Fasanara Capital | Investment Outlook | September 3rd 2013
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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. Syria may serve one purpose above all, which is to take the blame away from
Bernanke, Obama, Congress and the Euro crisis altogether for the possible steeper
correction we foresee. We view markets as structurally fragile at present, for any
one exogenous factor can legitimately take them down: over-leverage built-up in the
system, low liquidity / low inventories constant, market's blind optimism. Bubble
markets are gapping markets.
2. Our sense is that justifying ex-post a more sizeable correction of another 10%-20%
in G4 equity markets would suddenly be easier to do than most investors initially
3. Tapering may get postponed by few months, leading to a short-lived relief rally. So
much for the potential nominal rally we see possible in Q4.
4. Rising rates are the most poisoned threat to markets in the short term: 1) tapering,
while delayed, will still take place, 2) EMs might be forced to dump some Treasuries to
stem currency crisis, 3) rising expectations on GDP can easily justify 4% on 10yr govies
5. China: the key problem in China is the Corporate sector, whose leverage is 125%+ of
GDP. As long as nominal GDP growth comes in strong, China’s imbalances can be
contained. But growth numbers below 7% have the potential to lit the fuse on
Corporate China’s excess credit.
6. New elections in Italy are a 'fat tail' risk, which is not even a 'tail', as its probability
tops 40%. Italian bonds are well inside bubble territory against this backdrop; Italian
equities are historically cheap, but way off pricing in such risk scenarios..
7. VALUE BOOK: remains flat, as markets are toppy, still expensive vs fundamentals,
at risk of a 10%/20% steeper correction. Most of the opportunities in the HEDGING
BOOK: short S&P, long VIX, long Credit Curve Flatteners, short EUR, Long Interbanking
Spreads, long Currency Pegs, short JGB rates, short Yen, short Australian Dollar.
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Bubble Markets are Gapping Markets
In the month just past, the dreadful state of Commodity and Emerging Markets began to work
as a drag to global markets, including the mother ship US, where valuations stopped their ascent
and rowed some back. As of late, escalating tensions in Syria and Egypt served as a catalyst.
To believe that EMs/Commodities could be free-falling, while G4 countries kept rising ad
infinitum on Quantitative Easing and cross-border re-allocation of capital flows, is the
incompatibility we flagged up a while ago (Deleverage Chain vs Bubble Chain): we believe EMs are
nowadays too big not to have an impact on global growth, as they now contribute half of the world’s
GDP. We simply believe that they cannot be tell-tales of a totally different economic reality than the
one depicted in, say, the US.
To us, Syria may serve one purpose above all, which is to take the blame away from Bernanke,
Obama, Congress and the Euro crisis altogether for the possible steeper correction we foresee.
Perhaps, the heavy volatility is better attributed to the unsustainable disconnect between
economic fundamentals and financial assets’ pricing, produced by ill-conceived pump-priming
mantra, intended to domesticate markets to a virtual reality where current policymaking is
sustainable and strong GDP is waiting for us come 2014.
Such remains the key vulnerability of current markets, leaving them structurally fragile to VAR-
shocks and sudden digital adjustments to the downside. Bubble markets are gapping markets.
Against such background, Syria may be more the effect than the cause. We view markets as
structurally fragile at present, for any one exogenous factor can legitimately take them down. A
number of factors can then make such correction more violent at any given time, as investors
rush for the exit in a one way market, overcompensating to the downside: the over-leverage
built-up in the system (outstanding margin debt at almost 400bn at the NYSE), the low liquidity /
low inventories constant (which has become a recurring element of current markets), market's
blind optimism (as most investors have bought into the Central Banks' dogma, with most of the
market’s advance explained by P/E multiples, as opposed to earnings expansion).
Said otherwise, markets have been rendered structurally fragile by the present phase of recent
crisis resolution policies. As the dust is being chipped away under the carpet, the carpet is belly-
shaped now, and it is proving difficult to walk on it. The capital mis-allocations generated by QE-
type policies (of which the EMs bubble was on the receiving end), in the desperate attempt to
alienate tails risks and kick start growth, is biting back on any given opportunity. Syria is one,
but there are several other canaries in the coal mine.
Our sense is that justifying ex-post a more sizeable correction of another 10%-20% in G4 equity
markets would suddenly be easier to do than most investors initially perceived.
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Binary Events Ahead, Volatility To Stay Elevated
As we remain focused on Tail Risks, against which we design the portfolio to be over-hedged, here
we enumerate the most obvious catalysts ahead of us, warranting the need for protection strategies:
Tapering may get postponed by a few more months, as we anticipated (more upside in Q4 than
Q3), leading to a short-lived relief rally. So much for the potential nominal rally we see possible
in Q4. However, sooner or later, tapering is indeed happening, on the back of either or: 1)
supposedly improving macro data, 2) unsustainability of QE monumental program over the long run,
3) diminishing returns and ineffectiveness (the one real motive why it should be discontinued, in our
opinion) 4) one more way to stem a potential run-up in oil prices, now that geopolitical tensions drive
them up again. Undoubtedly, with important consequences for interest rates and assets’ pricing
at large over the medium term.
As it looks like at present, that is a two people race between Yellen and Summers. Effective as
Bernanke was in convincing markets in the face of a grim reality, the bar is set high for any successor.
If anything, we view Yellen as the best options for markets in the short term. We disagree to the
market’s perception of Summers as a safe choice. While he may first commit to continuity on
Bernanke’s largesse, Summers is volatile, vocal, aggressive, the polar opposite of Bernanke’s
soft touch and predictability. At best, volatility spikes would then have to be discounted.
US Federal Debt Ceiling Discussion
Come October, confrontations on the fiscal front may heat up again. While our base case is for an
extension of the debt limit for another year, this is also largely the consensus view, leaving the door
open to volatility and headline risks should it not be the case.
China’s Credit Crunch
To us, the key problem in China is the Corporate sector, whose leverage is 125%+ of GDP (after
jumping 30%+ in the last 4 years, the biggest single contributor to China’s debt/GDP ratio).
Typically, emerging markets have such ratio setting at between 40 and 70%. Beyond the corporate
sector, China’s leverage is not outrageous (approx. 200% of GDP, lower than in Japan). Critically, two
thirds of such Corporates are not SOEs with easy access to credit, local governments or large
property developers, but mid-caps which have grown increasingly reliant on the shadow banking
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system. Such reliance is sometimes borderline resembling Ponzi schemes. Inter-company
guarantees have reached the staggering amount of 83% of total guarantees (from 54% in 2008). At a
time when China seems trying to rein in credit excesses in the shadow banking system, in
transitioning to a consumer-led economy, they will do so messing around with the largest
vulnerability in their system, the Corporate sector.
As long as nominal GDP growth comes in strong, China’s imbalances can be contained. But
growth numbers below 7% have the potential to lit the fuse on Corporate China’s excess credit.
In the banking space too, there are worrisome developments. A recent HSBC report shows us that
City commercial banks became the largest issuers of Wealth Management Products, on which
they rely for their funding: some WMPs go all the way to invest in tea, ham, watches so as to seek
the 60%-type returns they promised depositors. WMPs are de facto capital guaranteed by the banks.
Moreover, local banks have now grown mismatches between assets and liabilities in foreign hard
currency. The Renminbi is the only EM currency which didn't lose ground to the dollar in the last
few months. No doubt authorities will attempt to avoid such devaluation in every possible way. As
they sit on massive FX reserves and $ 1.27 trn Treasuries, they might sell some if the markets were to
push them. Incidentally, China net sold $20 bn worth of Treasuries in July.
For all these reasons, we believe we are still not past the China’s risk, and its impact on deficit
countries like Australia and Brasil, in primis. While we convene that China will be the global growth
engine of the next decade or so, we do see digital risks first for the next couple of years, as their
delicate rebalancing process unfolds.
Elections in Europe
Market seems to be waiting for German elections on September 22
to go by. Past them, the
consensus is for more accommodative policies over peripheral Europe to be allowed by
Germany. To us, such expectation might be disappointed. If anything, moving the lens from cheap
talk to hard flows, evidence can be found for the opposite to be true: Germany's TargetII exposure
has declined by Eur 200 bn in the last 12 months (while the Euro area monetary base contracted by
some Eur 500 bn in the period).
Moreover, as we argued extensively in July Outlook, it is not only about German elections, but
perhaps about Italian elections too, soon enough. The political landscape in Italy is crystal-fragile,
as the governing party led by Berlusconi faces a lose-lose proposition between political irrelevance
and outright extinction. To them, returning to elections in some drama play on anti-EUR rhetoric,
might end up being the safer option to resort to. New elections in Italy are a 'fat tail' risk, which is
not even a 'tail', as its probability tops 40%. Italian bonds are well inside bubble territory against
this backdrop; Italian equities are historically cheap, but way off pricing in such risk scenarios.
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So far, the EUR proved to be way more resilient than we anticipated, especially vs USD and GBP.
Looking at things in retrospect, for what it’s worth, we can see few reasons for the EUR relative
strength. Firstly, the repatriation of flows from EMs makes for a powerful drive (it is estimated that
Eur 1 trn was invested into EMs by European funds only). Secondly, as LTROs got repaid for Eur 300
bn (on total Eur 1 trn), excess liquidity in the banking system compressed to ~Eur 250 bn. The ECB
estimates at 200bn the threshold for tightening pressures on EUR short rates. No doubt the
compression of the ECB balance sheet relative to BoE / FED is supporting the currency. We maintain
our bearish view on the EUR, although we know we may have to be patient before it plays out.
Interest Rate Rising
Rates rising are the most poisoned threat in the near term. We left for last the one risk we consider
the most dangerous. Higher long-dated US rates could lead the sell-off on global rates, with obvious
bad news for the housing market and for global fixed income portfolios (more than 70% of global
portfolios). The FED alone owns $2trn of Treasuries now, on which any rate increase equates to a loss
on very thin total capital (tiny ~$ 50 bn): although no mark-to-market applies, and accounting
gimmicks have been made widely available. Fiscal deficits are also affected, as 40% of the stock of
US government debt rolls within the next 24 months, at possibly higher rates. Higher long-dated
rates could be the casualty of few concurring forces:
1) Tapering is the most obvious factor: while it may possibly be delayed for a few
months, it is still going to take place. On the 18
September, the FOMC meeting should
shed some light on the timing, size and composition of tapering. The job report on the
will surely help direct that decision.
2) While the FED owns now $2trn of Treasuries, almost another 6trn is owned by
foreigners. China accounts for only $1.27 trn of Treasuries now. Amongst foreigners,
Emerging Markets central bankers and reserve managers own the bulk of it (out of total
$ 9 trn currency reserves). Differently than EM crisis in 80’s and 90’s, they now all sit on
large currency reserves. Critically, Emerging Markets are gripped in currency crisis on
fast depleting capital inflows, owing to large current account deficits and large
foreign ownership of local bonds. As they cannot easily and heavily hike rates, the
temptation could well be there to dump some Treasuries in defense of their
currencies. So far, only Brasil timidly attempted this avenue. India, Turkey, Indonesia
and the rest could well try this, with inevitable upside pressures on US yields. China too,
if the Renminbi ever comes into closer scrutiny. Surely, such dumping would be a
double-edged sword, as higher rates in US were catalyst to EM woes in the first place.
3) Discounting inflation target at 2%, 10-year US rates at 3% project a real GDP
growth of just 1%. Unimpressive, especially against the background of monumental
monetary injections: rising GDP expectations can easily justify rates at 3.5%-4%.
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The Structural Case for Staying Bearish and Hedging Tail Risks
Beyond short term noise and factor analysis, we want to try and isolate the root causes of today’s
market fragility, the way we see it.
So many other times in the past, the FED and other monetary authorities have attempted to
cure financial pandemics with heavily expansionary policies, trading one asset bubble for
another, creating the premises for the next coveted asset to fall victim of sudden deleverage and
overcompensation to the downside: just in the last decade, the looser policies following the tech
stocks bubble bust in 2000 led to the housing bubble in 2007, the bust of which led to the subprime
crisis and global deleverage, only for the looser policy then applied to lead next to commodities/EM
market bubble and then deleverage. The bubble in Emerging Markets was just the last Central
Banks’ unintended consequence in a long list of historical precedents, as EMs saw net inflows
doubling up to $ 8 trn in the last 5 years on ZIRP and QEs policies. Now again, a bubble has
inflated around Credit (especially government bonds) and equities (especially US) on the back of
heavily expansionary monetary policies.
As US President James Madison once said: ‘’The circulation of confidence is better than the
circulation of money’. The effectiveness of quantitative policies has always been about
perception and confidence. Any real mechanical linkage to neither sustainable equity valuations,
nor the real economy, has yet to be proven. To this day, the causality between monetary base and
financial valuations, between monetary base and economic growth, even between financial
valuations and economic growth (the Bernanke’s Portfolio Balance Channel), is nowhere to be found
in the observation sample of a century’s worth of data. While the FED and others claim to have
found a new way, these theories are still just at their crash test stage.
This time around, such linkages may even be proven right, but on such a timeframe which can
provide little help in managing today’s portfolios. We cannot help but to keep the focus on
historical empirical evidence, leaving the virtual reality described by monetary authorities to the
test of history. We prefer the prudent take of equipping our portfolio with hedging against the
severe downside risks which have typically followed similar market conditions so many other
times in the past.
The root cause of the market fragility is the accumulation of debt currently in progress, with the
inability to generate the income sources needed to service such debt overhang down the road.
Low interest rates are slowly hitting savings rates too, with even less firepower at hand to feed
consumer demand. As the FED accumulates Treasuries for $ 2 trn dollars and counting (and similarly
the BoJ and BoE do so), as such debt can never be dismissed easily, such overhang will provide a drag
to potential growth and real economic activity, the only variable which can lead to a sustainable
rosier outlook. To collect monumental debt with no capital stock growth or productivity gains in
return, is no different than building ghost towns in rural China and claim that a higher nominal GDP
growth was achieved in the process.
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No doubt further complicating the outlook, the real economy and the private sector in G4 countries
have not reacted to the illusory reality being proposed. Companies are not investing in capital stock,
in new ventures, nor are they hiring employees to grow new cash flows. If anything, they buy
competitors’ earnings stream, via M&A activity (and share buyback for share exchanges).
Consolidating industries, per se, lead to lower employment and higher debt metrics.
Debt is still to be repaid, and debt is higher than 1, 2, 3, 4 years ago. New debt from the public
sector (via QE and LTRO rehypothecation/financial engeneering) and the private sector (M&A, share
buybacks), with no new growth/real GDP/industrial production/real productivity to refer to for
the cash flows needed to service that new debt.
Critically, as we argue that perception and confidence is the main proven achievement to date of
heavy money printing, we also imply that blind trust and intellectual sclerosis is the real floor to
bubble valuations. But confidence is a double-edged sword, as it is evanescent, and can fast
dissipate as time goes by and more evidence is slowly gathered against it.
If such dogmatic trust were to abate, should the market wake up and smell the coffee of
policymaking ineffectiveness, then even lite- tapering or un-tapering would prove of little help.
The market could quickly realize that the safety net provided by Central Banks is not so safe after all,
depriving the market of its illusory floor.
Regrettably, it is impossible to call the day, the month, or even the quarter in which such
correction and reality-check may take place. Policymakers can indeed buy more time. Money
printing might still be in its early days, despite evident diminishing returns (tending to zero). For
all intents and purposes, we are left to rely on a sustainable multi-dimensional risk management
policy, intended to keep the guard high for long enough, being able to finance the renewal of
market protection strategies for the quarters to come.
At present, our task is made the most difficult as we have no significant carry generation within
the Value Book to rely upon in financing the cost of the hedging strategies. Ever since May, and
differently than in the last two years, we decided to keep the Value Book flat-ish, as carry strategies
would be exposed to digital downside risks in both equity and credit asset classes. When adjusted for
real risks, as opposed to deceptive historical vols, such carry strategies are a clear pass.
Consequently, the ability to fund and roll hedges and keep them alive for long enough will be the
key determinant of our ability to live to produce strong returns in the medium term.
Having discussed which risks we see possible in the remainder of 2013, let us offer an update on the
scenarios we do are currently hedged for.
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Investment Strategy: Value Book flat, Hedging Book active
Our positioning in the portfolio remains broadly unchanged:
1) VALUE BOOK: at present, our Value Book remains pretty flat, as markets remains
toppy despite their recent correction, still too expensive vs fundamentals,
especially now that rates may be on the rise and the Central Bank support shows
the first cracks. Our current small allocation to longs in the Value Book is filled with
select Special Sits which still offer asymmetric returns vs risks in our eyes. We will
change our bearish positioning once the disconnect between the real world and
financial markets tighten from here, as a consequence of market correcting further
or fundamentals improving (we remain skeptical on real growth recovery, as argued
extensively, but will remain open-minded as the situation develops and more data come
in). Also, we will change that stance if markets move side-ways for long enough
(which is just another way to digest their expensiveness, arithmetically equivalent
in real terms to a declining market if inflation is above zero). As argued last month
already, we have been in bubble markets similar to the current ones multiple times in
history: 1) the Credit markets are all too remindful of 2007 (at that time it was
Investment Banks inflating the bubble through leverage, this time it is Central Banks
themselves, with obviously more margin for error, but not infinitively so). 2) The Equity
markets, the Mothership US in primis, are remindful of conditions we have seen already
in 2007, but also in 2000, 1987, 1929, all followed by market crashes (we gave our take
on technicals/fundamentals for the US market in our previous Outlook on page 11: US
Equities have entered bubble territory). Let alone a sound risk/return policy, as we
observe that there has never been so much risk for so little return, over the last century
(long–only funds and Sharpe Ratio-driven allocators should feel the discomfort). We
suspect that the time for us to reload on long positions might be sometimes in Q4, as by
then the fundamentals might have improved to a level where they are visible, or they
will have stalled (as we suspect) thus forcing the hand of the FED to delay tapering and
a concurrent re-pricing of expectations around it.
2) HEDGING BOOK: on the other end, we currently see most of the opportunities in the
Hedging Book, and we banked on them in the month just past. As the market
misprices the potential for realized volatility to pick up from here and for ‘toppy
markets’ to be ‘gapping markets’ (Gold’s heart attack, Nikkei flash crash, next?). It
makes sense to us to be long volatility in such uncertain markets where rates cannot
possibly fall any further (and Credit can’t either in any meaningful way), where investors
go long on large margin, where shorts are cleaned out, and where silly talks of the
‘bondification of equity’ spread around. As early as September 2012, we were early to
say that equities would have been more ‘defensive’ than bonds (‘‘European Equities Will
Jump’ Video), as we migrated our book from High Yields into Equities; riding the bubble
of catch up rallies first (Europe), and Nominal Rallies later in December 2011/January
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2012 (US and Japan, currency hedged). We now dump that train too, until further
notice. Our methodology for Fat Tail Risk Hedging Programs should cover our –
currently small - exposure to the Value Book, while waiting for better valuations
before we reassess re-loading on longs. Amongst hedging strategies, on the list of
pre-identified scenarios in our Multi-Equilibria Markets roadmap, our top picks are as
a. Hedging against Inflation & Default Scenario / Equity Market Correction on
Bubble Markets: short the S&P, long VIX, short Japanese rates, short Yen. We
plan to augment hedges against Inflation Scenario as the year go by. As
monetary growth will lead to money supply growth sooner or later, as
money-supply would consistently exceed output growth, as credit-to-GDP
ratio deviates from its long-term trend (gap measure), we think it will be
proven wrong to have considered inflation dead. Inflation will have its day
again, soon enough, in our opinion.
b. Hedging against China Hard Landing Scenario: short Australian Dollar. We
are now adding new ways to gain exposure there.
c. Hedging against EUR-Break Up and Renewed Credit Crunch: Long Credit
Curve Flatteners, Short EUR. Also adding Long Inter-banking Spreads, Swap
Spreads, long Currency Pegs.
In terms of instrument selection, we follow our methodology for eligible instruments with target
multipliers on exit higher than 10X (and as high as 100X): Cheap Optionality first, but also Select
Shorts, Embedded Optionality and Dislocation Hedges.
We will offer an update on each one of those hedging strategies to current and potential investors
during our Monthly Outlook Presentation on the 19
of September in 55 Grosvenor street in
London, where supporting Charts & Data will also be displayed. Please do get in touch if you wish to
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What I liked this month
Federal Reserve owns more than $2 trillion in US debt. An additional $5.6 trillion — including the
amount held in China of 1.27trn — is owned by foreign entities, as of late June. Estimate the real debt
owed by the US is closer to a staggering $70 trillion: Read
Multiple Expansion, not earnings growth, Driving the Rally in U.S. Equities Research
Four economic indicators signal that US growth is off to a weak start for the quarter Charts
Fasanara Capital’s YouTube page now available: Videos
Sovereign risk: a world without risk-free assets? Working Paper
A Recovery In European Periphery .. In Burglaries! Chart
CEO & CIO of Fasanara Capital ltd
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London, W1K 3HY
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