After a prolonged cycle of US outperformance, 2026 marks a pivotal rebalancing. Europe is entering a ‘Goldilocks’ scenario of cooling inflation and lower rates, turbocharged by accelerating fiscal stimulus. Yet, equity valuations have not fully priced in this recovery. This lag is most acute looking across different market capitalisation ranges, offering investors an attractive entry point before capital rotates out of crowded large caps and into high-quality, underappreciated small caps.
Our 2026 base case is one of gradual stabilisation, underpinned by sustained disinflation and a more predictable policy backdrop. In parallel, lower interest rates, easing inflation, and elevated fiscal stimulus across many European countries should support a gradual improvement in activity. A firmer geopolitical environment would add a further tailwind, helping restore confidence and improve business visibility after the exceptional trade volatility in 2025 delaying investments.
Against this gradually more supportive macro backdrop, capital flows have begun to show early signs of rotation into Europe after an extended period of subdued allocations. Even so, European small caps still trade below long-run valuation norms at around 14x forward price to earning (P/E) ratio versus above 15x historically. The relative case is also attractive: small caps sit at roughly a 5% discount to large caps, compared with a historical premium of 10%+. Overall, small caps have lagged large caps and remain in ‘catch-up’ mode, which can be advantageous as the cycle progresses, given historical outperformance after periods of crisis.
This implies the risk-reward in European small caps is asymmetric. Valuations continue to price a cautious scenario, while a further easing in macro stress – consistent with historical patterns –typically supports small cap outperformance. Fundamentally, lower interest rates and cooling inflation tend to benefit small caps disproportionately given their greater sensitivity to monetary conditions, while Europe’s accelerating fiscal impulse is providing incremental tailwinds. Further, though capital flows into Europe are starting to improve, allocations tend to re-enter large caps first before cascading into small caps as risk appetite broadens.
A mixed picture across regions
That said, the picture for small caps is mixed across regions. Southern Europe, led by Spain and Italy, stand out given that small cap indices there have delivered 30%+ gains in 2025, outperforming other European regions. Both markets have seen a modest re-rating, underpinned by a stronger energy backdrop, supportive macroeconomic environments and the recovery of service-focused sectors. Meanwhile, Nordic markets are trading in line with historical levels supported by a structurally higher mix of high-quality companies and smoother macro normalisation.
On the other hand, this has coincided with a period of relative stagnation in Northern Europe’s more industrial, cyclically exposed markets – also grappling with a more complex geopolitical backdrop. Valuations are particularly depressed in the UK, where persistent capital outflows have pressured valuation levels. In France, protracted political volatility has pushed risk premia higher, while in DACH (Germany, Austria, Switzerland), complex energy supply bottlenecks and export headwinds have weighed on stock valuations.
Defence boost
European defence companies have been a key beneficiary of greater defence spending in Europe. The ongoing ramp-up in NATO spending has been a powerful driver of defence equities. Newly announced multi-year budget frameworks represent a material upgrade versus prior baselines and provide enhanced demand for defence companies through to 2030, with additional support thereafter from replenishment cycles and sustainment spending.
Over the past two decades, NATO defence spending outside the US averaged around 2% of GDP, but current European proposals point to a material step change, moving towards roughly 3.5% in core defence spending. This would imply an approximate 60% real-terms increase for around half of NATO allies (vs their average annual spending over the past 20 years), equivalent to more than US$270 billion of incremental annual outlays.
In parallel, the EU’s ReArm Europe plan signals more than €800 billion of defence-related capacity and procurement support, underscoring defence as a renewed budget priority amid a structurally less stable security environment following the war in Ukraine and heightened uncertainty over US foreign policy. Markets have repriced accordingly, with valuations in the European defence basket rising from a historical average of roughly 15x P/E to currently 28-30x on an average 12-month forward basis.
The strongest re-rating has accrued to businesses most directly exposed to near-term battlefield demand, including ammunition, missiles, armoured vehicles, and unmanned systems companies where orders have surged. However, the scale of planned spend should increasingly cascade through the supply chain as inventories are rebuilt and production capacity is expanded, widening the opportunity set beyond prime contractors.
We also see attractive, idiosyncratic potential in areas such as personal protective equipment, as land forces remain central to deterrence and several countries reassess military headcount after decades of decline, including active debate in Germany around measures that could extend to a form of conscription.
Looking ahead by region, a more stable post-pandemic equilibrium is emerging, with fiscal policy and capital investment becoming the main sources of regional divergence. Europe remains heterogeneous with southern European economies outperforming, while Germany is mobilising its balance sheet to offset energy constraints and China-related pressures, and France is facing tighter fiscal constraints and huge levels of government debt.
Across sectors, tariff-exposed industries such as autos, consumer goods and electronic hardware softened in Europe. By contrast, AI-driven technology has continued to outperform, while strategic sectors enjoyed exemptions and policy support, notably semiconductors, defence and commercial aviation. After several subdued years, Europe reactivated fiscal policy, led by Germany’s €1 trillion stimulus and increased joint funding tied to boost defence efforts in Ukraine’s war against Russia.
Favourable support from monetary policy
Monetary conditions have also turned more supportive in Europe and the US for economic growth, with the US Federal Reserve cutting interest rates and the European Central Bank aligning policy as inflation reached its 2% target.
In terms of currencies, a scenario of gradual US dollar depreciation should be broadly manageable for European equities. While a modestly stronger Euro can be a headwind for the most export-heavy companies through transaction effects and some competitive pressure, it also helps contain imported inflation and can support easier European financial conditions over time.
This is a dynamic that can be particularly helpful for small caps with more interest-rate sensitive capital structures. In this context, European small cap exposure would benefit from a selective, concentrated approach focused on either global leaders with local footprints and strong pricing power, thereby limiting foreign exchange pressures to translation impacts rather than impeding competitiveness, or domestically oriented local champions with limited US dollar exposure.
Taken together, easing monetary pressure and a renewed fiscal impulse improve the odds of a broader European equity market reignition in 2026. The main swing factors remain familiar but concrete: energy-price volatility, renewed US-EU trade friction, or a bout of bond-market stress if fiscal plans are tested. Even so, with small caps still below long-run valuation ranges and selective sectors benefiting from policy support, we see scope for a more diversified European rally as earnings breadth improves.
Francisco de Juan is a Managing Partner and CIO of the EQMC Fund at Alantra EQMC Asset Management, a fund manager partner of GSFM, a Firstlinks sponsor. The information included in this article is provided for informational purposes only.
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