Currency Wars Continue in the Shadows

by Thomas Kirchner, CFA & Paul Hoffmeister

·   Swiss Franc and Chinese Yuan continue to be manipulated by their central banks.

·   Investors should avoid China.

·   Swiss investments should have the currency hedged.

With everyone focused on the latest virus statistics and the riots, it is easy to overlook the ongoing saga of currency wars fought by the Bank of China (BoC) and the Swiss National Bank (SNB).

The Currency War 10 Years Ago

The term “currency war” had been largely absent from mainstream economic vocabulary since the 1930s until it was reintroduced by Brazil’s then-finance minister Guido Mantega in September 2010 in response to attempts by China, South Korea and Japan to lower the value of their currencies to gain a competitive advantage relative to other countries such as Brazil. At the time, the dollar had fallen nearly 25% against the Brazilian Real, so that further currency actions by other trading partners risked inflicting serious harm to Brazil. While the term “currency wars” captured the imagination of journalists and book authors, not much economic warfare ever erupted.

In today’s economy two central banks are managing the fixed rates of their currencies deliberately lower: the SNB and BoC.

Swiss Franc Front and Center

About two thirds of Switzerland’s economy depend on exports, so it is no surprise that the SNB is far more concerned about its exchange rate movements than the Fed. The last time the SNB made headlines was its surprise ending of intervention on January 15, 2015 which led to a subsequent sharp appreciation of the Franc. The SNB had intervened for more than three years to keep the Franc at a rate above 1.20 to the Euro. Markets had expected a continuation of the weak Franc policy, so that many speculators were caught wrong-footed by the sudden drop. NYSE-listed retail currency broker FXCM had to turn to Leucadia National to be bailed out with an emergency loan{i}.

The 2015 suspension of intervention caused the Franc to appreciate to 0.97, but in 2018, it fell back to 1.20 prior to recently appreciating again, despite heavy SNB intervention, to its current level near 1.06 (Figure 1). (A low rate represents a strong Franc and a weak Euro.)

Figure 1; Swiss Franc / Euro Exchange Rate. Source: Bloomberg.

One particularity of the SNB’s currency management is that it invests a portion of its foreign currency reserves that it accumulated during its interventions into stocks, whereas most other central banks hold their foreign currency reserves in bonds or short-term paper.

At the end of 2019 the SNB’s foreign currency reserves amounted to 770 billion Francs. Not too shabby for a country with 8 million citizens. On these reserves, the SNB generated profits of 49 billion Francs last year, of which 4 billion were handed over to Switzerland’s Treasury. During the market turmoil in March, however, investment losses were 38 billion Francs.

While existing investments crashed during the recent global market meltdown, demand for the Swiss Franc as a safe-haven intensified, causing the SNB to reinitiate its interventions to keep the Franc from appreciating.

Interest rate cuts are politically controversial – the SNB’s benchmark rate was negative 0.75% before the crisis. Apparently, in the eyes of many, this leaves currency intervention as the only option. Clearly, the SNB chose intervention. The substantial inflows in the Franc may have had a collateral benefit: the Swiss stock market is down only 4.42% year-to-date, outperforming the S&P 500 by 0.26% [iii].

The SNB’s intervention has not gone completely unnoticed. In January, the U.S. Treasury added Switzerland to the Monitoring List of potential currency manipulators along with China and eight other countries[ii].

China

China’s intervention in currency markets has the same goal as Switzerland’s: keep the currency low in order to export. Like Switzerland it has amassed significant foreign currency reserves as a result, which are, however, invested in the traditional manner in bonds. After all, it was the infamous call to then-Treasury Secretary Hank Paulson in which the Chinese threatened to stop purchasing securities of Fannie Mae and Freddie Mac that led to the takeover of these two Government-Sponsored Enterprises by the U.S. government.

The crucial difference between China’s and Switzerland’s currency regimes lies in the severe restrictions that the Chinese government imposes on its citizens’ ownership of foreign currencies. Chinese who earn foreign currency are required to hand much of it over to their government at the exchange rate that the same government deems appropriate, which also restricts the amount of foreign assets that Chinese citizens can hold legally. The Swiss have no such constraints and can hold unlimited amounts of currency or foreign assets.

These severe restrictions have enabled the BoC to keep the Yuan more stable than the Franc: over the last ten years it has fluctuated between a low of 6.0409 and a high of 7.1372, its rate last Friday (Figure 2). In contrast, the Swiss Franc has a spread of 45% between the lowest and highest rate over the same period. (In the same manner as for the Swiss Franc/Euro pair, a higher exchange rate signifies a devaluation of the Yuan).

Figure 2: Chinese Yuan / U.S. Dollar Exchange Rate. Source: Bloomberg.

Similar to the SNB, facilitating exports is the main motivator behind the BoC’s currency management. This is clearly visible in the devaluation of the Yuan in 2018 as U.S. tariffs were imposed: the initial 10% tariff rate led to a depreciation of the Yuan from the 6.30 area to 6.90, while the threat of additional 25% tariffs has caused the BoC to continue letting the Yuan depreciate.

Investment Implications

With the U.S. Presidential election season approaching and Hong Kong having turned into the new geopolitical hotspot, investors should be cautious about the potential for political rhetoric erupting about exchange rates. Clearly, labelling China a currency manipulator would have a dual effect of scoring political points inside the United States while also causing economic harm to investments in China, which would be hit by increased incentives to move supply chains out of China

Switzerland’s interventions are less exposed politically, and it is hard to see why it would suffer more than rhetorically. The country has managed to get through the epidemic much more smoothly than most other countries. Swift action in the initial phases coupled with an excellent healthcare system has kept the number of deaths low and has allowed a gradual reopening to start much earlier than the rest of the world. We believe that the Swiss market will outperform due to fundamentals as well as due to the weakening currency. However, any investment in Switzerland should be flanked with currency hedges because further weakness in the Franc is likely.

We would also like to point out an important investment implication of the China tariffs coupled with the devaluation: many commentators have warned of the potential impact that U.S. tariffs could have on the cost of consumer products in the U.S. While many retailers initially warned about a tariff impact, such complaints faded as 2019 progressed because the cost push of the tariffs was offset in part by a depreciation of the Yuan. We expect that China’s devaluation playbook will be repeated should trade tensions escalate again in the next few months over Hong Kong or due to the presidential election campaign.

Thomas Kirchner, CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously 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.

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). Mr. Hoffmeister is a graduate of Georgetown University with a BS in Accounting and Finance, and MBA from Northwestern’s Kellogg School of Management.

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[i] Anirban Nag, Steve Slater: “Swiss franc shock shuts some FX brokers; regulators move in.” Reuters, January 16, 2015.

[ii] “January 2020 Report to Congress on Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States.” Department of the Treasury, January 2020. The other eight countries are Germany, Ireland, Italy, Japan, Korea, Malaysia, Singapore, and Vietnam

[iii] Total return of the Swiss Market Index and S&P 500 year-to-date through 5/29/20. 

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 Event Driven Advisors.  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.

Originally published on http://www.camelotportfolios.com/commentaries  B04

Tale of Two Cities: Lufthansa vs United Capital Raises

by Thomas Kirchner, CFA & Paul Hoffmeister

·   Lufthansa’s rescue is entirely government-funded, while United Airlines has received government AND private market support.

·   Arguably, European markets are underperforming in the recovery due to overregulation.

·   European regulators are beginning to recognize the problem.

·   MiFID II to be relaxed by … even more regulation.

Lufthansa’s billion Euro government rescue stands in sharp contrast to the free market approach taken by U.S. airlines in raising the capital necessary to bridge the corona-lockdown. It also explains why the recovery of European stock markets lags the U.S. by substantial margins, illustrating what is going wrong in the Eurozone.

Raising Capital

On April 20, United Airlines raised $1 billion in equity in the financial markets. The capital raise occurred at a 5% discount to the already depressed stock price. But despite the bleak state of the industry, with 90% of the fleet grounded, United was able to raise a 10-figure amount in equity. As early as March other airlines had raised billions of dollars of capital in debt, both through asset-backed securitizations and unsecured or convertible debt offerings [ii]. However, United’s April raise was the first attempt to raise equity capital. The dilution suffered by shareholders was about 15%, a relatively modest amount in light of the circumstances. Separately, United had received $6 billion of government loans, with which it issued warrants to the government that diluted shareholders by about 7%.  [i]

In contrast, Lufthansa made plans to access capital markets but abandoned them in April. The planned capital increase of $2.6 billion of equity and convertible bonds would have diluted shareholders by approximately 36%, yet still would have been insufficient in the eyes of some analysts to see the company through the epidemic [ii]. The anticipated $9.7 billion rescue package of debt and equity would be entirely government-funded. Dilution appears at first sight less severe than what the original private market raise would have resulted in and will only be 25% if all conversion options are exercised. However, the real strings attached to the financing come from the influence that the government plans to exercise over the company: two board seats will be filled by government representatives. [iii] But the convertibility of the debt into up to 25% of the equity is what the government may be really after, because a 25% holder has, under most European corporate laws, the ability to block strategic transactions. Even though it is unlikely that Lufthansa will be the subject of a hostile takeover, this sets a precedent for more government influence over industry, a potential power grab that has featured prominently in political discussions for some time. As an aside, a similar ownership structure has been in place at Volkswagen for decades, where it seems to do little harm to the company, although it may not do much good anyway because the presence of State representatives did not prevent the emissions fraud scandal.

Europe’s fear of financial markets

The different approach to survival amidst today’s travel slump may be a direct function of the difference in development of financial markets on the two continents.

Europe’s financial markets have been underdeveloped. Capital was provided mostly by banks. In the U.S., however, financial markets have been more vibrant. Regulations in the wake of the financial crisis have only exacerbated the discrepancy.

Under the guise of stabilizing the economy, European regulations have sought to stifle markets. U.S. regulators have created bureaucratic burdens but arguably not enough to kill off markets to the same extent as the EU. Sure, as a result of Dodd-Frank overregulation, liquidity in high yield markets has been challenging for a couple of years -- even before the Covid-19 crisis. The rules born out of the 2008 financial crisis may also be responsible for the repo debacle that has roiled funding markets since last September. And while the current administration would like to relax these tight rules, it may actually be the banks themselves that want to keep them as barriers to entry against foreign competition.

But all these problems are minor compared to the anti-market activism of EU regulators. Now that private enterprise needs capital, there aren’t many markets to turn to in Europe. Government support may be the only option.

MiFID U-Turn

If you think this is an exaggeration consider this: French securities regulator AMF calls for a suspension of MiFID II, an EU-wide regulation enacted two years ago that limits how brokers can run their business. It is known for forcing brokerage firms to bill clients for research services that used to be provided for free, and are still free in U.S. and Asian markets. AMF chief Robert Ophele was recently quoted by Bloomberg as criticizing rules that limit the ability of companies to raise capital and recover from the coronavirus pandemic. “Right now we have debt, but debt could be only part of the story for the recovery. We need capital, and it’s clear in some parts MiFID II could be reviewed in order to enhance or facilitate the possibility of raising of capital... How do we increase capital, equity issuance in our European companies, which will be key for the recovery of our economy?” [iv]. Ophele’s criticism follows a report by AMF in January that decries how MiFID “undermines” the market. [v]

The irony in this lies in France’s reputation as a stalwart of anti-market rhetoric, which is now admitting defeat with what is a de-facto U-turn. Of course, such U-turns are nothing new in France. President Mitterand, France’s first Socialist president after World War II, nationalized major industries after his 1981 election, only to privatize them again starting in 1986 once it had become obvious that State ownership was counterproductive to the hoped-for benefits.

Of course, the idea of overregulation killing the market is not a new one and is what critics of the rules have been warning about since when the rules were first introduced.

Trapped in Underperformance

As we have pointed out in prior commentary, European markets are underperforming U.S. markets in the recovery from the sharp selloff in March. Over the last month the discrepancy has widened dramatically.

With the S&P 500 down about 8.5% year-to-date, Europe overall underperforms by roughly 13.7 percentage points as of last Friday. The problem markets are down even more, with France underperforming by nearly 18.5 and Italy 18.9 percentage points. Spain is dead last, underperforming by a devastating 21.8%. [vi]

It is clear now that short selling bans announced in Italy and France during the selloff in March have not helped these markets perform better. Whether these bans are responsible for the underperformance is another question. As tempting as it is to blame short selling for the underperformance, more research will be needed to answer that question definitively. Most likely, short selling bans are merely one aspect of a confluence of unfortunate policy decisions that also include the aforementioned MiFID II and ultimately high tax regimes that stifle investment.

Investment Conclusions

In our view, it is too early to invest in airlines as distressed investments. The outcomes are too binary to make financial commitments at this time. If the economic reopening is successful, then the airlines may well have sufficient funds to emerge from the crisis. However, if prognosticators of a second wave turn out to be correct, then we would not want to own any airline-related security that was purchased at current price levels. Should that scenario play out, then we would want to invest along the lines of the 2003 airline bankruptcies when the most successful investments were arguably in airplane lease securitizations, where investors were backed with good assets, yet the securities traded at substantial discounts to the value of the assets because the issuing airlines were in bankruptcy.

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Thomas Kirchner,CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously 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.

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).
Mr. Hoffmeister is a graduate of Georgetown University with a BS in Accounting and Finance, and MBA from Northwestern’s Kellogg School of Management.

 [i] Author’s calculations and Tracy Rucinski: “United Airlines sells $1 billion of stock in fresh move to weather pandemic.” Reuters, April 21, 2020.

[ii] Eyk Henning, William Wilkes, and Jan-Henrik Foerster:” Lufthansa Seeks Investor Support for Share Sale in Funding Push.” Bloomberg, April 9, 2020.

[iii] David Kaminski-Morrow: “Lufthansa Group nears deal for €9bn financing package.” Flightglobal.com, May 21, 2020.

[iv] Silla Brush, “‘Urgent’ MiFID Revisions Could Revive Europe, AMF Chief Says. “ Bloomberg, May 18, 2020.

[v] Jacqueline Eli-Namer, Thierry Giami: “Reviving Research in the Wake of MiFID II: Observations, issues and recommendations.” Autorite des Marches Financiers, amf-france.org, January 2020.

[vi] Total return of each index year to date through 5/21. Europe: STOXX50. Italy: FTSE MIB. France: CAC 40. Spain: IBEX 35. Source: Bloomberg.

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 Event Driven Advisors.  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.

Originally published on http://www.camelotportfolios.com/commentaries

Camelot Commentaries RSS

Winners and Losers of the Pandemic

by Thomas Kirchner, CFA & Paul Hoffmeister

Since the beginning of the crisis, perma bears and perma bulls have disagreed about whether we are headed for a severe depression or whether there will be a rapid V-shaped recovery once the economy opens up again. The stock market’s verdict so far validates the optimists: the S&P 500 has recently retraced 62 percent of its losses.

Predictably, Europa and Asia are lagging, but not by much: both the DAX and the Nikkei 225 have recovered half of their peak losses. Of the 500 stocks in the S&P, almost 100 are positive YTD, while that is the case for only four of the 30 DAX stocks and 15 of the 225 Nikkei stocks [i]. There are wide gaps between industries and sectors within each index: travel and financial stocks were the key drivers of the drawdown in the S&P while automotive and industrial stocks suffered the heaviest losses in the DAX. The winners seemingly everywhere were stocks that benefit from stock trading volume, mainly exchanges and brokers, as well as pharmaceutical stocks. In the S&P, large technology companies also were able to recover quickly after initial price losses. Many large cap tech companies, by the way, have grown so much in recent years that a handful of these companies now represent 20 percent of the total value of the S&P 500, a trend that their recent outperformance has reinforced further.

One of the big buyers during the selloff has been the Swiss National Bank (SNB) that is defending the Franc against a falling Euro. Not only does the Swiss Franc remain true to its reputation as a safe-haven during times of crisis, but negative yields in Swiss government bonds are now comparable to those in the Eurozone. With Swiss yields less punitive than before the crisis when compared to Eurozone yields, the Swiss Franc has become less unappealing as a currency relative to the Euro. This is likely to have encouraged further inflows. The SNB has used the foreign currency reserves that it has amassed over the last few years in an attempt to keep the Franc weak to invest not just in foreign government bonds, as central banks typically do, but also by investing in stocks. The SNB purchased some of the most famous large cap tech stocks during the first quarter. With turmoil in the FX market continuing into April, it is safe to assume that its purchases have continued in Q2. These massive purchases have arguably contributed to the outperformance of large cap stocks. [ii]

Smaller technology stocks are also among the winners, especially if they support teleworking. Citrix, Ringcentral and Zoom may generate record earnings thanks to their computer access and video conferencing software. Zoom founder, Eric Yuan, has become some $4 billion richer as the stock of that company has nearly doubled since the beginning of the year. Similarly, Docusign and Adobe have outperformed. They allow documents to be signed electronically.

In the pharmaceutical industry Gilead, Fresenius and Merck are some of the biggest winners. Gilead's share price has rallied 69 percent this year as investors placed high hopes in the Remdesivir drug approved for the treatment of Covid-19. However, it is still unclear if and by how much Gilead will be able to make profits from it. The company announced the free donation of 1.5 million doses, which will impact financials. What pricing and costs will look like once commercial sales begin is unclear. In the optimistic scenario, analysts estimate that the value of future Remdesivir profits may only represent 1-4 Dollars per share, or less than five percent of the current market price. [iii] In our view, much of the good news has already been priced into this stock. [iii]

Other notable winners and losers are mining stocks, which reflect the prices of the respective commodities: Newmont, the only gold producer in the S&P 500, rose almost 50 percent this year, whereas oil producers have in many cases lost about the same amount.

Finally, in this global fight against a sinister virus, the bleach maker Clorox has seen its stock rally by nearly one third since the beginning of the year, similar to the growth in sales in its cleaning products division. However, the actual demand for disinfectants is even higher than what the sales increase might suggest. Production capacity for disinfectants lags demand and the expansion of that capacity may be completed during the summer. Therefore, sales might be boosted further, if additional product can be shipped. [iv]

Stocks will likely have more volatility and turbulence in the months ahead. The stock market’s winners and losers may still take some surprising twists and turns. If the perma bears are correct, then current trends of who is a winner and a loser could persist. However, if the bulls are correct and the economy opens gradually and there isn’t a major second wave of viral infections, then we expect stocks that have been laggards so far to become some of the biggest winners.

[i] All returns are YTD through 5/8 unless noted otherwise. Source: Bloomberg.

[ii] Author’s analysis of Forms 13F-HR filed by the Swiss National Bank with the U.S. Securities and Exchange Commission for the periods ended 12/31/19 and 3/31/30.

[iii] Carter Gould, Andrew Ang, Justin Burns: “Gilead Sciences, Inc.: Our Thoughts Post the 1Q20 Call.” Barclays Bank Equity Research, May 1, 2020.

[iv] Clorox earnings press release for Q1 2020 filed with the U.S. Securities and Exchange Commission on Form 8-k on May 1, 2020.

Thomas Kirchner,CFA, has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously 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. 

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).
Mr. Hoffmeister is a graduate of Georgetown University with a BS in Accounting and Finance, and MBA from Northwestern’s Kellogg School of Management.

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.

Originally published on http://www.camelotportfolios.com/commentaries

The Covid-19 Economy

Understanding the Recent Behavior in Stock & Political Markets
by Paul Hoffmeister - Chief Economist, Camelot Portfolios

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Covid-19 Shutdown Has Been Economically Devastating

• According to the U.S. Department of Labor, more than 30 million Americans have filed for unemployment benefits since mid-March 2020.

• The national unemployment rate may now be 15%, up from 3.5% at the end of 2019.

• GDP may contract by 20-30%.

• Key Uncertainties:

  • how quickly will the pandemic fade?

  • what will be the scope and speed of an economic rebound?

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Stocks May Have Found a Bottom

• Covid-19 acceleration, economic shutdowns, and oil price war conspired to pull prices down in late February, early March.

• Improving case numbers, news of economies reopening, and oil production deal helped to start pushing prices higher in late March, early April.

• Most likely, stock indices will be primarily driven by Covid-19 outlook and economies restarting.

• We must focus on any hints of a ‘second wave’.

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 Covid-19 Data Has Improved

• According to Johns Hopkins, the most confirmed Covid-19 cases were in the United States, Spain and Italy.

• According to the University of Washington, Covid-19 deaths in Italy peaked on March 27.

• Covid-19 case trajectory in Italy seems consistent with recent stock market price action.

• In late April, some Italian businesses started to reopen

• According to the University of Washington, Covid-19 deaths   in Spain peaked on April 1.

• Covid-19 case trajectory in Spain appears consistent with recent stock market price action.

• Many Spanish businesses plan on reopening in coming days.

• According to the University of Washington, Covid-19 deaths   in New York peaked on April 9.

• Covid-19 case trajectory in New York appears consistent with recent stock market price action.

• New York “Pause Order”, effectively keeping non-essential businesses closed, is scheduled to be lifted on May 15.

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Credit Conditions Are Stressed Today

• One major macro risk in the current environment would be a disruption in credit markets, where a cascade of corporate defaults led to a weaker banking sector and reduced lending.

• Credit markets appear to be highly correlated with oil prices; where weak oil prices lead to greater credit market stress.

• Prolonged and excessively low oil prices may create systemic economic risk.

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Trump’s Reelection Odds Rebounded w/ Stocks

• President Trump’s reelection odds (based on betting markets) seem to be tied with the stock market.

• Currently, the Predictit betting market is implying a roughly 50% chance of the President winning the November election; up from a recent low of 45% on March 19.

• This suggests that President Trump’s political fate rests heavily on the evolution of Covid-19 and the reopening of the economy.

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Democrats’ Congressional Prospects Are Strong

• Despite President Trump’s recent rebound in betting markets, Democrats’ prospects for maintaining control of the House and retaking control of the Senate have improved.

• Currently, betting markets are suggesting that the most likely political scenario in January 2021 is a Trump White House and Democratically-controlled Congress.

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Conclusion

The pandemic’s impact on the US economy has been severe and unprecedented. Since mid-March, nearly       1 out of 10 Americans have filed for unemployment, and economic growth may have contracted by 20-30%.

Last month, we stated: “…the economy and financial markets will either improve or devolve during the next few weeks and months based on the spread of Covid-19, the availability of therapeutic and preventative remedies, and the reopening of the economy. Quite simply, financial markets need the spread of the virus to slow, viral treatments to show clear and conclusive efficacy, and economies to reopen.”

We believe the behavior of the S&P 500 in March and April confirms that view; as the growth in Covid-19 and global economic shutdowns appeared to correlate with the steep decline in stock prices, while the peaking of the virus in many regions (Italy, Spain and New York) and news of re-openings appeared to correlate with a rebound in prices.

Based on the recent behavior of betting markets, President Trump’s prospects for reelection are tied with the stock market, and thus implicitly, the trajectory of Covid-19 and the economy. While the prospects for Democrats to retake the White House haven’t improved during the last month, the prospect of Democrats gaining control of both chambers of Congress has improved. At the moment, betting markets are suggesting a divided government is most likely in 2021, with a Trump White House and Democratic majorities in the House and Senate.

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.

An Arbitrageur’s View of Negative Oil Prices

Until this week, negative energy prices were known to only occur in Germany’s renewables-fueled electricity market. Anytime a breeze blows during the summer while the sun is shining, so much excess electricity is generated that German consumers are paid for burning electricity. The underlying cause is the lack of technology for electricity storage on a large scale.

Storage is easier to find for oil: when too much of it is produced, then the excess ends up in giant storage tanks. Sometimes, even oil tankers are chartered for storage. But, what’s unusual now is the fact that as a result of lower oil consumption due to the corona crisis, oil tanks are filling up almost everywhere. JP Morgan estimated at the beginning of April that all available storage capacities on land would be fully utilized by the end of May. In June, the last tanker on the high seas might be full to the brim.

Regional bottlenecks may occur even earlier, such as these days in the town of Cushing, Oklahoma. With a population of 7,800, it does not have the vibe of a global oil trading hub. But on the first day of every month, Cushing is the physical delivery location for crude oil futures traded on the New York commodities exchange known as NYMEX. Delivery options are somewhat limited: only tanks and pipelines managed by Enterprise or Enbridge qualify.

Most futures contracts are closed out before the delivery date and no physical oil ever changes hands. The futures price typically serves market participants as a reference price for other oil transactions that they index to it. And for anyone who actually accepts physical oil delivery in Cushing, they have to store it somewhere, and that storage capacity is currently in short supply. In fact, the limited facilities in Cushing or those that are easily accessible from Cushing are full. As a result, many oil traders were forced to sell their futures contracts for May 1st delivery before the last trading day on April 21st. Due to the storage problems, few buyers were able to step in. With an excess of sellers over buyers, the price not only went to zero, but collapsed into negative territory to a low of -$40.32.

Remarkably, the prices of futures for June 1st delivery or for the following months were not as significantly affected by this extraordinary set of circumstances. Crude oil for delivery on June 1 held above $20, and the subsequent delivery months were correspondingly higher in price.

Under normal market conditions, arbitrageurs ensure the integrity of futures prices. Hence, prices differ from one month to another mainly by storage costs of under one to two dollars per barrel per month. If prices diverge by more than that, arbitrageurs could buy oil futures with a delivery date of May 1st, sell at the same time futures for delivery on June 1st and store it temporarily for a month. If prices differ by more than the storage costs the arbitrageurs can make risk-free profits. For example, with negative futures prices of -$40 for the May 1st delivery and positive prices of $20 for June 1st delivery, an astronomical profit of $59 could be generated without much risk. But only in theory, because this strategy won't work without storage capacities. And if the arbitrage strategy cannot be implemented, then prices can diverge to non-economic levels.

Instead of arbitrageurs making profits in oil, bargain hunters ended up facing huge losses. Anyone who bought an oil future for $17 a barrel on Monday morning had to pay $38 in the evening to get rid of it. A loss of 324 percent in less than a day.

Some other circumstantial evidence suggests that the negative price was not real but merely a technical phenomenon. Brent oil futures did not face a similar move in the price of the front month. The important difference between Brent and WTI futures are that Brent futures are cash settled rather than settled through physical delivery of oil. Moreover, the oil underlying Brent is traded in Rotterdam, a maritime port that in addition to having pipeline access is also reached by oil tankers. In contrast, the oil in Cushing is landlocked so that transportation is limited by pipeline capacity.

In theory, oil futures contracts that allow for physical delivery should produce price discovery that is closer to the actual underlying; however, as we see all too often, theory and practice don’t always align. It is up to the NYMEX to modify the contract specifications in a way to minimize delivery problems in the future.

Physical delivery always gives rise to opportunities for mispricing, whether by accident as in the case of this week’s WTI oil price behavior, or by deliberate market manipulation. One of the authors used to trade bonds in Europe and often observed games being played with bonds deliverable into European government bond futures contracts. This is much less of a problem for the U.S. Treasury futures contract due to the much larger size of U.S. government debt compared to that of individual European countries. The parallels between delivery problems in bond futures and oil suggest that it is time for a complete overhaul of physically settled commodities futures – what happened in oil this week could perhaps happen pork bellies or other commodities in the future.

We will see during the next few days who shouldered the losses on the NYMEX WTI futures that went negative in price. The big ETFs and most professional oil investors usually roll their exposures weeks before the expiration of the futures contracts. They are well aware of the risks of waiting to the last minute. Therefore, the parties remaining on Monday were probably opportunistic investors that dabble in oil only occasionally and saw $20 as a great entry point for the long run, without realizing the roll problems that can be experienced in the physical settlement of futures contracts. Given the amount of leverage that can be employed with futures, some speculators are likely to have suffered devastating losses.

Thomas Kirchner, CFA has been responsible for the day-to-day management of the Camelot Event Driven Fund since its 2003 inception. Prior to joining Camelot he was previously 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).

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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Originally published on http://www.camelotportfolios.com/commentaries