The end of financial year sale few investors are talking about

This year, international small caps stand out.

Despite signs that economic conditions are proving more resilient than expected, international small caps remain one of the few areas of global equity markets trading below historical valuation averages. The recent Federal Reserve meeting reinforced this view, suggesting the backdrop may not be as weak as many investors had anticipated. For investors reviewing portfolios ahead of EOFY, that disconnect between improving fundamentals and cautious valuations may be worth paying attention to.

A changing of the guard

While rates were left unchanged, new chair Kevin Warsh's remarks and the omission of easing guidance suggested policymakers may have less flexibility to cut rates than markets previously expected. Some Fed members are now forecasting another hike this year, while futures markets are pricing around 1.5 hikes by early 2027. The surprise hawkish shift reflects an economy that remains resilient while inflation stays sticky, conditions often associated with a reflationary environment.

Chart 1: Fed projections versus market expectations

Source: Bloomberg

Normally, this higher-for-longer rates outlook would be viewed as a headwind for small caps. But a reflationary environment is a little different.

Labour market conditions remain resilient while hiring intentions have started to improve. More importantly for small-cap investors, US manufacturing activity has returned to expansionary territory after several years of contraction and slowdown. In the chart below n the chart below, each part of the economic cycle is represented by a colour: recovery (blue), expansion (green), slowdown (orange) and contraction (purple). You can sere the recent rise to expansion.

Chart 2: US manufacturing activity returns to expansion

Source: VanEck, Bloomberg.

Taken together, these developments suggest the backdrop for smaller companies is becoming more supportive. Periods of expanding manufacturing activity have historically coincided with stronger earnings growth and outperformance from quality small caps.

For investors, that may represent an opportunity, as improving earnings alongside economic activity could make current valuations difficult to justify.

Earnings are beginning to respond

One of the more encouraging signs for small-cap investors is that earnings expectations are starting to improve.

As the chart below shows, forward earnings forecasts for global small companies have begun accelerating after an extended period of weakness. Historically, this has been an important signal, with improvements in earnings expectations often accompanied by stronger small-cap performance.

Chart 3: Small-cap earnings growth and forward EPS expectations

Source: Bloomberg, MSCI. MSCI World Small Cap is the MSCI World ex Australia Small Cap Index. You cannot invest in an index. Past performance is not indicative of future performance

Why quality matters

Not all small companies are positioned equally to benefit from changing economic conditions. Historically, companies with quality characteristics such as high profitability, stable earnings and lower leverage have outperformed across most phases of the economic cycle. While quality small caps have delivered particularly strong results during expansionary environments, they have also tended to hold up better during slowdowns and contractions.

Source: MSCI, to 31 May 2026. QSML is the MSCI World ex Australia Small Cap Quality Index. You cannot invest in an index.

This combination of participation and resilience is one of the key reasons we favour a quality approach within international small caps.

VanEck MSCI International Small Companies Quality ETF (QSML) provides exposure to 150 of the world's highest quality international small companies, selected using a disciplined framework focused on high return on equity, earnings stability and low financial leverage. This approach seeks to capture the growth potential of small companies while maintaining a focus on businesses with stronger fundamentals.

One implication of this shift is that earnings dispersion within the small cap universe may widen. In an environment where a single social media post can cause wild and sudden gyrations in markets, taking a more selective approach is crucial. Focusing on companies with proven track records can help investors capture the upside while managing any evolving risks.

The valuation disconnect

While the macro environment may be supportive, the most compelling reason for investing in this space may lie in where valuations are at.

International small caps are one of the few major equity asset classes still trading below their long-term average valuation levels. And as the chart below shows, discounts of this magnitude don’t come around often.

Chart 4: International small cap valuations remain below historical averages

Source: MSCI, to 31 May 2026. QSML is the MSCI World ex Australia Small Cap Quality Index. You cannot invest in an index.

Sale of the year?

As investors review portfolios ahead of EOFY, international small caps remain one of the few areas of global equity markets where valuations appear disconnected from improving fundamentals. Manufacturing activity is expanding, earnings expectations are improving and central banks are responding to an economic backdrop that appears more resilient than many expected.

Yet valuations continue to reflect a far more cautious outlook.

For investors seeking exposure to a segment of the market that may be poised for a re-rating, QSML provides a compelling and targeted exposure to high-quality international small companies.

Why QSML?

150 of the world's highest quality small companies

Access a diversified portfolio containing some of the world's highest quality small companies based on key fundamentals including high return on equity, earnings stability and low financial leverage.

Outperformance potential in growing companies

Investments focusing on quality small companies that have delivered outperformance over the long term relative to other global small-company benchmarks and relative to large- and mid-cap benchmarks.

Diversified across countries, sectors and companies

Offering investors a portfolio of 150 companies across a range of geographies, sectors and economies.

QHSM, the Australian dollar hedged version of QSML, allows you to also manage your desired currency exposure.

Key risks:

An investment in the ETF carries risks associated with ASX trading time differences, financial markets generally, individual company management, industry sectors, foreign currency, country or sector concentration, political, regulatory and tax risks, fund operations, liquidity and tracking an index. See the PDS for details.

QSML is likely to be appropriate for a consumer who is seeking capital growth, is intending to use the product as a core, minor or satellite allocation within a portfolio, has an investment timeframe of at least 5 years, and has a high risk/return profile.