2023 should have been the year for Europe's small and midcap (SMC) stocks. After Covid and the Russian gas shock there was a decent economic upswing, with falling inflation and risk-averse investors. For these stocks nothing came of it. The Stoxx Europe Small 200 Index more or less treaded water this year - gaining just over 2% - while the Stoxx 600 rose by almost 8%. As it is well known, the main party took place in the U.S., with technology stocks having the greatest time: the S&P 500 was up almost 20% and the Nasdaq almost 50%. A major reason for the SMCs’ 2-year underperformance can probably be found in the aggressive hiking cycle of central banks, to which SMCs historically have reacted allergically. That’s likely why SMCs in the U.S. have also underperformed - in 2023 the Russell 2000 also treaded water.
In our Chart of the Week, we compare the price/earnings (PE) ratio for Europe's small caps not with the Russell 2000 but with the S&P 500 Value Index. The reason that we use the S&P 500 index family for this comparison is that the Russell is regularly distorted upwards by low-profit young companies from the pharmaceutical sector, while the valuation of the S&P 500 has been inflated by the Big 7 technology companies.
Even compared to U.S. value stocks, Europe’s small & mid-caps have underperformed in 2023
At present U.S. investors appear over-optimistic. They believe the Fed is increasingly unlikely to raise interest rates again and might lower them sooner than previously expected. But the price for this highly anticipated monetary relaxation is an economic downturn whose low point is not likely to be seen until the first or second quarter of 2024. At the same time more expensive refinancing costs are only now eating their way gradually into the income statements of U.S. companies. In Europe, on the other hand, we believe that the low point has already been passed, as can be seen from indicators such as the Purchasing Managers' Index (PMI), which has bottomed out since August. However, a recovering European economy is not the main reason why we like Europe's SMCs so much. More important is that their balance sheets appear solid and earnings growth higher than that of blue chips. In addition, many of them are market leaders in their niches and are characterized by high rates of innovation. Last but not least, shareholders may also benefit from corporate takeovers, which generate share price premiums, though M&A activity is currently very weak in Europe.
We are well aware that Europe’s record-high valuation gap to U.S. equities is no guarantee that European SMCs will outperform in the near future. In order for international investors to regain interest in this asset class, which has also been lagging behind European blue chips for almost two years, the signs of an upturn in Europe and the promise of interest rate cuts by the ECB will probably have to materialize. But perfect timing on the stock market is usually more of a wish than a reality.