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

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September 3rd 2013

Fasanara Capital | Investment Outlook

1. Syria may serve one purpose above all, which is to take the blame away from

Bernanke, Obama, Congress and the Euro crisis altogether for the possible steeper

correction we foresee. We view markets as structurally fragile at present, for any

one exogenous factor can legitimately take them down: over-leverage built-up in the

system, low liquidity / low inventories constant, market's blind optimism. Bubble

markets are gapping markets.

2. Our sense is that justifying ex-post a more sizeable correction of another 10%-20%

in G4 equity markets would suddenly be easier to do than most investors initially

perceived.

3. Tapering may get postponed by few months, leading to a short-lived relief rally. So

much for the potential nominal rally we see possible in Q4.

4. Rising rates are the most poisoned threat to markets in the short term: 1) tapering,

while delayed, will still take place, 2) EMs might be forced to dump some Treasuries to

stem currency crisis, 3) rising expectations on GDP can easily justify 4% on 10yr govies

5. China: the key problem in China is the Corporate sector, whose leverage is 125%+ of

GDP. As long as nominal GDP growth comes in strong, China’s imbalances can be

contained. But growth numbers below 7% have the potential to lit the fuse on

Corporate China’s excess credit.

6. New elections in Italy are a 'fat tail' risk, which is not even a 'tail', as its probability

tops 40%. Italian bonds are well inside bubble territory against this backdrop; Italian

equities are historically cheap, but way off pricing in such risk scenarios..

7. VALUE BOOK: remains flat, as markets are toppy, still expensive vs fundamentals,

at risk of a 10%/20% steeper correction. Most of the opportunities in the HEDGING

BOOK: short S&P, long VIX, long Credit Curve Flatteners, short EUR, Long Interbanking

Spreads, long Currency Pegs, short JGB rates, short Yen, short Australian Dollar.

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Bubble Markets are Gapping Markets

In the month just past, the dreadful state of Commodity and Emerging Markets began to work

as a drag to global markets, including the mother ship US, where valuations stopped their ascent

and rowed some back. As of late, escalating tensions in Syria and Egypt served as a catalyst.

To believe that EMs/Commodities could be free-falling, while G4 countries kept rising ad

infinitum on Quantitative Easing and cross-border re-allocation of capital flows, is the

incompatibility we flagged up a while ago (Deleverage Chain vs Bubble Chain): we believe EMs are

nowadays too big not to have an impact on global growth, as they now contribute half of the world’s

GDP. We simply believe that they cannot be tell-tales of a totally different economic reality than the

one depicted in, say, the US.

To us, Syria may serve one purpose above all, which is to take the blame away from Bernanke,

Obama, Congress and the Euro crisis altogether for the possible steeper correction we foresee.

Perhaps, the heavy volatility is better attributed to the unsustainable disconnect between

economic fundamentals and financial assets’ pricing, produced by ill-conceived pump-priming

mantra, intended to domesticate markets to a virtual reality where current policymaking is

sustainable and strong GDP is waiting for us come 2014.

Such remains the key vulnerability of current markets, leaving them structurally fragile to VAR-

shocks and sudden digital adjustments to the downside. Bubble markets are gapping markets.

Against such background, Syria may be more the effect than the cause. We view markets as

structurally fragile at present, for any one exogenous factor can legitimately take them down. A

number of factors can then make such correction more violent at any given time, as investors

rush for the exit in a one way market, overcompensating to the downside: the over-leverage

built-up in the system (outstanding margin debt at almost 400bn at the NYSE), the low liquidity /

low inventories constant (which has become a recurring element of current markets), market's

blind optimism (as most investors have bought into the Central Banks' dogma, with most of the

market’s advance explained by P/E multiples, as opposed to earnings expansion).

Said otherwise, markets have been rendered structurally fragile by the present phase of recent

crisis resolution policies. As the dust is being chipped away under the carpet, the carpet is belly-

shaped now, and it is proving difficult to walk on it. The capital mis-allocations generated by QE-

type policies (of which the EMs bubble was on the receiving end), in the desperate attempt to

alienate tails risks and kick start growth, is biting back on any given opportunity. Syria is one,

but there are several other canaries in the coal mine.

Our sense is that justifying ex-post a more sizeable correction of another 10%-20% in G4 equity

markets would suddenly be easier to do than most investors initially perceived.

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Binary Events Ahead, Volatility To Stay Elevated

As we remain focused on Tail Risks, against which we design the portfolio to be over-hedged, here

we enumerate the most obvious catalysts ahead of us, warranting the need for protection strategies:

US Tapering

Tapering may get postponed by a few more months, as we anticipated (more upside in Q4 than

Q3), leading to a short-lived relief rally. So much for the potential nominal rally we see possible

in Q4. However, sooner or later, tapering is indeed happening, on the back of either or: 1)

supposedly improving macro data, 2) unsustainability of QE monumental program over the long run,

3) diminishing returns and ineffectiveness (the one real motive why it should be discontinued, in our

opinion) 4) one more way to stem a potential run-up in oil prices, now that geopolitical tensions drive

them up again. Undoubtedly, with important consequences for interest rates and assets’ pricing

at large over the medium term.

FED Chairmanship

As it looks like at present, that is a two people race between Yellen and Summers. Effective as

Bernanke was in convincing markets in the face of a grim reality, the bar is set high for any successor.

If anything, we view Yellen as the best options for markets in the short term. We disagree to the

market’s perception of Summers as a safe choice. While he may first commit to continuity on

Bernanke’s largesse, Summers is volatile, vocal, aggressive, the polar opposite of Bernanke’s

soft touch and predictability. At best, volatility spikes would then have to be discounted.

US Federal Debt Ceiling Discussion

Come October, confrontations on the fiscal front may heat up again. While our base case is for an

extension of the debt limit for another year, this is also largely the consensus view, leaving the door

open to volatility and headline risks should it not be the case.

China’s Credit Crunch

To us, the key problem in China is the Corporate sector, whose leverage is 125%+ of GDP (after

jumping 30%+ in the last 4 years, the biggest single contributor to China’s debt/GDP ratio).

Typically, emerging markets have such ratio setting at between 40 and 70%. Beyond the corporate

sector, China’s leverage is not outrageous (approx. 200% of GDP, lower than in Japan). Critically, two

thirds of such Corporates are not SOEs with easy access to credit, local governments or large

property developers, but mid-caps which have grown increasingly reliant on the shadow banking

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system. Such reliance is sometimes borderline resembling Ponzi schemes. Inter-company

guarantees have reached the staggering amount of 83% of total guarantees (from 54% in 2008). At a

time when China seems trying to rein in credit excesses in the shadow banking system, in

transitioning to a consumer-led economy, they will do so messing around with the largest

vulnerability in their system, the Corporate sector.

As long as nominal GDP growth comes in strong, China’s imbalances can be contained. But

growth numbers below 7% have the potential to lit the fuse on Corporate China’s excess credit.

In the banking space too, there are worrisome developments. A recent HSBC report shows us that

City commercial banks became the largest issuers of Wealth Management Products, on which

they rely for their funding: some WMPs go all the way to invest in tea, ham, watches so as to seek

the 60%-type returns they promised depositors. WMPs are de facto capital guaranteed by the banks.

Moreover, local banks have now grown mismatches between assets and liabilities in foreign hard

currency. The Renminbi is the only EM currency which didn't lose ground to the dollar in the last

few months. No doubt authorities will attempt to avoid such devaluation in every possible way. As

they sit on massive FX reserves and $ 1.27 trn Treasuries, they might sell some if the markets were to

push them. Incidentally, China net sold $20 bn worth of Treasuries in July.

For all these reasons, we believe we are still not past the China’s risk, and its impact on deficit

countries like Australia and Brasil, in primis. While we convene that China will be the global growth

engine of the next decade or so, we do see digital risks first for the next couple of years, as their

delicate rebalancing process unfolds.

Elections in Europe

Market seems to be waiting for German elections on September 22nd

to go by. Past them, the

consensus is for more accommodative policies over peripheral Europe to be allowed by

Germany. To us, such expectation might be disappointed. If anything, moving the lens from cheap

talk to hard flows, evidence can be found for the opposite to be true: Germany's TargetII exposure

has declined by Eur 200 bn in the last 12 months (while the Euro area monetary base contracted by

some Eur 500 bn in the period).

Moreover, as we argued extensively in July Outlook, it is not only about German elections, but

perhaps about Italian elections too, soon enough. The political landscape in Italy is crystal-fragile,

as the governing party led by Berlusconi faces a lose-lose proposition between political irrelevance

and outright extinction. To them, returning to elections in some drama play on anti-EUR rhetoric,

might end up being the safer option to resort to. New elections in Italy are a 'fat tail' risk, which is

not even a 'tail', as its probability tops 40%. Italian bonds are well inside bubble territory against

this backdrop; Italian equities are historically cheap, but way off pricing in such risk scenarios.

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So far, the EUR proved to be way more resilient than we anticipated, especially vs USD and GBP.

Looking at things in retrospect, for what it’s worth, we can see few reasons for the EUR relative

strength. Firstly, the repatriation of flows from EMs makes for a powerful drive (it is estimated that

Eur 1 trn was invested into EMs by European funds only). Secondly, as LTROs got repaid for Eur 300

bn (on total Eur 1 trn), excess liquidity in the banking system compressed to ~Eur 250 bn. The ECB

estimates at 200bn the threshold for tightening pressures on EUR short rates. No doubt the

compression of the ECB balance sheet relative to BoE / FED is supporting the currency. We maintain

our bearish view on the EUR, although we know we may have to be patient before it plays out.

Interest Rate Rising

Rates rising are the most poisoned threat in the near term. We left for last the one risk we consider

the most dangerous. Higher long-dated US rates could lead the sell-off on global rates, with obvious

bad news for the housing market and for global fixed income portfolios (more than 70% of global

portfolios). The FED alone owns $2trn of Treasuries now, on which any rate increase equates to a loss

on very thin total capital (tiny ~$ 50 bn): although no mark-to-market applies, and accounting

gimmicks have been made widely available. Fiscal deficits are also affected, as 40% of the stock of

US government debt rolls within the next 24 months, at possibly higher rates. Higher long-dated

rates could be the casualty of few concurring forces:

1) Tapering is the most obvious factor: while it may possibly be delayed for a few

months, it is still going to take place. On the 18th

September, the FOMC meeting should

shed some light on the timing, size and composition of tapering. The job report on the

6th

will surely help direct that decision.

2) While the FED owns now $2trn of Treasuries, almost another 6trn is owned by

foreigners. China accounts for only $1.27 trn of Treasuries now. Amongst foreigners,

Emerging Markets central bankers and reserve managers own the bulk of it (out of total

$ 9 trn currency reserves). Differently than EM crisis in 80’s and 90’s, they now all sit on

large currency reserves. Critically, Emerging Markets are gripped in currency crisis on

fast depleting capital inflows, owing to large current account deficits and large

foreign ownership of local bonds. As they cannot easily and heavily hike rates, the

temptation could well be there to dump some Treasuries in defense of their

currencies. So far, only Brasil timidly attempted this avenue. India, Turkey, Indonesia

and the rest could well try this, with inevitable upside pressures on US yields. China too,

if the Renminbi ever comes into closer scrutiny. Surely, such dumping would be a

double-edged sword, as higher rates in US were catalyst to EM woes in the first place.

3) Discounting inflation target at 2%, 10-year US rates at 3% project a real GDP

growth of just 1%. Unimpressive, especially against the background of monumental

monetary injections: rising GDP expectations can easily justify rates at 3.5%-4%.

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The Structural Case for Staying Bearish and Hedging Tail Risks

Beyond short term noise and factor analysis, we want to try and isolate the root causes of today’s

market fragility, the way we see it.

So many other times in the past, the FED and other monetary authorities have attempted to

cure financial pandemics with heavily expansionary policies, trading one asset bubble for

another, creating the premises for the next coveted asset to fall victim of sudden deleverage and

overcompensation to the downside: just in the last decade, the looser policies following the tech

stocks bubble bust in 2000 led to the housing bubble in 2007, the bust of which led to the subprime

crisis and global deleverage, only for the looser policy then applied to lead next to commodities/EM

market bubble and then deleverage. The bubble in Emerging Markets was just the last Central

Banks’ unintended consequence in a long list of historical precedents, as EMs saw net inflows

doubling up to $ 8 trn in the last 5 years on ZIRP and QEs policies. Now again, a bubble has

inflated around Credit (especially government bonds) and equities (especially US) on the back of

heavily expansionary monetary policies.

As US President James Madison once said: ‘’The circulation of confidence is better than the

circulation of money’. The effectiveness of quantitative policies has always been about

perception and confidence. Any real mechanical linkage to neither sustainable equity valuations,

nor the real economy, has yet to be proven. To this day, the causality between monetary base and

financial valuations, between monetary base and economic growth, even between financial

valuations and economic growth (the Bernanke’s Portfolio Balance Channel), is nowhere to be found

in the observation sample of a century’s worth of data. While the FED and others claim to have

found a new way, these theories are still just at their crash test stage.

This time around, such linkages may even be proven right, but on such a timeframe which can

provide little help in managing today’s portfolios. We cannot help but to keep the focus on

historical empirical evidence, leaving the virtual reality described by monetary authorities to the

test of history. We prefer the prudent take of equipping our portfolio with hedging against the

severe downside risks which have typically followed similar market conditions so many other

times in the past.

The root cause of the market fragility is the accumulation of debt currently in progress, with the

inability to generate the income sources needed to service such debt overhang down the road.

Low interest rates are slowly hitting savings rates too, with even less firepower at hand to feed

consumer demand. As the FED accumulates Treasuries for $ 2 trn dollars and counting (and similarly

the BoJ and BoE do so), as such debt can never be dismissed easily, such overhang will provide a drag

to potential growth and real economic activity, the only variable which can lead to a sustainable

rosier outlook. To collect monumental debt with no capital stock growth or productivity gains in

return, is no different than building ghost towns in rural China and claim that a higher nominal GDP

growth was achieved in the process.

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No doubt further complicating the outlook, the real economy and the private sector in G4 countries

have not reacted to the illusory reality being proposed. Companies are not investing in capital stock,

in new ventures, nor are they hiring employees to grow new cash flows. If anything, they buy

competitors’ earnings stream, via M&A activity (and share buyback for share exchanges).

Consolidating industries, per se, lead to lower employment and higher debt metrics.

Debt is still to be repaid, and debt is higher than 1, 2, 3, 4 years ago. New debt from the public

sector (via QE and LTRO rehypothecation/financial engeneering) and the private sector (M&A, share

buybacks), with no new growth/real GDP/industrial production/real productivity to refer to for

the cash flows needed to service that new debt.

Critically, as we argue that perception and confidence is the main proven achievement to date of

heavy money printing, we also imply that blind trust and intellectual sclerosis is the real floor to

bubble valuations. But confidence is a double-edged sword, as it is evanescent, and can fast

dissipate as time goes by and more evidence is slowly gathered against it.

If such dogmatic trust were to abate, should the market wake up and smell the coffee of

policymaking ineffectiveness, then even lite- tapering or un-tapering would prove of little help.

The market could quickly realize that the safety net provided by Central Banks is not so safe after all,

depriving the market of its illusory floor.

Regrettably, it is impossible to call the day, the month, or even the quarter in which such

correction and reality-check may take place. Policymakers can indeed buy more time. Money

printing might still be in its early days, despite evident diminishing returns (tending to zero). For

all intents and purposes, we are left to rely on a sustainable multi-dimensional risk management

policy, intended to keep the guard high for long enough, being able to finance the renewal of

market protection strategies for the quarters to come.

At present, our task is made the most difficult as we have no significant carry generation within

the Value Book to rely upon in financing the cost of the hedging strategies. Ever since May, and

differently than in the last two years, we decided to keep the Value Book flat-ish, as carry strategies

would be exposed to digital downside risks in both equity and credit asset classes. When adjusted for

real risks, as opposed to deceptive historical vols, such carry strategies are a clear pass.

Consequently, the ability to fund and roll hedges and keep them alive for long enough will be the

key determinant of our ability to live to produce strong returns in the medium term.

Having discussed which risks we see possible in the remainder of 2013, let us offer an update on the

scenarios we do are currently hedged for.

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Investment Strategy: Value Book flat, Hedging Book active

Our positioning in the portfolio remains broadly unchanged:

1) VALUE BOOK: at present, our Value Book remains pretty flat, as markets remains

toppy despite their recent correction, still too expensive vs fundamentals,

especially now that rates may be on the rise and the Central Bank support shows

the first cracks. Our current small allocation to longs in the Value Book is filled with

select Special Sits which still offer asymmetric returns vs risks in our eyes. We will

change our bearish positioning once the disconnect between the real world and

financial markets tighten from here, as a consequence of market correcting further

or fundamentals improving (we remain skeptical on real growth recovery, as argued

extensively, but will remain open-minded as the situation develops and more data come

in). Also, we will change that stance if markets move side-ways for long enough

(which is just another way to digest their expensiveness, arithmetically equivalent

in real terms to a declining market if inflation is above zero). As argued last month

already, we have been in bubble markets similar to the current ones multiple times in

history: 1) the Credit markets are all too remindful of 2007 (at that time it was

Investment Banks inflating the bubble through leverage, this time it is Central Banks

themselves, with obviously more margin for error, but not infinitively so). 2) The Equity

markets, the Mothership US in primis, are remindful of conditions we have seen already

in 2007, but also in 2000, 1987, 1929, all followed by market crashes (we gave our take

on technicals/fundamentals for the US market in our previous Outlook on page 11: US

Equities have entered bubble territory). Let alone a sound risk/return policy, as we

observe that there has never been so much risk for so little return, over the last century

(long–only funds and Sharpe Ratio-driven allocators should feel the discomfort). We

suspect that the time for us to reload on long positions might be sometimes in Q4, as by

then the fundamentals might have improved to a level where they are visible, or they

will have stalled (as we suspect) thus forcing the hand of the FED to delay tapering and

a concurrent re-pricing of expectations around it.

2) HEDGING BOOK: on the other end, we currently see most of the opportunities in the

Hedging Book, and we banked on them in the month just past. As the market

misprices the potential for realized volatility to pick up from here and for ‘toppy

markets’ to be ‘gapping markets’ (Gold’s heart attack, Nikkei flash crash, next?). It

makes sense to us to be long volatility in such uncertain markets where rates cannot

possibly fall any further (and Credit can’t either in any meaningful way), where investors

go long on large margin, where shorts are cleaned out, and where silly talks of the

‘bondification of equity’ spread around. As early as September 2012, we were early to

say that equities would have been more ‘defensive’ than bonds (‘‘European Equities Will

Jump’ Video), as we migrated our book from High Yields into Equities; riding the bubble

of catch up rallies first (Europe), and Nominal Rallies later in December 2011/January

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2012 (US and Japan, currency hedged). We now dump that train too, until further

notice. Our methodology for Fat Tail Risk Hedging Programs should cover our –

currently small - exposure to the Value Book, while waiting for better valuations

before we reassess re-loading on longs. Amongst hedging strategies, on the list of

pre-identified scenarios in our Multi-Equilibria Markets roadmap, our top picks are as

follows:

a. Hedging against Inflation & Default Scenario / Equity Market Correction on

Bubble Markets: short the S&P, long VIX, short Japanese rates, short Yen. We

plan to augment hedges against Inflation Scenario as the year go by. As

monetary growth will lead to money supply growth sooner or later, as

money-supply would consistently exceed output growth, as credit-to-GDP

ratio deviates from its long-term trend (gap measure), we think it will be

proven wrong to have considered inflation dead. Inflation will have its day

again, soon enough, in our opinion.

b. Hedging against China Hard Landing Scenario: short Australian Dollar. We

are now adding new ways to gain exposure there.

c. Hedging against EUR-Break Up and Renewed Credit Crunch: Long Credit

Curve Flatteners, Short EUR. Also adding Long Inter-banking Spreads, Swap

Spreads, long Currency Pegs.

In terms of instrument selection, we follow our methodology for eligible instruments with target

multipliers on exit higher than 10X (and as high as 100X): Cheap Optionality first, but also Select

Shorts, Embedded Optionality and Dislocation Hedges.

We will offer an update on each one of those hedging strategies to current and potential investors

during our Monthly Outlook Presentation on the 19th

of September in 55 Grosvenor street in

London, where supporting Charts & Data will also be displayed. Please do get in touch if you wish to

participate.

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What I liked this month

Federal Reserve owns more than $2 trillion in US debt. An additional $5.6 trillion — including the

amount held in China of 1.27trn — is owned by foreign entities, as of late June. Estimate the real debt

owed by the US is closer to a staggering $70 trillion: Read

Multiple Expansion, not earnings growth, Driving the Rally in U.S. Equities Research

Four economic indicators signal that US growth is off to a weak start for the quarter Charts

W-End Readings

Fasanara Capital’s YouTube page now available: Videos

Sovereign risk: a world without risk-free assets? Working Paper

A Recovery In European Periphery .. In Burglaries! Chart

Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001 E-Mail: francesco.filia@fasanara.com Twitter: https://twitter.com/francescofilia 55 Grosvenor Street London, W1K 3HY Authorised and Regulated by the Financial Conduct Authority (“FCA”)

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