Published on February 18, 2014
“Learn how to see. Realize that everything connects to everything else.” ― Leonardo da Vinci 1|Page
February 10th 2014 Fasanara Capital | Investment Outlook 1. We maintain our view for the structural rising trend in equities to stay the course in the foreseeable future, as Central Bank's activism gets perpetuated, although in way more volatile fashion than it did in the year just past. Corrections of more than 10% can return to be the norm, with the risk of a larger correction of 20%/30% being a real one, under the drive of excessive leverage in the system (almost 3% of GDP on the NYSE, at $450bn), low levels of inventory for market makers, passive turtle-trading of juggernaut ETFs, super-thin liquidity, high complacency. 2. US Equity markets should look more like Japan than they do to US Treasuries (as they deceptively did in 2013) 3. The single most important data the market has ruled out in dogmatic certainty, without the shadow of a doubt, is ramping inflation. A bad Inflation print, however unlikely, is the blind spot of markets, its most acrimonious fat tail risk at present. On an inflation print unexpectedly and decisively above 2%, monetary printing would be instantaneously off the table, not by choice but by imposition, while rate hikes would be suddenly contemplated, departing from zero bound all too quickly. 4. We concur on the need to stay net long the equity markets (mainly outside of the US), as we believe the direction for them is up. Hedging programs must run in parallel, as volatility will exceed expectations. Enough dry-powder must then be kept on the sidelines, in preparation of such volatility to the downside. 5. Europe: while tail risks lay dormant, ‘Japanification’ is progressing undisturbed. Downplaying disinflation will not do Europe any good, but rather make Southern Europe's debt burden more unbearable in real terms. We believe that a sub-par intervention by the ECB is likely in the near term. Strategy-wise, we look at higher rates in the inter-banking markets as opportunities to receive such rates for carry purposes, in preparation of an ECB intervention in the months to come. 6. Japan: we stay the course in Japan, as the country presses ahead on its game plan for inflating out of an unbearable debt burden. Right because we are skeptical about third arrow of structural reforms, we see money printers stepping up their game once more, while the FED attempts at phasing out his, thus driving Yen weaker (second leg of devaluation), and equity nominally higher (although in volatile manner). ‘Fight like a samurai, or die as a kamikaze’ 2|Page
Soft Corrections, Hard Corrections The outset of the New Year proved unpleasant to several consensus trades: long equities, long USDYEN, short rates. Equity markets in particular, started on a down note, with US equities correcting almost 6% at some point. To us, in making sense of weakness in equities, there is no need to call up outsiders such as Emerging Markets woes, China credit crunch, tapering itself: markets’ inherent expensiveness vs fundamentals should suffice. - Emerging Markets sold off in rather orderly fashion, and we sense the contagion fears are overdone. While Argentina will likely get worse before it gets better, other EMs are only digesting the aftermath of the deflation of the commodity super cycle, and have indeed taken the right steps to restore order in the medium term (let alone that several of them are in much better shape than they were back in the 80' and 90's, having equipped themselves with domestic bond markets, financial institutions able to deal with crisis management, FX reserves, decent growth). - China is a threat but not any more than it was a threat for the better part of the last year, as Shibor spiked way more than it did this time around. - Tapering did not play a major role either, as the tick lower in equity markets coincided with yields rallying massively, instead of moving higher as tapering would have entailed. All in all, in our eyes, the correction is to be attributed to no more than the wide divide between shabby fundamentals and sky-high valuations. Tapering is work in progress, until further notice (our own base case is for a mild suspension in March-April, and a more sensible suspension later on in the year). Inevitably, tapering brings with it more data dependency. As markets need strong economic numbers to close the gap between high valuations and shallow fundamentals, whenever fundamentals are decisively weak and parting ways even further, valuations have to try to come down, in spite of financial repression policymaking all around. As we remain skeptical of a strong economic rebound in the US, let alone elsewhere around a troubled world, we view January price action as foretelling of similar price action patterns over the course of 2014. Markets seeing new highs in 2014, but hefty volatility along the way We maintain our view for the structural rising trend in equities to stay the course in the foreseeable future, as Central Bank's activism gets perpetuated, although in way more volatile fashion than in the year just past. Corrections of more than 10% can return to be the norm, with the risk of a larger correction of 20%/30% being a real one, under the drive of excessive levels of leverage in the system (almost 3% of GDP on the NYSE, at $450bn), low levels of inventory for 3|Page
market makers, passive turtle-trading of juggernaut ETFs, and super-thin liquidity all around. Such larger corrections are heavily underestimated by complacent markets, making then all the more probable. A 20-30% correction is not a massive correction in our roadmap, in the context of artificial bubbly markets. It is to be looked at as no oddity, but rather discounted as normality, in manipulated toppy markets as we live within. Bubble markets are gapping markets, at some point sooner or later. Bubble markets, held together by Central Banks easy money and the promise of even easier money to come if needed, are just that: fragile, overreacting. They may not show their real face for long enough that investors draw more in complacency and make the painful awakening just more probable than it would be otherwise. The propensity to buy-on-dips, in spite of GDP growth remaining a known unknown, far away from mathematical certainty, is itself a confirmation of exuberant markets, where greed reigns undisturbed over fear. Should markets not rightfully be fearful, as mild corrections bring it closer to the cliff of an S&P military advance from 666 in 2009 to 1850 today (as Marc Faber noted)? Should markets not be feel vertiginous up here? Fundamentals are nowhere near there to provide comfort and a safety net. Central banks alone are believed to stand in the way of a free fall, and so they get most mentions in investors' prayers. On any given reliable valuations metric, tested on the several decades of history behind us, current US credit and equity markets lie comfortably in bubble territory: price to cyclically-inflation-adjusted earnings (above 25), price to sales ratios (above 1.6), market cap to GDP, leverage ratios, share of covenants-lite bond issuance, and the list goes on (Valuations in Stratosphere). P/E multiples expanded some 18% in 2013, versus 2% on average in the past 20 years. Not one single metric can be brought up to justify current valuations, with the exception of global central bank activism. So then, vertigo forces and ((duck-skin)) should be felt, where they are not. Japan Docet Yet, there is one market out there who attempts at behaving with more sense of normality: Japan. On early fears of correction all around, it was down a quick 20%. So what? It did so already in May 2013, after a massive rally brought it well ahead of fundamentals and well ahead of the Central Bank balance sheet expansion itself. When looking at Japan’s volatile price action, many less investors raise eyebrows. After all, it is conventional wisdom for Japan to warrant high volatility, as it multiplied its monetary base with reckless abandon. Not so much deducting from it, though, that Japan did so in emulation of the mother-ship FED, and leads from its policy advisor Ben Bernanke in late 90's. Why then, the same 4|Page
policy should not lead to similar outcomes and price action. Sure thing, distinguos are there, as always; and misplaced, as often. If anything, as to market volatility, US Equity markets should look more like Japan than they do to US Treasuries (as they deceptively did in 2013). The Fallacy of ‘Bondification’ of Equity Supposedly-rationale investors, when imagining the future, they see the present. They see equities behaving like bonds, going up in a straight fashion, so they rush to buy on 5% correction for rejoining the pull-to-par ascension. However, as we argued in the past, equities are not bonds, ‘bondification’ of equities is a fallacy, which drew into equity territory VAR-adverse market participants from the fixed-income world, even less equipped to withstand such volatility, due to their own skills or the constraints of their constituents (investors mandates not up for it). A recent article summarized our thoughts on it (Opalesque - Analysing the Great Rotation). The early stages of the rotation from bonds to equities, on the false expectation that equities behave like bonds, can only exacerbate volatility in the medium term. At a minimum, the Great Rotation is a two-way bridge. It is estimated that the Great Rotation reversed spectacularly in January, with a $50bn shift from equity to bond ETFs over the past two weeks, wasting 3-month worth of previous Great Rotation flows. Outlier scenario: a bad US inflation print Rather curiously, a more violent correction than that, heavier than normal 20-30%, can also be imagined, on one count. The single most important data the market has ruled out in dogmatic certainty, without the shadow of a doubt, is ramping inflation. Disorderly Inflation, however unlikely, is the blind spot of markets, its most acrimonious fat tail risk at present. The market seems to know with certainty that unprecedented monetary printing in the scale of 30% of GDP have no chance in triggering a disorderly burst of inflation. There was a time when monetary base itself computed mechanically into inflation expectations. Long gone is that time, and the bag of experience it carried with it. Today, no market participant seems to give it any serious credit. If anything, it seems obvious to most that deflationary pressures still abound: from either technological revolution shedding jobs and depressing input prices, to low energy prices (on shale gas revolutionary discoveries and the end of the Commodity super-cycle), weaker than potential growth, slack in the labor market, weaker dollar on ZIRP policies, Southern European internal devaluation, Yen devaluation exporting deflation, China slowing down, etc. Critically then, as it is totally ruled out, a firmly bad inflation print can do the trick, and drive a truly major correction. Instantaneously then, on an inflation print unexpectedly and decisively 5|Page
above 2%, monetary printing would be instantaneously off the table, not by choice but by imposition, while rate hikes would be suddenly contemplated, departing from zero bound all too quickly. All of this while the employment markets seemed to be recovering (where possibly in such a scenario slack in labor market was underestimated, so much for disattending the Taylor rule on wage pressures last year, for the first time in twenty years), housing markets was just making it, robust GDP was still a great prospect but not so much of a present reality as yet. A bad inflation print would seriously take the market on the back foot, leading to overnight fall in confidence, and panic selling across the board, equities and bonds together, DM and EM together. Again, a low probability event it is, we concur, but surely one that the market is flatly blind to. It makes for the classic definition of a tail risk event: one with low probability, but high impact. Needless to say, hedges against such scenario are cheaper now than they would when Inflation was to show its ugly face, demanding a digital adjustment in risk premia. Bothering to spend the amount of money needed, with out of the pocket expenses, is the hurdle to overcome here, however unlikely the scenario may be. Proxy hedges are the elected solution of choice, to us. While not perfect, they allow for minimal expense and cost of carry, a critical feature in hedging low-probability scenarios. From the Outlook to the Investment Strategy Where does all of this take us in terms of investment strategy? We concur on the need to stay net long the equity markets (mainly outside of the US), as we believe the direction for them is up. Hedging programs must run in parallel, as volatility will exceed expectations. Enough dry-powder must then be kept on the sidelines, in preparation of such volatility and overcompensation to the downside. We do not expect such volatility / steep correction to impair the structural upward trend in financial assets. As we believe that tapering will be followed by more monetary expansion, as we project nominal GDP targeting in the US at some point down the road, we also believe the trend up for financial assets is here to stay for the few years ahead, although on a bumpier ride than the one it enjoyed thus far. As we think we live in an environment of illusory stability and debatable sustainability, we maintain our baseline investment policy for renting the rally in financial assets, mainly equities outside of the US, while preparing for Japan-style volatility. A re-pricing in realized volatility is well overdue, and more so than a re-pricing of the absolute level of asset values overall. As we argued last month, so we do now: artificial markets are structurally fragile, artificial markets are gapping markets. Stay long, but only tactically so. Stay fully hedged. 6|Page
Our baseline scenario is for tapering first, un-tapering later. A correction in between, Japanstyle, where markets may gap down 20-30%. Targeting NGDP next. By then, the sea level of asset prices will be increased once more. Nominal rally, not so much of a real rally left after discounting Inflation and Currency Debasement. Assets can rise in price, while they lose in value. Interestingly, the best hedge for the benign (so far) equity market correction in January was being long long-dated Treasuries, as they moved 40 basis points lower in between. To be sure, that is in line with the most typical historical relationship between equity and bonds, let alone a flight-toquality typical occurrence on EMs hiking rates to stem devaluations. However, As tapering remains one of the catalyst to a larger correction, as tapering bring with it higher rates (not lower), we believe we will see 3% again on 10yr US Treasuries soon enough, yet again. Should rates rise back again to 3% on Yellen taking the helm and delivering the first bold commitments, we may plan to then receive such rates tactically, in preparation of the next reflexive Pavlovian reaction by the markets to weak data releases or EMs woes. Europe: tail risks lay dormant, ‘Japanification’ progressing undisturbed Prospects for inflation are both dramatically different and further diverging between Europe and the US/Japan/UK. While we believe global deflationary pressures to face headwinds in most developed nations in the years to come, they do stand a better chance in Europe, as the continent moves to secular stagnation. Deflationary forces in Europe are indeed taking hold, making a multi-year slow deleverage the likeliest outcome for the Eurozone: a prolonged period of sub-par growth, high unemployment, low inflation at risk of turning into disinflation first, deflation later. Meanwhile, public and private debt ratios worsening (owing to contracting GDP and deflation, debt is 30% higher than before the crisis), loss of competitiveness increasing, tight credit rationing by undercapitalised banks to SMEs (employing 70% of labor force in peripheral Europe), will concur to make political risks higher, as the loss of hard-achieved welfare leads to social unrest. To be sure, negative demographics are at play too, all around. It should be said that our concerns on Europe are accelerated by the above-mentioned structural deficiencies, more than they are by cyclical factors like smoking-mirrors AQR banking tests. We expect loosening of official requirements to occur, until the vast majority of banks can satisfy them. Our bearish stance on Europe and our call for the inevitability of a EUR break-up were reaffirmed against recent incoming data and evidence from policymaking. Faced with the spectrum of disinflation turning into deflation all too soon, the ECB proved unable yet again to do much more than cheap talking and moral suasion. While benign markets decided once again not to call the bluff, the economic landscape can only deteriorate further on inactive policymaking, as more real debt is silently amassed along the way on the shoulders of peripheral Europe. 7|Page
Last week, we learned from Draghi that disinflation in Europe is not to lead into the same vicious cycle it provoked in Japan in early 90's. That is because the drop in inflation comes from the programme countries, so it is a sign of cyclical adjustment rather than broader deflationary environment. That is because it is mainly due to lower energy prices. That is because disinflation actually strengthens disposable income. So it is not so bad after all, it would seem. Downplaying disinflation will not do Europe any good, but rather make Southern Europe's debt burden more unbearable in real terms (while nominal terms are worsening too). The structural hurdles of over-indebtedness, overvalued currency, and current account deficits (after discounting cyclical adjustments on falling GDP and imports) are to saddle the block with vengeance in a disinflationary environment. Disinflation matters. According to Bruegel, for each percentage point of lower inflation, Italy needs to increase its primary budget surplus by 1.3% just to stabilise debt and keep debt/GDP ratio from rising more. Disinflation takes time to provoke damage, but not so much time. Anecdotally, It took Japan itself four years of inactive policymaking to see disinflation turning into outright deflation in the early 90's. To be sure, we believe that the ECB's stance on inflation is purely masking their inability to act against it in an effective manner, as their political mandate to operate is questioned. ECB may not be in a position to play the full role of a lender of last resort to the Eurozone, neither through the implementation of quantitative easing nor through other measures entailing fiscal transfers from Northern to peripheral Europe. As we argued multiple times, ever since declaring to stand behind the EUR at every cost ('whatever it takes' magic formula), risk sharing and mutuality features across Europe decreased, and Germany reduced their risk exposure to programme countries by close to EUR 300bn. So much for being fully committed to the European project. We will not expand on this as we have done so extensively in previous write-ups (December 2013 Outlook). As the hands of the ECB are tied behind its back, Draghi keeps its freely available remaining tools for last, delaying as much as possible their use. For all intents and purposes, we believe that a sub-par intervention is likely in the near term. Such intervention should meet three criteria: - be the least visible for Germany, or the easiest to explain to German taxpayers - be the least equating to fiscal transfers, or more opaquely so - be the least contributing to moral hazard on the side of peripheral Europe. 8|Page
Therefore, we see three forms of potential intervention in the months to come, ranked in reverse order of likelihood: - BOE-type Funding for Lending programme. Designed to benefit lending to SMEs, alleviating the pain on Southern Europe strangled corporate sector - Rate cut on refi rate MRO or repo rate. Taking real rates more decisively into negative territory, now that disinflation pushes them higher. Negative nominal rates are more difficult, while possible, as we learn from market participants that banks are not even prepared to process the change from an operational standpoint. - un-sterilising SMP operations. At present, the ECB sterilizes its now-terminated Secutities Market Programs via weekly time deposits designed to drain the liquidity generated by such SMP purchases. It would be enough to stop offering such time deposit to inject liquidity in the system for approx EUR 180bn As short rates on the EUR curve are under upward pressures, and inter-banking spreads on the widening, following a squeeze of liquidity on LTRO repayments and some deleverage, one of these measures can be delayed for only that long. Excess liquidity in the European banking markets stands at just EUR 144bn as we speak, from peaking at EUR 813bn two years ago. The deposit facility stands at EUR 47bn. The liquidity current account at EUR 200bn. On tightening liquidity, Eonia (overnight unsecured inter-banking rate) and other short rates exceeded 30 basis points at times (before compressing again to 15 basis points), well above the MRO base rate itself. Following liquidity squeeze and higher short term rates, the EUR currency was pushed too strong against the dollar too, making the adjustment on peripheral Europe all more painful. Strategy-wise, we look at higher rates in the inter-banking markets as opportunities to receive such rates for carry purposes, in preparation of an ECB intervention in the months to come. Incidentally, such strategy can provide a good hedge on equity longs in Europe in the short-term, as market weakness would force the hand of the central bank, who is now otherwise downplaying deflation risks and the need for intervention. Again, such intervention will not be conclusive, it can at best buy time, in wishful expectation of a banking union and more structural measures to be implemented. If a banking union needs a painful crisis to be forged, is the next question. Once a crisis is triggered, there is little certainty on where it may lead to. Curiously, a painful crisis can be envisaged as inevitable by Euro-skeptics and Euroobsessed alike. 9|Page
Japan, stay the course: Short Yen, Long Nikkei We stay the course in Japan, as the country presses ahead on its game plan for inflating out of an unbearable debt burden. Lightening up positions ahead of the double election rounds (Okinawa City Mayoral Race and Tokyo Gubernatorial Elections) proved to be well timed. The quick 20% correction in January provides for a decent re-entry point. As discussed above, the only surprise in a 20% digital retracement in Japan is that investors are surprised about it. For a country standing on the cliff of outright default, embarked on multiplying its monetary base few folds over, such or higher volatility is to be discounted, and will stay with us over the course of the year. In the new year, we actually learned that corporations like Sony, for the first time in many years, decided to take the painful route to restructuring/downsizing/divestitures/spin-offs, thus preferring profitability and shareholders’ value to the old dogma of expansion, revenues and size. Sony is part of a long list of corporates taking similar actions. That is good news. On a different note, we read Abe’s manu propria reiterating its commitment to flood the market with rd liquidity, in any way possible On the 23 Jan he stated: ‘Japan’s management of public funds – such as the Government Pension Investment Fund, which now holds about $1.2 trillion – will also undergo far-reaching change. We will press ahead with reforms, including a review of the GPIF’s portfolio, to ensure that public funds contribute to growth-nurturing investments’. The GPIF is the world's largest public pension with 112 trillion yen ($1.16 trillion) in assets. As we highlighted last time around, such wall of money is likely to meteor-hit the stock market too. On top of it, last month, the NISA program got started. Designed for individual investors, it will offer tax exemptions on capital gains and dividend income from investments of up to 1 mn YEN a year for a maximum of five years. Nomura estimates that $700bn equivalent could move out of deposits into equities, as a result of NISA only. That is 25% of total NIKKEI market cap. Again, as exposed at lengths here, we do not believe in the third arrow of Abenomics. Reforms will be hard to accomplish in Japan’s close, old and protective society, especially over the course of 2014. Because of the fact that we are skeptical about the third arrow of structural reforms, we thus expect the money printers to have to step up their game once more, while the FED attempts at phasing out his, thus driving Yen weaker (second leg of devaluation), and equity nominally higher (although in volatile manner). As we reasoned earlier on, while US’ money printing is led by optimism, a genuine belief that growth can be resurrected and escape velocity is just round the corner, Japan’s money printing is led by realism and desperation, as there is no alternative left to it. After unsuccessfully fighting over deflation for the better part of the last 20 years within conventional policy tools, Japan has resorted to all-out unconventional actions, flooding the economy with fiat paper money, in a desperate attempt to achieve Debt Monetization through Currency Debasement: ‘fight like a samurai, or die as a kamikaze’. 10 | P a g e
Abe and Kuroda today, have put themselves in a corner where they are confronted with one of two options: print, and buy bonds only, hoping for the market to grow before inflation kicks in; or print more, and buy all bond and some equity, if inflation kicks in and/or the market does not grow. Stop printing and you die. Already as we speak, Japan is monetizing almost $60bn per months, vs $65bn for the FED, despite the fact that the Japanese economy is 35% of the US economy in actual size. To be sure to trash the Yen, we expect the BoJ to increase the stakes of its monetary game from here, and to likely do so in H1 2014. As the consumption tax gets introduced in April, as the balance sheet of the BoJ has not been expanding for three months now, as Capex is lagging behind, as the cost-push inflation currently visible in Japan in unwelcome, the timing may be right for more monetary activism to take place, sooner rather than later, driving the Yen lower. The current level of the YEN vs the USD reflects current interest rate differentials, same as before the first leg of devaluation of the YEN at the end of 2012. No credit is given to the expected path of rates now that Central Banks’ policies are set to move in diametrically opposite directions by end 2014. Although it is believed to be a consensus trade, no such credit is built in as yet. As we have run out of space for this Outlook, we will defer to next month write-up a few observations on Emerging Markets and China. Thank-you for reading us today. For those of you who may be interested, we will offer an update on our portfolio positioning to existing and potential investors during our Bi-Monthly Outlook th Presentation, to be held on the 19 of February, in 55 Grosvenor street (London). Supporting Charts & Data will be displayed for the views rendered here. Specific value investments and hedging transactions will be analyzed. Please do get in touch if you wish to participate. Francesco Filia CEO & CIO of Fasanara Capital ltd Mobile: +44 7715420001 E-Mail: firstname.lastname@example.org Twitter: https://twitter.com/francescofilia 55 Grosvenor Street London, W1K 3HY Authorised and Regulated by the Financial Conduct Authority (“FCA”) 11 | P a g e
What I liked this month Japan’s New Dawn by Shinzo Abe Read Emerging Markets blues analysed Read The global long-term interest rate, financial risks and policy choices in EMEs – BIS Research W-End Readings When Conventional Success Is No Longer Possible, Degrowth and the Black Market Beckon. Rather than a disaster, this wholesale loss of middle-class incomes and aspirations is enormously liberating. Instead of the yoke of debt-based ownership, young people are finding sharing to be better than owning. Read Juan Enriquez: Your online life, permanent as a tattoo Video “This document has been issued by Fasanara Capital Limited, which is authorised and regulated by the Financial Conduct Authority. The information in this document does not constitute, or form part of, any offer to sell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or the fact of its distribution form the basis of or be relied on in connection with any contract. Interests in any investment funds managed by New Co will be offered and sold only pursuant to the prospectus [offering memorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carries a high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and no assurance can be given that the stated investment objectives will be achieved. Fasanara Capital Limited may, to the extent permitted by law, act upon or use the information or opinions presented herein, or the research or analysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnel may have, or have had, investments in these securities. The law may restrict distribution of this document i 12 | P a g e
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