Covid Abates; Tax and Geopolitical Risks Emerge

by Paul Hoffmeister, Chief Economist

• Covid outlook continues to improve.

• Fed prioritizes Covid over inflation.

• Tax hikes to pay for spending.

• Relations with China and Russia introduce geopolitical risks..

The S&P 500 has continued its ascent on the back of aggressive monetary and fiscal policies, improving Covid case numbers, and the vaccine rollout. In recent weeks, equity market volatility, as measured by the CBOE VIX Index, sustained a drop below 20 for the first time since the start of the pandemic. It may not be a coincidence that this occurred around the same time as California, perhaps the most locked down state in the country, announced a target date for a complete reopening.

In this month’s letter, we review the status of the major macro variables: Covid, Fed policy, and the tax and spending outlooks – along with brief updates on two geopolitical variables, China and Russia.

In sum, the light at the end of the Covid tunnel appears to be getting much brighter, and the Federal Reserve is telegraphing that it won’t seek to interrupt the positive market and economic recovery with any aggressive change in policy course. Congress continues to pass historic spending legislation. But the tax man finally cometh, with the Biden Administration proposing to raise corporate taxes in an attempt to pay for new infrastructure programs. All the while, the geopolitical environment has turned slightly more negative. US relations with China continue to worsen, and the situation in Ukraine may have devolved to its worst point since the country’s revolution in 2014.

Overall, the market outlook remains constructive as there appears to be an end in sight to the current pandemic and the Federal Reserve keeps using its firepower to keep interest rates low.

Covid-19: Arguably, the coronavirus remains the most important market variable, and the news continues to improve.

According to the University of Oxford, approximately 34% of Americans have received at least one vaccine dose so far, and it appears that over 3 million doses are now being administered daily.

Even more, the dramatic decline in daily confirmed Covid cases since January appears to be holding, despite a slight uptick in March. Governor Newsom of California announced last week that he plans to fully reopen his state by June 15 if this trend continues. Being roughly the sixth largest economy in the world and having been one of the most locked down states in the country, this is the latest sign that we may very well be near the latter stages of the pandemic.

Fed Policy Outlook: For the most part, Federal Reserve officials appear most concerned about Covid-19 than inflation. As a result, the expectation remains that the central bank’s zero interest rate policy and $120 billion in monthly bond purchases will continue for a prolonged period of time.

Last Thursday, St. Louis Federal Reserve President James Bullard said: “We need to get the pandemic behind us first. There are still risks, and things could go in a different direction. [i] On the same day, while speaking at virtual events for the World Bank and IMF, Fed Chairman Powell echoed the sentiment that the coronavirus (and its correspondent impact on the global economy) is the primary macro variable today. "Viruses are no respecters of borders, and until the world really is vaccinated, we're all going to be at risk of new mutations and we won't be able to really resume with confidence all around the world." [ii]

According to the Chicago Mercantile Exchange interest rate futures, the market is currently assigning an 89% probability that the federal funds rate will remain near 0% in December 2021. And according to the Fed dot plots released in mid-March, Fed policymakers are collectively forecasting a median federal funds rate of 0.25% by 2023; although four members expect rate increases to begin in 2022.

Note, with the prices of precious metals relatively stable during the last year, we remain unconcerned about the inflation outlook. Most likely, the core PCE deflator (personal consumption expenditures index) will rise modestly to nearly 2.0% year-over-year by the end of 2022, from its current rate of 1.4%.

Fiscal Policy Outlook: To date, Congress has passed nearly $6 trillion in Covid-related spending to shoulder some of the economic damage caused by the virus and the associated lockdowns. Now, quickly following last month’s $1.9 trillion package, the Biden Administration is crafting an infrastructure bill worth more than $2 trillion that would be coupled with an increase in the corporate tax rate to 28% from 21%, which would undo a portion of the Trump tax cut from 35% in late 2017.

As we expected, the plan is for these tax increases to be passed via the budget reconciliation process, which will only require 50 votes from Democratic senators (assuming Vice President Harris’s tiebreaking vote). Given that Republicans will likely oppose the bill unanimously (some have instead proposed a nearly $600 billion infrastructure bill unattached to any major taxes), all eyes are now on moderate Democrats, namely Joe Manchin of West Virginia, who the party will need in order to reach 50 votes in the Senate.

On April 7, Manchin penned a Washington Post Op-Ed clearly stating that he opposed eliminating or weakening the filibuster, and criticized the use of the budget reconciliation process to pass major economic legislation. He argued that the rights of small, rural states must be protected with the power of the filibuster, and reconciliation stifles debate and compromise, leading to drastic swings in federal policy making. While it’s likely that the filibuster will effectively remain in place for now, Manchin seemed to leave the door open a little bit when it comes to the budgetary legislative process. As a result, to win over some moderates, we believe the White House’s initial outlines for an infrastructure bill will be modified slightly to include less new taxes – perhaps an increase in the corporate tax rate to 25%. Negotiations could take another 30-60 days.

US-China Relations: In a bipartisan bill recently introduced by the Senate Foreign Relations Committee, the Strategic Competition Act of 2021 may continue the trend of a fracturing of the global economy into American-centric and Chinese-centric spheres.

The bipartisan bill, called the Strategic Competition Act of 2021, would forbid certain technologies to be sold to Chinese companies, place additional sanctions on Chinese officials over human rights abuses in Xinjiang, earmark funding for pro-democracy efforts in Hong Kong, forge closer diplomatic ties with Taiwan, and strengthen military ties with allies and partners in the Indo-Pacific region.

US-Russia Relations: Tensions between the United States and Russia are escalating over Ukraine again, which ignited in the 2014 Euromaidan revolution. Clashes continue in the eastern regions of the country, Donetsk and Lugansk, and Russian troops seem to be building the largest presence along the border since seven years ago. On Tuesday, April 7, Ukraine’s President Volodymyr Zelensky called for speeding up the country’s membership into NATO, which may be a red-line that the Kremlin will never allow. In a show of support from the Biden Administration, two American warships will enter the Black Sea in the coming week. It’s difficult to see US relations with Russia and China meaningfully improving anytime soon.

[i] “Fed policymakers see risk from infections, not inflation,” by Ann Saphir and Howard Schneider, April 9, 2021, Washington Post.
[ii] “Jerome Powell: Vaccination key to global economic recovery,” by Sarah Ewall-Wice, April 8, 2021, Yahoo News.

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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 the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

 
Disclosures: B188
• 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 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.
•Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798
Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved.

Tech Bubbles: What You Need To Know

By Thomas Kirchner, CFA

• Today’s tech market shares similarities with prior bubbles.

• Investors should reduce tech allocations.

• Limited risk to broader market

March 10, 2000 marked the peak of the dot-com bubble. Almost to the day 21 years later, a new tech bubble is in the process of bursting. The peak of the current NASDAQ-bubble occurred on February 9, while the 2020 Corona-trough had its one-year anniversary on March 23rd. If we want to know whether we are in a bubble yet again, we need to examine its characteristics.

Analogies abound

While the specifics vary, there are many similarities between the tech bubble over 20 years ago and the one that we may be in today.

• Unproven business models
  One of the reasons why SPACs have been so active in the M&A space is because they take public companies without profits that would find going public to be be quite difficult otherwise. For example, helicopter ride sharing may be cool. But it's far from clear that it will ever be a viable business, if only due to the energy inefficiency of rotor-based leviation compared to the highly efficient lift of fixed-wing aircraft, whose efficiency beats even that of land-based transportation for longer distances.

• Overly optimistic market size projections
  The top 5 car manufacturers (Toyota, Volkswagen, Ford, Honda, Nissan) have a combined market share of about 1/3 of the worldwide car market [ii]. Their combined market capitalization is around $200bn. We find it hard to imagine a scenario for market share and margins in which a valuation of Tesla of over $800 bn could be justified [iii]. There simply aren’t enough car buyers in the world, even when you account for additional business lines that Tesla may have. A similar calculation can be made for the market size and pricing power of Covid-vaccines, as we wrote in January [iv].

• Ignoring margin compression and commoditization
  Fiber optic cables used to be very profitable; until everyone laid them everywhere and the price of bandwidth crashed. The same phenomenon occurred with solar cells – their prices remained elevated until Chinese manufacturers decided to build not just one, but several giga factories. In today's boom, Uber and Lyft are going after the legacy taxi and livery market and struggle to make a profit despite charging exorbitant commissions. As a result of their competition, taxi fares have dropped significantly, which in turn has depressed the pricing power of ride share apps. We can think of several me-too rideshare apps that disappeared as quickly as they popped up.

• Winner-takes-it-all risk
  Facebook is a great business, yet not the first one of its kind. Just like Netscape was the first internet browser whose business died when Microsoft bundled its browser for free with Windows, MySpace became irrelevant when Facebook induced many kids to switch. We have been invited to join quite a few me-too social networks since then, but none has been able to steal substantial market share from Facebook. Of course, that can change any day when someone comes up with a better mouse trap, at which point we would not want to have bought Facebook shares at a market cap of $800bn [v].

• Underestimating obsolescence
  If you were invested in Amazon many years ago, you'd be doing quite well today. But Amazon is an outlier. Survivorship has otherwise been very low and obsolescence is high. Palm Pilot and Motorola's Razr are history. Similarly, many companies that are tech leaders today and that have driven most tech returns more recently didn't even exist in 2000 – think Facebook and Twitter. Remember Angry Birds? Its maker Rovio went public in 2017 in the midst of the craze for €11.50 per share and now trades at half that, despite growing earnings[vi].

• Margin debt at new highs
  Charts showing record levels of margin debt circulate on the internet. The growth looks exponential and commentators claim that levels are unsustainable and represent bubble levels. However, by our calculation, margin debt is not particularly elevated when expressed as a percentage of S&P 500 market capitalization. In fact, when you look at past extremes in the market and the subsequent pullbacks, margin debt has tracked very closely the pullback in the market. Similarly, in strong rallies, margin debt expands at roughly the same speed as the market. This phenomenon has been persistent in the current expansion, irrespective of whether you put its starting point at the 2009 trough or the 2016 beginning of the latest move higher.

• Novice investors lured by message boards
  Silicon Investor and the Yahoo message board seemed to be driving a lot of the stock market mania during the late 1990s. Today it seems to be the WallStreetBets forum on Reddit. We have learned from Congressional testimony that stock promoters in these forums have made millions, while reporters of the Wall Street Journal have found novice investors who paid $300 for GameStop with money borrowed on credit cards.

• Regulatory risk
  Often overlooked is the risk of regulatory action, because the dot-com bubble was not followed by a major regulatory clampdown on technology companies. Yet, if we look back at the investment boom in radio stations in the 1920 and 1930s, which was state-of-the-art communications technology at the time, the government created the Federal Communications Commission (rather, its predecessor) in response to the growing might of radio monopolies. Along with the commission came a byzantine web of ownership rules that survive to this day. Social media companies are already under threat from regulation of hate speech (penalties of up to $50 million per violation in Europe) and it is not hard to foresee a scenario where even stronger regulatory requirements could regulate away the profits of these companies.

But tech works?

Sure, tech has worked very well indeed in recent years. It depends, however, on the time period you look at. Over the last 10 years, the NASDAQ has outperformed the S&P 500 by 263 percentage points[vii]. This strong performance helps it offset much of its underperformance of the 2000-2010 period. Since the peak of equity markets on March 10, 2000, the NASDAQ underperformed the S&P 500 by 46 percentage points over the next decade [viii].

In other words: technology outperforms, but, like any other asset class only in the right environment. Since environments tend to change, outperformance can be mean-reverting. After a decade of technology-sector dominance the risks favor future technology-sector underperformance for an extended period. The trillion dollar question is: when does the tide turn?

Not many or possibly no one has the market timing skill to answer that question, but we can go back and look at the last turning of the tide.

After its 2000 peak, it took the NASDAQ about a year to give back its outperformance that had started in late 1996 and fall back to the level of the S&P 500. However, losses did not end there but continued until the S&P 500 started turning around in 2004. Overall, the bubble was a 5-year roundtrip. For comparison, we are now in at least year 10 of a technology rally (we won't start debating where we should set the starting point). The quick pullback that started in 2000 suggests that once mean-reversion starts, investors will have little time to adjust their allocations. Therefore, investors with a slow reaction time, in particular those whose allocation decisions need to be sanctioned by a process that involves consultants, investment committees and boards, would be well advised to trim their technology sooner rather than later.

The broader market is, in our view, not as overvalued as it was in 2000 because valuations look less stretched than they did back then. However, passive index investors could still suffer due to the high allocation of market-weighted indices to highly valued tech companies. The S&P 500 in particular looks vulnerable from a tech pullback as more than 25% of its top holdings are tech companies. [ix].
 

[i] Global automotive market share in 2019, by brand. Statista.com
[ii] Camelot calculations based on Bloomberg data.
[iii] Source: Bloomberg data.
[iv] Thomas Kirchner; “Vaccine stocks in the coming vaccine glut.” Camelot Portfolios, January 12, 2021.
[v]-[vi] Source: Bloomberg data.
[vii] – [viii] Camelot calculations based on Bloomberg data.
[ix] Source: Bloomberg data.

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Thomas Kirchner, CFA, 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 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) and has earned the right to use the CFA designation.

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.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798

Copyright © 2021 Camelot Event-Driven Advisors, All rights reserved. B182

Currency Wars Continue in the Shadows

by Thomas Kirchner, CFA & Paul Hoffmeister

·   Swiss Franc and Chinese Yuan continue to be manipulated by their central banks.

·   Investors should avoid China.

·   Swiss investments should have the currency hedged.

With everyone focused on the latest virus statistics and the riots, it is easy to overlook the ongoing saga of currency wars fought by the Bank of China (BoC) and the Swiss National Bank (SNB).

The Currency War 10 Years Ago

The term “currency war” had been largely absent from mainstream economic vocabulary since the 1930s until it was reintroduced by Brazil’s then-finance minister Guido Mantega in September 2010 in response to attempts by China, South Korea and Japan to lower the value of their currencies to gain a competitive advantage relative to other countries such as Brazil. At the time, the dollar had fallen nearly 25% against the Brazilian Real, so that further currency actions by other trading partners risked inflicting serious harm to Brazil. While the term “currency wars” captured the imagination of journalists and book authors, not much economic warfare ever erupted.

In today’s economy two central banks are managing the fixed rates of their currencies deliberately lower: the SNB and BoC.

Swiss Franc Front and Center

About two thirds of Switzerland’s economy depend on exports, so it is no surprise that the SNB is far more concerned about its exchange rate movements than the Fed. The last time the SNB made headlines was its surprise ending of intervention on January 15, 2015 which led to a subsequent sharp appreciation of the Franc. The SNB had intervened for more than three years to keep the Franc at a rate above 1.20 to the Euro. Markets had expected a continuation of the weak Franc policy, so that many speculators were caught wrong-footed by the sudden drop. NYSE-listed retail currency broker FXCM had to turn to Leucadia National to be bailed out with an emergency loan{i}.

The 2015 suspension of intervention caused the Franc to appreciate to 0.97, but in 2018, it fell back to 1.20 prior to recently appreciating again, despite heavy SNB intervention, to its current level near 1.06 (Figure 1). (A low rate represents a strong Franc and a weak Euro.)

Figure 1; Swiss Franc / Euro Exchange Rate. Source: Bloomberg.

One particularity of the SNB’s currency management is that it invests a portion of its foreign currency reserves that it accumulated during its interventions into stocks, whereas most other central banks hold their foreign currency reserves in bonds or short-term paper.

At the end of 2019 the SNB’s foreign currency reserves amounted to 770 billion Francs. Not too shabby for a country with 8 million citizens. On these reserves, the SNB generated profits of 49 billion Francs last year, of which 4 billion were handed over to Switzerland’s Treasury. During the market turmoil in March, however, investment losses were 38 billion Francs.

While existing investments crashed during the recent global market meltdown, demand for the Swiss Franc as a safe-haven intensified, causing the SNB to reinitiate its interventions to keep the Franc from appreciating.

Interest rate cuts are politically controversial – the SNB’s benchmark rate was negative 0.75% before the crisis. Apparently, in the eyes of many, this leaves currency intervention as the only option. Clearly, the SNB chose intervention. The substantial inflows in the Franc may have had a collateral benefit: the Swiss stock market is down only 4.42% year-to-date, outperforming the S&P 500 by 0.26% [iii].

The SNB’s intervention has not gone completely unnoticed. In January, the U.S. Treasury added Switzerland to the Monitoring List of potential currency manipulators along with China and eight other countries[ii].

China

China’s intervention in currency markets has the same goal as Switzerland’s: keep the currency low in order to export. Like Switzerland it has amassed significant foreign currency reserves as a result, which are, however, invested in the traditional manner in bonds. After all, it was the infamous call to then-Treasury Secretary Hank Paulson in which the Chinese threatened to stop purchasing securities of Fannie Mae and Freddie Mac that led to the takeover of these two Government-Sponsored Enterprises by the U.S. government.

The crucial difference between China’s and Switzerland’s currency regimes lies in the severe restrictions that the Chinese government imposes on its citizens’ ownership of foreign currencies. Chinese who earn foreign currency are required to hand much of it over to their government at the exchange rate that the same government deems appropriate, which also restricts the amount of foreign assets that Chinese citizens can hold legally. The Swiss have no such constraints and can hold unlimited amounts of currency or foreign assets.

These severe restrictions have enabled the BoC to keep the Yuan more stable than the Franc: over the last ten years it has fluctuated between a low of 6.0409 and a high of 7.1372, its rate last Friday (Figure 2). In contrast, the Swiss Franc has a spread of 45% between the lowest and highest rate over the same period. (In the same manner as for the Swiss Franc/Euro pair, a higher exchange rate signifies a devaluation of the Yuan).

Figure 2: Chinese Yuan / U.S. Dollar Exchange Rate. Source: Bloomberg.

Similar to the SNB, facilitating exports is the main motivator behind the BoC’s currency management. This is clearly visible in the devaluation of the Yuan in 2018 as U.S. tariffs were imposed: the initial 10% tariff rate led to a depreciation of the Yuan from the 6.30 area to 6.90, while the threat of additional 25% tariffs has caused the BoC to continue letting the Yuan depreciate.

Investment Implications

With the U.S. Presidential election season approaching and Hong Kong having turned into the new geopolitical hotspot, investors should be cautious about the potential for political rhetoric erupting about exchange rates. Clearly, labelling China a currency manipulator would have a dual effect of scoring political points inside the United States while also causing economic harm to investments in China, which would be hit by increased incentives to move supply chains out of China

Switzerland’s interventions are less exposed politically, and it is hard to see why it would suffer more than rhetorically. The country has managed to get through the epidemic much more smoothly than most other countries. Swift action in the initial phases coupled with an excellent healthcare system has kept the number of deaths low and has allowed a gradual reopening to start much earlier than the rest of the world. We believe that the Swiss market will outperform due to fundamentals as well as due to the weakening currency. However, any investment in Switzerland should be flanked with currency hedges because further weakness in the Franc is likely.

We would also like to point out an important investment implication of the China tariffs coupled with the devaluation: many commentators have warned of the potential impact that U.S. tariffs could have on the cost of consumer products in the U.S. While many retailers initially warned about a tariff impact, such complaints faded as 2019 progressed because the cost push of the tariffs was offset in part by a depreciation of the Yuan. We expect that China’s devaluation playbook will be repeated should trade tensions escalate again in the next few months over Hong Kong or due to the presidential election campaign.

Thomas Kirchner, CFA, 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) and has earned the right to use the CFA designation.

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). Mr. Hoffmeister is a graduate of Georgetown University with a BS in Accounting and Finance, and MBA from Northwestern’s Kellogg School of Management.

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[i] Anirban Nag, Steve Slater: “Swiss franc shock shuts some FX brokers; regulators move in.” Reuters, January 16, 2015.

[ii] “January 2020 Report to Congress on Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States.” Department of the Treasury, January 2020. The other eight countries are Germany, Ireland, Italy, Japan, Korea, Malaysia, Singapore, and Vietnam

[iii] Total return of the Swiss Market Index and S&P 500 year-to-date through 5/29/20. 

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.

Originally published on http://www.camelotportfolios.com/commentaries  B04

Tale of Two Cities: Lufthansa vs United Capital Raises

by Thomas Kirchner, CFA & Paul Hoffmeister

·   Lufthansa’s rescue is entirely government-funded, while United Airlines has received government AND private market support.

·   Arguably, European markets are underperforming in the recovery due to overregulation.

·   European regulators are beginning to recognize the problem.

·   MiFID II to be relaxed by … even more regulation.

Lufthansa’s billion Euro government rescue stands in sharp contrast to the free market approach taken by U.S. airlines in raising the capital necessary to bridge the corona-lockdown. It also explains why the recovery of European stock markets lags the U.S. by substantial margins, illustrating what is going wrong in the Eurozone.

Raising Capital

On April 20, United Airlines raised $1 billion in equity in the financial markets. The capital raise occurred at a 5% discount to the already depressed stock price. But despite the bleak state of the industry, with 90% of the fleet grounded, United was able to raise a 10-figure amount in equity. As early as March other airlines had raised billions of dollars of capital in debt, both through asset-backed securitizations and unsecured or convertible debt offerings [ii]. However, United’s April raise was the first attempt to raise equity capital. The dilution suffered by shareholders was about 15%, a relatively modest amount in light of the circumstances. Separately, United had received $6 billion of government loans, with which it issued warrants to the government that diluted shareholders by about 7%.  [i]

In contrast, Lufthansa made plans to access capital markets but abandoned them in April. The planned capital increase of $2.6 billion of equity and convertible bonds would have diluted shareholders by approximately 36%, yet still would have been insufficient in the eyes of some analysts to see the company through the epidemic [ii]. The anticipated $9.7 billion rescue package of debt and equity would be entirely government-funded. Dilution appears at first sight less severe than what the original private market raise would have resulted in and will only be 25% if all conversion options are exercised. However, the real strings attached to the financing come from the influence that the government plans to exercise over the company: two board seats will be filled by government representatives. [iii] But the convertibility of the debt into up to 25% of the equity is what the government may be really after, because a 25% holder has, under most European corporate laws, the ability to block strategic transactions. Even though it is unlikely that Lufthansa will be the subject of a hostile takeover, this sets a precedent for more government influence over industry, a potential power grab that has featured prominently in political discussions for some time. As an aside, a similar ownership structure has been in place at Volkswagen for decades, where it seems to do little harm to the company, although it may not do much good anyway because the presence of State representatives did not prevent the emissions fraud scandal.

Europe’s fear of financial markets

The different approach to survival amidst today’s travel slump may be a direct function of the difference in development of financial markets on the two continents.

Europe’s financial markets have been underdeveloped. Capital was provided mostly by banks. In the U.S., however, financial markets have been more vibrant. Regulations in the wake of the financial crisis have only exacerbated the discrepancy.

Under the guise of stabilizing the economy, European regulations have sought to stifle markets. U.S. regulators have created bureaucratic burdens but arguably not enough to kill off markets to the same extent as the EU. Sure, as a result of Dodd-Frank overregulation, liquidity in high yield markets has been challenging for a couple of years -- even before the Covid-19 crisis. The rules born out of the 2008 financial crisis may also be responsible for the repo debacle that has roiled funding markets since last September. And while the current administration would like to relax these tight rules, it may actually be the banks themselves that want to keep them as barriers to entry against foreign competition.

But all these problems are minor compared to the anti-market activism of EU regulators. Now that private enterprise needs capital, there aren’t many markets to turn to in Europe. Government support may be the only option.

MiFID U-Turn

If you think this is an exaggeration consider this: French securities regulator AMF calls for a suspension of MiFID II, an EU-wide regulation enacted two years ago that limits how brokers can run their business. It is known for forcing brokerage firms to bill clients for research services that used to be provided for free, and are still free in U.S. and Asian markets. AMF chief Robert Ophele was recently quoted by Bloomberg as criticizing rules that limit the ability of companies to raise capital and recover from the coronavirus pandemic. “Right now we have debt, but debt could be only part of the story for the recovery. We need capital, and it’s clear in some parts MiFID II could be reviewed in order to enhance or facilitate the possibility of raising of capital... How do we increase capital, equity issuance in our European companies, which will be key for the recovery of our economy?” [iv]. Ophele’s criticism follows a report by AMF in January that decries how MiFID “undermines” the market. [v]

The irony in this lies in France’s reputation as a stalwart of anti-market rhetoric, which is now admitting defeat with what is a de-facto U-turn. Of course, such U-turns are nothing new in France. President Mitterand, France’s first Socialist president after World War II, nationalized major industries after his 1981 election, only to privatize them again starting in 1986 once it had become obvious that State ownership was counterproductive to the hoped-for benefits.

Of course, the idea of overregulation killing the market is not a new one and is what critics of the rules have been warning about since when the rules were first introduced.

Trapped in Underperformance

As we have pointed out in prior commentary, European markets are underperforming U.S. markets in the recovery from the sharp selloff in March. Over the last month the discrepancy has widened dramatically.

With the S&P 500 down about 8.5% year-to-date, Europe overall underperforms by roughly 13.7 percentage points as of last Friday. The problem markets are down even more, with France underperforming by nearly 18.5 and Italy 18.9 percentage points. Spain is dead last, underperforming by a devastating 21.8%. [vi]

It is clear now that short selling bans announced in Italy and France during the selloff in March have not helped these markets perform better. Whether these bans are responsible for the underperformance is another question. As tempting as it is to blame short selling for the underperformance, more research will be needed to answer that question definitively. Most likely, short selling bans are merely one aspect of a confluence of unfortunate policy decisions that also include the aforementioned MiFID II and ultimately high tax regimes that stifle investment.

Investment Conclusions

In our view, it is too early to invest in airlines as distressed investments. The outcomes are too binary to make financial commitments at this time. If the economic reopening is successful, then the airlines may well have sufficient funds to emerge from the crisis. However, if prognosticators of a second wave turn out to be correct, then we would not want to own any airline-related security that was purchased at current price levels. Should that scenario play out, then we would want to invest along the lines of the 2003 airline bankruptcies when the most successful investments were arguably in airplane lease securitizations, where investors were backed with good assets, yet the securities traded at substantial discounts to the value of the assets because the issuing airlines were in bankruptcy.

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Thomas Kirchner,CFA, 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) and has earned the right to use the CFA designation.

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).
Mr. Hoffmeister is a graduate of Georgetown University with a BS in Accounting and Finance, and MBA from Northwestern’s Kellogg School of Management.

 [i] Author’s calculations and Tracy Rucinski: “United Airlines sells $1 billion of stock in fresh move to weather pandemic.” Reuters, April 21, 2020.

[ii] Eyk Henning, William Wilkes, and Jan-Henrik Foerster:” Lufthansa Seeks Investor Support for Share Sale in Funding Push.” Bloomberg, April 9, 2020.

[iii] David Kaminski-Morrow: “Lufthansa Group nears deal for €9bn financing package.” Flightglobal.com, May 21, 2020.

[iv] Silla Brush, “‘Urgent’ MiFID Revisions Could Revive Europe, AMF Chief Says. “ Bloomberg, May 18, 2020.

[v] Jacqueline Eli-Namer, Thierry Giami: “Reviving Research in the Wake of MiFID II: Observations, issues and recommendations.” Autorite des Marches Financiers, amf-france.org, January 2020.

[vi] Total return of each index year to date through 5/21. Europe: STOXX50. Italy: FTSE MIB. France: CAC 40. Spain: IBEX 35. Source: Bloomberg.

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.

Originally published on http://www.camelotportfolios.com/commentaries

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Winners and Losers of the Pandemic

by Thomas Kirchner, CFA & Paul Hoffmeister

Since the beginning of the crisis, perma bears and perma bulls have disagreed about whether we are headed for a severe depression or whether there will be a rapid V-shaped recovery once the economy opens up again. The stock market’s verdict so far validates the optimists: the S&P 500 has recently retraced 62 percent of its losses.

Predictably, Europa and Asia are lagging, but not by much: both the DAX and the Nikkei 225 have recovered half of their peak losses. Of the 500 stocks in the S&P, almost 100 are positive YTD, while that is the case for only four of the 30 DAX stocks and 15 of the 225 Nikkei stocks [i]. There are wide gaps between industries and sectors within each index: travel and financial stocks were the key drivers of the drawdown in the S&P while automotive and industrial stocks suffered the heaviest losses in the DAX. The winners seemingly everywhere were stocks that benefit from stock trading volume, mainly exchanges and brokers, as well as pharmaceutical stocks. In the S&P, large technology companies also were able to recover quickly after initial price losses. Many large cap tech companies, by the way, have grown so much in recent years that a handful of these companies now represent 20 percent of the total value of the S&P 500, a trend that their recent outperformance has reinforced further.

One of the big buyers during the selloff has been the Swiss National Bank (SNB) that is defending the Franc against a falling Euro. Not only does the Swiss Franc remain true to its reputation as a safe-haven during times of crisis, but negative yields in Swiss government bonds are now comparable to those in the Eurozone. With Swiss yields less punitive than before the crisis when compared to Eurozone yields, the Swiss Franc has become less unappealing as a currency relative to the Euro. This is likely to have encouraged further inflows. The SNB has used the foreign currency reserves that it has amassed over the last few years in an attempt to keep the Franc weak to invest not just in foreign government bonds, as central banks typically do, but also by investing in stocks. The SNB purchased some of the most famous large cap tech stocks during the first quarter. With turmoil in the FX market continuing into April, it is safe to assume that its purchases have continued in Q2. These massive purchases have arguably contributed to the outperformance of large cap stocks. [ii]

Smaller technology stocks are also among the winners, especially if they support teleworking. Citrix, Ringcentral and Zoom may generate record earnings thanks to their computer access and video conferencing software. Zoom founder, Eric Yuan, has become some $4 billion richer as the stock of that company has nearly doubled since the beginning of the year. Similarly, Docusign and Adobe have outperformed. They allow documents to be signed electronically.

In the pharmaceutical industry Gilead, Fresenius and Merck are some of the biggest winners. Gilead's share price has rallied 69 percent this year as investors placed high hopes in the Remdesivir drug approved for the treatment of Covid-19. However, it is still unclear if and by how much Gilead will be able to make profits from it. The company announced the free donation of 1.5 million doses, which will impact financials. What pricing and costs will look like once commercial sales begin is unclear. In the optimistic scenario, analysts estimate that the value of future Remdesivir profits may only represent 1-4 Dollars per share, or less than five percent of the current market price. [iii] In our view, much of the good news has already been priced into this stock. [iii]

Other notable winners and losers are mining stocks, which reflect the prices of the respective commodities: Newmont, the only gold producer in the S&P 500, rose almost 50 percent this year, whereas oil producers have in many cases lost about the same amount.

Finally, in this global fight against a sinister virus, the bleach maker Clorox has seen its stock rally by nearly one third since the beginning of the year, similar to the growth in sales in its cleaning products division. However, the actual demand for disinfectants is even higher than what the sales increase might suggest. Production capacity for disinfectants lags demand and the expansion of that capacity may be completed during the summer. Therefore, sales might be boosted further, if additional product can be shipped. [iv]

Stocks will likely have more volatility and turbulence in the months ahead. The stock market’s winners and losers may still take some surprising twists and turns. If the perma bears are correct, then current trends of who is a winner and a loser could persist. However, if the bulls are correct and the economy opens gradually and there isn’t a major second wave of viral infections, then we expect stocks that have been laggards so far to become some of the biggest winners.

[i] All returns are YTD through 5/8 unless noted otherwise. Source: Bloomberg.

[ii] Author’s analysis of Forms 13F-HR filed by the Swiss National Bank with the U.S. Securities and Exchange Commission for the periods ended 12/31/19 and 3/31/30.

[iii] Carter Gould, Andrew Ang, Justin Burns: “Gilead Sciences, Inc.: Our Thoughts Post the 1Q20 Call.” Barclays Bank Equity Research, May 1, 2020.

[iv] Clorox earnings press release for Q1 2020 filed with the U.S. Securities and Exchange Commission on Form 8-k on May 1, 2020.

Thomas Kirchner,CFA, 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) and has earned the right to use the CFA designation. 

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).
Mr. Hoffmeister is a graduate of Georgetown University with a BS in Accounting and Finance, and MBA from Northwestern’s Kellogg School of Management.

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.

Originally published on http://www.camelotportfolios.com/commentaries