Investors seek Europe’s potential beneficiaries of rate cuts

Interest Rate Cuts Spark New Opportunities in European Equities

Investors in European equities are intensifying their search for stocks set to benefit from reduced borrowing costs following the European Central Bank’s (ECB) first interest-rate cut in nearly five years. Though anticipated, analysts view the cut as a potential turnaround for beleaguered sectors like utilities, small caps, and even highly shorted stocks, all of which have been hit hard by rising and high rates. This shift might prompt banks, which have thrived on policy tightening, to face some profit-taking.

Much hinges on how rapidly inflation declines towards the ECB's 2% target, potentially allowing for more rate cuts as the region's economy recovers. Historically, policy easing has been supportive of European equities, and with improving earnings, this could justify additional market gains. Following the ECB’s quarter-point reduction, the deposit rate stands at 3.75%, aligning with previous rate cuts by Sweden and Switzerland earlier this year.

Small Caps Poised for a Comeback

Small caps are viewed as significant beneficiaries of the ECB's rate cuts. These stocks have lagged behind larger ones since rate hikes began in mid-2022. Now, major investors like Amundi foresee a rebalancing in their favor. Small caps, often leveraged, have struggled with rising rates, unlike mid and large caps that have cash reserves or easier access to debt markets. Goldman Sachs points out that European small caps represent a cyclically sensitive market segment that has yet to catch up with the broader rally, and UBS suggests focusing on UK small and mid-caps, citing tax cuts, potential rate cuts, and fiscal spending as key drivers.

Potential Gains for Utilities and Real Estate

Utilities and real estate have been some of the hardest-hit sectors due to high rates, but portfolio managers are repositioning for potential gains. Utilities, highly sensitive to rate changes, may benefit from lower energy prices and long-term investments tied to artificial intelligence and electric vehicle initiatives. Real estate, which performs well in bond bull markets, could see renewed interest as lower rates stimulate new projects, increase asset values, and reduce debt costs. These sectors, having underperformed this year, could reverse their fortunes post-rate cuts.

Short-Covering and Its Implications

The resurgence of meme stock frenzies in the U.S. has spotlighted short-covering risks. While the retail ownership dynamic differs in Europe, rate cuts could fundamentally drive investment into shorted stocks, particularly those with debt issues. Examples like Alstom and BT demonstrate significant stock price jumps tied to potential debt restructuring and earnings beats. Lower rates also facilitate mergers and acquisitions, making shorting potential buyout targets risky.

Bank Sector Outlook

European banks have benefited from rising borrowing costs since 2022, enjoying improved margins after a prolonged period of low rates. Despite strong performance this year, strategists are becoming cautious. As rate cuts potentially lower bond yields, the tailwind supporting bank profits might diminish. While some short-term profit-taking is expected around ECB and Bank of England rate cuts, the long-term outlook remains positive due to attractive valuations and ongoing buybacks.

The potential shift in the economic landscape following the ECB’s rate cuts opens various strategic opportunities and risks for different sectors in the European equities market, making it a critical period for investors to reassess their positions.