Currency Crises Make a Comeback

by Thomas Kirchner, CFA

• Fed rate hikes cause currency dislocations.

• Turmoil in yen and sterling are just the beginning.

• Dollar appreciation is headwind for S&P earnings.

It has been quiet in the currency markets during the last few years. Now, currency crises are coming back with a vengeance.

In the last 10+ years of worldwide synchronized low interest rates, with some even running below zero, currency movements have been mostly benign. The early days of these loose monetary policies saw allegations of currency wars, an allegation first waged by Brazil's Finance Minister of the time, Guido Mantega. Smaller currencies had occasional hiccups, of which the surprise Swiss Franc revaluation of 2018 was the most notable. But generally, near-simultaneous interest rate cuts and central bank balance sheet expansions in the three major currency blocks have prevented a policy divergence that would have led to crisis-style currency movements. Now, with the U.S. going it alone in its aggressive tightening, we expect turmoil in the currency markets to return to levels of the 1980s.

Divergence

The Fed is pretty much alone in its aggressive rate hikes and is seen as the only major central bank that is not just talking about inflation, but acting. Neither the ECB nor the BoJ dare to follow its lead due to the high level of indebtedness of the public sectors in these two currency blocks. Despite a decade of ultra-low and negative interest rates (two decades in Japan), governments have not been able to balance their budgets, much less reduce debt levels. And we are not even talking about the UK, where we have no doubt that tax cuts will encourage investment and raise GDP in the long run, but in the near future, absent spending discipline, debt levels may increase. Then again, if anyone can reign in spending, it would be the Tories, the political heirs of Margaret Thatcher.

Sterling and Yen take the lead

While the pound's brief flash crash to its lowest level created headlines, many seem to have overlooked that the pound's weakness is not an isolated case. Against the Euro, at 55% of exports still the dominant trading partner of the UK, sterling is barely changed. The brief all-time low against the US dollar on September 25 that made headlines was reversed within hours. It appeared to be a technical move during Asian trading hours early on a Monday morning. The sell-off started around 2 a.m. London time. By the time traders in Europe arrived at their desks at 6 or 7 a.m. local time, the reversal was in full swing and by the end of the day, the pound had staged a 5% comeback rally from its low. By Friday, Sterling had recovered to over 1.12, returning to the pre-selloff level from the week before. When Prime Minister Liz Truss refused to undo her supply-side budget, the pound experienced another, albeit smaller, flash crash, which reversed within a few hours. [ii] Somehow, headlines focused on the low point of the exchange rate only, while volatility is the real story. 5% intraday moves in a currency typically are associated with currency crises.

Even before the pound sterling made headlines last week, the yen hit a low last seen in 1990, causing the Bank of Japan to intervene on September 22nd; its first intervention since 1998 [iii]. While the pound recovered its losses quickly on its own, the yen reacted to the intervention for only a couple of days. A brief post-intervention rally has since been completely reversed. The main difference between the pound and the yen is that Japan's monetary policy is in a dead-end with low interest rates being the only option, while the UK still has the chance to see an economic turnaround.

Pipeline of trouble

Smaller currencies are even more troubled. Here are just a few headlines over the last few days [iv]:

China State Banks Told to Stock up for Yuan Intervention

Rupee recovers from record lows

Forint Plunge to Record Tests Hungary’s Pledge to End Rate Hikes

Swiss franc's surge against the euro a boon for business

Nigeria's Forex Crisis Deepens As Gap Between Naira's Official, Black Rates Widest in Six Years

Exploring Africa's Ongoing Currency Crisis and Possible Solutions

Zloty Drops to Six-Month Low as Global Recession Fears Spread

That's just a random selection. It is clear that dollar strength is wreaking havoc on currencies. And no end is in sight.

No Plaza Accord is bad news for the S&P 500

On Wednesday, the White House ruled out a new Plaza accord to stem the rise of the dollar [v]. Dollar strength will persist for some time, and that is bad news for pretty much every currency around the world whose central bank is not raising interest rates. The only exception is probably Russia, which has lowered its interest rates to 7.5% -- down from 20% in the immediate aftermath of the Ukraine invasion -- and still saw the Ruble appreciate. But commodity currencies are a completely different story in the current environment. 

It is also bad news for S&P 500 earnings. Every 10% appreciation in the dollar is a 3% headwind to S&P earnings [vi]. While the U.S. economy overall is mostly a domestic affair, that is not true for the largest companies in the country, which operate on a global scale and, in some cases, generate more revenue from exports. The dollar has risen about 17% this year on a trade weighted basis (DXY). Therefore, earnings would fall about 5% if the above rule of thumb applies [vii].

The Fed's aggressive rate hikes have at least two transmission mechanisms that can crash the economy. First, directly through higher interest rates. Second, fewer exports due to a strong dollar will slow the economy further, while at the same time, imports become cheaper, threatening market share of U.S. firms, not to mention employment effects.

Overall, the strong dollar is bad news for the stock market and the economy. After the strong moves that we have seen in currencies, we would normally be inclined to be contrarian and recommend increasing exposure to foreign equities. After all, the risk/reward ratio now favors the dollar over other currencies – we would need dollar-appreciation-forever to make a case for pulling out of non-dollar assets and reallocating to dollars. All it takes is a Fed pivot, and we would expect to see a violent dollar depreciation, given that everyone is positioned for a strong dollar. Having said that, further short-term dollar strength is to be expected. However, the question is: which foreign equities to invest in? Aside from the risk of a sudden dollar reversal, U.S. equities remain, in our view, the most appealing asset class compared to every other equity market in the world.

[I] www.worldstopexports.com/united-kingdoms-top-import-partners/
[ii] www.dailyfx.com/gbp-usd
[iii] Camelot research based on Bloomberg data.
[iv] Camelot selection of headlines from Bloomberg.
[v] Akayla Gardner: “White House’s Deese Doesn’t Expect Another Plaza Accord Coming” Bloomberg, September 27, 2022
[vi] Daniela Sirtori-Cortina, Mary Biekert: “Surging Dollar Threatens $60 Billion Hit to Corporate Revenue” Bloomberg, September 27, 2022.
[vii] Camelot calculations.

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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 // B405

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.

Summer Relief Rally. What Are the Risks?

by Paul Hoffmeister, Chief Economist

• Rate expectations since mid-June have become less hawkish, coinciding with the relief rally in equities.

• The market is expecting rate cuts next year, but not the Fed.

• We highlight three major market risks that could ultimately trigger economic or financial panic.

The S&P 500, up nearly 17% from its lows on June 16, has staged a seemingly impressive rally. As we see it, the general story behind the strong market action is that CPI may be peaking and there’s a growing belief that the Fed will not need to raise rates as much as previously feared.

Indeed, the inflation data may have started to turn for the better. On July 13, the Bureau of Labor Statistics reported that headline CPI for the month of June had increased 9.1% year-over-year; then on August 10, the index showed a slightly lower year-over-year increase of 8.5% for the month of July. With energy prices declining since the end of June, forthcoming inflation data should show further improvement.

With hopes growing about better inflation data ahead and the Fed already having raised interest rates quickly and aggressively, Chairman Powell left the door open in his July 27 post-FOMC meeting press conference about the Committee’s next move in September, saying that it will be data dependent. He said, “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.” [i]

The peak in hawkish Fed expectations occurred on June 14, when the fed funds futures market implied that the funds rate would likely be around 3.75% by year-end 2023. By August 1, that expectation had declined to 2.75%; and by the end of last week, it moved only a little higher to 3.25%. It’s no surprise that the “hopeful” shift in interest rate expectations has closely correlated with the June equity market bottom and subsequent rally.

As a result, we may now be in an environment where inflation data will be declining and an end is in sight for higher interest rates. It's certainly possible that the Fed will succeed in achieving a “soft landing” scenario, where the Fed significantly raised interest rates and oversaw declining inflation without tipping the economy into a deep recession.

But we continue to believe that the risk of Fed error is high. As we have indicated before, history is not on the Fed’s side. The Fed’s interest rate campaigns of ’88-’89, ’99-’00, and ’04-’07 each preceded a recession or market panic; while some view Greenspan’s ’94-’95 rate increases as the only exception of recent history. Note, too, that the equity market panic in late 2018 seemed to persuade the Fed to terminate that rate hiking campaign sooner than it was forecasting at the time.

For more cautious observers like us today, the general view is that the Fed will maintain these higher interest rates until something “breaks” in the economy or a financial crisis emerges, at which point the monetary authorities will begin cutting rates to support economic and financial conditions.

What we find revealing or peculiar about current market expectations is that the market is already pricing in a rate cut in 2023. As of last Friday, fed funds futures expected the funds rate to trade near 3.44% by year-end 2022, but around 3.25% by year-end 2023.

This rate cut forecast contradicts the current FOMC position. The FOMC’s projections on June 15 showed that the median expectation by Fed officials for the funds rate by year-end 2022 and year-end 2023 to be 3.4% and 3.8%, respectively. There is a nearly half percentage point difference between the FOMC’s long-term rate policy assumption and the market’s.

What does the market know? Or what is it sensing that creates uncertainty around the Fed’s projections? Or is the market wrong about forthcoming events?

It's more likely that the market, with its innumerable inputs, knows more than the 12-member FOMC committee. From our perspective, we see three major market risks in coming months.

First, the current global interest rate cycle has seen one of the fastest rate rises in recent history. The significant increase in financing costs, alongside rising inflation costs, is squeezing businesses and consumers around the world. This is uncharted territory for the global economy of the last 40 years and will likely lead to a more meaningful economic slowdown than currently appreciated.

Second, it’s possible that we’ll see political turmoil in Europe erupt again, similar to the Greek debt crisis nearly a decade ago. Italy will be holding elections on September 25, and a new coalition government could force another major debate in the euro currency zone about sovereign debt limits and the sharing of debt burdens.

Third, China is facing a major property market slowdown and defaults among development companies. In turn, Chinese investors are increasingly withholding funds from developers, further exacerbating industry and financial conditions. Making matters worse, the country’s Covid lockdowns persist and continue to pressure the economy. China’s central bank surprised markets today by cutting interest rates and injecting 2 billion yuan into the economy. But it’s doubtful that this alone will be sufficient to engineer a broad-based turnaround.

We are pleased that the Fed has recently begun to telegraph forthcoming, data-dependent gradualism. But with inflation still well above the long-term goal of 2% and the unemployment rate at 3.5%, the Fed risks being more “stubborn” than warranted given the major risks on the horizon. Should any of those risks be realized, we could see a panic that ultimately forces the Fed to cut rates, just as the market seems to expect today.

[i] “Fed hikes interest rates by 0.75 percentage point for second consecutive time to fight inflation,” by Jeff Cox, July 27, 2022, CNBC.

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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 // B384

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.

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.