1. “Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci
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2. December 16th 2013
Fasanara Capital | Investment Outlook
1.
As we move into 2014, we maintain our current investment strategy for renting the
rally in equities, mainly outside of the US, while preparing for Japan-style volatility
by Q2 2014. Artificial markets are structurally fragile, artificial markets are gapping
markets. Stay long, but only tactically so. Stay fully hedged.
2.
US: bubbles in both Equity and Credit. Our baseline scenario is for tapering first, untapering later. A correction in between, Japan-style, 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.
3.
Europe: the momentum it enjoyed as of late has turned yet again to inertia. Being
long Europe as we have been recently, feels more and more like picking up dimes in
front of a steamroller. We reduced our tactical longs there, while increasing our hedges
arrangements. Longer-term, we believe the EUR construct if structurally flawed and
set for implosion in the few years ahead.
4.
Japan: 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’-type policy in full motion.
5.
China: as long as nominal GDP growth comes in strong, China’s imbalances can be
contained. But growth numbers below 7% have the potential to light the fuse on
Corporate China’s excess credit. We are positive in the short-term (artificially so, as
fixed investment habits are hard to die), negative for the next two years (as credit
excesses are exposed in a rebalancing economy), positive again in the next decade (as
demographic factors, GDP quality catch up, and reserve currency status take hold).
6.
VALUE BOOK, remains light, but reloaded selectively:, as markets are toppy, still
expensive vs fundamentals, at risk of a steep correction. Long Nikkei, Gold-stocks
accumulation started. HEDGING BOOK, active: short S&P, long Credit Curve
Flatteners, Long Interbanking Spreads & Currency Pegs. TACTICAL BOOK, expanding:
long Greek Banks, long select Shipping, long China-led stocks and commodity for short
term reflation to continue.
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3. Investment Outlook & Opportunity Set in 2014
In our last write-up of the year, we like to offer our quick observations on the US, Europe, Japan and
China, so as to highlight where we see the opportunity set in 2014 portfolio-wise.
Before we do that, let us summarize our portfolio’s positioning at present. 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 (CNBC Interview). 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.
Our conviction remains that the market may gap down, in sizeable amount of 20-30%, is a
consequence of the glowingly larger disconnect between asset values and fundamentals, in an
environment of excess complacency, dogmatic confidence in central banks policies, excessive and
unbearable levels of debt and leverage, low volumes / low inventories. While it is impossible to call
the day, week or quarter where such a correction might occur, we would be surprised if such
volatility was not to resurface by Q2 2014.
That said, we do not expect such 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 later in 2014, 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.
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4. Bubble Chain vs Deleverage Chain
Before we start our read across through main countries, let us revisit a valuation tool we used over
the course of 2013. Our framework for attempting to make sense of market chaos isolates too
opposing forces: Bubble Chain vs Deleverage Chain. The players for the two chains are displayed in
the Chart below (for a full description of the timeline of the two chains please refer to page 2 of the
attached: Timeline of Bubble Chain and Deleverage Chain). The Bubble Chain reacts to Central
Bank’s liquidity and puts dogmatic trust into the holy promise of open-ended Quantitative
Easing, in spite of fundamentals being foretellers of a parallel universe. Here, chasing the yield
(income stream) in the markets has become chasing the rally (capital gains), which is turn has
become chasing the next bubble. The Deleverage Chain speaks of the real universe, and still tries
to price itself against real GDP, against the unfortunate reality of an end-of–journey Keynesian
economy gripped by 40 years of over-leverage with no growth to support it.
We believe that Japan is an important driver of the Bubble Chain, as its fate will affect the perceived
effectiveness of QE policies globally. On the Deleverage Chain, China is the chief catalyst, and
understanding what happens to China’s credit markets may help understand what happens next to
the Deleverage Chain.
KEY
DRIVERS
On a longer term, we believe re-coupling is most likely: the virtual reality manufactured by Central
Banks can deflect from the physical world of real GDP/real Industrial Production for only that long.
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5. US Equity and Credit: Beware of Blue-Sky Markets
Beware of blue-sky markets where the only price they are prepared to pay for uncertainty is a
slowdown of the rally (Bloomberg interview).
There is an element of the current markets well overdue an inflection point: realised volatility: more
than we contest the absolute levels the market is trading at, we do contest the smooth linear
interpolation it got there with.
In the absence of real economic growth, liquidity-induced rallies are to show liquidity-induced
volatility and sell-offs, sooner or later.
Volatility is to resurrect from the ashes it has been reduced to by Central Banks activism,
rebelling to it, as they run into exhaustion mode: after years of ripping the easy benefits, the law of
diminishing returns is kicking in, and the underlying patient, treated with huge doses of morphine,
starts to cough out of breath again. In shorthand, ‘toppy markets’ are ‘gapping markets’. We
anticipate Japan-style volatility within Q2 2014 (CNBC Interview).
We expect market’s complacency to be the biggest troublemaker in 2014. ‘Circulation of
confidence is more effective than circulation of money’, former US president Madison once said. But
confidence is evanescent, hardly a durable safety net in artificial markets as we live into. This is
where we differ the most from market consensus. In the widespread feeling for the 'bondification'
of equity we see the key vulnerability of the markets.
Investors expecting equities to behave like bonds, showing low realized volatility and pull to
par/infinity, are likely to be disappointed at some point down the road, leaving on the table most of
their earlier gains.
Misconceptions are all over:
1-
In the markets believing that Central Banks can put a floor to valuations lies the little
consideration given to the fact that monetary policies were indeed expansionary during the
largest corrections of 2000 and 2008.
2- Earlier this year, we used to live in an environment where ‘bad news were good news’ and
‘good news were bad news’. As the rallies which followed the two latest strong US job
numbers demonstrated, we now moved into an environment where ‘bad news are good
news’ and ‘good news are good news’. Markets want it both ways. Either growth will justify
expensive valuations, making them less expensive, or monetary printing will resume,
making valuations justified from a liquidity standpoint. Markets are indifferent.
3- Forward guidance is to pick it up from QE policies. What is its value if inflation picks up? No
question asked. Markets seem to buy into it. ‘Cheap talk’ follows ‘hard flows’, moral suasion
follows monetary activism. Normally, it should be the other way round! As QE policies failed
to achieve a good enough level of growth, Central Banks resort to ‘cheap talk’. Hardly
convincing. Still, markets seem fine with it. So far.
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6. Valuations in Stratosphere
US markets are in bubble territory, both in Equity and in Credit. None of this is to say that a
correction is imminent. Central bank can inflate the bubble some more, attempting to reach escape
velocity in the real economy. However, we believe that the risk-reward is vastly in favour of
avoiding US markets, contrary to consensus, as the upside is limited and the downside is large
and overdue. Similarly, we think it is compelling to stay fully-hedged there.
In the last outlook we went through the valuation metrics we believe are being overlooked by
markets (November 2013 Outlook):
-
In Equity, a toxic valuation mix is served: cyclically-adjusted P/Es (CAPE 10) stand at approx.
25, P/S at almost 1.6, NYSE margin debt exceeded 400bn in sept (2.5% of GDP), multiples
expanded some 18% in 2013 (versus 2% on average in the past 20 years), super-thin
volumes, low inventories, high complacency.
-
In Credit, covenant-lite issuance stands at approx 60% this year vs 30% in 2007 (the year
preceding the largest credit crunch since the Great Depression) and 5% in 2005. After
spreads compressed to minuscule levels by mid-2012 already (under the push of financial
repression), collateral started to be taken away, slowly and safely, leaving less cushion
against interest rate risks (in terms of spreads) and against default losses (in terms of
liquidation/recovery value). More than 10% of junk bond issuance currently serves the
purposes of a dividend recap, where cash is paid straight to the coffins of shareholders,
often private equity funds: not only an unproductive use of capital, but a detriment to credit
worthiness, no doubt. Still, no question asked by the complacent investor swallowing it at
market, in a record-breaking size larger than anytime before (including bubble year 2007).
Sometimes the complacent investor is the hot money flows of passive ETFs and Index vehicles,
which have grown monstrously in the last few years. Amongst Blackrock, Vanguard, State Street,
Fidelity, PIMCO, AUMs stand at staggering $ 10 trillions+. A good portion of which is passive
strategies. Taking the 30 largest asset managers, AUMs are at $ 38 trillions.
The role of the passive portion of the fund management industry is largely ignored, so is its
potential impact on price action. We won't expand on the way we see the mechanics of a potential
correction playing out, as we have done so extensively in the last Outlook, describing the various
phases of it we see possible.
In a nutshell, our conviction that the market may gap down, in sizeable amount of 20-30%, is a
consequence of the glowingly larger disconnect between asset values and fundamentals, in an
environment of excess complacency, dogmatic confidence in central banks policies, excessive
and unbearable levels of debt and leverage, low volumes / low inventories.
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7. Potential catalysts for a correction
We see three main possible catalysts for a market correction in the months ahead:
-
Tapering/data disappointing: we do believe tapering is still currently a likely trigger for a
sizeable market sell-off. As we argued in our October Outlook, we expect that Central
Bankers will do attempt to implement it, within the next six months, while escape
velocity seems in reach, taking markets on the back foot yet again. As soon as tapering
takes place, dependency on data will resurface, leaving complacent markets vulnerable
to data flow, as such data crashes against rosy expectations.
-
Protection of accumulated nominal gains. Lightening up of portfolios on year-end or
quarter-end is a possibility. Although this year-end may be playing just fine, as US debt
ceiling negotiations uncertainty, together with ‘escape velocity’ still being debated,
may drive FED into waiting mode on tapering, yet again, and resilience seems hard to die.
-
Corporate Earnings: the bubble within the bubble. In the US, corporate earnings stand at
70-year highs as a percentage of GDP (11% including foreign earnings, 8% excluding them),
courtesy of large government deficits, super-low interest rates, structurally falling wages,
low taxes. We see margins compressing in the quarters ahead, as a consequence of
upside pressures on base salaries, downside pressures on revenues (60% of which is
foreign related, including battered-down EMs), rising rates. Are blue-sky markets
prepared for falling earnings? We do not believe so.
While such catalysts are our best guess, at present, other factors can easily play a role. By
definition, artificial markets, disconnected to fundamentals, are structurally fragile, for any one
exogenous factor can legitimately take them down.
Regrettably, it is impossible to call the day, the month, or even the quarter in which a reality-check
correction may take place. Policymakers can indeed buy more time. Money printing might still be in
its early days, despite evident diminishing returns (tending to zero). For all intents and purposes, we
are left to rely on a sustainable multi-dimensional risk management policy, intended to keep the
guard high for long enough, being able to finance the renewal of market protection strategies
for the quarters to come.
Monetary policy in the US vs Japan
There is a defining difference between monetary expansion in the US and the one in Japan.
Japan has embarked on outsized money printing in an utterly desperate attempt to engineer Debt
Monetization through monumental Currency Debasement. At 500%+ total debt on GDP, there is
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8. no other way out of chronic indebtedness for Japan: (i) it is way too late to try out austerity, (ii)
financial repression alone was insufficient in the last decade and , (iii) real growth is nowhere to be
seen. What is left is a binary choice between Default and Debasement, to achieve kind of the
same result: liquidation of the debt overhang. It may look like a big different, but is it not: rather it is
the difference between a Real Default and a Nominal Default. Surely, the classes of investors
affected are different (for example, inflation curtails the value of a fixed income claim as surely as
default), but not so much the end result from a system-wide viewpoint.
The US is still in a different camp than Japan, in so much as there is a genuine belief that ‘escape
velocity’ is just round the corner, private sector deleverage is completed, while debt metrics are
not as extreme as in Japan.
Activity data seems to be pointing upward, GDP data gather momentum (although inventory built
up likely faked Q3 numbers), consumer confidence holding on, buoyant equity and credit markets.
If we are right about growth remaining the elephant in the room in 2014, such genuine belief for
escape velocity to be round the corner is itself a key vulnerability for markets come 2014. If data
disappoint, as we project, markets can experience deep corrections.
At that point, after such correction, we expect monetary printing to resume - ‘un-tapering’ - and
being taken to a whole new level: nominal GDP targeting, like in Japan.
Our baseline scenario is for tapering first, un-tapering later. A correction in between, Japanstyle. 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.
Tapering first, un-tapering later: which Asset Classes on our map
From last month Outlook: ‘’If we are right about the lack of economic growth remaining the elephant
in the room, then after tapering lies more Quantitative Easing. Perhaps, the new entry monetary tool
of 2014 will be Nominal GDP Targeting (NGDP). Which means by then the sea level of asset prices
will be stepped up once again. Visible inflation is better than stagflation.
Fast-Forward there, and inflation might look less of a prehistoric fossil than it looks today. Fastforward there, and Gold could have its day again, within 2014.
As we argued earlier on in this Outlook, we do feel aligned with that camp who looks at equity as
more defensive than bonds in a world of debt monetization and currency debasement. Especially
so, once proper hedging strategies are there to sustain the volatility that equities inevitably carry
over inside portfolios.
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9. Not all equity, obviously, as some industries, and within those industries some players in particular,
are better able to withstand an inflationary environment. Wherever balance sheet has been taken
out already, while a market leading position commands pricing power, is where we focus our
attention. More specifically, a stagflation scenario is the one against which we map out our stock
selection.
Somehow counter-intuitively, what might trigger NGDP targeting is the confirmation that the
lack of economic growth is indeed the elephant in the room.
While excessive levels of debt have drained resources from productive private investments away into
debt services payment, as the excess debt has failed to create the income sources required to service
such debt, GDP is gripped down by QE policies themselves, in vicious unintended dynamics.
Critically also, the contribution to US growth of interest-rate sensitive segments of the economy is to
be downgraded: housing locally, emerging markets abroad.
Undeniably, debt is too large for QE to have an easy transmission system to the real economy
(interesting research). Still, QE might still look the only way out of trouble, as inflating out of the
debt overhang is preferable to be suffocated by it. It is not so much about the medicine, but
rather about the doses of such medicine for intake.
By then, inflation may turn out to be less a ghost than it looks today. Wage pressures have
already kicked off in the US, while ignored by monetary authorities who for the first time in decades
dis-attended the so-called ‘Taylor rule’ (rate actions had always followed an early rise in wages in the
past, preemptively, almost mechanically).
On the other hand, the weak global cycle, the shale gas revolution, the humiliation of Gold, made
demand for oil and other commodities weaker in 2013, thus mitigating the inflation threat to date.
But the loser asset classes of 2013 could well turn out to be the winners in 2014-2015, should our
expectation for a stagflation-type economy materialize by then. Don't call them out too early.’’
Historical precedent in the US, a successful one
To be true, it should be said that there is a positive historical precedent for an exit strategy of the
FED in a similar environment. The period from the early 50’s to the end 70's saw the Central Bank
exiting the large debt accumulated during WWII in safe mode. During the period, rates rose but
only gradually so, and in line with growth picking up in the real economy, while equity markets
prospered in the early 50’s and debt ratios decreased from almost 120% to just 26% over the period
(courtesy of financial repression, which kept real rates below the rate of GDP growth).
However, several differences make us skeptical about the possibility of a successful replay. For
starters, Shiller P/Es are well above where they used to be in early 50’s. Valuations are vastly
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10. different. Secondly, interest rates are more vulnerable to global flows: $5.6trn Treasuries are owned
by foreigners (the bulk being Emerging Markets). That includes China for $1.27trn, interested itself in
reaching the status of reserve currency (to which goal it is also silently growing to be the largest
producer and the largest buyer of Gold in the world, estimated to have the second largest Gold
reserves within its borders - 7,000 tons, between official reserves and the private sector). Thirdly, if
we are right, accumulation of debt in the US is not over yet: after tapering lies more Quantitative
Easing. To name a few.
Europe: ‘hard flows’ vs ‘cheap talk’ conundrum
We may have been too positive on Europe recently, as in the past month the ECB failed to
deliver on what we thought was a necessary adjustment in policy. As tightening liquidity was
driving short rates higher in the Euro Area, more was needed from the Central Bank, in the form of
an additional refi rate cut, a depo cut, or a new cheaper LTRO (funding for lending-style). None of it
has been delivered and we now wonder if it can be delivered at all. As Europe (especially Southern
Europe) lives through a race against deflation and depression similar to Japan in the 90’s, as doing
something sooner costs less than doing something later (as Japan’s experience has shown), Europe
seems to be adding self-inflicted pain to structural difficulties.
The momentum that Europe may have enjoyed, courtesy of monetary largesse all around it, has
turned yet again to inertia. Being long Europe as we have been recently, feels more and more
like picking up dimes in front of a steamroller. You know that payback time lies somewhere
sometimes ahead of you.
2014 brings with it much uncertainty, amongst which the Asset Quality Review and the stress tests
on European banks. European banks are largely undercapitalized, and this is no surprise. Tangible
Common Equity is 1% to 2% across the continent (including virtuous Germany). During market
storms a 5-7% buffer is what is needed to absorb losses. NPLs have yet to show an inflection point,
probably because they are vastly under-stated. Banks are soon to couple a capital problem with a
liquidity problem, at current speed. LTROs have been repaid, adding to the tightness in the interbanking markets, low excess cash (below Eur 200bn overall in European banking system), upward
pressures on short rates, stronger Euro, lower inflation expectations, a concurrent worsening of real
debt ratios. The vicious cycle can hardly be worse. The whole market is kept afloat by the wishfulthinking expectation of the ECB to inject liquidity, or buy assets outright, or Germany consenting to a
fiscal union of sort. Waiting for Godot, it is.
Meanwhile, Germany has chipped in, as we repeatedly presented. Not only its private sector
decreased its exposure to peripheral European sovereign bonds by some Eur 0.5 trn in 4 years, but
also its public sector saw its exposure to Target II Eurosystem decreasing by some Eur 200bn on total
Eur 800bn in the last 12 months, ever since Draghi used the wizardry of language in support of the
EUR.
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11. So much it is said about the political willingness to keep the Eur fixed-exchange currency together.
So much it is repeated that the political project behind the Euro is not to be underestimated. It occurs
to us that over the past 12 months the economic goals of Germany have coincided to its political
targets, as opposed to diverging. Rephrased, ever since the ECB stated its determination to stand
behind the Euro at all costs, LTROs have been repaid, risk sharing across countries has decreased,
Northern Europe is less exposed to Southern Europe than before. If one were to judge hard flows as
opposed to cheap talks, there would be little discussion.
So much it is made of the tentative improvements in the economic landscape in peripheral Europe.
Not a lot is said about how much more debt per unit of growth has been needed to engineer such
improvement in growth. As growth is projected to improve by a pale 0.1-0.5% at best in 2014
across peripheral Europe, debt/GDP will have moved from 130% to 140% in Italy, to 150% in
Portugal, to 200% in Greece. The bang for the buck can hardly be worse. Projecting a positive trend
out of two quarters of pale GDP numbers is the next bridge, which the market seems to have no
trouble in crossing.
Anecdotally, Italy lost 10% of GDP in the last 5 years, in absolute terms. No wonder current account
deficit turned positive, as aggregate demand falling decreases imports too, cyclically, inevitably. Not
the sort of current account dynamics one should be cheerful about, or misguided by.
Meanwhile, youth unemployment is at 40%, worse than what Italy experienced during the Great
Depression (on par with Portugal, vs 60% in Greece and Spain). If you live in the South of Italy, and
you are a women, and you are less than 30 years old, then the chances that you are unemployed go
asymptotically close to 100%.
Peripheral Europe is similar to Japan in the 90’s in so many ways. Multi-year slow deleverage being
the baseline scenario one has to incorporate in models. Yet, Japan never experienced such striking
unemployment over the course of the last lost two decades. Yet, the growth rates Japan experienced
over this period would look like a dream to Europe.
Against this backdrop, the EUR appreciates some more recently (1.38 to the Dollar, 142 to the Yen),
rates rose in the inter-banking markets, inflation fell to go closer to outright deflation, while the ECB
was pondering its actions. Dum Romae consulitur, Saguntum expugnatur est.
The key questions in 2014 are the same as in 2013:
-
Can the ECB really do more? Is German newly-formed coalition really open minded to it?
-
Does a banking union/fiscal union require a banking crisis first, to drive in political gains
on the side of Germany?
-
Will the market itself be patient enough to still buy into ECB’s rhetoric, without
demanding some evidence of the heavy artillery they say they are easy ready to deploy?
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12. Overall, being outright long Europe seems a dangerous place to be in. Thus, we reduced our
tactical longs there, while increasing our hedges arrangements. Good news is that such hedges
are cheap, courtesy or market complacency, more so than Central Bank’s activism.
We disagree with the consensus on Europe, when it sees more accommodative ECB policies, lesser
pressures on government bonds and funding markets and softer fiscal adjustments as the reasons for
a structural shift in sentiment in Europe. As we repeated ad nauseam, we believe the EUR construct
if structurally flawed and set for implosion in the few years ahead. Looking through real GDP per
capita massive losses in peripheral Europe, un-recoupable unemployment, perilous youth
unemployment on the rise, we cannot but confirm our bleak assessment for the medium- and longterm. Forewarned is forearmed.
The Case For Staying Hedged Against EUR Break-Up Risk
Talking of instability and un-sustainability of the current state of affairs of the EUR as a currency peg,
we argued in the past how difficult it would be for the rebalancing of competitiveness across the Euro
Area to take place via Internal Devaluation only, in the impossibility of resorting to any external
depreciation/currency adjustment. We argued months ago that, in spite of ~40% youth
unemployment in Italy and Portugal, ~60% in Spain and Greece, such rebalancing requires salaries to
being cut some additional 40%: difficult to imagine. Moreover, that was true when the EUR was 1.28
to the USD. How more unlikely did it get now that the EUR is 1.38 and appreciated against any other
currency globally? How much more pain is needed in Internal Deflation to fill up gaps in
competitiveness? How much more pain is tolerable before it is not anymore?
Again, ‘’the fact that the fear of destruction, either in the form of widespread unemployment,
civil unrest or sequential failures, is preventing the EUR currency peg from being dismantled,
must delay the final extinction of the currency, until such same destruction is to happen anyway,
under the squeeze of an overvalued currency, overleverage and current account deficits’’.
Contrary to what we hear all around, forming the consensus view, rebalancing across countries
is not taking place. Current account surplus for Northern Europe stands at Eur 500bn. Germany's
surplus keeps expanding and now represents 7.5% of GDP, from 6% last year. This is making
Southern Europe no favour: the need for looser policy on the part of Germany fell on deaf ears.
Elsewhere, the shrinking deficit in Italy and Spain is misleading as is achieved by the contraction in
the economy and a fall in domestic demand - which only incidentally reduces imports. Critically then,
France's deficit is on the rise at 3.5% of GDP. At current rates of change, before having Italy and
Spain look like Germany, we will have France look like Italy and Spain.
Interestingly, Italy looks all too similar to Japan. Over-indebtness, declining economy,
demographic drag on GDP (at least 0.5% yearly), too strong of a currency. At least Japan has the
tools (debt monetization/currency debasement) and the willingness (political leadership for
structural reforms) to have a shot at a different future.
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13. Again then, we remind ourselves of hard data evidence: ‘if history is any guide, three conditions
were met in past currency crisis and emerging market crisis: an over-valued currency (read, the
EUR to countries like Italy and Spain), over-indebtedness, as a share of GDP or the productive
economy (rephrased, too much debt and no growth against it), and current account deficit. By any
objective criteria, all three levers are met for certain countries in southern Europe, making the
case for a reshaping of the EUR-fixed currency regime a genuine one. In advanced economies the
readjustment may be slower to occur than in emerging economies (as we learn from the attached
interesting piece looking at past banking crisis), but it may still do occur over time, including a
currency-driven one.’
Japan’s consensus trade we like: Short Yen, Long Nikkei
We do not believe in the three-arrows strategy 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 and 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’.
Once total debt/GDP private and public is well above 500% (UK there already), there is little else to
do but desperate debt monetization and heavy currency debasement.
Second leg of Yen devaluation
We may be nearing the second leg to JPY devaluation. 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.
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14. As the consumption tax gets introduced in early 2014, as the balance sheet of the BoJ has not
been expanding for two 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.
All in all, weaker JPY seems the safest bet in town. Higher Japanese rates seems the cheapest bet in
town. Higher Nikkei seems to require the boldest view to take.
Abenomics’ precedent in history: Takahashi policy
For what is worth, Abenomics has a model in history. It is Takahashi policy in 1932-1935, which
managed successfully to lift Japan out of the Great Depression (although inflation broke out in 1937,
after he was assassinated).
Back then, the currency played a similar role to today, as the Yen weakened out by 60% vs the
USD, before stabilizing around 40% depreciation.
However, rates were cut 3%, which cannot be done today as they already are at 0%, and fiscal
policy was loosened back then, which cannot be done today (as fiscal consolidation has been
promised to keep bond vigilantes at bay).
More money printing needed, as Inflation is not the right one
As of now, prices in Japan are generally not rising due to stronger domestic demand - which is
what the nation really needs. Instead a large portion of price increases is generated by weaker yen
and costlier imports. The prices on many domestically manufactured products (such as household
appliances) as well as domestic services continue to fall.
‘‘You can't have sustainable inflation without rising household incomes. An exit from deflation will
become distant if we're seeing cost-push inflation, where wages aren't catching up with rising
prices.’’ Economics Minister Akira Amari said.
Wages (base salaries) declined again in October you by 0.4%, partly due to rise in the proportion of
part-timers, labor's share of income has declined, as corporate earnings have been on the rise.
Spring 2014 labor negotiations should deliver higher wage growth, possibly leading to higher
consumer confidence, consumer spending and consumer prices. Abe is most determined in
accelerating a spillover of corporate earnings into higher wages. Anecdotal evidence of the
Government calling up on Sony after positive number release to pressure on increasing wages is
foretelling.
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15. Wall of money flooding: private and public united
Anecdotally, the printing press of the BoJ is joined by a wall of money from the private sector:
-
The NISA programme, designed for individual investors, 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.
-
GPIF to Raise Target Allocation of Domestic Stocks. ‘Japan's mammoth pension fund
recently said that it will boost its investment in domestic stocks and overseas assets, while
cutting its holdings of domestic bonds, a move that could help support shares and curb the
yen's strength but could affect the volatile government debt market.’ The Government
Pension Investment Fund said, at a joint news conference with Japan's welfare ministry. The
GPIF is the world's largest public pension with 112 trillion yen ($1.16 trillion) in assets. It
is closely watched by many investors for any hints about potential portfolio rebalancing,
which could have broad implications for financial markets. The Government Pension
Investment Fund should review domestic bond holdings and consider investing more in
overseas assets, according to a report released by the advisory group last month. The fund
should also look at diversifying into private equity, commodities and real-estate investment
trusts, where returns may be higher than on local sovereign bonds, the expert panel
recommended.
Fight like a ‘samurai’, or die as a ‘kamikaze’
As we wrote in our Outlook at the end of June: ‘’We have been long Japanese equity already as of
last December 2012/January 2013 into March, as we thought the change in policy was structural,
and equity would have rallied more than the currency depreciated (Outlook and our CNBC
interview). Such 'nominal rally', as we called it then, was hedge-able into hard currency at cheap
costs. So we could rent a 'illusory rally', by hedging it out of its fake context. We have now reestablished the same trade as then, by entering a tactical long equity position, for the short
term, while shorting the currency.
Shorting the Yen remains our single largest position in Japan. Indeed, as we noted last month,
‘’we believe that it is hard to imagine a state of the world where the Yen is not significantly
weaker than it is today.
-
Rates could be higher, which means equity would be lower, as debt crisis may
snowball abruptly, and JPY weaker in reflection of such calamity.
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16. -
Or rates could be managed down successfully, anchored at zero across the curve
via more monumental money printing, and equity up, just nominally so, as JPY
weakens further, and rapidly so.
The one scenario where the JPY goes back to its highs (around 75 vs USD) seems at present the most
unlikely. The dynamics that the BoJ has set in motion are irreversible. By promising to print so
much, they now can print so much or much more than that. By having selected such an overdose
of monetary expansion, the more bonds sell-off the quicker they might have to step-up their printing
presses. The more they crowd out the private sector on JGBs, the more they will eventually have to
print. The more the market flies on liquidity-havens, the more it will be addicted to such printing.
Samurai-Japan’s policy is remindful of the ‘burning the bridges behind’ war strategy of Sun Tzu.
General Sun Tzu (from China, actually), in its “The Art of War”, explains that one technique for
success in war is burning boats or bridges for escape. The tactic is basically this, taking an army
across a river, burning all their boats, the only routes of escape. Left with two choices when facing
the enemy army, to win or to die, people will do super human feats to survive. Similarly, 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.
Fight like a samurai, or die as a kamikaze.
Another factor can drive the Yen weaker, in the short term: real rates differentials. After real rates in
Japan plummeted below US real rates for the first time in years during May, the divide between
them has widened further since then. 5yr real rates are at a new super low beyond -1.5% in Japan
(as nominal yields rose less than inflation expectations), whereas they moved up from -1.5% to -0%
in the US (as break even inflation rates lowered and nominal rates rose). Declining inflation
expectations in the US, possibly on the back of the Deleveraging Chain shown above (whilst Japan
seems kamikaze-committed to 2% percent inflation) are at the basis of such increase in real rates in
the US.
Incidentally then, local Japanese money managers (especially the VAR-shock sensitive ones like
banks, broker dealers, regional and Shinkin banks) should be compelled to divest from shaky JGBs
and sinking Yen, and move to USD cash, pure and simple cash, for a real yield pick-up.’’
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17. China’s Bumpy Road Ahead
In the long run, there can be little doubt that China is going to be the most powerful contributor to
global growth. Across Asia, middle-class population will increase by 1 billion people in the next 10
years. This single statistic may say it all (article).
But in the medium term, our view is less positive. To us, the key problem in China is the Corporate
sector, whose leverage is 150%+ 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 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.
China’s bold reform agenda (Third Plenary session) had no reference to credit bubbles: are they
taking it seriously enough? NPLs is a real issue. Need immediate action, not just long term plans.
As long as nominal GDP growth comes in strong, China’s imbalances can be contained. But
growth numbers below 7% have the potential to light the fuse on Corporate China’s excess
credit.
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.
In summary, in China we hold a barbell type of view; positive in the short-term (artificially so, as
fixed investment habits are hard to die), negative for the next two years (as credit excesses are
exposed in a rebalancing economy), positive again in the next decade (as demographic factors,
GDP quality catch up, and reserve currency status take hold).
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18. Investment Strategy
We now provide an update across the 3 books in our portfolio construction.
VALUE BOOK
FLAT
Remains light, as we see a risk of
10%+ correction over the medium
term
We recently piled up a few
opportunities here, after profit
warning drove prices down on
selected stocks on our radar.
TACTICAL BOOK
HEDGING BOOK
EXPANDING
In absence of sustainable carry
generation in the Value Book
 Tactical Long EuroStoxx –
also vs US - postponed ITA
elections
 Tactical Long single stocks
linked to EMs / Commodities
- catch up theme
 L / S positions
ACTIVE
This is where we see MOST
OPPORTUNITIES for 2014
 Short S&P, vanilla and
contingent
 Long Credit Curve
Flatteners
 Short EUR
 Long Inter-banking spreads
/ currency pegs
Value Book
At present, our Value Book remains pretty flat, as markets are toppy, still too expensive vs
fundamentals, especially now that rates may be on the rise and the Central Bank support shows
the first cracks. Our current small allocation to longs in the Value Book is filled with select Special
Sits which still offer asymmetric returns vs risks in our eyes. We will change our bearish positioning
once the disconnect between the real world and financial markets tighten from here, as a
consequence of market correcting further or fundamentals improving (we remain skeptical on real
growth recovery, as argued extensively, but will remain open-minded as the situation develops and
more data come in). Also, we will change that stance if markets move side-ways for long enough
(which is just another way to digest their expensiveness, arithmetically equivalent in real terms
to a declining market if inflation is above zero). As argued last month already, we have been in
bubble markets similar to the current ones multiple times in history: 1) the Credit markets are all too
remindful of 2007 (at that time it was Investment Banks inflating the bubble through leverage, this
time it is Central Banks themselves, with obviously more margin for error, but not infinitively so). 2)
The Equity markets, the Mothership US in primis, are remindful of conditions we have seen already in
2007, but also in 2000, 1987, 1929, all followed by market crashes
One market we find attractive is Japan, after having hedged rates and currency risks. Within Japan
we look at three types of stocks: (i) high ROE companies, (ii) local-costs export-champ producers, (iii)
consumer stocks.
Gold and Gold Miners is out-of-fashion enough for us to have an interest. As explained above,
Gold is set to have its day again, possibly within 2014.
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19. Tactical Book
We recently lightened up our longs in Europe, both outright and vs the US. This is a tactical
position, which we expect to perform in the short term should the market maintain its positive
tone. Such positioning follows delayed Italian election, Greece /Portugal issues to remain dormant
for a while longer, thus leading to false calm in the markets, and possibly an LTRO/rate cut by the
ECB, weaker euro.
Longer term, no change in views to this day: we maintain our bearish bias in Europe, for we expect
the crisis to flare up again and the EUR-peg to be dismantled down the line. In the same vein,
hedging overlay strategies via cheap optionality and positive carry formats are to be held
throughout the period.
Elsewhere in the Tactical Book, we look at the equity of Greek Banks, as a cheap optionality on their
capital structure, as a proxy high Beta / cheap upside hedge of any reflation potential in Europe.
Elsewhere in the Tactical Book, we look at the Shipping Market. Capacity has been taken out over
the last few years, and few industry segments in particular look valuable investment opportunities.
Elsewhere in the Tactical Book, we look at China, Korea, India, Argentina. In China, the renewed
push into fixed investment-led growth, while not sustainable, is not to be underestimated for the
short-term. We look at beneficiaries of such flows, tactically for the short-term, before implosion few
months from now. Commodity stocks who fell out of favor with the market to levels where a
temporary catch up reflation looks possible. Generally, we prefer agricultural commodities to hard
commodities.
Hedging Book
Regrettably, it is impossible to call the day, the month, or even the quarter in a reality-check
correction may take place. Policymakers can indeed buy more time. Money printing might still be
in its early days, despite evident diminishing returns (tending to zero). For all intents and purposes,
we are left to rely on a sustainable multi-dimensional risk management policy, intended to keep
the guard high for long enough, being able to finance the renewal of market protection
strategies for the quarters to come.
At present, our task is made the most difficult as we have no significant carry generation within
the Value Book to rely upon in financing the cost of the hedging strategies. Ever since May, and
differently than in the last two years, we decided to keep the Value Book flat-ish, as carry strategies
would be exposed to digital downside risks in both equity and credit asset classes. When adjusted for
real risks, as opposed to deceptive historical vols, such carry strategies are a clear pass.
Consequently, the ability to fund and roll hedges and keep them alive for long enough will be the
key determinant of our ability to live to produce strong returns in the medium term.
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20. What I liked this month
If QE is "heroin", what is "methadone" and how do we avoid "side effects"? Read
Money printing, search for yield and the mirage of financial stability Read
Renminbi Rising? Read
Grading Abenomics Read
W-End Readings
Fasanara in the media: Analysing the Great Rotation Article
QE and ultra-low interest rates: Distributional effects and risks Read
We will offer an update on the portfolio to existing and potential investors during our Bi-Monthly
Outlook Presentation at end January 2014 in 55 Grosvenor street, London, where supporting
Charts & Data will also be displayed. Please do get in touch if you wish to participate.
Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
Twitter: https://twitter.com/francescofilia
55 Grosvenor Street
London, W1K 3HY
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