Economy at Tipping Point

by Paul Hoffmeister, Chief Economist

• The economy is at a tipping point facing recession.

• In 2000, 2008 and 2019 when the yield curve inverted like this, the Fed stopped raising rates, but recession still followed. This time, the outlook is more ominous, as the Fed plans to carry on raising rates aggressively.

• We continue to believe that things will get worse before they get better.

Last Wednesday, the Federal Reserve raised the fed funds rate 75 basis points to a target range of 3.75-4.00%. It was the Fed’s fourth consecutive rate increase of that size. The FOMC written statement that afternoon indicated that officials would soon slow down the increases, sparking a rally in equities. But soon thereafter, Chairman Powell emphasized that it was “premature to think about pausing.” Markets weren’t pleased, and stocks turned lower, leaving the S&P 500 down 2.5% for the day.

Powell acknowledged that the window for a soft landing that would avoid pushing the economy into recession had “narrowed.” Then, on Friday, employment data from the Bureau of Labor Statistics was a mixed bag as it showed some strength and some weakness. The economy added more than 260,000 jobs in October, although the unemployment rate had jumped from 3.5% to 3.7%.

This seems to be hardly enough labor market weakness to persuade Fed officials to stop their current campaign. Yesterday, former New York Fed President Bill Dudley went so far as to say that the Fed “hasn’t accomplished anything” in loosening the labor market.

The Fed’s recent policy pronouncement and economic data reaffirm our view that things will get worse before they get better. With headline inflation near 8% and unemployment less than 4%, inflation is the primary concern between the Fed’s two mandates, which are to maximize employment and minimize inflation. As a result, the Fed is telling us that it must raise interest rates even further to slow the economy in order to reduce overall demand and ultimately prices.

It's important to note as well that Fed officials also do not want to see exuberant financial markets. For example, in May, Powell said, “It’s good to see financial markets reacting in advance based on the way we’re speaking about the economy, and the consequence I mentioned is that financial conditions overall have tightened significantly… That’s what we need.”

Maya Angelou famously said, “If someone shows you who they are, then believe them the first time.” We are taking the Fed at face value and expect a recession and challenged financial markets during the next year.

On October 26th, the spread between the 3-month T-bill and 10-year Treasury inverted for the first time since 2019. An inversion of this segment of the yield curve is a well-known, leading indicator of a potential recession, including the last three in 2001, 2008 and 2020. The New York Federal Reserve, for its part, estimates that the probability of recession during the next year is 23%. Indeed, given the inversion of the Treasury curve today, Jerome Powell’s acknowledgement of the narrowing window for a soft-landing makes sense.

Notably, during the last 30 years when this spread went negative, the Federal Reserve did not proceed with additional rate increases. But this is not the case today. Fed officials are telegraphing the possibility of another 100 basis points of increases in the coming months.

Adding to our worry is the fact that the Fed is engineering the fastest interest rate hiking campaign of the last 30 years, and with it, the fastest flattening and inversion of the Treasury curve.

As we see it, the economy is now at the tipping point facing recession; and the Fed is going to keep strangling it.

DIAL IN FOR OUR QUARTERLY
EVENT-DRIVEN CALL
3rd Wednesday in Each Quarter at 2:00pm EST

REGISTER FOR CALL

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 // B426

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 Ahead; Time for Fed Pivot

by Paul Hoffmeister, Chief Economist

• Recent market sentiment shifted for the worse on August 26 when Jerome Powell delivered his much-anticipated policy speech at Jackson Hole.

• We continue to expect more pain ahead for financial markets.

• There’s a long list of things to worry about that pose risks to the financial system. Europe may be the biggest one today.

• Growing economic risks and improving forward-looking inflation indicators suggest now is the time for a Fed pivot.

Fed Outlook Remains Hawkish

Recent market sentiment shifted for the worse on August 26 when Jerome Powell delivered his much-anticipated policy speech at Jackson Hole. The Federal Reserve Chairman signaled that interest rates will go higher and stay there for longer in order to extinguish the 40-year high in inflationary pressures that have bubbled up during the last year.

He said, “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”[i]

Powell explained that the FOMC’s policy deliberations are predicated on three lessons from the 1970s and 1980s. First, “central banks can and should take responsibility for delivering low and stable inflation.” Second, “the public's expectations about future inflation can play an important role in setting the path of inflation over time.” Third, “we must keep at it until the job is done.”

Unfortunately, the recent economic data suggests that the Fed’s job isn’t close to done. Last Friday, the Bureau of Labor Statistics announced that the U.S. unemployment rate fell from 3.7% to 3.5% in September, a multi-decade low. And based on August’s numbers, the CPI is rising 8.3% year-over-year. We’ll learn about September’s CPI number later this week; many are expecting it to fall slightly to 8.1%.

With this combination of a strong job market and unacceptably high inflation, the broad market perception is that the Fed is unlikely to pull back from its aggressive policy posture anytime soon. Understandably then, the S&P 500 is down more than 13% (not including dividends) since the day before Powell’s speech in August… and more than 20% year-to-date. The Nasdaq composite is down more than 30% year-to-date.

More Pain Ahead

As we’ve said numerous times this year, we’re worried that the Fed will continue raising interest rates and maintain those high rates until something breaks in the global economy.

There’s a long list of things to worry about that pose risks to the financial system: the UK and Japan are struggling with abnormally weak currencies that might spiral into currency crises, Europe may be entering a deep recession, real estate and banking risks continue to manifest inside China, and the Ukraine war may escalate following the sabotage of the Nordstream pipeline and Russia’s annexation of four regions in Ukraine. All the while, businesses and individuals around the world are being squeezed between higher costs and less revenue and income growth.

In our view, the top economic risk today is Europe. As of last week, the spread between 10-year Italian and German government bonds reached multi-year highs. This arguably reflects concern about the coming winter when the economy could come under severe stress due to high energy prices and the possibility of geopolitical tensions rising even further. The Russian army, which has mobilized an additional 300,000 soldiers and seems to be fortifying its positions in Eastern Ukraine, could pursue an aggressive, westward offensive across Ukraine to the Polish border.

Time for a Fed Pause

Even though inflation is unacceptably high and must come down, we believe the Fed does not need to be so aggressive and should pause now.

The current funds rate target range is 3.00%-3.25%, and according to the Chicago Board Options Exchange, futures markets are suggesting a greater than 80% probability of the target range being raised 75 basis points at the FOMC’s next meeting on November 1-2.
Within the next few months, we expect the entire Treasury curve between overnight T-bills and the 10-year to invert, indicating a strong chance of recession and a greater likelihood of an economic or financial crisis.

Pushing the economy into a recession looks unnecessary to us. Forward-looking indicators such as the 5-year breakeven and gold appear to be showing inflationary pressures significantly subsiding since April. The market is now expecting CPI to be closer to 2.55% in 5 years; whereas in April it expected more than 3.70%. During the same time, gold has declined from nearly $2000 to $1700. These are not signs of a lurking inflation monster.
Fed policy today appears to be guided by backward-looking economic data. Already, with the recent declines in gas, hotel and used car prices, as well as airfares, it appears that we’re seeing evidence of peaking inflation.

With precious metal prices such as gold on the decline, there is arguably little monetary-related inflation embedded in the current inflation statistics. Instead, most of the 5-8% inflation that the US economy is experiencing today is likely due to the myriad and highly complicated supply chain disruptions that have emerged due to changing US-China trade policies and Covid lockdowns, not to mention the war in Ukraine.

Time is required for normal price discovery to rebalance supply and demand for goods and services; in other words, supply shortages and higher prices will attract more producers who will ultimately normalize a supply-demand imbalance and thereby reduce prices, and vice versa. Arguably, a more stable economy that is not being exogenously and negatively impacted by choking interest rates would allow the price discovery process to proceed more efficiently, as opposed to a weakening economy with increasingly sharp changes in demand that must be accounted for at the same time as supply dynamics. One variable is easier to deal with than two.

With the myriad and complex risks around the world, and forward-looking inflation indicators arguably benign, we believe now is the time for a Fed pivot.

The Fed is talking tough these days, which took a toll recently on stock and bond markets. Hopefully, declining inflation data will compel them to pause their rate increases sooner rather than later. The economy could find its footing, albeit at a weaker baseline, and financial markets might cheer. In that scenario, a “soft landing” could be realized. On the other hand, if Fed policy continues to be driven strictly by backward-looking indicators while significant economic risks exist around the world, then we fear that it will likely go too far and the economy will overshoot to the downside.

[i] “Monetary Policy and Price Stability,” by Jerome Powell, Economic Policy Symposium Jackson Hole, Wyoming, August 26, 2022.

DIAL IN FOR OUR MONTHLY
MARKET UPDATE CALL
Every 2nd Tuesday at 11:00am EST

REGISTER FOR CALL

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 Portfolios LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B406

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 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 © 2022 Camelot Portfolios, All rights reserved.

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.

DIAL IN FOR OUR MONTHLY CALL
Every 2nd Tuesday at 11:00am EST

REGISTER FOR CALL

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.

DIAL IN FOR OUR MONTHLY
EVENT-DRIVEN CALL
Every 3rd Wednesday at 2:00pm EST

REGISTER FOR CALL

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.

DIAL IN FOR OUR MONTHLY
EVENT-DRIVEN CALL
Every 3rd Wednesday at 2:00pm EST

REGISTER FOR CALL

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.