are picking up

Improved financing conditions also tend to revive the capital cycle. In 2025, M&A activity rebounded, with deal volume rising around 26% year-on-year. Lower funding costs increased buyer flexibility, while attractive small-cap valuations created compelling acquisition opportunities. As M&A targets are often small-cap companies, stronger deal activity provides both sentiment support and valuation upside.

Earnings momentum is building

Consensus forecasts reflect this cyclical sensitivity. The STOXX 600 is expected to deliver approximately 10–11% EPS growth in 2026. By comparison, European small caps are projected to grow around 17% in 2026, following 8% growth in 2025. This exceeds both the broader European index and the S&P 500, which is forecast to grow roughly 13%. Momentum is expected to extend into 2027.

Chart 5: European small cap is expected to deliver faster earnings growth than broader Europe or US

The stronger earnings profile is largely driven by sector composition. European small caps carry greater exposure to cyclical industries that benefit directly from domestic recovery and lower rates.

• Industrials represent roughly 18% of the index (vs. 16% in the broader benchmark), including capital goods, electrical equipment, energy infrastructure, and defence supply chains, areas leveraged to fiscal expansion and manufacturing recovery.
• Financial Services account for 11% (vs. 4% in the broader index). Unlike large-cap financial exposure, which is bank-heavy, small caps are more tilted toward wealth management, asset management, and brokerage firms, segments that benefit from stronger capital markets and improving sentiment.
• Real Estate represents approximately 9%, compared with negligible exposure in the broader benchmark, and stands to benefit directly from declining financing costs.

The sector mix reinforces the index’s cyclical bias. European small caps are structurally positioned to benefit more from accelerating domestic growth and easing monetary policy.

Chart 6: Small caps overweight cyclical sectors

A compelling “double discount”

Despite stronger expected earnings growth, European small-cap valuations remain attractive.

First, small caps are trading below their historical average multiples, even as earnings momentum improves.

Chart 7: European small caps are trading below their historical average

Second, at the regional level, European equities continue to trade at a structural discount to global peers, particularly the US. Over the past decade, Europe has traded at an average discount of around 22% to the US. The current discount remains approximately 35%, leaving room for mean reversion. We believe part of this discount can narrow for structural reasons.

Chart 8: Europe is trading below its historical discount to US

First, Europe’s financial sector, a large index component, has undergone a fundamental repair. Following the Global Financial Crisis and sovereign debt turmoil, banks have spent more than a decade deleveraging, strengthening capital and tightening underwriting standards. Non-performing loan ratios have fallen to roughly 1.9%, less than one-third of levels seen a decade ago. At the same time, the return to a more normal interest-rate environment has structurally improved profitability. Forward return on equity expectations for European banks have converged with, and in some cases exceeded, US peers since 2023. This represents a structurally stronger earnings engine than in the past cycle.

Second, global capital flows are gradually diversifying. With US equity markets increasingly concentrated and richly valued, Europe serves as the primary liquid alternative for institutional diversification. Flow data show investors rotating toward Europe during periods of US-specific policy or valuation concerns. As Europe’s role as a strategic diversification hub strengthens, its structural risk premium has scope to compress, supporting a gradual narrowing of the valuation gap.

Third, small caps have historically traded at a premium to large caps, reflecting their higher growth potential and greater sensitivity to economic cycles. Today, however, they trade at roughly an 8% discount to the broader European index, despite delivering stronger earnings growth.

This valuation premium has been trending lower since 2020, largely due to the region’s sluggish post-COVID recovery. During economic slowdowns, investors typically rotate toward larger, more defensive names in risk-off environments.

With clearer signs of economic improvement now emerging, we believe this valuation gap has room to narrow as confidence in the recovery builds.

Chart 9: Small caps historically are trading at premium to broader index

This creates what we describe as a “double discount”:

• A regional discount relative to global equities
• A segment discount relative to European large caps

Against elevated US equity valuations, this divergence between earnings expectations and valuation presents a compelling alternative. Assuming earnings growth of 17% and 13% over the next two years, we estimate potential upside of approximately 36% by end of 2027.

Capture the opportunity through active management

Small caps remain structurally under-researched and receive limited analyst coverage. Pricing inefficiencies are therefore more common, creating fertile ground for disciplined active managers.

We recommend the BNP Paribas Europe Small Cap Classic Cap EUR as a preferred vehicle to access this opportunity. The strategy has been operating since 2007 and has delivered long-term cumulative performance above its benchmark, broadly in line on a net-of-fees basis. Over the past three years, it has generated meaningful outperformance (48% vs. 44%), and year-to-date 2025 it has delivered significant excess returns (approximately 28% vs. 20%).

Chart 10: The recommended fund outperforms its benchmark over the past three years

The fund follows a GARP (Growth at a Reasonable Price) approach, targeting companies with sustainable growth at disciplined valuations. The team conducts 150–200 company meetings annually. In small-cap investing, management quality often determines long-term outcomes, and primary research can provide a meaningful edge over passive strategies.

Importantly, in small caps, the greatest challenge is often not stock selection but risk control and execution discipline. The strategy applies a structured three-layer framework:

1.      Valuation discipline

Buy and sell decisions are guided by clearly defined target prices and minimum upside thresholds, supported by DCF analysis to maintain appropriate risk-reward balance.

2.      Portfolio construction discipline

The fund typically holds 60–90 positions and actively manages sector and regional exposures to avoid concentration risk.

3.      Liquidity discipline

Liquidity is continuously monitored through analysis of the time required to exit each position. Less liquid names carry lower weights to preserve flexibility during market stress.

This disciplined framework ensures the portfolio remains stable, executable, and risk-controlled even in volatile environments.

In conclusion, European small caps are direct beneficiaries of improving domestic growth across Europe, particularly as fiscal expansion and easing monetary policy gain traction. Their higher sensitivity to interest rates positions them well in a lower-rate environment, while earnings growth is expected to outpace broader benchmarks.

Valuations remain compelling. Trading at a discount to the US and to larger European peers, the segment offers a rare “double discount”, an attractive entry point at a time when global equities look stretched.

Declaration:

This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a NIL position in the abovementioned securities.