Election Upset and a Supportive Fed

by Paul Hoffmeister, Chief Economist

• Virginia’s gubernatorial contest last week forced a House vote on the bipartisan infrastructure bill.

• Democratic Congressional leadership aims to vote on the $1.75 trillion Build Back Better legislation later this month. Its passage remains highly uncertain, given the current political climate.

• Fed Outlook remains supportive to equities.

Arguably the biggest macro news in the United States recently was the surprise upset last week in Virginia’s gubernatorial race, as Republican Glenn Youngkin beat former governor and Democratic National Committee Chairman Terry McAuliffe. Given the fact that President Biden won the state by nearly 10 percentage points just a year ago, the election results imply a major repudiation of the Democratic policy trajectory of 2021.

Youngkin opposed vaccine mandates while personally supporting the vaccine and advocated a range of tax cuts including a doubling of the state’s income tax deduction, eliminating a 2.5% grocery tax, and suspending a recent gas tax increase. But it may have been McAuliffe’s position on education that put Youngkin over the top.

McAuliffe said in a debate on September 28 in reference to the state’s largest school district removing two books from its libraries: “I’m not going to let parents come into schools and take books out and make their own decision… I don’t think parents should be telling schools what they should teach.” Youngkin’s response was, “We watched parents so upset that there was such sexually explicit material in the library they had never seen. It was shocking… I believe parents should be in charge of their kids’ education.” And, for the next month, McAuliffe seemingly refused to back away from his position.

Before that debate, Youngkin’s odds of winning the race according to Predictit was between 20-25%. By election day, it was 50%... He ultimately won by 2 percentage points.

The events in Virginia, along with a much closer than expected gubernatorial race in New Jersey, confirmed the political headwinds facing Democrats one year into the Biden Administration and their Congressional majority. According to FiveThirtyEight, the President’s approval rating has fallen from nearly 53% on Inauguration Day to 43% today.

Last week’s election results quickly changed the legislative landscape in Washington, as the bipartisan infrastructure bill was finally put to a vote in the House last Friday. It passed the House 228-206, with 13 Republicans crossing the aisle. The legislation passed the Senate in August 69-30.

Congressional Democrats now have their sights set on passing President Biden’s $1.75 trillion Build Back Better legislation. Their goal is to vote on it during the week of November 15. That bill seeks to install a 15% minimum corporate tax rate and a surtax on individuals in the highest income tax bracket, as well increase funding for the IRS. Passage of the bill remains highly uncertain. Democratic moderates, Joe Manchin and Kyrsten Sinema, have been the key roadblocks for many months, and the recent political signals by voters may only reinforce their recalcitrance, rather than persuade them to compromise with the rest of their caucus.

For his part, Manchin called the Virginia results as a “wake up call for all of us.” Let’s not forget that Manchin represents West Virginia, where nearly 69% of its voters chose Donald Trump in 2020.
Fed Policy: In his press conference last Wednesday, Fed Chairman Jerome Powell telegraphed that the Fed will begin reducing its bond purchases, but he did not give a definitive date for when the central bank will begin raising interest rates. With statistical inflation stubbornly high (CPI recently rose 5.4% year-over-year, according to the Bureau of Labor), the threat to equities would have been a nod from Powell that Fed policymakers were going to soon raise rates to slow the economy in order to temper those price pressures.

Also, to us, it seemed that the Fed left the door open to pausing or even reversing the taper. This could be a nod to financial markets that the Fed will try to avoid spooking markets and will reverse course if asset prices significantly weaken. If this is an accurate interpretation, then it may be that Jerome Powell’s Fed is installing a Fed put under equity prices.

For now, the outlook appears to be that the Fed will maintain low rates, allowing the economy to grow even more and unemployment to fall even lower. Currently, the official US unemployment rate is approximately 5.1%; it stood at 3.8% before the Covid shutdowns. Long-term bonds benefited from the Fed news. The US 10-year yield has fallen to nearly 1.45%, compared to 1.60% prior to the meeting. Meanwhile, the S&P 500 continues to break new highs.

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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

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 // B270

Fake News About The Tax Gap

by Thomas Kirchner, CFA

• Tax gap to bring in $175 bn in annually.

• Questionable calculations vastly overstate tax gap.

• Pandora papers show few U.S. taxpayers hide income.

• Spending hoped-for collections from a nonexistant tax gap will increase government debt.

Filling the so-called tax gap is one of the pillar's of the administration's plans for paying for its proposed spending largesse. However, the tax gap is based on faulty assumptions. A reality check suggests that it does not exist at all.

The tax gap mirage

The tax gap refers to the amount of taxes that by some estimates are supposed to be collected and compares them to the actual collections. The difference is a gap amounting to $175 billion annually [i]. Over 10 years, that if that money were collected, it would pay for almost $2 trillion in extra spending.

The problem is that nobody knows what the taxes are the IRS is supposed to collect. We only know what taxpayers declare, and what audits later find in undeclared income. But how much are the audits missing? Academics have found a simple formula, that, in our opinion, is far too simplistic and yields fantasy results. The estimate looks at the income group with the highest discrepancy between declared income and what audits determine the actual income was. For incomes in the 30th to 50th percentile of the distribution, the audits find that between 5 and 6% of overall incomes are unreported. Of all income groups, these middle percentiles have the highest rate of evasion. In the top 0.01 percentile of the income distribution, audits find that only about 0.5% of overall income is unreported [i].

The proponents of the tax gap then make a strong assumption: the high rate of tax evasion of between 5 and 6% found in the middle of the income distribution is the same for higher incomes. It simply goes undetected in the audits.

If you apply this high rate of 5-6% to the top end of the income distribution, then you reach said $175 billion per year in theoretically undetected tax evasion.

There is one obvious fallacy in the approach: not all income groups will have the highest rate of evasion. The reason can easily be seen when you look at why middle incomes appear to evade so much in their taxes: Schedule C, business income. The vast majority of tax evasion is detected in business income of middle income taxpayers. For higher income groups, evasion of business income becomes much smaller. The likely cause for this evasion is not malfeasance, but the difficulty of figuring out how much in taxes is due: business income is hard to calculate when you have to deal with depreciation schedules and revenue recognition. Many small businesses who make $40k per year probably don't want to incur the expense of a business accountant, who may charge $1k or 2k for their services. So they try to do their own taxes – and get it wrong. The IRS doesn't have a category for “incorrect completion of a tax return.” They only know taxes paid or taxes evaded. So all these errors on Schedule C end up being counted as tax evasion. And clearly, many simply make mistakes due to the complexity of business taxes, or simply out of ignorance.

As you go up the income ladder, taxpayers have the means to afford an accountant to do their business taxes. Therefore, fewer errors are made, which would have counted as “evasion” in IRS statistics. The audits detect fewer errors, which leads to a lower reported “evasion”.

The proponents of the alleged fantastically large tax gap claim that foreign tax evasion is the reason why tax evasion by the rich does not get caught by the IRS audits. Fortunately, we have a way to test the plausibility of that claim.

Pandora Papers are a non-event

We can test the plausibility of foreign tax evasion in high income groups by looking at some recent leaks of data from offshore legal firms whose services are alleged to be used for tax evasion. Two such major leaks have occurred in recent years: the Panama Papers in 2016, and this year the Pandora Papers. If the ultra-wealthy engage in tax evasion of trillions of dollars, we would expect to find the traces in these documents. The names of a dozens, if not hundreds of wealthy Americans must pop up in these leaks if there really is $175 billion each and every year in offshore tax evasion by the nation's wealthiest.

Spoiler alert: there's next to nothing.

The Pandora Papers, a collection of documents leaked to the International Consortium of Investigative Journalists (ICIJ) from 14 providers of offshore vehicles, shows surprisingly few Americans among the many wealthy individuals and politicians using offshore entities. If offshore tax evasion were a major problem, we would have expected to see headline-grabbing lists of billionaire members of the Forbes list. After all, of the 2,755 billionaires currently counted by Forbes, America's 724 billionaires outnumber those of any other country. China is next with 698 [ii]. The only billionaire named by ICIJ so far is Robert F. Smith, and his his involvement with offshore entities is not even news. He settled tax evasion charges with prosecutors, as ICIJ point out, last year without being charged. The New York Times reports that the settlement, one of the largest ever in a tax evasion case, amounted to $139 million on untaxed income of $200 million over 15 years. This is not exactly an earth-shattering amount: had $200 million been taxed at the top rate of currently 37%, it would have brought in only $74 million, or a little more than half the amount of the settlement.

So the only U.S. billionaire that surfaces in what is billed as one of the largest leaks of otherwise secret offshore tax evasion documents is one who was already in the crosshairs of the IRS.

First, that tells us that IRS audits are actually effective. Second, this makes it absolutely implausible that tax evasion is endemic among Americas wealthiest. Moreover, if this case amounted to only $74 million over 15 years, then it is even more implausible that the administration will be able to raise trillions through stepped-up enforcement.

We also note that American names are similarly sparse in the 11.5 million leaked documents of the Panama Papers published by ICIJ in 2016.

Two large leaks of alleged proof of offshore tax evasion turn out to be big nothing burgers. We can only conclude that offshore tax evasion is far from being endemic. It is a fringe phenomenon and clearly not sufficient to bring in $175 billion in extra tax revenue each year.

Swiss cheese

The absence of U.S. wealthy among tax evaders is no big surprise. First of all, penalties for non-compliance are severe. More importantly, the tax code is so complex that it has more holes than a Swiss cheese. There are plenty of legal ways to minimize taxes.

Moreover, trust law is well established in the U.S., giving taxpayers plenty of flexibility . For most Americans, here is no need to enter into far-flung offshore structures. They can get the same treatment at home, where it is fully transparent to the IRS. Which in turn means that there is probably very little in hidden income that the IRS can put a legitimate tax claim on.

Income worth half a trillion

Another way to look at the numbers: at a marginal top rate of 37%, a tax gap of $175 billion corresponds to roughly half a trillion of income. That corresponds to an economy the size of Austria or Sweden. And the IRS supposedly does not catch that so much money secretly sneaks out of the U.S. every year ? We find this not just implausible, but outright ridiculous.

Tax gap folklore

Talk of the tax gap to plug budget holes is no more than political folklore, a theater to justify spending plans. While we will not dispute that stepped-up enforcement may bring in additional revenue to the IRS, we simply cannot see how this can come anywhere near the hoped-for $175 billion every year. However, if this revenue is counted on and spent before it is received, this simply means that government debt will go even further through the roof. Government debt is estimated to have reached 125% of GDP in Q2 [iv] and may raise to 202% of GDP by 2051 [v]. If we spend income from a non-existant tax gap, we will get there a lot faster.

[i] John Guyton, Patrick Langetieg, Daniel Reck, Max Risch, Gabriel Zucman: “Tax Evasion at the Top of the Income Distribution:Theory and Evidence.” NBER Working Paper 28542, March 2021.
[ii] www.forbes.com/billionaires/.
[iii] Matthew Goldstein: “A Buyout Fund C.E.O. Got in Tax Evasion Trouble. Here’s Why Investors Shrugged.” The New York Times, March 12, 2021.
[iv] Federal Debt: Total Public Debt as Percent of Gross Domestic Product. Series GFDEGDQ188S, Federal Reserve Bank of St. Louis.
[v] David Lawder: “U.S. debt burden to rise to 202% of GDP in 2051, CBO projects” Reuters, March 4, 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.

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

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

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.