Fasanara Capital | Investment Outlook | October 7th 2013
“Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci
October 7th 2013
Fasanara Capital | Investment Outlook
Beware of blue-sky markets, when the only price they are prepared to pay for
uncertainty is a slowdown of the rally.
We maintain our view for Japan-style volatility to permeate markets in the months
to come. Artificial markets are structurally fragile. Renting rallies, while keeping
overlay hedging strategies in place against sudden adjustment to the downside,
remains our elected investment strategy. Stay long, but only tactically so. Stay overhedged.
In Europe, the tail risk of Italian elections has only been postponed. Still, we are
constructive on Europe in the short-term, especially against the US. Long-term, we
believe the case for a break-up of the EUR remains a genuine one.
In the US, we expect rates to drift lower going into the heat zone of Debt Ceiling.
Once new recent lows have been established in rates, we plan to try and reverse
course and position for somewhat higher rates, in more sizeable amounts.
Longer-term in the US, if we are right about the lack of economic growth remaining
the elephant in the room, then after tapering lies more Quantitative Easing. Perhaps,
the new entry monetary tool of 2014 will be Nominal GDP Targeting. Which means by
then the sea level of asset prices will be increased once again. Visible inflation is
better than stagflation.
VALUE BOOK, remains flat:, as markets are toppy, still expensive vs fundamentals, at
risk of a 10%/20% steeper correction. HEDGING BOOK, active: short S&P, long VIX,
long Credit Curve Flatteners, short EUR, Long Interbanking Spreads & Currency Pegs,
short JGB rates, short Yen, short Australian Dollar. TACTICAL BOOK, expanding: long
Europe vs US in equities (similarly to September 2012), long China-led stocks and
commodity for short term reflation to continue.
Beware of Blue Sky Markets
In the last few weeks, in spite of several risk factors at play simultaneously, markets remained
broadly directionless, volatile within their recent range bound, across Equity and Credit. Not so
much because they are unsure as to the direction to take from here, but rather because the only
price they are prepared to pay for uncertainty is a slowdown of the rally.
Despite the specter of Italian elections in Europe and a prolonged government shutdown in the US,
leading straight into another standoff on Debt Ceiling, equity markets kept hold of their cool,
remaining optimistic about positive resolutions on all, and standing ready to grind higher.
In fairness, while such risk factors are in action mode, others have meanwhile been defused:
September tapering got postponed, possibly into next year, while Summers left the race to FED
chairmanship. Both elements speak of sustained government support to financial valuations, as the
mother-ship Central Bank keeps the gates of liquidity to Wall Street wide open.
That is, markets put dogmatic trust in the parachute offered by monetary authorities, and do
not even flinch as they look down the barrel of the gun of potential government defaults, neither
in the US nor in Europe. We could not get better indication of widespread overdose of optimism
than the one we got this past month. As fundamentals speak of a different world, markets bought
fully into the rosy picture depicted by the FED for GDP growth come 2014.
None of this is to say that we see events turning for the worst, neither in the US nor in Italy (in the
short term). However, we surely look at markets’ over-bullishness as a connotation of fragility. As we
recently argued (CNBC Interview) we maintain our view for Japan-style volatility to permeate
markets in the months to come. Artificial markets are structurally fragile.
Renting rallies, while keeping overlay hedging strategies in place against sudden adjustment to
the downside, remains our elected investment strategy.
Artificial Markets are gapping markets. Stay long, but only tactically so. Stay over-hedged.
We attach the link to the recent Investor Presentation we held in London two weeks ago, where
Charts & Data were provided for the analysis summarized in this Outlook (Artificial Markets are
Structurally Fragile | Investors Presentation | 19th September 2013).
Short-Term Outlook For Europe:
Italian Elections Off-The-Table, But For How Long?
Let’s start with Italy, where last month we argued: ’’as per 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
It ended up playing just along those lines. If not for two unexpected elements, one political and
one market related.
Surprisingly, while we thought Berlusconi’s party was to stand by him at all costs until
the end, some of it decided instead to part ways in what they thought was going to be
his final hour. It is not for us to opine on politics and have a view on whether or not this
is game-end for Berlusconi. We suspect not, as he still commands large popularity.
However, as elections are postponed into next year, he may not be in a position to
monetize that value soon enough (for he may be banned from public office
beforehand). Surely, while the government coalition remains crystal-fragile, the
iceberg of a fully-fledged crisis has been sailed around this time.
Surprisingly, while looking at a critical confidence vote the next day, as new
elections loomed, the reaction of the markets was just subdued.
The market resilience in the face of adversity was yet another proof of its total deafness to risk
bells. As we argued here (CNBC interview Oct.3rd), the market may have been too complacent those
days. New elections could have put chain effects in motion, such as:
The only Rating Agency with a single A- rating on Italy is the Canadian DBRS. Last
time around, DBRS downgraded Italy upon new elections. Losing a single A rating is no
small deal, it is a trigger. When haircutting BTPs held as collateral, the ECB takes into
account the best rating of the four agencies. Should Italy lose that single A rating, the
average charge on a 5yr BTP would suddenly rise from 1.5% (where it is taxed in line
with Bunds) all the way to 9%. An higher haircut is bad news to the local banking
system, already stretched with funding, let alone capital.
As LTROs got repaid for Eur 300 bn (on total Eur 1 trn) and some deleverage took place,
excess liquidity in the banking system in Europe compressed to ~Eur 210 bn. The
ECB estimates at Eur 200bn the threshold for tightening pressures on EUR short rates.
A new LTRO is therefore needed, or else stress in the inter-banking market is to be
expected, especially to Italian and Spanish banks. Yet again, what would have been the
likelihood of the ECB offering a new LTRO if Italy was to go into new elections, in most
uncertain outcomes, encompassing anti-EUR parties (which accounted for 25% of the
votes last time around)? It all revolves around the independence of the Central Bank, I
guess. As Germany may not have taken the risk of handing out that cash fast enough,
Adding fuel to the fire, Cyprus is the blueprint for the next crisis. Bail-in is the name
of the game. Bail-in means bondholders contribute to a bank rescue by writing down
part of their bonds. Any restructuring goes through the need to haircut certain classes
of bondholders (maybe all) and certain classes of depositors too. Not only for peripheral
Europe: SNS Reaal, suffered the same fate, despite being located in core Europe,
Holland that is. The market seems to have forgotten that completely. In spite of the
European Commission confirming it as recently as in August, when saying that ‘State
aid must not be granted before equity, hybrid and sub debt have fully contributed to
offset any losses’. Rephrased, there can be no aid for any bank anywhere in Europe,
unless there have been haircuts first. The European Commission has full executive
power over State Aid rules in the EU, legally binding, no need for ratification by any of
the member states.
Once the chain effect had been ignited, there was no telling where it would stop.
Such concurring elements were defused right before hitting the wall, at the last quarter mile.
Markets held their breath, then brushed it off all too quickly, deducting it had never been a real
threat. Over-optimism reigns over blue-sky markets.
For what is worth, there was a cheap way to hedge back then, providing for heavily asymmetric
profile, which goes as simple as being long Bunds vs BTPs, just across those few hours. At a
spread of approx. 250bps, a potential positive resolution to the crisis was fully priced in (and indeed it
did not tighten much right afterwards). In contrast, were new elections to be called, the spread
widening could have been sizeable.
Such strategy may become relevant all over again when new elections are called out of Italy. We do
believe that Italian elections have only been postponed: as the government remains flaky (and
flakier than before), the economy keeps imploding (as deficit tightens only due to contracting
aggregate demand), debt/GDP worsens (to 130% at year-end), youth unemployment keeps
rising (from Weimar-style 40%), ECB remains missing in action (let alone cheap talk). Next time
around, the entry point on such hedging position might even be at a tighter spread of ~150bps,
courtesy of the ECB soft talk and market over-bullishness. We plan to use this or similar
contingency arrangements to sail through the next risk zone with a full hedging kit equipment in
place. Forewarned is forearmed.
Long-Term Outlook For Europe:
The Case For Staying Hedged Against EUR Break-Up Risk
Talking of instability and un-sustainability of the current state of affairs of the EUR as a currency peg,
we argued in the past how difficult it would be for the rebalancing of competitiveness across the Euro
Area to take place via Internal Devaluation only, in the impossibility of resorting to any external
depreciation/currency adjustment. We argued months ago that, in spite of ~40% youth
unemployment in Italy and Portugal, ~60% in Spain and Greece, such rebalancing requires salaries to
being cut some additional 40%: difficult to imagine. Moreover, that was true when the EUR was 1.28
to the USD. How more unlikely did it get now that the EUR is 1.36 and appreciated against any other
currency globally? How much more pain is needed in Internal Deflation to fill up gaps in
competitiveness? How much more pain is tolerable before it is not?
Italy did not experience 40% Youth Unemployment during the Great Depression of 1929. It is doing
so now. While losing 10% in actual GDP in 5 years.
Again, ‘’the fact that the fear of destruction, either in the form of widespread unemployment,
civil unrest or sequential failures, is preventing the EUR currency peg from being dismantled,
must delay the final extinction of the currency, until such same destruction is to happen anyway,
under the squeeze of an overvalued currency, overleverage and current account deficits’’.
Contrary to what we hear all around, forming the consensus view, rebalancing across countries
is not taking place. It is certainly not happening at an acceptable speed, when compared to the
accumulation of total debt in the system undergoing. Let’s look at numbers. Current account surplus
for Northern Europe stands at Eur 500bn. Germany's surplus keeps expanding and now represents
7.5% of GDP, from 6% last year. This is making Southern Europe no favour: the need for looser policy
on the part of Germany fell on deaf ears. Elsewhere, the shrinking deficit in Italy and Spain is
misleading as is achieved by the contraction in the economy and a fall in domestic demand - which
only incidentally reduces imports. Critically then, France's deficit is on the rise at 3.5% of GDP. At
current rates of change, before having Italy and Spain look like Germany, we will have France
look like Italy and Spain.
Interestingly, Italy looks all too similar to Japan. Over-indebtness, declining economy,
demographic drag on GDP (at least 0.5% yearly), too strong of a currency. At least Japan has the
tools (debt monetization/currency debasement) and the willingness (political leadership for
structural reforms) to have a shot at a different future.
Again then, as repeated ad nauseam, we remind ourselves of hard data evidence from the past: ‘if
history is any guide, three conditions were met in past currency crisis and emerging market
crisis: an over-valued currency (read, the EUR to countries like Italy and Spain), over-indebtedness,
as a share of GDP or the productive economy (rephrased, too much debt and no growth against it),
and current account deficit. By any objective criteria, all three levers are met for certain countries
in southern Europe, making the case for a reshaping of the EUR-fixed currency regime a genuine
one. In advanced economies the readjustment may be slower to occur than in emerging economies
(as we learn from the attached interesting piece looking at past banking crisis), but it may still do
occur over time, including a currency-driven one.’
Short-Term Outlook on the US:
Tactically Trading Around Government Shutdown / Debt Ceiling
The attached article on Game Theory applied to Debt Ceiling makes for a fun reading: 'If I say “Row,
or I’ll tip the boat over and drown us both,” you’ll say you don’t believe me. But if I rock the boat so
that it may tip over, you’ll be more impressed.' (read)
The market consensus is that the Government Shutdown will not produce any lasting damage, while
the Debt Ceiling risk is not for real. We agree with consensus. However, when consensus is one-way
widespread there is clearly room for volatility.
Trading tactically around the debt ceiling might provide opportunities. We will use our Tactical
Book to try and do that. We are currently positioned for lower rates going into the deadline, as risk
aversion might procure a similar environment to the one experienced in August 2011 (although less
pronounced, as it is widely anticipated, this time around, and the surprise factor is missing). If we and
the consensus are right over politicians finding a solution in extra time, then such possibly lower rates
may provide an excellent entry point for the reverse position, as we believe rates are going to be
higher come 2014. Best curve place to us to play the view is 5 years.
Thus, we expect rates to drift lower going into the heat zone of Debt Ceiling discussions. Once
new recent lows have been established in rates, we plan to try and reverse course and position
for somewhat higher rates, in more sizeable amounts. We do believe that the tree of potential
outcomes will plan out as follows, by then:
No Debt Ceiling disarray: as soon as debt ceiling discussions are past us, we may
possibly see the FED chairmanship confirmed, and the market may start focusing again
on tapering. As we argued extensively, while delayed, tapering is taking place. That is
what matters, more than the specific month it gets initiated at. To us, tapering should
take place because QE is ineffective and comes at outsized risks and unintended
consequences, while not yielding any commensurate result in the real economy. To the
market, tapering should take place as rosy GDP prospects are round the corner, come
2014. Whatever the motives for tapering, tapering brings with it higher long-term rates.
Debt Ceiling leads to technical default: in the unfortunate/unlikely case in which
irrational political behavior prevails over economics and common sense, bonds may get
sold for nobody likes to hold paper in the presence of a technical default (as Bill Gross
noted). Starting with the reserve managers of the Emerging Markets, as they account
for the bulk of the $5.6 trillion of Treasuries owned by foreign entities, as of late June
(including China at 1.27trn).
It should be noted that the duration of the government shutdown/ debt ceiling impasse is a factor
too: should its duration be too long, the impact on GDP and the call for more prolonged QE cannot
be ruled out. In such instance short rates positions are more risky than otherwise.
In the equity markets, we suspect that multiple mini-rallies might take place as news of an
agreement filter in, only to be disappointed as more negotiation is needed right behind. As
volatility is cheap, especially on high strike calls, those patterns can also be played out
opportunistically. That is what we intend to do for the coming days/weeks.
Long-Term View for the US:
Tapering First within 6 months, then no tapering, then NGDP?
On June 28 we wrote: “ if we are right about the LACK OF GROWTH being the elephant in the
room, then Bernanke will be next confirming QE and delaying tapering’’. On Sept. the 3 we
confirmed: “Tapering may get postponed by a few months, leading to a short-lived, relief rally. So
much for the potential nominal rally we see possible in Q4”
The reason why we expected Bernanke to delay tapering, has to do with our skepticism around the
quality of the GDP growth and the sustainability of it. We view Bernanke’s decision as
confirmation of our assumptions on real economic activity, in contrast to market consensus. The
FED seems to believe extraordinarily measures are still indeed needed. GDP growth is weak and
shallow at best, far insufficient to fund the huge funding gap created by additional debt inherited
from QEs policies. The market may realise that at some point. The market should realise that as
some point. That may lead to the steep re-pricing we see possible (benchmark for it is a 10-20%
downside on S&P, possibly digitally so).
We expect Japan-style volatility. We therefore plan to stay fully hedged (CNBC Interview).
If we are right about the lack of economic growth remaining the elephant in the room, then after
tapering lies more Quantitative Easing. Perhaps, the new entry monetary tool of 2014 will be
Nominal GDP Targeting (NGDP). Which means by then the sea level of asset prices will be
stepped up once again. Visible inflation is better than stagflation.
Fast-Forward there, and inflation might look less of a prehistoric fossil than it looks today. Fastforward there, and Gold could have its day again, within 2014.
If Japan is any guide, once total debt/GDP private and public is well above 500% (UK there
already), there is little else to do but desperate debt monetization and heavy currency
debasement. You are boxed out in the corner, as higher rates are a Damoclean sword pending down
your neck, while the drag of indebtedness in real terms on economic growth is unbearable, calling for
more financial repression and negative real rates.
China’s Bumpy Road Ahead
Recent data shows that China resorted to the bad old habits of fixed investments to ring-fence
growth from an inevitable decline. August exports and industrial output came out stronger than
expected. Interestingly enough, however, construction starts fell 20% yoy. Typically, residential
housing was leading the way of Chinese GDP growth. Has china found a new way of growing through
manufacturing and industrial investments? We doubt it. To us, this is one more reason to cast
doubts over the sustainability of this short term reflation in china.
We did some research the Imperial College library in London this week end. Early Saturday morning
and 90% of the many students at work around us are Chinese. Not any significant observable sample,
obviously. But if it was just because it is week end (where commuters go home) and early morning,
then it would be even more telling. There can be little doubt that the future speaks Chinese.
Across Asia, middle-class population will increase by 1 billion people in the next 10 years. This single
statistic may say it all (article).
We convene that China is going to be the driver of growth in the next 10-20 years. However, we
expect the next two years to be problematic, as the country works out its delicate rebalancing
from export/fixed investments to a domestic demand -driven economy. The excesses in the credit
system, the sheer magnitude of Corporate China indebtedness (120% plus of GDP, well above...) will
be exposed once GDP growth falls from the diving board of unsustainable 7% GDP growth. We
discussed this at lengths last month (September Outlook).
In summary, in China we hold a barbell type of view; positive in the short-term (artificially so, as
fixed investment habits are hard to die), negative for the next two years (as credit excesses are
exposed in a rebalancing economy), positive again in the next decade (as demographic factors,
GDP quality catch up, and reserve currency status take hold).
Japan: Interesting Q4 Ahead
Not enough space and time to discuss Japan in this Outlook, although we believe the next quarter is
going to offer valuable opportunities. In this respect, good entry levels might materialize for the
hedging book re Japan. We aim to discuss more on Japan at the next investor presentation.
During the latest Investor Presentation, we provided examples of positions over the 3 books in our
portfolio (Artificial Markets are Structurally Fragile | Investors Presentation | 19th September 2013).
Remains light, as we see a risk of
10%+ correction over the medium
In absence of sustainable carry
generation in the Value Book
Tactical Long EuroStoxx –
also vs US - postponed ITA
Tactical Long single stocks
linked to EMs / Commodities
- catch up theme
L / S positions
This is where we see MOST
Short S&P / Long VIX
Long Credit Curve
Long Inter-banking spreads
/ currency pegs
At present, our Value Book remains pretty flat, as markets remains toppy, 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 like tactical longs in Europe at present, fully hedged via shorts in the US. This is a tactical
position, which we expect to hold into possibly year end. Such view is independent from debt
ceiling discussions, as we expect them to have an eleventh hour fix. Such positioning follows delayed
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Italian election, and Greece /portugal issues to arise with a time lag, thus leading to false calm in the
markets, and possibly an LTRO/rate cut by the ECB, weaker euro.
Longer term, no change in views to this day: we maintain our bearish bias in Europe, for we expect
the crisis to flare up again and the EUR-peg to be dismantled down the line. In the same vein,
hedging overlay strategies via cheap optionality and positive carry formats are to be held
throughout the period.
Elsewhere in the Tactical Book, we look at China, and the impact of short-term push into fixed
investment-led growth all over again. While not sustainable, it is not to be underestimated for the
short-term. We look at beneficiaries of such flows, tactically for the short-term, before implosion few
months from now. Commodity stocks who fell out of favour with the market to levels where a
temporary catch up reflation looks possible.
Regrettably, it is impossible to call the day, the month, or even the quarter in a reality-check
correction 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.
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What I liked this month
Roubini predicts Indonesia growth to exceed China, India Read
Cashing demographic dividend: India lures foreign colleges Read
IMF chides Turkey on reckless policies as taper looms Read
Fasanara Capital recent interviews available on our page: Videos
The Structure and Resilience of the European Interbank Market Working Paper
Canadian billionaire: US dollar is soon to be dethroned as the worlds 'de facto currency' Video
Jeff Bezos: What matters more than your talent. Video
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