More Pain to Come

by Paul Hoffmeister, Chief Economist

• Fed Governor Waller’s expectation that unemployment will increase to 4% or more suggests to us that a Fed-induced recession is inevitable.

• Economic data do not warrant a change of course anytime soon by Fed officials.

• We expect more economic and financial pain..

The most important macro variable of 2022 is arguably the Federal Reserve’s interest-rate hiking campaign. The federal funds rate target stands at 1.50-1.75% today, compared to nearly zero percent between March 2020 and March 2022. And there appear to be much higher rates to come. The fed funds futures market currently predicts that the most likely scenario is for the overnight rate to be somewhere around 3.50% by year-end. This means the FOMC has four more meetings to raise rates by nearly 200 basis points.

The pain in stock and bond markets is obvious this year. Equity indices such as the S&P 500 and Nasdaq Composite are down more than 15% and 25%, respectively; and the Bloomberg Aggregate U.S. Bond Index has fallen more than 10%. Optimists are hoping that the Fed will back away from its hawkishness sooner rather than later, and give relief to stocks and bonds.

Indeed, a Fed relief rally could be powerful. The most recent relief rally occurred during the first half of 2019 when the Fed backed away from the hawkish rhetoric that roiled markets at the end of 2018. The S&P 500 and Bloomberg Bond Index rallied nearly 20% and 9%, respectively, during the first six months of 2019.
If we go deeper into history to when the Fed was aggressively fighting inflation -- during the early 1980s under Chairman Volcker -- the end of that tightening campaign occurred in August 1982. The relief in markets led to a nearly 40% rally in the S&P 500 into the end of that year.

Without question, the hope that the Fed will soon back off is enticing for investors given the gains that were catalyzed when the Fed shifted policy course in the past. Unfortunately, it doesn’t appear that the Fed is close to shifting anytime soon.

The CPI rose 8.6% year-over-year as of May, and is expected by many to register an 8.7% annual increase for June. That data will be released this week. Furthermore, employment data released last week showed the national unemployment rate remained at 3.6%; no change from the prior month and nearly the same job market strength the economy experienced before the Covid outbreak over two years ago. In sum, inflation is rising at a nearly 40-year high and the job market is nearly the strongest in history.

In the eyes of monetary policy technocrats, this isn’t an economic scenario that calls for dovishness. Instead, it gives the Fed more room to fight inflation and “vigilance” in using the blunt tool of high interest rates to slow growth to dampen the demand for goods and services (i.e. economic growth) and therefore reduce the price pressures in the economy.

All this suggests that there is more pain to come, economically and/or financially. Federal Reserve Governor Chris Waller said last month that moving rates quickly to a neutral level and into restrictive territory is necessary to slow demand and reduce inflation. He added that he foresees the unemployment rate rising to 4%-4.25%. In our view, Waller’s forecast basically suggests that the Fed is going to push the economy into recession.

For unemployment to rise from 3.6% today to more than 4%, it would most likely require a Fed-engineered recession. This is based on the Sahm Rule, which as discussed last month posits that recessions have in the past occurred whenever the 3-month moving average of the unemployment rate rises 0.5 percentage points over its minimum rate over the previous 12 months. It’s hard to envision a scenario where the unemployment rate will rise half a percentage point to more than 4% without recession, especially as the Atlanta Fed’s GDPNow model is already indicating that GDP is shrinking more than 1% during the present quarter.

Just as worrisome as the Fed driving the economy into recession are the gradually worsening financial conditions. The spread between the Moody’s Baa and Aaa-rated corporate bonds has been steadily widening since February. And, it’s trading near levels that in the past coincided with financial disruptions or widespread panic in markets.

For example, during the last 10 years, wide credit spreads correlated with the Covid-induced economic shutdown, the Fed panic of late 2018, and the European debt crises in 2012 and then 2015-2016.
What’s interesting today is that despite the steady widening in credit spreads since February, global financial markets have not been dealing with a major financial crisis. Instead, the pain is somewhat confined to weak equity and bond markets. But there seem to be a multitude of macroeconomic factors that could ignite some sort of crisis.

Interest rates have risen globally (and quickly so), which will likely choke growth. Input and living costs have risen as well, choking profit margins and consumer spending. And higher interest rates today will likely make it more difficult for the most leveraged or vulnerable consumers, corporations, and countries from easily rolling over their debts without significant haircuts to those debts and losses to their respective lenders.

While the losses in financial markets have been significant during the first half of 2022, the Federal Reserve is unlikely to back away from its tightening campaign anytime soon. As a result, we expect to see more economic and financial pain ahead. There’s most likely a Fed relief rally in the future. But we believe that something more serious will need to break in the global economy and financial markets for the Fed to change its present course.

We’ve been asked: what should the Fed do? In our view, the fact that precious metal prices, such as gold, are not sky-rocketing but are actually trading in the lower end of their range of the last two years suggests that there isn’t much monetary inflation in the system. Therefore, the higher prices that the economy is experiencing lately is being driven more by specific supply and demand dynamics -- which may be caused in part by global supply chain disruptions, historic fiscal spending, business closures of the last two years, and changes in consumer spending patterns due to the pandemic. In which case, the market for these goods and services are going through a “price discovery” that will eventually lead to more normal supply/demand balances and more stable prices. Given this classical economic point of view, the Fed should ensure that gold prices remain stable and long-term inflation expectations remain anchored, while at the same time not aggressively slow the economy and consequently create additional noise in the price discovery process. Doing so would arguably make supply/demand imbalances even more difficult to normalize and create additional economic pain to consumers and businesses.

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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 //  B380

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 © 2022 Camelot Event-Driven Advisors, All rights reserved.

ECB Emergency Meeting Creates Emergency

by Thomas Kirchner, CFA

• ECB emergency meeting created an emergency.

• Similarities to 1992 currency crisis and Italian devaluation.

• Financial conditions in 1992 were more favorable than today.

• Europe is headed for another debt and political crisis.

Were it not for the ECB calling an emergency meeting last Thursday, most market participants would not have realized there was an emergency in the bond market. Apparently, the sharp rise in yields on Italian bonds after the ECB stopped buying amounts to an emergency. The “emergency” label draws attention to the precarious state of public finances in parts of Europe. We would argue that debt levels are what is a real emergency, not the level of credit spreads or interest rates.

In our view, it was the ECB's own actions that facilitated this situation through its bond purchase programs. Instead of giving highly indebted welfare states breathing room to reduce their debt burdens, it led to the exact opposite: countries increased their debt levels. It depends on your view as to whether the ECB had acted in the last few years as a buyer of last resort or as a greater fool who vastly overpaid for bonds that should have had much higher yields.

The episode reminds us of the 1992 currency crisis of the European Monetary System (EMS).

Replay of 1992

The 1992 crisis of the EMS is today best remembered for when George Soros broke the Bank of England and forced the British Pound's exit from the system. Of course, that is the popular depiction of events. The reality to us is that the pound would have had to exit the EMS irrespective of whether or not it had been shorted by the Quantum Fund.

Less well remembered is the 7% devaluation of Italy's Lira over the weekend before September 14, 1992 [i], which preceded the exit of the British pound from the EMS on September 16, 1992[ii]. Over the two years following that devaluation, the Lira weakened further by a total of nearly 30% [iii]. Italy had achieved a balanced primary budget at the time, meaning that if you ignored the cost of interest on debt, the government had no deficit. However, once you took debt costs into account, the actual budget deficit was 10% of GDP [iv]. With interest rates on the rise and debt representing 105% of GDP[v], Italy was headed down an unsustainable fiscal path. Italy's central bank increased the discount rate from 11.5% in November 1991 to as much as 15.0% in September 1992, an increase of 3.5 percentage points [vi]. Yields on 10-year Italian government bonds rose from 12.5% in May 1992 to 14.4% by October [vii].

If we compare this to the current situation, then Italy is not actually in as precarious a situation as it was in 1992. The 2021 government deficit represented 7.2% of GDP [iv] including debt cost compared to 10% in 1992.

But the lower deficit is achieved in an environment with much lower debt service costs. As a result, Italy's primary budget deficit could be in a really bad spot. Reuters reports that it expects a level of 5.6% for 2022 [viii]. Moreover, as of 2021, debt stands at 151% of GDP compared to 105% in 1992.

Italy entered the 1992 devaluation with a manageable level of debt (which would be comparable to the U.S. today) but high interest rates, which could arguably only go down. In 2022, however, Italy enters an interest rate hiking cycle with debt at a crippling level, and low interest rates that can arguably only go up. It is a recipe for disaster.

Where the parallel to 1992 of last week's ECB meeting becomes relevant is when we consider the trigger of the 1992 currency crisis. On September 5, 1992, finance ministers and central bankers met in Bath but failed to agree on a plan to realign currencies in combination with a rate cut by the Bundesbank. This meeting drew attention to the disequilibrium that high interest rates were causing across the currency system. Everybody knew the problems that the EMS was facing, but the failure of the meeting became the catalyst for a panic.

We believe that the ECB emergency meeting has had a similar effect, albeit the immediate impact is likely to remain much less dramatic than the events that unfolded in 1992. Nevertheless, by lifting the Italian debt sustainability question to the level of an ECB emergency meeting, the ECB turned a latent problem into a near-term danger.

Over-reliance on banks

What makes sovereign debt problems in Europe more dangerous for the economy than elsewhere is the high prevalence of bank loans in the financing of businesses. While in the U.S., 80% of corporate financing happens in the bond market; in Europe, 80% of such financing is done via bank loans [ix]. That means that if banks are in trouble, companies no longer have access to financing and what starts as a credit crunch becomes a full-blown credit crisis. And because banks are required by various regulations to invest in government bonds, a haircut on sovereign debt will result in a banking crisis. In the U.S., the bond market may be able absorb a shock to the banking system, at least given the right circumstances. With the corporate bond market being underdeveloped in Europe, that isn't in the realm of possibilities.

Of course, that's what happened during the Greek sovereign debt crisis and is the reason why Europe had no choice but to bail out its banks. In the meantime, nothing has been done to reduce the reliance on the banking sector. Officials remain as suspicious of financial markets as ever.

The endgame: yield curve control

We see no easy solution for Europe's predicament of high government debt levels and expensive welfare states that lead to budget deficits, which further increase debt levels. The ECB may have only one way out: yield curve control in the hope that inflation will reduce the real burden of government debts. Unfortunately, that is exactly what Northern Europeans wanted to prevent when the Euro was created, and insisted on the stability pact, which has become obsolete. We will not make predictions on the political implications within the European Union, but it's clear that it won't be pretty.

[I] Christina Sevilla: “Explaining the September 1992 ERM Crisis: The Maastricht Bargain and Domestic Politics in Germany, France, and Britain.” Presented at the European Community Studies Association, Fourth Biennial International Conference, May 11-14, 1995.
[ii] Id.
[iii] Andrea Capussela: “Italy’s crisis viewed from the year 1992.” Il Mulino, June 6, 2018.
[iv] Italy Government budget deficit. retrieved from countryeconomy.com.
[v] Italy Government Debt to GDP. National Institute of Statistics (ISTAT) retrieved from tradingeconomics.com.
[vi] International Monetary Fund, Interest Rates, Discount Rate for Italy [INTDSRITM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRITM193N, June 20, 2022.
[vii] Organization for Economic Co-operation and Development, Long-Term Government Bond Yields: 10-year: Main (Including Benchmark) for Italy [IRLTLT01ITM156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/IRLTLT01ITM156N, June 19, 2022.
[viii] Giuseppe Fonte, Gavin Jones: “EXCLUSIVE Italy to stick to 5.6% deficit target despite slashing growth outlook.” Reuters, March 29, 2022.
[ix] Torsten Sløk: “US and European Companies Financed Differently.” Deutsche Bank Research, retrieved from ritholtz.com/2020/10/financed-us-europe/

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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 // B377

   
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.

Fed and Markets: Data Dependent Key Data We’ll Be Watching and What We Expect to Happen

by Paul Hoffmeister, Chief Economist

As we’ve outlined in recent months, financial markets transitioned in January from a ‘20-21 Covid recovery’ phase to today’s ‘high inflation, rate-hiking’ phase. With CPI growing 8.6% year-over-year in May (a 40-year high) and unemployment at a post-Covid low of 3.6%, the Federal Reserve is fixated on slowing economic activity to reduce inflation. As a result, the most important economic data in coming months will be inflation-related, as it will be a key driver of both monetary policy and the direction of stock and bond markets.

In mid-May, during a Wall Street Journal livestream, Jerome Powell summarized the Fed’s policy outlook in the following way: ‘What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down — and if we don’t see that, then we’ll have to consider moving more aggressively… If we do see that, then we can consider moving to a slower pace.’

At the end of May, many believed that the Federal Reserve would pause in September to evaluate the impact of this year’s rate increases. But with inflation remaining stubbornly high, Fed Vice Chair Lael Brainard said last week that it’s ‘very hard to see the case for a Fed pause’. As a result, markets discounted the possibility of even more rate hikes by year-end.

Federal funds futures currently suggest that the Fed will most likely raise the fed funds rate from its current 0.75%-1.00% range to somewhere between 3.00%-3.50% by year-end. This suggests the strong possibility of 50 basis point increases at each of the Fed’s next 5 policy meetings.

The recent increase in rate expectations coincided last week with the worst equity market performance since January, as the Dow, S&P 500 and Nasdaq respectively declined 4.6%, 5.0% and 5.6%.

With the trajectory of monetary policy and financial markets highly dependent on economic data, what data should investors monitor? The following slides show key data sets that we’ll be watching. They focus on inflation, inflation expectations, growth, and financial conditions.

Given the Fed’s operational framework today, the ideal market scenario will be for CPI to trend from 8.6% today toward 5% by year-end; inflation expectations to decline from 2.3% to the Fed’s long-run target of 2%; unemployment to stop declining or rise slowly to no higher than 4% during the next year; and for credit spreads to remain near current levels.

Arguably, this would be the ‘soft landing’ that many hope the Fed will be able to achieve, as it would likely avoid an economic recession and financial market crisis.

Unfortunately, the last three rate-hiking cycles preceded major economic and/or market disruptions. This history coupled with today’s steep rise in input and living costs as well as higher interest rates globally have made the Fed’s job exceedingly difficult. Therefore, we believe that a ‘hard landing’ is the more likely scenario in the next 12-24 months.

• In May, CPI rose 8.6% year-over-year, while the core PCE Index increased 4.9%.

• Inflation is unacceptably high due to a number of factors, including supply chain disruptions, the Ukraine conflict, and high energy prices.

• Fed is currently failing its price stability mandate and 2% long-run inflation target.

• Doves are hoping that an inventory glut, reduced demand in China, and base year effects will pull CPI lower to 5% by year-end.

• The 5-year breakeven inflation rate is currently 2.32%.

• The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury constant maturity securities and 5-Year Treasury inflation-indexed constant maturity securities. The latest value implies what market participants expect inflation to be in the next 5 years, on average.

• Fed officials may perceive the recent decline in inflation expectations as validation of their recent hawkishness.

• In May, the US unemployment rate fell to 3.6%, a post-Covid low.

• The “Sahm Rule” posits that recessions have in the past occurred whenever the 3-month moving average of the unemployment rate rises 0.5 percentage points over its minimum rate over the previous 12 months.

• This suggests that the US economy will be on the verge of or entering recession if the unemployment rate exceeds 4% during the next year.

• One of our favorite indicators of financial conditions is the spread between Moody’s Baa and Aaa-rated corporate bonds.

• Spread of 150 basis points or more suggests severe financial conditions.

• Spread below 100 basis points suggests a relatively favorable financial environment.

• We’ll become concerned about the economic and systemic financial risk if the Baa-Aaa spread breaches and keeps rising past 100 basis points… It recently traded at 97 bps.

• We believe more economic and financial pain are ahead.

• Each of the last 3 rate-hiking cycles preceded severe economic or financial conditions.

• The 99-00 cycle preceded the Tech Wreck; 04-06 preceded the Great Financial Crisis; and 2015-2018 culminated with a nearly 20% decline in the S&P 500 in Q4 2018.

• Employment and financial conditions are strong today. But with headline inflation at a 40-year high, the Fed is aggressively moving the US economy into its latest rate-hiking cycle.

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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 //  B376

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 © 2022 Camelot Event-Driven Advisors, All rights reserved.

Fed in Control of Stocks

by Paul Hoffmeister, Chief Economist

• The most important macroeconomic variable today is the Fed.

• The correlation this year between the Fed’s hawkish shift and weak equity markets is seemingly undeniable.

• Equities will find support when the Fed stops pushing longer-term rate expectations higher.

• Weaker economic activity and improved inflation data in coming months should stall the hawkish Fed momentum.

The macroeconomic circumstance of financial markets today appears to be fairly straight-forward. The U.S. economy has strongly recovered from the Covid pandemic, but inflation is now uncomfortably high and the Federal Reserve is focused on raising interest rates to slow growth to alleviate those inflationary pressures. In addition, the war in Ukraine has worsened inflation by exacerbating food and energy prices. Not to mention, it may have increased some risk for the financial sector due to concerns about Russian banks, the possibility of a Russian sovereign default, and general geopolitical uncertainty between the West and Russia.

But arguably, the most important macroeconomic variable in the world today is the Fed, and more specifically, its plan to raise interest rates. The major shift toward the hawkish Fed outlook that we have today began around the beginning of the year.

On January 5th, the Fed released the minutes of its FOMC meeting on December 14-15. The minutes stated that “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.” During the weeks that followed, Fed officials began to telegraph a change in monetary policy, including a March rate increase. The January 26 FOMC statement ultimately confirmed that shift: “With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.” Since then, the hawkish Fed rhetoric has steadily increased as year-over-year CPI growth jumped to 8.5% and unemployment fell to 3.6%.

As a result, the 10-year Treasury yield has been on a tear higher this year, jumping from 1.51% on December 31st to more than 3.10% as of Friday.

The correlation between the Fed’s hawkish shift and weak equity markets is seemingly undeniable. As the chart below shows, the breakout in long-term interest rates in recent months has correlated with the selloff in the S&P 500.

Of course, financial markets aren’t driven by only one variable. For example, the invasion of Ukraine in late February was another factor that temporarily impacted stocks and bonds. But the general correlation between stocks and monetary policy this year underscores for us, once again, just how impactful Fed policy can be for financial markets.

So, as investors, where do we go from here?

If the predominant market variable is Fed policy, the first question we need to answer is: will the Fed outlook materially change from where it stands today? If we try to understand markets with this simple framework, it would suggest that additional signals from the Fed of even higher-than-expected interest rates will translate into further equity market weakness; and vice versa.

Unfortunately, last Friday, former Fed Vice Chairman Richard Clarida suggested that the federal funds rate will need to rise to at least 3.50% to get inflation under control. Currently, based on fed funds futures, the market seems to be expecting almost a 3.25% funds rate by year-end 2023. Therefore, Clarida’s comments were new, hawkish comments that markets needed to digest and discount.

If Clarida’s comments are any indication, it appears that the Fed has some more hawkish “telegraphing” to go. And, it's difficult to forecast how much further it will go in the coming weeks and months.

But to look at things optimistically today, the Fed has shifted market expectations significantly already. At the beginning of the year, fed funds futures were expecting nearly a 1.25-1.50% funds rate by year-end 2023. The futures market now expects approximately 3.25%. As such, the market has priced in nearly 200 basis points of additional rate increases for the medium-term policy horizon.

It's likely as well that the inflation picture will improve soon.

The Fed’s intention is to slow growth to reduce inflationary pressures (however flawed its policy tool is). The recent rise in interest rates, and the general rise in input costs and living costs, are likely having a dampening effect on growth already, which should translate into limited inflation gains in the coming months.

Furthermore, the post-pandemic phenomenon where consumers increased spending on goods could start to wane, and the ratio between goods and services spending could normalize. What this means is, the boom in spending on refrigerators and other household items, for example, should decline as consumers start spending more on travel and other services. If this normalization in spending patterns occurs, it should alleviate goods demand and bottlenecks in the supply chain; both of which should reduce the pressure on inflation statistics.

In sum, we could start to see slightly slowing economic growth AND a peak in inflation data. It’s possible, for example, that the year-over-year growth in CPI will start to decline from its current 8.5% rate to 4-5% by year-end.

In this scenario, we could see the aggressively hawkish Fed rhetoric of the last four months start to calm. And in turn, holding all other variables constant, this could ultimately translate into equity markets finding support again. Hopefully, nothing else in the global economy breaks in the meanwhile.

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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 //  B372

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 © 2022 Camelot Event-Driven Advisors, All rights reserved.

Fed Will Use a ‘Brute-Force’ Tool

by Paul Hoffmeister, Chief Economist

• Fed ready to raise rates aggressively.

• Recession risk appears contained, for now.

• Ukraine peace deal outlined but not imminent.

• Betting markets overwhelmingly favor Macron in France’s April 24 election and Republicans in the midterms.

Higher Interest Rates: According to the Bureau of Economic Analysis, the CPI and PCE indices respectively increased 7.9% and 5.4% year-over-year through February, and the unemployment rate stood at 3.6%. Against this backdrop, monetary policymakers are currently more concerned about inflation than growth. And they appear ready to act by raising interest rates aggressively.

On March 16, the FOMC raised the funds rate target range to 0.25%-0.50%; its first increase in more than three years. It also telegraphed another 6 rate increases by year-end, and another three increases in 2023.

Underscoring the Fed’s inflation concerns, St. Louis Federal Reserve President James Bullard said last week that the Fed is “behind the curve” and suggested it must raise the overnight benchmark rate to 3.50%[i]. Soon thereafter, Fed Governor Lael Brainard indicated that the Fed will likely shrink its balance sheet “considerably more rapidly than in the previous recovery”. She added, “It is of paramount importance to get inflation down”. [2]

As a result, the market’s expectations of future monetary policy have caused long-term interest rates to skyrocket, with the 10-year Treasury yield jumping from approximately 1.50% at the beginning of this year to 2.75% as of last week.

The intention of interest rate increases, or what’s called the “monetary transmission mechanism”, is to slow the economy in order to ultimately reduce price pressures. Arguably, the interest rate lever is a blunt tool, and a natural concern is whether the Fed will succeed in threading the needle by engineering a so-called soft economic landing while reducing inflationary pressures at the same time.

Federal Reserve Governor Christopher Waller seemed to echo this sentiment on April 11. He said: “When you have to use a brute-force tool, sometimes there’s some collateral damage that happens. We’re trying to do this in a way that there’s not much of it, but we can’t tailor policy.”[iii]

We’re skeptical that the Fed will succeed in reducing inflationary pressures by raising rates aggressively without harming certain segments of the economy. But, for now, recession doesn’t appear to be imminent. The New York Federal Reserve’s probability of recession indicator for the next 12 months shows a 5.5% chance of recession.

Ukraine War:

The financial panic following the February 24 Russian invasion of Ukraine has significantly abated. As of Friday April 8, the S&P 500 is up more than 7% from its post-invasion low on March 8 and close to its trading levels in mid-February. Meanwhile, the USD-Ruble exchange rate is trading around 81.50 per dollar, compared to 78.65 on February 23 and nearly 135 rubles on March 10. Gold, arguably a useful geopolitical barometer, is trading around $1955, compared to $1910 on February 23 and its peak of $2050 on March 8.

Holding all other macro variables constant, these market prices suggest that the worst of the financial panic related to the Ukraine war is behind us for the near-term. However, the long-term consequences of this conflict are significant; they include higher inflation, slower economic growth, and the continued realignment of the global order.

According to AAA, the national average for a gallon of gasoline in the United States increased to $4.11 on April 8 from $3.54 on February 23. Meanwhile, according to the Chicago Mercantile Exchange, corn and wheat prices have increased approximately 13% and 21%, respectively. This is consistent with the 12.6% jump in the United Nation’s Food Price Index in March, which is the highest level for that index since its inception in 1990. Furthermore, in certain parts of the world, the price of fertilizer has increased more than 30%.

With the jump in food prices and the fact that Ukraine and Russia account for 20% and 30% of global wheat and corn exports, fears of a global food crisis are legitimate. Not to mention, an incipient rise in the cost of living will negatively impact consumers and the global economy.

Even more, we continue to see a bifurcation of the world into two economic spheres: the West with the United States at its center, and the East with China at its center and secondarily Russia.

While this bifurcation has been slowly in the making -- and we’ve highlighted it in recent years -- its reality was underscored again on February 4 when Presidents Xi Jinping and Vladimir Putin met and declared a partnership to counter the United States, stating: "Friendship between the two States has no limits, there are no 'forbidden' areas of cooperation." Among many other agreements, the countries forged a $117B Russian gas deal, Russia voiced its support for China’s stance on Taiwan and opposed NATO expansion and the AUKUS alliance (the alliance between Australia, UK and USA).[iv]

Thus far, the fighting in Ukraine does not appear to have dented the Chinese-Russian alliance. On Monday March 7, for example, China’s Foreign Minister Wang Yi emphasized that the relationship was “rock solid”.[v]

While the global order is important and its implications massive, the more acute concern for financial markets is the war right now. Will the fighting end soon? Or will it spill over into bordering countries?

On March 29, Russian and Ukrainian negotiators reached the outlines of a possible peace deal. Kiev would agree to not join alliances or host bases of foreign troops, but would have security guarantees similar to NATO’s Article 5 collective defense clause. Additionally, there would be a 15-year consultation period on the status of Crimea, which was annexed by Russia in 2014, and the status of the Donbas region would be worked out during direct talks between Putin and Zelensky.[vi] Kiev presented Moscow with a draft proposal last week, and the Russian government quickly proclaimed that it contained “unacceptable” elements, including details that were contrary to what had been previously discussed.[vii] Clearly, any peace deal will require more time. Many military observers expect Russian troops, after regrouping recently, will focus and step up operations in Eastern Ukraine.

Political Outlook:

A major political shift appears on the horizon in the United States. According to Predictit, Republicans currently have an 85% and 75% probability of regaining control of the House and Senate, respectively… Meanwhile, the Predictit market is giving Emmanuel Macron almost an 80% chance of beating Marine Le Pen in France’s second round presidential election, to be held on April 24. We wouldn’t easily assume a Macron victory. A Le Pen upset could be as significant as the Brexit referendum result of June 2016

[i] “Fed’s Bullard says interest rate policy is ‘behind the curve’, but it’s making progress”, by Jeff Cox, April 7, 2022, CNBC.
[ii] Fed’s balance sheet runoff will be rapid, Brainard says”, by Ann Saphir and Lindsay Dunsmuir, April 5, 2022, Reuters.
[iii] “Fed’s Waller Nods to Economic ‘Collateral Damage’ as Rates Rise,” by Craig Torres, April 12, Bloomberg News.
[iv] “China, Russia partner up against West at Olympics summit”, by Tony Munroe, February 5, Reuters.
[v] “China says Russia relations are still ‘rock solid’”, March 6, Deutsche Welle.
[vi] “Russia pledges to reduce attack on Kiev, but US warns threat not over”, by Jonathan Spicer, March 29, Reuters.
[vii]“Russia says Ukraine presented ‘unacceptable’ draft peace deal”, April 7, Reuters.

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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).

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