Fasanara Capital | Investment Outlook | June 9th 2014
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“Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci
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Fasanara Capital | Investment Outlook
1. ECB MOVED TO ENGAGE IN BATTLE OVER DEFLATION. WATERSHED MOMENT.
Markets still underestimate its potential implications. Not only the package of
measures is powerful, but we believe it is more likely to be sized up from here than
it is likely to be downsized, especially as ECB is late in the game.
2. THE MOVIE OF THE BATTLE AGAINST DEFLATION HAS ONLY JUST BEGAN, AND
IS LIKELY TO BE THE LEITMOTIF IN MARKETS FOR MONTHS TO COME. The ECB is
likely to be behind the curve, in entering an active role, and as such it is possible to see
inflation moving to new lows first. Europe looks like Japan in the early 90’s.
3. ECB POLICIES AND DEFLATIONARY FORCES ARE TWO WEAPONS FIRING IN THE
SAME DIRECTION. From here, odds are high for European rates to move lower, credit
spreads to narrow, risk premia to implode, interest rate curves to go flatter.
4. WE EXPECT 20%/30% UPSIDE FOR EUROPEAN EQUITIES, ESPECIALLY IN
SOUTHERN EUROPE, ESPECIALLY IN THE FINANCIAL INDUSTRY. Our favorite
markets are Italian equities and Greek banks. Fixed income-wise, we expect yields to
plummet, spreads to narrow further: Italian 10yr BTPs at 2% yield (from 2.75%), and at
100bps spread over Bunds (from 150bps), 60bps over French OATs (from 100bps),
lower than Spanish Bonos (currently +10bps above); Greek 10yr GGBs at below 5%
(from 5.7%), Greek CDS at 350bps (from 450bps), soon enough.
5. AN ACTIVE ECB IS A MILD POSITIVE FOR US MARKETS TOO. In line with our
previous forecast, we see the S&P finishing the year at between 2,000 and 2,100. 10yr
Treasuries can drift lower into 2.30%-2.40% territory, before resuming their
uptrend. We believe the catalyst for the uptrend to resume might be provided by
Q2/Q3 GDP releases, which we expect strong at 3% to 4%.
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Calm Above the Storm
Calm and peaceful markets deceptively hide stormy waters right below the surface. The first 5
months of 2014 proved to be a nightmare for each of the consensus trades you can think of:
momentum stocks, tech /pharma stocks, USD longs, CNH longs, JPY shorts, Nikkei, USD rates
shorts, and most recently peripheral Europe. Consensus trades might have had good merit against
the logic of the fundamental analysis they originated from. Yet, they got crashed one after another,
mercilessly, some of them to recover somewhat, some others being pushed back until further
notice. All the while as implied volatility reached all-time lows and main market indexes advanced at
walking speed, making the ride for active money managers a tumultuous one.
It served as a stark reminder of the artificial markets we like within. Zero to negative interest rate
policy, zero volatility, zero volumes, zero inventories, ample liquidity, high financial leverage,
excess complacency, high cross-asset correlation, are the main defining features of the
manipulated markets we have to come to terms with. Inefficiencies in the form of over-reactions or
delayed responses, idiosyncrasies over fundamentals factors are likely to stay with us for the
foreseeable future. These are markets where you can get a 288k NFP vs 210k expected (2
and rates move lower instead of higher. Efficient markets these are not, and it seems like they are
set to become even more deceptive going forward, as the price of money is manipulated further,
long-term interest rate rigged, equity inflated on Central Bank policies well beyond fundamentals
would support. As always, such market choppiness in zero surface volatility must present
opportunities so mush as it present challenges. Reading through the price action of 2014 thus far,
should help decipher the months to come and fine-tune an opportune investment strategy. As we
cannot change the market, we will attempt to adapt to it. Learn and evolve.
One first conclusion out of the last few months of price dynamics seems clear: the usual hedging
instruments we became accustomed to are of little use and can actually back-fire: dynamic hedges
via market indexes and volatility instruments seem more dangerous than the underlying they
seek to hedge against. It may suffice to notice the defiant behavior of implied volatility, for
example, moving to new all-time lows right before European elections, by many feared to be a
potential game changer for markets in Europe. Those using it for risk management, like us,
remember it all too well. Illogical as it may seem, it is surely going to repeat itself, as investors use
less and less of such instruments for hedging portfolios.
Skew-ness in option prices stands in confirmation of it, as the price of puts narrows the gap to the
price of calls for the same out-of-the-moneyness: it reflects and projects less and less investors
using put options to hedge equity portfolios, as (i) it did not work recently, to the point that it
eventually back-fired, and (ii) it costs progressively more and more in relative terms, as term rates
move to new lows (especially in Europe).
Against this backdrop, volatility is free to set new historic lows from here. One day it will prove
useful again, one day it will resurrect, but that day is not close enough to compensate for the cost of
carry and time value it currently entails. Alternative hedging mechanics must be engineered,
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meanwhile. If history is any guide, volatility was depressed in the run-up to the Black Monday in
October 1987 too, nor did it spike on the market free-fall itself either. It took a few days to see it
rebounding, as the market lost its one-sided positioning, its innocence/complacency, and started
splitting between longs and shorts again.
Cover Tail Risks Of One-Sided Markets
Needless to say, as positions in the market are likely to get more one-sided than they have been
thus far, which means more ‘de facto long-only’ strategies than ever before, the risks for the
market itself intensifies. With everybody sitting on same side of the boat, the boat may capsize
sooner or later. Nobody will be able to legitimately be surprised of a steep downfall in the months
ahead, across bonds and equity, wiping out months if not years or earlier elusive gains. In our mind,
the call for Tail Risk Hedging is therefore a valid one, now more than before. Tail risk hedging can
be devised at negligible costs, sometimes even as positive carry strategies, and be amassed within
the portfolio as dormant beauties, for when they may come to fruition, for the day true tail risks
decide to awake from their deep sleep.
ECB Moved to Engage in Battle: Watershed Moment
The most notable event of the past few months is the ECB policy move, which may prove to be a
watershed event for market dynamics in H2 2014. ECB has officially engaged in battle. After more
than a year of contracting its balance sheet from a peak of Eur 3.1 trillion to Eur 2.15 trillion, the
ECB decided to step into the market again, and take an active role in tackling the deflationary
threat gripping down Europe.
Without diving into the specifics of the package, as you probably have seen them presented into
abundant details these days, the few features which attracted our attention the most are the
(i) ECB decision was unanimous – included Weidman and the Bundesbank – not
irrelevant for Draghi to achieve that, as it carries consequences
(ii) ECB policy move happened before completion of AQR tests on the banking sector, as
testament to its urgency (deflation is with us) and boldness
(iii) Beyond the rate cut, SMP sterilization policies are interrupted. No more drag, large
liquidity injection, which we estimate at around Eur 200bn
(iv) New targeted LTROs are long-dated and super cheap, not simply a replay of LTRO1
and LTRO2. Generous terms: free money to banks, as long as it is not parked at the
ECB (alternatives are available, even without lending to real economy).
(v) No real penalty for using LTRO for carry on government bonds, as opposed to
corporate lending, at least as yet. Positive for banks. The ECB might have thought that
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lowering government yields is needed in itself. This is at the upper end of expectations,
winning over Bundesbank resistance
(vi) Plenty of leeway, both quantitatively and qualitatively, both stock and flow, to adjust
the levers to make the TLTRO effective, or at least more effective than currently
expected and more effective than similar Funding for lending policies in the UK (which
experience in itself is insightful for the ECB). Draghi was already a master of war when
war was fought with cheap talk, he can now use a full range of levers on top of it.
Whether or not such measures will be successful depends on the actual take-up and actual
stimulus to bank lending. We will not now that with certainty for several months. In the
meantime, it is a definitive market positive, leading to substantial upside for equities in
ECB Went Beyond Expectations, Full Impact Not Priced In Yet By markets
We believe that the ECB’s intervention was not priced in by bond and equity markets. Just a rate
cut was factored into market prices, in our eyes. Equities had just recovered the ground lost in the
run up to European elections, while bonds and credit spread for peripheral Europe had not even fully
recovered. The EURUSD only had priced it all in. Markets kept their back foot ready for yet another
disappointment, and profusion of cheap talk for some future actions to be contemplated down the
line. In contrast, ECB delivered not just NIRP (negative interest rate policies), already tested by
Switzerland and Denmark last year (although with different targets in mind), but also a whole
package of meaningful measures, including Targeted LTRO.
As discussed in earlier Outlooks this year, we believed that a powerful ECB intervention was
inevitable. Three conditions led us to anticipate an intervention, in order of importance:
1. Liquidity conditions had deteriorated sharply in the 15 days leading up to the
meeting, presenting credit-crunch type connotations. Inter-banking spreads had
markedly widened to levels seen last during the sovereign crisis of late 2011 or the summer
of 2012. Excess liquidity for the European banking system had plummeted dangerously,
from over Eur 800 bn at the peak of LTRO2 down to less than Eur 100 bn, on repayment of
LTROs and banking deleverage. Absent an intervention, a credit crunch would have been a
likely scenario, despite funding spreads for deficit countries starting from far lower than
they were in mid-2012 and less of a redemptions’ wall than back then. A policy move had to
be devised, beyond the simple cut in rates, into interrupting the SMP liquidity drag and a
new LTRO. The one place in the market were such intervention was contemplated was short
rates on the Eonia curve and, consequently, the level of the EURUSD.
2. Europe’s disinflation had just dangerously moved to the cliff of outright deflation,
and will likely worsen from here, for a period of time, despite ECB intervention. CPI
numbers for most countries in Europe, including Germany, are a tad away from the zero
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line. High levels of unemployment (youth unemployment reached 43% in Italy, above 60%
in Spain and Greece), excess public debt on shallow GDP advances, an over-valued currency,
fiscal austerity, have all concurred to push internal devaluation across peripheral Europe and
beyond. France is dangerously losing productivity, while worsening debt metrics, and now
losing political stability too. Price stability (against downside risks) had to be preserved,
cornerstone to the ECB mandate. Moreover, as the ECB is ‘too late’ already, most likely
behind the curve in tackling deflation forces, it could not also be ‘too little’: a soft
intervention (just a rate cut) would have been outright counterproductive.
3. Contrary to conventional wisdom, we think that European elections helped push the
ECB into an active role. The low turnout at the elections, together with the powerful
advance of anti-Euro parties, helped define a deadline for austerity policies over growth
policies across the Euro bloc, as the next election rounds at national levels in various
European countries are otherwise likely to push such parties further ahead into tipping
point. To Merkel, European elections might have sounded like a last call to fix growth in
Europe, or otherwise face the grim reality of a dissolving currency union, slowly but
surely. Our readers know how skeptical we are of a survival of the currency peg in the long
term (next five years): however, we believe an attempt will be made to try and avert it. The
time is now to try that. European elections helped define such timing, as the clock of the
countdown to next election rounds (and their likely winners by a landslide) started ticking.
Markets Still Underestimating Inflection Point in ECB Policy
We believe that markets still underestimate the full impact of the ECB move, and its potential
implications. We do not believe markets are listening, as yet. The ECB has come out and
quantified its first move. From here, it is a one-way road of stepping up efforts if it is to preserve
its credibility and market confidence, as data flow is likely to show further deterioration in the
Rephrased, not only the package of measures is powerful, but we believe it is more likely to be
sized up from here than it is likely to be downsized. Once you come out in the open, and engage in
battle, you have little alternative but to be all-gun out, especially if you are late in the game.
The Battle Against Deflation Has Only Just Began
The movie of the battle against deflation has only just began, and is likely to be the leitmotif in
markets for months to come. We discussed it during a recent CNBC interview here. The ECB is likely
to be behind the curve, in entering an active role, and as such it is possible to see inflation moving to
new lows, affecting market expectations, creating disconcert in markets over the ability of the
Central Bank to win over it.
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We do believe Europe looks like Japan in the early 90’s, when it took four years for deflation to
materialize, and force the BoJ into an active role (which there proved spectacularly unsuccessful - we
expanded on this in previous Outlooks).
Critically, ECB policies and deflationary forces are two weapons firing in the same direction.
From here, odds are high for European rates to move lower, credit spreads to narrow, risk
premia to implode, interest rate curves to go flatter.
That is financial repression at his best, with the added help of deflationary forces, putting any
sort of risk premia and rate differentials under attack.
Without the ECB policy move, such process was less obvious. In the absence of an active ECB, such
deflationary forces could have failed to drive rates lower and spreads narrower, as credit and risk
spreads could have widened massively on fears of a replay of the sovereign and liquidity crisis of
late-2011, mid 2012. Credit spreads could have widened out well in excess of base rates moving
lower. An active ECB, moving decisively and unanimously (including Weidmann), helps generate
the expectation of mutuality across Europe, rendering deflationary expectations even across
Pushing lower a 10year German bund yield of 1.35% might be difficult (although Japan shows
the downside is still wide), but forcing lower a 2.75% yield on a BTP is easier, as it offers twice
the yield of a Bund, for the same Central Bank. So it is easier to push down a 6% yield on a Greek
govie (and its CDS at 450bps over), on the presumption of mutuality and ECB backstop. For the
time being, until further notice.
Against this backdrop, we believe that the activism of the ECB can lead into further 20%/30%
upside for European equities, especially in Southern Europe, especially in the financial industry.
Our favorite markets are Italian equities and Greek banks, which we think have the potential of
being best performers in the next 12 months, although with heavy (realized) volatility along the way.
Fixed income-wise, we expect yields to plummet, spreads to narrow further: Italian BTPs at 2%, and
at 100bps spread over Bunds, 60bps over French OATs, lower than Spanish Bonos (currently
+10bps); 10year Greek yield at 5% and below, soon enough.
An active ECB can be a mild positive for US markets too. In line with our previous forecast, we see
the S&P finishing the year at between 2,000 and 2,100. In contrast with what we previously
thought, we now believe that 10yr Treasuries can drift lower into 2.30%-2.40% territory, before
resuming their uptrend. We believe the catalyst for the uptrend to resume might be provided by
Q2/Q3 GDP releases, which we expect strong at 3% to 4%. Before that, payrolls/NFP numbers can
accelerate the move, although that is not our baseline view.
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Biggest Risk to Our View: S&P Correction
As presented in earlier Outlooks, we see few main assumptions for our baseline view to materialize.
The background against which we believe such expectations to hold is as follows:
(i) abundant liquidity (likely to persist until the first FED rate hike gets vividly
visible in markets’ rear mirror, only accelerated if we get a bad US inflation print
– more on it on next chapter),
(ii) broadly neutral economic landscape (stable or slightly improving data set), and
(iii) broadly neutral geopolitical environment (on exogenous factors out of
Ukraine, Syria, East China sea, North Korea and the likes).
Absent one of these elements, steep downside is possible, as US valuations are held on the thin
air of central bank liquidity, dramatically disconnected from fundamentals, on record levels of
leverage built into the system, high complacency and thin liquidity (Valuations in Stratosphere).
Predictably, we will continue to monitor incoming data flows and economic data for evidence of any
inflection point on how imbalances evolve from here.
To this point, the one place which concerns us the most is the US Equity market. A correction of
the S&P might derail the process we see unfolding in Europe and affect our positioning the most.
Our views rest on the expensiveness of the US market, end-of-journey type market, leading to re-
allocation of flows into Europe, primarily peripheral Europe. Should the US market become cheaper,
following an important correction, it would raise the bar commanding a more than commensurate
cheapening for Europe, all too obviously.
The US market is admittedly expensive, and lives through the final phase of Central Bank’s activisms
(unless it is resumed later on down the road, as we suspect). As the ECB enters its active zone, the
FED is exiting its. Tapering is expected to complete by year-end, with two important
(i) Completion of tapering might focus minds on the timing of a first rate hike,
driving US equity markets lower. US rates will rise, into year-end, widening the
spread to European paper. Although deflation dynamics in Europe have little in
common with similar pressures in the US (motivated by different factors), rates
differentials between US and Euro are already stretched by historical standard, and
have tented to move in a wide range, showing mean reversion historically. One
trend to watch carefully, as it is headwind to the baseline view of collapsing yields
and spreads in Europe.
(ii) A melt up scenario of US equities would also pose a risk to our views. An SPX
rising above 2,000 all too quickly could set it up for a powerful correction. Robust
multi-year resistances are at 1970-1990. Better the market does not test it all too
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quickly. A market moving in sidelines in the US for long enough is not only our base
view but also our best case scenario.
On our timetable, both risks are unlikely before Q4, leaving 2/3 months of potential upside for
peripheral European equities, bonds and spreads.
Abundant Liquidity Is Here To Stay For Foreseeable Future: Asset Bubbles vs Credit
The large disconnect between fundamentals and valuations in US markets is unlikely to pose the
threat of a Central Bank policy shift. The FED is likely to do very little about it, and keep interest
rate low for long after tapering is completed, thus inflating the bubble some more into
A cursory glance at Central Banks’ mentality nowadays can help explain that. We may disagree to
such stance, but gauging what is likely to be on their minds might help define the shape and tempo
of Central Banks policies, and thus the end game for markets.
Central Banks seem to buy into the difference between Credit Bubbles and Asset Prices Bubbles.
They are more concerned about Credit Bubbles, whereas they appear to be content in making Asset
Price Bubble inflate further, at least up until the point where they become Credit Bubbles too.
Not every market crash is created equal. Both 2000 tech/telco crisis and 2008 subprime crisis had
devastating impact on markets. However, whereas the 2008 crisis led into a severe multi-year global
recession, the 2000 crisis entailed only a mild short-lived recession and was never a threat to financial
The difference may reside in private-sector leverage and financial sector leverage, which was
subdued in 2000, while it was excessive in 2008. In 2008, the housing bubble led into a build up in
debt in the financial sector and across the economy at large. When housing and asset prices
subsequently fell, they ignited a deleverage spiral, overcompensating to the downside (under the
push of capital calls on margin loans, on LTV ratios breached, and leverage being withdrawn fast).
The point is that the 2008 crisis managed to bring down the financial system, owing to the leverage
built up in it. Absent such leverage and credit bubble, the market crash alone would have not
managed to bring down the banking sector, and therefore would have failed to cause a deep and
painful economic recession (similarly to 2000).
Ergo, an Asset Prices Bubble alone poses less systemic risks than a fully-fledged Credit Bubble,
which means it is less of a concern for Central Banks, who conclude that ‘cleaning up the mess’
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after the crash is better strategy than trying to do something beforehand to avert it, as implications
for real economy will be temporary anyway. Put simply.
At present, Central Banks seem to conclude that a Credit Bubble is not there, as the Asset
Bubble did not lead into an increase indebtedness of the private sector (credit growth subdued)
and into an increase in financial sector leverage (we may disagree, thinking of NYSE $ 400bn+
leverage at ~2.5% of GDP, but we are not the Central Bank). Therefore, using monetary tools to
dampen asset prices can be counterproductive. Therefore, Central Banks remain reluctant to target
asset prices. Therefore, asset price inflation and equity bubble have further to go.
Things will change, and Central Bank will be a sure headwind to markets, if and when private-sector
credit growth and financial sector leverage pick up speed. That is then the variable to watch. Only
then will rates may be allowed to rise, as manipulating interest rates (and indirectly equity) may run
into a sudden stop, under such supposed Central Bank framework.
Central Banks reckon that macro-prudential policies alone (without hiking rates) can take care of
Asset Bubbles: countercyclical capital buffers, direct restrictions on bank lending, leverage limits,
collateral requirements, forward-looking loss provisioning etc. No need to hike rates.
Recent BIS papers seem to have influenced such convictions the most (how to tackle systemic risks –
attached below). A recent Research by Lombard Street describes it beautifully.
For all intents and purposes, we draw two conclusions:
(i) It is highly likely that, absent an inflation scare, interest rates will be kept lower
for longer than currently anticipated, and well beyond the completion of
tapering in the US. Equity bubbles can inflate further, before their point of
bust/deflation. Interest rate curves may result structurally steeper, as the long-
end will attempt at pricing future GDPs and some minuscule inflation risk premia,
while the short-end remains heavily anchored.
(ii) Future Credit Bubbles are likely to go un-checked, market busts inevitable.
Rephrased, liquidity-induced markets are bubble prone. Fat Tail Risk Hedging is
the natural antidote, likely to be included in any portfolio which is not long-
only, likely to make the difference if it is not, over the completion of the
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At present, our allocation across the three building blocks of our portfolio looks as follows:
In the following few pages we will update briefly our views on each of our main convictions. A full
download of our views is available here.
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VALUE BOOK: Long Peripheral European Equity & Bonds, Long Japan
Within Equity, we prefer Italy, Greece and Japan. We avoid US markets, as we believe they are
toppish, deceptively un-volatile, while substantially more upside potential is achievable elsewhere
in Europe and Japan within the same baseline scenario.
Benchmark-wise, we see the mother-ship S&P having the potential to finish the year in 2,000-
2,100 area. 5 to 10% corrections can return to be the norm, as experienced in late January this year.
Critically, as explained earlier on in this Outlook, such potential upside is only achievable on
the rosy combination of three key conditions: (i) abundant liquidity, (ii) broadly neutral
economic landscape, and (iii) broadly neutral geopolitical environment.
Absent one of these elements, steep downside is possible, as valuations are held on the
thin air of central bank liquidity, disconnected from fundamentals, on record levels of
leverage built into the system, high complacency and thin liquidity (Valuations in
Stratosphere). Predictably, we will continue to monitor incoming data flows and economic
data for evidence of any inflection point on how imbalances evolve from here.
More upside outside of the US: peripheral Europe and Japan
If the positive backdrop created by ample liquidity, stable or slightly improving economics,
neutral geopolitical environment is to materialize, then we see way more upside outside of the
US, namely in peripheral Europe and Japan. Against such baseline positive scenario, the US is
underperforming both Japan and Europe in the short term. Conversely, we believe they share similar
volatility to the downside, for the next few months. A margin of safety on cheaper valuations
exists for peripheral Europe and Japan that does not exist in the US.
To be clear, at Fasanara we remain skeptical of economic recovery in the US (where tapering might
get discontinued later on in the year, and QE re-instated), convinced of a slow motion train wreck in
Europe (where a dismantling of the EUR currency union seem likely to us few years down the road),
and wary of Japan’s over-indebtedness (debt monetization through monumental currency
debasement is the only alternative to a fully-fledged default on obligations, while being the financial
equivalent to such default in forward value real terms, especially to fixed income investors).
However, what matters is the market’s perception of things in the near term, more than Fasanara’s
long-term convictions, all too obviously. Markets can deflect from economic reality for that long,
before they adjust to fundamentals. But ‘that long’ period can indeed be quite long, requiring
investors to stay solvent long enough, before they see the end game to their theories. Markets are
voting machines in the short term, but they are weighing machines in the long run, Buffet is quoted
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as saying. True value must emerge only on a long enough timescale. We feel similarly of today’s
For all intents and purposes, we see equities structurally moving higher from here, although in
more volatile cyclical manner than shown last year (more similarly to 2014’s realized volatility). If
forced to embrace the nominal rally, we then prefer to do it where the potential upside is
commensurate to the risks undertaken, which to us means peripheral Europe and Japan, over
the highly priced US markets. The former are still to be lifted out of misery, while the latter trade
closer to the end of their journey.
Europe On The Receiving End Of Assets Re-Allocation Flows
We see the reallocation of capital flows to continue hitting the shores of peripheral Europe, and
being the main driver of its out-performance. As large US, Asian allocators look at a toppish
S&P, seeking diverse destination for their excess cash, Europe might benefit for pure lack of
To large foreign investors, Europe may now look great: stable, cheap, with deep liquidity, on the
slow mend of its old wounds, while guaranteeing rule of law.
- Emerging Markets have eliminated themselves from the allocation race, in any
meaningful amount, as they are likely to continue showing high volatility on feeble
financial conditions over the course of 2014, owing to the end of the commodity super-
cycle, the re-onshoring of US manufacturing, rates moving higher in the US, re-instating of
geopolitical risk premium.
- More specifically on LATAM, Argentina is likely to see the situation getting worse before it
gets better, and Venezuela is a clear potential troublemaker in the short term.
- Russia too has likely left the allocation race, as the cheapness of its stocks finds new
justification in unpredictable political behavior, clearly not driven by pure economical
- Japan is large and liquid, but likely to be already included in most portfolios, while
giving investors headaches these days on excessive downside volatility due to fears of
potential failure of Abenomics
If you are a large US allocator, flushed with liquidity from ballooning ETFs inflows, bullish not by
choice but by design, willing to look at the bright side of things and relieved by hopes of Ukraine
uncertainties giving in, then Europe may look like your only viable destination these days,
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Within Europe, peripheral Europe is dominant choice
Within Europe, peripheral Europe is a dominant choice. In core Europe, France is a clear laggard in
economic terms, mispriced against the emerging fragility of its economy. Germany is the most
exposed to Russia’s uncertainties, and it is just starting to feel the heat of an unjustifiably strong
EUR. The UK market shares the stellar performance of a US-type liquidity-induced market, skating
on thin ice, while also having in common decelerating advances up there at the top (and lately a
stronger currency). At the very least, peripheral Europe is not toppish already. Its economy
languishes in shallow GDP pick-ups, superficial recovery in industrial production trends, but here
the market is fully equipped to plug-in its iron optimism, projecting a rosy future right around
the corner. De minimis non curat praetor.
Within peripheral Europe, Italy is the obvious choice
Within peripheral Europe, Italy is the obvious choice, representing the lion share of the block,
with more GDP and liquidity than all other border countries put together.
More specific to Italy, the inflection point in politics is added value to incoming foreign flows. Mr
Renzi won a landslide victory at the European elections, in stark contrast to a defeated governing
party in France, amongst largest nations. Such victory is a game changer. The magnitude of the
victory is astonishing, and wont go without consequences. His political capital will last some
time. In the meantime, the odds of him delivering powerful reforms in the months ahead are high.
The one reform we think could matter the most for markets is pay back of arrears to Italian
SMEs. That counts for 4.5% of GDP, at approx. Eur 70 bn. European authorities have less of a
leverage to block it than before, as Mr Renzi’s votes at the European parliament are badly needed
now. The same inflection in ECB policy is not independent variable to a stronger government in Italy,
at a time France weakens both economically and politically.
The change in GDP between 2013 and 2014 is +2.6% already (from -1.8% to +0.8% expected), with
the pay back in arrears contributing an additional potential 4.5% over the next 12 months period.
Music to the ears of markets, particularly foreign allocators.
Italian Equity and Bonds are likely to price that in at some point, leading to a further upside of
20% to 30% in Equity, 75/100bps rally in 10year BTP rates, down to 2% approx., spreads to
Bunds closer to 100bps (helped by deflationary forces and now an active ECB (perceived as
mutualizing debt costs across Europe). In Italy, the risk of a melt-up scenario is higher than the
risk of a steep downfall, in the short-term.
Funny as it may look to an outside viewer not considering deflation trends and growth rate
differentials, Italy may soon look like more ‘’creditworthy’’ than the US, as she will be able to finance
itself at cheaper levels. A paradox, but one which may last a while.
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Three ways our view is implemented (discussed at our recent CNBC interview here):
(i) We are long Italian Equity, particularly in the financial sector, most directly affected
by ECB policies.
(ii) We are long BTPs, on the 10year sector of the curve, both outright and in spread
against French OATs. France has an economy deteriorating at alarming speed
(similarly to Italy, while pricing is way dissimilar at present), while political risk in France
increased after European elections as much as it decreased in Italy. Not sure markets
give it the right price as yet, with OATs just 30 bps over Bunds vs 150 for Italy (a 5X
multiplier is unsustainable in a heavy deflationary environment with a Central Bank
active in financial repression policies).
(iii) To a lesser extent, we also look at BTPs over Spanish Bonos at current spreads (Bonos
10 bps tighter than BTPs) and potentially more attractive entry points over time.
Beyond Italy: Greek Banks
Outside of Italy, we also like Greek Banks. While providing less liquidity than Italy, they are
mispriced against the rosy scenario investors seem to be willing to embrace, both in absolute
levels and in implied volatility terms.
Over the past few months, Greek banks experienced VAR-type fluctuations, losing 30% to 50%,
while simultaneously fundamentals were improving on well over-subscribed new bond issuances at
record-low yields, a highly successful round of re-capitalization, bringing their fully loaded core Tier I
ratios ahead of European averages, preparing them for Asset Quality Review tests in October.
Dramatic panic selling hit them right when their fundamentals got better than anytime over the
past 5 years, driving them into new all-time lows, although temporarily. Such is the inefficiency,
schizophrenic state of mind for markets these days. If there was any need for it, such violent price
action serves us as a stark reminder of the realized volatility which lay dormant beneath the surface
of peaceful markets.
Implied volatility for Greek banks warrants was 25% before the downfall, vs realized at 100% in a
matter of days. Riding a long on Greek banks is painful, complex from a VAR perspective if one is to
abide to monthly and weekly NAVs and his own investors’ anxieties. Nonetheless, it is the right thing
to do with a longer time horizon in mind, as these banks will be trading significantly higher 12
months from now, significantly out-performing cross-assets.
Optimal timing is impossible to determine absent a crystal ball, so we resorted to the need to be in
position, while weathering the storm in between, as the road to high returns is bumpy and
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The market is likely to underestimate the upside potential of a heavily concentrated banking
industry in Greece, now that GDP is inflecting (delta change in GDP of 4%/5%, from -3.9% in 2013
to +0.2%/+1.2% expected in 2014, with primary surplus at 1.2% in 2013), with sizeable slow-down in
NPLs formation trends, while EBA Core Tier I ratios at 15% approx. are ready to withstand the
AQR review in October (8% minimum requirement), well ahead of European averages (~10%).
As we said earlier, we believe Italian stocks and Greek banks can end up being some of the best
performing assets for 2014.
In terms of fundamentals, within the recent past we had the following:
(i) Greek Government upgrade, and new benchmark government bond issue, 7 times
oversubscribed (Eur 3bn issue, 4.95% yield, 5yr maturity)
(ii) Greek banks successfully completed their heavy-loaded recapitalization round (for
more than 20% of Greek GDP cumulatively), taking them to roughly 12% of fully loaded
Basel III CT1 ratios.
(iii) Greek banks came out exceeding expectations at their latest earnings releases,
across the board. Declining NPLs formations, benefiting from funding
normalization (recent Blackrock Solutions stress tests and upcoming AQR will make
investors progressively more comfortable in owning the risk).
(iv) Lower levels of austerity from here on. Worst is behind them.
Our top picks are now Piraeus Bank (target price 2.50) and National Bank of Greece (target price 4).
Beyond Europe, Japan: nominal rally in equities is likely, as BoJ boxed itself in the
corner and has yet plentiful room to expand
Elsewhere, Japan is dangerously running the risk of losing the momentum on its monumental
monetary printing and fiscal injection, aimed at kicking off the animal spirit within the country, and
wages and consumer price inflation with it.
We believe that the worse financial markets perform, the more inevitable further monetary
interventions become, in the desperate attempt to keep the momentum alive, debase the
currency further, monetize an otherwise unbearable debt overhang.
We expect monetary printing to be confirmed for 2015 and possibly up-scaled. BoJ is already
printing more than the FED in absolute terms ($ 60 bn vs $ 45 bn monthly), despite having an
economy 70% smaller. Currency debasement is just monumental.
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Two elements are to be added, which emerged over the course of the past weeks:
(i) Abe growing impatient with low equity market allocations for its largest pension
funds (an almost $ 2 trn industry). The largest pension fund on earth, the GPIF ($ 1.2 trn
firepower) and others seem to slowly give in to political pressures. GPIF has a current
allocation of 60% into government bonds, which could be brought down to less than
30% 0ver time, in favor of local and foreign equities, pushing Nikkei higher and JPY
(ii) The last week of May saw Japanese investors buying the most foreign stocks in a
week since 2009.
On such scenario of extremely aggressive policymaking, we foresee a nominal rally of equity
markets (upside potential 20,000 on the Nikkei by year-end), counterbalanced by a further
depreciation of the Yen (upside potential 110-120 USDYEN by year-end).
The pain inflicted year to date on both the Nikkei and the Yen made it less of a consensual trade than
it used to be. Being long Japan Equity and short the Yen is still a consensus trade, and as such
painful to maintain. Nevertheless, we believe its upside potential is sizeable, making the pain
commensurate to the potential gain, therefore one to keep and carry forward. Together with
Italian equities and Greek banks, we believe Japan equities and JPY shorts have the potential to
rank as some of the best performers globally for the next 12 months.
We were wrong in being short US rates too early, and wrong in being long implied volatility too
soon. We were right about Eonia rates plummeting to zero on the inevitability of ECB move.
Going forward, we plan to:
(i) Discontinue dynamic hedges through market indexes (with the exception of the
S&P) and implied volatility instruments (for the reasons presented earlier on). In the
past few months, we over-spent trying to dynamically hedge and time the gyrations of
the Value Book, and un-successfully so. By design, our Value Book is intended to keep
positions in place for the long-term, as buy and hold. Average holding period 6 months
to 2 years.
(ii) Keep the guard high on tail risk, through our ‘Fat Tail Risk Hedging Programs’, via
which we mechanically amass growing quantities of cheap optionality, or positive carry
optionality to provide for hedging tail scenarios.
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There is no room left to discuss properly the Hedging Book. We will do so at next month Investors
Before we go, to recap, our current and expected positioning for the few weeks to come is
formed against such convictions as:
- US: neutral on real economy, neutral to bearish on equity, bullish on bonds short term but
bearish medium term
- Europe: bearish on real economy, bullish on equities and bonds
- Within Europe, long Italian equities, long Greek banks, long Disinflation
- Japan: super-bearish on real economy, long equities for nominal rally, short yen, hedged on
tightness of rates/credit spreads
- China: bearish on economy, inevitable GDP slow down exposing imbalances, but market has
priced it in for the short term. Thus, tactically long segments of the market there
- Emerging Markets – open eyes on Argentina, Korea, Eastern Europe buying tactically on
dips over the next few months
Thanks 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. 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
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
The idea of permanently raising inflation targets to 4%. Kenneth Rogoff Read
The Disenchantment of Europe. Instead of a eurozone caged in by Germany’s narrow interests as a
creditor, Europe needs a monetary union that works for all of its citizens. Philippe Legrain. Read
Bill Gross: New Neutral. During the period of similarly high leverage from 1945–1982 in the U.S.
and U.K., real policy rates averaged -31 and -133 basis points respectively. Other developed
countries in Europe and Japan were even lower. The commonsensical correlation between high
leverage and low interest rates comes to us most recently via the past few decades of experience in
The Liquidation of Government Debt. Carmen Reinhart, 2011 Read
Fasanara Capital at CNBC: ECB action to boost Greece and Italy Video
Asset prices, financial and monetary stability: exploring the nexus. By Claudio Borio and Philip
Lowe. 2002. Read
Redesigning the central bank for financial stability responsibilities. Speech by Mr Jaime Caruana.
Independence of action against the build-up of financial imbalances is important. It is crucial to avoid
a bias towards inaction. Read
Credit Growth, Monetary Policy, and Economic Activity in a Three-Regime TVAR Model. By
Stefan Avdjiev and Zheng Zeng. June 2014. Read
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