Early Stages of a Slowdown

by Paul Hoffmeister, Chief Economist

As many clients know from our previous letters and conference calls, we have been very cautious about the overall economic and financial environments because of the interest rate shock from the Fed’s aggressive interest rate campaign. Something was likely to “break”, and the first example of that in the United States appears to have been the collapse of Silicon Valley Bank last Friday.

In short, the quick and steep rise in interest rates eroded the value of long-term bonds owned by the bank; and as depositors made withdrawals in recent weeks, the bank was forced to realize those losses and seek new capital. Unfortunately, worries about the viability of the bank appear to have triggered a run on the bank late last week, leading to its takeover by the FDIC.

The federal government has guaranteed the deposits at SVB, and the Federal Reserve initiated a new emergency program called the Bank Term Funding Program, which will allow banks to pledge bonds such as Treasuries and mortgage-backed securities so they can meet withdrawals without selling those bonds for a loss and risking further bank runs.

So where does this leave us? Has the pain completely emerged? Will this backstop for banks create a foundation for a reinvigorated market outlook?

Quite simply, we remain concerned – because the demise of Silicon Valley Bank appears to be mostly symptomatic of the interest rate hikes themselves and not yet of a major economic downturn. In other words, Silicon Valley Bank’s problems weren’t significantly related to the economy, and the economy has not yet meaningfully turned lower. Unfortunately, we believe the downturn is in its early stages and this will ultimately create pressure beyond the banks and on to consumers and corporations.

It’s particularly worrisome is that SVB’s failure is the result of interest hikes that have reduced the value of assets on the balance sheet. This is an unusual case of a bank’s collapse. In a typical bank failure, credit losses cause a capital depletion, leading to an insolvency. However, the banking system does not appear to be experiencing meaningful credit losses at this point. For some context: according to the FDIC, of the nearly $2.2 trillion in bank equity among US banks at the end of 2022, $620 billion would be wiped out if the asset losses due to interest rate hikes were recognized, leaving significantly less capital in the banking system to weather credit losses in a major economic downturn.

Because the economy is incredibly complex, economic indicators can be quite nebulous. Notwithstanding, we present in the following charts certain data that strongly suggest to us that the economy is entering a significant downturn.

The charts, in sum, suggest that a simultaneous and severe slowdown is occurring in the western world. During the last 30 years, we’ve never seen a simultaneous yield curve inversions in the United States, Canada, UK and Germany to the degree that we see today. In our view, this a very ominous signal. As for the US economy, we also see that the manufacturing and services sectors are weakening to degrees reminiscent of 2000 and 2008; a major inventory downturn appears to be underway; home prices are weakening quickly; unemployment is about to rise; and bank lending is about to worsen.

This diverse set of data points to a significant economic recession and earnings slowdown. Therefore, our highly cautious view of the market remains unchanged.

Inverted Yield Curves in Western Economies: Ominous Signal?

Leading Economic Indicators Are Worrisome

U.S. Manufacturing and Services Sectors Are Slowing

Oil Inventories Rising: Less Demand from Economy?

Beginning of Inventory Liquidations?

Housing Market Is Slowing

Weak Shipping Costs Suggest Weak Global Economy

Beginning of Major Layoffs?

Bank Lending Likely to Decline: Less Future Demand

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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 Portfolios LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B456
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 © 2023 Camelot Portfolios, All rights reserved.

Unattractive Equity Outlook

by Paul Hoffmeister, Chief Economist

As clients might know from our previous letters and conference calls, we believe that the currently inverted yield curve effectively being spearheaded by the Fed’s aggressive rate-hiking campaign is signaling a high likelihood of recession during the next year. As of Friday, the 3-month/10-year Treasury spread traded at a negative 107 basis points. This is a historic degree of inversion, which we haven’t seen since the early 1980s, which has only increased our concern about the economy weakening significantly in the near future. The last three times that this segment of the curve inverted was in 2000, 2006 and 2019. Of course, each of those years preceded major ructions in the economy: the Tech Wreck, the Great Financial Crisis, and the Covid Pandemic. Notably, in each of those instances, the yield curve did not invert as much as it has today.

So, while we may feel confident in the view that the US economy will slow meaningfully in 2023, what does this mean for equities? After all, with many equity indices having fallen 20% to 30% last year, doesn’t that set us up for stronger equity returns in 2023? We’re not so optimistic.

According to Bloomberg, analysts are generally expecting the S&P 500 Index to earn about $225 per share in 2023. If one applies a 20 multiple to those earnings (we’d argue that a lower multiple is more appropriate), that would equate to a 4500 year-end price target in the S&P 500. With the Index starting the year at 3839.50, that would be an attractive +17.2% return this year, not including dividends.

Unfortunately for the outlook, when one looks at the three previous periods of yield curve inversions (2000, 2006 and 2019), S&P 500 earnings declined substantially, by at least 30%. That would equate to $157.50 per share and, at a generous 20 multiple, a 3150 target for the S&P 500 or -18% return (not including dividends).

If one assumed that the economy will only suffer a shallow recession and earnings slowdown this year and therefore assumed, let’s say, a 10%-15% decline in earnings to $191.25-$202.5, this would equate to a 3825 to 4050 S&P 500 by year-end at a 20 multiple; in other words, about a -0.40% to +5.5% return for 2023 (not including dividends).

Adding to our lack of enthusiasm for equity returns this year and bolstering our view that earnings will decline are clues that the US economy is already weakening, in a way reminiscent of the economic malaises of the last 20 years.

Specifically, the Institute for Supply Management’s Manufacturing PMI registered below 50 in November and December, indicating that the manufacturing sector is already shrinking. But even more notable, the ISM Services PMI registered a sub-50 reading for December. This services reading tends to shrink less frequently than manufacturing and appears to be a better predictor of a broader economic weakness. For example, each of the last times this index fell below 50 to signal a shrinkage in the services sector, the recessions associated with the Tech Wreck, Great Financial Crisis, and Covid Pandemic followed.

Amidst all this, unfortunately, the Federal Reserve remains intent on raising short-term interest rates to slow the economy even more and is telegraphing to markets that once it’s done with its rate hikes, it plans to keep interest rates high for a prolonged period of time.

Indeed, news in the coming weeks or months that the Fed is done with its rate-hiking cycle could spark some relief and strength in equities. But this arguably won’t adequately reflect the delayed effects of high interest rates and anti-growth monetary policy that will likely weigh on the economy throughout the first half of 2023. As such, today’s extreme yield curve inversion and emergent signs of economic weakness lead us to believe that corporate earnings are highly vulnerable to a decline in the coming year. And as a result, the risk-reward for equities in general is unattractive.

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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 Portfolios LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B435

 
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 © 2023 Camelot Portfolios, All rights reserved.

Crypto Needs A Reset Button

by Thomas Kirchner, CFA

• Crypto fails to live up to its promises of peer-to-peer disintermediation.

• Abysmal safety and soundness.

• Reboot and return to its roots are needed.

The FTX debacle puts a hard stop to the dream of alternative digital currencies. A peer-to-peer cash system without banks or central banks was the promise of Satoshi Nakamoto's original Bitcoin white paper [i]. What we ended up with is a carbon copy of the fiat monetary system, but without its protections and safeguards. The result is that crypto investors lose billions, most recently from the suspected fraud at FTX.

Crypto copies fiat

The path crypto currencies have taken over the last 15 years has no connection to the ideals its early prophets had in mind. They were looking to establish alternatives to what many consider an errant monetary fiat system. However, if we look at the state of the crypto industry today, we find an industry structure that resembles the conventional fiat banking and brokerage system surprisingly closely. Little is left of the original peer-to-peer concept. Instead, crypto has become completely intermediated.

Few crypto users have the technical skills to hold their coins in a real wallet, much less transact on the blockchain. Therefore, service providers help users out by letting them open an account, in which they can store their coins and make transactions. This is no different than traditional banking and brokerage, except that, as we will discuss later, these intermediaries also run an order book to match buyers and sellers like a traditional securities exchange. In fact, that's what they are called – exchanges.

The parallels go even further. Exchanges extend credit to their customers, like a traditional broker in a margin or prime brokerage account. A wide range of derivatives is also available. Clearly, none of this is peer-to-peer, but fully intermediated like in the fiat banking and brokerage system. And with that come the same counterparty and fraud risks as in the fiat system, except that the crypto world is severely underdeveloped in its safety and soundness.

Prevalence of pump-and-dump schemes

That something was amiss in crypto land became apparent when the Terra-Luna pair of stablecoins collapsed in a rather unstable descent in October. Two interlinked tokens raise red flags. It appears that one token props up the other, while the second props up the first. It is a circular pump-and-dump scheme. It is now known that Sam Bankman-Fried admitted as much in a Bloomberg “Odd Lots” podcast with Matt Levine as early as April 2022. Of course, using one token to prop up the other has nothing to do with the original disintermediated peer-to-peer concept underlying cryptocurrencies, but when everyone makes money, such details didn't seem to bother anyone.

Similarly, nobody seemed to question the double-digit yields offered by some crypto schemes. If we were running a crypto project that were producing legitimately high yields in the double digits, we would not pay out that much to investors. Instead, we would pay them a generous high single digit yield, while fattening our own bottom line with the extra spread. A legitimate single digit yield would still be enough to attract plenty of yield starved investors. Clearly, double digit yields are offered by those who cannot actually generate a return in order to part the gullible and clueless from their money.

Exchanges are the weak link

For most people, the only practical way to access crypto currencies is to invest through an exchange. Exchanges are very different from other securities markets in that they act as brokers who hold the funds, while simultaneously running the order book. And they are not particularly efficient at running order books. While high frequency trading has generated lots of headlines on traditional stock exchanges with microsecond execution, known as latency in industry parlance, crypto exchanges are notorious for their slow speed. The fastest exchange we found at a recent check was Coinbase with a lame 180 milliseconds, while the exchange at the 95th percentile ranking had an astonishingly poor 1.8 second latency[ii]. This compares with as little as 26 microseconds for the NYSE [iii], faster by a factor of almost 7,000 than best-in-class Coinbase. That's a terrible verdict for the crypto bros, who are often technology geniuses, yet cannot beat the incumbents in technology. Latency measured in seconds is what we had three decades ago in open outcry futures pits.

As an alternative technology to traditional stock exchanges, crypto exchanges clearly are unsuitable. But the technical challenges of exchanges don't end there. If you want your crypto assets to be safe, you can withdraw them and place them in an offline wallet. However, we venture the guess that most clients of crypto exchange have no idea how to get their cryptocurrencies out of the exchange and into cold storage. With a bank account, it's easy: you go to an ATM and withdraw fiat currency. For most exchange customers, the only option to recover their investment is to transfer fiat currency from their exchange to a bank account. This, in turn, makes exchanges particularly vulnerable to bank runs. We would argue that in the absence of exchanges, with the current state of crypto technology, it would be more practical to use gold coins than crypto to make payments.

Exchanges are the critical infrastructure of the current crypto industry structure, and they are the weak link. At the same time, the need for an exchange to make crypto currencies usable negates the entire appeal of peer-to-peer digital currencies. In fact, much of crypto today resembles traditional finance, with crypto lurking somewhere in the background. Claiming crypto exchanges have something to do with crypto currencies is a bit like claiming that the dollar is gold backed just because the Fed holds a lot of gold in Fort Knox. In reality, crypto exchanges are leveraged balance sheets indexed on Bitcoin and other crypto currencies.

Crypto 2.0 versus the government

Just like the dot-com bust of 2000 was not the end of the internet, crypto will reboot from its current crisis. Somebody will figure out actual use cases and solutions to the shortcomings of the current crypto infrastructure. We doubt that the world needs 100s of cryptocurrencies, and thousands of VC-funded solutions for crypto-specific problems for which there is no actual business case.

The question is how the government will react to the scandals. We suspect that regulation will accelerate the reboot of the sector as crypto 2.0: exchanges will be regulated out of business, more or less. This, in turn, will give innovators the opportunity to return to the original concept and create a genuine peer-to-peer infrastructure that does not rely on intermediaries.

[i] Satoshi Nakamoto: “Bitcoin: A Peer-to-Peer Electronic Cash System” Available at bitcoin.org/en/bitcoin-paper
[ii] https://www.api.expert/collection/crypto-currency-exchanges retrieved on November 20, 2022.
[iii] https://www.nyse.com/data-insights/nyse-pillar-migration-adding-efficiency-to-the-marketplaceretrieved on November 21, 2022.

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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 // B429
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.

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.

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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 // 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.

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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 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

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