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Perspective

Structured Credit Market 2022 Outlook

What will 2022 Bring?

For 2022, the Orange Investment Advisors team anticipates greater and more permanent inflationary pressures due to factors beyond those resulting directly from the COVID-19 pandemic (money supply and supply chain), which can be portrayed as transitory. These include permanent labor shortages due to cultural changes, ESG mandates such as climate change initiatives and China recentralization. In addition to this, poor monetary and fiscal policy decisions driven by political rather than economic considerations heading into the 2022 mid-term elections will weigh on growth. This could compress U.S. corporate profit margins from record historical margins due to rapidly rising labor and input costs. The regulatory environment in Washington, focused on large technology companies (FAANG), is likely to put pressure on lofty equity valuations.

Risks for the Markets in 2022 

At Orange Investment Advisors, there are several policy dependent risks in 2022 that we’re keeping an eye on: 

  1. A hawkish policy mistake: The Fed tightening monetary conditions at a more aggressive pace than currently anticipated by the market (more than 3 interest rate hikes in 2022). Potential unexpected Fed tightening could lead to a rapid economic slowdown as well as yield curve flattening and potential inversion. 
  2. A dovish policy mistake: The Fed decides against taking aggressive measures to moderate inflation and doesn’t tighten beyond ending tapering in mid-2022. This scenario will cause the yield curve to steepen, with long rates rising significantly above 2%. Rising long-term rates will weigh on the valuations of growth stocks, and the U.S. economy could enter an environment of stagflation where consumers are forced to retrench on spending due to increasing housing, energy, food and other end goods-related price burdens. 

Against the backdrop of potential aggressive Fed tightening, historically high U.S. equity valuations, along with an explosion in the cryptocurrency market, should give investors cause for concern in 2022. Given the high probability for a policy error by monetary authorities, credit spread volatility is likely to increase in 2022 compared to 2021’s very benign market conditions. 

What’s Keeping Us Up at Night 

We view the possibility of an environment of stagflation, where nominal growth doesn’t keep up with price increases, as a major concern. The distress resulting from a collapse in equity and cryptocurrency valuations, due to some unexpected catalyst such as overly aggressive Fed tightening, could easily spill over affecting other markets, among them structured credit. Under this dislocation scenario, our current portfolio positioning should mitigate initial drawdown due to spread widening, allowing us to capitalize on value opportunities created. A collapse in yields in the long end of the curve, due to overly hawkish Fed related tightening or any other risk-off events, may cause some structured credit sectors to underperform. A couple other items that are top of mind for us are poor monetary and fiscal policy driven by politics over prudent economic policy, and elevated geopolitical tensions between the U.S., China, Russia, Iran and North Korea and their impact on rates and risk assets. 

Do Increasing Rates Concern Us? 

Our biggest concern is a curve flattening scenario. In that scenario, our interest rate exposure is somewhat mitigated by an allocation to floating rate securities (RMBS, CLOs, CMBS) and a small, long position in 30- year treasuries. Our base case interest rate scenario is a gradual steepening of the yield curve. In a steepening scenario we believe our portfolio will benefit from an allocation to corporate structured notes. We expect significant interest rate volatility in 2022 due to uncertainties related to Fed policy. This impending rate volatility should cause credit spreads to widen from historic tights, offering what we believe are relative value opportunities across structured credit sectors. 

What Type of Inflationary Environment Are We In? 

We feel inflation related to the rise in prices for goods, emanating from COVID-19 related supply chain disruptions, is likely to be transient in nature, as supply chain issues will normalize over time. Even monetary policy-induced inflation could be transitory if the Fed acts apolitically and does what is best from an inflation perspective. However, we believe there are more permanent inflationary forces behind the current spike in prices. These include climate-related energy initiatives that deemphasize and discourage investments in fossil fuel related industries, record job openings and concomitant wage growth against a backdrop of lower labor force participation. An increasing number of workers are leaving their jobs. This shift in attitude toward labor is inflationary and we compare this attitude with defaulting on a mortgage, which became much more socially acceptable during the Great Financial Crisis than it previously had been. A large portion of our securities (>40%) have floating rate coupons that reset higher with Fed interest rate increases. Also, in the case of the Fed choosing not to pursue an aggressive monetary tightening policy and leave short term rates anchored near zero, we expect the long end of the curve to rise and the yield curve to steepen. Yield curve steepening will benefit our corporate structured note positions that have a steepening bias. 

Value Strategies with Reasonable Growth Rates will be Rewarded this Year 

In our base case, we expect rising long term interest rates, which should benefit value rather than growth as long duration interest rate sensitive sectors are likely to underperform. A scenario where the Fed is forced to hike rates more aggressively than is priced by the market could cause further yield curve flattening along with a risk-off interest rate rally. In our opinion, this type of a bull flattener will generally favor growth over value strategies. 

Consider the Following Items when Rebalancing your Portfolio 

The prospect of a less accommodative Fed starting to tighten monetary conditions is likely to weigh on markets throughout 2022. This shift in the Fed’s approach is against a backdrop of post-crisis tight credit spreads and advocates for a flexible risk-adverse approach. Investors should also focus on carry from their fixed income allocation, and not rely on continuing credit spread tightening or improving borrower credit performance. A barbell of fixed income securities with solid carry (such as legacy RMBS fixed-rate passthroughs), small balance commercial fixed-rate and floating rate securities, AA through BBB rated CLO mezzanine tranches, along with select higher rated CMBS conduit mezzanine bonds, plus an allocation to cash should enable investors to earn decent carry while not subjecting their portfolios to significant credit spread widening risks or credit default risks. Income generated from carry plus dry powder in the form of treasuries and cash can be reinvested in sectors experiencing spread widening during periods of macro related volatility. 

How to Plan for the Year Ahead 

In our opinion, investors should de-risk and be prepared for both interest rate and credit spread volatility in response to an active Fed which could unsettle the markets. We believe investors should maintain a healthy cash and a short duration bucket and not bet on additional spread tightening from current compressed spread levels. In our opinion, investors should also expect the majority of returns to be generated from carry and remain nimble and opportunistic. While we expect greater spread volatility, we don’t expect a major risk-off environment in structured credit, hence we believe investors should be ready to take advantage of what we consider opportunities as they appear.

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. 

Risks & Disclosures 

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 Orange Investment Advisors, 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. 

There is no assurance that the portfolio will achieve its investment objective. A CLO is a trust typically collateralized by a pool of loans. A CBO is a trust which is often backed by a diversified pool of high risk, below investment grade fixed income securities. A CDO is a trust backed by other types of assets representing obligations of various parties. For CLOs, CBOs and other CDOs, the cash flows from the trust are split into two or more portions, called tranches. MBS and ABS have different risk characteristics than traditional debt securities. Although certain principals of the Sub-Adviser have managed U.S. registered mutual funds, the Sub-Adviser has not previously managed a U.S. registered mutual fund and has only recently registered as an investment adviser with the SEC. 

Easterly Funds, LLC and Easterly Investment Partners, LLC both serve as the Advisors to the Easterly Fund family of mutual funds and related portfolios. Both Easterly Funds, LLC and Easterly Investment Partners, LLC are registered as investment advisers with the SEC. Mutual Funds are distributed by Ultimus Fund Distributors, LLC, a member of FINRA and SIPC. Although Easterly Funds, LLC and Easterly Investment Partners, LLC are registered investment advisers, registration itself does not imply and should not be interpreted to imply any particular level of skill or training. 

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. 

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