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

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June 1st 2015

Fasanara Capital | Investment Outlook

1. Bunds Market Riot: Our Take

Seismic Markets. Liquidity-induced markets are prone to asset bubbles and

recurring bouts of volatility. Thin liquidity, low inventories, abundant leverage,

crowded positioning on consensus trades, on stretched valuations when not

outright asset bubbles, make VaR shocks inevitable.

2. Our Medium-Term View: Deflationary Boom Markets

Our bearish view for global economies, and especially so for Europe and Japan,

entails that the strenuous battle against die-hard deflation will force the hand of

Central Bankers into monetary printing, driving up further bonds and equities.

We expect: Bund weakness to maybe last another couple months and then fade

away, taking yields into new lows. Spreads between European government bonds

to tighten back to pre-ECB’s QE levels, and then eventually reach new lows.

Spreads cross-markets to compress, Interest Rate Curves to flatten. European

Equities to move to new highs, melting up further

3. Our Long-Term View: Deflationary Bust ?

If we are right about the global economy, there will be no normalization of growth

rates, just sluggish GDP growth, deflationary trends may prevail, over-

indebtedness may go uncured, un-employment may remain high in Europe.

Against such backdrop, Central Banks will continue pumping liquidity and fueling

the bubble, until their arsenal runs thin, at which point political regime changes

may provoke an unplug. In Europe, a dissolution of the currency peg (EUR break-

out) would then be a genuine option.

4. Deflationary Trends: Secular Stagnation or Global Savings Glut

Structural deflation is the backbone of the macro outlook we endorsed for the last

few years. Here below we will try to characterize our conceptual framework on

Secular Stagnation and Structural Deflation a bit better.

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5. Greece: Three Scenarios

We think that the three events are separate and to some extent independent: (i)

Technical default, alone, (ii) Technical default leading to ‘Grexit’, alone, (iii)

Technical default leading to ‘Grexit’, leading to panic/contagion across global

markets. The first scenario of a technical default is potentially a favorable one,

and preferable to a muddle-through situation: a technical default (where not only

debt but also wages/pensions go unpaid in Euros) could potentially tip over the

current government in Greece and can therefore lead to a best-case scenario.

6. Crystal Ball

Our Target Levels for S&P, Nikkei, Eurostoxx, Fed Fund Rates, US Treasuries,

Bunds, BTPs, WTI, Gold, USD, JPY, EUR, CNH, inflation, spreads

Bunds Market Riot: Our Take

The most informative and impactful event of the last few months has undoubtedly been the VaR

shock on German government bonds. The 10yr Bund moved from 0.05% yield to 0.77% in a rapid

shift, catching most investors by surprise, including us, sending shockwaves across bond markets in

Europe (on peripheral European yields and spreads, pushed to pre-ECB ‘s QE levels) and the US

(where ultra-long Treasuries moved back above 3%, for a time).

The brutal move on Bunds, a 10-sigma event when measured against deceptively low levels of

(daily realized) volatility, is confirmation of the dislocated markets we live within, and joins the

list of numerous other recent schizophrenic episodes and sudden bouts of volatility, what we

described in the past as ‘seismic markets’.

One more confirmation of fat-tailed distributions (as opposed to normally-distributed), exhibiting a

tendency for outliers: low-probability high-impact events do occur (statistician David Hand would

say ‘must occur’), deep excursions from the central value do happen, and when they do their

magnitude is great. What we failed to see this time around is another connotation of today’s markets

we must account for: a bias for CoVaR to spike at times, sky-high cross-asset correlation to kick-in,

especially in downside scenarios for markets, pushing an idiosyncratic risk into a systemic one.

Please find below an updated version of our summary chart for ‘seismic markets’.

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Unfortunately, having foreseen the disposition to dislocations of current markets did not make us

anticipate this one specific move on Bunds. It caught us by surprise. All we could predict is the

inability to maintain portfolio’s volatility low in today’s markets while pursuing high returns, given

the very nature of those markets characterized by seismic activity.

In justification of the move in Bunds, we can (uselessly ex post) think of a few concurring factors:

- All too obviously, liquidity-induced markets are prone to asset bubbles, but also prone

to recurring volatility shocks. Thin liquidity, low inventories, abundant leverage, on

stretched valuations when not outright asset bubbles, around crowded positioning on

consensus trades, have all contributed to this move on government bonds. Unexpected

losses on the part of the portfolio that should be the least volatile (risk parity funds in

primis), have triggered stops and unwinds, which fed on the sell-off. Margin calls on

MAS debased SGD at

Unexpected Policy

Meeting

RUSSIA CB

UNEXPECTEDLY

CUT

YEN DEBASEME

NT by 15% in few weeks in

Nov14

OIL PRICE DROP from

$107 in Jun14 to $45 now

DENMARK CB CUT RATES

THREE TIMES in 10 DAYS

US 10yr TREASURY DROP

30bps intraday

BUND RATES

IMPLOSION from 180 to 30 bps in 1yr

year

ECB ANNOUNCED

open-ended QE: 60bn EUR

monthly

EU FORWARD INFLATION

YIELD IMPLOSION

SNB SURPRISE REMOVAL EUR floor

Peaceful markets these are not !!!

CALM ABOVE THE STORM

INCREASING SEISMIC ACTIVITY, VOLATILITY SHOCKS LIKELY

CB of CANADA

CUT RATES unexpected

BUND MARKET

RIOT: rates moving from 5bps to 77bps

EUR lost ~20% vs

USD

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excessive leverage created then overcompensation to the downside, and overshooting.

Admittedly, a textbook reaction to asset bubbles in overleveraged markets.

- Additionally, the move was fueled by some seeing ECB’s policies being successful in

reigniting some form of inflation expectations, as reflected by economic releases

surprising to the upside (although in minimal fashion), a stronger Euro, and the 5y5y

forward inflation swaps moving ca. 30bps higher from the lows reached in January.

Investors expecting that would call it ‘normalization of markets’, and reversion to the

mean of a pre-Lehman economic environment. We do not see it as sustainable and

durable, but it surely took place this time around and played a role.

- Also, outside of Europe, the move was helped by somehow higher Emerging markets’

equities and currencies (especially equities), somehow higher commodity markets (oil

in primis, rebounding at some point 40% from the lows, but also copper and iron ore, in

turn driven by some expectations of liquidity injections in China, where Shibor rates

halves from 4% to 2%, at a time when a Chinese competitive devaluations seems to be

in the bucket list of many traders).

We classify the Bund movement as idiosyncratic, for it was not validated by other asset classes

all around it, be it equities or FX. The nature of the dislocation is detectable in equity markets

behaving like bond markets, while bond markets behaving like equity markets. Whilst Bunds

were losing 20% of their value, in equity market-type volatility (or even private equity market-type

volatility, nowadays), the DAX index was losing approx. 7% from its peak, a bond market-type

volatility. In a way, in the last few months, a good allocation to equities would have helped hedge the

downfall in the bond markets, paradoxically. Think also of the FTSEMib, the Italian stock market,

close to the highs of the last several years, while Italian government bonds were sent off trading

close to the lows, both in absolute terms and relative to Bunds/OATs, as low as seen only before the

ECB launched QE operations. The paradox is evident when thinking of an economic environment

where data releases came out on the weak side of expectations (in the US and Asia), hardly

confirming any imminent robust global economic recovery (which might have justified a combination

of stable equities and rising interest rates): if anything, the United Nations forecast for WGP global

growth was revised downward to 2.8%, dangerously close to the 2.5% which was once considered to

be equivalent to a recessionary/stall speed global economy.

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Our Medium-Term Baseline Scenario: Deflationary Boom Markets

Going forward, we expect the following to happen, by year-end 2015:

- Recent Bund weakness to maybe last a bit more but then fade away, taking Bunds

to new lows on yields (5yr Bund in negative territory, 10yr Bunds close to zero).

Combined with inflation forward rates remaining low or moving lower, commodities

staying weak or weakening from here, China staying the course of a stable CNH.

- Spreads between European government bonds to tighten back to pre-ECB’s QE

levels, and then eventually reach new lows (our preferred vehicle is BTPs-OATs at

110bps, which we see closing down to 0.60% come year end, especially once the

Greek summer is gone by). Incidentally, the ECB announced front-loading of QE

activities for the summer period, with the pretext of avoiding summer illiquidity: a dry-

powder of up to Eur 180bn for the month of June alone, to possibly overcome any

volatility arising from Greece. Then the question becomes what if there is no volatility

arising from Greece and such tsunami of liquidity hits the shores? What happens then to

rates and spreads.

- Spreads cross-markets to compress, Interest Rate Curves to flatten

- European Equities to move into new highs, melting up further. If anything, recent

schizophrenic bond markets might have pushed few more bond investors away into the

nearby riskier asset class. If not only bonds offer negative, zero or zero-like returns, but

also they present private equity market-type volatility, at times, then what is the point

in being invested in them for the bulk of one’s portfolio. Let them go freely into the

coffers of the ECB and Co., and help inflate equities into bubble territory (which is not

the case yet in Europe, differently than in the US). We made our case in a recent CNBC

interview (Video).

- Japanese equities to set new highs. This is the other equity market globally we like,

where we continue looking for a purely nominal rally. Nominal as opposed to real,

when adjusted for currency fluctuations. Nominal and not real, when compared to a

deteriorating economy. Elusive returns, but returns. We had a target on the Nikkei at

20,000 two years ago, now we are there but we kept our longs for the time being,

anticipating new highs. Similarly to our views on European Equities, we deem

Japanese Equities as being:

o cheap on valuations (high P/Es and low prospective returns, but fat dividend

yields when compared to shallow bond yields and low bar for investors’

expectations),

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o cheap against the backdrop of excess liquidity (induced by Central Bank, but

also by macro(im)prudential policies forcing the hand of a $2trn pension fund

industry – led by GPIF – or the hand of retail – think of PAYE schemes,

estimated impact being $0.8trn in 5 years),

o not so cheap against economic activity, but that is actually a positive,

essential to our views, as a truly accelerating economy would jeopardize

central Banks’ policies and withdraw liquidity). Critically, we have a bearish

view of the economy, especially so in Europe and Japan, as we believe that

‘secular stagnation’ theories have merit (explained in further details later in

this Outlook). Differently than in Europe, in Japan you also get the added value

of policy decisionism (Abe has an all-in approach, in stark contrast to the

dysfunctional/muddle-through European policymaking), fiscal expansion (VAT

hike delayed vs miscalculated austerity overkill inducing structural reform

fatigue).

Such forecast are in line with our call for a ‘deflationary boom’ market environment, as our

readers and investors have seen us advocating for for over two years now. It goes hand in hand

with, and assumes, a bearish view for global economies, and especially so in Europe and Japan, a

weak economic environment and a strenuous battle against die-hard deflation, forcing the hand

of Central Bankers into continued monetary printing, until they go closer to run out of

ammunitions, over the next few years. We think such ‘deflationary boom’ is to last for the

foreseeable future.

In a nutshell, we believe monetary authorities are behind the curve and global structural deflationary

trends at work will motivate their actions: we discuss these themes here VIDEO and here READ.

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Long-Term Scenario: Deflationary Bust

At some point, though, we expect a change in regime, once Central Banks run dry of

ammunitions, and things may then unravel. If we are right about the global economy, there will

be no normalization of growth rates, just sluggish GDP growth, deflationary trends may prevail,

over-indebtedness may go uncured, un-employment may remain high in Europe. Against such

backdrop, Central Banks will continue pumping liquidity and fueling the bubble, until their

arsenal is running thin (which is still not the case today), at which point political regime changes

may possibly provoke an unplug. In Europe, a dissolution of the currency peg (EUR break-out)

would then be a genuine option.

In other words, to us, the famous quote ‘ do not fight Central Banks’ is permutated into ‘‘ do not fight

Central Banks as yet’. There will be a time for that. There will be a time where market forces are

more in line with residual Central Bank forces left over.

In the past six years, the FED could go from cutting rates, to zero rates, to QE1, QE2, QE3 waves in

2008 (upped in 2009), 2010, 2012, Operation Twist and all sort of other tools (US Treasury’s

preference shares, TARP, CPP, P-PIP etc). The ECB went from cutting rates, to moving rates to zero,

to bringing rates into negative territory, from MRO to LTROI, LTROII, to SMP, then OMT, then T-

LTROs, to ABS purchases, and now into QE1. There might as well be a ECB’s QE2 and a QE3 in

front of us, if recent history is any guide. And that can easily fill the next few years, while superficial

but timidly improving GDP/inflation/unemployment numbers make mainstream agents baptize it as

successful policymaking. At some point though, as the arsenal go emptier, several months or few

years from now, one will have to look around, analytically, and if (i) GDP is still shallow, (ii) debt

is still high and has grown some more, (iii) inflation is still zero / negative (taking debt ratios

higher with it), (iv) unemployment is still awfully high, down there then a new phase can open

up, with political instability forcing a change to the status quo, with bond yields rising in no

inflation/growth, equities giving back fictitious gains all too quickly.

We remind ourselves of the main risks to our long-term view: fast rising GDP, rising Inflation,

rising productivity rates, rising working population, declining indebtedness, disruptive technological

breakthrough innovation of a type we cannot foresee now (the one we see now is in line with our

current long-term view). Should we see any of these elements emerging in global economies), and

do so in a durable fashion (and especially so in Europe and Japan, the preferred spots of our asset

allocation and where we have been the most active in the last couple years), we stand ready to

change our views and throw overboard our current portfolio positioning. Veritas filia temporis.

Irrespective of fundamentals and the gravitational forces they exert over the long term (‘markets are

voting machines in the short term, but weighting machines in the long term’ Buffett says), we should

also be reminded that markets are irrational most of the times, and can derail any process all too

quickly. Not only high leverage in thin liquidity leads to overcompensation to the downside at times

when such leverage is prematurely withdrawn (when the bubble decides to peak and deflate some),

but also market participant’ behavioral bias has a huge impact on the final outcome (Soros’

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reflexivity theory). For example, in the attached article, Paul Krugman shares his vies around the fact

that a third of today’s traders have only ever seen zero interest rates. That’s all they have ever

experienced (as they started trading after 2009). Except for the (many?) ones amongst them who we

can assume are librarians, zero interest rates is all they might think there is. How can we therefore

expect them to react to rising rates? If we can at all? Food for thought.

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Deflationary Trends: Secular Stagnation or Global Savings Glut

Structural deflation is the backbone of the macro outlook we endorsed for the last few years.

Last year, it made us think that the ECB would have been forced into action, making us think of

upcoming Sovereign QE as a certainty. Such belief made us stay invested into European equities

and European bonds and spread also during volatile times.

As we argued in our February Outlook, deflation is a multi-years process, not a data point. It takes

years to reverse deflationary trends, absent a shock of some sort. Last year, we argued that

Deflation in Europe is just beginning. We believe the ECB is behind the curve, late in the game,

facing global deflationary trends, and therefore unable to anchor inflation expectations. We

made our case during the attached interview.

The economic outlook for ‘Secular Stagnation’ we currently buy into has similarities to the one

described by Larry Summers. While disagreeing with the conclusions, Ben Bernanke speaks of a

similar state of affairs when referring to a ‘Global Savings Glut’. Here below we will try to

characterize our conceptual framework on Secular Stagnation and Structural Deflation a bit

better. We will expand on it during our next Investors Presentation.

The basic point of our take on the subject is that the current depressed economy, with its low

inflation, low GDP growth rates, low potential GDP growth, low working population growth

rates, low interest rates, is not a consequence of the Global Financial Crisis and the Lehman

moment, but rather the result of more structural forces who have been at play for decades. The

GFC has at best been an accelerator, weighting on a more chronic long-running pandemic.

Indeed, it is vividly noticeable that in the years going into the GFC, from 2003 to 2008, despite what

we would today admit being bubbles levels of credit expansion and real estate expansion, definitive

and unsustainable manias, GDP growth was not impressive but rather just fine. During those boom

years, despite an unprecedentedly over-leveraged private sector, GDP growth was un-impressive,

while inflation risks were subdued.

Let’s start from defining the type of ‘depressed economy’ we have in mid:

- Deficient global aggregate demand

- Low GDP growth rates

- Low potential GDP growth

- Low inflation

- Low functional Commodity Prices (falling prices and decelerating volumes). Oil is

the most visible one. Admittedly, it has lately been manipulated by supply-side effects

driven by geopolitics, more than anything else. However, its inability to materially rise

during Arab Springs is informative. Medium-term, oil is under pressure due to additional

supply generated by technological advances, alternative energies getting cheaper,

global drive for energy efficiency. Longer-term, oil is one technological breakthrough

away from extinction (e.g. batteries). A matter of when, not if.

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To distinguish between causes and effects is not easy. We define some consequential connotations

for such depressed economy, although they may partially be drivers too, in a negative feedback loop:

- Low interest rates are engineered by Central Banks to combat deflationary trends and

stimulate growth.

o At the same time, though, they may reflect high savings rates, and savings

rates exceeding investment rates. As such, they may signal an increased

’savings propensity’. If there is any structural change in the propensity to save

over investing, that would bode badly for productivity.

o Also, viciously, low interest rates compress bank margins, therefore somehow

de-incentivizing bank lending, therefore leading to low loan supply.

o Low rates may also be consequent upon low demand for loans, low Capex,

on the back of low expected returns. In this respect, they are a reflection of

stagnation, not just a policy response to it.

o Low rates may still be too high, impeding recovery. Rates are low by

historical standards, trading at multi-centuries lows. Rates are low against the

Taylor rule, when one is to account for (US) unemployment. But they are

probably not low against the Wicksellian natural rate (the rate that produces

stable inflation). If inflation is to be sub-zero for long, nominal rates are surely

too high (financial repression fails / debt-ratios rise).

o Low rates are expected to damage rentiers and push them into riskier asset

classes, including investments in the real economy. However, Central Banks

policies have inflated financial assets to a level where those rentiers have vastly

profited. Indeed, anecdotally, the return from US stocks since Mar2009 has

been 30%, vs historical average of 10%; the return from US Corporate Bonds

has been 12%, vs historical average of 6%. Capital gains have substituted the

income stream. In this respect, despite rates being at zero, rentiers prevail over

productive forces in the economy, leading to greater income inequality, lower

productivity, lower propensity to invest, and viciously then ultimately even

lower aggregate demand. (in this respect a low Oil price is much more

positively impacting the odds of aggregate demand, than rates, as it affects

the lower-income households, more elastic to price).

A few drivers can be isolated:

- Falling working population. Demographics affect long-term anti-cyclical growth. An

ageing population is much of a global issue (including China), although it is clearly more

visible in countries like Japan, Italy, Germany. In Japan in particular, the depressed

economy of the 90s owed much to the combination of falling fertility rates (from 1.8

children per woman from 1980 to 1.4 from 2010) and increased life expectancy. That

coupled with Japan’s stance over no immigration, no women at work, no job cuts, no

wages cut, helped fuel 24 years of depressed economy (Japan’s‘ lost decades’).

Undoubtedly, a falling working population played a big role.

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- Falling productivity rates

- Over-indebtedness. As inflation moved lower, debt ratios went higher for most large

economies globally (except perhaps today’s austerity stakhanovistes in Germany). Debt

diverts resources away from productive investments into sterile debt service. Even at

minimal interest rates, such diversion is material. Over-indebtedness constraints the

wings of productivity and growth from opening up.

- Diminishing effects of monetary printing and the credit cycle. This is visible when

looking at the 40-year chart of ‘Money Multiplier’ (how many $$$ of commercial bank

money for any $ of Central Bank money, how many $$$ of money supply for any $ of

monetary base, the famous $$$ lent to the real economy) and ‘Velocity of Money’ (how

many $$$ of GDP produced for any $ of loans extended to the real economy). The end

of the Bretton Woods System triggered by Nixon’s New Economic Policy in August

1971, unleashed the full power of the fractional-reserve banking system, and the beauty

of credit expansion and its multiplier effect on growth and productivity. Has the credit-

based expansion now run into some kind of a dead end? Has it permanently gone into

exhaustion mode, or are there ways to reigniting the virtuous cycle. The impossibility of

exponential growth in a finite environment makes us propend to think it cannot.

- Technological advances: this is a striking difference to past occurrence of secular

stagnation. When Alvin Hansen in 1938 referred for the first time to ‘secular stagnation’

he enlisted ‘low technological advances’ as a key driver. Today, in contrast, we believe

we are in the middle of a technological revolution (Google, Apple, Amazon, 3-D printing

etc), reshaping the world we live within. However, incidentally, such technological

revolutions calls for (i) shredding jobs (Nike employed 106k less people in 2013 due to

automation, WhatsUpp was a 50-employee company when it was valued as much as

Nokia, an employee- and plants-rich company), (ii) reducing unit production costs to

levels where one can live almost without working or working less (even sequencing

human genome used to cost $ 2.5bn in 1990,it now costs $ 750 to produce), (iii)

increasing income inequality and further concentrating wealth into elites, while

reducing the economy’s capital intensity. Less labor, but also less capital. Less

investments needed.

More specifically in Europe, deflationary trends are helped by dysfunctional politics:

- As demographics are a paramount factor, it should be noted that fiscal policy only can

affect demographics, not monetary policy. As Europe’s obsession for austerity

impedes a fiscal expansion to join monetary expansion, the chances of success of

European policymaking must be lower, against the same conceptual framework they

advocate to (monetary printing alone will not kick off escape velocity; fiscal overkill will

induce structural reforms fatigue, as opposed to force structural reforms).

- At times of deficient aggregate demand, monetary expansion without fiscal expansion

and redistribution policies is ineffective in the long run. It avoids circuit breaks, but does

fail to reignite a growth / inflation cycle.

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None if this is clearly conclusive but rather is a conceptual framework, one that we hope can help us

navigate our views on the economy, and the consequences for markets over time. Against these

assumptions, we will evaluate incoming data and their durable nature, so as to ascertain if the theory

gets confirmed or invalidated. Unhelpfully, such theory will take years to be confirmed. On the other

hand, it might quickly be invalidated. As Soros argues, we never know we are right, we can only know

if we are proven wrong, we can be temporarily right until falsification comes, one failed test is

enough to falsify, but no amount of confirming evidence is sufficient to verify.

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Greece: Three Separate Scenarios

No material change in views here, from our previous write-ups on the matter, but just a few

comments.

As the months go by and negotiations on Greece are let drag on, we distinguish the three scenarios

we see playing out going forward:

- Technical default, alone

- Technical default leading to ‘Grexit’, alone

- Technical default leading to ‘Grexit’, leading to panic/contagion across global

markets

Obviously, none of these scenarios is necessarily imminent. Extra time can indeed be bought and

the can could easily be kicked down the road some more, as the creditors to whom the money is

owned are ultimately the ones lining themselves up for more credit (no new outside agent involved,

bail-in is bail-out), and a compromise for short term financing or grace periods could easily be

arranged, if there is political will and negotiations are carried out in good faith by either parties.

However, at some point down the road, the three scenarios do open up, sooner or later.

Such scenarios are dependent (scenario 2 and 3 assume scenario 1 has taken place), but not

consequential (scenario 1 does not imply scenario 2 nor 3). Few comments:

- Not necessarily a technical default leads to a Grexit. It surely leads to capital controls,

deposits freeze and IOUs being issued. But not necessarily an exit from the currency

union.

- Not necessarily a Grexit leads to financial panic and contagion across global bond

and equity markets. Surely, a period of volatility opens up, but not necessarily a

durable one. After all, the ECB prints Eur 60bn per month, expected to be frontloaded

at times (like this month in June for the summer period, making up a de facto war chest

of Eur 180bn at a minimum to go to battle with, before activating other venues which

have also been predisposed). Such war chest amounts to more than half of the

remaining Greek GDP, and the bulk of the debt due over time by Greece. Markets may

determine that that is enough (helped by inevitable ECB’s bold statements in the

process), and decide to sidestep durable panic/contagion. In 2001, (i) the ‘surprise

effect’ had an impact, (ii) the non-existence of European financial institutions designed

to deal with such intra-union pandemics also played a role, (iii) the reluctance of the

ECB to assume the role of lender of last resort was crucial in letting the crisis unravel

back then (the much celebrated Weidman/German Constitutional Court’s fierce

opposition to QE/deficits monetization left us prematurely and mysteriously). None of

those factors can now play a role’. This is not to say a durable panic crisis is out of the

cards (as Larry Summers says, this is not a live experiment anyone would want to see),

but is surely not a given.

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This is to say that the third scenario is the only which can be clearly categorized as negative for global

markets. In some respect, the first scenario of a technical default is potentially a favorable one,

and preferable to a muddle-through situation where the can is kicked down the road further and

uncertainty remains. A technical default (where not only debt but also wages/pensions go unpaid in

Euro denomination) could potentially tip over the current government in Greece and could therefore

lead to a best-case scenario.

Crystal Ball

Our target levels across markets and across asset classes for end-2015 are unchanged since we

first published them in January. Please find the list reported below.

From our January Outlook:

- S&P closing the year at 2,100-2,200 (from 2,000 today). Which means limited upside,

as the market is priced for perfection. Implied volatility VIX closer to 20% than 14%

(average 2014). More than four sell-offs of 5% to 10%. Potentially a larger one along the

way. Last year 5% to 10% sell-offs took place in Jan, Aug, Oct, Dec.

o We remain overall positive on the S&P, despite bubble levels disconnected

from fundamentals and the headwind of corporate margins / sales affected by

a stronger USD. This is because of the FED remaining active (their balance

sheet is still expanding as we speak), remaining concerned of the impact of a

larger draw-down on the animal spirit (‘Portfolio Channel Theory’ of

Bernanke), and the tailwinds of a much cheaper Oil (great for price-elastic low-

income households and businesses and non-energy Capex), and lower rates for

longer (boosting P/Es and net present values, in addition to helping leverage

and margins preservation). A robust economy driven by internal demand helps

too, but that alone would not suffice, as valuations are stretched, well above

what the fundamentals of a robust economy would dictate.

o Perhaps, the real issue for the S&P may come when the market perceives that

the USD strengthening trend is close to be over. Then, expected real returns

for investing in S&P would be sub-zero, as the positive impact of an

appreciating USD cannot be priced in any longer.

- Eurostoxx closing the year above 3,600 (from 3,350 today), although on a rough ride

too. Implied volatility V2X closer to 25%/30% than 18% (average 2014).

o Boost from ECB’s QE. The 20% risk sharing rule is irrelevant. Target II System

balances are a dominant factor - true mutuality feature within Europe. It

assumes our baseline scenario of Greece/Grexit risk abating, and not

managing to derail the European bandwagon. We remain negative on the

prospects for the economy, although some pick up in economic activity seems

likely and in line with the pick up unfolding in credit formation across Europe.

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- FTSEMIB above 25,000 (from 20,500 today) at some point in 2015. Possibility for

snap elections to be called by Italian government in 2015.

o ECB’s QE expected to drive down real rates and still large real rates differential

within Europe. Positive.

- BTPs 10yr yield at ca. 1% (from 1.60% today). BTPs/OATs spread at 0.60%, from

1.15% today. Laggard.

o Deflation, deflation, deflation.. within the debt mutualisation framework of a

ECB having capitulated to its role of ‘lender of last resort’, forced into it by

Deflation itself

- Bunds 10yr yield at 0.00%, from 0.40%, below Japanese JGBs (currently at 0.25%),

and possibly going negative (-1%).

- OATs at 5 basis points over Bunds.

- Bund 10y-30y spread at 40bps (from 70bps today), possibly turning negative.

- US Treasuries 10yr at 1.00% (from 1.7% today), 30yr at below 1.70% (from 2.30%

today).

o The best carry trade available globally. Strong credit risk, nice yield, no

inflation risks near term, real yield appealing when adjusted for likely

strengthening of the currency

o Scarcity value: 50% of all government bonds globally yield less than 1%

o Global supply / demand for bonds in favor. As Central Banks crowd out the

private sector, global demand outstrips supply by ca. $ 600 bn in 2015.

Demand for bond is expected at 2,5trn in 2015. Collateral shrinkage is one

more weapon firing in the same direction

- AUD 10yr govies at below 2% yield

- 5y5y UK Inflation at below 2.5% (from 3.1% today)

- 5y5y EUR Inflation at below 1% (from 1.6% today)

- FED Fund Rates at 0.50%, FED to hike rates, but only moderately so. FED to deem

current growth/job mix good enough to slowly normalize rates, so as to create some

buffer for the next downturn in activity. FED already tested for this at the end of 2014,

when withdrawing $400bn from monetary base with large term-deposit operation,

squeezing up effective FED fund rates in the process. No ‘rate tantrum’ there.

- Nikkei at 20,000, from 17.500 today. Currency debasement, regulation-driven flows

(GPIF and friends, in a 2trn$ pension fund industry invited to relocate to equity), and

some genuine momentum improvement in corporate profitability.

- JPY at 130 vs USD, from 117 today. Currency debasement, in progress (no new

injection needed, although likely).

- EURUSD at 1.05, from 1.135 today. Consensus.

- EURJPY at above 145, from 133 today (ECB will print $700bn this year, Japan is printing

800bn$, for an economy which is less than 30% of Europe’s economy, while having 2x

its inflation, a lower current account surplus, both in absolute and relative terms, etc)

- Gold at above 1,400, from 1,270 today. Upside risk.

- EUR at below 0.95 vs CHF, from 1.04 today. SNB to fail again.

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- CAD at above 1.30 vs USD, from 1.28 today.

- CNH below 6.20 vs USD, from 6.28 today.

- Brent Crude at below 40$, from 51$ today, possibly overshooting to below 30$.

- Athens Stock Exchange 20%+ up. Greece is a macro call, now more than before. We

remain positive on rational behavior prevailing and a compromise be struck.

o Debt forgiveness is a false issue, and can easily be achieved through interest

payments being cut further from current Eur 8bn annually, the financial

equivalent to haircuts in net present value terms. Debt ratios are to worsen

anyway, not just for Greece but Europe overall owing to negative inflation

rates (as we argued HERE, deflation is death penalty to debt-laden countries).

With QE having put to bed ‘debt vigilantes’ for the time being, headline

debt figures are kind of irrelevant. Debt rules can easily be adapted. What

matters is concession on primary surplus, which is now what is truly

transferred to creditors on a yearly basis, as opposed to be distributed on

Greece’s welfare. At 4.50% it is unsustainable for Greece, and would not yield

the desired effect for Troika anyway as it is achieved through shrinking the

economy (shrinking out of debt in pointless). A primary surplus threshold at 1%

should make both parties content. At present, European authorities have way

more to lose than Greek authorities, making the case for a compromise a

genuine one. As most of their debt is owned by foreigners, Greece threat to

default is a credible one. Should Greece leave the EUR-peg, they may re-

emerge just fine 2/3 years from now, showing there is life after the EUR,

which would make for a serious blow to the EUR construct. Troika badly

managed negotiations with former government, playing hard-ball and

consigning the country to a more radical government. As Spain’s Podemos

turtle trades Greece (and goes to polls later this year), Troika may change

course this time, avoid further damage and compromise.

o Why is Deflation a game changer for European policymaking? Refer to

previous Outlook.

Our levels for end-2014 can be found HERE. Please consider these new levels purely an exercise of

imagination. As fund managers, we are not only ready but committed to change up our mind and

portfolio positioning at no notice, to adapt to a changing market environment and incoming data.

Especially so in 2015 markets, which we expect to be erratic, volatile, potentially chaotic,

characterized by policy shifts, if not policy mistakes.

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Portfolio Construction: The Role of Optionality

As argued above, unconventional monetary policy and financial environment calls for

unconventional money management. In our opinion, this is best played through cheap

optionality, convexity and heavily asymmetric profiles, whenever available and in line with the

macro backdrop we project. Luckily, despite seismic activity being on the rise in the market,

Central Banks’ activism has depressed volatility. We live in a market environment characterized

by low implied volatility (still) and high cross-asset correlation (especially to the downside). Such

combination can be taken advantage of, via building asymmetric profiles in optional format.

Such asymmetry can provide one’s portfolio with the necessary convexity to navigate uncertain,

unstable markets, still have risk on and the potential for losses, but also be wide-open to the full

upside potential on volatility shocks. The volatility can be substantial, some risk remains,

inevitably, but at least the upside is few times over the risk undertaken.

In terms of portfolio construction and how to position for these eventful markets, we invite you to

join our next Investor Presentation later on this month (date TBD). A video recording of our latest

OUTLOOK PRESENTATIONS can be found here: December Presentation and February

Presentation. Our previous Outlook also went through the description of the role of optionality

within our portfolios: please find it available: February Outlook.

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Thanks for reading us today! We will offer an update on our portfolio positioning to existing and

potential investors during our Quarterly Outlook Presentation to be held in the next few weeks.

Supporting Charts & Data will be displayed for the views rendered here. Specific value investments

and hedging transactions will be analyzed. Please do get in touch if you wish to participate.

Francesco Filia

CEO & CIO of Fasanara Capital ltd Mobile: +44 7715420001 E-Mail: francesco.filia@fasanara.com Twitter: https://twitter.com/francescofilia 25 Savile Row London, W1S 2ER

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