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

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December 1st 2014

Fasanara Capital | Investment Outlook

1. Three Defining Features for markets in 2015

a. Deflation in Europe is just Beginning

b. Cross-Countries Competitive Policies are Increasingly Confrontational

c. Keynesians Winning Over Austrians in the Academic Debate

2. Three Big Trades for 2015

a. European Deflation Trades

ECB’s activism and deflation are two weapons firing in same direction.

Rates to move even lower, credit spreads to narrow, risk premia to

implode, interest rate curves to flatten. Bund yields moving flat to

below JGBs, Italian 10yr BTPs below 2% yield, below 100bps spread

over Bunds and below 60bps over OATs; Greek 10yr GGBs below 5%

b. Optionality in Peripheral Europe

ECB forced to step up its game from here, further inflating the bubble.

Record levels of vol and availability of option-type instruments allow

for heavily asymmetric profiles and 2x to 3x payout ratios

c. Japan Entering Second Phase of Abenomics

Activism stepped up, further inflating the bubble in Nikkei. Yen to

weaken further. Private-sector credit spreads at rock-bottom levels

offer outsized payout ratios to hedge potential failure of Abenomics

3. We will also quickly comment on few more discussion points:

a. Why European Government bonds are now less in a bubble than 2 years ago

b. Why US Equity is in bubble territory and should make one nervous

c. Why this is the time to fear Russia, and the potential for external shocks

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Investment Outlook for 2015

In our last write-up of the year, we would like to quickly review what worked and what went wrong

for our views in 2014, before moving on to our top trades for 2015.

Over the course of the last quarter, few things materialized in line with our expectations:

- ECB took the center stage in European policymaking, intentionally orchestrated

benign AQR’s results, stepped-up efforts to make TLTROs cheaper/larger while kicking

off outright asset purchases in Covered Bonds and ABSs. Also, the ECB prepared the

ground for what is inevitable: Sovereign QE. As anticipated, European equities

fluctuated heavily, and are now on the rise, while bonds rallied massively, under the

double fire of deflationary trends and ECB’s activism to come.

- Japan officially entered Phase II of Abenomics. Yen moved quickly close to 120

against the USD, Nikkei closer to 20,000. This is just the beginning.

Our targets for end 2014, as per our June Outlook, did read as follows:

- ‘’S&P finishing the year at between 2,000 and 2,100’’

- 10yr Treasuries to drift lower into 2.30%-2.40% territory (from 2.60%)’’

- ‘’Italian 10yr BTPs at 2% yield (from 2.75%), and at 100bps spread over Bunds (from

150bps), 60bps over French OATs (from 100bps), lower than Spanish Bonos (currently

+10bps above); Greek 10yr GGBs at below 5% (from 5.7%), soon enough’’

- ‘’20/30% upside on Peripheral European Equity, esp. banks in in Italy and Greece’’

We were right on a few trades (BTPs, Bunds/Buxl, S&P), late on some (BTP-OAT spread is half way

through, whilst moving in the right direction), outright wrong on others (Greece in primis - although

fundamentals here make us hold the line). We have changed our mind on a few too, like US

Treasuries, which we now expect to drift even lower before they resume an upward trend.

We apologies in advance for not having a clear-cut view of how 2015 will play out, while more of

the same seems to be the baseline scenario for most commentators. We believe 2015 will be best

navigated by ear, ready to change course at short notice as the year progresses.

2015 is going to be a very difficult year to navigate. We cannot avoid stating the obvious here.

Equities are bubble territory in the US, the world’s reserve currency and the mother-ship for global

capitalism, dictating the Beta in capital markets most of the time. European bonds, while not

expensive against valuation and flows, are close enough to the zero bound to make one nervous. Tail

risks are abundant: (i) Russia first, a military power dangerously boxed in the corner, (ii) structural

weakness in Commodities on global deficient demand affecting EMs, (iii) competitive devaluations

becoming increasingly bold and confrontational, putting one country against another in competing

for a share of the shrinking pie of global GDP and trade flows (most obviously then, they can force

policy shifts elsewhere which are external shocks to asset pricing).

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The good side of the story is that chaos and headwinds will bring opportunities too.

Unconventional monetary policymaking and potential for chaos/psychosis call for unconventional

portfolio management, embedded cheap optionality / correlation for building heavily

asymmetric payout profiles, large inclusion of convexity, rapid defensive shifts in portfolio

allocations on short notice as incoming data evolve. If tectonic shifts cannot be ruled out in 2015,

big waves are a certainty. Recent empirical evidence is no coincidence: quick slides such as the

Yen (-12% in one month from Oct-15th

), the price of Oil (-40% in 4 months since June), rates on

Bunds (-130bips down to minuscule 0.7% YTD, or a staggering 64% down), schizophrenic shifts

of the 10yr Treasury (30bips intraday in Mid-October), EU forward inflation rates plummeting

abruptly (-40bps in couple months since August) are perhaps only the first telltales of a market

structure leaning towards higher realized volatility. Increasingly, Governments and market

participants will call for a change of the status quo, out of desperation (Japan, peripheral Europe)

or out of geopolitics/opportunity (oil fluctuations, wars). Volatility shocks are to be anticipated,

if some key variables (like Oil) can move so much so suddenly, especially at a time when

algorithmic trading and passive management strategies represent a chunky portion of global

trading, in small global volumes, shallow liquidity, low inventories, high leverage. More eventful

markets are ahead of us.

In the following few pages we will analyze:

- Three Defining Features for markets in 2015, which form the conceptual framework

behind our current portfolio positioning

o Deflation in Europe is just Beginning

o Cross-Countries Competitive Policies are Increasingly Confrontational

o Keynesians Winning Over Austrians in the Academic Debate over Crisis Resolution

policies

- Three Big Trades for 2015 (revisited from our September Outlook)

o European Deflation Trades

o Optionality in Peripheral Europe

o Japan Entering Second Phase of Abenomics

We will also quickly comment on few more discussion points:

- Why European government bonds are now less in a bubble than 2 years ago

- Why US equities are in bubble territory and should make one nervous (while we closed

our S&P/Nasdaq/EEM shorts, reluctantly but luckily enough, on 15th

Oct)

- Why this is the time to fear Russia, potential for external shocks

More data and charts will be provided at our Investor Presentation on December 10th

. Please call us

up if you wish to participate. The VIDEO REPLAY of our previous Investor Presentation can be found

here HERE.

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Three Defining Features for Markets in 2015

We can isolate 3 game changers for markets in 2015. We will analyze them briefly, as we believe each

one of them has the potential to (i) shape the economic debate over the course of 2015, thus driving

crisis resolution policymaking, and (ii) affect the dominant narrative adopted by market participants,

thus affecting price action and assets’ performance in 2015.

(1) Deflation in Europe is Just Beginning

Some would say the seeds of deflation have been planted long ago, decades ago. Surely, the

downtrend in European inflation has visibly progressed since 2012, but it is only after June 2014 that

Europe has entered the danger zone and got in direct eye contact with outright deflation. Such

factor will affect ECB policies well into 2015. We believe deflation is structural in Europe and likely

to affect market dynamics for months to come. Europe is entangled in secular stagnation, which

has just started to show up in deflation terms, helped by a flawed fixed currency regime.

A summary of our views on this topic has been featured in ZeroHedge blogosphere back in

September and can be found here HERE (we thank ZeroHedge for that!).

In a nutshell, years of austerity measures have exacerbated disinflationary trends in Europe, bringing

it on the brink of outright deflation. From our September Outlook:

‘’In crafting crisis resolution management, European policymakers blamed the lack of

reforms for the low levels of productivity, whereas Europe was suffering from a

structural lack of demand. A much more dominant problem. Given that, the ECB balance

sheet was allowed to shrink for almost two years now, the EUR was allowed to strengthen

against most currencies around the world (which were actively engaging in the opposite

effort, one of bold currency debasement, ranging from the US, to the UK, to Japan..

including even Switzerland and Norway), and austerity was imposed to shrink fiscal

deficits. The candidly stated goal was to drive Internal Devaluation across peripheral

European countries, so as to close the competitiveness gap to northern Europe: output

contractions, wage declines, fall in prices. Almost the opposite of what should have

happened if the problem was diagnosed as one of deficient demand. Tightening fiscal and

monetary policies took place in Europe for two consecutive years, all the while as most other

large economies were engaging in the polar opposite.

‘’Nomen omen. Internal Devaluation in Southern Europe is itself an intentional form of

deflation. It should have been confined there where it mattered to level off imbalances

across nations in Europe. Instead, the laboratory experiment failed as it metastasized

around.

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‘’Globally, other structural forces were inductive of deflation, from robotics and

technological advances shedding jobs and depressing input prices (the Amazon effect), to

low energy prices (on shale gas revolutionary discoveries and the end of the Commodity

super-cycle), to weaker than potential growth, slack in the labor market, weaker dollar on

ZIRP policies, Yen devaluation exporting deflation, China slowing down, etc.’’

To that, we could add here the most relevant 40% drop in Oil prices occurred of late. It is surely

disinflationary. However, we probably look at it more benignly as it is definitive positive on so many

other fronts. A drop in oil prices has the potential to do more good to aggregate demand than QE-

type financial engineering. Said that, the drop in oil prices can only help the case we make here for

ECB’s activism set free by deflationary trends.

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

surpluses) are regulated by European rules. Here then, Germany’s surplus at over 8% of GDP

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(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.’’

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(2) Keynesians winning over Austrians in the academic debate

Critically, Keynesians are the apparent winners over Austrians in the academic debate on crisis

resolution policies needed to tackle the malaise affecting global economies: the dilemma

between deficient structural demand and supply-side issues, QE and debt monetization over fiscal

rectitude and return to competitiveness, German orthodoxy vs US-type monetary and fiscal largesse.

The anectodal narrative of Paul Krugman, one of the most prominent Keynesians alive, convincing

Japan’s Abe of scrapping a planned austerity measure (VAT increase), during a taxi drive, helps to

frame the current situation. The story can be read HERE.

It seems increasingly clear, in the US, UK, Japan but even in Europe, that Keynesians are having

the upper hand in shaping global policymaking. It is the logical consequence of what we see before

our eyes after years of competing policymaking: the recent objective strength of the US economy

after years of QE infusions, the renewed chance Japan has to defeat a deflationary trap, the good

relative state of health of the UK economy, all compared to moribund European countries (Germany

included) where austerity was tested instead, and shallow emerging markets all around.

We believe that the recent stance of the ECB is to be read within this context. If anything, recent

anecdotal evidence from the BoJ shows that a non-unanimous approach is the next step, if needed.

The story of how the process to step up QE in Japan was managed is interesting and is attached

HERE. Draghi stated all too clearly his willingness to engage in combat over deflation. So far, he

played the game masterfully, achieving unanimous decisions. Next step could be to step it up non-

unanimously. The surprise element Japan tested may well work in the short-term, and provide one

more empirical tool for the second most active Central Bank in 2015, supposedly.

Whether we believe that Keynesians will be proved winners or not over time doesn’t matter. Soros

says that ‘’even scientific laws cannot be verified without the shadow of a doubt, they can only be

proven wrong, falsified by testing. One failed test is enough to falsify, but no amount of confirming

evidence is sufficient to verify’’. It should be said that we live through an unfinished cycle, it is still

half game, and the few years ahead will say if the US is truly out of the woods and the economy can

indeed normalize in terms of potential GDP growth and interest rates. The massive debt expansion

of the past decade, together with the falling marginal effectiveness of new credit advancements

(falling money multiplier and falling velocity of money) make us believe that tail risks are abundant,

and nobody can be certain as to the end effects of the current state of affairs. Again, what matters

to the markets and us as fund managers is the next 12 months – the foreseeable future – where

additional monetary printing the world-over can legitimately be expected on the presumption of

its success in the US/Japan/UK this year. ‘Short-termism’ will likely prevail in crisis-resolution

policymaking.

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(3) Competitive Policies becoming Confrontational

This point is quite obvious. As governments and their Central Banks engage in economies and

markets more forcefully and boldly than they ever did in the past few decades, such policies can

be expected to collide against one another more than they ever did in decades.

Take Japan, for example, where the Yen slide by 56% from the highs in 2012 will affect other

countries at large. The Yen will make Japan’s products more competitive at the expenses of other

countries, in what is effectively a zero-sum game. Against the virtuous goal of kick-starting

aggregate domestic demand and breaking years of falling prices, Japan will export deflation globally

via a weaker Yen, exacerbating already disinflationary global trends. China may have to react to that

too, and recent evidence is there to testify it. Germany will be affected the most, as its economic

model looks more like Japan than Korea’s. The ECB has one more motive to move into combat.

The massive waves created by ‘purely domestic’ policies (i.e. BoJ’s QE) may become recurring

elements for markets in 2015. The torpor of the moribund markets of the last few years may be

shaken by more aggressive public policies, now that in the US such activism looks successful.

The ‘beggar-thy-neighbour’ mercantilist policies of the 30’s come to mind. For what it matters, it

should be noted that one participant actions, especially if bold and aggressive, forces another

participant into action. According to prisoner's dilemma known from game theory, each country

individually has an incentive to follow such a policy, thereby making everyone (including themselves)

worse off. Mercantilist trade policies, when they gather momentum (at it seems the case now),

can lead to trade wars and policy retaliation between countries.

In 2014 fiscal and monetary policies across different countries varied and impacted each other to

a limited extent. It looks like policies across countries may be vastly similar to each other in

2015, and will increasingly affect each other, leading to a self-reinforcing cycle of increased

activism.

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Fasanara’s Big Trades for 2015

We see three main areas of opportunity at present:

- European Deflation Trades

- Optionality on Peripheral Europe Equity Upside

- Japan Second Phase of Abenomics

(1) European Deflation Trades

Our quick views on the theme can be found in this SHORT VIDEO RECAP.

ECB policies and deflationary forces are two weapons firing in the same direction. From here,

odds are high for European rates to move even lower, credit spreads to narrow, risk premia to

implode, interest rate curves to go flatter, Equity melt-up first. That is financial repression at its

best, trying to push real rates negative where they can still be below anemic growth rates so as to

monetize unbearable levels of debt overhang. On top of it, the additional push of cyclical and

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structural deflationary forces. End result is putting any sort of risk premia and rate differentials under

attack:

- Rates to reach new lows, especially in the far end of the interest rate curve,

especially in Germany. Bunds 10yr yields moving flat to JGBs, Bunds’ 30yr yields

below JGBs

- Spreads to compress, both between peripheral debt and core European debt,

and across the curve. Italian 10yr BTPs at 2% yield by year end (just got there),

and at below 100bps spread over Bunds, below 60bps over French OATs (far from

it still); Greek 10yr GGBs at below 5% (moved away on market psychosis next to

vanish)

- Risk premia to implode, interest rate curves to flatten. Curve spreads to

tighten, volatility spreads to compress, cross-spreads to narrow.

From our June Outlook: ‘’Pushing lower a 10year German bund yield of 1.35% might

be difficult (although Japan shows the downside is still wide), but forcing lower a

2.75% yield on a BTP is easier, as it offers twice the yield of a Bund, for the same

Central Bank. So it is easier to push down a 6% yield on a Greek govie (and its CDS

at 450bps over), on the presumption of mutuality and ECB backstop. For the time

being, until further notice Fixed income-wise, we expect yields to plummet,

spreads to narrow further: Italian BTPs at 2%, and at 100bps spread over Bunds,

60bps over French OATs; 10year Greek yield at 5% and below, soon enough’’.

‘’The impact on equity we expect is one of melt-up, at least in a first phase,

pushing them into bubble levels, not supported by fundamentals but rather by

the mix of lower yields, zero inflation rates, modest economic growth. Our

favorite markets are Italy and Greece, which we think have the potential of being

best performers in the next 12 months, although with heavy (realized) volatility

along the way.’’

We expected the ECB approach to be three-phased:

- Enhancing already generous terms for T-LTROs to maximize take-up, while

stepping up rhetoric over QE-type policies. Increasing the generosity of terms

attached to TLTROs might increase their take-up, a key measure of success for

the T-LTROs’ programs.

- Finalising a benign AQR / stress test. This is done now and behind us.

AQR/Stress Tests were pretty much of a non-event, in so far as they led to no

need for capital actions on the side of relevant banks.

- Delivering on ECB’s own version of QE. This phase is in progress still.

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AQR is now past us. It indeed proved to be benign, although market action was tepid/anxious at

first, but that changes quickly, together with the dominant narrative in the market.

TLTROs can be made more generous (quantity-wise and cost-wise), still, to increase total take-up

to Eur 200bn+ at December auction. Such more generous terms may be delivered already at this

week ECB’s meeting.

ECB’s version of QE is next in line. Few ECB officials have already alluded to the fact that Sovereign

Bonds are included in the basket the ECB may target, if needed. Here ‘if needed’ means a further

deterioration of economic and deflationary conditions. As that is a given, Sovereign QE is a

certainty in Europe.

Extract from previous Outlook: ‘’ Private assets, including equities, could be included in

some part. Caveats will need to apply to minimize risks of moral hazard for peripheral

European countries engaged in structural reforms. Other caveats will need to apply to

attach conditionality to QE policies, and hand-over of parts of sovereignty.’’

‘’Monetary policy could run in parallel with a large ECB-financed Europe-wide fiscal

program, traded against structural reforms, targeting underinvested European public

goods. Infrastructure projects across the energy sector (where a energy plan for Europe is

badly needed), energy savings/efficiency and telecoms could be a start. The Bruegel think

tank offers few ideas here.’’

Draghi was a master of war when war was fought via ‘cheap talks’ only (‘whatever it takes’

language proved more effective than first LTROs hard cash): he can legitimately be expected to be

more effective now that he provided himself with plenty of levers to play with.

Preconditions to QE have been met:

- Inflation expectations have come down further and are now decisively lower

than they were when Draghi last spoke. 10y, 5y and 5y5y forward inflation

break-evens are all at new historical lows

- The EUR is weaker against the USD alone, but more expensive versus other

relevant currencies (in trade-weighted basket) than when Draghi last spoke.

- Germany is less competitive now that Japan debased the Yen by another

monumental 12% in one month (and we have not taken the dragging tensions

with Russia into account yet). Germany more likely than before to give consent.

Undoubtedly, rates have moved lower massively already. 10yr Bunds are at approx. 0.70% yield,

minuscule levels already. 10yr BTPs in Italy at 2% do yield less than US Treasuries, admittedly a

better borrower than Italy despite its reckless use of the printing press. Yield on 10yr OATs in France

is below 1%. 30yr Bunds are ca. 1.50%, where they rallied to during mid-October flash crisis, not far

from the 1.37% yield of 30yr JGBs in Japan.

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One could argue that current low yields already point to bubble-type conditions for European

government bonds. After all, they are at century lows: 200y-ears lows in Germany, 500-years low in

Holland, and so on. We do not think that European govies are in bubble territory, once the new entry

of H2 2014 is taken into account: deflation. Deflation is the game changer to European

policymaking and asset pricing. In 2012 European inflation was at 2.6%. Today it is effectively zero

across Europe. One could then argue that European bonds are less in a bubble today than they

were in 2012, when bond prices were significantly lower, once adjusted for the prospect of zero

to negative inflation rates and the prospect of shallow to contracting GDP growth. We made our

case in a recent CNBC interview (attached here VIDEO).

Moreover, real rates differentials are still wide across European countries. Real rates in Italy are

still almost 150bps higher than in France and almost 200bps higher than in Germany. That is 2 times

the full yield of a 10yr duration risk on Bunds: too much to live with, in a deflationary world, at ~140%

debt/GDP.

More to the point, interest rate differentials, a large driver of EUR relative strength, have recently

narrowed between Europe and the US/UK, as US/UK yields were dragged lower. That carries with it

the decent risk of an appreciating EUR from here. After all, Europe shows a (deceptive) 200bn Eur

current account surplus, which could well push the EUR stronger, now that rates differentials are

narrowing. Europe cannot tolerate a stronger EUR, as deflationary pressures would be

overwhelming then. Thus, ECB is called to act, again.

To this point, it should be noted that the EUR is weaker when measured against the USD, but

against trade-weighted currencies (e.g. JPY, CHF, SEK, GBP) it is actually stronger than when

Draghi last spoke (Chart attached).

Further to the point, in analyzing deflationary trends and downward pressures on yields, one cannot

avoid commenting on last week new entry: an additional 8% drop in the price of Oil, taking the

cumulative drop from peak to a staggering 40%. Surely, one should differentiate between ‘good’

and ‘bad’ deflationary factors. Not all deflationary shocks are created equal. Oil is a true QE-type

boost to consumption, as it positively impacts the spending power of low-income household, the

largest and most elastic contributor to consumption, in itself the largest contributor to GDP growth.

Still, assumptions on nominal inflation expectations have to have changed between this week and

last, mechanically. Oil is too big a factor to miss. With oil, other commodities seem to be on an

endless downward path, after digesting hangover from China overblown/unproductive fixed asset

demand and their inevitable attempt now to rebalance sources of growth (we expect $10 trn GDP in

China to grow from +7.5% to below +5% in 2-years). A tsunami is hitting the shores of inflation

expectations, leaving the ECB (and other Central Banks for that matter) with little alternative

but to act boldly, and still fail.

Final comment on whether yields should fall more from here or not: one cannot dismiss the global

trend lower for yields from the US to Australia to the UK, Japan and so on. As we said, global

disinflationary trends, end of commodity super-cycle, China’s growth rebalancing, Japan exporting

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deflation, robotics…they are all to blame. But let’s also not forget the global supply / demand for

bonds, heavily in favor of higher bond prices from here. As Central Banks are crowding out the

private sector, it has been estimated that demand outstrips demand of bonds by approx $ 400

bn in 2015. Demand for bond is expected at 2,4trn in 2015, well below global demand for collateral.

Collateral shrinkage is one more weapon firing in the same direction.

The private sector is competing with the public sector and scrambling for yielding fixed-income

assets, pushing prices higher. All bonds are virtually on auction these days in the market. The

highest/dullest bidder determines pricing. It clearly cannot last forever. The closer we get to the zero

bound on long duration bond yields, the less upside there is, and the more It feels like picking up

dimes in front of a steamroller. Also, convexity increases meanwhile, and as an investor your

duration goes higher, resembling that of a zero-coupon bond, making you longer and longer as yields

compress. This is to say that being long bonds is not the most marvelous trade when adjusted for

risk, but on today’s expensive markets there is hardly anything left which is low-risk.

US Treasuries at 2.20% on 10yr and 3% on 30yr Treasuries offer good carry, and an implicit hedge on

flight-to-safety crashes like mid-October or Lehman-moment. With the street position apparently

for higher rates in 2015, if one is to consider top trades’ lists from major houses, they look like good

buy. Fundamentally and flows-wise. Which also implies that it is difficult to see major headwinds

for low European rates anytime soon.

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(2) Optionality on Peripheral Europe Equity Upside

Our quick views on the theme can be found in this SHORT VIDEO RECAP.

Our one liner on Europe could read as follows: European policymaking may fail (too little too late),

the EUR may break few years from now, but before that happens the ECB will step up its game,

further inflating the bubble across European debt and equity markets.

For the next 1 to 2 years we see the most upside materializing in the equity of Italy and Greece,

primarily in the financial sector.

Record low levels of implied volatility (even lower than realized) and the availability of option-

type instruments offer the opportunity to play this upside in optional format, with potential for

2x to 3x payout ratios.

Greece

We have been wrong on Greece. We see good potential in Greece and consider Greece here no

more than a macro call on Europe at large and the ECB. Still, markets punished Greek assets

severely this year, bringing them down 50% on average. We may yet be vindicated by 2015’s

markets but, as Howard Marks notes, being too early is indistinguishable from being wrong. So,

we were wrong.

Said that, looking at risk/reward here based on current pricing, separating fundamentals from

what we believe is market psychosis, we remain invested and see massive upside in 2015 for the

stocks of the Greek banks we own.

Fundamentals have only improved as of late.

- Greece has best GDP growth numbers across the Euro Area, resurrecting from

large negative prints a year ago. We expect growth to pick up from here.

- The funding gap for Greece and Greek banks is close to zero for 2015. Given

that (i) we look at Greece as a macro call, (ii) it is too small to fail in the context of

European policymaking, (iii) the public sector owns the vast majority of Greek

debt, funding gap can be considered close to zero. The level of the 10yr Greek

government bonds – driving market panic at times - is kind of irrelevant, then.

Hard nut negotiators/bureaucrats at the Troika better focus at the disastrous

outlook for European growth and deflation and look no further for trouble/self-

inflicted pain/internal shocks.

- Unemployment improved recently, unfortunately the same cannot be said of

Italy, amongst others

- AQR Damoclean sword is past us now. A huge risk has vanished. Greek banks

are not forced into raising new capital, unless they wish so themselves.

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- Deposit trends, NPLs trends, costs trends, profitability trends are all on the

mend if they have not already turned positive

- Haircuts for Greek collateral at the ECB improved massively recently. ECB

accepts junk ABSs for TLTROs from Greece/Cyprus. Hardly more can be imagined

by the ECB here. It is the closest it gets to free money.

Still, other factors prevailed in driving assets pricing in the past few months, as follows:

- Syriza is gaining popularity and threatens to overhaul the government if a new

President fails to be elected come February 2015. This is hardly new news, as it

was in the cards since months.

- Market thinks of a new debt restructuring and funding gap as deal breakers in

2015, as Greece exit the program.

- Hot money flows from hedge funds fire-selling Greece, most likely due to

redemptions after few difficult consecutive months for the industry. Greek assets

are owned for most part by hedge funds, which exacerbated volatility to extreme

levels.

In our eyes, Syriza’ risk was there already there earlier this year, when Greek assets were in fashion.

Syriza has neutralized itself quite a bit lately, currently holds a moderate political position when

compared to Le Pen’s in France (for similar popularity). The chances of new elections in February are

high but not higher than 60%. Even so, the chances of Syriza gaining majority are less than 20%. A

new coalition government would seem then unavoidable, which further dilutes the presence of

Syriza wihin it.

We are more inclined to think that excess volatility of Greek assets, hardly a feature you can be

surprised about when investing in Greek assets, is motivated by large flows from hedge funds

facing redemptions in thin liquidity.

In a nutshell, to us Greece is a macro call, not sui generis but rather a necessary piece of the

European puzzle at this stage, therefore odds are high for a strong performance of Greek assets

in 2015. At current levels, Greece factors in a liquidity crisis without any liquidity crisis, it is priced

to near-destruction without such odds being any higher than they were earlier on this year, or

are for Europe at large down the line. At current levels, we estimate 2x to 4x returns for Greek

bank stocks and warrants. As seen several times this year, market’s dominant narrative can

change dramatically overnight, psychosis can vanish and rationality re-established, and a frog

returns a prince.

For more data crunching on this theme we refer our readers /investors to our Investor Presentation

on the 10th

December and to our earlier Outlook (attached HERE).

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Italy

GDP contracted in Q2, leaving the country in technical triple-dip recession. Stocks corrected as

investors fled the country. If one were to project the trajectory from here, Italy would be bankrupt

in less than two years. A debt crisis is all it takes to tip the balance, as the a lethal mix is served:

Debt/GDP hitting 140% by year-end, a debt denominated in foreign currency (the Euro), GDP

contracting again after falling 10% in absolute levels in six years (being now where it was in 2000),

Industrial Production falling 26% in six years, youth unemployment at 43%, implementation of

structural reform agenda lagging behind on shameful resistance by hard-to-die political

establishment, Renzi’s popularity just starting to wane.

However, we believe the days of reckoning for Italy are to be postponed. Italy is the key to the

European project, and the European authorities have at their disposal the tools to engineer such

postponement. Now that Germany’s economy itself is contracting, now that outright deflation is

about to enter the stage, now that Russia refreshes the old fears that once brought Europe together,

now that ruling parties across Europe are the best subjugates Germany can ever aspire to, the time is

right to fire what is in the arsenal and try to fix it. The ECB is the main player here, together with a

large fiscal program, as explained earlier on in this Outlook.

Against this backdrop, we see large catch-up upside on Italian stocks and bonds within the next

6-12 months. Again, optional formats are both preferable and available to play the view.

Catalyst to be the same as presented above: ECB’s policy, spreads compressing further.

Fixed income wise, we see BTPs below 2% absolute yield on the 10yr tenor, for a spread of

100bps over Bunds and 60bps over OATs. Catalyst to be the same as presented above: ECB’s

policy, deflation biting.

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(3) Japan Second Phase of Abenomics

Our quick views on the theme can be found in this SHORT VIDEO RECAP.

Our forecasts for Japan earlier on this year read as follows:

‘’Abenomics may likely fail, eventually, but before that efforts will be stepped up,

further inflating the bubble in the equity markets. BoJ may be close to confirming its QE

operations for 2015 and even increasing their magnitude from already monumental levels.’’

‘’Two years from now, the Yen is significantly weaker than it is today in both a

Abenomics’ failure scenario and a more benign scenario. Currency debasement is either

the result of a successful laboratory experiment of the BoJ or the poster child of its

failure.’’

‘’Private-sector credit spreads are at rock-bottom levels and offer the best payout ratios

to hedge failure of Abenomics in the years to come. We start an accumulation program

here, as spreads can hit bottom in the next six months.’’

Position-wise, our baseline for Japan scenario is two-phased:

- First phase: Short Yen, Long Equity, Tighter Credit Spreads

- Second phase: Short Yen, Lower Equity, Higher Rates / Credit Spreads

On the last day of October, Japan officially entered Phase II of Abenomics on our timetable. Few

things happened simultaneously:

- BoJ increased monetary printing to even more monumental levels, with a bold

non-unanimous decision (anecdotal evidence of how the move was orchestrated

is quite telling READ)

- The GPIF (the leading indicator of a $2trn local pension industry) made official

their new asset allocation, moving more into Equity, locally and abroad

- Few days later a planned VAT tax hike on the road to fiscal rectitude was

scrapped and postponed to where it is totally irrelevant (by the time it is due,

Japan will have either made it or break it).

- Snap elections were called by Abe to consolidate its power grip, to further

solidify the execution of the plan

In a nutshell, Abe went all-in. It is clear that he will stop at nothing until he achieves his goals:

breaking the back of deflation, kick-starting growth, reflating the Japanese economy by

bringing nominal inflation to 2%.

Few months back, we described their policymaking as ‘fighting like a Samurai, or dying like a

Kamikaze’. Tertium non datur.

19 | P a g e

In a way, their policy tools are similar to those used in the US, with one important caveat. The US is

driven by genuine ‘optimism’, as the recovery always seemed around the corner, and has indeed now

materialized. The same policies in Japan seem driven by vivid ‘desperation’.

As we run out of space here, we will expand on actual portfolio trades’ terms and conditions and

execution strategy in our Investor Presentation.

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What worries us: Bubble US Equity Markets and Russia’s Tail Risk

In implementing our portfolio into 2015 we think of two risks above all: US Equity markets are

expensive, well into bubble territory, and Russia’s tensions are dragged over from 2014, making

final resolution more and more uncertain.

There are clearly so many other risk factors in markets these days: China’s hard landing,

Commodity/EMs weakness, Europe’s crisis flaring up again, failure of Abenomics.

However, these are all in investors’ radars, while those two risks seem to be market’s blind spots.

US Equity in Bubble Territory

US Equities are in bubble territory on so many valuation metrics that it is hard to ignore.

- Price/Earnings are at ~18, forward P/E at 16, but well above 25 when cyclically-

adjusted (CAPE or Shiller ratio), several times in history a precursor of a crash

- Most recent forward P/E advances from 15 to 16 were justified by both increases

in price (+4.1%) and decreases in EPS (-0.7%)

- Most of the market advance of the last two years is justified by multiple

expansions more than earnings growth

- Corporate margins (the denominator on P/Es) are themselves at a 70-year high

as a percentage of GDP, usually a mean reverting metric

- Price / Sales well above 1.50, historically led to corrections, including hard ones

- Market Cap / GDP (Buffett’s favorite indicator) well into bubble territory (above

1.2, it was higher than this only in 1999, before DotCom crash)

- Market Internals have deteriorates lately: advance/decline line, % of stocks

above 200d averages, new highs/new lows. Hard to ignore that the peace that

one can see on the Dow Jones/S&P/Nasdaq is deceptive, as the Russell 2000,

EMs, Commodities, Gold, Inflation, small tech/pharma are all in tatters, including

the fact that market advances are shared by a growingly smaller number of stocks

- NYSE leverage at record highs (higher only in 2000 as % of GDP), despite thin

liquidity and small inventories / small market-making left (no-exit markets)

- USD is appreciating fast and corporate margins cannot but be affected going

forward. Oil is a net positive and offsetting factor, for now: big boost,

counterbalancing USD headwinds, although some smaller side-effects are to be

seen on Shale Gas/Oil producers/industry

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We have had our shorts on the S&P/Nasdaq several times this year. Luckily enough, last time around,

we unwound them in mid-October (before a powerful bounce of the markets, which left us with

October being our best month ever). Reasons why we unwound shorts in mid-October:

- Markets were overly worried with two elements, which we disagreed upon. The

first is interest rates moving lower, to approx. 2% on 10-year Treasuries. That

was interpreted at the time as a sign of weakness in the economy. Hardly

convincing, as latest market corrections in August 2014 and May2013 (taper

tantrum) were justified by the exact opposite – higher rates. We think low rates

are a definite positive, for corporate profits, for over-levered

households/businesses/investors/governments.

- Markets were overly worried about a fall in oil prices, as they read in it a falling

global demand and secular stagnation (coupled with lower rates) more than

supply-side issues (Saudi Arabia/OPEC, Iran/Russia, US shale gas,

renewables/energy efficiency etc). We could argue that geopolitics here matter

too: any conspiracy theory looking at Saudis squeezing Shale Gas/Oil

competitors, or the Pentagon playing financial warfare on Russia’s sole

contributor to GDP are all but unjustified. To us, they are reality. But even aside

from that, lower oil is a definitive boost to consumption, especially to low-

income households, which are the most elastic to price movements (more so

than supply-side and oil producers), which are also the biggest contributors to

GDP advances. So, a definitive positive. A true QE-4. Much more mechanically

linked to aggregate demand than QE itself has ever proved to be (e.g. theories

of second-order effects of Bernanke’s portfolio balance channel, debasement of

currencies, real rates repression, forcing into riskier assets).

Indeed, narrative in the market changed almost overnight, a huge buy on dip materialized in mid-

Oct, algorithmic trading followed swiftly, shorts were squeezed and brought to tears/redemptions,

and a strong rebound into new highs served.

Still, shorts on the S&P are intriguing, and should be considered. While higher S&P does not

necessarily imply higher valuations elsewhere, the opposite holds true. A correction of the S&P

would lower the bar on everything else the world-over.

The US is undoubtedly the best economy around, thanks to bold fiscal and monetary policies, a fierce

determination to make things work fast, a reserve currency sharing the burden of debasement so

that it is a no-brainer for the US to do, a game-changing industry leadership in Technology. Still, it is

so expensive on valuations that it is difficult to ignore. It is priced to perfection, and perfection exists

but does not last.

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Russia is Wild Card in 2015

In our latest Outlook, we argued:

‘’Dangerously, the Russian economy looks similar enough to the economy of 1998,

having failed to progress much on other sectors of the economy beyond energy and power /

metal and mining. A disappointing outcome, considering Russia had one of the fastest rising

middle classes globally. Its dependence on the gyrations of oil pricing remains the same as

back then. Critically, oil is in secular decline, as global demand lags, energy efficiency

progress, alternative sources of energy are made available (from shale to renewables). A

steady influx of technological advances can only maintain such trend, while any

breakthrough discovery is set to accelerate oil implosion, at some point down the road.

Quite tellingly, not even geopolitical tensions spanning all the way from Ukraine to the

Middle East to most of North Africa managed to spur a sustained recovery in oil prices.

True, there was an unsustainable fixed currency regime back in 1998 (followed by a 70%+

devaluation of the Ruble in one month), an economy still transforming itself from Soviet-era

format. But differences between now and then do not go enough beyond that. Inflation is

not much lower today than it was in 1998 before the crisis: single-digit trending lower in

1998, single-digit trending higher in 2014. International reserves are higher today than

they were in 1998 (table), but External Debt is also much higher today than it was back

then (4 times over).

On the other hand, it is estimated that Europe risks approx. 0.5% of GDP knocked off 2015

numbers were the tensions with Russia to escalate from here, resulting in further

sanctions. Not a rosy scenario, given a Europe-wide near-zero growth. It means recession.

Still, not a default scenario.’’

The confrontation with the West was lost by Russia from the very beginning. Irrespective of the

political debate around Crimea/Ukraine, no confrontation can ever be won if one engineers to have

everybody and their sisters against. Divide et impera (divide and rule), a Romans’ maxim, has often

proven right. It is difficult to get few apartments in a condo to agree on pretty much anything.

Russia’s government managed in the incredible task to get them all on one side: the other side.

Said that, Russia is now squeezed in a corner, and as it commands one of the largest military

forces in the world, that can hardly be ignored. Markets have gone silent on the risk, which

makes us nervous. The single quickest way for Russia to put a floor to oil prices (now that OPEC

let them down) would be to increase geopolitical risk premia in global markets.

It is easy to mention here that economic isolation leads to either re-integration or to more radical

moves. The economic decline it implies makes inaction an inferior course of action for the

government who suffers from it. Amongst several precedents in history, at the outset of WWII, a

23 | P a g e

militaristic Japan drove closer to Nazi Germany a year after the US imposed on them

embargo/sanctions owing to the invasion of Manchuria (Export Control Act: ‘US moves were

interpreted by Japan's militaristic leaders as signals that they needed to take radical measures to

improve the Empire's situation, thereby driving Japan closer to Germany’).

In conclusion, our baseline scenario remains de-escalation and re-integration. On that basis, we

have entered optional longs on the Ruble with heavily-asymmetric potential contributions to NAV.

Still, the acceleration in the collapse of Oil last week is the most concerning in this respect. We

expected a decline, but a floor around 80$.

Geopolitics are impossible to call, as they do not follow rationale number crunching alone but so

many other factors, including personal ego. However, while we were dismissive of risks when

markets were paranoid about them, now that Russia has disappeared from the rear mirrors of

markets and the gridlock drags along, we grow concerned of tail shocks arising from it.

What I liked this month

How BOJ’s Kuroda Won the Vote for Stimulus Expansion - WSJ READ

How a Limo Ride With Paul Krugman Changed Abenomics READ

A Crazy Idea About Italy | Jim O‘Neill at Bruegel READ

Keynes is Slowly Winning – Paul Krugman READ

The $400 Billion Bond Mismatch READ

W-End Readings

Fasanara Capital recent CNBC interview VIDEO

Mussolini’s great monetary policy failure | The Market Monetarist READ

Between the wars: Japan Invades China VIDEO

Crimean War VIDEO

The Next QE? Switzerland Prepares "Living Wage" Of $62,400 Per Year For Every Citizen READ

"The World in 2030" by Dr. Michio Kaku VIDEO

24 | P a g e

Thanks for reading us today and this year! 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 on December the 10th

at 5.00PM. 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.

Happy end-2014 and all the best for 2015!

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

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