Fasanara Capital Investment Outlook | February 1st 2015 1. Seismic Activity On The Rise 2. No Volatility No Gain 3. The Role Of Optionality 4. Crystal Ball 5. Deflation Is A Multi-Year Process 6. Three Big Trades for 2015

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“Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci

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February 1st
2015
Fasanara Capital | Investment Outlook
1. Seismic Activity On The Rise
When policy shifts increase in frequency, the likelihood of policy mistakes rises with
it. We expect 2015 markets to be erratic, volatile, potentially chaotic, characterized
by policy shifts, if not policy mistakes
2. No Volatility No Gain
Eventful markets carry risks but also uncommon opportunities. We do not think
such eventful markets are best played through defensive portfolio behavior. Avoid
the trap of a ‘timidity portfolio’. There is nowhere to hide.
3. The Role Of Optionality
Unconventional monetary and financial environment calls for unconventional
money management. To us, this is best played through cheap optionality,
convexity and heavily-asymmetric profiles
4. Crystal Ball
Our Target Levels for S&P, Nikkei, Eurostoxx, Fed Fund Rates, US Treasuries,
Bunds, BTPs, WTI, Gold, USD, JPY, EUR, CNH, inflation, spreads
5. Deflation Is A Multi-Year Process
Deflation is a process, not a data point. It takes years to reverse deflationary trends,
absent a shock. Deflation in Europe is just beginning
6. Three Big Trades for 2015
European Deflation Trades. Optionality in Peripheral Europe. Japan Entering
Second Phase of Abenomics

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Seismic Activity On The Rise
Hardly a month can go by with more events in it than the one just past.
- Equity markets moving down in size earlier on, to erase losses quickly afterwards,
erratically, and take a leg up on ECB’s historical move into heavy QE, after days of
fine-tuning it with orchestrated leakages and blitzes of communication to markets.
- SNB dropping the towel on unsustainable currency floor to the CHF/EUR (we wrote
how to position for de-peg CHF/EUR through Call Spread Options in 2012 and 2013 –
attached HERE, on pag. 14), provoking an epic 30% intra-day move on a major currency
cross, something which has the same probability of a new Glaciation on planet Earth,
when measured against historical volatility (i.e. how probability is measured by any risk
management VAR model nowadays)
- Bank of Canada and Bank of Singapore unexpectedly cutting rates, debasing
currencies and following up on the lead of BoJ / BoE / ECB
And the list goes on and on.. This month alone, the following Central Banks felt compelled to ease
monetary policy: ECB, SNB, Denmark, Turkey, Canada, India, Egypt, Albania, Peru’,
Uzbekistan, Pakistan, Russia. Yes, even Russia!
Actually, Denmark eased three times in the space of two weeks, in January.
Signs of desperation? Uncertainty reigns? Time will tell. One thing is for certain: when policy shifts
increase in frequency, the likelihood of policy mistakes rises with it. Accidents happen, when you
stay out there in the open for long. No wonder why Gold picked up on it, and started to give signs
of life after years of lethargy.
A few comments:
- Can we call the SNB policy shift a policy mistake? Yes, we can. Of course, the peg
was unsustainable. It was so already in 2012, when we first flagged up that FX reserves
had reached 60% of GDP (while China had been dubbed a currency manipulator for
much less). Of course, Switzerland was doing peripheral Europe no favor when buying
those 300bn+ worth of Euros while trying to debase their currency, at a time when (i)
Europe fiscal policy was tightening amid badly-sized austerity policies, (ii) monetary
policy was tightening (rates lower but ECB balance sheet shrinking by Eur 1 trn), and (iii)
EUR was appreciating (sole currency appreciating globally, even against healthy ones
like Norwegian Krone and, well .. Swiss Franc). So, a de-peg was overdue. Still, there
were several ways to engineer that, for triggering less of a 30% intra-day move. SNB
thought that cutting rates to -0.75% would have counterbalanced the effects of the
outright drop of the peg: they mis-calculated. In doing that, it provoked unnecessary
casualties in its reference market, the one where it is expected to safeguard price
stability. Most importantly, it lost credibility, arguably the most important asset of any
Central Bank. Without credibility, the leverage of any policy tool is debatable.

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- And what can we say of a Central Bank of Russia unexpectedly cutting rates after
having raised them massively lately, to stem currency implosion, inflation shock and
bank runs? With Brent Crude having floored for just 10 days (while WTI timidly testing
new lows), after losing 60% of its value, and perhaps reading itself for a further 50%
drop, with a Ruble 106% weaker than 6 months ago, such move is difficult to
rationalize. Probably not a policy mistake (in line with so many other EM Central
Banks), but surely proof of erratic behavior, making any investor uncertain whether to
hold that currency anytime soon, at any price.
- And what can we say of the Central Bank of Denmark being in the market every other
week with rate cuts? Have they grown bored of inactivity? Or do they not quite know
what needs be done yet, and try out some?
As we argued last year, seismic activity encompasses not just Central Banks’ activism. Within the
last 6 months, few more things happened:
- Japanese Yen, a major currency cross, debasing by 15% in a matter of few weeks,
following a widely-anticipated BoJ balance sheet expansion
- Inflation expectations (as measured by Inflation swaps, break-evens, 5y5y forwards), a
major macro indicator, imploded as never seen in decades. What is most alarming is the
speed of implosion, more than its magnitude. Monetary authorities behind the curve
and global structural trends at work (we discuss this here: VIDEO and READ).
- Oil prices, another major macro lever, imploded by 60% in 7 months only, without any
Lehman-moment, but actually within the framework of expansionary policies the
world-over. To us, such a major move is supply more than it is demand, and it is
geopolitics more than it is true markets. But still, a fat tail event, probability-wise.
- German Bunds, the bonds of one of the healthiest economies in the world, reaching
staggering 0.40% yield, on their possible way down to zero. 10yr Swiss govies are below
zero already.
Again, these variables are not side-pockets in the market or small economics. They rather are
major levers for financial markets globally. One cannot but expect that more eventful markets are
ahead of us, and we better prepare for it, mentally and portfolio-wise. Unconventional monetary
and financial environment calls for unconventional money management – we discuss this below.

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Now then, key questions for 2015 might be the following:
- Accidents happen when activism increases. Who will be next dropping its towel and
engineering a major policy shift? Danish Central Bank on evidently unsustainable
DKK/EUR peg? Or the ECB itself, should 5y inflation expectations become negative?
Inflation curve up to 1yr had already turned negative in early December.
- Who will be next bumping into a policy mistake? CRB? Russia itself, escalating
tensions? BoC? PBoC? BoJ? Governments in Oil producing countries?
EUR lost
~20% vs
USD
MAS
debased
SGD at
Unexpected
Policy
Meeting
RUSSIA
CB
UNEXPEC
TEDLY
CUT
YEN
DEBASEMEN
T by 15% in
few weeks in
Nov14
OIL PRICE
DROP from
$107 in Jun14
to $45 now
DENMARK
CB CUT
RATES
THREE TIMES
in 10 DAYS
US 10yr
TREASUR
Y DROP
30bps
intraday in
BUND RATES
IMPLOSION
from 180 to
30 bps in 1
year
ECB
ANNOUNCE
D open-ended
QE: 60bn EUR
monthly
EU
FORWARD
INFLATION
YIELD
IMPLOSION
SNB
SURPRISE
REMOVAL
EUR floor
Peaceful markets these
are not !!!
CALMABOVETHESTORM
INCREASING SEISMIC ACTIVITY,VOLATILITY SHOCKS LIKELY
CB of
CANADA
CUT RATES
unexpected

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- Will we see a -1% refi rate in Europe next? Rates have been negative in Switzerland
and Denmark for several months already. But those are small economies. What if they
turn negative in the largest economic block in the world? Most people would say it
cannot happen (banks are not even ready to handle it, operationally). Government
bonds look expensive now (we believe they are fair value now, when measured against
inflation and GDP prospects, and on their way to get expensive), but what if inflation
and rates go well into negative territory?
- Will we see Oil at 10$-20$ anytime in 2015? Saudi Arabia break-evens with oil at 8$,
while in excess of 80% of US shale producers break-even at 39$: both are lower than
numbers floating around these days. Indeed, market expects a rebound from here, as
indicated by contango (2015 forwards at 60$, 2020 forwards at 77$), production plans
(smaller cuts until contango holds), and Energy sector fwd P/E (the highest since 2002,
at 22.4). We may all agree that the price of Oil these days is geopolitically driven more
than falling because of weak global demand. What happens, then, if geopolitics drive it
south of 20$? Will it affect inflation expectations first, and drive more bullish and
inflationary QE? Or will it trigger corporates/governments defaults first, derailing the
QE’s plans and crashing markets as a Lehman-type event? What happens to Russia
then, and what reaction could it trigger? What happens in Nigeria, Venezuela? What
happens to energy majors if that is the case?
- Will we see the USD appreciating by cumulative 70% (as it did in early 80’s) or 50%
(as it did in late 90’s) anytime soon? And what happens to Emerging Markets,
Commodities, Oil, Rates, if that is the case?
- We may all agree that S&P equity market is over-valued vs fundamentals. We may also
agree that, should it fall by 10% tomorrow, it would still be over-valued vs
fundamentals. What happens then, if the S&P falls by 20%+ tomorrow? What impact
would it have on the reaction function of the FED? To animal spirit in the US? What
would then happen to the USD, the largest consensus trade of 2015? What to Oil?
o S&P mark expensive against fundamentals on so many metrics that worked
well on a century worth of data: P/E Shiller, Buffett’s Sales/GDP, Leverage
and Leverage/GDP, P/Sales, Corporate Margins/GDP, market internals,
disconnect to High Yield trend.
- What if Yen depreciation accelerates, and inflation actually do pick up in Japan first?
What if it triggers a VAR-shock on rates, and therefore ignites a bond avalanche? How
does it affect the reaction function of the ECB at a point where QE shows the ugly face
of its most-feared unintended consequence?
- What if China drops its peg to the USD first? What happens to the strong USD then,
and to all of its correlated consensus trades?
Can we really rule any of these outcomes out? Given seismic activity this far, and how January
got started, probably not. Is any of these outcomes a less than 10% probability event? Probably
not even that.

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No Volatility No Gain
Eventful markets carry risks but also opportunities. We do not think such eventful markets are
best played through defensive portfolio behavior. A defensive stance could have pushed into yield-
enhancement strategies such as selling minuscule volatility of a major Gold-like safe-haven currency
like the CHF, entrusting the iron credibility of a grown-up Central Bank like the SNB: it would have
been an unmitigated disaster, and so it has been for a few unlucky ones, as events unfolded. There is
little safe spot in a market – and an economy for that matter - which navigates into uncharted
waters as the one we live in today. There is nowhere to hide.
Government bonds are safe haven? If rates on 10yr Bunds go to zero and then negative, they will be
less and less so, evidently.
And look what happened this month to VAR-adverse pension funds invested into government bonds
in Japan. 30yr JGBs yield move up 30bps on no notice, in isolation (the 10yr JGB stood still, driving
the 10yr-30yr spread sharply higher). The same can happen, and it will likely happen, to long-dated
US Treasuries and Bunds, at some point down the road. Surely.
This is no strong argument for not owning US Treasuries or German Bunds. We actually like both and
think they will tighten further from here. This is just to say that volatility shocks are to be expected
and managed, as opposed to avoided outright and have no part in the trade. It won’t be as easy as in
the past to avoid volatility this year, and still produce an acceptable return on capital.
Cash is the only asset classes with low volatility left out there. In a deflationary world it is not that
bad of an investment either. But one has to accept having capped its potential nominal upside to,
well.. ZERO.
Our election is for stomaching more volatility than usual, in an attempt to have part in the
upside. In markets like these, upside is substantial, and warrants taking on higher volatility.
‘VOLATILITY’ does not automatically equate to ‘RISK’ (see EURCHF), but it can turn out to be,
surely.
As always in life, no pain no gain. In markets, to us it reads as ‘no volatility, no gain’. Avoid the trap
of a ‘timidity portfolio’. As Howard Marks says: ‘if you can’t lose, you can’t win’.

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The Role Of Optionality
As argued above, unconventional monetary policy and financial environment calls for
unconventional money management. In our opinion, this is best played through cheap
optionality, convexity and heavily asymmetric profiles, whenever available and in line with the
macro backdrop we project. Luckily, despite seismic activity being on the rise in the market,
Central Banks’ activism has depressed volatility. We live in a market environment characterized
by low implied volatility (still) and high cross-asset correlation (especially to the downside). Such
combination can be taken advantage of, via building asymmetric profiles in optional format.
Such asymmetry can provide one’s portfolio with the necessary convexity to navigate uncertain,
unstable markets, still have risk on and the potential for losses, but also be wide-open to the full
upside potential on volatility shocks. The volatility can be substantial, some risk remains,
inevitably, but at least the upside is few times over the risk undertaken.
Here below, we highlight some of our cheap optionality positions. It is a treasury of optionality,
which we amass in growing quantities over time, as each becomes available and hits pre-defined
entry levels. We call them Tail Risk Hedging Programs (‘TRHPs’). We once called them ‘Fat Tail Risk
Hedging Programs’, but we now took out the ‘Fat’ connotation, as most of the strikes on our optional
positions are only marginally Out-Of-The-Money at inception, if not At-The-Money.

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Such positioning helps us taking into account the intersection of different scenarios, multi-
dimensionally. Here below what we own in few scenarios in a wide variety of optional formats.
We have elaborated on this concept extensively in previous write-ups, so we will roll quickly to a
conclusion. A description of the Tables above can also be found in the VIDEO RECORDING of our
latest OUTLOOK PRESENTATION at the link HERE.

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Crystal Ball
Having spent a thousand words explaining how difficult it is to predict markets in 2015, let us
now try to do just that! Please find below the levels we have in mind at some point over the
course of 2015:
- S&P closing the year at 2,100-2,200 (from 2,000 today). Which means limited upside,
although on a rougher ride than last year. Implied volatility VIX closer to 20% than
14% (average 2014). More than four sell-offs of 5% to 10%. Potentially a larger one
along the way. Last year 5% to 10% sell-offs took place in Jan, Aug, Oct, Dec.
o We remain overall positive on the S&P, despite bubble levels disconnected
from fundamentals and the headwind of corporate margins / sales affected by
a stronger USD. This is because of the FED remaining active (their balance
sheet is still expanding as we speak), remaining concerned of the impact of a
larger draw-down on the animal spirit (‘Portfolio Channel Theory’ of
Bernanke), and the tailwinds of a much cheaper Oil (great for price-elastic low-
income households and businesses and non-energy Capex), and lower rates for
longer (boosting P/Es and net present values, in addition to helping leverage
and margins preservation). A robust economy driven by internal demand helps
too, but that alone would not suffice, as valuations are stretched, well above
what the fundamentals of a robust economy would dictate.
o Perhaps, the real issue for the S&P may come when the market perceives that
the USD strengthening trend is close to be over. Then, expected real returns
for investing in S&P would be sub-zero, as the positive impact of an
appreciating USD cannot be priced in any longer.
- Eurostoxx closing the year above 3,600 (from 3,350 today), although on a rough ride
too. Implied volatility V2X closer to 25%/30% than 18% (average 2014).
o Boost from ECB’s QE. The 20% risk sharing rule is irrelevant. Target II System
balances are a dominant factor - true mutuality feature within Europe. It
assumes our baseline scenario of Greece/Grexit risk abating, and not
managing to derail the European bandwagon. We remain negative on the
prospects for the economy, although some pick up in economic activity seems
likely and in line with the pick up unfolding in credit formation across Europe.
- FTSEMIB above 25,000 (from 20,500 today) at some point in 2015. Possibility for
snap elections to be called by Italian government in 2015.
o Electoral law is ready and a new President has been elected, paving the way for
surprise elections. Unemployment unexpectedly improved as of late, and
consumer confidence seems on the rise. ECB’s QE expected to drive down real
rates and still large real rates differential within Europe. Positive.
- BTPs 10yr yield at ca. 1%, from 1.60% today. BTPs/OATs spread at 0.60%, from 1.15%
today. Laggard.

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o Deflation, deflation, deflation.. within the debt mutualisation framework of a
ECB having capitulated to its role of ‘lender of last resort’, forced into it by
Deflation itself
- Bunds 10yr yield at 0.00%, from 0.40%, below Japanese JGBs (currently at 0.25%),
and possibly going negative (-1%).
- OATs at 5 basis points over Bunds.
- Bund 10y-30y spread at 40bps (from 70bps today), possibly turning negative.
- US Treasuries 10yr at 1.00% (from 1.7% today), 30yr at below 1.70% (from 2.30%
today).
o The best carry trade available globally. Strong credit risk, nice yield, no
inflation risks near term, real yield appealing when adjusted for likely
strengthening of the currency
o Scarcity value: 50% of all government bonds globally yield less than 1%
o Global supply / demand for bonds in favor. As Central Banks crowd out the
private sector, global demand outstrips supply by ca. $ 600 bn in 2015.
Demand for bond is expected at 2,5trn in 2015. Collateral shrinkage is one
more weapon firing in the same direction
- AUD 10yr govies at below 2% yield
- 5y5y UK Inflation at below 2.5% (from 3.1% today)
- 5y5y EUR Inflation at below 1% (from 1.6% today)
- FED Fund Rates at 0.50%, FED to hike rates, but only moderately so. FED to deem
current growth/job mix good enough to slowly normalize rates, so as to create some
buffer for the next downturn in activity. FED already tested for this at the end of 2014,
when withdrawing $400bn from monetary base with large term-deposit operation,
squeezing up effective FED fund rates in the process. No ‘rate tantrum’ there.
- Nikkei at 20,000, from 17.500 today. Currency debasement, regulation-driven flows
(GPIF and friends, in a 2trn$ pension fund industry invited to relocate to equity), and
some genuine momentum improvement in corporate profitability.
- JPY at 130 vs USD, from 117 today. Currency debasement, in progress (no new
injection needed, although likely).
- EURUSD at 1.05, from 1.135 today. Consensus.
- EURJPY at above 145, from 133 today (ECB will print $700bn this year, Japan is printing
800bn$, for an economy which is less than 30% of Europe’s economy, while having 2x
its inflation, a lower current account surplus, both in absolute and relative terms, etc)
- Gold at above 1,400, from 1,270 today. Upside risk.
- EUR at below 0.95 vs CHF, from 1.04 today. SNB to fail again.
- CAD at above 1.30 vs USD, from 1.28 today.
- CNH below 6.20 vs USD, from 6.28 today.
- Brent Crude at below 40$, from 51$ today, possibly overshooting to below 30$.

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- Athens Stock Exchange 20%+ up. Greece is a macro call, now more than before. We
remain positive on rational behavior prevailing and a compromise be struck.
o Debt forgiveness is a false issue, and can easily be achieved through interest
payments being cut further from current Eur 8bn annually, the financial
equivalent to haircuts in net present value terms. Debt ratios are to worsen
anyway, not just for Greece but Europe overall owing to negative inflation
rates (as we argued HERE, deflation is death penalty to debt-laden countries).
With QE having put to bed ‘debt vigilantes’ for the time being, headline
debt figures are kind of irrelevant. Debt rules can easily be adapted. What
matters is concession on primary surplus, which is now what is truly
transferred to creditors on a yearly basis, as opposed to be distributed on
Greece’s welfare. At 4.50% it is unsustainable for Greece, and would not yield
the desired effect for Troika anyway as it is achieved through shrinking the
economy (shrinking out of debt in pointless). A primary surplus threshold at 1%
should make both parties content. At present, European authorities have way
more to lose than Greek authorities, making the case for a compromise a
genuine one. As most of their debt is owned by foreigners, Greece threat to
default is a credible one. Should Greece leave the EUR-peg, they may re-
emerge just fine 2/3 years from now, showing there is life after the EUR, which
would make for a serious blow to the EUR construct. Troika badly managed
negotiations with former government, playing hard-ball and consigning the
country to a more radical government. As Spain’s Podemos turtle trades
Greece (and goes to polls later this year), Troika may change course this time,
avoid further damage and compromise.
o Why is Deflation a game changer for European policymaking? Refer to note
(1) below.
Our levels for end-2014 can be found HERE. Please consider these new levels purely an exercise of
imagination. As fund managers, we are not only ready but committed to change up our mind and
portfolio positioning at no notice, to adapt to a changing market environment and incoming data.
Especially so in 2015 markets, which we expect to be erratic, volatile, potentially chaotic,
characterized by policy shifts, if not policy mistakes. Critically, it is not only difficult to predict
which scenario is more likely, but more importantly which event will happen first, and affect events
down the line of the binomial tree. Competitive policies will collide against each other, and force
other actions in retaliation/defense. Who will move first? What will happen then? Which accidents
along the way? Path-dependency will affect future outcomes, this year more than last, as we
price in more chaos for 2015.

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Deflation Is A Multi-Year Process
Deflation is a process, not a data point. It takes years to reverse deflationary trends, absent a shock
of some sort. Last year, we argued that Deflation in Europe is just beginning (link to article can be
found HERE).
Our views have not changed now that the ECB committed to open-ended massive QE monthly
infusions, above market expectations. We believe the ECB is behind the curve, late in the game,
facing global deflationary trends, and therefore unable to anchor inflation expectations.
Inflation expectations are indeed falling and we expect them to reach new lows. Therefore, we
maintain our views and positioning for Deflation Trades within our portfolio.
We expect:
- Rates to reach new lows, turning negative on some core Europe up to 10yr maturities
(at present 20% of government bonds in Europe is already in negative territory, for a
total of Eur 1.4 trn worth of securities)
- Spreads cross-markets to compress to shallow levels
- Interest Rate Curves to flatten further
- Equities to melt-up, first
True, rates are already very low. And it feels like picking up dimes in front of a steamroller. However,
government bonds in Europe, for example, are less in bubble territory now than they were in
2012. At the time, inflation had peaked at 2.6%, and GDP was low but somehow meaningful.
Now both of them stand at periodic zero.
We made our case in a recent CNBC interview (VIDEO).
We wrote: ‘rates are at a multi-year low in Europe: in Germany at the lowest level in 200 years, in
France at 125-year lows, in Holland at 500-year lows, in the US at 220-year lows’. That was 2012,
sadly. Since then, they could still descend.
Are we sure, today, in Europe, that the zero line is a floor? Is it where the journey ends?

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Fasanara’s Big Trades 2015
Please find the link HERE to the video recording of latest Outlook Presentation, where our top trade
ideas are described.
Three Big Trades for 2015:
o European Deflation Trades
o Optionality in Peripheral Europe
o Japan Entering Second Phase of Abenomics

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What I liked this month
Europe on its way to being the new Japan - Larry Summers VIDEO
A New Ceiling For Oil Prices – Anatole Kaletzky READ
Highest Forward P/E Ratio for Energy Sector since 2002: READ
Denmark EUR-peg at Risk READ and READ
What Happened at the SNB: READ
W-End Readings
Managing North Korea’s Collapse READ
China’s Slow Down: From a Very Big Base READ
Monetary Policy: the Great Illusion READ
Arnold Schwarzenegger amazing story: VIDEO
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 to be held in the next few weeks. 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.
Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
Twitter: https://twitter.com/francescofilia
25 Savile Row
London, W1S 2ER
Authorised and Regulated by the Financial Conduct Authority (“FCA”)

16. 16 | P a g e
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NOTE (1): Why is Deflation a Game Changer for European Crisis Policymaking
Deflation is a game changer because there is no chance of survival for heavily indebted European
countries (especially in peripheral Europe but not only) in a world where deflation takes hold. The
debate over austerity / fiscal balances / spending cuts / return to competitiveness loses any
relevance in the presence of deflation. No matter how virtuous one’s cycle can get to be, debt
ratios deteriorate at zero inflation. As a logical and conclusive proof, take Italy as an example: despite
austerity cuts and a primary surplus of ca. 2% of GDP (best in Europe), debt/GDP is worsening and
dangerously approaching 140% on the back of zero inflation and stagnating GDP.
The reason is mathematical before it is anything else. GDP cannot run at past glory days as credit
acceleration in the economy is well past its peak, and its marginal effectiveness. Inflation then is key. As
a country, for your debt/GDP to improve, and therefore for debt to represent less of a drag on your
economy, primary budget balances have to exceed the difference between real GDP growth and real
interest rates on public debt. For the same amount of shallow GDP’s growth, if inflation is zero or
negative, real rates rise and debt/GDP worsens.
It follows that for Italy would need a primary surplus of ~8% if it wanted to stabilize its debt/GDP at
zero inflation. Trying that would be suicidal, as deflation would get even worse as a consequence.
Which means more austerity and more contractionary policies, to cause more internal devaluation than
it is currently the case, more declines in unit labor costs, more salary cuts, more unemployment, less
consumer spending, less corporate investments. The absurdity of it should suffice to close the argument
here. In conclusion, zero inflation is like death penalty to debt-laden countries.
Critically, it also follows that price stability in the Euro Area can be blamed at least as much as
dissolute fiscal policies in peripheral Europe. In other words, European authorities can blame
peripheral Europe for years of reckless budgets as much as peripheral countries have a right to blame
European authorities for allowing inflation to reach the zero bound, thus making anything now left in the
control of said countries totally irrelevant.
In the same context, it should also be noted that Germany’s current account surplus is to blame as much
and more than France’s deficit on GDP. As is known, imbalances on both sides (deficits but also

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surpluses) are regulated by European rules. Here then, Germany’s surplus at over 8% of GDP (according
to IMF) exceeds the threshold for EU sanctions (EU Macroeconomic Imbalance Procedure sets it at 6%)
more than France’s deficits exceed deficit parameters (at 3%).
Most obviously, all this is said in reference to the dominant political debate holding the stage in Europe,
in between German orthodoxy / austerity measures, and the opposing views of debt monetization
through ECB Quantitative Easing policies / possible monetization of fiscal deficits down the road (a’ la
Japan, which Europe looks so much like). More on this debate in the next section.
For all these reasons, we think deflation is a game changer and it has forced the ECB into bold
activism, to be increased going forward as it is too little too late, in an attempt to avoid a fully-
fledged debt crisis, a long period of Japan-style depression, and an implosion of the EUR fixed
currency regime.
If the ECB is to avoid defaults and debt restructuring in Europe, it must engineer financial repression
and debt monetization. A more subtle form of default, but still a default, as it curtails the value of fixed-
income claims as surely as a default. That entails driving real rates below nominal GDP growth. As
Europe’s growth is a flat zero, real rates must be negative to achieve this. At present, there is only one
country globally achieving that - and they might still fail: Japan (Chart attached).
For all that matters, we believe such efforts have a decent chance of failing. We think the EUR
currency experiment may likely implode few years from now. At current rates, the structure of
Europe is both instable and unsustainable. Nevertheless, meanwhile, efforts will be made to avoid
such end-game, pushing up bond and equity prices first.
Extract from our September Outlook again: ‘’Whether it is going to be enough to avert a
currency/debt crisis in Europe in the long run is a different matter. We think that there is a
genuine case to be made for seeing dissolution of the currency union down the line, in an
attempt to save the European Union. Early days to visualize that, though. What matters to
the financial markets is the next twelve months - the foreseeable future - and we believe the
next twelve months to be highly supporting of financial assets in Europe, both bonds and
equity.’’
‘’Incidentally, we have for European assets and the ECB the same feeling we have for
Japan and the BoJ. Abenomics has a high chance of failure, in the long term. Nevertheless, on
the road to perdition, chances are that efforts will be stepped up and more bullets shot in an
attempt to avert the end game. As stakes are raised, financial assets will be supported and
melt-up in bubble territory, doing so at the expenses of a more turbulent end-game in the years
ahead.’’