From our friends at Fasanara Capital we get their latest contrarian – and very bearish – Investment Outlook, which can be summarized as follows: “Reflation Phase To Be Temporary, More Downside Ahead“, and which also contains four key conviction trade ideas over the next 12 months.
This is what fund manager Francesco Filia cautions about the market over the next year:
Earlier on in 2016, markets went off to panic mode out of (i) fears over China’s messy stock market and devaluing currency, (ii) plummeting oil price to levels where it could trigger covenant breaches/defaults, (iii) FED hiking rates and a strong US Dollar strangling Commodities and their producing countries. In response to such risks, market action was legitimate but exaggerated in magnitude and speed, leading us into calling for ‘random and violent markets’ (Read). ‘Random’ as they often refuse to follow the logic of fundamentals, ‘violent’ because they shift with great momentum when the narrative changes and the tide turns.
Today, we believe markets are similarly illogical and over-reacting, this time on the way up. Illogical in believing those underlying risks have abated, for the only difference is the actual price of Oil, Renminbi, US Treasury yields, while no fundamental change has occurred. To us, no game changer between now and then, just a narrative shift.
The narrative of reflation is today dominant and can continue to propel markets for a while longer. But as we know the narrative changes fast, and when it does we can expect a quick re-pricing. As we re-assess the validity of the underlying risks, we expect a shift in narrative in the few months ahead and a sizeable sell-off.
According to Fasanara there are four key risks ahead:
- China Risk. China remains entangled in the messy rebalancing of its economy. While managing to sedate panic in equity and currency markets for now, China failed to address its structural issues. The size of NPLs is staggering at 30% of GDP. Short term rates are spiking in recognition of defaults happening on the ground at accelerating speed, and involving not just small enterprises, not just private enterprises, but large and state-owned enterprises too. In Q1, it only managed to keep GDP in shape by means of graciously expanding credit by a monumental 1trn$. Unsurprisingly, you cannot borrow 10% of GDP per quarter for long without a currency adjustment, whether desired or not. And generally, what is the point in selling reserves to defend the peg, thus doing monetary tightening, when you seek so desperately monetary expansion.
- Oil Price Risk. The price of Oil moved from 27$ earlier this year to approx. 47$ today. The Doha meeting failed to freeze production, but the market could count on a declining production out of US frackers. While the bullish camp sees further reduction in production in the US, Venezuela, and an agreement on freezing production at the next OPEC/non OPEC meeting, we believe Oil will follow a volatile path around a declining trend-line, which will take it one day to sub-$10.
- Strong US Dollar Risk. The weak Dollar is the major factor propelling the reflation sentiment in the market – EMs and Commodities greeted it with enthusiasm. However, it seems to us more a story of appreciating Yen and Eur out of the failed attempts of the Boj and the ECB to reflate their economies, as markets doubt their capacity at negative rates. It is not the typical weak Dollar out of increasing US current account deficit and increasing spending / imports, positive for the world and inflation. We expect the USD to have another leg up in the months ahead. A stronger Dollar alone has the potential to revive January-type fears over Oil, CNH, Emerging Markets, leading to a risk off of global assets, including the S&P, which is priced to perfection, with a P/E close to record highs.
- European Banking Sector Risk. While the micro picture / relative performance of each bank is under the control of its management team (legacy issues and disposal of NPLs, overcapacity and layoffs/cost cutting, restructurings, industry consolidation, monetization of subsidies from Central Banks), macro structural headwinds for banks these days are too heavy a burden (negative sloped interest rate curves, deeply negative interest rates, deflationary economy, depressed GDP growth, over-regulation, Fintech), and will likely push valuations to new lows in the months/years ahead.
Fasanara caveats that “none of this is to claim that all of these outcomes are just about to materialize, imminently. It is, however, to say that the risk of one of them derailing complacent markets is material. While the probability of each of those events happening may seem low at present, the probability of any of them happening is hard to ignore. They bear across the same overall hypothesis of a steep market sell-off, January-style.”
That said it adds that “we stand next to a sleepy volcano. To be bullish risk assets today is to be blindfold to the underlying risks, dismissing them all too quickly while their core drivers are left playing out, mistaking optimism for wishful thinking. We live through transformational times, where we are fast reaching the limits of monetary printing, and markets are still to price that in. GDP growth, inflation, productivity are all missing in action despite various rounds of monetary doping and financial engineering the world over. The un-anchoring of inflation expectations from Europe to Japan, previously believed to be stationary variable, i.e. mean reverting, may best testify to the falling credibility of Central Bankers, as they ran out of policy space. Falling credibility is typical precursor to financial imbalances compounding (including bubbles) and then tipping off into financial crisis.”
It wouldn’t be the first time markets have gone though such a violent phase:
It is not the first time in history that we go through an existential crisis of global capitalism. In the 20’s structural deflation led to Keynes revolution in economics. In the 70’s chronic inflation led to Milton Friedman counter-revolution, and governments like Thatcher or Reagan. Market-based economies survived both. Today, a new form of global capitalism might have to be worked out, to decipher how could we still be entangled in deflation despite what we learned from past experiences. We thought we knew it all and we do not. The disruption from technology, working wonders at accelerating returns, is happening so fast that it is tough to come to terms with it and fully grasp its many implications. For what is worth, the industrial revolution too took time to equate to growing productivity and wealth, while it went past its implementation phase.
A new evolutionary phase of ‘helicopter money’ and the nuclear fusion of monetary and fiscal policies might well be the next stop, as policymakers move from price setting to direct resource allocation, in certain markets more than others, in certain places sooner than in others, but the road to that next stage is certain to be bumpy. Policy mistakes and market accidents are legitimate along the way.
The conclusion is troubling:
A drastic 50%+ cash allocation and a defensive/net short approach seems to us as the only antidote against expensive, random, violent markets, moving from one storm to the next. While warranted, such approach is no easy task. It entails suffering from lack of carry, while showing up as underperformers against exuberant markets for certain periods. It might, however, prove right in the longer term, which is what matters. Picking up carry has been the mantra of the asset management industry for as long as the industry existed. Today however, as 7trn$ bonds are trading negatively, as equities expanded multiples on rising prices and contracting earnings, picking up what is left of carry today is like willfully trading what used to be good yield for illiquidity premium and bad credit risk: a value trap, if not a financial guillotine. Picking up carry in end-of-cycle fractured markets like these ones, as VAR shocks are ever more frequent and liquidity evaporates fast on downfalls, extracting it out of expensive fixed income and equity assets, feels to us like picking up dimes in front of a steamroller. It may just be the financial equivalent of the unaware ant of the Aesop fables, dancing while winter is coming. The financial grasshopper looks boring, impractical, uninspiring, for lack of carry and as it refused to follow the trend higher, until the winter comes.
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How will Fasanara trade its conviction? Four trades.
- Short Chinese Renminbi Thesis. In Q1, China only managed to keep GDP in shape by means of graciously expanding credit by a monumental 1 trn $. Unsurprisingly, at 250% total debt on GDP, you cannot borrow 10% of GDP per quarter for long, without a currency adjustment, whether desired or not.
- Short Oil Thesis. Long-term, we believe Oil will follow a volatile path around a declining trend-line, which will take it one day to sub-10$. Within 2016, we expect global aggregate demand to stay anemic and supply to surprise on the upside, inventories to grow, primarily due to the accelerating speed of technological progress.
- Short S&P Thesis. To us, the S&P is priced to perfection, despite a most cloudy environment for growth and risk assets, thus representing a good value short, for limited upside is combined with the risk of a sizeable sell-off in the months ahead.
- Short European Banks Thesis. We believe that micro policies at the local level, while valid, are impotent against heavy structural macro headwinds, and only the macro environment can save the banking sector in its current form in the longer-term. Macro structural headwinds for banks these days are too heavy a burden (negative sloped interest rate curves, deeply negative interest rates, deflationary economy, depressed GDP growth, over-regulation, Fintech), and will likely push valuations to new lows in the months/years ahead.
Full letter below:
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