Small caps losers, large caps winners of ECB QE

Small caps in the UK are set to outperform, according to the predictions of a fund manager last year, but it looks like their eurozone peers will underperform larger companies.

Large caps will outperform small caps in continental Europe once the European Central Bank (ECB) starts quantitative easing next month, according to analysts at Societe Generale.

The performance of European small caps relative to European large caps has been strongly correlated (a correlation of 73%) with the euro/dollar exchange rate, the analysts said in a recent report.

When the euro weakens, European large caps tend to outperform European small caps because they are more international and benefit from the added boost to exports.

Small caps vs the euro

Small caps likely to underperform large caps if the euro weakens. Source: Societe Generale

“We recommend favouring large caps as ECB QE will put pressure on the euro,” the analysts at Societe Generale wrote.

Another factor that supports their theory is the correlation between volatility and the Federal Reserve’s rate-hiking cycle.

When the Fed raises interest rates, equity volatility increases, as has been shown by the fact that only talk about rate rises has been enough to make stock markets much more volatile.

“We can expect a change in equity volatility regime this year as the Fed looks set to hike by mid-year for the first time in 10 years,” the Societe Generale report said.

Their report shows a positive correlation of 64% between the volatility index (VIX) and the relative performance of European large caps versus European small caps over the last 13 years, on a year-on-year basis.

If one month lag is applied for volatility, the correlation rises to 71%. This suggests that volatility is a leading indicator for the performance of European large caps versus small caps, therefore they should benefit from the increase in volatility that is ahead.

A look at small caps performance across the globe shows that they have outperformed large caps between the end of November 2008, when the Fed started its money printing, until March last year, when it announced it would end its quantitative easing programme.

In the US, small caps outperformed by 83 percentage points within that period, in Europe by 114 percentage points, while in the UK they outperformed by a whopping 165 percentage points.

However, since March 2014 small caps have underperformed large caps in all regions: in the US by nine percentage points, and in Europe and the UK by five percentage points.