Inflation and other macro headwinds dampen stock performance


Q3 2022 Putnam Small Cap Growth Fund Q&A

  • The fund slightly underperformed its benchmark for the third quarter, but outperformed for the 1-, 3-, 5-, and 10-year and life-of-fund periods ended September 30, 2022.
  • In a repeat of the second quarter, we saw wide performance divergences within the small-cap growth index, with health care and energy stocks performing best.
  • We exited several positions that were tied to the auto end markets, and added positions in the industrials sector.

How were conditions for investing in the third quarter?

The magnitude of the market’s volatility is not apparent in the final results. Small-cap growth stocks eked out a gain of 0.24% for the quarter. Within the quarter, however, we saw some massive moves in equity performance. The S&P 500 Index was up nearly 14% through August 15, then it fell more than 16% by quarter-end. This decline was a bit more exaggerated for small-cap stocks.

Once again, the story for the quarter was inflation — and the Federal Reserve’s aggressive moves to tame it. Interest rates have moved from zero at the start of 2022 to a range of 3.00% to 3.25% by the end of September. Forward estimates are for rates over 4% by the close of the year, and the Fed has downplayed expectations for a rate cut in 2023. Fed Chair Jerome Powell described inflation as enemy number one, essentially saying that rate hikes are necessary even if they result in a recession or pain for the financial, housing, and labor markets. Globally, the ongoing Russia-Ukraine War remains a key risk for markets, most recently due to a widening energy supply crisis. On a rare positive note, Covid-19 appears to be on the decline through most of the world, and even China seems to have reduced its pandemic-related lockdowns.

From a sector perspective, how was performance for small-cap stocks?

Also in a repeat of the second quarter, we saw wide performance divergences within the small-cap growth index. The two best-performing sectors at the index level were health care and energy. The weakest sectors were real estate and consumer staples. The health care sector’s return of more than 8% was largely driven by the biotech industry, which returned over 15% for the quarter.

How did the fund perform?

For the quarter, the fund narrowly underperformed its benchmark. Stock selection was positive, but cash and currency impacts related to individual holdings detracted slightly from returns. The U.S. dollar’s strength meant that what companies earned overseas translated into fewer dollars. Stock selection was positive in 6 of 10 sectors, and was strongest in the industrials sector. Consumer discretionary and health care holdings were detractors. Looking at longer periods, the fund outperformed the benchmark for the 1-, 3-, 5-, and 10-year and life-of-fund periods ended September 30, 2022.

Have you made any shifts in the portfolio’s positioning?

In the quarter, we exited several positions that were tied to the auto end markets. Despite strong operating histories for these companies, we believe the Fed’s interest-rate hikes are likely to curtail demand for autos. Weaker consumer spending, spiking lending rates, and instability in global supply chains may make balancing supply and demand more difficult going forward. We also sold out of a few holdings that had greater exposure to the foreign exchange markets. We added new positions in the industrials sector, in businesses that we believe will benefit from multiyear demand backlogs in their industries.