European Central Bank Cuts Interest Rates by 0.25%

On June 6, the European Central Bank (ECB) cut its main interest rates by 0.25%, becoming the first major developed markets (DM) central bank to cut rates. This follows recent decisions by central banks in Canada, Sweden, and Switzerland to reduce their policy rates, and it marks a change in the interest rate cycle that we expect will buttress European economic activity and small-cap equities across developed markets.

The reduction in the ECB’s policy rates was well signalled by governing council members and was enabled by a persistent disinflationary environment over the past year. While preliminary inflation data for May came in hotter than anticipated, headline inflation has nonetheless moderated from a peak of 10.6% in 2022, to 2.6%. However, the recent uptick in sequential monthly inflation prints has served to curtail the total quantity of easing expected from the ECB this cycle. At the beginning of the year, approximately eight cuts were expected, with the trough priced in for late 2025. By contrast, between five and six cuts are now cumulatively priced in through the end of 2026.

The Federal Reserve’s peers have typically lagged its moves in monetary policy, particularly in cutting cycles, for fear of material currency depreciation, which could result in imported inflation. That worry is ameliorated for the ECB this time around by a couple of factors. One is that the market has already priced in a certain amount of policy divergence between the United States and Eurozone, thereby mitigating the market impact when this eventuates. The other is that the growth impulse is lower in the Eurozone—the first quarter improvement notwithstanding—and would more clearly benefit from a reduction in interest rates.

While the level of inflation has, until now, hampered the ECB’s ability to cut rates to support economic activity in the bloc, policymarkers’ confidence has grown that inflation will return to their 2% target. Business indicators, such as PMI output prices and the euro area survey of selling price expectations, have been reliable leading indicators of inflation and point to further declines ahead. Similarly, though wage growth remains high, it has reliably lagged the Harmonised Index of Consumer Prices inflation by a year, suggesting wage pressures should continue to moderate and the risk of a wage-price spiral is low. Nonetheless, the last mile of normalisation will likely be bumpy. The fact that the ECB raised their near-term growth and inflation projections indicates they will want to see further evidence that disinflation is continuing before delivering additional rate cuts.

Monetary easing should serve to foster the European economic recovery that began in first quarter 2024. This broadening out of economic growth beyond the United States should act as an earnings tailwind for DM small-cap equities, which have a greater cyclical tilt than the broad market. The prospect of a turn in the interest rate cycle should also aid the many small-cap firms that have struggled under the weight of higher rates, due to greater leverage and shorter debt maturities. This convergence of fundamentals can serve as the catalyst for narrowing the substantial valuation gap that currently exists between small caps and their larger peers. All told, this environment should be conducive to small caps repeating their historic tendency to deliver excess returns during economic recoveries and expansions.

Thomas O’Mahony
Senior Investment Director, Capital Markets Research