Small Cap Value – Q1 2022 Commentary
During the first quarter, equities collectively finished lower as measured by most major equity indices. After a robust fourth quarter and full year in 2021, investors reacted to the prospects of higher inflation, a reduction in fiscal stimulus, an increasingly hawkish Fed position, and a new level of geopolitical risk from Russia’s invasion of Ukraine. For the quarter, the Kennedy Capital Small Cap Value (SCV) composite declined 6.24% (gross of fees) and declined 6.45% (net of fees) compared to the Russell 2000® Value (R2V) Index which declined 2.40%. For the rolling 12-month period, the SCV composite has increased 8.93% (gross of fees) and increased 7.97% (net of fees) compared to the R2V Index which has increased 3.32%.
Russia’s invasion set off a spike in the price of oil, leading to Energy being the best performing sector, in the index, during the first quarter. Within the index, Utilities also generated positive returns despite rising interest rates due to their relatively defensive nature in the face of increasing economic uncertainty. Consumer Discretionary proved to be the weakest sector, in the index, with inflation, particularly in food and energy, coupled with the end of many of the fiscal stimulus programs beginning to have a negative effect on many consumers. The Health Care sector was the second weakest sector in the index, for the quarter. Specifically, for the SCV composite, our Industrial and Consumer Discretionary holdings were the biggest detractors to relative performance.
Declining consumer confidence will likely lead to some moderating of consumer demand and could begin to temper some inflationary pressures. However, we continue to believe a significant portion of the fiscal and monetary stimulus injected into the US economy over the last 18-24 months remains unspent. Coupled with extremely low unemployment rates, we believe the economy is still on relatively sound footing, and economic softness is unlikely to be severe.
The sense of urgency to contain inflation has increased significantly at the Federal Reserve during the first quarter. The Fed began to recognize inflation was not transitory like they had predicted and began to reduce their monetary stimulus program last December. They have now transitioned from Quantitative Easing to Quantitative Tightening by allowing their purchases of treasuries and mortgage back securities to begin to run off. In addition, the Fed has begun to raise the target for short-term interest rates for the first time since 2018 and has signaled more aggressive actions are likely to follow. This has led to an increase in investor discount rates evidenced by the compression of PE multiples.
Without question, economic uncertainty has increased of late as investors are faced with the highest rate of inflation observed in the last 40 years, rising interest rates, a substantial increase in geopolitical tensions, and the lingering effects of a pandemic that is still exhibiting a frustrating persistence. While unprecedented levels of fiscal and monetary stimulus were effective in offsetting much of the economic impact of the Covid pandemic, our economy is now facing monetary headwinds as the Fed moves to reign in inflationary pressures. Much like we did during the early stages of the pandemic, we will continue to focus on the long-term, value-creating capacity of businesses as we look for investment opportunities. Often times of increased uncertainty yield profitable investment opportunities.
We welcome the opportunity to discuss any questions or concerns you may have, and we thank you for the opportunity you have given us to manage your account.
|Frank Latuda, Jr., CFA®
Chief Investment Officer & Portfolio Manager
|McAfee Burke, CFA®