Quick View: How are tariffs reshaping the market for European smaller caps?

Giving insight into the impact of US President Trump’s tariffs on European smaller companies can be a tricky topic, as it requires some certainty as to the logic behind their implementation and the policy goals that they aim to achieve. The idea that the US can resolve all bilateral trade deficits in this manner is beyond comprehension and one doubts that it is the real policy goal being pursued. One thing we would expect is for tariffs to reduce the overall welfare of the US consumer, with some distributional effects both within the US and globally.

All else being equal the tariffs would be expected to make the prices of European-produced goods in the US more expensive, likely reducing demand for them. This is clearly negative for European companies that export to the US. The fact that tariffs on China look to be dramatic also has an impact as many European companies produce in Asia and ship to the US.

What could happen next?

As a knock-on effect of US tariffs, we expect China to try and offload excess capacity elsewhere in the world, leading to more competition for domestically produced goods in Europe, and thus likely lower margins for European businesses. Herein lies the big risk. Should the EU Customs Union retaliate and put tariffs on the US? Should the EU Customs Union protect domestic producers from Chinese supply by imposing tariffs on China? Very quickly we could end up in a global trade war as protectionism escalates and that would be devastating for the global economy.

Countries with a trade surplus typically fare less well in a trade war and this means there is a big risk to Europe and to China if they retaliate. Nonetheless, we saw China respond in tit-for-tat fashion to the US, with each side escalating in a damaging stand-off.

China has, however, anticipated a trade war and has been planning for this situation. There is considerable scope to drive consumption in China and create a source of domestic demand that could cushion the economy. Europe typically struggles to act with the same decisiveness as China and responses are unlikely to be co-ordinated. For that reason, we hope that the EU charts a careful course in its response. The US has, headline rhetoric aside, implied it is open to negotiations on tariffs and there is a scenario where tariffs and non-tariff trade barriers are negotiated down.

What are the implications for European smaller caps?

Recent times have shown us that the world is a much more uncertain and dangerous place than Europe had complacently assumed. Defence spending is clearly going to have to go up, given concerns about the durability of the Western Alliance. This has generally been seen as an opportunity for defence companies and some defence-adjacent businesses, and recent market volatility could represent an opportunity for stock picking investors to augment their exposure to this area.

In less certain times, one way to drive economic growth is to unleash housebuilding, and this could represent an opportunity to position around a housing recovery in a European market that has been stagnant since 2022. Globally positioned companies with diversified production across countries could appeal too, given that they might not face tariffs in the same way. Countries with sufficient debt capacity to spend on stimulating their economy are likely to have more options than those who have already burdensome debt loads – Germany stands out here as having fiscal room to act.

Conversely, investors are likely to frown on companies with bad balance sheets. Now is not the time to be struggling with debt or high costs, especially if a company is vulnerable to the price shock of tariffs. We would also be cautious on European companies producing in China and exporting to the US – the US-China dispute does not seem like an argument that will be quickly resolved.

More broadly, European smaller companies are coming into this shock on extremely low valuations. Global stock markets have been mesmerised by ‘American exceptionalism’ in recent years and this has resulted in a heavy concentration into mega cap technology stocks. However, Europe is home to plenty of great companies with great balance sheets that can be bought at what we see as very attractive prices, given the impact of current market stress. The only real response from Europe to MAGA has to be MEGA – Make Europe Great Again. Build houses, build infrastructure, rearm and deregulate. The fact this strategy seems to be on the cards in Europe gives room for optimism.