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

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January 18th 2016

Fasanara Capital | Investment Outlook

1. Risk Factors Ranked

Without discovering anything new, we see three key risk factors for market these days,

in order of importance:

USD strengthening. In what might prove a policy mistake, the FED plans to hike

rates 4 times this year. A super USD has heavy contractionary effects and triggers

global debt deleverage. We think that DXY rising above 100 is to signal risk-off

mode for markets in 2016.

Oil breaking into new lows. 2016 will likely be a year of heavy volatility for the oil

market. Prices can go down further first, and then easily travel back to 50$-60$ in

a violent overshoot, as casualties along the way occur, while the case is genuinely

strong for oil to be sub-5$ in the longer run.

CNH weakening. To us, China is not intentionally pursuing a devaluation strategy.

However, there are two scenarios that may trigger significantly weaker levels for

the Renminbi: (i) capital outflows gathering momentum, or (ii) USD strengthening:

monthly FX reserve depletion figures above $100bn or DXY rising above 100

may both trigger a substantial (1.5%+) devaluation of the CNH and another ugly

reaction by global financial markets.

2. Struggle between market forces and Central Banks emerge

In 2015, financial markets started rioting against monetary activism and market

manipulation by global Central Banks. 2016 may see a continuation and exacerbation of

such struggle between market forces and Central Banks’ actions/reactions.

3. Random and Violent Markets

The fabric of the market is showing signs of fracturing, as 9 years of declining policy rates

and 6 years of QEs failed to kick-off growth, while further easing has a visibly decreasing

marginal effectiveness. It is end-of-cycle-type policymaking and market responsiveness.

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The market has shown its capacity to be random and violent, over-shooting on incoming

data, able to drive itself into pain trades, crushing consensus and crowded positioning as it

moves away from fundamentals (macro releases) and technicals (Central Banks’ targets for

asset pricing and wealth effect), irregularly, in size and for lengthy periods of time.

4. Implications for Portfolio Positioning

Medium-term, our fundamental views do not change, nor the list of our top trades. For

all intents and purposes, for the next year or two, ‘Deflationary Boom Markets’ do remain

our likeliest scenario. Deflation forces Central Banks into action. Central banks push Bonds

and Equities higher, inflating the bubble some more, although on a way rougher path and

with higher volatility than we got accustomed to in recent years. However, the way to

position for it has changed substantially, as buy and hold strategies are hard to maintain

in rodeo-type markets, and random moves are wild enough to trigger any pre-set stop

along the way.

In fractured market like these ones, we prefer to keep the risk light, positions small, and act

opportunistically, and to do so in line with our fundamental views, preferring optional

formats to delta one formats, to skew the risk-reward as much as possible.

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Risk Factors Ranked

In setting the tone for 2016, financial markets started the new year on steroids, with China venturing

off-piste all over again, equities in both developed markets and EMs in double-digits sell-offs, oil

breaking below 30$ at 12-years lows. Without discovering anything new, we see three key risk

factors for market these days, in order of importance:

1. US Dollar strength: in what might prove to be a policy mistake, with its forward

guidance the FED prepared the ground for a potential of 100bps hikes in 2016,

likely in 4 bites of 25bps at the 4 FOMC meetings with press conferences of

March, June, Sept, Dec. Less than half of it is priced in now. The FED might find it

hard to avoid hiking some of it without losing the face, in an electoral year.

Further strength of the USD will weigh on (i) EM’s dollar-debt position, therefore

on EM currencies, including CNH, and (ii) most obviously on commodities and oil,

and (iii) HY and credit as a follow-on effect. DXY breaking 100 is to us a risk-off

indicator, as it proved to be so in 2015.

2. Oil breaking into new lows. As we write, WTI has successfully breached the 30$

support. Weak aggregate demand meets a positive supply shock, driven by an

un-operational OPEC and the proxy war between Saudi Arabia and Iran, Russia,

US frackers. Absent a supply adjustment (due to either defaults in the

energy/fracking sector, war moving to oil sensitive areas in Iraq or Saudi, civil war

in Saudi or else), oil is likely to test new lows, especially so as USD strengthens

further, owing to US monetary policy and to global risk-off mode.

3. CNH weakening. CNH should most sensibly be looked at as trade-weighted

CNH, i.e. compared to a basket of currencies, rather than to the USD alone. On

Dec 11th, the PBOC introduced the CFETS index, a basket of 13 currencies,

following inclusion into the IMF’s SDR basket. Should the USD appreciate,

USDCNH will head higher even as it stays unchanged vs JPY and EUR. Yet, the

market no doubt views the USDCNH moving higher as (i) an indicator of

disorderly capital outflows in the face of failing intervention by the PBOC and (ii)

heavily deflationary for the global economy. Critically then, the PBOC made

massive interventions in the FX market in order to engineer a funding squeeze

while agent banks have been selling USDCNH to contain the devaluation of the

offshore Renminbi. It will be important to see if the PBOC can manage to

contain extreme volatility as it did in September after the August’s shock.

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Here below, we offer our observations and forecast for each of these risk factors:

1. US Dollar strength: As Gavekal’s Charles Gave says, “ a debt deflation always

occurs when the currency in which the debt is denominated starts to rise for

reasons that nobody understands”. A strong Dollar has highly contractionary

effects, as international bank financing tends to be dollar-denominated, so much

as the bulk of international bond markets and 80% of global payments. In 2015,

the Dollar Index DXY failed three times to rise above 100, while equities hit a

similar ceiling in valuations, and bad volatility hit markets after that. We think

that the DXY rising above 100 is to be signaling risk-off mode for markets in

2016.

2. Oil breaking into new lows. As our readers and investors know, looking beyond

the cycle, we think Oil goes down fundamentally because of Structural

Deflation, Secular Stagnation and technological innovation. Such conceptual

framework entails an economy characterized as ‘depressed’, weak global

aggregate demand, less industry and manufacturing vis-a-vis services and digital

goods, and therefore lower need for functional commodities for all intents and

purposes. To us, the inability of Oil to make new highs during the 2010-2011 Arab

Springs was informative in testifying to the new environment for oil well before

the supply shock of 2014 and Saudi Arabia’s manipulative market-share war.

Within ten years from now, we believe Oil prices will be sub-5$, due to the

deadly combination of (i) additional supply generated by technological advances,

(ii) alternative energies getting cheaper, (iii) global drive for energy efficiency and

low-carbon future post COP21. Finally, most critically, oil is inevitably just one

technological breakthrough away from irrelevance (e.g. batteries). A matter of

when, not if.

Shorter term though, we should prepare to see excess volatility, rather than a

smooth downward trend. First, the combination of (i) ugly momentum, (ii)

warm winter and (iii) seasonally higher March inventories may manage to push

oil prices into new lows. However, the price of Oil at the end of 2016 will be

determined by a likely supply response. Analysts say that while demand is

expected to slow-down in 2016, non-OPEC supply is also set to fall, while OPEC

production may stay flat despite Iran’s return. The oil market has typically been

in denial of weak oil for long, if one is to judge from either oil market forwards,

P/E on energy companies, or OPEC forecasts (especially when they say they

expect that 94% of cars will be run on fossil fuel by 2040, delusional). It is

relevant then that Oil 2020 forwards have for the first time in many years

descended below 50$, showing that the oil market itself is growingly aware that

we might be standing in front of a long period of depressed oil prices. This is

likely to lead to curtailing substantially Capex for the industry, and project

deferrals statistics are indeed on the rise (already 4 mb/d of non-OPEC

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megaprojects have been delayed or cancelled, led by Canadian oil sands). The

‘global oil glut’ may therefore heal somewhat going forward. In addition to this,

supply may experience more dramatic reductions if weak oil prices cause

covenant breaches and defaults in the energy sector, which might lead to a

violent spike and probable over-shooting. Within 2016, Oil could easily shoot

up to 50$-60$ in such a scenario, although temporarily. In the past, Saudi

Arabia would have been expected to play as the swing producer in offsetting

shocks to international supply: today, they may be unable to do so (as non-OPEC

production has grown too much), or unwilling (given their new geopolitical game

vs Iran/Russia/US frackers, and as also testified by their decision to IPO Saudi

Aramco and likely focus on profits-optimization via refining as opposed to

revenue-maximization).

So, in a nutshell, 2016 will likely be a year of heavy volatility for the oil

market. Prices can go down further first, and then easily travel back to 50$-

60$ in a violent overshoot, as casualties along the way occur, while the case is

genuinely strong for oil to be sub-5$ in the longer run.

3. CNH weakening. In itself, what is happening in China is not all bad news. A

slowdown in its growth rate was inevitable, in our opinion, both within the

framework of Secular Stagnation and because what has become now a 10 trillion

dollar economy (60% of US GDP, larger than Japan) cannot possibly grow at

Emerging Markets-type rate for much longer. At 7.5% growth rate, it would

double-up in size every 9.58 years. The impossibility of exponential growth in a

finite environment comes to mind. Most naturally, growth rate in China must fall,

the higher China’s share of wallet of the global economy. Sub-5% growth rates

in China are inescapable, we think. Even absent a debt crises and subsequent

debt deleverage.

On the other hand, slower growth in China and a better composition of such

growth (less wasteful fixed investments, more domestic demand and

services) drove down the price of commodities and oil, worldwide. That

served as a huge transfer of wealth from commodity producer countries to

developed countries, but most importantly to global consumers. And especially

so to households and businesses, and even more importantly so to low-income

households, who have the highest marginal propensity to spend, and are

therefore able to impact global aggregate demand. It is a true real income

boost, a sizeable tax cut, way more powerful than QE policies in stimulating

growth.

But market gyrations matter to the real economy. If lower growth in China is to

bring on currency outflows and a market collapse, and if such collapse ends up

causing a global recession via the wealth effect, while household and businesses

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decide to save that gain in real income, then the positive effects of lower

commodity prices will be of little use. As Paul Samuelson famously said once,

“the stock market has predicted nine of the last five recessions”.

What the market seems to be most worried about is whether or not China has

joined the currency wars, and intends to drive the value of the CNH vs the US

substantially lower. Last time around, China engineered a large devaluation in

2009, in response to the Global Financial Crisis. It was then followed by the US in

2011, Japan in 2013, finally Europe in 2015. Is it now time for China again, as its

growth rebalancing strategy failed and a debt crisis looms over?

In our opinion, China is not intentionally pursuing a devaluation strategy, as it

does not need to. It sits on $ 3.3 trn of currency reserves, against just $ 1.2 trn of

foreign debt, and trade surplus of $ 600bn in 2015.

However, there are two scenarios that may trigger significantly weaker levels

for the CNH and therefore an ugly market response:

A. If capital outflows gather momentum, China will see its cost of

FX intervention rise to a point where it might decide to

capitulate. Since Q2 2014, JPM Research estimates that $930bn

fled China cumulatively. China still has in excess of $3trn of FX

reserves, but it may find impossible to stem outflows if they go on

for much longer. Critically, the low overall net $ exposure of

Chinese banks and corporates removes one hurdle for China to

allow a larger deval from here. Also critically, CNH inclusion into

IMF’s SDR removed another hurdle for further devaluation. Here,

the variable to watch is the speed of monthly FX reserve

depletion: if it comes out at $100bn+ again, in line with the

peaks of December and August 2015, in spite of FX restrictions

and FX interventions, then a weaker value of the CNH is in the

cards.

B. If the Dollar strengthens further, with the DXY rising above

100 too fast too soon, while the global economy remains

anemic, China may decide to not tag along but rather let the

CNH be driven to equilibrium by market forces. This would be a

USD appreciation story then, more than a CNH-driven

devaluation, as CNH would remain unchanged vs CFETS index.

If this analysis is to prove correct, monthly FX reserve

depletion figures above $100bn or the Dollar Index DXY rising

above 100 may both trigger a substantial (1.5%+) devaluation

of the CNH and ugly reaction by global financial markets.

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Struggle between market forces and Central Banks emerge

While most of new rounds of US QEs (2008, 2010, 2012), and Japan QE (2013) managed to depress

volatility and boost asset pricing, late-cycle European QE failed to domesticate markets for long. By

Q2, markets were already toppish, and volatility able to erupt, in the face of Central Banks activism.

In 2015, financial markets started rioting against monetary activism and market manipulation by

global Central Banks.

2016 may be see a continuation and exacerbation of such struggle between market forces

reacting to the risk factors detailed above and Central Banks’ actions/reactions. As we estimate

(full analysis in our June 2015 Outlook, pages 6 to 9) that the arsenal of Central Banks is ~70%

exhausted, we expect the remaining ~30% ammo left to be forceful and able to domesticate markets

for a while longer. Bold actions include further rounds of QE on the part of the ECB and BoJ (perhaps

already by Q1 2016), deeply negative policy rates, direct FX intervention, regulation/macro-

prudential policymaking, and capital controls. However, along the way, there can either be (i)

delayed actions (perceived as under-delivering), like the ECB of the 3rd of December, due to a failure

to build consensus on time or (ii) potential for policy mistakes, like possibly the FED hiking rates.

Our call is for Central Banks to manage to get their act together and eventually prevail, what we refer

to as ‘Deflationary Boom Markets’ (to be followed by a ‘Deflationary Bust’ phase, once they run

closer to exhaustion of their arsenal – our analysis attached in the July 2015 Investor Presentation

page 24 to page 53 and July 2015 VIDEO minute 26:50 to 01:00:53), which will see equities and

bonds closing the year in positive territory. However, on the way, Central Banks and market forces

will come to attrition and produce excess volatility of the likes we have seen several times last year

and now again this year. The market has shown its capacity to be random and violent, able to

drive itself into pain trades, crushing consensus and crowded positioning as it moves away from

fundamentals (macro releases) and technicals (Central Banks’ targets for asset pricing and

wealth effect), irregularly, in size and for lengthy periods of time.

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Random and Violent Markets

The fabric of the market is showing signs of fracturing, as 9 years of declining policy rates and 6

years of QEs failed to kick-off growth, while further easing has a visibly decreasing marginal

effectiveness. It is end-of-cycle-type policymaking and market responsiveness. In the random and

violent markets which have emerged last year, long-dated rates can move hectically 10-15bps/day up

and down several days in a row, major equity indexes 6%/day up and down several times/year, major

crosses (like the EURUSD) move 2-3 sigma several times/year, all typically away from

fundamentals/consensus, without the necessity of the real fundamental driver. Rephrased, driven

more by perception than by reality, on either panic selling / stops triggered or panic buying / short

covering.

The characterization of end-of-cycle markets include thin liquidity, crowded positioning on

consensus trades, high leverage, all the while as over-sized players play their games (reserve

managers and SWFs, giant passive money managers, algorithmic strategies and risk parity funds).

Fundamentally, the nature of end-of-cycle-type policymaking and market responsiveness is

intertwined with the inability of new credit expansion to meaningfully impact GDP growth. The

falling productivity of credit is a chief component in our characterization of Secular Stagnation

(together with demographics, over-indebtedness, technological advances, see March 2015 Investor

Presentation, pages 52 to 72). Multiple rounds of debt expansion and quantitative easing have visibly

produced a falling marginal effectiveness. This is nowhere more visible than in the simple chart

plotting GDP expansion against credit expansion, here below:

Source: BAML Research

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If one wanted to be a notch more accurate, it could visualize the trends in such indicators as the

‘money multiplier’ and the ‘velocity of money’, which encapsulate a similar message in their multi-

decades declines. Here below:

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. The falling productivity of Credit is

now hard to ignore. Legitimate questions then arise: 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 answer to such questions goes beyond the scope of this piece. However, the market phase we

live within may have to be seen as the terminal phase of a process started several decades ago, when

it all began, with the end of Bretton Woods itself.

In confirmation of such secular trends, and as further empirical evidence, one can consider that while

the FED printed in excess of 3 trn of new dollars during its several rounds of QE, additional debt

worldwide was created for $ 57 trn, according to McKinsey research, the bulk of which is in US

Dollars. The effect (or non-effect) on global GDP is before everybody’s eyes.

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Implications for Portfolio Positioning

Medium-term, our fundamental views do not change, nor the list of our top trades. For all intents

and purposes, for the next year or two, ‘Deflationary Boom Markets’ do remain our likeliest

scenario. Deflation forces Central Banks into action. Central banks push Bonds and Equities

higher, inflating the bubble some more, although on a way rougher path and with higher

volatility than we got accustomed to in recent years. However, the way to position for it has

changed substantially, as buy and hold strategies are hard to maintain in rodeo-type markets,

and random moves are wild enough to trigger any pre-set stop along the way.

Rephrased, ‘random and violent markets’ have one important bearing: market views can prove

right but after long delays and after wild-west diversions from target levels. Typically, being

visibly late on your views is indiscernible from being wrong. A change in the investment plan is

therefore warranted.

Thus, investing-wise, we prefer to keep the risk light, positions small, and act opportunistically

on markets, and to do so in line with our fundamental views, preferring optional formats to delta

one formats, to skew the risk-reward as much as possible.

Patiently waiting for an opportunity to enter markets in what we expect to be another random and

violent year of trading, and preferring cheap optionality as vehicle to express views, might be the

right way to go in fractured market like these ones.

Likewise, on delta 1 positioning, we prefer trading tactically to buy and hold mode, as we expect

market’s excess volatility and wild swings to succeed at pushing most pain trades into stop-loss.

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Thanks for reading us today!

For those of you who may be interested, we will offer an update on our portfolio positioning to

existing and potential investors during our Quarterly Outlook Presentation to be held in Q1.

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

Authorised and Regulated by the Financial Conduct Authority (“FCA”)

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Appendix I:

Glossary and Reference Fasanara Research

Our definition and analysis for ‘Deflationary Boom Markets’ is available at the link June 2015

Outlook on pages 6 and 7, and July 2015 Investor Presentation on pages 26 to 35.

Our definition and analysis for ‘Deflationary Bust’ is available at the link June 2015 Outlook on pages

8 to 9, and July 2015 Investor Presentation on pages 36 to 53.

Our definition and analysis for ‘Structural Deflation and Secular Stagnation’ is available at the link

June 2015 Outlook on pages 10 and 13, and July 2015 Investor Presentation on pages 54 to 75.

Appendix II:

Our Conceptual Framework for Secular Stagnation, Structural Deflation

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

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.

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

economies globally. 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

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of credit expansion and its multiplier effect on growth and productivity. The falling

productivity of Credit is before everybody’s eyes. 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.

Herbert Stein’s law states that ‘if something cannot go on forever, it will eventually

stop’. A cursory glance at the chart plotting Credit expansion vs GDP expansion in the

US shows the point.

- 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, WhatsApp 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 capital

investments needed.