Exchange traded fund investors who are looking to reposition for the market ahead should consider the compelling cyclical opportunities in the small-cap space.

In the recent webcast, Re-thinking the equity equation: Take another look at small caps, Todd Jablonski, Chief Investment Officer, Principal Global Asset Allocation, warned that divergent COVID-19 experiences drive de-synchronized global growth. For example, vaccinations aid re-openings and recovery in developed markets. Supply constraints and bottlenecks are temporarily inflating price pressures. Meanwhile, once policy support ends, consumer spending will sustain the recovery. Easy financial conditions and strong earnings growth still support risk assets while fixed income continues to be challenged by low rates and tight spreads.

Looking ahead, Jablonski argued that excess household savings could translate to a spending boom that could help support the ongoing economic expansion. Markets increasingly see inflation become less pronounced over the long term, and Principal forecasts inflation settling around the 2% target.

While the Federal Reserve has been extolling the virtues of inflation patience, its actions speak louder than words as two rate hikes are expected by 2023. Over the short-term, though, easy financial conditions are likely to remain in 2021. In the meantime, historically low rates and tighter spreads support the case for equities.

Jablonski outlined the current base case environment with a global cyclical upturn spreading in a staggered fashion as vaccine progress broadens and the U.S. economy is expected to expand 6.8% in 2021. Fiscal policy is still supportive but monetarily, central banks are becoming less accommodative with the Fed to begin tapering in 1Q 2022 and raising policy rates mid-2023. Supply side dynamics drive inflation pressure globally with YoY U.S. CPI inflation is expected to fade slightly to 4.8% by end-2021, before settling in the 2.00–2.25% range in 2022. Lastly, financial conditions are still easy, providing support to risk assets, but inflation and central bank fears will be disruptive to market dynamics.

Nevertheless, Jablonski warned of potential risks. For example, inflation expectations become de-anchored as supply side issues extend and firms pass on higher costs to consumers. Fed could tighten policy prematurely on transitory factors. Additionally, a growth scare could be triggered by additional significant waves of virus activity and worsened by virus variants.

For this type of market outlook, Jablonski argued for a biased tilt toward risk assets, both secular and cyclical.

“We remain constructive on risk assets, staying overweight equities, funded by an underweight to fixed income. Our neutral stand on alternatives reflects improved prospects for real assets and other up-in-risk categories, balanced against a tactical bias away from risk-reducing strategies,” Jablonski said.

“Within a broader equity overweight, the U.S. remains our favorite region. The U.S. equity market features secular mega cap tech strength as well as cyclical opportunities in value and small cap,” he added.

To help investors better focus on the small-cap segment, Jeffrey Schwarte, Portfolio Manager, Principal Global Equities, highlighted the Principal U.S. Small-Cap Multi-Factor Index ETF (NASDAQ: PSC).

PSC tries to reflect the performance of the Nasdaq US Small Cap Select Leaders Index, which uses a quantitative model designed to identify equity securities (including growth and value stocks) of small-capitalization companies in the Nasdaq US Small Cap Index that exhibit potential for high degrees of sustainable shareholder yield, pricing power, and strong momentum while adjusting for liquidity and quality.

The multi-factor, small-cap equity solution offers an active index design that exploits value, quality, and momentum factor anomalies in small-cap stocks for long-term growth. The rules-based framework helps diversify and reduce unintended risks. Additionally, the portfolio construction combines multiple factors with desirable characteristics to help avoid fundamentally distressed small-cap companies.

Matthew Cohen, Head of ETF Specialist Team, Principal Global Investors, explained that PSC can provide investors with innovative factor definitions, combinations, and portfolio construction aimed to increase returns and/or reduce risk. The active index design may make PSC an attractive complement or replacement to passive, cap-weighted strategies and fundamental, active strategies.

Financial advisors who are interested in learning more about the small-cap segment can watch the webcast here on demand.