Q2 2022 Putnam Small Cap Growth Fund Q&A
- The fund outperformed its benchmark for the second quarter and for the 1-, 3-, 5-, and 10-year and life-of-fund periods ended June 30, 2022.
- We saw wide performance divergences within the small-cap growth index, most of which appeared to signal concerns about recession.
- We exited several positions that were tied to housing and consumer spending, and we continued to add new positions in the energy sector.
How were conditions for investing in the second quarter?
The very difficult conditions of the first quarter continued for another three months. For the first half of the year, the broader market, as measured by the S&P 500 Index, declined 19.96%, its second-worst start in 60 years.
The story of the quarter was inflation. After very accommodative monetary policies over the past few years, the prospect of runaway inflation emerged as a serious headwind for financial markets. The Federal Reserve began raising interest rates aggressively, with rates going from zero at the start of 2022 to a range of 1.5% to 1.75% by the close of the quarter. Forward estimates are for rates to peak near 3.25% in early 2023, meaning we have more hikes to come. As the Fed uses its “rate hammer” to cool inflation, we are already seeing demand destruction in interest-rate sensitive areas like housing. The 30-year mortgage rate, for example, has moved from 3% to 6%.
Toward the end of the quarter, we saw a steep drawdown in many commodity markets, with oil and copper coming off their highs. With high input cost inflation, high wages, disrupted supply chains, and reemerging consumers, it is tough for businesses to predict near-term inventory levels and margins. Together there are many cross currents, but most seem to point to weakening demand, which is what the Fed needs to curb inflation. However, the stock market likes high demand because it tends to lead to earnings growth.
How did small-cap growth stocks perform relative to other styles?
In this tumultuous quarter, there were few places for investors to hide. Large-cap stocks outperformed small caps, and — for a seventh consecutive quarter — small-cap value outperformed small-cap growth. Compounding the negative equity market performance was continuing weakness in bond indexes, many of which are down over 10% year to date. As a result, many portfolios with a balance of stocks and bonds delivered negative returns.
From a sector perspective, how was performance for small-cap stocks?
We saw wide performance divergences within the small-cap growth index, most of which appeared to signal concerns about recession. In the quarter, the two best-performing sectors at the index level were consumer staples and utilities, which are very small weights in the index. The health care and information technology sectors declined 19% and 23%, respectively, in the quarter. The energy sector declined late in the quarter after posting stunning gains in first quarter and throughout 2021.
How did the fund perform?
The fund outperformed its benchmark for the quarter. Stock selection was strongest in the health care and technology sectors, while selection in industrials, consumer staples, and materials detracted somewhat. The fund also outperformed the benchmark for the 1-, 3-, 5-, and 10-year and life-of-fund periods ended June 30, 2022.
How are you positioning the portfolio as we begin a new quarter?
In the second quarter, we exited several positions that were tied to housing and consumer spending. Despite some strong individual stories, the expected growth rates are now lower for many of these businesses. This is due to the rapid, and likely persistent, rise in interest rates, which will affect their end markets.
We added some new positions in cyber security, and we continued to add new positions in the energy sector. Energy’s weighting in the benchmark index was under 0.2% two years ago, but is now near 6% following the rebalancing of the Russell indexes. It’s not the higher index weighting that explains our new energy positions. Rather, we have been impressed as many management teams in the energy space are now generating real free cash flow and have started to return it to shareholders.
For informational purposes only. Not an investment recommendation.
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Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
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