Easy Part of the Rally is Over­­

By Paul Hoffmeister, Chief Economist

March 2019

·      Assessing market conditions today, we believe that the easy part of this year’s rally in the S&P 500 is behind us and that if there is another 10% or more upside in the market this year, it will be harder to come by. As we see it, if stock market prices were asymmetrically in investors’ favor in late December, they are more symmetric today.

·      The outlooks in many of the major macro variables appear to be more balanced, and not too extreme one way or the other. To an optimist, this “setup” suggests that if these variables continue to improve and resolve themselves, then equity markets could experience a sizeable rally from current levels. Conversely, to a pessimist, if these variables deteriorate, then upside should be limited, and there could be another bout of market panic.

·      In this month’s client letter, we parse through what we believe to be the most important macro variables today: the Fed, US-China trade, Brexit, the slowdowns in Europe and Asia, and the possibility of a Trump impeachment. And then we explain how, after putting these pieces together, we expect a little volatility in coming months but are generally optimistic about the rest of the year.

·      The current macroeconomic outlook could be reasonably described as ambiguous, which seems to be consistent with the relatively flat Treasury curve this year. The general flatness of the curve suggests to us that the Treasury market is sensing some risks farther out on the horizon that could ultimately erupt and harm economic growth; but just not in the near-term.

·      There are percolating risks. But importantly, in our view, the dollar (the world’s reserve currency) is fairly stable, deregulation and corporate tax cuts in the United States are still supporting economic growth, and credit conditions are recently improving. Of course, we don’t expect all of the major macro variables in play today to evolve perfectly in the coming months, and some near-term volatility is likely. The UK will need to sort through Brexit, Europe and Asia are relatively weak, and political uncertainties persist in the United States.

In our view, the equity market rebound continued in February mainly because the outlooks for Fed policy and US-China trade continued their positive trajectory. Not to mention, there didn’t seem to be any new, significant macro variables that erupted.

In our January client letter, we believed there was a big opportunity in equities with our forecast for a 15% return in the S&P 500 this year. The projection was based on both quantitative and qualitative factors.

Quantitatively, it appeared that history was on our side: looking at calendar quarters since 1970 in which the S&P 500 sold off 10% or more, the average return during the subsequent four quarters was approximately 14.6%. And qualitatively, we believed that the Fed was going to back off its hawkish plans in 2019 to raise the funds rate another two quarter points – similar to the Fed U-turn in early 2016; and we were optimistic about at least a partial US-Sino trade deal.

With the S&P 500 up 11.1% through February (not including dividends)[1], that 15% forecast looks too low, for now. Assessing market conditions today, we believe that the easy part of the rally is behind us and that if there is another 10% or more upside in the market this year, it will be harder to come by. As we see it, if stock market prices were asymmetrically in investors’ favor in late December, they are more symmetric today.

Another way to look at the current market environment is that the outlooks in many of the major macro variables appear to be more balanced, and not too extreme one way or the other. To an optimist, this “setup” suggests that if these variables continue to improve and resolve themselves, then equity markets could experience a sizeable rally from current levels. Conversely, to a pessimist, if these variables deteriorate, then upside should be limited, and there could be another bout of market panic.

In the following, we parse through what we believe to be the most important macro variables today: the Fed, US-China trade, Brexit, the slowdowns in Europe and Asia, and the possibility of a Trump impeachment. And then we explain how, after putting these pieces together, we expect a little volatility in coming months but are generally optimistic about the rest of the year.

Fed Outlook: “Patient” seems to be the predominant descriptor of Fed policy today. In his testimony before Congress on February 27-28, Chairman Powell said the Fed was “in no rush to make a judgment” about the path of short-term rates. He added, “With our policy rate in the range of neutral, with muted inflation pressures and with some of the downside risks we’ve talked about, this is a good time to be patient and watch and wait and see how the situation evolves.”[2] This policy positioning is in stark contrast to the seeming assuredness that Powell telegraphed in December about raising rates twice this year. In addition to backing off the rate lever, the Fed is also close to announcing updated plans for its balance sheet runoff. Powell indicated in his testimony that the runoff could conclude by year-end.[3]

Powell’s recent testimony reaffirmed for us the dovish comments by St. Louis Fed President James Bullard on February 1st when he said that the Fed’s current policy position (i.e. its “patient” posture) “sets us up for a very good couple of years”.[4]

At the moment, we view Fed policy to be a neutral macro variable – no longer the major negative as it appeared in 2018, while at the same time not a major positive given the relatively flat Treasury curve today.

US-China Trade: In recent weeks, there didn’t seem to be a day that went by without headlines about an imminent deal between President Trump and China’s President Xi Jinping.

According to the Wall Street Journal, both sides are in the final stages of completing a trade deal, which will include lower tariffs by both countries, increased purchases by China of US farm, chemical and auto products, and new provisions to protect American intellectual property. One area where there doesn’t seem to be significant progress is on Chinese industrial policies and subsidies, which Beijing views to be central to the country’s state-led development model. Trump and Xi may meet in Florida on March 27 to sign the agreement.[5]

The US-China trade variable appears to be a net positive. If a deal is reached, it should clear major uncertainties for producers and risk-takers globally; offer some relief to Chinese risk assets (the Shanghai Composite was down nearly 25% last year)[6]; and improve US business prospects inside China.

Brexit: The current plan is the UK will leave the European Union on March 29. But in our opinion, the Brexit variable is a complicated mess with no one in the world, not even Prime Minister Theresa May, certain how it’ll exactly play out.

This is an issue that doesn’t easily map onto one party in the UK. There are members in both the Conservative and Labour parties that favor Brexit, and members in both that support remaining in the EU.

For the most part, “Brexiteers” want more independence from EU rules and regulations, including the end of the free movement of labor between member countries; whereas Brexit supporters view EU membership as a guardian of the free movement of goods and people.

What makes the issue even more complicated is Northern Ireland. The “Good Friday” peace agreement in 1998 between Northern Ireland and the Republic of Ireland was predicated to some extent on an open border between the two. And, fortunately, both UK and the EU leaders seem to agree that they want to keep it that way. In that spirit, the May government and EU leadership reached the so-called “backstop agreement”, which would keep an open border if the UK left the EU without a deal.

The backstop, however, has been rejected by the UK Parliament for a number of reasons, including concern that it would keep the UK in a customs union with the EU indefinitely (the exact opposite objective of many Brexiteers) and would create a regulatory border down the Irish Sea between Northern Ireland and the rest of the UK – which is strongly opposed by many unionists whose votes are arguably propping up the May government.

Prime Minister May is still negotiating with EU counterparts to reach a deal, notably to make the Irish backstop temporary. May has promised to present Parliament with a new deal by March 12.[7] In recent weeks, it has appeared increasingly likely that if any new deal is rejected, then Parliament will have the opportunity to vote on a “no deal” Brexit (viewed by some to mean an economically messy and costly divorce) or to vote on delaying Brexit by extending the EU’s Article 50 negotiating period.[8] The majority of Parliament seems to favor a delay, and there is speculation that the Brexit deadline will be postponed by two months.

Despite the many moving parts and complicating factors, we believe the Brexit variable has marginally improved during the last month because it appears increasingly likely that a messy, no-deal Brexit will be avoided due to significant Parliamentary opposition to such an outcome, as well as its support for a delay if a deal is not reached.  

That said, a delay means that the Brexit variable is simply being pushed out rather than being resolved. And, as the popular adage goes, markets hate uncertainty.

Some European business leaders like Dieter Kempf, the President of the Federation of German Industry, would rather just have a no-deal divorce to avoid the persistent uncertainty surrounding the issue. Kempf believes German firms have made sufficient plans for a no-deal scenario. “They have increased their storage capacity. They have planned a transition period for the reorganisation of logistics processes without loss of production…. My experience is that the economy can live better with bad conditions than with uncertainty.” [9] Kempf’s views, however, seem to be in the minority inside the UK Parliament.

In sum, it appears that Brexit will be delayed and markets will be forced to deal with the associated uncertainties of Brexit for many more weeks and months. We view this variable as a net negative today, although not as bad as a month ago when a no-deal Brexit scenario appeared to be a higher probability.

Slowdowns in Asia and Europe: For us, the most startling economic data out of Asia recently has been in the manufacturing sector. According to Markit, the manufacturing PMI’s in February for China, Japan, South Korea and Taiwan were 49.9, 48.9, 47.2 and 46.3, respectively. This indicates that the manufacturing sectors in these major Asian economies have been contracting.

Even worse for the global economic picture, industrial production in Europe has been declining. Markit’s manufacturing PMI’s in February in Germany, the UK, France and Italy were 47.6, 52.0, 51.5 and 47.7, respectively. As the next chart illustrates, this follows significant weakness late last year, when in November and December 2018, industrial production in Germany, the UK, France and Italy each fell year-over-year.

According to Destatis, preliminary Q4 2018 GDP data revealed that the German economy grew 0.0%, narrowly avoiding a technical recession after -0.2% growth in Q3.[10] Italy’s economy, after having contracted in Q3 and Q4, is already in recession.

The U.S. economy, on the other hand, appears to be in better shape. According to the Bureau of Economic Analysis, the economy grew 3.1% year-over-year in Q4 and 3.0% in Q3. Furthermore, ISM manufacturing PMI in the United States registered 54.2 in February; and according to jobless claims data from the Department of Labor, the American labor market appears fairly strong with claims near multi-decade lows. In sum, the United States looks to be the strongest economic region in the world, with Asia the weakest and Europe slightly better.

While slowdowns in other countries and regions threaten to mute global demand and therefore limit corporate profit growth generally, we are concerned about the risk in coming years of a severe economic slowdown leading to increased corporate defaults that in turn lead to highly distressed credit markets, including sovereign distresses.

According to data from the Institute of International Finance, Bureau of International Settlements and the IMF, total global debt in 2018 was $244 trillion; with a debt-to-GDP ratio of 382% for mature economies and 210% for emerging markets. This compares to total global debt of $74 trillion in 1997, and debt-to-GDP ratios of 266% for mature economies and 131% for emerging markets. The global economy, being so leveraged, may be more sensitive to a GDP deceleration and higher interest rates than it has been in decades.

As we see it, excess leverage doesn’t usually appear to be excessive until underlying economic fundamentals deteriorate, which in turn cause corporate profits and tax revenues to decline, so as to cause unsustainable debt burdens. In that light, we are watching, particularly closely, the economic weakness abroad and the possibility of mounting systemic risks as a consequence. To us, the slowdowns in Asia and Europe are one of the most negative macro factors today.

Trump Impeachment: According to a column in the Washington Post by Greg Sargent, “smart money” in Washington is predicting that special counsel Robert Mueller’s report, expected to be delivered soon to the Attorney General, will be a “dud”.[11] Notwithstanding, it appears that the possibility of a Trump impeachment and removal from office isn’t going away. House Judiciary Chairman Jerold Nadler said on March 3rd that he’d be requesting documents from more than 60 people “to begin investigations to present the case to the American people about obstruction of justice, corruption and abuse of power.”[12]

Although Nadler states that “impeachment is a long way down the road”, these steps could be meant to set the political foundation to pursue impeachment. While the growing belief that the Mueller Report will not directly or immediately lead to the President’s impeachment might be increasing certainty surrounding the Office of the Presidency, growing Congressional scrutiny suggests that some uncertainty is likely to linger.

Putting the Macro Pieces Together

While this is certainly not an exhaustive list of the major macro variables that exist today, it provides us with a framework to contextualize the current market environment, which looks like a “glass half full, glass half empty” kind of market.

For example, if the Fed doesn’t threaten to raise interest rates and consequently inhibit risk-taking, if a US-China trade deal is reached, a concrete resolution to Brexit emerges, Asia and Europe stabilize, and the specter of political uncertainty in the United States fades away, then there is arguably still significant upside to risk assets, even after the recent equity market rally.

And, conversely, markets could be at risk if the Fed restarts its rate-hiking campaign, a US-China trade deal is scuttled, a chaotic Brexit occurs, Asian and European economies continue to worsen, or the United States enters a Watergate-type era of political uncertainty and flux.

The macroeconomic outlook today could be reasonably described as ambiguous, which seems to be consistent with the relatively flat Treasury curve this year.

The Treasury curve in 2019 is the flattest it has been since the 2008-2009 Great Recession. And between the 2 and 5-year Treasuries, the curve is slightly inverted. But, it’s positive to see that the curve, generally, is not meaningfully inverted.

The general flatness of the curve suggests to us that the Treasury market is sensing some risks farther out on the horizon that could ultimately erupt and harm economic growth; but just not in the near-term.

And so, the glass looks half full to us today. There are percolating risks. But importantly, in our view, the dollar (the world’s reserve currency) is fairly stable, deregulation and corporate tax cuts in the United States are still supporting economic growth, and credit conditions are recently improving. We are, therefore, generally optimistic about the next 12 months as long as anti-growth policies don’t emerge in the major economies and credit markets continue to behave. Of course, we don’t expect all of the major macro variables in play today to evolve perfectly in the coming months, and some near-term volatility is likely. Indeed, the UK will need to sort through Brexit, Europe and Asia are relatively weak, and political uncertainties persist in the United States. However, counterbalancing those variables, we have a patient Fed and brightening prospects for US-China trade. We expect more equity gains in 2019, but we believe they’ll be harder to come by compared to January and February.  

Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

*******

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 Portfolios LLC 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.

[1] Source: Yahoo Finance

[2] “Powell Says Fed Is Close to Agreement on Plan to End Portfolio Runoff”, by Nick Timiraos, February 27, 2019, Wall Street Journal.

[3] Ibid.

[4] “Bullard Says Patient Fed Should Mean ‘Very Good Couple of Years”, by Steve Matthews and Jeanna Smialek, February 1, 2019, Bloomberg.

[5] “China, U.S. Near Accord on Trade”, by Linling Wei and Bob Davis, March 4, 2019, Wall Street Journal.

[6] Source: Yahoo Finance

[7] “UK Likely to be Forced into Brexit Delay If PM May’s Deal Rejected”, by Kylie MacLellan, March 3, 2019, Reuters.

[8] Ibid.

[9] “German Business Terrified Short Brexit Delay Will Wreak Havoc – ‘It’s Bad for the Economy’”, by Joe Barnes, March 4, 2019, by Express.

[10] “Germany Narrowly Escapes Recession after Flat Growth in the Fourth Quarter”, by Holly Ellyatt, February 14, 2019, CNBC.

[11] “Democrats Set to Take a Big Step Toward Impeaching Trump”, by Greg Sargent, March 4, 2019, Washington Post.

[12] “House Judiciary Chairman Says He Will Launch Probe of Trump’s ‘Abuse of Power’”, by Mike DeBonis and Rachael Bade, March 3, 2019, Washington Post.

Is the Fed Pause Enough?

Camelot Portfolios Market Commentary

IS THE FED PAUSE ENOUGH?

By Paul Hoffmeister, Chief Economist

·      As we see it, the strong equity market rebound in January transpired along the lines we anticipated at the start of the year, as the outlooks improved for both Fed policy and US-China trade.

·      Chairman Powell and other Fed officials have emphasized throughout the course of the current rate-hiking cycle that policy will be data dependent, and in our view the data in late 2018 turned unquestionably negative to justify their about-face. 

·      Amid the significant market and economic weakness in Q1 2016, the Fed backed away from the two to four rate increases they were telegraphing for that year (it only raised a quarter point in December 2016), and the dovish pause correlated with a major stock and credit market rebound. The 2016 market narrative creates a compelling analogue for market bulls today.

·      But the parallels aren’t perfect between 2016 and today. Although some credit spreads have narrowed substantially in recent weeks, the spread between Moody’s Baa and Aaa-rated bonds is only narrowing a little bit so far. Furthermore, the slope of the Treasury curve is much flatter today than in 2016.

·      The significantly flatter yield curve today signals, in our view, a more vulnerable economy than the one in early 2016 when the Fed last paused. If anything, we believe a major revitalization in market conditions will be harder to achieve in 2019 than 2016; new pro-growth policies are more important today than they were three years ago.

·      The easy part of the stock market rally seems to have occurred in January. Indeed, equity indices in late December could have been viewed as having been asymmetrically favorable to the upside given the extreme pessimism at the time. With the relief rally now over, we believe financial markets will need to see that structural macro foundations are sound or improving, and that many of the looming uncertainties today are resolved.

As we see it, the strong equity market rebound in January transpired along the lines we anticipated at the start of the year, as the outlooks improved for both Fed policy and US-China trade. This reversed the seemingly pessimistic sentiment in late December, when it appeared to some that the Fed would stubbornly raise rates in 2019 and a trade deal was a low probability event. As the outlook reversed in January, the S&P 500 rallied 7.9%, marking its best start to the year since ­1987, according to Dow Jones.[1]

For the moment, it appears that the US and China are on the verge of reaching a trade deal. On January 31, President Trump met Chinese Vice Premier Liu He in the Oval Office and said: “We’re trying to work out a new trade deal with China. I think it’ll happen, something will happen. But it’s a very big deal. It’ll be, if it does happen, it’ll be by far the largest trade deal ever made.”[2]

Many anticipate that the expected meeting in late February between Presidents Trump and Xi will iron out the final details of an agreement.[3] Note, March 2nd remains the deadline before President Trump is expected to raise tariffs on Chinese imports again.

But in our view, the major macro variable – the elephant in the living room -- remains Fed policy and the interest rate outlook, and it has turned decidedly dovish.

The January 30th FOMC statement announced that the Committee will be “patient” in determining the future path of short-term interest rates. This is in sharp contrast to the December 19th announcement where the Committee telegraphed more rate increases for 2019.[4]

Chairman Powell, when explaining what changed in the course of the prior six weeks, highlighted in the post-meeting press conference slowing global growth, the federal government shutdown, and tight financial conditions.[5]

Interestingly, Powell was asked by Jim Puzzanghera of the LA Times whether the Fed caved to President Trump’s demands to stop raising rates. The Fed chief responded:

… we’re always going to do what we think is the right thing. We’re never going to take political considerations into account or discuss them as part of our work. You know, we’re human. We make mistakes, but we’re not going to make mistakes of character or integrity. And I would want the public to know that, and I want them to see that in our actions.[6]

The statement that the Fed is human and makes mistakes could be perceived to be a tacit acknowledgement that the FOMC made a mistake in December by sounding a hawkish policy path for this year. While it is hard to recall such an abrupt and significant U-turn in Fed policy, it is also hard for us to find such an admission from the Fed. If this interpretation of Powell’s statement is accurate, then it suggests to us that the Fed will be extremely cautious in raising rates during the next twelve months.

Of course, Chairman Powell and other Fed officials have emphasized throughout the course of the current rate-hiking cycle that policy will be data dependent, and in our view the data in late 2018 turned unquestionably negative to justify their about-face.  

In the United States, the Richmond Fed manufacturing index for December showed the largest month-over month decline in history, and the Dallas Fed survey showed the largest decline since the 2008-2009 financial crisis. Furthermore, the S&P 500 declined nearly 14% in the fourth quarter, which possibly foreshadows a major deterioration in the U.S. economy and corporate profits. This prospect seems to have been validated by the slope of the Treasury curve at the end of December, which according to the New York Federal Reserve was predicting a 21.35% probability of recession occurring by the end of 2019. This compares to an approximately 4% chance of recession within twelve months at the beginning of 2018.[7] As we see it, the macroeconomic environment deteriorated substantially during the course of the last year.

In China, the Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI) registered 48.3% in January, marking the second consecutive month of contraction in China’s manufacturing sector. [8] Furthermore, the Chinese economy grew 6.4% in Q4 2018, a 28-year low.[9] And in Europe, Italy officially entered into recession in late 2018, and growth in the Eurozone, according to the EU statistics agency, slowed in 2018 to 1.8% from 2.4% in 2017, the weakest pace in four years.[10] [11]

Fortunately, we have seen in recent weeks some stabilization in the growth trajectory in the United States. ADP payrolls data at the end of January showed better-than-expected hiring: 213,000 jobs were added versus the consensus estimate of 178,000, with medium-sized businesses adding the most jobs.[12] Importantly, too, the ISM manufacturing index rebounded in January to 56.6%, from 54.3% in December.[13] As we have said before, we want to see the job and manufacturing environments remain strong, otherwise we believe the U.S. economy will start veering toward recession.

We believe the biggest question today is: will the Fed pause be enough?

In other words, will it be enough to enable global growth to stabilize or re-accelerate? Or will it be insufficient in forestalling the economic slowdown of late 2018?

Amid the significant market and economic weakness in Q1 2016, the Fed backed away from the two to four rate increases they were telegraphing for that year (it only raised a quarter point in December 2016), and the dovish pause correlated with a major stock and credit market rebound. The 2016 market narrative creates a compelling analogue for market bulls today.

But the parallels aren’t perfect between 2016 and today.

Although some credit spreads have narrowed substantially in recent weeks, the spread between Baa and Aaa-rated bonds is only narrowing a little bit so far. Furthermore, the slope of the Treasury curve is much flatter today than in 2016.

Approximately speaking, by the end of January 2016, the 3-month/10-year Treasury spread was 160 basis points; the 2-year/10-year spread was 114 basis points; and the 2-year/5-year spread was 55 basis points.[14] As of January 31, 2019, they were 23, 17, and -2 basis points, respectively.[15]

The significantly flatter yield curve today signals, in our view, a more vulnerable economy than the one in early 2016 when the Fed last paused. If anything, we believe a major revitalization in market conditions will be harder to achieve in 2019 than 2016; new pro-growth policies are more important today than they were three years ago.

Importantly, major currency prices, particularly the dollar, appear healthy; but we do not see significant growth-incentivizing tax cuts around the world, on net. Furthermore, markets are facing a range of policy and political uncertainties, including Brexit and the results of the Mueller investigation. Indeed, we want to see positive developments in these variables, much like what occurred in January with the Fed and US-China trade variables.

The easy part of the stock market rally seems to have occurred in January. Equity indices in late December certainly could have been viewed as having been asymmetrically favorable to the upside given the extreme pessimism at the time. With the relief rally now over, we believe financial markets will need to see that structural macro foundations are sound or improving, and that many of the looming uncertainties today are resolved.

[1] “Stocks Post Best January in 30 Years,” by Amrith Ramkumar, Wall Street Journal, February 1, 2019.

[2] “Trump Optimistic on Trade Deal with China, But May Keep Tariffs Anyway,” by Alan Rappeport and Mark Landler, New York Times, January 31, 2019.

[3] “Xi Jinping and Donald Trump May Meet in Da Nang, Vietnam, at the End of February,” by South China Morning Post, February 3, 2019.

[4] Federal Open Market Committee statement, Federal Reserve Board of Governors, January 30, 2019.

[5] Transcript of Chairman Powell’s Press Conference, Federal Reserve Board of Governors, January 30, 2019.

[6] Ibid.

[7] Source: New York Federal Reserve Bank: “The Yield Curve as a Leading Indicator”.

[8] “Another Number Paints a Bleak Picture of Manufacturing in China,” by Yen Nee Lee, CNBC, January 31, 2019.

[9] “China’s Economy Cools in Q4, 2018 Growth Hits 28-year Low,” Reuters, January 21, 2019.

[10] “Mama Mia! Italy Now in Recession Stunts Europe’s Growth Prospects,” by CBS News, January 31, 2019.

[11] “Eurozone Slowdown Feeds Fears about Faltering Global Growth,” Paul Hannon and Eric Sylvers, Wall Street Journal, January 31, 2019.

[12] “Private Companies Add 213,000 Jobs in January, Easily Topping Expectations,” by Fred Imbert, January 30. 2019, CNBC.

[13] ISM Manufacturing Index Rebounds in January, Easing Worries about the Sector,” Greg Robb, February 1, 2019, MarketWatch.

[14] Source: St. Louis Federal Reserve Bank.

[15] Ibid.

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 Portfolios LLC 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. A779

December Market Commentary

Market of Extremes in 2019

By Paul Hoffmeister, Chief Economist

---

·      We believe the equity market in 2019 will be one of extremes – where indices will be either significantly higher or lower. Less likely will be a market of middling or average returns.

·      Major macro variables -- including Fed policy, the political outlook and US-China trade – remain highly ambiguous, despite some market-friendly news in each during the last month.

·      These uncertainties should either resolve themselves positively and cracks in the global economy will heal (allowing for a strong market rally), or uncertainties and economic fundamentals will deteriorate significantly (and drag markets meaningfully lower).

·      In our judgment, we are more likely to see in 2019 more market-positive news than negative, even though it is difficult to see the economy improving markedly from current levels.

In last month’s letter, we suggested that with the midterms completed and impeachment prospects seemingly diminished, the primary market drivers would become the Fed outlook and US-China trade negotiations. Indeed, during the last month major news emerged from both variables and moved markets in a big way.

On Wednesday, November 28, Federal Reserve Chairman Powell said that interest rates appeared to be “just below” neutral, suggesting that slightly more dovish Fed policy was likely next year.[1] That day, the comment contributed to a 2.3% rally in the S&P 500.[2]

Then on December 2, it appeared that President Trump had reached a temporary truce with China’s President Xi. Following their dinner at the G20 Summit, Trump announced that he would hold off on raising tariffs on Chinese goods to 25%.[3] In exchange, China reportedly promised to increase its purchases of US farm, energy and industrial products, and start new talks on Chinese policies related to forced technology transfers, intellectual property, cyber theft, and other perceived regulatory abuses against foreign companies.[4]

One could assume that if the White House didn’t see a significant shift in views by Chinese officials toward the US position, then this temporary agreement would not have been reached. The White House has stated, however, that if a larger agreement isn’t reached within 90 days (from December 1), then President Trump may apply the 25% tariff.[5] In trading on Monday December 3, the S&P 500 rallied 1.1%.[6]

To put last month’s trading into context, the S&P 500 rallied 2.1% the day after Election Day, 2.3% the day of Powell’s testimony, and 1.1% on the Monday following the Trump-Xi truce. These three major rallies speak to how much these macro variables have been weighing on financial markets.

So, do equity markets have the “all clear” sign?

We believe not yet, and ultimately the market in 2019 will be one of extremes – where indices will be either significantly higher or lower. Less likely will be a market of middling or average returns.

While it’s arguably positive that we’ve apparently seen (a) more political certainty following the elections, (b) a Fed that’s “listening” to market signals, and (c) positive headway in US-China negotiations, none of these variables have been completely eliminated. Major uncertainties persist and underlying cracks in the global economy are beginning to appear. China, Japan, and India are showing notable signs of weakness; and in the United States, slowing home sales and declining oil prices could portend weakening demand.[7]

In our view, these uncertainties will either resolve themselves positively and the cracks will heal (allowing for a strong market rally), or the uncertainties and economic fundamentals will deteriorate significantly (and drag markets meaningfully lower).

Some important questions for 2019 are: Will the Mueller investigation lead to the President’s impeachment and removal from office? Will the Fed simply announce an end to its rate-hiking campaign? And will China concede to the United States on some of the most intractable trade issues?

The Special Counsel investigation is a major wild card that could produce sudden, far-reaching outcomes. In a recent column for USA Today, Peter Zeidenberg, a former special prosecutor and deputy special counsel in the prosecution of Scooter Libby, suggested that the Mueller investigation appears to be reaching its endgame, and it will make the case that a conspiracy occurred to interfere with the 2016 elections “that will likely ensnare the president’s family and, quite likely, Trump himself.” [8] While Speaker Pelosi seemingly played down last month the prospect of impeachment, Democrats will very likely use their Constitutional power of executive oversight if conditions on the ground change.

As for the Fed outlook, we view Chairman Powell’s conciliatory remarks that the current funds rate is “just below” neutral as reaffirmation that forthcoming rate increases will be highly data dependent, rather than off the table. As a result, financial markets will most likely be constrained during the coming year due to concerns that good news (economically) could be used as justification for additional rate increases to temper such activity. This should also have a depressive effect on the economy. How can businesses confidently deploy risk-taking capital as the Fed seems to continuously consider “restrictive” interest rate policy?  

A vague Fed policy outlook in the forthcoming year is especially probable given that some Fed officials subscribe to the Philips Curve Theory that low unemployment can spark inflation. With the official unemployment rate at 3.8% and the so-called natural rate of unemployment (known as “NAIRU”) at 4.6%, it’s hard to imagine that these FOMC members will stand by quietly while their models suggest that the historic shrinkage in excess labor threatens to cause wage-push inflation.[9] Consequently, we expect the Fed to threaten financial markets next year, at least in spirit and/or jawboning, should there be too much of an economic good thing.

A major question regarding US-China trade negotiations remains, as we outlined last month: the degree to which both sides will concede on the most sensitive trade disagreements. The 2017 US National Security Strategy Assessment concluded that China pursues six strategies of “economic aggression” with 50 acts, policies, and practices to achieve those aims.[10] Even if China acquiesced on twenty-five of those major tactics, will that be enough for President Trump? After all, any unresolved tactics will continue to be a serious thorn in the trade relationship.

Pessimists could argue that President Xi does not face as much pressure as President Trump, which could delay any meaningful resolution. Mr. Trump’s re-election is quickly approaching, and US equity market performance, a barometer that seems to be closely watched by the White House, is waning. Maybe Xi will accept short-term economic pain in China and wait for Trump to bend, or otherwise gamble to deal with a different US President in 2021?

As one might reasonably see, these three variables could easily devolve and threaten equity markets in 2019. Conversely, they could be resolved; and given the great uncertainty that exists in these variables today, it could catalyze a major relief rally.

The Mueller investigation could ultimately avoid implicating the President, forestalling an impeachment push; the Fed might “thread the needle”; and the US and China could reach at least a partial deal that’s married with a framework for future negotiations on a range of outstanding areas of disagreement.

Perhaps, amidst all the ambiguities facing the market today about a range of fundamentally important issues, the biggest question for 2019 is, which market extreme will we see?

In our judgment, we are more likely to see in 2019 more market-positive news than negative, even though it is difficult to see the economy improving markedly from current levels.

Predicting the political implications of the Mueller investigation is seemingly impossible. But, the market’s (not to mention the White House’s) protestations against the current Fed policy trajectory seem too loud and obvious to ignore. We expect Fed pronouncements to increasingly acknowledge global economic risks and the FOMC to not raise the funds rate more than a quarter point next year.

Furthermore, the pressure on Presidents Trump and Xi to reach an agreement to reduce trade tensions is, in our view, equally great. Mr. Trump is facing re-election and will be unable to easily employ other market-friendly levers to appease financial markets. As such, he appears more likely to find areas of compromise.

As for Mr. Xi, prosperity is vital for political stability in a one party system. And arguably, China has “caught up” enough, economically, with the rest of the world -- thanks in part to its protectionist trade policies. Even more, it’s unlikely that Mr. Xi would be willing to gamble on waiting for another U.S. President with whom to negotiate. Were it a Democratic-controlled White House in 2021, it’s very possible that the drive for restructuring the US-China trade relationship will be even stronger. After all, Speaker Pelosi has been a vocal critic of the relationship for a long time. For example, she unequivocally stated last year: “For years now, China’s brazenly unfair trade practices have weakened America’s economy and hurt American workers.”[11] Xi has been described by Donald Trump as a “world class poker player”; we believe he’s more likely than ever to cash in a lot of his chips while he’s ahead, rather than face even bigger risks in the coming year.[12]  

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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 Camelot Event-Driven Fund  (tickers: EVDIX, EVDAX).

[1] “Did Fed’s Powell ‘Light the Fuse’ For a Year-End Stock-Market Rally?” by William Watts, November 29, 2018, MarketWatch.

[2] Ibid.

[3] “Trump’s China Trade Truce”, WSJ Editorial Board, December 2, 2018, Wall Street Journal.

[4] Ibid.

[5] “White House Corrects Top Aide on China Negotiations Timeline”, by Caroline Kelly and Kaitlan Collins, December 3, 2018, CNN.

[6] “Stocks Close Higher as S&P 500 Has Best Start to December since 2010 on Trade-War Truce”, by Sue Chang, December 3, 2018, MarketWatch.

[7] “Asia’s Weakening Economies, Record Supply Threaten to Create Oil Glut”, by Henning Gloystein, November 13, 2018, Reuters.

[8] “Mueller Is Building a Conspiracy Case That’s Likely to Ensnare Trump and His Family”, by Peter Zeidenberg, December 3, 2018, USAToday.

[9] Data source: Federal Reserve Bank of St. Louis.

[10] Full Transcript: White House National Trade Council Director Peter Navarro on Chinese Economic Aggression,” July 9, 2018, Hudson Institute.

[11] “Pelosi Statement on China Trade Investigation Memo”, Press Release, August 14, 2017, Office of Speaker-Designate Pelosi.

[12] “Trump: Xi Is a World Class Poker Player”, May 22, 2018, BBC News.

Midterms Over, Shifting Focus onto Fed and China

By Paul Hoffmeister, Chief Economist

November 2018

One could say that the midterm elections were a split decision, and neither a “blue wave” nor “red wave” occurred.  By early indications, Democrats appeared to gain at least 26 seats (they needed 23) to regain the majority in the House, while Republicans expanded their Senate majority from 51 to 54 seats. [1] [2]

Perhaps the most important development following the election results was the tone from the leadership of both Parties. On Wednesday, President Trump congratulated Speaker Pelosi and expressed a desire to work together during the next two years. He said:

“Hopefully, we can all work together next year to continue delivering for the American people, including on economic growth, infrastructure, trade, lowering the cost of prescription drugs. These are some of things that the Democrats do want to work on, and I really believe we’ll be able to do that. I think we’re going to have a lot of reason to do it.”[3]

Nancy Pelosi sounded a similar message:

“We will strive for bipartisanship. We believe we have a responsibility to seek common ground where we can. Where we cannot, we must stand our ground. But we must try. So openness and transparency, accountability, bipartisanship, are a very important part of how we will go forward.”[4]

When asked about impeachment Tuesday evening, Pelosi told CNBC, “I don’t think there’s any impeachment unless it’s bipartisan. Our priority is to get results for the American people.”[5] And later, in an interview with PBS, Pelosi said, “For those who want impeachment, that’s not what our caucus is about.”[6]

Very quickly, concerns about a potential impeachment seemed to have been put to rest. Arguably, this is important for financial markets, which could have faced serious headwinds if they were mired in months of political uncertainty. As we explained in September, we believe the Clinton-Lewinsky scandal and impeachment prospects in 1998 were a significant factor behind a nearly 15% sell off in the S&P 500.

There also seems to be, at least for now, a real desire by both President Trump and Speaker Pelosi to legislate on issues where they can – perhaps infrastructure, prescription drug prices, and trade issues. Mr. Trump even acknowledged that he was willing to make a deal on middle-class tax cuts if Democrats proposed an idea.

With impeachment prospects seemingly eliminated and the possibility of dealmaking in Washington (within certain parameters, of course), it makes sense to us that equity markets were relieved and even optimistic last Wednesday, with the S&P 500 rallying almost 2.1%.[7]

So, what now for markets?

We believe some of the most important variables that will drive markets in the coming months will be the Fed outlook and US-China trade.

Art Laffer once said: “If regulatory policy is important by a factor of 1, then fiscal policy is important by a factor of 10, and monetary policy is important by a factor of 100.” In that vein, we believe Fed policy was a key factor behind much of the market volatility this year, and will be a critical factor behind market performance next year.

With some Fed members concerned about the so-called Philips Curve (the theory that low unemployment can spark inflation), how will the Federal Open Market Committee respond today’s historically low unemployment rate? Will it go so far as to invert the yield curve next year? If so, we expect even more criticism from the White House and classical economists. As Larry Kudlow told CNBC’s Scott Wapner last month, “…low unemployment is a good thing. Rising wages is a good thing. More people working and prospering is a good thing.”[8]

US-China relations are another major issue. The relationship seems to be changing massively, and China appears to be increasingly viewed in Washington as an economic rival and even adversary.

The New York Times reported in October that if a trade deal isn’t reached soon, the Trump trade strategy will be to reach trade deals with other countries and isolate China.[9] For example, if the United States reaches bilateral trade deals with Korea, Japan, Canada, Mexico, and the EU, this sphere of trade could comprise the majority of global commerce; and leave China on the outside.

Gary Cohn, President Trump’s former National Economic Council Director, isn’t too optimistic about a deal being reached soon. The day after the elections, he told Bloomberg’s David Rubenstein:

“I don’t think there’s a instant cure for the trade issue. I really don’t. I wish that I could sit here and say after the midterm elections, the White House, the Administration understand they’ve got to solve the trade issues. I think China would like to solve the trade issue. It really comes down to two... I would say there’s two main topics. Topic number one, for some reason, is the size of the trade deficit. The actual trade deficit with China is about $300 billion, net. And the President seems to think that number is way too large. I tend to differ with that. I tend to say that’s $300 billion worth of goods that we’re buying cheaper than we could produce ourselves. Because if we could produce them cheaper, we would be doing that. So there’s that issue. And then there is a more interesting issue that I think is more pertinent, which is the open access to Chinese markets and the enforcement of intellectual property, forced technology transfer where the Chinese have historically not allowed US companies into China and have not paid for much of the technology they have taken from the US. I think that is the bigger issue. I think the Chinese would solve the first issue and buy a lot more natural LNG, natural gas from us, and more agricultural products and bring down the trade deficit. But it doesn’t really solve the core issue, which is paying for intellectual property and respecting copyrights…”[10]

President Trump, on the other hand, struck a more optimistic tone early this month when he tweeted, “Just had a long and very good conversation with President Xi Jinping of China. We talked about many subjects, with a heavy emphasis on Trade. Those discussions are moving along nicely with meetings being scheduled at the G-20 in Argentina. Also had good discussion on North Korea!”[11]

It’s possible that the US and China will reach a partial deal and create a roadmap for further negotiations, but a complete resolution to the disagreement between both countries is highly unlikely.

In our view, there is tremendous pressure on President Xi. While the US appears to be creating its own sphere of trade that will exclude China, the CSI 300 Index is down more than 20% year-to-date and China reported the weakest manufacturing growth since July 2016.[12] [13]

But a comprehensive resolution seems impossible at the moment. The 2017 US National Security Strategy assessment concluded that China pursues six strategies of “economic aggression”, with 50 acts, policies and practices – or “tactics” – to achieve those aims.[14] In June, White House National Trade Council Director, Peter Navarro discussed these strategies and tactics at the Hudson Institute. When alluding to the negotiations with the Chinese government, he ended his speech with the following statement: “If you’re in a negotiation, and you take 25 of these off the table in a successful negotiation, you still have 25 left.”

The comment seems ominous, and suggests that President Xi will need to offer significant concessions to President Trump in their highly anticipated meeting during the G20 later this month. But, if in fact China’s economy is deeply driven by the series of trade strategies and tactics laid out by Mr. Navarro, how much can Xi concede so much without causing severe domestic disruptions?

In sum, the completion of the 2018 midterm elections and conciliatory tone of President Trump and Speaker Pelosi seemed to have caused a sigh of relief in financial markets. Now we must turn our attention to other major macrovariables, notably the Fed and US-China trade, both of which could have significantly transformative economic effects during the next year. 

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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 Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).

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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 Portfolios LLC 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. A716

[1] “Democrats Capture Control of House; GOP Holds Senate”, by Jonathan Martin and Alexander Burns, November 6, 2018, New York Times.

[2] “How Republicans Made Gains in the Senate”, By Geoffrey Skelley, November 7, 2018, November 7, 2018.

[3] “Remarks by President Trump in Press Conference after Midterm Elections”, November 7, 2018, White House.

[4] “Nancy Pelosi Holds a Press Conference”, November 7, 2018, Fox News.

[5] “Nancy Pelosi Took Donald Trump Impeachment off the Table as Democrats Won House”, by Tim Marcin, November 7, 2018, Newsweek.

[6] Ibid.

[7] “S&P 500 and Dow Surge in Best Rally after Midterm Elections since 1982,” by Fred Imbert and Michael Sheetz, November 7, 2018, CNBC.

[8] CNBC Transcript: National Economic Council Director Larry Kudlow Speaks with CNBC’s Scott Wapner on CNBC’s ‘Fast Money Halftime Report’ Today,” October 12, 2018, CNBC.com.

[9] “The Trump Trade Strategy Is Coming into Focus. That Doesn’t Necessarily Mean It’s Going to Work,” by Neil Irwin, October 6, 2018, New York Times.

[10] “Gary Cohn Sees No Instant Cure on U.S.-China Trade Dispute,” November 7, 2018, Bloomberg.

[11] President Trump, Twitter.

[12] Bloomberg.com

[13] “China Reports Weakest Manufacturing Growth in More than Two Years,” by Huileng Tan, October 30, 2018, CNBC.

[14] Full Trasncript: White House National Trade Council Director Peter Navarro on Chinese Economic Aggression,” July 9, 2018, Hudson Institute.