In the US, July’s jobs report showed double the expected gains despite talk of a recession. In the UK, the Bank of England made its largest rate hike in nearly 30 years. In the midst of uncertainty and higher rates, could small caps have a role to play?
Despite higher long-term yields, Tech led the market higher last week while Energy had its worst week since June. The US 2-year Treasury yield jumped following strong July payrolls, compressing 10-and-2-year spreads further into the negative territory.
Mixed Results Contribute to Continued Uncertainty
Nonfarm payroll employment rose by 528,000 in July, more than twice expectations,1 sending the market-implied probability of a 75 basis point (bp) hike in September up from 32% to 68%.2 A tight labor market provides more room for monetary tightening if inflation remains elevated. US services activity expanded further in July, with ISM Services PMI increasing to 56.7, and prices paid declining for the third straight month — a sign of easing price pressure.3
Adding to geopolitical uncertainty, House Speaker Nancy Pelosi visited Taiwan last week despite warnings from China. Taiwan was encircled by China’s live-fire military drills after the meetings.
UK Sees Large Rate Hike
The Bank of England (BoE) raised interest rates by 50 bps to 1.75%, its largest move since 1995, and expects inflation to remain elevated into 2023.4 Q2 GDP in the UK is expected to decline slightly given higher energy prices.
Resilience in Small Caps
Small-cap equities have struggled this year in the face of monetary tightening and a slowing economy. The Russell 2000 Index is down 12% year to date and has a maximum drawdown of 27%.5 But macroeconomic headwinds have not impacted all small-cap exposures equally. The SPDR® S&P SmallCap 600 ESG ETF (ESIX) has outperformed the Russell 2000 Index by 4% since its inception in early January 2022, and with a lower drawdown.6
The profitability screen on the S&P SmallCap 600® Index — the parent index of ESIX’s benchmark — means that ESIX’s portfolio has exhibited both a value tilt and higher quality than the Russell 2000 (see the chart). This may lead to greater resilience for ESIX in the face of higher rates and heightened economic uncertainty, evidenced by its lower volatility and lower drawdown year to date.
ESIX’s Quality and Value Traits
ESIX takes a best-in-class/positive screening approach that emphasizes firms with more positive ESG traits relative to peers based on certain levels of ESG criteria, while maintaining similar industry group weights to that of the broad market.
In today’s complex economic environment, ESIX’s quality- and value-oriented characteristics may position it as a strong ESG core building block. And if harvesting small-cap losses, ESIX at 12 bps could serve as a lower-cost swap for more expensive small-cap ESG funds or help introduce an ESG focus to portfolios with traditional core equity exposures.
ESIX Standard Performance as of June 30, 2022
1 Bureau of Labor Statistics, August 5, 2022. 2 CME Group FedWatch Tool, August 5, 2022. 3 ISM, August 5, 2022. 4 Bank of England, August 5, 2022. 5 FactSet, as of July 29, 2022. Past performance is not a reliable indicator of future performance. 6 FactSet, as of July 29, 2022. ESIX inception date is January 10, 2022. Past performance is not a reliable indicator of future performance.
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