After a prolonged period of underperformance, European small cap equities have shown signs of life, outperforming their large cap peers in recent months. Is this a temporary blip or the start of a broader structural shift? The answer may lie in a unique confluence of macroeconomic shifts, valuation disparities, and market microstructure dynamics.

*Source: Bloomberg. MSCI European Small & Large Cap Indices*

Why the sudden spotlight on small caps?

Over the last two years, European small caps have endured a tough environment marked by high inflation and elevated interest rates. These conditions hit smaller companies disproportionately hard:

Limited pricing power made it difficult to pass on rising costs to consumers.
Tight cash flows and limited borrowing capacity left little buffer to absorb financial shocks.
Investors steered clear of these higher-risk names, especially with US large cap tech leading global returns.

As a result, European small caps became a relatively under-owned segment in global equities, with funds experiencing significant outflows. This in-turn has left valuations near discount levels.

A reversal in fortunes?

Now, the macroeconomic environment is shifting in Europe.

The European Central Bank (ECB) has started to cut interest rates, improving borrowing conditions and corporate cash flows.
Lower rates support capex expansion and allow smaller companies to better fund new growth initiatives.
Valuations remain attractive: Small caps trade at relatively low price-to-earnings multiples, providing an appealing entry point for investors looking for value and growth.

These changes position small caps to benefit from both a cyclical rebound and a structural catch-up.

Structural strengths: Why small caps are built to benefit

Several key features give small caps an edge in the current environment:

Agility: Smaller firms can adapt quickly — switching suppliers, pivoting strategies, or shifting business models in response to new regulations or tariffs.
Domestic focus: Unlike large European multinationals, which often derive around 60%* of revenues from outside the region, small caps are more locally anchored. This makes them less vulnerable to international trade tensions and currency volatility.
High growth potential: Being early in their business lifecycle, small cap firms often have longer growth runways. A successful expansion has a larger impact on valuation due to the small base effect.
Valuation discovery: Less analyst coverage means more opportunities to find undervalued or mispriced assets with strong fundamentals.

But there are risks

Despite the optimism, investors should remain aware of the risks:

Volatility is higher — both in stock price and earnings.
Bankruptcy risk is real: Smaller firms have thinner margins and weaker buffers.
Inflation pressures remain. Rising energy prices, especially due to geopolitical tensions in the Middle East, could complicate the ECB’s dovish stance.

Tariffs also remain a wildcard. While large caps might better absorb increased input costs through scale, small caps may struggle. However, their domestic focus might shield them from the brunt of these external frictions.

Europe vs US: A diverging narrative

While Europe has started to ease monetary policy, the U.S. Federal Reserve has held firm. US small caps remain under pressure from elevated rates and macro uncertainty. Inflation trends in the U.S. are still being evaluated, and policy decisions remain finely balanced.

In contrast, Europe’s earlier shift to rate cuts gives its small caps a relative tailwind, at least for now.

Microstructure momentum: What's happening beneath the surface?

Beyond performance and valuation, market microstructure data offers valuable insight into how investors are positioning themselves — and it’s telling a compelling story for European small caps.

During key geopolitical and policy events such as Liberation Day and tariff go-live periods, both small and large cap equities experienced notable stress. Spreads widened, volatility surged, and touch sizes (a proxy for market depth) dropped sharply. This reflects the typical liquidity crunch associated with heightened uncertainty.

However, what followed has set small caps apart.

While large cap stocks partially normalized, they haven’t fully returned to their pre-Q2 liquidity levels. Comparing Q1 2025 to Q2 Ex-April:

Spreads remain elevated by ~4%**,
Touch sizes are still 14% lower** than the Q1 2025 average,
Suggesting persistent caution from institutional investors in this segment.

In contrast, small cap stocks showed a clear rebound in market quality, and perhaps a resurgence in confidence:

Touch sizes rose by 25% post-April**, indicating a sharp recovery in depth and institutional willingness to engage.
Spreads narrowed by 5%**, improving execution quality and reinforcing a shift toward increased liquidity.
This data may suggest that there is not just a change in sentiment, but real reallocation of trading volume and capital into the small cap space.

*Source: BMLL technologies – Based on MSCI European Small & Large Cap Indices*

This aligns well with broader market observations: small caps are starting to draw institutional capital again, potentially due to their leverage to lower interest rates, domestic resilience, and attractive valuations.

*Source: BMLL technologies – Based on MSCI European Small & Large Cap Indic*

Conclusion

European small caps may be standing at the intersection of macroeconomic relief and structural advantage. With interest rates falling, valuation multiples still compressed, and investor positioning still light, the path of least resistance might be up — barring any major macro shocks.

That said, this is still a stock picker's market. The dispersion within the small cap universe is wide, and while some firms may falter, others could thrive in this new regime. With less analyst coverage across this segment, putting in the work may lead to potentially outsized rewards.

* MSCI 2025

** BMLL technologies – Based on MSCI European Small & Large Cap Indices

Written by Prashanth Manoharan, Head of Execution Consulting, EMEA

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European small caps: A potential resurgence?