Throughout the first quarter of 2022, media headlines and investor sentiment were as volatile as the markets themselves. 2022 began with the end of the pandemic and its restrictions in clear sight, strong backlogs across multiple sectors, optimistic business sentiment, low interest rates, pent-up consumer demand, and healthy corporate and consumer balance sheets. It appeared that GDP would continue to grow with the benefit of rising wages, improving employment and a post-COVID recovery. Companies incorporated input cost inflation and price increases in their 2022 outlooks and were generally assuming moderation of cost headwinds through the year. However, the Russian invasion of Ukraine and new COVID-19 shutdowns in China have significantly changed the inflation outlook with commodity price spikes and supply chain constraints that will clearly take a toll on corporate earnings. Additionally, the Federal Reserve admitted that inflation is no longer transitory. As the market began to factor in the number and magnitude of future interest rates hikes – after years of accommodative monetary policy – markets struggled to appropriately reprice assets.
As inflation surges, interest rates rise and sanctions against Russia mount, not only is sentiment much more cautious, but the “r” word (”recession”) is being bandied about by market pundits. Barring a larger scale conflict with Russia, we believe a prolonged recession is unlikely at this point; but concerns abound, and we are watching the data. Consumption trends remain strong across many categories, and we are seeing ample evidence of resilient consumer demand despite higher gas prices. The shock of COVID and the steep recovery of 2021 make for challenging comparisons, but negative growth off unprecedented GDP expansion in 2021 are not the same as an economic slowdown with rising unemployment. On the housing front, which represents 15-18% of GDP, higher interest rates are pushing mortgage rates to pre-financial crisis levels – the likes of which have never been seen by younger home buyers. While higher rates will limit the affordability for some, demand for housing remains robust with inventories at lows and new home backlogs stretching months because of supply chain, labor and permitting delays. In addition, new household formation and permanent work from home solutions have increased the need for different living accommodations. We acknowledge that much of housing demand was pulled forward during the pandemic; however, aside from rising rates, the largest issue for housing at this point in the cycle is driven by a lack of supply. We also note that customers unable to buy a new home may spend those dollars saved for a down payment on other discretionary purchases.
Consumers are still relatively flush with cash and credit remains benign. Two years of quarantine and government stimulus, coupled with rising wages and strong saving rates have created an insatiable appetite for restaurant dining, traveling and shopping. The most recent research suggests consumers are unhappy about the price of gas, but unwilling to stay home, instead choosing to use savings or cut back on other expenditures to keep enjoying the spoils of pre-pandemic life. If wages and job availability can keep pace with inflation, we see a recession as less likely. Further, if larger ticket items such as houses, cars and appliances are unavailable for purchase because of supply shortages or steep inflationary pricing, we think consumers will choose to spend incremental dollars on other items. Companies in segments of consumer discretionary should benefit from this pent-up demand while at the same time lapping the last quarter of very difficult comparisons from 1Q21. Given how much this sector has sold off recently because of recessionary fears, we believe there could be a significant opportunity for patient investors as the recovery from the pandemic continues and consumer spending remains stable.
Traditionally, an inverted yield curve is a harbinger of a future recession. As of this writing, the US Treasury yield curve is inverted on the medium part of the curve. While a potential recession is concerning, the data does not support that one is imminent. Looking back over 40 years of data, the S&P 500 was higher two years after the initial inversion in every case except one. Other research suggests that the fixation with this part of the curve is misleading and not the best indicator for macro forecasting. For example, banks, which fund a bulk of economic expansion, depend on the shorter end of the curve to generate earnings because of the duration of their loan books and lending cadence. This part of the curve remains fairly steep, suggesting that the financial sector is not about to roll over. In time, we believe that the Fed will be forced to sell many of the long-dated notes at the end of the curve, which should cause further steepening. All financials – banks and insurers – will benefit from a steeper curve with strong net interest margins and more profitable lending and investment portfolio spreads. We remain heavily invested in this sector as we think the street is underestimating the long-term earnings power of many of these institutions under such a scenario – even if credit begins to deteriorate.
In the face of all the uncertainty, we are encouraged as many companies remain in good standing despite the pressures of a global pandemic. Balance sheets are stronger than ever, with much of the debt refinanced at lower rates or extended to longer-dated maturities. Cash balances are robust. Credit remains benign across the board as government stimulus took much of the default risk off the table. While rising raw material, transport and supply chain costs have temporarily eroded corporate margins, price increases instituted last year will most likely continue as management teams look to pass through higher costs. Costs could moderate or decline, but we are not assuming that scenario in our models. We believe that COVID-19 and today’s inflationary environment have allowed quality companies to gain significant market share due to the exit of smaller players, superior speed to market with innovative pandemic business solutions, sophisticated, large scale logistics, and better access to capital. If corporate margins have peaked, investors will most likely increase focus on stocks that offer innovative margin recovery stories at attractive valuations.
In the first quarter, the Easterly Snow Long/Short Opportunity Fund benefitted from strong stock selection and an overweight to the energy sector. The market’s ‘valuation sell off’ in January and February disproportionately benefitted our lower P/E, higher free cash flow yield portfolio. As the market declined, our portfolio was buoyed by short positions and investments in energy and healthcare equities.
The Russian invasion of Ukraine was a turning point for the market and for the fund’s performance. A rapid rise in commodity prices, and particularly oil and gasoline, quickly set fire to smoldering inflation concerns. Strength in the portfolio’s energy and materials stocks was quickly offset by weakness in consumer discretionary positions, and specifically companies with exposure to European consumers. We’ve looked at potential downside earnings scenarios for our affected portfolio companies and, frankly, it looks like the market has gone too far. In some cases, we’ve taken advantage of market volatility to opportunistically sell puts where the risk/reward may be attractive. Unfortunately, irrational behavior is often on its own frenetic schedule, so we are patiently selecting only what we believe to be the most compelling investments.
Net exposure increased through the quarter from 76% to 79% (Gross exposure is 90% long and 11% short). What seems like a minor move belies a very active quarter. We significantly increased the number of securities on which we have written put options, providing lucrative option premiums and the opportunity to own high quality securities at very attractive entry points. Call options written on existing long positions declined in value as stocks moved lower, which had the effect of increasing our net exposure. We decided to trim select market hedges as the market declined and will look to add new hedges as opportunities arise.
Although market volatility comes with increased fear, we find that a dislocation in the marketplace presents some of our best investment opportunities. When high quality companies experience sharp share price declines, in some cases on pure macro speculation and not actual earnings information, we are able to add positions with significant upside and reduced risk. With a longer-term investment horizon, we welcome short-term disruptions as many investors are not willing to do their homework or jump in when not all lights are green. Nevertheless, risks are ever present, especially in a contrarian value strategy where our holdings are often in the midst of a turnaround. We feel strongly that a hedging strategy complements the value investing process and helps reduce the likelihood of negative outcomes. In addition, by opportunistically buying and selling options to build or reduce position sizes, we seek to capture attractive premiums that increase fund income.
Financial markets are continuing to digest rapidly rising interest rates and the beginning of quantitative tapering as the Fed finally addresses inflation. When a higher interest rate is factored into discounted cash flow models, a value stock’s current cash flows are more attractive than a growth stock’s theoretical future cash flows, which historically leads to the outperformance of value versus growth strategies. As yields rise, we continue to believe that value investing will come back into favor for the first time in almost 15 years.
We believe the Fund is well positioned as we are overweight high quality, low valuation stocks in under-owned areas of the market including energy, materials and consumer discretionary and financials. While we expect continued volatility in coming months until geopolitical tensions are resolved and investors contemplate higher rates, we continue to find many opportunities in the marketplace. As always, we thank investors for their continued patience and support.
|3/31/2022||QTD||1-Year||3-Year||5-Year||10-Year||Since Inception (04/28/2006)|
|Morningstar Long/Short Equity Category||-2.70%||4.49%||6.86%||5.36%||4.51%%||2.91%|
|70%/30% Blended Index||-0.57%||7.81%||9.64%||7.71%||8.43%||6.00%|
|Russell 3000 Value||-0.85%||11.10%||12.99%||10.16%||11.61%||7.75%|
Performance data quoted above is historical. Past performance does not guarantee future results and current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate, so that shares when redeemed may be worth more or less than their original cost. Investors cannot directly invest in an index, and unmanaged index returns do not reflect any fees, expense, or sales charges. For performance information current to the most recent month-end, please call 888-814-8180.
Source: Morningstar Direct. 70%/30% Blended Index: 70% Russell 3000 Value TR and 30% ICE BofA 3 Month U.S. Treasury Bill Index. Prior to June 29, 2018, the Fund was named the Snow Capital Opportunity Fund and employed a different strategy.
The Fund’s management has contractually waived a portion of its management fees until November 5, 2023 for I Shares, A Shares, C Shares and R6 Shares. The performance shown reflects the waivers without which the performance would have been lower. Total annual operating expenses before the expense reduction/reimbursement are 1.62%, 1.87%, 2.62% and 1.62%, respectively; total annual operating expenses after the expense reduction/ reimbursement are 1.62%, 1.87%, 2.62% and 1.49%, respectively. 5.75% is the maximum sales charge on purchases of A Shares.
The Fund’s investment adviser has contractually agreed to reduce and/or absorb expenses until at least November 5, 2023 for I, A, C and R6 Shares, to ensure that net annual operating expenses of the fund will not exceed 1.30%, 1.55%, 2.30% and 1.00%, respectively, subject to possible recoupment from the Fund in future years.
About Easterly Investment Partners
Easterly Investment Partners (EIP) is the advisor of the Easterly Long/Short Opportunity Fund. EIP is the traditional, fundamental based investment arm of Easterly Asset Management’s multiaffiliate platform. EIP’s current investment line-up spans the entire value equity market cap spectrum. Guided by a consistent contrarian investment philosophy, our value strategies are led by industry veterans and experts that have refined their craft and delivered strong performance through multiple market cycles. As of March 31 2022, EIP had approximately $2.6 billion in AUM.
Long/Short Morningstar Category: Long-short portfolios hold sizeable stakes in both long and short positions in equities and related derivatives. Some funds that fall into this category will shift their exposure to long and short positions depending on their macro outlook or the opportunities they uncover through bottom-up research. Some funds may simply hedge long stock positions through exchange- traded funds or derivatives. At least 75% of the assets are in equity securities or derivatives.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyFunds.com.
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and Easterly Investment Partners, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
Risks & Disclosures
Diversification does not assure a profit nor protect against loss in a declining market.
Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
Mutual fund investing involves risk; principal loss is possible. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility. Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks are greater in emerging markets. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The fund may invest in lower-rated and non-rated securities which present a greater risk of loss to principal and interest than higher-rated securities. The fund may invest in other investment companies, and the cost of investing in the Fund will generally be higher than the cost of investing directly in the shares of the mutual funds in which it invests. By investing in the Fund, you will indirectly bear your share of any fees and expenses charged by the underlying funds, in addition to indirectly bearing the principal risks of the funds. The fund also invests in ETFs. They are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value (“NAV”), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact the Fund’s ability to sell its shares. The Fund may use options and futures contracts which have the risks of unlimited losses of the underlying holdings due to unanticipated market movements and failure to correctly predict the direction of the securities prices, interest rates and currency exchange rates. This investment may not be suitable for all investors. Small- and Medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Performance over one year is annualized.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.