Covid Data Got Better Last Month

by Paul Hoffmeister, Chief Economist

• The spread of Covid around the world meaningfully decelerated during the last month.

• Small caps and energy have recently outperformed large caps and tech.

• No tax increases for now.

• While tensions in Taiwan are the worst in more than 40 years, Biden Administration appears open to exemptions from the China trade tariffs that President Trump instituted.

In terms of the economic data, the Covid recovery scenario remains in full force. The unemployment rate fell to 4.8%; the ISM manufacturing and services indices registered greater than 60, meaning that growth remains unusually robust historically speaking; and jobless claims have improved from September’s jump and close to their Covid lows. But, in our view, the most important data point of the last month was the significant decline in Covid cases and death rates.

As of the last week, the week-over-week rate of new Covid cases and deaths around the world was approximately 2.3 million and 37 thousand. This compares to nearly 4.1 million and 63 thousand at the end of August. In other words, according to the official global data, the spread of Covid meaningfully decelerated during the last month.

We note that some observers draw analogies with the 1917 pandemic and other historical pandemics, which had 3-4 waves before abating. While we cannot opine on the relevance of such analogies to the current pandemic, we note that the third wave seems to be behind us. Should the dynamic of such past pandemics be applicable to Covid, then this would indicate that the worst is behind us.

This positive news has correlated with some of the most sensitive financial indicators moving higher: the oil price and the 10-year Treasury yield. Between August 31 and October 11, the price of a barrel of oil (West Texas Intermediate) jumped from around $68.50 to over $80; while the 10-year yield jumped from 1.31% to 1.61%. This reflex suggests that financial markets are adjusting to the prospect of greater-than-expected economic activity and demand, which would also translate into Federal Reserve policymakers raising interest rates sooner-than-expected.

As mentioned last month, we expected small caps and the energy sector to outperform large caps and technology in the event that Covid data were to significantly improve. Between August 31 and October 8, the Russell 2000 and XLE exchange-traded fund returned -1.8% and +16.8%, respectively; whereas the S&P 500 and QQQ exchange-traded fund returned -2.9% and -4.9%, respectively. While a lot of discounting may have already occurred recently, this market behavior suggests that a further return to post-Covid normalcy should continue to favor these segments of the market.

This positive momentum does bring with it economic risk, notably in the form of inflation. While monetary inflation does not appear to be a problem today, with gold prices steadily drifting lower, and money supply and money velocity relatively tame, the supply chain dislocations of the last year and a half have created distortions, causing higher prices and higher inflation statistics. Early this year, we highlighted bottlenecks at the lumbermills and the resultant jump in lumber prices. At the moment, significantly more oil supply from within the United States does not appear to be forthcoming, and OPEC appears resistant to adding more supply than previously planned. As a result, the recent jump in oil prices (and energy prices generally) pose a significant risk to keeping statistical inflation data elevated, which in turn will likely pressure Fed policymakers to raise interest rates. This could ultimately spook financial markets, as we experienced in 2018.

Fiscal Policy: 

Democratic centrists and progressives have so far failed to come to an agreement on a $500+ billion infrastructure bill and $3+ trillion tax and spending legislation.

The two most important holdouts have been Senators Joe Manchin and Kyrsten Sinema. While Sinema has been quiet publicly about where exactly she disagrees with her caucus, Manchin has been vocal about his concerns over such a large spending package being passed through the simple-majority, budget reconciliation process. At the same time, some swing district House Democrats are concerned about the tax increases being proposed.

Manchin recently revealed that he’d only support up to $1.5 trillion in new taxes. This would implicitly entail less tax increases, which could also win the support of other centrists in Congress. As a result, the White House and the Democratic leadership have pared back their tax and spend ambitions. For now, it doesn’t appear that a deal will be reached until year-end, if at all.

US-China Relations: 

In her first major public speech, the new US Trade Representative Katherine Tai described the US-China relationship as “complex and competitive”. The last month was filled with evidence of that – militarily and economically.

At the beginning of October, the Chinese military broke records three times for the number of planes entering Taiwan’s Air Defense Identification Zone in a day, and Taiwan’s defense minister described his country’s tensions with China to be at their worst point in over four decades. Then, last weekend, Xi Jinping said "achieving unification through peaceful means is most in line with the overall interests of Chinese people, including Taiwan compatriots…those who forget their heritage, betray their country, and seek to break up their country, will come to no good end." At the same time, Taiwan publicly acknowledged the presence of US troops conducting military exercises in-country.

While the issue of Taiwan looks to be increasingly dangerous, Ambassador Tai may have conveyed conciliatory signals by announcing that the Biden Administration was considering a targeted tariff exclusion process for US importers of Chinese goods on 549 import product categories. The US Trade Rep’s office will accept public comments in the coming weeks. While Trump Administration duties remain in place today, it appears that those duties could be alleviated soon – for some companies.

Current Market-based Political Outlook: 

According to Predictit betting markets, the current probability of Republicans regaining control of the House and Senate in the 2022 midterms are 73% and 55%, respectively. President Trump’s probability of being the 2024 Republican nominee has notably sky-rocketed to 48%, from 30% in July… As for who will win the 2024 presidential election: Trump is at 30%, President Biden 28%, Vice President Harris 15%, and Governor Desantis 13%.

Summary: 

In summary, the US economy is performing well, Covid data has substantially improved in recent months, and the tax threat to financial markets has abated. This positive news has correlated with strength in some of the most risk-sensitive segments of the financial market. US-China remains an important complicated, long-term variable to monitor: both militarily and economically. While Taiwan is becoming a major proxy of US-China strategic interests in the region, the Biden Administration may rescind some of the Trump trade tariffs in the coming months.

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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).

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B267

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 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.

Evergrande and Threats to Growth

by Thomas Kirchner, CFA

• No Lehman or Minsky moment in sight.

• China's real estate market to crash.

• Domestic repression and international conflicts will cover up economic problems.

The Evergrande default on $2 billion of Dollar-denominated foreign bonds itself, or the broader collapse of the Chinese real estate market, poses little threat of contagion and certainly is no Lehman moment. However, we see risks of indirect contamination of the global financial system.

No Lehman moment

Whether you call it a Lehman or Minsky moment after the late author of “Stabilizing an Unstable Economy,” the idea is that large losses in one part of the financial system will cause panic among investors who fear that other market participants will suffer similar losses. During the Global Financial Crisis, the wide distribution of MBS gave some credence to the notion that losses from U.S. real estate would spread to financial institutions that are not normally involved in U.S. mortgage lending. With the Chinese property market in contraction, there have been similar fears, mainly because the numbers are so large – we will discuss the extent below. However, what is missing are the transmission mechanisms of losses in Chinese real estate into the broader global financial system. This is not only due to the lack of convertibility of the Yuan into dollars, but also due to the protectionism of China's financial industry, which prevents foreign financial institutions from competing with domestic players. As a result, Chinas mortgage market is hermetically insulated from the rest of the world. Evergrande is one of the exceptions in that it has issued $2 billion worth of foreign bonds; however, the amount of dollar bonds issued by all Chinese corporate remains a minuscule slice of the overall global bond market, so that any losses will not spiral out of control. Therefore, we doubt that the Evergrande problems or even a greater real estate crash in China would have a direct systemic impact. However, we do see risks in indirect transmission mechanisms.

Hong Kong is the weak link

With direct contagion out of the picture, we can see only two transmission mechanisms.

The first is through the Hong Kong real estate market. Unlike mainland China, Hong Kong has no currency controls and its financial markets are integrated with the world. Although geographically small, Hong Kong has a sizable mortgage market due to the exorbitant cost of its real estate: the average home costs the equivalent of US$ 1.2 million [i]. UBS considers it to be a bubble risk [ii]. Two of the top mortgage lenders are actually British banks, HSBC and Standard Chartered, while most other lenders are Chinese banks. Aggregate outstanding residential mortgage loans are a relatively modest $200 billion, some of which have been securitized. However, given the overall limited amount, it is unlikely that home mortgage losses in Hong Kong would threaten the global financial system. In contrast, commercial mortgages are more likely to spread losses widely. Banks are allowed to lend only 40% on the value of a building, but mezzanine and other non-bank lenders will provide financing to bring the total to the 80% level typically seen elsewhere in the world [iv]. Their financing, in turn, shows up elsewhere in the financial system. With values of commercial buildings substantially lower due to Covid, any selling by Chinese banks in Hong Kong real estate or lending products could accelerate a downturn and spread around the world.

The second transmission mechanism takes longer to play out: a recession induced by the collapse of China's real estate bubble would reduce demand by Chinese consumers and would impact profitability in China-dependent industries in the West such as automotive or luxury goods.

Importance of China's real estate market

Real estate is the backbone of China's non-export economy, representing anywhere from 10%, if we believe Statista [v], to as much as 29 percent of GDP, if we believe Ken Rogoff [vi]. Moreover, home ownership rates are high at 90% [vii], so that changes in house prices and affordability have a much stronger impact than in Western countries with lower home ownership rates. Housing represents 79% of household wealth, although that percentage may have increased recently as households lost about $1 trillion in tech stocks after the recent clampdown. Housing is important not only for the economy overall, but, in the absence of pensions and social security, also serves as a retirement savings plan.

The housing sector is at risk of not just a pullback, but an outright crash. In 2020, the PBOC and Ministry of Housing issued the “three red lines” directive which limits leverage for developers. This year to date, more than 400 new regulations [ix] have been issued. 27% of all bank loans [ix] are tied up in real estate projects, so capping leverage feels like a logical step to reduce financial fragility.

Except that it seems to be counter-productive. Evergrande is the poster child of the failure of these regulations. The company completed a $13 billion debt-to-equity swap in 2020 to reduce its debt load, yet is in a worse shape now. Relative to a total debt load of $300 billion, $13 billion in extra equity capital is just a drop in the bucket when the market turns south. The only accomplishment of this move was to highlight the risks inherent in China's highly leveraged developers, without actually reducing this risk by more than a token amount.

Therefore, a real estate crash in China seems inevitable to us. The question is to what extent it will reduce consumer demand and by extension, demand for imports.

Risk of unrest and war

The other significant risk from a recession in China is political. The Chinese Communist Party has built its legitimacy since Tiananmen on progress and wealth creation, a theme President Xi perpetuates with his “common prosperity” campaign that appears to take China back to stone-age communist principles. If a real estate crash were to threaten prosperity, the CCP will have to act. For Xi personally, this presents a challenge. Although he made himself President for life in 2018 by abolishing term limits, he still needs to be elected to a third term in the 20th CCP National Congress that is scheduled for the fall of 2022. Xi has eliminated many rivals, in some cases executing them on corruption charges, but his clampdown on tech and entertainment industries have doubtlessly made him many enemies recently. We would expect increased domestic repression in the runup to the congress, with many more business leader disappearing who may be deemed insufficiently loyal to Xi.

Of greater concern is China's already aggressive foreign policy. If Xi's position were threatened at home because of an economic crisis, there would be no easier way to stay in power than to drum up nationalist favor through a military adventure. Taiwan is the first target to spring to mind, but the collateral damage would be significant. An easier target would be an expansion of the border skirmishes with India. This conflict has recently de-escalated, but the underlying differences remain. The conflict is remote enough that it would have little impact on the large population centers, making it ideal for achieving political goals. Similarly, Xi could reignite conflict over the various disputed atolls in the Pacific, including the fake islands that China created when it poured concrete on submerged rocks and installed flagpoles in 2015.

[i] “Hong Kong Holds Spot As World's Priciest Residential Property Market” CBRE, June 8, 2020.
[ii] “ UBS Global Real Estate Bubble Index” UBS, September 2020.
[iii] “Mortgage Market in Hong Kong” EconomyWatch, May 18, 2021.
[iv] Claire Jim: “Hong Kong's commercial lenders on edge as building values tumble” Reuters, July 29, 2020.
[v] Daniel Slotta: “Real estate in China - statistics & facts” Statista, April 21, 2021.
[vi] Kenneth Rogoff: “Can China’s outsized real estate sector amplify a Delta-induced slowdown?” VoxEU.org, September 21, 2021.
[vii] Youqin Huang, Shenjing He, and Li Ganc: “Introduction to SI: Homeownership and housing divide in China” Elsevier Public Health Emergency Collection, PMC7546956, October 10, 2020.
[viii] Yu Xie, Yongai Jin: “Household Wealth in China” Chin Sociol Rev. 2015; 47(3): 203–229, January 1 2016.
[ix] “Evergrande Debt Crisis Is Financial Stress Test No One Wanted” Bloomberg, September 22, 2021.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) 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.

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B265

Uranium Leads Energy Cost Explosion

by Thomas Kirchner, CFA

• Uranium prices more than doubled since pandemic lows.

• Natural gas prices explode in Europe, also North America.

• Conflict in Ukraine, winter temperatures and Nordstream 2 are key factors to watch.

It has been 17 months since oil futures prices turned negative due to buyers unable to take delivery in Cushing, TX. This week, a similar squeeze is developing in a more esoteric segment of the energy market: uranium futures. This comes as disruption in natural gas markets signals significant risk of price hikes throughout the winter months.

Uranium rally

Uranium and its associated futures prices has risen from pre-pandemic levels of below $20 per pound to current levels in the high $40s. During the pandemic, the initial spike into the $30s was attributed to mine closures in Kazakhstan due to Covid outbreaks. Two thirds of uranium comes from just a handful of mines in Kazakhstan (41%), Australia (13%) and Namibia (11%) [i], so it is not a surprise that the disruption in one of the top mines affects the overall market. Add to that the discrepancy between uranium consumption and production: for more than a decade, uranium consumption has exceeded production, so that inventories are gradually being depleted (pun intended). Unless mining capacity is expanded, the production deficit can only get worse: 50 reactors are currently under construction and will supplement the currently operating 445 reactors and increase capacity by 15% by 2040, around 300 are in various stages of proposal [ii]. Against this clearly supportive backdrop stands the decarbonization trend, where many see nuclear as a CO2-free substitute to fossil fuels.

The strong investment thesis has led to financial investors seeking exposure to the metal. Unlike in other commodity markets, uranium futures are illiquid, which is probably a reflection of the high degree of concentration in the market with a limited number of producers and consumers. Physical uranium is challenging to invest in as storage and transportation require special equipment and licenses.

The Sprott Physical Uranium Trust launched in August fills that void. It launched with $300 million worth of uranium and has begun raising and additional $1.3 billion in equity from investors. It has been estimated that Sprott's purchases in its first month have increased demand by 3%- that is in just one month[iii]. Sprott is no longer alone: Uranium Royalty Corp announced last week that it has purchased physical uranium equivalent to roughly $120 million[iv]. Now that physical uranium has become financialized, we expect investment demand to become a significant driver of price performance, especially to the upside.

The good news for consumers is that the cost of uranium is a comparatively small component of the cost of electricity generated by nuclear power stations, where depreciation of the enormous investments required to build the plant dwarf the cost of the consumable.

Natural gas price explosion

Unlike uranium, the cost of natural gas contributes significantly to the cost of electricity from gas-powered plants. The recent increase of natural gas prices in Europe, and to a lesser extent in North America,

NYMEX gas futures have risen from a low of $2 during the Covid-panic to a recent high round $5[v]. In Europe, the increase has been even more dramatic. Gas for delivery in the Netherlands increased from a pandemic low of around 13 Euros to a recent high of 42. The situation is even more dramatic in the UK, where gas futures hit a recent high of 189 from a Covid-nadir in the low 30s[vi], a six-fold increase.

Unlike oil, which is easy to transport through pipelines and takers, the gas market used to be local and depended on pipelines. However, the increase in LNG transport capacity in recent years has broken down geographic barriers, and the gas market is now much more global than it used to be. That means that substantial price differentials between regions will lead LNG operators to ship gas from where it is cheaper to where it can be sold for more. LNG is one of the last markets where substantial arbitrage profits can be made. This is mainly due to constraints in terminal capacity. Nevertheless, due to LNG, natural gas price spikes in Europe will, over time, raise natural gas price levels in North America.

Causes and outlook

The increase in natural gas prices in Europe is attributed to unusually low inventory levels for this time of year. Russia has delivered less gas than typical over the summer, which is the season in which storage tanks would normally be replenished. This raises the question as to why Russia has delivered less gas than normal. The three main transit routes from Siberia to Western Europe run through Ukraine, Eastern Europe and underneath the Baltic Sea, where a second pipeline, the controversial Nordstream 2, is about to be opened. One explanation for the low summer deliveries may be a desire by Russia to demonstrate to Europeans the necessity of the new Nordstream2 pipeline. Europe is likely to be undersupplied this winter unless this pipeline becomes fully operational. Another explanation could be the military situation in Ukraine: there have been rumors that a flare up of violence in the Dombass region is imminent. Therefore, Russia may have cut deliveries in order to minimize transit fees that would otherwise have been paid to Ukraine's national gas company Naftogas. These fees amounted to $2 billion in 2020 [viii], which is significant for a country whose GDP is only $153 billion[ix].

We believe that high gas prices pose a substantial economic threat due to the importance natural gas has both as a direct source of energy for industry and households, and for electricity production. At a time of generally rising inflation, increases in natural gas prices could have an effect similar to the oil shocks in the 1970s if they persist for an extended period of time. The factors to watch will be winter temperatures in Europe and Asia, which was a big LNG importer last year due to an unusually harsh winter, as well as the opening of the Nordstream2 pipeline. Should we experience a combination of harsh winters in Europe and Asia, or a failure to open the Nordstream2 pipeline, energy costs would pose a significant risk to the economy. Moreover, a flare-up in hostilities in Ukraine could also lead to further price increases in natural gas.

[i] 2020 production per “World Uranium Mining Production” World Nuclear Association, September 2021.
[ii] “Plans For New Reactors Worldwide” World Nuclear Association, August 2021.
[iii] “Uranium spot price reaches nine-year high as Sprott resumes purchases ” S&P Global Platts, September 15, 2021.
[iv] “Uranium Royalty Corp Expands Physical Uranium Holdings to 648,068 Pounds of U3O8 at a Weighted Average Cost of US$33.10 per pound U3O8” Press release on newswire.ca, September 15, 2021.
[v] Front month of the NYMEX contract. Quoted in US$ per BTU. Source: Bloomberg.
[vi] Front month of the ICE contract. The price is quoted in pence per therm, not in BTU. Source: Bloomberg.
[vii] Front month of the ICE contract for Dutch delivery. The price is quoted in € per MWh. Source: Bloomberg.
[viii] “US-German deal addresses Ukraine gas transit” Argus Media, July 22 2021.
[ix] For 2019. Source: World Bank.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) 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.

Camelot Portfolios LLC | 1700 Woodlands Drive | Maumee, OH 43537

 B264
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 Portfolios, 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 Portfolios, LLC’s disclosure document, ADV Firm Brochure is available at www.camelotportfolios.com

Copyright © 2021 Camelot Portfolios, All rights reserved.

Quiet Macro, But Significant Shifts Brewing

by Paul Hoffmeister, Chief Economist

Let’s create context for what’s led us to where markets are now to help create a framework for how they might evolve during the next 12-24 months. To some, markets might seem a little boring recently. For example, equity markets are generally trending higher, and bouts of weakness are relatively temporary. But these are times when, to others, markets are uncomfortable. Are things “too quiet”? There are a list of important things happening underneath the surface: notably in relation to Covid, the Fed and taxes – not to mention the political outlook.

Market Crash and Recovery

In February and March 2020, Covid-related travel bans and business closures correlated with panic in stock markets.

Beginning in late March 2020, new information about the segments of the economy reopening as well as aggressive monetary policy (zero interest rate policy and bond buying) correlated with the equity market recovery.

It appears that by the last week of March 2020, the worst fears were priced in and hopes emerged that at least some of the economy would reopen, at least in a limited way.

The 2020 Covid crash could be considered the third financial crisis of the last 20 years, at least for the United States. The speed and degree of the Covid panic and recovery typify the latest crisis.

At one point in 2020, the S&P 500 was down nearly 30% year-to-date; the Nasdaq down nearly 24%... The S&P 500 returned over 16% by year-end 2020; the Nasdaq over 43%.

Today, the State of Union is strong.

In recent months, the US economy is experiencing the strongest activity in the manufacturing and services sectors of the last decade, from the perspective of ISM data.

The U.S. unemployment rate is now below 6%, compared to almost 13% during the Covid crisis (and 3.8% prior to the global shutdowns).

Equity market volatility has recently been near a pandemic low.

Risk-taking in credit markets has rarely been stronger during the last 15 years, at least in terms of the spread between Moody’s Baa and Aaa-rated corporate credit.

There is some concern about the recent jump in inflation. Inflation spikes are not uncommon after economic crises. If gold prices stay calm, then we aren’t too concerned. We believe that the amelioration of supply chain bottlenecks will help the inflation environment stabilize.

But what to worry about today? First, as we have seen during the last 18 months, the Covid pandemic and the economic shutdowns/reopenings have been a key driver of financial markets.

Will the recent uptick in Covid numbers lead to renewed lockdowns and business restrictions?

In June 2021, some Federal Reserve policymakers began to seriously discuss the timeframe for raising interest rates. In 2018, the Fed’s interest-rate hiking outlook was arguably the primary driver of the market panics that year. Will the Fed delicately and adeptly handle any departure from its current ultra-dovish policy?

The Biden Administration is working with Congress on legislation to undo the 2017 corporate tax cuts (from 35% to 21%).

It’s possible that the U.S. statutory corporate tax rate will be raised to 25-27% in the coming months.

U.S. equities appeared to react favorably in 2017, early 2018 to corporate tax cuts. To us, it seems that the rescinding of some of those cuts will lead to a flat equity return environment or some weakness.

Kamala Harris’s prospects to be the Democratic presidential nominee in 2024 have worsened since early June, as her odds have fallen in the Predictit.org betting market.

The worsening in her probabilities appears correlated with her trip to Central America.

At the moment, former President Trump is the front-runner to be the Republican presidential nominee in 2024. Governor Desantis is slightly behind him as the next likely candidate.

---

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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).

Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B248
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 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.

Chinese ADRs: Not (Yet) At Risk From The Clampdown

by Thomas Kirchner

• Legal uncertainties rekindled by Chinese clampdown.

• VIE structures have been found to be illegal by Chinese courts.

• Nuclear economic option unlikely except in major geopolitical conflict.

After Chinese regulators clamped down recently on tutoring companies and some online services, which is said to have wiped one trillion dollars off stock market valuations [i] some investors have expressed concern about further regulatory action. Especially at risk are Variable Interest Entities (VIEs), the structure used by all U.S.-listed Chinese companies because these structures are merely allowed by administrative action, and no law specifically allows them. With such weak legal underpinnings, a simple administrative measure could declare the VIE structure illegal and would wipe out $1.6 trillion in equity of all 248 U.S.-listed companies[ii]. The question is not whether, but on what occasion Chinese regulators will wipe out foreign shareholders.

Chinese VIEs and their risks

When Sino Forest went bankrupt after fraud allegations were revealed in June 2011, the complex structures of Chinese companies listed in the West became known widely. Because foreigners are not allowed to own companies in industries on China's 'restricted' list, a workaround was developed: Chinese nationals own the assets in China and then assign their economic interests to a holding company, often based in Cayman or the BVI, whose shares or ADRs are then listed on foreign exchanges. For example, Alibaba and ANT Financial are actually majority owned by co-founders Jack Ma and Simon Xie. The IPO prospectus states clearly how it works:

Due to PRC legal restrictions on foreign ownership […] we operate our Internet businesses and other businesses in which foreign investment is restricted or prohibited in the PRC through wholly-foreign owned enterprises, majority-owned entities and variable interest entities. The relevant variable interest entities, which are 100% owned by PRC citizens or by PRC entities owned by PRC citizens, hold the ICP licenses. [...]These contractual arrangements collectively enable us to exercise effective control over, and realize substantially all of the economic risks and benefits arising from, the variable interest entities.[iii]

The key risk of this complicated arrangement is also disclosed in plain English:

If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations. […] It is uncertain whether any new PRC laws, rules or regulations relating to variable interest entity structures will be adopted or if adopted, what they would provide. [iv]

In other words: nobody knows how solid the structure is.

There seem to be two schools of legal thought here: not surprisingly, law firms writing legal opinions for IPO prospectuses hold the view that the VIE structure is legal. This view is bolstered by their tacit endorsement by Chinese bureaucrats, who would probably take action if hundreds of large, public financial transactions were gross violations of the law.

Skeptics counter that contracts written to circumvent the law are unenforceable under Chinese law. There have been several cases in which Western shareholders have tried to enforce VIE contracts in Chinese courts, all of which failed. In the 2012 Chinachem case, the People's Supreme Court ruled after 12 years of litigation that Hong Kong-based Chinachem could not enforce the VIE contracts for shares of Mingsheng Bank because the contracts were designed to circumvent the law. However, the court ordered compensation be paid to Chinachem in the amount of 40% of the value of the shares, so the investor did not suffer a complete loss. In Gigamedia, the local nominee owner of the business, Wang Ji, simply transferred the assets to himself. When VIE shareholders attempted to recover their investment through arbitration, the tribunal took a similar rationale as the People's Supreme Court in Chinachem and declared the VIE contract unenforceable. [v] [vi] It is notable that a private arbitration tribunal came substantially to the same conclusion as a court of law. We take that as an indication that the favorable legal opinions of law firms in IPO prospectuses may be overly optimistic.

It appears to us that VIEs are tolerated by Chinese regulators mainly because they bring in foreign investment. Regulators maintain the upper hand and have a free option to enforce Chinese law any time it becomes convenient for them to expropriate foreign shareholders quietly.

How serious is the VIE risk?

To gauge the risk that Chinese regulators may take action against VIEs and wipe out U.S. shareholders, it helps to look at another precedent in which an emerging market dictatorship seized a company and wiped out foreign shareholders: the 2003 arrest of Russian oligarch Mikhail Khodorkovsky and subsequent breakup and forced bankruptcy of oil company Yukos over allegedly unpaid taxes.

As Russia's richest man at the time, Khodorkovsky had challenged Vladimir Putin's ascent to power and was openly contemplating entering politics. The ferocity of Khodorkovsky's prosecution and seizure of Yukos should not be mistaken as capricious acts of a mad dictator, but were carefully calculated to set an example and dissuade others from challenging Putin. In that sense, the strategy worked very well, because numerous other Putin-critical oligarchs promptly went into exile.

We believe that China's current clampdown follows a similar logic of power preservation by a dictator who is still consolidating his position. This view is consistent with the suspension of Ant Group's IPO in October 2020, which is reported to have been ordered by President Xi Jinping personally [vii], a clear indication the decision was political in nature. The widely reported explanation for the suspension concerns Jack Ma's October 24 criticism of regulators during a conference in Shanghai. However, a decision taken at such a high level points to another reason: Jack Ma was close to former Premier Jiang Zemin, whose vision of free enterprise is on the opposite end of the spectrum compared to Xi's stone-age communist emphasis on state ownership. Many Zemin associates are said to have been investors in a private equity fund run by Zemin's grandson, which was heavily invested in ANT Financial. The IPO would have given Zemin's circle a multi-billion dollar windfall, which would have been a substantial war chest in any future power battle, an outcome Xi prevented by stopping the IPO.

We believe that we can extrapolate this precedent and that an eventual clampdown on VIEs is inevitable, but it will not come as a result of domestic policy considerations, much less due to random, capricious regulatory actions. Wiping out $1.6 trillion in wealth from foreigners is not something the Chinese government would take lightly. It is an economic nuclear option whose use makes sense only under overwhelming foreign policy considerations. For example, should China attempt to invade Taiwan and should the United States actively support Taiwanese resistance, a cancellation of all VIE contracts would be a possible form of economic warfare. Similarly, should the trade war escalate, disputes over mineral right in the South China Sea intensify or should the West become more serious about human rights violations in China, retaliation against VIEs could be a policy option for Xi.

The market, of course, recognizes the risks inherent in Chinese companies listed in the West. That is why many trade at a discount to what they would be worth in the Chinese market, which opens the door for management to take them private for a low valuation and relist them shortly thereafter in China at a much higher valuation, pocketing the difference.

[i] “Investors Lose $1 Trillion in China's Wild Week of Market Shocks” bloomberg.com, July 30, 2021.
[ii] Noriyuki Doi, Takenori Miyamoto: “Crackdown on US listings: Will China close $1.6tn VIE loophole?” Nikkei Asia, July 14, 2021.
[iii] Form F-1 filed with the Securities and Exchange Commission by Alibaba Group Holding Limited on May 6, 2014.
[iv] ibid.
[v] Brandon Whitehill: “Buyer Beware: Chinese Companies And The VIE Structure.” Council of Institutional Investors, December 2017.
[vi] Charles Comey , Paul McKenzie, Y. Michelle Yuan, Sherry Yin: “China VIEs: Recent Developments And Observations.” Morrison and Foerester, August 19, 2013.
[vii] Jing Yang, Lingling Wei: “China’s President Xi Jinping Personally Scuttled Jack Ma’s Ant IPO.” The Wall Street Journal, November 12, 2020.

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Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund (EVDIX, EVDAX) 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.

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