Fed Policy: Threat of Phillips Curve Rate Hikes

by Paul Hoffmeister, Chief Economist

• Hawkish Fed minutes: 2% inflation goal reached.

• Economy at or near full employment.

• Philips curve logic to drive rate decisions.

On Wednesday, January 5, the FOMC released the minutes from its December 14-15 meeting, providing important insight into their views about the trajectory of monetary policy during the coming year. In our view, the minutes seemed especially hawkish, and their policy framework is somewhat concerning.

The Committee’s median projected timing for the first rate increase was pulled forward from Q1 2023 to June 2022, and many members believed that it was appropriate to start balance sheet runoff sooner after the initiation of the first rate increase than during the last rate-hiking cycle. Many believed it should transpire faster as well; in the previous cycle, the balance sheet runoff began almost two years after the policy rate lift-off commenced.

Note, at the time of the December meeting, the unemployment rate had declined from 4.8% in September to 4.2% in December, and core PCE price inflation (core personal consumption expenditures) had increased 4.1% year-over-year. Participants were generally constructive about the environment, with the minutes noting that “progress on vaccinations and strong policy support, indicators of economic activity and employment had continued to strengthen.”

With the relatively sanguine economic environment, some committee members noted that certain measures of inflation had reached decade-high levels and the percentage of product categories with substantial price increases continued to climb. Rising housing costs and rents, wage growth due to labor shortages, and supply constraints were also cited. Some participants expressed concern that “the recent elevated levels of inflation could increase the public’s longer-term expectations for inflation to a level above that consistent with the Committee’s longer-run inflation objective.”

To us, the following is one of the most important sections of the minutes:

Participants agreed that the Committee’s criteria of inflation rising to 2 percent and moderately exceeding 2 percent for some time had been more than met. All participants remarked that inflation had continued to run notably above 2 percent, reflecting supply and demand imbalances related to the pandemic and the reopening of the economy. With respect to the maximum-employment criterion, participants noted that the labor market had been making rapid progress as measured by a variety of indicators, including solid job gains reported in recent months, a substantial further decline in a range of unemployment rates to levels well below those prevailing a year ago, and a labor force participation rate that had recently edged up. Many participants judged that, if the current pace of improvement continued, labor markets would fast approach maximum employment. Several participants remarked that they viewed labor market conditions as already largely consistent with maximum employment.

Our interpretation of this is that a significant contingent of FOMC members believe that the economy is at or near full employment, and that inflation is excessive and must therefore be addressed. With inflation running at nearly 5% year-over-year and unemployment currently below 4% (near pre-pandemic levels), the Federal Reserve appears to be setting the stage for anti-inflation monetary policy in 2022. This means that it’s likely to pursue a prolonged rate-hiking campaign, which by definition seeks to limit economic growth.

While inflation is a major economic negative and can be pernicious in its effects, the Federal Reserve’s use of interest rates to modulate growth is arguably a poor tool to control inflation and has in the past led to major downturns that then required policymakers to backtrack on their respective rate increases. Furthermore, as clients have heard us say in recent years, we belive the view that too many people working is inflationary (and bad) is flawed. This framework of inflation is called the “Phillips Curve” and is highly disputed, and in our view, led to the excessively aggressive and mistaken rate hiking cycle of 2017-2018. Arguably, more people working and greater economic activity increases the demand for money and therefore can be deflationary.

Unfortunately, Phillips Curve-focused monetary policy is back.

As an aside, while we’re optimistic that currently high readings of inflation will abate over time, we believe that the Fed’s forecasts are too optimistic that they’ll hit their 2% inflation objective so quickly. The minutes stated: “PCE price inflation was therefore expected to step down to 2.1 percent in 2022 and to remain there in 2023 and 2024.”

We do not anticipate housing and energy-related prices to materially abate. As a result, a 2.1% PCE reading seems unlikely, in which case, this could only support inflation hawks on the Committee and the campaign for higher rates and a policy aimed at slowing economic growth at the margin. Is aggressive and perhaps misguided monetary policy a major, immediate macroeconomic risk? It may not be for the near-term. But this is something to closely monitor during the coming 12-24 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 // B298

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.

Thinking about Inflation

by Paul Hoffmeister, Chief Economist

• Inflation is always and everywhere a monetary phenomenon.

• What could keep a lid on Inflation.

• Energy prices are biggest inflation risk.

Historical View of Money and Inflation

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” This is the fundamental idea behind the monetarist school of economics that focuses on controlling the money supply to control the price level.

If there is inflation, then there is an excess supply of money in the economy; and the central bank can extract that money (by selling bonds) to appropriately balance the supply and demand for money. If there is deflation, then there is too little supply of money; and the central bank can add money (by purchasing bonds) to appropriately balance the supply and demand for money.

Over thousands of years, civilization ultimately identified precious metals as the most stable store of value and unit of account. Prices of many goods and services would generally fluctuate around a specific ratio of gold. Rather than bartering and trading specific goods, humans could use gold or other precious metals as the means of exchange because the price in terms of precious metals did not significantly change. Commercial transactions were far easier to perform with precious metals.

When the concept of money or currency emerged, central banks sought to maintain a stable price of gold in their respective currency. If a British pound note or US dollar represented a fixed price of gold, then commercial transactions were even easier to perform than carrying gold coins. To keep its currency value stable, the central bank would add or subtract currency on a regular basis by keeping its eye on the gold price of the currency. If the gold price rose (indicating inflation), then the bank would reduce money supply, and vice versa. By keeping the currency value stable with respect to gold, then prices of goods and services should generally be stable in that currency as well.

The objective of central banks of maintaining a fixed gold price and the basic operations to meet that objective is the spirit of the idea that inflation is always and everywhere a monetary phenomenon.

Inflation Since 1971

Unfortunately, things have gotten a little more complicated with the advent of the modern monetary system. In August 1971, President Nixon abandoned the gold standard, and for the first time in history, humans began to transact within a fiat monetary system where not one major currency was tied to something real. Since then, no central banks have officially managed their money supplies with the objective of keeping a stable currency price in terms of gold. This has led to violent currency swings and extreme inflations and deflations (see chart 1). And it has made the inflation discussion more complex.

Under successfully run fixed monetary regimes where the currencies were stable with respect to gold, prices for goods and services would change relative to gold. But when they did, it was typically not a monetary phenomenon. Instead, it was a signal to the market that there was too much or too little of that good or service. As a result, producers would then respond accordingly to properly align supply and demand. For the most part, the price changes under fixed monetary regimes were tame, in comparison to periods when there was no monetary standard.

Today, unfortunately, price swings can occur because of monetary error as well as specific supply and demand effects for a given good or service. Price signals are much more complicated or distorted. A rise or fall in prices might be due to too much or too little money supply, supply disruptions or sudden changes in demand.

Thinking about Inflation Today

The global economy is currently experiencing a surge in prices. For example, as of last month, the CPI was rising 6.8% year-over-year; whereas in June 2020, the US CPI had risen 0.1% year-over-year. How much of this increase is monetary, economic, or product-specific? And, are we on the verge of a breakout in inflation, or even hyperinflation?

In our view, it’s more the latter than the former. Indeed, gold has risen from $1200 per ounce in 2018 to just nearly $1800 today (see chart 2). This indicates inflationary monetary error and will contribute to a broad price level rise in coming years. However, the prospect of, let’s say, 15% inflation is highly unlikely today. Between 1976 and 1980, gold sky-rocketed from nearly $100 to more than $850; at which time, year-over-year growth in CPI had jumped from approximately 5% to 15% (see chart 3). This is why we’ve been saying that we’re not concerned about a major outbreak of inflation, unless gold were to start exploding higher past $2000-$3000 per ounce.

This leads to focus on supply and demand for goods and services in the economy. With the nearly sudden shutdown of the global economy in 2020, the demand for goods and services plummeted, causing the year-over-year growth in CPI to fall from 2.1% (in December 2019) to 0.1% (in June 2020). Demand collapsed and producers were forced to slash prices.

With the resurgence in demand thanks to the relatively quick reopening of the global economy as well as supply chain constraints and supply shortages, prices have surged, which is reflected in the 6.8% year-over-year growth in CPI.

What Could Keep a Lid on Inflation

A few things are working in favor of CPI now.

First, some of the pressure on port operators and logistics providers appear to be improving. Drewry’s global benchmark freight rate is down about 11% since its September high. According to Freightos, the cost of shipping goods from China to the West Coast is down nearly 30% from its high. According to the Port of Los Angeles, the number of container ships waiting to dock has fallen by nearly 50% in recent months. And, railroads are now picking up shipments within 2 days, compared to almost 13 days during the summer.

Second, the reality of the CPI statistic is starting to favor slower growth. The bottom in the CPI Index data was the second half of 2020. As a result, the year-over-year comparisons in the coming year will be more favorable, and no longer compared to the low prices during the period of inventory liquidation of 2020.

For the most part, the inflation outlook is not great, and as it naturally tends to do, hurts the most vulnerable members of the economy whose wages are not keeping pace with their cost of living. But the CPI data will unlikely misbehave as it has during the last 12 months.

Biggest Concern about Inflation Outlook

My biggest concern, however, is the continued rise in energy prices, and this goes back to earlier comments about prices keeping their historical ratio with gold over the long-term. Since 2001, the oil-gold ratio has generally traded around 17.1; meaning that 17.1 barrels of oil traded per ounce of gold, on average. With gold at nearly $1800 and oil near $70, recently, the ratio trades at approximately 26 (see chart 4). If oil traded at a more normal ratio with gold, then this would translate to $100+ oil. This would lead to a significantly higher CPI and hurt the most vulnerable even more.

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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 //  B290

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.

Have Chinese Tech Stocks Bottomed?

by Thomas Kirchner, CFA

• Tech clampdown helped President Xi's grab power.

• No need for further aggressive action.

• Chinese tech stock likely have bottomed.

It has been about a year since President Xi's clampdown on tech companies began. With Xi having won prophet status in the Sixth Plenum of the CCP, we believe that the worst is over and that Chinese tech companies present a good entry point.

President Xi's Power Grab

We believe that the main motivation behind the tech clampdown is President Xi's power grab. Many tech entrepreneurs are affiliated with the Shanghai clique around former Premier Jiang Zemin. President Xi himself rose up through the CCP ranks as a member of this group but has since split with his own group of supporters. Weakening tech companies meant a weakening of the remnants of the Shanghai clique. For example, Jiang Zemin's grandson Jiang Zhicheng is said to be behind Boyu Capital, a fund that would have made substantial gains from the IPO of Ant Financial. By blocking the IPO, reported the Wall Street Journal, Xi prevented Jiang's clique from making billions of dollars in gains. Boyu has since relocated to Singapore.

The CCP's Sixth Plenum earlier this month put President Xi on an equal footing as a key leader in the continuity of Mao and Deng, as has been reported widely. But more importantly, it also overturned one of the core tenants of Deng's reforms: collective leadership. This opens the door to a Mao-style dictatorship under President Xi. Collective leadership has been a key characteristic of the post-Stalin Soviet Union as well as post-Mao China. Its abandonment is bad news for the freedom and life of anyone not completely subservient to Xi as it signals a return to brutal repression. Xi will seek a third term at next fall's Communist Party conference. All signs point to him winning

The Great Leap from Common Prosperity to Common Poverty

President Xi's policy of “common prosperity” through stone-age communism risks creating “common poverty,” warns one of the few pro-market voices allowed to speak openly, economics professor Zhang Weiying. Social media distribution of Zhang's article was blocked; but interestingly, the article itself remained available on the internet.

Clearly, as much as the CCP spreads an image of harmony and consensus, China is large and opposition still exists within the Party. President Xi may want to create an absolute dictatorship but if he were to pursue overly suicidal economic policies, it will eventually hit CCP officials' personal wallets. After all, many Party officials have accumulated substantial wealth, and not just through amazingly well-timed land or real estate investments, but also in other industries. The technology sector may have been in cahoots with Jiang Zemin's clique, but it remains key for future growth. Even more so if the real estate sector is in decline and less likely to contribute as much to future economic activity as it has done historically. In addition, technology is also crucial to produce modern weapons, which Xi will need to project Chinese power globally.

Therefore, it is unlikely that the clampdown on tech will go much deeper. While there is room for tough regulatory action at the margins, such as with Didi recently, further generalized action against the sector will have more negative effects on Xi's power than it will help.

Mafia state

The counterargument to this optimistic view is the already high degree of violence with which CCP officials dispose of rivals. This allows the party to stifle any complaints about economic policies that turn out to be a disaster without suffering adverse consequences.

Disappearances have become widespread and are no longer limited to officeholders who are little known outside of a narrow circle of bureaucrats. They happen to world-famous businessmen, pop culture idols or tennis players. The recent re-appearance of disappeared tennis star Peng Shuai was contrived so transparently that we wonder whether the actual message the propaganda sent was not that she is fine, but that the CCP has absolute power over the disgraced. Any dictator can murder a dissident, but coercing a disappeared to fake their own re-appearance, that is dictatorship 2.0.
An obviously fake re-appearance is similar to the message Zimbabwe's then-dictator Robert Mugabe sent in January 2000 when he won a lottery that was believed to be incorruptible because its drawing was transmitted on live TV: Mugabe showed that he is so powerful that he can even manipulate a lottery in front of millions of viewers. Clearly, Mugabe did not care for the $2,600 prize, but for demonstrating his absolute control and discourage any wannabe-opponents. Peng's odd re-appearance has a similar feel to it.

Almost forgotten is an account by China Daily from 2011, which pointed out the unusual frequency with which Chinese billionaires die untimely deaths: one died every 40 days on average in the prior eight years. Of 72 billionaires, 14 had been executed after a trial. The others died, in descending order of suspiciousness, of murder (15), suicide (17), accidents (7) and illness (19) [i]. Those who died from illness averaged only age 48, so we may have to reorder that list.

In short, China is run like a mafia state, and hence President Xi has few constraints in implementing and perpetuating economically harmful policies. Further actions against tech companies would be practicable under this scenario even if they turn out to be counterproductive.

Sanity will prevail

On balance, we believe that economic sanity will prevail even while substantial room for abuses remains. Just a few days ago, Bloomberg [ii] reported an upcoming clampdown on Variable Interest Entities (VIEs), something we had warned about a few months ago. However, China Securities Regulatory Commission promptly denied that VIEs were to be banned. The denial leaves open the possibility of other regulatory action short of a ban. We suspect that the Bloomberg report was leaked deliberately to prepare the market for measures that will be less stringent than the worst-case scenario of an outright ban.

We believe that this playbook will repeat more broadly across the tech sector. Therefore, investments are not a binary yes/no decision, but a question of price. And in particular in light of the recent weakness in price and the likely slowing in the clampdown, we believe it is a good time to re-up investments in Chinese tech companies.


[i] Ray Kwong: “Friends Don't Let Friends Become Chinese Billionaires” Forbes, July 15, 2011.
[i] “China to Close Loophole Used by Tech Firms for Foreign IPOs” Bloomberg News, December 1, 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

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. B283

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.

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