Fasanara Capital | Investment Outlook | February 10th 2014Document Transcript
“Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci
February 10th 2014
Fasanara Capital | Investment Outlook
We maintain our view for the structural rising trend in equities to stay the course in
the foreseeable future, as Central Bank's activism gets perpetuated, although in way
more volatile fashion than it did in the year just past. Corrections of more than 10%
can return to be the norm, with the risk of a larger correction of 20%/30% being a
real one, under the drive of excessive leverage in the system (almost 3% of GDP on the
NYSE, at $450bn), low levels of inventory for market makers, passive turtle-trading of
juggernaut ETFs, super-thin liquidity, high complacency.
US Equity markets should look more like Japan than they do to US Treasuries (as
they deceptively did in 2013)
The single most important data the market has ruled out in dogmatic certainty, without
the shadow of a doubt, is ramping inflation. A bad Inflation print, however unlikely, is
the blind spot of markets, its most acrimonious fat tail risk at present. On an
inflation print unexpectedly and decisively above 2%, monetary printing would be
instantaneously off the table, not by choice but by imposition, while rate hikes would be
suddenly contemplated, departing from zero bound all too quickly.
We concur on the need to stay net long the equity markets (mainly outside of the
US), as we believe the direction for them is up. Hedging programs must run in
parallel, as volatility will exceed expectations. Enough dry-powder must then be
kept on the sidelines, in preparation of such volatility to the downside.
Europe: while tail risks lay dormant, ‘Japanification’ is progressing undisturbed.
Downplaying disinflation will not do Europe any good, but rather make Southern
Europe's debt burden more unbearable in real terms. We believe that a sub-par
intervention by the ECB is likely in the near term. Strategy-wise, we look at higher
rates in the inter-banking markets as opportunities to receive such rates for carry
purposes, in preparation of an ECB intervention in the months to come.
Japan: we stay the course in Japan, as the country presses ahead on its game plan
for inflating out of an unbearable debt burden. Right because we are skeptical about
third arrow of structural reforms, we see money printers stepping up their game once
more, while the FED attempts at phasing out his, thus driving Yen weaker (second
leg of devaluation), and equity nominally higher (although in volatile manner).
‘Fight like a samurai, or die as a kamikaze’
Soft Corrections, Hard Corrections
The outset of the New Year proved unpleasant to several consensus trades: long equities, long
USDYEN, short rates. Equity markets in particular, started on a down note, with US equities
correcting almost 6% at some point. To us, in making sense of weakness in equities, there is no
need to call up outsiders such as Emerging Markets woes, China credit crunch, tapering itself:
markets’ inherent expensiveness vs fundamentals should suffice.
Emerging Markets sold off in rather orderly fashion, and we sense the contagion
fears are overdone. While Argentina will likely get worse before it gets better, other
EMs are only digesting the aftermath of the deflation of the commodity super
cycle, and have indeed taken the right steps to restore order in the medium term
(let alone that several of them are in much better shape than they were back in the
80' and 90's, having equipped themselves with domestic bond markets, financial
institutions able to deal with crisis management, FX reserves, decent growth).
China is a threat but not any more than it was a threat for the better part of the last
year, as Shibor spiked way more than it did this time around.
Tapering did not play a major role either, as the tick lower in equity markets
coincided with yields rallying massively, instead of moving higher as tapering
would have entailed.
All in all, in our eyes, the correction is to be attributed to no more than the wide divide between
shabby fundamentals and sky-high valuations. Tapering is work in progress, until further notice
(our own base case is for a mild suspension in March-April, and a more sensible suspension later on in
the year). Inevitably, tapering brings with it more data dependency. As markets need strong
economic numbers to close the gap between high valuations and shallow fundamentals, whenever
fundamentals are decisively weak and parting ways even further, valuations have to try to come
down, in spite of financial repression policymaking all around.
As we remain skeptical of a strong economic rebound in the US, let alone elsewhere around a
troubled world, we view January price action as foretelling of similar price action patterns over the
course of 2014.
Markets seeing new highs in 2014, but hefty volatility along the way
We maintain our view for the structural rising trend in equities to stay the course in the
foreseeable future, as Central Bank's activism gets perpetuated, although in way more volatile
fashion than in the year just past. Corrections of more than 10% can return to be the norm, with
the risk of a larger correction of 20%/30% being a real one, under the drive of excessive levels of
leverage in the system (almost 3% of GDP on the NYSE, at $450bn), low levels of inventory for
market makers, passive turtle-trading of juggernaut ETFs, and super-thin liquidity all around. Such
larger corrections are heavily underestimated by complacent markets, making then all the more
A 20-30% correction is not a massive correction in our roadmap, in the context of artificial bubbly
markets. It is to be looked at as no oddity, but rather discounted as normality, in manipulated toppy
markets as we live within. Bubble markets are gapping markets, at some point sooner or later.
Bubble markets, held together by Central Banks easy money and the promise of even easier money
to come if needed, are just that: fragile, overreacting. They may not show their real face for long
enough that investors draw more in complacency and make the painful awakening just more
probable than it would be otherwise.
The propensity to buy-on-dips, in spite of GDP growth remaining a known unknown, far away from
mathematical certainty, is itself a confirmation of exuberant markets, where greed reigns
undisturbed over fear.
Should markets not rightfully be fearful, as mild corrections bring it closer to the cliff of an S&P
military advance from 666 in 2009 to 1850 today (as Marc Faber noted)? Should markets not be
feel vertiginous up here? Fundamentals are nowhere near there to provide comfort and a safety
net. Central banks alone are believed to stand in the way of a free fall, and so they get most
mentions in investors' prayers. On any given reliable valuations metric, tested on the several
decades of history behind us, current US credit and equity markets lie comfortably in bubble
territory: price to cyclically-inflation-adjusted earnings (above 25), price to sales ratios (above 1.6),
market cap to GDP, leverage ratios, share of covenants-lite bond issuance, and the list goes on
(Valuations in Stratosphere). P/E multiples expanded some 18% in 2013, versus 2% on average in the
past 20 years. Not one single metric can be brought up to justify current valuations, with the
exception of global central bank activism. So then, vertigo forces and ((duck-skin)) should be felt,
where they are not.
Yet, there is one market out there who attempts at behaving with more sense of normality:
Japan. On early fears of correction all around, it was down a quick 20%.
So what? It did so already in May 2013, after a massive rally brought it well ahead of fundamentals
and well ahead of the Central Bank balance sheet expansion itself.
When looking at Japan’s volatile price action, many less investors raise eyebrows. After all, it is
conventional wisdom for Japan to warrant high volatility, as it multiplied its monetary base with
reckless abandon. Not so much deducting from it, though, that Japan did so in emulation of the
mother-ship FED, and leads from its policy advisor Ben Bernanke in late 90's. Why then, the same
policy should not lead to similar outcomes and price action. Sure thing, distinguos are there, as
always; and misplaced, as often.
If anything, as to market volatility, US Equity markets should look more like Japan than they do to
US Treasuries (as they deceptively did in 2013).
The Fallacy of ‘Bondification’ of Equity
Supposedly-rationale investors, when imagining the future, they see the present. They see equities
behaving like bonds, going up in a straight fashion, so they rush to buy on 5% correction for rejoining
the pull-to-par ascension. However, as we argued in the past, equities are not bonds, ‘bondification’
of equities is a fallacy, which drew into equity territory VAR-adverse market participants from the
fixed-income world, even less equipped to withstand such volatility, due to their own skills or the
constraints of their constituents (investors mandates not up for it). A recent article summarized our
thoughts on it (Opalesque - Analysing the Great Rotation). The early stages of the rotation from
bonds to equities, on the false expectation that equities behave like bonds, can only exacerbate
volatility in the medium term. At a minimum, the Great Rotation is a two-way bridge. It is
estimated that the Great Rotation reversed spectacularly in January, with a $50bn shift from equity
to bond ETFs over the past two weeks, wasting 3-month worth of previous Great Rotation flows.
Outlier scenario: a bad US inflation print
Rather curiously, a more violent correction than that, heavier than normal 20-30%, can also be
imagined, on one count. The single most important data the market has ruled out in dogmatic
certainty, without the shadow of a doubt, is ramping inflation.
Disorderly Inflation, however unlikely, is the blind spot of markets, its most acrimonious fat tail
risk at present. The market seems to know with certainty that unprecedented monetary printing in
the scale of 30% of GDP have no chance in triggering a disorderly burst of inflation. There was a time
when monetary base itself computed mechanically into inflation expectations. Long gone is that
time, and the bag of experience it carried with it.
Today, no market participant seems to give it any serious credit. If anything, it seems obvious to
most that deflationary pressures still abound: from either technological revolution shedding jobs
and depressing input prices, to low energy prices (on shale gas revolutionary discoveries and the end
of the Commodity super-cycle), weaker than potential growth, slack in the labor market, weaker
dollar on ZIRP policies, Southern European internal devaluation, Yen devaluation exporting
deflation, China slowing down, etc.
Critically then, as it is totally ruled out, a firmly bad inflation print can do the trick, and drive a
truly major correction. Instantaneously then, on an inflation print unexpectedly and decisively
above 2%, monetary printing would be instantaneously off the table, not by choice but by
imposition, while rate hikes would be suddenly contemplated, departing from zero bound all too
quickly. All of this while the employment markets seemed to be recovering (where possibly in such a
scenario slack in labor market was underestimated, so much for disattending the Taylor rule on wage
pressures last year, for the first time in twenty years), housing markets was just making it, robust
GDP was still a great prospect but not so much of a present reality as yet. A bad inflation print
would seriously take the market on the back foot, leading to overnight fall in confidence, and
panic selling across the board, equities and bonds together, DM and EM together.
Again, a low probability event it is, we concur, but surely one that the market is flatly blind to. It
makes for the classic definition of a tail risk event: one with low probability, but high impact.
Needless to say, hedges against such scenario are cheaper now than they would when Inflation was
to show its ugly face, demanding a digital adjustment in risk premia.
Bothering to spend the amount of money needed, with out of the pocket expenses, is the hurdle to
overcome here, however unlikely the scenario may be. Proxy hedges are the elected solution of
choice, to us. While not perfect, they allow for minimal expense and cost of carry, a critical feature in
hedging low-probability scenarios.
From the Outlook to the Investment Strategy
Where does all of this take us in terms of investment strategy?
We concur on the need to stay net long the equity markets (mainly outside of the US), as we
believe the direction for them is up. Hedging programs must run in parallel, as volatility will
exceed expectations. Enough dry-powder must then be kept on the sidelines, in preparation of
such volatility and overcompensation to the downside.
We do not expect such volatility / steep correction to impair the structural upward trend in financial
assets. As we believe that tapering will be followed by more monetary expansion, as we project
nominal GDP targeting in the US at some point down the road, we also believe the trend up for
financial assets is here to stay for the few years ahead, although on a bumpier ride than the one
it enjoyed thus far.
As we think we live in an environment of illusory stability and debatable sustainability, we maintain
our baseline investment policy for renting the rally in financial assets, mainly equities outside of
the US, while preparing for Japan-style volatility. A re-pricing in realized volatility is well overdue,
and more so than a re-pricing of the absolute level of asset values overall. As we argued last month,
so we do now: artificial markets are structurally fragile, artificial markets are gapping markets.
Stay long, but only tactically so. Stay fully hedged.
Our baseline scenario is for tapering first, un-tapering later. A correction in between, Japanstyle, where markets may gap down 20-30%. Targeting NGDP next. By then, the sea level of asset
prices will be increased once more. Nominal rally, not so much of a real rally left after discounting
Inflation and Currency Debasement. Assets can rise in price, while they lose in value.
Interestingly, the best hedge for the benign (so far) equity market correction in January was
being long long-dated Treasuries, as they moved 40 basis points lower in between. To be sure, that
is in line with the most typical historical relationship between equity and bonds, let alone a flight-toquality typical occurrence on EMs hiking rates to stem devaluations. However, As tapering remains
one of the catalyst to a larger correction, as tapering bring with it higher rates (not lower), we believe
we will see 3% again on 10yr US Treasuries soon enough, yet again.
Should rates rise back again to 3% on Yellen taking the helm and delivering the first bold
commitments, we may plan to then receive such rates tactically, in preparation of the next
reflexive Pavlovian reaction by the markets to weak data releases or EMs woes.
Europe: tail risks lay dormant, ‘Japanification’ progressing undisturbed
Prospects for inflation are both dramatically different and further diverging between Europe and the
US/Japan/UK. While we believe global deflationary pressures to face headwinds in most
developed nations in the years to come, they do stand a better chance in Europe, as the
continent moves to secular stagnation.
Deflationary forces in Europe are indeed taking hold, making a multi-year slow deleverage the
likeliest outcome for the Eurozone: a prolonged period of sub-par growth, high unemployment,
low inflation at risk of turning into disinflation first, deflation later. Meanwhile, public and private
debt ratios worsening (owing to contracting GDP and deflation, debt is 30% higher than before the
crisis), loss of competitiveness increasing, tight credit rationing by undercapitalised banks to
SMEs (employing 70% of labor force in peripheral Europe), will concur to make political risks higher,
as the loss of hard-achieved welfare leads to social unrest. To be sure, negative demographics are
at play too, all around.
It should be said that our concerns on Europe are accelerated by the above-mentioned structural
deficiencies, more than they are by cyclical factors like smoking-mirrors AQR banking tests. We
expect loosening of official requirements to occur, until the vast majority of banks can satisfy them.
Our bearish stance on Europe and our call for the inevitability of a EUR break-up were reaffirmed
against recent incoming data and evidence from policymaking. Faced with the spectrum of
disinflation turning into deflation all too soon, the ECB proved unable yet again to do much
more than cheap talking and moral suasion. While benign markets decided once again not to call
the bluff, the economic landscape can only deteriorate further on inactive policymaking, as more
real debt is silently amassed along the way on the shoulders of peripheral Europe.
Last week, we learned from Draghi that disinflation in Europe is not to lead into the same vicious
cycle it provoked in Japan in early 90's. That is because the drop in inflation comes from the
programme countries, so it is a sign of cyclical adjustment rather than broader deflationary
environment. That is because it is mainly due to lower energy prices. That is because disinflation
actually strengthens disposable income. So it is not so bad after all, it would seem.
Downplaying disinflation will not do Europe any good, but rather make Southern Europe's debt
burden more unbearable in real terms (while nominal terms are worsening too). The structural
hurdles of over-indebtedness, overvalued currency, and current account deficits (after
discounting cyclical adjustments on falling GDP and imports) are to saddle the block with
vengeance in a disinflationary environment.
Disinflation matters. According to Bruegel, for each percentage point of lower inflation, Italy
needs to increase its primary budget surplus by 1.3% just to stabilise debt and keep debt/GDP
ratio from rising more.
Disinflation takes time to provoke damage, but not so much time. Anecdotally, It took Japan itself
four years of inactive policymaking to see disinflation turning into outright deflation in the early
To be sure, we believe that the ECB's stance on inflation is purely masking their inability to act
against it in an effective manner, as their political mandate to operate is questioned. ECB may not be
in a position to play the full role of a lender of last resort to the Eurozone, neither through the
implementation of quantitative easing nor through other measures entailing fiscal transfers from
Northern to peripheral Europe. As we argued multiple times, ever since declaring to stand behind the
EUR at every cost ('whatever it takes' magic formula), risk sharing and mutuality features across
Europe decreased, and Germany reduced their risk exposure to programme countries by close to
EUR 300bn. So much for being fully committed to the European project.
We will not expand on this as we have done so extensively in previous write-ups (December 2013
Outlook). As the hands of the ECB are tied behind its back, Draghi keeps its freely available
remaining tools for last, delaying as much as possible their use. For all intents and purposes, we
believe that a sub-par intervention is likely in the near term.
Such intervention should meet three criteria:
be the least visible for Germany, or the easiest to explain to German taxpayers
be the least equating to fiscal transfers, or more opaquely so
be the least contributing to moral hazard on the side of peripheral Europe.
Therefore, we see three forms of potential intervention in the months to come, ranked in reverse
order of likelihood:
BOE-type Funding for Lending programme. Designed to benefit lending to SMEs,
alleviating the pain on Southern Europe strangled corporate sector
Rate cut on refi rate MRO or repo rate. Taking real rates more decisively into
negative territory, now that disinflation pushes them higher. Negative nominal
rates are more difficult, while possible, as we learn from market participants that
banks are not even prepared to process the change from an operational standpoint.
un-sterilising SMP operations. At present, the ECB sterilizes its now-terminated
Secutities Market Programs via weekly time deposits designed to drain the liquidity
generated by such SMP purchases. It would be enough to stop offering such time
deposit to inject liquidity in the system for approx EUR 180bn
As short rates on the EUR curve are under upward pressures, and inter-banking spreads on the
widening, following a squeeze of liquidity on LTRO repayments and some deleverage, one of these
measures can be delayed for only that long.
Excess liquidity in the European banking markets stands at just EUR 144bn as we speak, from
peaking at EUR 813bn two years ago. The deposit facility stands at EUR 47bn. The liquidity current
account at EUR 200bn.
On tightening liquidity, Eonia (overnight unsecured inter-banking rate) and other short rates
exceeded 30 basis points at times (before compressing again to 15 basis points), well above the
MRO base rate itself.
Following liquidity squeeze and higher short term rates, the EUR currency was pushed too strong
against the dollar too, making the adjustment on peripheral Europe all more painful.
Strategy-wise, we look at higher rates in the inter-banking markets as opportunities to receive
such rates for carry purposes, in preparation of an ECB intervention in the months to come.
Incidentally, such strategy can provide a good hedge on equity longs in Europe in the short-term,
as market weakness would force the hand of the central bank, who is now otherwise downplaying
deflation risks and the need for intervention.
Again, such intervention will not be conclusive, it can at best buy time, in wishful expectation of a
banking union and more structural measures to be implemented. If a banking union needs a painful
crisis to be forged, is the next question. Once a crisis is triggered, there is little certainty on where it
may lead to. Curiously, a painful crisis can be envisaged as inevitable by Euro-skeptics and Euroobsessed alike.
Japan, stay the course: Short Yen, Long Nikkei
We stay the course in Japan, as the country presses ahead on its game plan for inflating out of an
unbearable debt burden. Lightening up positions ahead of the double election rounds (Okinawa
City Mayoral Race and Tokyo Gubernatorial Elections) proved to be well timed. The quick 20%
correction in January provides for a decent re-entry point. As discussed above, the only surprise in a
20% digital retracement in Japan is that investors are surprised about it. For a country standing on
the cliff of outright default, embarked on multiplying its monetary base few folds over, such or
higher volatility is to be discounted, and will stay with us over the course of the year.
In the new year, we actually learned that corporations like Sony, for the first time in many years,
decided to take the painful route to restructuring/downsizing/divestitures/spin-offs, thus preferring
profitability and shareholders’ value to the old dogma of expansion, revenues and size. Sony is part
of a long list of corporates taking similar actions. That is good news.
On a different note, we read Abe’s manu propria reiterating its commitment to flood the market with
liquidity, in any way possible On the 23 Jan he stated: ‘Japan’s management of public funds – such
as the Government Pension Investment Fund, which now holds about $1.2 trillion – will also undergo
far-reaching change. We will press ahead with reforms, including a review of the GPIF’s portfolio, to
ensure that public funds contribute to growth-nurturing investments’. The GPIF is the world's
largest public pension with 112 trillion yen ($1.16 trillion) in assets. As we highlighted last time
around, such wall of money is likely to meteor-hit the stock market too.
On top of it, last month, the NISA program got started. Designed for individual investors, it will
offer tax exemptions on capital gains and dividend income from investments of up to 1 mn YEN a
year for a maximum of five years. Nomura estimates that $700bn equivalent could move out of
deposits into equities, as a result of NISA only. That is 25% of total NIKKEI market cap.
Again, as exposed at lengths here, we do not believe in the third arrow of Abenomics. Reforms will
be hard to accomplish in Japan’s close, old and protective society, especially over the course of 2014.
Because of the fact that we are skeptical about the third arrow of structural reforms, we thus
expect the money printers to have to step up their game once more, while the FED attempts at
phasing out his, thus driving Yen weaker (second leg of devaluation), and equity nominally
higher (although in volatile manner).
As we reasoned earlier on, while US’ money printing is led by optimism, a genuine belief that
growth can be resurrected and escape velocity is just round the corner, Japan’s money printing is
led by realism and desperation, as there is no alternative left to it.
After unsuccessfully fighting over deflation for the better part of the last 20 years within
conventional policy tools, Japan has resorted to all-out unconventional actions, flooding the
economy with fiat paper money, in a desperate attempt to achieve Debt Monetization through
Currency Debasement: ‘fight like a samurai, or die as a kamikaze’.
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Abe and Kuroda today, have put themselves in a corner where they are confronted with one of two
options: print, and buy bonds only, hoping for the market to grow before inflation kicks in; or print
more, and buy all bond and some equity, if inflation kicks in and/or the market does not grow. Stop
printing and you die.
Already as we speak, Japan is monetizing almost $60bn per months, vs $65bn for the FED, despite
the fact that the Japanese economy is 35% of the US economy in actual size. To be sure to trash the
Yen, we expect the BoJ to increase the stakes of its monetary game from here, and to likely do
so in H1 2014.
As the consumption tax gets introduced in April, as the balance sheet of the BoJ has not been
expanding for three months now, as Capex is lagging behind, as the cost-push inflation currently
visible in Japan in unwelcome, the timing may be right for more monetary activism to take place,
sooner rather than later, driving the Yen lower.
The current level of the YEN vs the USD reflects current interest rate differentials, same as
before the first leg of devaluation of the YEN at the end of 2012. No credit is given to the
expected path of rates now that Central Banks’ policies are set to move in diametrically opposite
directions by end 2014. Although it is believed to be a consensus trade, no such credit is built in
As we have run out of space for this Outlook, we will defer to next month write-up a few observations
on Emerging Markets and China.
Thank-you for reading us today. For those of you who may be interested, we will offer an update on
our portfolio positioning to existing and potential investors during our Bi-Monthly Outlook
Presentation, to be held on the 19 of February, in 55 Grosvenor street (London). Supporting
Charts & Data will be displayed for the views rendered here. Specific value investments and hedging
transactions will be analyzed. Please do get in touch if you wish to participate.
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
55 Grosvenor Street
London, W1K 3HY
Authorised and Regulated by the Financial Conduct Authority (“FCA”)
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What I liked this month
Japan’s New Dawn by Shinzo Abe Read
Emerging Markets blues analysed Read
The global long-term interest rate, financial risks and policy choices in EMEs – BIS Research
When Conventional Success Is No Longer Possible, Degrowth and the Black Market Beckon.
Rather than a disaster, this wholesale loss of middle-class incomes and aspirations is enormously
liberating. Instead of the yoke of debt-based ownership, young people are finding sharing to be
better than owning. Read
Juan Enriquez: Your online life, permanent as a tattoo Video
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