The slow return of Eurosclerosis

by Thomas Kirchner & PAUL HOFFMEISTER

Portfolio ManagerS

With protests by yellow vests in France approaching their six month anniversary and the European economy showing signs of not a temporary dip, but prolonged weakening, it is a good moment to take a step back and analyze the current situation as well as its implications for the medium to long-term outlook for Europe.As we see it, European economies have been weakening significantly, and even worse, Germany, the European Union’s largest economy comprising almost 21% of the area’s GDP in 2018[i], is on the verge of recession. With Germany the economic locomotive of the euro area, there may not be much reason to be optimistic. The country’s economic problems appear to be structural, due to high taxes, excessive government spending, failed energy policies and other regulatory constraints. Thinking about the years ahead, we aren’t optimistic that the policy response from the German government -- as well as other European governments such as in France, Italy and Greece -- will be strong enough to avoid a prolonged economic malaise for the continent. As a result, we believe that the global economy will suffer from Eurosclerosis in the coming years.

Figure 1: GDP of EU Member States and Share of Total. Source: Statistics Times.

Struggling European Economies

According to the OICA, automobile production in Germany fell 9.3% in 2018[ii], year-over-year. In our view, the prospects for Europe’s leading economy are ominous given that the auto industry is linked to almost 8%% of German GDP.[iii] Business sentiment in Germany appears to have recently turned from euphoria to gloom: as of April 2019, IFO business sentiment has declined 2.8%[iv] while the Markit/BME purchasing managers index has crashed from 58.1 to 44.5 year-over-year[v]. 

Figure 2: German Automotive Car Production. Source: International Organization of Motor Vehicle Manufacturers

Optimists could point to low unemployment in Germany, which hovers near 5%, according to the OECD[vi]. But low unemployment data could be misleading because German companies can be reluctant to lay off workers, not only because restrictive labor laws make layoffs difficult and expensive, but also because hiring talent can be a lengthy drawn-out process should the economy recover quickly. Many firms experienced that problem during the last decade of relative economic strength when qualified labor was hard to come by and growth for some firms remained below potential due to labor shortages. While this helps to sustain economic statistics, it can destroy corporate profitability and eventually end up costing investors.

According to Eurostat, real GDP growth in Germany is waning, growing only 0.6% in Q4 2018, from 2.8% in Q4 2017[vii]. We are worried about the specter that when Europe’s economic locomotive sneezes, the rest of the continent catches a cold.

Unfortunately, the situation in most of Europe is just as gloomy. According to Eurostat, Italy experienced 0% growth in real GDP year-over-year in Q4 2018 (compared to 1.7% in Q4 2017), while France’s real GDP grew 1.0% in Q 2018 (compared to 2.8% in Q4 2017)[viii]. While Italy seems hard pressed to enact aggressive pro-growth stimulus due to European Union budgetary rules, there doesn’t seem to be much appetite by President Macron to catalyze the French economy by increasing business-friendly incentives. Furthermore, the ongoing protests by the yellow vests inside France, which underscore the economic frustration among many French people, should hamper the growth picture further. And across the Channel, the UK may or may not struggle with Brexit, and while the eventual outcome could be positive, strains during any transition are likely.

The sluggish GDP data in Europe is supported by poor industrial production, which has been declining in Italy, the UK, France and Germany since late 2017. In sum, the four leading European economies appear to be simultaneously entering a state of economic distress.

Figure 3: European Industrial Production.

We believe that the current downcycle in Europe is a harbinger of something much bigger: a secular economic decline in Europe driven by lackluster performance by Germany due to a series of poor policy decisions and even outright policy failures. Germany is yet again set to become the sick man of Europe. In our view, like 20 years ago when the German economy was a laggard, the problems appear to be self-inflicted: a combination of encrusted labor markets with well-intentioned but costly and failing reforms.

Energy

Energy policy is one of Germany’s most significant policy failures. Following the Fukushima nuclear disaster of 2011, Chancellor Merkel single-handedly flip-flopped on longstanding conservative support for nuclear energy and announced the phasing out of all of Germany’s nuclear reactors by 2022. To some people today, it is understood that this radical shift was less motivated by fears of a nuclear disaster, and more so by fears of political gains by the Green Party, which scored significant regional electoral victories in the immediate aftermath of Fukushima. Merkel’s strategy worked well for her, allowing her to hold on to power. Unfortunately, it worked less well for the users of electric energy and the German economy at large and is an example of well-intentioned government policy gone bad.

Estimated annual subsidies of nearly 15 to 40 billion Euros, according to Clean Energy Wire[ix], may be required to implement this policy failure. While industrial users of electricity have their consumption subsidized, it may not be enough to fully offset the pincreases wrought by the replacement of nuclear power by more expensive alternatives, renewables in particular. BASF’s ex-CEO Kurt Bock, who has been a vocal critic of high energy prices in Germany, curtailed his company’s investments there, despite electricity subsidies available to industrial users.

At the same time, households are bearing the brunt of the burden because retail electricity prices are used to finance the subsidies to industrial users and now pay some of the highest electricity prices in the world. Less affluent households see their power cut off for non-payment of electricity bills at a record rate[x]. And one nuclear power plant that had been completed only recently operated for only 13 months before being dismantled, costing energy company RWE losses of at least five billion Euros[xi].

Policy planners in the German government were hoping that wind and solar energy would replace the production capacity lost from nuclear reactors. A massive buildout of these technologies has dotted the country’s landscape, particularly in the north, with windmills. At a nominal capacity of over 100GWh, equivalent to five Chinese Three Gorges Dams, wind and solar now exceed peak demand[xii]. But only on paper.

Because they work only when the wind blows or the sun shines, their contribution to energy production is highly variable. The unreliability of renewables has meant that an equal capacity of conventional coal and gas power plants had to be built, effectively doubling the amount of capital needed to produce a given amount of electricity and boosting electricity costs.

The variability of energy production by renewables poses serious challenges to the operators of the electricity grid. Widespread blackouts can be avoided only by shutting off electricity to power users such as aluminum furnaces or glass manufacturers. 78 such mini-blackouts occurred last year[xiii]. Unreliable electricity coupled with high costs is something found otherwise in developing countries, and this may be the direction in which the German economy is heading as the energy policy failure is beginning to lead to a slow, and perhaps certain deindustrialization.

Chemical giant BASF is the most vocal and prominent company so far to have announced its intention to reduce investments in plants in Germany – other companies have taken this decision quietly without much fanfare, such as SGL Carbon, which built its latest carbon fiber factory in the United States instead of Germany.

Excessive government spending, high taxes

Although uninhibited government spending is far from being a uniquely German problem, it has become particularly problematic as a result of the relatively strong performance of the German economy during the last decade or so.

Since Merkel’s accession to power in 2005, tax revenue has increased by 78%[xiv], yet many core government activities suffer from acute underfunding. The army’s desolate condition has been well documented elsewhere – not a single functioning submarine, pilots who cannot complete their required minimum flight hours due to a large number of aircraft permanently grounded for service, and even the fleet of aircraft shuttling government ministers around the world tends to break down during state visits to remote locations. Even Angela Merkel arrived late to the G20 summit in Argentina late last year after her aircraft experienced technical difficulties. Netjets might go out of business with such a track record. Although infrastructure is still generally in excellent condition, maintenance has been delayed due to lack of funds so that future deterioration has become inevitable.

Where did all the money go? Government debt declined by approximately 5% between 2012 and 2017 but still exceeds pre-crisis levels by almost one third[xv]. Spending categories with the largest increases are personnel and material costs. So ever more bureaucrats need ever more offices.

A good example is the Chancellery in Berlin: Angela Merkel’s staff has increased from 400 to 750, so only 18 years after its completion, Berlin’s Chancellery has become too small. An extension with 400 new offices will cost 460 million Euros – more than one million per office[xvi]. At that cost we can only hope that the offices will be stately and representative, although it is more likely that they will look dull and dreary as government offices typically do. In any case, the decade-long timeline until completion leaves plenty of room for cost overruns. Further spending increases are seemingly guaranteed, as public sector unions have negotiated an 8% raise[xvii].

The irony about the increase of tax revenue from less than 20% to over 23% of GDP during Merkel’s term in office is that she campaigned on an increase in value added taxes to be offset by a reduction in income taxes[xviii]. Once in power, value added taxes went up as promised, as did a host of other taxes, particularly taxes on capital; the promised reduction in income taxes was shelved. Tax cuts were last implemented nearly 20 years ago by former Chancellor Schroeder’s left-leaning government.

Ever more bureaucrats also means that they need ever more areas to regulate. Despite steady population growth, the city administration in Berlin has reduced the number of housing permits issued, and it has lengthened the time it takes to receive a permit. Residential housing in Berlin can now take ten years from concept to completion. To appease an angry public, the local government talks about expropriating residential REITs without explaining how that would increase the stock of housing.

Social spending largesse

Not only in phasing out nuclear energy did Merkel adopt positions that were previously held only by her coalition partner SPD, following the 2017 election, she wholeheartedly allowed Social Democratic ministers to implement numerous expensive programs, the costs of which have saddled taxpayers with enormous unfunded liabilities. For example, the extension of pension benefits to stay-at-home mothers who raise children but make no pension contributions will cost billions, with even higher costs for decades after that. This follows a 2013 decision to offer free childcare to all.

To the chagrin of Social Democrats, none of these new programs have translated into electoral benefits for them. The SPD’s standing in the polls today is the lowest ever. Were elections held tomorrow, they would underperform their lowest election result ever.

In a desperate attempt to stem its decline, the current SPD leadership now tries to do more of what has failed before: more spending. Given Merkel’s record of appeasing her coalition partner, there is a good chance that taxpayers will be saddled with even more liabilities.

Political uncertainty

Merkel’s decision not to run again in the 2021 election has turned her into a lame duck chancellor and introduces significant political uncertainty. It is surprising that Merkel chose this route due to the risk of recreating the atmosphere of inaction that permeated the last years of the Helmut Kohl era during the late 1990s, who was her mentor and whose office ended when he lost an election after voters grew tired of him. Arguably, her decision to retire at the time of the election was driven by a desire to avoid such an embarrassing election loss. However, two years of stalemate will mean that her departure will likely have a negative tone.

Another sobering aspect of Merkel’s departure plan has been the appointment of her successor. Normally, a successor would be expected to break with the Merkel era. However, Annegret Kramp-Karrenbauer (“AKK”) is perceived to be Merkel’s mini-me, who will perpetuate Merkel’s overall policies, including the politically unpopular aspects of energy policy and migration. Friedrich Merz, a free marketeer with a deeper understanding of economic policy, deregulation and taxes, lost narrowly. We believe, however, that there is a chance that he will be involved in a future government and potentially even stage a challenge to AKK, although that may not happen until after the 2021 election. AKK’s economic thinking does not appear growth-friendly, namely her support for an increase in the top individual income tax rate from 42% to 53% and her opposition to inflation-indexing of tax rate thresholds, leading to creeping tax increases[xix].

Malaise set to worsen

After a decade of ultra-low interest rates, the German economy that helped to keep Europe going is not only slowing but may be in a much more precarious position than before the financial crisis. Therefore, the real risk today is not just a cyclical recession, but a prolonged downturn. Overcoming a decade of significant policy errors is not going to be achieved during the normal duration of a recession, much less so if you also need to overcome a decade of misinvestment due to low interest rates and onerous tax policies.

The impact of an emergent economic downturn on employment is likely to be muted at first because companies will be reluctant to fire workers. This is partly the effect of stringent employment laws that make it difficult to adjust the size of the workforce to changes in production, and partly companies’ recent experience of extremely difficult hiring conditions.

While the German economy is flooded with low-skilled and unskilled workers, partly as a result of recent migratory trends, qualified workers with strong technical backgrounds are scarce and companies were unable to fill many such jobs during the recent boom. As a result, many companies will keep workers on the payroll and hope to ride out the recession. This favorable employment picture in the midst of a recession will likely reduce political pressure for much-needed reforms and exacerbate problems in the future.

The most likely response by governments to reduced tax and social security receipts will be tax increases, rather than reductions in spending or aggressive tax cuts on investment capital. If you want less of something, tax it. As such, tax increases will only exacerbate the slowdown in economic activity through a decline in investment. Although the nominal tax rate on capital in Germany is 25%, only five points higher than in the U.S., this rises to almost 30% once various surcharges are included[xx]. Moreover, deductibility of losses has been curtailed sharply in the name of tax justice to ensure that companies pay a minimum tax rate, which reduces the attractiveness of investments that are profitable in the long run but are lossmaking early on.

Not surprisingly, investment is limited in many cases to saving projects in established firms. While there has been a mini-boom in internet and technology firms, it is nowhere near a level that you would expect from the fourth largest economy in the world. Germany is lagging far behind technology leaders U.S.A. and China. Nothing illustrates this lag better than the opening of offices in Silicon Valley by the few German technology and internet companies who end up succeeding and want to gain scale. They desire to tap into venture capital and the technology scene in general, which is woefully lacking inside Germany. A study by PwC of the Global 100 Software Leaders lists only five German companies among the top 100 by revenue, and we would question whether Siemens should even be counted as a software company so that the real share is a measly four out of 99[xxi].

The Kiel Institute for the World Economy (IfW) sees Germany in a much weaker economic position than prior to the 2008 financial crisis because of deficiencies in infrastructure spending and a lack of corporate tax reform since the government of Chancellor Schröder nearly two decades ago[xxii].  IfW warns that bureaucracy has increased and with trade partners from Europe to China experiencing an economic slowdown, export growth will not likely bail out the economy this time. We would add that the U.S. is going to be the beneficiary of the corporate tax stalemate thanks to U.S. corporate tax rates that are now in line with Switzerland, the U.K. and Eastern Europe.

Germany’s economy remains rooted in old tech such as chemicals, industrial equipment and automobiles. While these industries have generated substantial trade surpluses over the last decade, this has not led to a corresponding increase in household wealth. Today Germans are, on average, less wealthy than Italians, Spaniards or the French[xxiii]. In our view, an important factor behind this discrepancy is the low rate of homeownership, and also the propensity to invest savings in assets with low volatility, mainly low-yielding savings accounts and life insurance policies, which prevents savers from accumulating wealth. Even worse, negative interest rates have reduced the wealth of citizens while facilitating excessive government consumption.

While it is true that many of the problems faced by the German economy are faced by other economies elsewhere in the world, too, it is the ignorance by the political leadership of the origins of the strong economic performance that is unique. Wealth and growth are taken for granted, capitalism is considered evil and must be contained. The United States also suffers from a terribly inefficient public sector, but a combination of low tax rates, entrepreneurship and readily available capital for new ventures offset many of these problems.

As a consequence, we believe that Europe will return to a state of Eurosclerosis in the decade of 2020, triggered by the inability of Germany to continue to act as the growth engine for the continent. Continued problems in the European periphery from Italy to Greece are likely to add to the downward economic pressure.

Investment Implications of Eurosclerosis

For investors, Euroscelrosis raises the question of portfolio implications. The old dogma of not investing in European companies and instead investing in U.S. firms no longer works due to globalization. For example, Roche had only 24% of its 2018 sales in Europe, while Bristol-Myers Squibb achieved a similar percentage of its sales there[xxiv]. Substituting European pharma Roche with an investment in U.S.-based Bristol-Myers will in no way reduce portfolio exposure to the European economy. This is a practical consequence of globalization: everyone has global exposure. Therefore, traditional large and mega cap investment strategies offer poor prospects for reducing portfolio exposure to Europe by divesting Europe-based stocks.

In our opinion, the impact of Eurosclerosis is more benign, potentially even favorable for event-driven investments. In a weak economy the pressure to optimize corporate structures is likely to increase, in particular when European companies benchmark themselves against U.S. firms that have gone through a decade of mergers and splits. Therefore, opportunities in merger arbitrage and spin-offs should increase, while simultaneously a growing number of distressed opportunities will arise.  While Eurosclerosis will be difficult for traditional investment strategies we believe that it will present many opportunities for event-driven investors.

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Mr. Kirchner has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously was the founder of Pennsylvania Avenue Advisers LLC and the portfolio manager of the Pennsylvania Avenue Event-Driven Fund. He is the author of 'Merger Arbitrage; How To Profit From Global Event Driven Arbitrage.' (Wiley Finance, 2nd ed 2016)

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

[i] Statistic Times based on IMF data.

[ii] International Organization of Motor Vehicle Manufacturers (“Organisation Internationale des Constructeurs d’Automobiles”).

[iii] “German Car Trouble and the CEE”, April 4, 2019, ING.

[iv] „ifo Business Climate Index Falls.“ ifo Institute for Economic Studies, Munich, April 24, 2019.

[v] https://tradingeconomics.com/germany/manufacturing-pmi

[vi] OECD (2019), Unemployment rate (indicator). doi: 10.1787/997c8750-en (Accessed on 07 May 2019).

[vii] GDP growth rates in the fourth quarter of 2018, % change over the previous quarter, based on seasonally adjusted data - Source: Eurostat (namq_10_gdp).

[viii] Ibid.

[ix] Sören Amelang; “How much does Germany’s energy transition cost?” Clean Energy Wire, 01 Jun 2018.

[x] „Mehr Haushalten wegen unbezahlter Rechnungen Strom abgestellt“ faz.net, November 10, 2018.

[xi] Michael Rasch: „Wahrzeichen des deutschen Verwaltungswahnsinns“ nzz.ch, February 7, 2019

[xii] Sandra Enkhardt: „Renewables surpassed fossil fuels capacity in Germany last year.” Pv-maganzine, November 28, 2018.

[xiii] Holger Douglas: „Deutschland (fast) ohne Strom“ tichyseinblick.de, January 21, 2019.

[xiv] Author’s calculations based on data from https://www.bundesfinanzministerium.de/Content/DE/Standardartikel/Themen/Steuern/Steuerschaetzungen_und_Steuereinnahmen/2-kassenmaessige-steuereinnahmen-nach-steuerarten-1950-bis-2017.html

[xv] Eurostat.

[xvi] „Bundeskanzleramt: Neubau mit 400 Büros für 460 Millionen Euro“ Handelsblatt, January 15, 2019.

[xvii]Detlef Essinger: “ Acht Prozent mehr Gehalt im öffentlichen Dienst” sueddeutsche.de, March 2, 2019.

[xviii] Ansgar Neuhof: „Große Koalition: Nichts kommt den Bürger teurer“ Tichys Einblick, December 13, 2017.

[xix] Jürgen Streihammer: „‘Wir Sozialdemokraten‘: Als die CDU-Chefin ihre Partei verwechselte.“ Die Presse, February 11, 2019.

[xx] „International Tax - Germany Highlights 2019.“ Deloitte Touche Tohmatsu Limited, January 2019.

[xxi] „PwC Global 100 Software Leaders“ PwC, Available at pwc.com/gx/en/industries/technology/publications/global-100-software-leaders/explore-the-data.html

[xxii] Kiel Institute Economic Outlook Germany, Nr. 53 (2019 | Q1).

[xxiii] Vereinigung der Bayerischen Wirtschaft e. V.: „Die Vermögensverteilung im internationalen Vergleich.“ Institut der deutschen Wirtschaft e. V., June 2018.

[xxiv] Annual reports for Roche Holding AG and Bristol-Myers Squibb Company per December 31, 2018.

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Event Driven Advisors.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

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Strong US Growth, Cautious Yield Curve, Healthcare Policy Concerns

By Paul Hoffmeister, Chief Economist

·      At the end of December, the predominant concerns among investors appeared to be an excessively hawkish Fed and worsening US-China trade relations. Now, the outlooks for both seem to have completely shifted for the better.

·      Of the uncertainties that need to get sorted out in coming months, our two biggest concerns today relate to Brexit, which includes the EU parliamentary elections, as well as the slowdown in the major economies outside the United States.

·      The results of the EU parliamentary elections in late May could be market moving; perhaps not so much because of their implications for future policy developments inside the EU Parliament but for their clues about the UK’s views going forward regarding Brexit and a forthcoming general election.

·      We believe that the cautionary signals implied by the flat Treasury curve today could very well be saying that the principal macroeconomic risks reside outside the United States. And if an economic “crackup” were to occur during the next 1-2 years, it’s most likely to originate from and be most severe in foreign countries, and cause some knock-on effects to radiate back to the United States.

·      Similar to 2010 with the dawn of the Affordable Care Act, we believe the major reason for this year’s selloff in the healthcare sector is uncertainty surrounding future healthcare policy, particularly because the popularity of “Medicare for All” within Democratic circles appears to be growing. But fears of an imminent demise of many of today’s healthcare companies is probably an overreaction, and the path to Medicare for All is long and windy and by no means easy.

What a difference four months make. At the end of December, the predominant concerns among investors appeared to be an excessively hawkish Fed and worsening US-China trade relations. Now, the outlooks for both seem to have completely shifted for the better.

The Fed is on pause for “some time”, according to Chairman Powell.[i] Markets believe it and are even hopeful about a rate cut. Based on interest rate futures trading on April 26, the CME Group calculated a 63.8% probability of a rate cut by year-end, 36.2% probability of no change, and no chance of a rate increase.

And in the latest sign of an imminent trade deal, President Trump said that Xi Jinping will be visiting the White House soon.[ii] This is consistent with the latest reports of significant concessions from China. In Xi’s speech at the recent Belt and Road Forum, he pledged to make a host of reforms, including changes to state subsidy policies, protecting intellectual property rights, allowing more foreign investment, and avoiding competitive devaluations – each of which are key American demands.[iii]

With the dark clouds of December having parted, the sun is now shining on markets and, in terms of macro risks, there don’t seem to be many clouds in the sky. So it makes sense that most stock markets around the world have rallied strongly year-to-date, with the S&P 500 breaking new highs. US corporate credit spreads have also tightened in recent months. Clearly, it’s been a “risk on” market environment.

Ironically, however, the current environment seems trickier today than it did in late December when many investors were panicking. At that time, there was so much worry and such a collapse in risk asset prices that the risk-reward profile of the equity market, for example, appeared to be significantly skewed in favor of being aggressively long. Today, the risk-reward dynamic seems, however, to be much more balanced.

Nonetheless, despite the appearance of less risk and less concern being priced into markets at the moment, stocks could easily continue to rise as long as no major surprises pop up. But in our view, the speed and ascent of stock prices year-to-date should slow. Most likely, the current stock market rally will shift gears from the quick, strong rebound price action to a slower “melt up”.

Of the uncertainties that need to get sorted out in coming months, our two biggest concerns relate to Brexit, which includes the EU parliamentary elections, as well as the slowdown in the major economies outside the United States.

 Brexit Uncertainty Persists: Watch EU Parliamentary Elections

Based on our assessment of market behavior in recent months, the postponement of Brexit and the growing possibility of it being tabled has been a market positive – even though we believe Brexit could be endured by markets and the global economy if British policymakers swiftly combined it with new strong, pro-growth policies, such as big tax cuts on capital investment and major trade deals including with the United States. President Trump was indeed dangling that possibility in March when he said, “I’d like that whole situation with Brexit to work out. We can do a very big trade deal with the UK.”[iv]

As it stands today, Britain and the EU have a new Brexit deadline: October 31. Unless an arrangement between the UK and EU can be passed through the UK Parliament, this is just kicking the can down the road where, come October, markets could be faced again with the possibility of a no-deal Brexit.

Theresa May and her conservative counterparts have reportedly sought to make a deal with the opposition Labour Party in order to design a Brexit package that could pass Parliament. But so far, they’ve been unsuccessful.

It also appears that the Prime Minister is desperate to reach a compromise with the Labour Party to avoid the UK from having to participate in the EU parliamentary elections between May 23-26, which could result in major victories for Nigel Farage’s new no-deal Brexit Party as well as a historic rebuke of May’s Conservatives.

The results of these elections in late May could be market moving; perhaps not so much because of their implications for future policy developments inside the EU Parliament but for their clues about the UK’s views going forward regarding Brexit and a forthcoming general election.

Would a resounding victory by the Brexit Party in May’s EU parliamentary elections make Brexit inevitable? It’s possible that a big win by the Brexit Party could force the UK Parliament, the majority of which has so far refused to allow a no deal Brexit, to ultimately concede.

The Flat Treasury Curve: A Cautionary Signal

A popular question we’re hearing these days is, “Are you worried about the yield curve?” We’re not overly concerned just yet, but the flat (and in some segments inverted) Treasury curve is a cautionary signal.

Indeed, an inverted yield curve has preceded each recession during the last half century. When the yield curve flattens/inverts, the probability of recession generally rises. According to the New York Federal Reserve, between January 2018 and March 2019, the spread between the 10-year Treasury and 3-month T-bill has narrowed from 115 to only 12 basis points, increasing the probability of recession during the next 12 month s from 4% to 27%.

The good news is, however, that the US economy continues to show strength. The Bureau of Economic Analysis reported last week that real GDP grew 3.2% in Q1. At the same time, US manufacturing and job conditions appear healthy, suggesting to us that a substantial slowdown is not yet looming.

But when looking at economic growth globally, specifically the next four largest economies, there is an obvious slowdown occurring. According to the National Bureau of Statistics of China, the Chinese economy slowed from an annual growth rate of 6.8% in 2018 to 6.4% more recently. But these statistics are considered by some to be inaccurate and inflated. As for Japan, Germany and the UK, their GDP meaningfully turned lower last year; respectively slowing from 2.4%, 2.8% and 1.6% in Q4 2017 to 0.3%, 0.6% and 1.4% in Q4 2018.[v]

Quite clearly, based on the GDP data, the US economy is the healthiest economy in the world today. The US is growing while the next four largest economies are slowing.

The key differentiating macro features of the United States, in our view, are the corporate tax cuts and deregulation of 2017-2018, whereas China appears to have been struggling with changing trade rules and supply chains, and the major European countries have been enduring the uncertainties of Brexit.

As a result, we believe that the cautionary signals implied by the flat Treasury curve today could very well be saying that the principal macroeconomic risks reside outside the United States. And if an economic “crackup” were to occur during the next 1-2 years, it’s most likely to originate from and be most severe in foreign countries, and cause some knock-on effects to radiate back to the United States.

Looking at the year ahead, no economic path or consequence is set in stone. But within this slowing and more vulnerable global economy, we especially do not want to see new, anti-growth policies emerge in the major foreign economies. And just as importantly, we believe that a stronger dollar from here could be especially harmful to foreign economic actors because it would increase the real burden of dollar-denominated debts, which would be occurring within the context of a slower growth, higher interest rate world.

Healthcare: Long Way from Policy Doom for Private Healthcare Companies?

According to the Wall Street Journal, the S&P healthcare sector had fallen by 0.9% through April 17th, whereas the S&P 500 had risen nearly 16%.[vi] This is a historic underperformance. As the Journal reported, the largest deficit for healthcare stocks previously through April was 7.6 percentage points in 2010.[vii]

Similar to 2010 with the dawn of the Affordable Care Act, we believe the major reason for this year’s selloff is uncertainty surrounding future healthcare policy, particularly because the popularity of “Medicare for All” within Democratic circles appears to be growing. Bernie Sanders, for example, has made the idea a signature issue. One concern is that this version of universal healthcare could threaten or even wreck the business models of many private healthcare companies today. Almost certainly, with Joe Biden entering the race for the Democratic presidential nomination, investors will be listening closely for his views. So far, the perceived Democratic front-runner has been relatively vague about the subject.

But fears of an imminent demise of many of today’s healthcare companies is probably an overreaction, and the path to Medicare for All is long and windy and by no means easy. As we see it, for Medicare for All to become law, the idea must at the very least become a part of the Democratic platform in 2020; the Democratic nominee must beat President Trump; and Democrats would need to pick up at least 3 seats in the Senate, keep the House, and win over each Democratic senator and probably each House Democrat. A lot needs to happen in the next 2-3 years.  

For his part, President Trump declared last month that the Republicans “will soon be known as the party of healthcare”. In that vein, his administration is working on new healthcare policies, which could be unveiled next year. And at the same time, the President continues to signal a desire to work with Democrats on prescription drug prices. But there appears to be no indication that he’ll propose a form of universal healthcare that will cause many of today’s private healthcare companies to go extinct.

So, given the drift and attention of both parties in Washington, we expect changes to healthcare policy in the coming years. But a lot needs to happen politically for there to be a wholesale restructuring of the system as we know it today.

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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

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Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

[i] “Powell Signals Prolonged Fed Pause as Inflation Lags, Risks Loom”, by Jeanna Smialek and Matthew Boesler, March 20, 2019, Bloomberg.

[ii] “President Trump Says Xi Jinping of China Will Visit Soon, Stirring Anticipation of a Completed Trade Deal”, by Ana Swanson, April 25, 2019, New York Times.

[iii] “China’s Xi Signals Approval for Trump’s Trade War Demands”, by Sharon Chen, John Liu and James Mayger, April 26, 2019, Bloomberg.

[iv] “Trump Eyes Big Trade Pact with Britain, Says EU Deal Ongoing”, by Susan Heavey and Kylie MacLellan, March 14, 2019, Reuters.

[v] Source: St. Louis Federal Reserve

[vi] “Health-Care Stock Rout Deepens Amid Political Pressure”, by Amrith Ramkumar, April 17, 2019, Wall Street Journal.

[vii] Ibid.

A847

Brexit Uncertainty; Trump Wins in 2020?

Brexit Uncertainty; Trump Wins in 2020?

By Paul Hoffmeister, Chief Economist

April Commentary

·      New information in March regarding both the Brexit situation and the Mueller investigation caused, in our view, some choppiness in financial markets, but overall, the information appeared to be a net positive.

·      With the Mueller investigation concluded and the Brexit variable evolving favorably for markets, the S&P 500 could easily break its September 20 closing price of 2930.75 in the coming days or weeks; especially with the Fed seemingly no longer threatening to raise interest rates.

·      For us to be increasingly comfortable about the risk environment in coming months, we particularly want to see credit spreads continue to narrow and the Treasury curve steepen. In our view, this would signal that underlying economic and financial variables were rebounding from the late 2018 economic weakness. Recent better-than-expected manufacturing data might be pointing to such a scenario.

·      At the moment, it appears­ a Trump impeachment is no longer a possibility, and the political outlook will be more centered on the 2020 election cycle. Will President Trump be re-elected? Will the trend of tax cuts and deregulation continue – not to mention the pressure on the Fed to refrain from anti-growth interest rate increases? Or will Democrats regain control of the executive branch and Senate, and change the economic policy trajectory? These are some of the questions facing investors.

·      As we outline in this letter, President Trump will likely be re-elected next year given the improved economy of the last two years, his campaign infrastructure, and his approach to campaigning. But his biggest risk could be the economy, especially within the context of the flat/inverted Treasury curve today, which is signaling potential dangers on the horizon.

Macro Developments in March

As we laid out in our client letter last month, we’ve been constructive about the medium-term outlook for equities and other risk assets. But we expected to see near-term market volatility as some of the major macro variables get sorted out, such as Brexit, US-China trade, and political questions in the United States. New information in March regarding both the Brexit situation and the Mueller investigation caused, in our view, some choppiness in financial markets, but overall, the information appeared to be a net positive.

Looking back at the last month, the UK’s March 29 deadline to leave the EU came and went, without a divorce. While it’s still unclear how this variable will play out (it’s a highly fluid situation), it appears that a sudden, no deal Brexit will be avoided. Additionally, special counsel Robert Mueller submitted the report of his investigation to Attorney General Barr, finding that there was no proof of collusion between President Trump and Russia.[1]

At the moment, it appears a Trump impeachment is no longer a possibility, and the political outlook will be more centered on the 2020 election cycle.

As for Brexit, we believe our statement last month still holds true: “…the Brexit variable is a complicated mess with no one in the world, not even Prime Minister Theresa May, certain how it’ll exactly play out.”

While the UK House of Commons rejected Prime Minister May’s backstop plan for the third time on March 29, the EU pushed back the Brexit deadline to April 12 if a majority of the Parliament doesn’t soon agree on a plan. If a plan is, however, agreed upon, the deadline will be postponed to May 22.[2]

What comes next is still highly uncertain. At the moment, Prime Minister May has reached out to opposition party leader Jeremy Corbyn to forge a compromise between the Conservative and Labour parties. May has reaffirmed that she does not want a no deal Brexit scenario, and it therefore looks as though either a soft deal Brexit plan will be reached (such as a customs union scheme) or a long extension will be requested from the EU.

That said, a no-deal Brexit could still occur in the coming weeks, given the widespread disagreement in Parliament on this issue. Although we don’t believe that a no-deal Brexit would be necessarily catastrophic were it to occur (immediate, pro-growth options could be pursued), the current outlook of a “soft” Brexit or long extension appears to be most friendly to markets during the near-term.

With the Mueller investigation concluded and the Brexit variable evolving favorably for markets, the S&P 500 could easily break its September 20 closing price of 2930.75 in the coming days or weeks; especially with the Fed seemingly no longer threatening to raise interest rates. If anything, investors view a rate cut more likely than an increase. According to the Chicago Mercantile Exchange on April 1, the market expected no chance of a rate increase by year-end, and a 58.3% probability of a rate cut.

For us to be increasingly comfortable about the risk environment in coming months, we particularly want to see credit spreads continue to narrow and the Treasury curve steepen. In our view, this would signal that underlying economic and financial variables were rebounding from the late 2018 economic weakness. Recent better-than-expected manufacturing data might be pointing to such a scenario.

According to the St. Louis Federal Reserve, the spread between 10-year and 3-month Treasuries was only +1 basis point at the end of March, indicating the highest risk of recession than we’ve seen in almost a decade. Based on the spread of 24 basis points at the end of February 2019, the New York Federal Reserve was estimating a 24.62% probability of recession within the next 12 months.

We do not yet expect a recession during the next two quarters, but further inversion of the yield curve will signal to us that a strong slowdown or even recession could occur late this year or next.

Thinking about the 2020 Elections

During the next year and a half, we will be closely following U.S. political trends and their potential impact on the economy and financial markets.

Of course, politics impact policy. Will President Trump be re-elected? Will the trend of tax cuts and deregulation continue – not to mention the pressure on the Fed to refrain from anti-growth interest rate increases? Or will Democrats regain control of the executive branch and Senate, and change the economic policy trajectory? These are some of the questions facing investors.

Some of the major policy positions put forth by Democrats in recent months are “Medicare for All” (by Bernie Sanders), the “Green New Deal” (by Alexandria Ocasio-Cortez), and annually paying taxes on unrealized capital gains (by Ron Wyden).[3] 

In a recent Wall Street Journal opinion column, Brookings senior fellow William Galston  argued that Democrats could win in 2020 by either focusing on the Southern and Sunbelt states (namely North Carolina, Florida, Georgia, Arizona and Texas) with a progressive candidate, or on the “blue wall” states (Wisconsin, Michigan and Pennsylvania) with a more moderate nominee.[4]

It increasingly looks like the 2020 presidential contest will be decided by the blue wall states because that’s where Democrats seem to have the best chance of victory.

As Galston put it, President Trump’s approval ratings are generally higher in the Southern/Sunbelt states; Democrats hold a relatively better party-ID advantage in the blue wall; and in those blue wall states, Democrats won all six statewide elections in 2018, whereas they lost six of seven statewide races in the Southern/Sunbelt states.[5]

This electoral dynamic helps to explain the growing demand for former Vice President Joe Biden to enter the race. For example, according to last month’s Des Moines Register/CNN/Mediacom Iowa Poll, Biden was the first choice of likely Democratic caucus-goers.[6] Although Biden hasn’t officially announced his candidacy, rumor has it he will run.

Biden’s VP role in the Obama Administration and his Scranton, PA roots create, as William McGurn highlighted last month, a potentially formidable combination that could “bridge the growing gap between the principal elements of the winning Obama coalition—women, racial minorities, wealthy white liberals and the young—and the working-class white voters who live in key battleground states, who voted for Mr. Obama in 2012 but who bolted for Mr. Trump in 2016.” [7]

The centrality of the blue wall in 2020 also explains why massive investments are being made in Wisconsin, Michigan, Pennsylvania and Florida by both Democratic and Republican groups. According to the Wall Street Journal, Democratic Super PAC, Priorities USA, announced a $100 million spending plan in these states, and the Trump campaign, which raised more than $100 million last year, plans to spend heavily in those states as well.[8]

For his part, President Trump doesn’t look necessarily weak. In addition to the relatively strong economy and historically low unemployment rate, his re-election campaign may be the strongest of its kind in history.  

In their recent in-depth look into Trump’s 2020 campaign, CNN’s Jeremy Diamond, Dana Bash and Fredreka Schouten suggest that it’s a “presidential re-election campaign unlike any other at this early stage.”[9] The campaign’s strengths are rooted in best-in-class data analytics, strong field operations, and never-seen-before fundraising and advertising.

Key to the Trump infrastructure is the fact that the Republican National Committee and the Trump campaign have merged their field operations and fundraising efforts. Now, Republicans – who were outmatched in 2008 and 2012 -- have better voter data and targeting capabilities than Democrats.[10] The importance of data and targeting is underscored by the fact that Brad Parscale, a former digital marketing executive and Trump’s 2016 digital director, is this year’s campaign manager.

And this competitive advantage will be leveraged in a big way, as Trump’s re-election campaign has raised and spent more money than any other re-election campaign at this point in the cycle. According to Axios, the Trump campaign has spent year-to-date through March 10th nearly twice as much as all the Democratic presidential candidates combined on Facebook and Google Ads.[11]

This combination of data supremacy and deep pockets could be an insurmountable advantage if Democrats cannot quickly catch up during the next 12 months. Former Governor Howard Dean has been tasked with getting the DNC’s data infrastructure and analytics quickly up to speed.[12]

Some recent polling also bodes well for the President. According to a recent Wall Street Journal/NBC News poll, Trump’s approval rating is 46%, similar to that of Presidents Clinton and Obama at this point in their first terms.[13] Even more, Trump cumulatively leads a generic Democrat opponent 46% to 40% in Indiana, Michigan, Ohio, Wisconsin and Pennsylvania.[14]

In addition to his impressive infrastructure, Trump also has, as the 2016 elections proved, his unique and effective campaigning style that quickly catapulted a political outsider to the presidency. Trump’s tactics in the coming year might not change too much. Vanity Fair’s Bess Levin reported in February that President Trump is already testing new labels and nicknames for his opponents, in anticipation of the general election.[15] This kind of “opponent branding” coupled with Trump’s ability to leverage social media like no previous president will be hard to counter. Needless to say, it will be interesting to see how Democrats choose to combat Trump’s tactics this time around.

I’d suggest that President Trump will very likely be re-elected next year given the improved economy of the last two years, his campaign infrastructure, and his approach to campaigning. But his biggest risk could be the economy, especially within the context of the flat/inverted Treasury curve today, which is signaling potential dangers on the horizon.

As a result, to bolster his economic credentials, it’s likely during the next 12 to 18 months that President Trump will continue to emphasize his objections to Fed policy, demand further tax relief and reciprocal trade agreements, and pivot to the political center on matters related to the social safety net, notably healthcare and entitlements; while attempting to brand Democrats as the party of socialism (think Venezuela). Politics is a combat sport. This election cycle should prove that once again.  

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of  Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

*******

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

[1] “Mueller Finds No Proof Trump Collusion with Russia; AG Barr says evidence ‘Not Sufficient’ to Prosecute”, by Pete Williams, Julia Ainsley, Gregg Birnbaum, March 25, 2019, NBC News.

[2] EU Approves Brexit Extension, But Chaotic Departure Still Looms”, by Stephen Castle and Steven Erlanger, March 21, 2019, New York Times.

[3] “Key Democrat Revives Plan to Make Capital Gains Tax Due Annually”, by Laura Davison and Lynnley Browning, April 2, 2019, Bloomberg.

[4] “Two Ways Democrats Can Win in 2020”, by William Galston, February 26, 2019, Wall Street Journal.

[5] Ibid.

[6] “Iowa Poll: Not Even in the Race, Joe Biden Leads Herd of Democrats; Bernie Sanders Close Behind”, by Brianne Pfannenstiel, March 9, 2019, Des Moines Register.

[7] “The Case for Joe Biden”, by William McGurn, March 11, 2019, Wall Street Journal.

[8] “Democratic Big Money Flows into Four Key States”, by Julie Bykowicz, March 14, 2019, Wall Street Journal.

[9] “Money, Power and Data: Inside Trump’s Re-Election Machine”, by Jeremy Diamond, Dana Bash and Fredreka Schouten, March 19, 2019, CNN.

[10]

[11] “Another Trump Facebook Election”, by Sara Fischer, Mary 19, 2019, Axios.

[12] “Money, Power and Data: Inside Trump’s Re-election Machine,” by Jeremy Diamond, Dana Bash and Fredreka Schouten, March 19, 2019, CNN.

[13] “Trump’s Job Approval Rating Ticks Up, Along with Warning Signs”, by Reid Epstein, March 3, 2019, Wall Street Journal.

[14] Ibid.

[15] “Trump Workshopping Strategy to Psychologically Devastate Opponents”, by Bess Levin, February 19, 2019, Vanity Fair.

Easy Part of the Rally is Over­­

By Paul Hoffmeister, Chief Economist

March 2019

·      Assessing market conditions today, we believe that the easy part of this year’s rally in the S&P 500 is behind us and that if there is another 10% or more upside in the market this year, it will be harder to come by. As we see it, if stock market prices were asymmetrically in investors’ favor in late December, they are more symmetric today.

·      The outlooks in many of the major macro variables appear to be more balanced, and not too extreme one way or the other. To an optimist, this “setup” suggests that if these variables continue to improve and resolve themselves, then equity markets could experience a sizeable rally from current levels. Conversely, to a pessimist, if these variables deteriorate, then upside should be limited, and there could be another bout of market panic.

·      In this month’s client letter, we parse through what we believe to be the most important macro variables today: the Fed, US-China trade, Brexit, the slowdowns in Europe and Asia, and the possibility of a Trump impeachment. And then we explain how, after putting these pieces together, we expect a little volatility in coming months but are generally optimistic about the rest of the year.

·      The current macroeconomic outlook could be reasonably described as ambiguous, which seems to be consistent with the relatively flat Treasury curve this year. The general flatness of the curve suggests to us that the Treasury market is sensing some risks farther out on the horizon that could ultimately erupt and harm economic growth; but just not in the near-term.

·      There are percolating risks. But importantly, in our view, the dollar (the world’s reserve currency) is fairly stable, deregulation and corporate tax cuts in the United States are still supporting economic growth, and credit conditions are recently improving. Of course, we don’t expect all of the major macro variables in play today to evolve perfectly in the coming months, and some near-term volatility is likely. The UK will need to sort through Brexit, Europe and Asia are relatively weak, and political uncertainties persist in the United States.

In our view, the equity market rebound continued in February mainly because the outlooks for Fed policy and US-China trade continued their positive trajectory. Not to mention, there didn’t seem to be any new, significant macro variables that erupted.

In our January client letter, we believed there was a big opportunity in equities with our forecast for a 15% return in the S&P 500 this year. The projection was based on both quantitative and qualitative factors.

Quantitatively, it appeared that history was on our side: looking at calendar quarters since 1970 in which the S&P 500 sold off 10% or more, the average return during the subsequent four quarters was approximately 14.6%. And qualitatively, we believed that the Fed was going to back off its hawkish plans in 2019 to raise the funds rate another two quarter points – similar to the Fed U-turn in early 2016; and we were optimistic about at least a partial US-Sino trade deal.

With the S&P 500 up 11.1% through February (not including dividends)[1], that 15% forecast looks too low, for now. Assessing market conditions today, we believe that the easy part of the rally is behind us and that if there is another 10% or more upside in the market this year, it will be harder to come by. As we see it, if stock market prices were asymmetrically in investors’ favor in late December, they are more symmetric today.

Another way to look at the current market environment is that the outlooks in many of the major macro variables appear to be more balanced, and not too extreme one way or the other. To an optimist, this “setup” suggests that if these variables continue to improve and resolve themselves, then equity markets could experience a sizeable rally from current levels. Conversely, to a pessimist, if these variables deteriorate, then upside should be limited, and there could be another bout of market panic.

In the following, we parse through what we believe to be the most important macro variables today: the Fed, US-China trade, Brexit, the slowdowns in Europe and Asia, and the possibility of a Trump impeachment. And then we explain how, after putting these pieces together, we expect a little volatility in coming months but are generally optimistic about the rest of the year.

Fed Outlook: “Patient” seems to be the predominant descriptor of Fed policy today. In his testimony before Congress on February 27-28, Chairman Powell said the Fed was “in no rush to make a judgment” about the path of short-term rates. He added, “With our policy rate in the range of neutral, with muted inflation pressures and with some of the downside risks we’ve talked about, this is a good time to be patient and watch and wait and see how the situation evolves.”[2] This policy positioning is in stark contrast to the seeming assuredness that Powell telegraphed in December about raising rates twice this year. In addition to backing off the rate lever, the Fed is also close to announcing updated plans for its balance sheet runoff. Powell indicated in his testimony that the runoff could conclude by year-end.[3]

Powell’s recent testimony reaffirmed for us the dovish comments by St. Louis Fed President James Bullard on February 1st when he said that the Fed’s current policy position (i.e. its “patient” posture) “sets us up for a very good couple of years”.[4]

At the moment, we view Fed policy to be a neutral macro variable – no longer the major negative as it appeared in 2018, while at the same time not a major positive given the relatively flat Treasury curve today.

US-China Trade: In recent weeks, there didn’t seem to be a day that went by without headlines about an imminent deal between President Trump and China’s President Xi Jinping.

According to the Wall Street Journal, both sides are in the final stages of completing a trade deal, which will include lower tariffs by both countries, increased purchases by China of US farm, chemical and auto products, and new provisions to protect American intellectual property. One area where there doesn’t seem to be significant progress is on Chinese industrial policies and subsidies, which Beijing views to be central to the country’s state-led development model. Trump and Xi may meet in Florida on March 27 to sign the agreement.[5]

The US-China trade variable appears to be a net positive. If a deal is reached, it should clear major uncertainties for producers and risk-takers globally; offer some relief to Chinese risk assets (the Shanghai Composite was down nearly 25% last year)[6]; and improve US business prospects inside China.

Brexit: The current plan is the UK will leave the European Union on March 29. But in our opinion, the Brexit variable is a complicated mess with no one in the world, not even Prime Minister Theresa May, certain how it’ll exactly play out.

This is an issue that doesn’t easily map onto one party in the UK. There are members in both the Conservative and Labour parties that favor Brexit, and members in both that support remaining in the EU.

For the most part, “Brexiteers” want more independence from EU rules and regulations, including the end of the free movement of labor between member countries; whereas Brexit supporters view EU membership as a guardian of the free movement of goods and people.

What makes the issue even more complicated is Northern Ireland. The “Good Friday” peace agreement in 1998 between Northern Ireland and the Republic of Ireland was predicated to some extent on an open border between the two. And, fortunately, both UK and the EU leaders seem to agree that they want to keep it that way. In that spirit, the May government and EU leadership reached the so-called “backstop agreement”, which would keep an open border if the UK left the EU without a deal.

The backstop, however, has been rejected by the UK Parliament for a number of reasons, including concern that it would keep the UK in a customs union with the EU indefinitely (the exact opposite objective of many Brexiteers) and would create a regulatory border down the Irish Sea between Northern Ireland and the rest of the UK – which is strongly opposed by many unionists whose votes are arguably propping up the May government.

Prime Minister May is still negotiating with EU counterparts to reach a deal, notably to make the Irish backstop temporary. May has promised to present Parliament with a new deal by March 12.[7] In recent weeks, it has appeared increasingly likely that if any new deal is rejected, then Parliament will have the opportunity to vote on a “no deal” Brexit (viewed by some to mean an economically messy and costly divorce) or to vote on delaying Brexit by extending the EU’s Article 50 negotiating period.[8] The majority of Parliament seems to favor a delay, and there is speculation that the Brexit deadline will be postponed by two months.

Despite the many moving parts and complicating factors, we believe the Brexit variable has marginally improved during the last month because it appears increasingly likely that a messy, no-deal Brexit will be avoided due to significant Parliamentary opposition to such an outcome, as well as its support for a delay if a deal is not reached.  

That said, a delay means that the Brexit variable is simply being pushed out rather than being resolved. And, as the popular adage goes, markets hate uncertainty.

Some European business leaders like Dieter Kempf, the President of the Federation of German Industry, would rather just have a no-deal divorce to avoid the persistent uncertainty surrounding the issue. Kempf believes German firms have made sufficient plans for a no-deal scenario. “They have increased their storage capacity. They have planned a transition period for the reorganisation of logistics processes without loss of production…. My experience is that the economy can live better with bad conditions than with uncertainty.” [9] Kempf’s views, however, seem to be in the minority inside the UK Parliament.

In sum, it appears that Brexit will be delayed and markets will be forced to deal with the associated uncertainties of Brexit for many more weeks and months. We view this variable as a net negative today, although not as bad as a month ago when a no-deal Brexit scenario appeared to be a higher probability.

Slowdowns in Asia and Europe: For us, the most startling economic data out of Asia recently has been in the manufacturing sector. According to Markit, the manufacturing PMI’s in February for China, Japan, South Korea and Taiwan were 49.9, 48.9, 47.2 and 46.3, respectively. This indicates that the manufacturing sectors in these major Asian economies have been contracting.

Even worse for the global economic picture, industrial production in Europe has been declining. Markit’s manufacturing PMI’s in February in Germany, the UK, France and Italy were 47.6, 52.0, 51.5 and 47.7, respectively. As the next chart illustrates, this follows significant weakness late last year, when in November and December 2018, industrial production in Germany, the UK, France and Italy each fell year-over-year.

According to Destatis, preliminary Q4 2018 GDP data revealed that the German economy grew 0.0%, narrowly avoiding a technical recession after -0.2% growth in Q3.[10] Italy’s economy, after having contracted in Q3 and Q4, is already in recession.

The U.S. economy, on the other hand, appears to be in better shape. According to the Bureau of Economic Analysis, the economy grew 3.1% year-over-year in Q4 and 3.0% in Q3. Furthermore, ISM manufacturing PMI in the United States registered 54.2 in February; and according to jobless claims data from the Department of Labor, the American labor market appears fairly strong with claims near multi-decade lows. In sum, the United States looks to be the strongest economic region in the world, with Asia the weakest and Europe slightly better.

While slowdowns in other countries and regions threaten to mute global demand and therefore limit corporate profit growth generally, we are concerned about the risk in coming years of a severe economic slowdown leading to increased corporate defaults that in turn lead to highly distressed credit markets, including sovereign distresses.

According to data from the Institute of International Finance, Bureau of International Settlements and the IMF, total global debt in 2018 was $244 trillion; with a debt-to-GDP ratio of 382% for mature economies and 210% for emerging markets. This compares to total global debt of $74 trillion in 1997, and debt-to-GDP ratios of 266% for mature economies and 131% for emerging markets. The global economy, being so leveraged, may be more sensitive to a GDP deceleration and higher interest rates than it has been in decades.

As we see it, excess leverage doesn’t usually appear to be excessive until underlying economic fundamentals deteriorate, which in turn cause corporate profits and tax revenues to decline, so as to cause unsustainable debt burdens. In that light, we are watching, particularly closely, the economic weakness abroad and the possibility of mounting systemic risks as a consequence. To us, the slowdowns in Asia and Europe are one of the most negative macro factors today.

Trump Impeachment: According to a column in the Washington Post by Greg Sargent, “smart money” in Washington is predicting that special counsel Robert Mueller’s report, expected to be delivered soon to the Attorney General, will be a “dud”.[11] Notwithstanding, it appears that the possibility of a Trump impeachment and removal from office isn’t going away. House Judiciary Chairman Jerold Nadler said on March 3rd that he’d be requesting documents from more than 60 people “to begin investigations to present the case to the American people about obstruction of justice, corruption and abuse of power.”[12]

Although Nadler states that “impeachment is a long way down the road”, these steps could be meant to set the political foundation to pursue impeachment. While the growing belief that the Mueller Report will not directly or immediately lead to the President’s impeachment might be increasing certainty surrounding the Office of the Presidency, growing Congressional scrutiny suggests that some uncertainty is likely to linger.

Putting the Macro Pieces Together

While this is certainly not an exhaustive list of the major macro variables that exist today, it provides us with a framework to contextualize the current market environment, which looks like a “glass half full, glass half empty” kind of market.

For example, if the Fed doesn’t threaten to raise interest rates and consequently inhibit risk-taking, if a US-China trade deal is reached, a concrete resolution to Brexit emerges, Asia and Europe stabilize, and the specter of political uncertainty in the United States fades away, then there is arguably still significant upside to risk assets, even after the recent equity market rally.

And, conversely, markets could be at risk if the Fed restarts its rate-hiking campaign, a US-China trade deal is scuttled, a chaotic Brexit occurs, Asian and European economies continue to worsen, or the United States enters a Watergate-type era of political uncertainty and flux.

The macroeconomic outlook today could be reasonably described as ambiguous, which seems to be consistent with the relatively flat Treasury curve this year.

The Treasury curve in 2019 is the flattest it has been since the 2008-2009 Great Recession. And between the 2 and 5-year Treasuries, the curve is slightly inverted. But, it’s positive to see that the curve, generally, is not meaningfully inverted.

The general flatness of the curve suggests to us that the Treasury market is sensing some risks farther out on the horizon that could ultimately erupt and harm economic growth; but just not in the near-term.

And so, the glass looks half full to us today. There are percolating risks. But importantly, in our view, the dollar (the world’s reserve currency) is fairly stable, deregulation and corporate tax cuts in the United States are still supporting economic growth, and credit conditions are recently improving. We are, therefore, generally optimistic about the next 12 months as long as anti-growth policies don’t emerge in the major economies and credit markets continue to behave. Of course, we don’t expect all of the major macro variables in play today to evolve perfectly in the coming months, and some near-term volatility is likely. Indeed, the UK will need to sort through Brexit, Europe and Asia are relatively weak, and political uncertainties persist in the United States. However, counterbalancing those variables, we have a patient Fed and brightening prospects for US-China trade. We expect more equity gains in 2019, but we believe they’ll be harder to come by compared to January and February.  

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

*******

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.

[1] Source: Yahoo Finance

[2] “Powell Says Fed Is Close to Agreement on Plan to End Portfolio Runoff”, by Nick Timiraos, February 27, 2019, Wall Street Journal.

[3] Ibid.

[4] “Bullard Says Patient Fed Should Mean ‘Very Good Couple of Years”, by Steve Matthews and Jeanna Smialek, February 1, 2019, Bloomberg.

[5] “China, U.S. Near Accord on Trade”, by Linling Wei and Bob Davis, March 4, 2019, Wall Street Journal.

[6] Source: Yahoo Finance

[7] “UK Likely to be Forced into Brexit Delay If PM May’s Deal Rejected”, by Kylie MacLellan, March 3, 2019, Reuters.

[8] Ibid.

[9] “German Business Terrified Short Brexit Delay Will Wreak Havoc – ‘It’s Bad for the Economy’”, by Joe Barnes, March 4, 2019, by Express.

[10] “Germany Narrowly Escapes Recession after Flat Growth in the Fourth Quarter”, by Holly Ellyatt, February 14, 2019, CNBC.

[11] “Democrats Set to Take a Big Step Toward Impeaching Trump”, by Greg Sargent, March 4, 2019, Washington Post.

[12] “House Judiciary Chairman Says He Will Launch Probe of Trump’s ‘Abuse of Power’”, by Mike DeBonis and Rachael Bade, March 3, 2019, Washington Post.

Is the Fed Pause Enough?

Camelot Portfolios Market Commentary

IS THE FED PAUSE ENOUGH?

By Paul Hoffmeister, Chief Economist

·      As we see it, the strong equity market rebound in January transpired along the lines we anticipated at the start of the year, as the outlooks improved for both Fed policy and US-China trade.

·      Chairman Powell and other Fed officials have emphasized throughout the course of the current rate-hiking cycle that policy will be data dependent, and in our view the data in late 2018 turned unquestionably negative to justify their about-face. 

·      Amid the significant market and economic weakness in Q1 2016, the Fed backed away from the two to four rate increases they were telegraphing for that year (it only raised a quarter point in December 2016), and the dovish pause correlated with a major stock and credit market rebound. The 2016 market narrative creates a compelling analogue for market bulls today.

·      But the parallels aren’t perfect between 2016 and today. Although some credit spreads have narrowed substantially in recent weeks, the spread between Moody’s Baa and Aaa-rated bonds is only narrowing a little bit so far. Furthermore, the slope of the Treasury curve is much flatter today than in 2016.

·      The significantly flatter yield curve today signals, in our view, a more vulnerable economy than the one in early 2016 when the Fed last paused. If anything, we believe a major revitalization in market conditions will be harder to achieve in 2019 than 2016; new pro-growth policies are more important today than they were three years ago.

·      The easy part of the stock market rally seems to have occurred in January. Indeed, equity indices in late December could have been viewed as having been asymmetrically favorable to the upside given the extreme pessimism at the time. With the relief rally now over, we believe financial markets will need to see that structural macro foundations are sound or improving, and that many of the looming uncertainties today are resolved.

As we see it, the strong equity market rebound in January transpired along the lines we anticipated at the start of the year, as the outlooks improved for both Fed policy and US-China trade. This reversed the seemingly pessimistic sentiment in late December, when it appeared to some that the Fed would stubbornly raise rates in 2019 and a trade deal was a low probability event. As the outlook reversed in January, the S&P 500 rallied 7.9%, marking its best start to the year since ­1987, according to Dow Jones.[1]

For the moment, it appears that the US and China are on the verge of reaching a trade deal. On January 31, President Trump met Chinese Vice Premier Liu He in the Oval Office and said: “We’re trying to work out a new trade deal with China. I think it’ll happen, something will happen. But it’s a very big deal. It’ll be, if it does happen, it’ll be by far the largest trade deal ever made.”[2]

Many anticipate that the expected meeting in late February between Presidents Trump and Xi will iron out the final details of an agreement.[3] Note, March 2nd remains the deadline before President Trump is expected to raise tariffs on Chinese imports again.

But in our view, the major macro variable – the elephant in the living room -- remains Fed policy and the interest rate outlook, and it has turned decidedly dovish.

The January 30th FOMC statement announced that the Committee will be “patient” in determining the future path of short-term interest rates. This is in sharp contrast to the December 19th announcement where the Committee telegraphed more rate increases for 2019.[4]

Chairman Powell, when explaining what changed in the course of the prior six weeks, highlighted in the post-meeting press conference slowing global growth, the federal government shutdown, and tight financial conditions.[5]

Interestingly, Powell was asked by Jim Puzzanghera of the LA Times whether the Fed caved to President Trump’s demands to stop raising rates. The Fed chief responded:

… we’re always going to do what we think is the right thing. We’re never going to take political considerations into account or discuss them as part of our work. You know, we’re human. We make mistakes, but we’re not going to make mistakes of character or integrity. And I would want the public to know that, and I want them to see that in our actions.[6]

The statement that the Fed is human and makes mistakes could be perceived to be a tacit acknowledgement that the FOMC made a mistake in December by sounding a hawkish policy path for this year. While it is hard to recall such an abrupt and significant U-turn in Fed policy, it is also hard for us to find such an admission from the Fed. If this interpretation of Powell’s statement is accurate, then it suggests to us that the Fed will be extremely cautious in raising rates during the next twelve months.

Of course, Chairman Powell and other Fed officials have emphasized throughout the course of the current rate-hiking cycle that policy will be data dependent, and in our view the data in late 2018 turned unquestionably negative to justify their about-face.  

In the United States, the Richmond Fed manufacturing index for December showed the largest month-over month decline in history, and the Dallas Fed survey showed the largest decline since the 2008-2009 financial crisis. Furthermore, the S&P 500 declined nearly 14% in the fourth quarter, which possibly foreshadows a major deterioration in the U.S. economy and corporate profits. This prospect seems to have been validated by the slope of the Treasury curve at the end of December, which according to the New York Federal Reserve was predicting a 21.35% probability of recession occurring by the end of 2019. This compares to an approximately 4% chance of recession within twelve months at the beginning of 2018.[7] As we see it, the macroeconomic environment deteriorated substantially during the course of the last year.

In China, the Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI) registered 48.3% in January, marking the second consecutive month of contraction in China’s manufacturing sector. [8] Furthermore, the Chinese economy grew 6.4% in Q4 2018, a 28-year low.[9] And in Europe, Italy officially entered into recession in late 2018, and growth in the Eurozone, according to the EU statistics agency, slowed in 2018 to 1.8% from 2.4% in 2017, the weakest pace in four years.[10] [11]

Fortunately, we have seen in recent weeks some stabilization in the growth trajectory in the United States. ADP payrolls data at the end of January showed better-than-expected hiring: 213,000 jobs were added versus the consensus estimate of 178,000, with medium-sized businesses adding the most jobs.[12] Importantly, too, the ISM manufacturing index rebounded in January to 56.6%, from 54.3% in December.[13] As we have said before, we want to see the job and manufacturing environments remain strong, otherwise we believe the U.S. economy will start veering toward recession.

We believe the biggest question today is: will the Fed pause be enough?

In other words, will it be enough to enable global growth to stabilize or re-accelerate? Or will it be insufficient in forestalling the economic slowdown of late 2018?

Amid the significant market and economic weakness in Q1 2016, the Fed backed away from the two to four rate increases they were telegraphing for that year (it only raised a quarter point in December 2016), and the dovish pause correlated with a major stock and credit market rebound. The 2016 market narrative creates a compelling analogue for market bulls today.

But the parallels aren’t perfect between 2016 and today.

Although some credit spreads have narrowed substantially in recent weeks, the spread between Baa and Aaa-rated bonds is only narrowing a little bit so far. Furthermore, the slope of the Treasury curve is much flatter today than in 2016.

Approximately speaking, by the end of January 2016, the 3-month/10-year Treasury spread was 160 basis points; the 2-year/10-year spread was 114 basis points; and the 2-year/5-year spread was 55 basis points.[14] As of January 31, 2019, they were 23, 17, and -2 basis points, respectively.[15]

The significantly flatter yield curve today signals, in our view, a more vulnerable economy than the one in early 2016 when the Fed last paused. If anything, we believe a major revitalization in market conditions will be harder to achieve in 2019 than 2016; new pro-growth policies are more important today than they were three years ago.

Importantly, major currency prices, particularly the dollar, appear healthy; but we do not see significant growth-incentivizing tax cuts around the world, on net. Furthermore, markets are facing a range of policy and political uncertainties, including Brexit and the results of the Mueller investigation. Indeed, we want to see positive developments in these variables, much like what occurred in January with the Fed and US-China trade variables.

The easy part of the stock market rally seems to have occurred in January. Equity indices in late December certainly could have been viewed as having been asymmetrically favorable to the upside given the extreme pessimism at the time. With the relief rally now over, we believe financial markets will need to see that structural macro foundations are sound or improving, and that many of the looming uncertainties today are resolved.

[1] “Stocks Post Best January in 30 Years,” by Amrith Ramkumar, Wall Street Journal, February 1, 2019.

[2] “Trump Optimistic on Trade Deal with China, But May Keep Tariffs Anyway,” by Alan Rappeport and Mark Landler, New York Times, January 31, 2019.

[3] “Xi Jinping and Donald Trump May Meet in Da Nang, Vietnam, at the End of February,” by South China Morning Post, February 3, 2019.

[4] Federal Open Market Committee statement, Federal Reserve Board of Governors, January 30, 2019.

[5] Transcript of Chairman Powell’s Press Conference, Federal Reserve Board of Governors, January 30, 2019.

[6] Ibid.

[7] Source: New York Federal Reserve Bank: “The Yield Curve as a Leading Indicator”.

[8] “Another Number Paints a Bleak Picture of Manufacturing in China,” by Yen Nee Lee, CNBC, January 31, 2019.

[9] “China’s Economy Cools in Q4, 2018 Growth Hits 28-year Low,” Reuters, January 21, 2019.

[10] “Mama Mia! Italy Now in Recession Stunts Europe’s Growth Prospects,” by CBS News, January 31, 2019.

[11] “Eurozone Slowdown Feeds Fears about Faltering Global Growth,” Paul Hannon and Eric Sylvers, Wall Street Journal, January 31, 2019.

[12] “Private Companies Add 213,000 Jobs in January, Easily Topping Expectations,” by Fred Imbert, January 30. 2019, CNBC.

[13] ISM Manufacturing Index Rebounds in January, Easing Worries about the Sector,” Greg Robb, February 1, 2019, MarketWatch.

[14] Source: St. Louis Federal Reserve Bank.

[15] Ibid.

Disclosures:

•       Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.

•       This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client.  These materials are not intended as any form of substitute for individualized investment advice.  The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own.  Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors.  Camelot Portfolios LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.

•       Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC.  Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach.  Only your professional adviser should interpret this information.

•       Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified. A779