1. Reflation Phase To Be Temporary, More Downside Ahead Earlier on in 2016, ‘random and violent markets’ went off to panic mode out of (i) fears over China’s messy stock market and devaluing currency, (ii) plummeting oil price, (iii) strong US Dollar. Today, we believe complacent markets are similarly illogical and over-shooting, this time on the way up. 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 for risk assets. 2. Four Key Conviction Ideas We analyze below our key ideas for the next 12 months: 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.

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

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May 3rd
2016
Fasanara Capital | Investment Outlook
1. Reflation Phase To Be Temporary, More Downside Ahead
Earlier on in 2016, ‘random and violent markets’ went off to panic mode out of (i) fears over
China’s messy stock market and devaluing currency, (ii) plummeting oil price, (iii) strong US
Dollar. Today, we believe complacent markets are similarly illogical and over-shooting,
this time on the way up. 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 for risk assets.
2. Four Key Conviction Ideas
We analyze below our key ideas for the next 12 months:
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.

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The Ant and the Grasshopper
In a field one summer’s day a Grasshopper was hopping about, chirping and singing to its heart’s
content. An Ant passed by, bearing along with great toil an ear of corn he was taking to the nest.
“Why not come and chat with me,” said the Grasshopper, “instead of toiling and moiling in that way?”
“I am helping to lay up food for the winter,” said the Ant, “and recommend you to do the same.”
“Why bother about winter?” said the Grasshopper; “we have got plenty of food at present.” But the Ant
went on its way and continued its toil. When the winter came the Grasshopper had no food, and found
itself dying of hunger, while it saw the ants distributing every day corn and grain from the stores they
had collected in the summer. Then the Grasshopper knew:
“IT IS BEST TO PREPARE FOR THE DAYS OF NECESSITY.”
Æsop. (Sixth century B.C.) Fables.
The Harvard Classics. 1909–14.
Winter is coming
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.

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Our assessment of the underlying risks is as follows:
1. 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$. Unsurprisingly, you
cannot borrow 10% of GDP per quarter for long without a currency adjustment,
whether desired or not. And generally, what is the point in selling reserves to defend
the peg, thus doing monetary tightening, when you seek so desperately monetary
expansion. From here, at some point, one of two outcomes seems plausible:
a. China determines that 1 trillion dollars per quarter is too high a cost for printing
GDP, and lets the currency devalue. An illusion of demand exchanged for another.
A bad habit exchanged for another, but at least cheaper. CNH devaluation is a
clear risk-off factor for global markets.
b. China keeps going printing recklessly, debt increases further into the
stratosphere and drags down GDP growth anyway, leading to currency
outflows and a weaker CNH. Total debt on GDP at almost 250% is already record-
breaking for both emerging and advanced markets. Especially so as the ratio
doubled up in a short 10-year period, making a productive use of proceeds unlikely.
As debt ratios rise further, then, a slowdown in growth is a textbook outcome that
cannot take by surprise. Weak China GDP numbers are a clear risk-off factor for
global markets.
2. Oil Price Risk. The price of Oil moved from 27$ 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$.
a. In the medium term, we expect global aggregate demand to stay anemic,
constrained by the structural drivers of secular stagnation (Read), and we expect
supply to surprise on the upside, inventories to grow, due to technological trends
in the US and due to the reaction function of Oil producers now that Oil has re-
priced. Incidentally, in 2015 the same pattern was followed, as Oil rose ca. 50% to
60$ area over a period of 6 months, before collapsing 60% into new lows. At the
time, a declining rig count held the promise of a declining production, except
productivity of oil rigs went up 4-fold, spoiling the party.

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b. Longer term, we expect Oil to follow the path of natural gas and coal. Oil is one
technological innovation away from extinction, with battery storage being the
likeliest fatal blow waiting to happen.
3. 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. We see few reasons for USD strength:
a. The FED took the steam off the Dollar by moving its expected path of tightening
from 4 hikes to 2 hikes only. The FED may become more dovish than that, but the
market already factors that in. Of the 2 rate hikes planned, a tiny 20% is priced in at
present. Not much headwind for the US Dollar is left from the FED this year. At
the other end of the equation, after recent failures, the BoJ first and then the ECB
will go back at it, trying again to reflate their stagnant economies, with the
debasement of the JPY and the EUR either a working tool or a side effect.
b. A contracting current account deficit and budget deficit in the US will help
strengthen the US Dollar. Anecdotally, recent trade balance numbers showed an
unexpected marked improvement. The propensity to take on more debt for
households and businesses may well be on a declining path. Savings rate for lower
income brackets may rise as uncertainties loom large, the cost of retirement has
gone up on zero rates environment, together with growing healthcare and
education costs. Corporates desire for leverage, buybacks and M&As, may also
deflate somewhat, as short rate rise, leverage ratios are now high (the median
credit rating for S&P companies is now BB and declining, for a median net
debt/ebitda above 3), regulation changes (inversion trades), pricing power is weak,
excess capacity abounds. The public sector should fill the gap, but that is unlikely
to happen in an election year. You can’t increase deficit if you do not take on more
debt. If borrowing declines, the deficit declines, the US Dollar rallies.
c. Most likely, the relative performance of the US economy will continue to
outclass growth in EMs, Europe and Japan. Technology is a huge plus for the US
economy, their lead likely to outlast any potential political speed-bumps on
elections.

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4. 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.
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.
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 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.

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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.
In the following few pages we briefly analyze four key conviction ideas for the next 12 months, to
be tested for validation against incoming data in the months ahead. As always, we stand ready to
trash our theories out should the fundamentals change, while we will attempt at sticking to them if
pure narrative and illusory sentiment put them in doubt. We will try to avoid the confirmation bias
trap. The conceptual framework tying them all together is the one for Structural Deflation and
Secular Stagnation we depicted in previous write-ups.
1. Short Chinese Renminbi Thesis
2. Short Oil Thesis
3. Short S&P Thesis
4. Short European Banks Thesis
We briefly touched upon our views on these trade convictions in this recent CNBC appearance:
Video.
Short Chinese Renminbi Thesis
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. In the
first quarter of 2016, it only managed to keep GDP in shape by means of monumental 1trn$
credit expansion (a whopping 10% of GDP in one quarter); easily unsustainable at the current
pace, clearly a Pyrrhic victory. The credit bubble has then gone worse, as China resumed the old
habits of government spending (as state-owned sector was the bulk of fixed investments
expansion), in what can only be seen as the ultimate panic move of a desperate player. Couple that
with unprecedented increase in banks loans (12.6trn RMB) and you get that for every 12 currency

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units of credit expansion, a single unit of Chinese GDP was engineered (Gavekal research: Read), a
lousy achievement. All of this happening while debt metrics are now way worse than in 2009, when
such credit expansion took off, as total debt/GDP approaches 250% from 150% back then. Also, the
economy is way larger now at over 10trn$, second biggest globally, double the size of the third
biggest - Japan, making any misstep hard to digest for them and the intertwined rest of the world.
The size of NPLs is staggering at 30% of GDP. Short term rates are rising in recognition of credit
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.
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.
From here, at some point, one of two outcomes seems plausible:
a. China determines that 1 trillion dollars per quarter is too high a cost for printing
GDP, and lets the currency devalue. An illusion of demand exchanged for another.
A bad habit exchanged for another, but at least cheaper. CNH devaluation is a
clear risk-off factor for global markets.
b. China keeps going printing recklessly, debt increases further into the
stratosphere and drags down GDP growth anyway. Total debt on GDP at almost
250% is already record-breaking for both emerging and advanced markets.
Especially so as the ratio doubled up in a short 10-year period, making a productive
use of proceeds unlikely. As debt ratios rise further, then, a slowdown in growth is a
textbook outcome that cannot take by surprise. Weak China GDP numbers are a
clear risk-off factor for global markets.
When China returns to the spotlight, it will matter. Interestingly, the S&P vastly ignored European
banking woes, and was even somewhat unscathed during Oil gyrations, taking a true gap down only
at times when China seemed like it was spinning out of control: August 2015, January 2016. What
happens in China holds instantaneous knock-down potential for global markets. When China
sneezes, the US catches a cold, everybody else gets broken bones.
China’s slowdown will continue affecting commodities markets front and center, metals in primis.
China has grown to become the world’s largest purchaser of aluminum, iron ore, zinc, nickel and
copper, asking every year for more than double the needs o the US, Europe and Japan altogether.
Incidentally, moreover, the speculative flows that determined massive volatility in RMB equity
markets earlier on and possibly boosted propensity to currency outflows, are now to be seen in the

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commodity market. Not only then China buys a lot of metals, but speculative flows multiply those
flows a few times over. Anecdotally, twice in the last few month, trading volumes in Iron Ore on the
Dallan Commodities Exchange exceeded total China’s 2015 imports (950m tonnes) in a single day.
Rebar trading volumes exceeded Iron Ore, across 100 million trading accounts. Authorities rushed to
curb speculation through higher fees and more margin requirements, but we have seen how effective
they were last time around. An epic unwind may loom large (Read).
CHART: Total Social Financing on GDP vs FX Reserves
China avoided scaring markets with more FX Reserves depletion, but did so at the expense of resuming
massive credit expansion. How long can it be done for?
CHART: Total Social Financing vs FX Reserves
China credit expansion picked up momentum again, close to the highest peaks of 2009 and 2013
Source: Bloomberg

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Short Oil Thesis
In the first half of 2015 an apporx 55% rally of Oil was to lead to a major disappointment as early
as July, and a subsequent 60% fall-off. At the time, too much emphasis was put on the relevancy
of a decreasing US oil rig count, believing it would have led to diminishing supply. In contrast,
new technologies led to improvements in productivity, and generated the unexpected outcome of
increased production and inventories in the face of decreasing rig count. We believe additional
improvements in oil rigs productivity are likely this year and next, similarly to what happened to gas
rig productivity in the years since 2007 when it rose 13-fold (Article and EIA Report). A freeze in
production may then similarly fail to rebalance the market, contrary to what the market seems
to wishfully assume at present.
Contrary to what believed by most, we expect Saudi Arabia to accept lower oil prices from here.
Current prices are inconsistent with the market share price war fought by Saudis to preserve market
share for 18 long months against incumbent US frackers / Russia / Iran. Pushing prices down
60%/70% will have achieved little if now that such players are under stress they are given a breathing
space and are let to live another day. 83% of US frackers are believed to break-even at approx. 38$,
with such break-even moving lower on advancing technology (horizontal drilling as opposed to
vertical, flexibility of the rigs, shortening rigs’ time to delivery). At current prices, such producers are
incentivised to expand production, not contract it, to cover fixed costs. Rising inventories are there to
testify it. Also, 2020 oil forwards at 54$ have allowed producers to hedge production at very decent
levels, an unlikely window of opportunity only a couple months ago. Flooring prices at or above 40$
is inconsequential to the strategy followed by Saudis in the past 18 months.
Longer term, we expect Oil to follow the path of natural gas and coal. Oil is one technological
innovation away from extinction, with battery storage being the likeliest fatal blow waiting to
happen. In this respect, Oil seems to be under the coordinated attack by the best minds of our
times, that also helpfully command great capital capacity. Bill Gates has committed his fortune to
bring the world past fossil fuels. He is convinced energy access is key to address world poverty, let
alone climate change. He does not call for just an energy revolution; he calls for an energy miracle
(Read). Ray Kurzweil projects the U.S. will meet 100 percent of its electrical energy needs from solar
in 20 years. Elon Musk is a bit more conservative, pegging it at 50 percent in that timeframe (Read).
Elon Musk alone, in his Gigafactory, plans to produce 35 Gigawatts worth of the batteries by 2020,
more than 2013′s total global battery production capacity. Such plans reduce dependence on fossil
fuels and the national grid altogether. Bill Gates recently unveiled the Breakthrough Energy
Coalition, a group of more than two dozen wealthy sponsors that plan to pool investments in early
stage clean energy technology companies. (Read).
We could keep going, but the message is clear. The race is set, and is not between oil and clean
energy, or between Saudis or US producers, but rather it is between technology and fossil fuels:
we bet on technology. Energy abundance is our long-term call.

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Not that the message is not heard across the financial industry. While banks keep lending to the
fossil fuel sector despite an outstanding total 3trn$ global energy debt, smart money has started to
sail off already: we recently learned that the Rockefeller Family Fund will divest from fossil fuels as it
'makes little sense –financially or ethically - to continue holding investments in companies like Exxon
[..]. The process will be completed as quickly as possible.’ Read.
The speed of technological change is such that many are taken by constant surprise. Gas rig
productivity increasing 11-fold in the last 10 years is a clear example. But also clean energy is getting
cheaper and cheaper to produce, the more goes online, to a point where it can almost compete on
price with fossil fuels. The cost of solar panels is dropping exponentially: the cost per watt of silicon
photovoltaic cells over the past few decades plummeted from $76 in 1977, to less than $0.36 today.
The cost of power generated by solar has plummeted to the point where, in many parts of the world,
it is now close to coal or gas generated electricity. Fossil Fuels are Losing their Cost Advantage Over
Solar, Wind, an IEA Report Says. Read.
Simultaneously, Energy storage is advancing rapidly, the ability to take solar energy captured
during the day (peak production hours), and time-shift it into the night (peak consumption hours): a
50%+ reduction over the past four years, and an additional 50%+ reduction by 2020 (Peter Diamandis
is an absolute authority in analyzing the speed of change of innovation Read).
Not that the demise of Oil needs any helping hand, but climate change may also prove an
important factor. The urgency of reducing carbon emissions can only go up from here, to include
late-comers US and China, as global warming thesis seems to get validated by incoming data:
March temperature smashed a 100-year global record and 2015 was the hottest since 1880 (Read).
CHART: Brent Crude vs Natural Gas, common fate
The simplest of Charts.
(source: Bloomberg)

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Short S&P Thesis
The S&P is priced to perfection. It trades right below all-time highs, at Price-to-Sales higher than in
2007, at 26X Shiller adjusted Price-to-Earnings multiples, after being propelled for four consecutive
years by multiple expansions (while earnings stagnated or declined), buybacks for 1.1trn$ (running
now at 60% of EBIT), various rounds of QEs for 4.7trn$, declining rates. Where can it go from here?
Up 5%? And then what? Shorting S&P looks like a good hedge for any Beta long a portfolio may
have, let alone a good short in its own merit.
The US economy is easily the best out there, by and large, but hardly a shining star in itself. After
an investment of almost 25trn of stimulus (Lawrence McDonald at SocGen estimates Fannie/Freddie
at 7trn, Federal deficits at 10trn, state/local deficits at 3trn, QE at 4.7trn), the economy returned 0.5%
GDP growth in Q1 2016. Hardly a home run.
The US Dollar has weakened as rate hike expectations were priced out. Today, a tiny 20% of meager
two hikes is left priced in. More weakness is conceivable, from a pure rate differentials perspective,
should the US contemplate negative rates or new round of QE or helicopter money. That is all too
possible, but perhaps not a 2016 issue. Making the case for a strengthening Dollar in the months
ahead a genuine one; an additional headwind to US stocks.
As we argued earlier on, we think the current account deficit might shrink from here, out of lack
of new borrowing by the private sector, rising savings, and a public sector inactive during the
electoral year, leading to more fuel in the tank for the Dollar. A consequential tightening of
international USD liquidity would follow swift.
Any crisis or market accident has also the potential to propel the US Dollar forward, adding pressure
on stocks in general, including US ones.
P/E multiples are even more expensive than face value suggests, were one to normalize them for
a declining return on equity, once the effect of slowing leverage is factored in. Should spot P/E
multiples compress to 13/14, it would still provide for a great multiple within a deflationary global
environment. It would not take a recession to get there.
Needless to say, a US recession would take multiples there or below even faster, and a recession is
not to be ruled out with certainty.
ZeroHedge reminds us of sector specific multiples hitting both fabulous and hilarious levels:
‘Consumer Staples sector multiples have never been more risky. At a P/E valuation of 22x, food,
beverage, and tobacco companies have never been more expensive. The S&P 500 Energy Sector
currently trades at 101.5x analysts' expectations of next 12 months earnings’ (Read).
In a nutshell, the S&P is priced to perfection and represents a good value short in 0ur opinion, for
limited upside is combined with the risk of a sizeable sell-off in the months ahead.

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CHART: S&P vs Earnings
Earnings beat came against ever falling expectations. Declining actual earnings have repeatedly
signaled market tops.
Source: Bloomberg, Fasanara
Short European Banks Thesis
In the last few months, the banking sector got given a boost by a few good news. The ECB
devised subsidized T-LTROs to help banks cope with the ongoing laboratory experiment of negative
rates. The ECB proved way ahead of the BoJ, for example, in assessing the unintended consequences
of its actions, and provide for it to the best of one’s ability. Moreover, Governments implemented
structural reforms, like the repossessions law approved in Italy these days, a definitive positive for
the present value of NPLs, thus directly affecting banks’ valuations. The private sector itself made
progress, most specifically again in Italy where a smart private-sector bank rescue fund was quickly
engineered, so to circumvent EU laws on state aid and help alleviate the pain for smaller banks. It is a
surprisingly creative and well-thought initiative, surely relieving the local sector off easy and
unnecessary catalysts to market panic. We can only wish the EU authorities were as innovative and
proactive in tackling issues and matching problems with prompt solutions.
Unfortunately, that is not the case, as lack of leadership and German ideological stubbornness on
misguided economic dogmas prevails within the EU. Also unfortunately, we believe that micro
policies at the local level 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. The
current macro trajectory projects trouble ahead.

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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.
Too much emphasis is put on a beat of depressed earnings guidance, vs the fact that revenues are
down a 10%/25% and net income is down 25%/60% from a year earlier (MS/GS/Standard Chartered
are just examples), for reasons largely outside the control of specific management teams.
Valuation metrics like P/TBV are generally of little meaning in determining value, even more so now
that TBV is part of the problem.
We see four main macro handicaps for the sector in the longer term:
1. Deeply negative interest rates for a prolonged period of time. Banks’ business model
is at risk. If deeply negative interest rates is the way forward, it doesn’t matter
consolidation or bad banks talks or country-specific policymaking: the business model
is impaired, needs a rethink/restructuring. No bank is ever designed to function in
durable negative rates environment. It is a profitability issue, not a balance sheet
problem. Banks’ capitalization then, however healthy it may seem today, may have
to be looked at as no more but the number of years of negative profitability it can
withstand before a recap is eventually needed. Banks to be looking like Utilities, cost
centers more than profit centers. Theoretically and practically, they could still
functionally operate, while their equity moved closer to zero.
2. Inverted interest rate curves. Now then, one more element is potentially adding to
negative rates in impacting banks’ business: negatively-sloping interest rate curves. The
spread between 10y JGBs and overnight rates turned negative in Japan last month. The
same spread in Germany is only 20bps steep. The curve steepness tightly correlates,
in broad terms, to how much of a spread profit is left for banks when lending to
good large businesses in Europe. No creditworthy business in Europe will accept
borrowing for the longer term at much higher costs than that, especially when
factoring in a weak-inflation environment. Incidentally, such business is better off
borrowing for shorter terms, at more inverted curves, for then rolling-over such debt at
a time when it has better visibility on how things evolve in the real economy and if the
inflation outlook deteriorates from here or not. Also, with flat curves, free-risk carry
trades on local govies usually utilized to recap weak banks are no longer at hand.
3. In a deflationary economy, demand for loans is anemic. By subsidizing T-LTROs to
the private business sector, Draghi was masterful in avoiding immediate damage to
the banking sector. Banks’ agonizing core business model was given a breathing space,

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in the name of helping the real economy. Surely a smart and well-thought system of
incentives. However, as Keynes once wrote, quoting the old English proverb, “You can
lead a horse to water but you can’t make him drink”. The lack of positive real expected
returns dampens new investments in hiring plans, plant & machinery, and related
borrowing and credit formation with it. The gross underinvestment in the capital stock
has itself depressing effects on GDP, viciously. Households are similarly constrained in
gearing up for more spending by rising real costs of healthcare, education, retirement.
Making Draghi’s move just another artifact of financial leverage, not a game changer.
4. Fintech is inevitably going to reshape the sector, much like is happening anywhere
else in the economy. Banks are not necessarily the best suited actors driving the
change, and therefore benefiting from it, as barriers to entry are impotent against
disruptive technological change. It is no coincidence that Walmart did not invent
Amazon, BMW did not invent Tesla, IBM/Microsoft did not invent Google/Apple. Nor
were they able to contain them. Not all is lost though: regulation is widely blamed for
the lack of profitability of the banking sector these days, but it may instead turn out
to be the best ally of banks in riding technological trends to their advantage.
Regulations can distort the playing field by putting emphasis on macro-prudential
policy, systemic risk and the critical role banks play in protecting the par value of the
monetary float (usually with collateral - Read). For all intents and purposes, Fintech
investments are only getting started, with PWC expecting an expansion of 150bn+ in
the next 3-5 years (Fintech is shaping Fin Services from the outside in – Read).
We briefly touched upon our views on banks here: Video and Video and Read.
CHART: Ratio of EU Banks / Eurostoxx vs European Interest Rate Curve
Banks tend to underperform the broader market index when interest rates curves flatten/invert (curve
defined as 10yr Bund minus refi rate). Correlation is causation here, and they also share a common cause
in secular stagnation trends. In Japan same curve is already inverted (Charts).

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Thanks for reading us today.
As usual, the ideas discussed in this paper will be further expanded upon via our ‘COOKIEs’ and
‘CHARTBOOKs’, aimed at connecting market events to the macro views framed here, in either
confirmation or invalidation. If you want to be included in these more frequent communications
please do get in touch!
Francesco Filia
CEO & CIO of Fasanara Capital ltd
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E-Mail: francesco.filia@fasanara.com
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Appendix: What I liked this month
China expected to see $538 billion capital exodus in 2016. IIF Read
Bubble trouble: The Red Dragon heats up markets again – this time in commodities Read
IMF Warns of Threats to Financial Stability. IMF Survey. On Banks, China Read
Addressing the ‘rebus’ of the weak economic response to Oil prices. They suggest the rise real
interest rates due to falling inflation expectations is the reason, due to the zero rate bound. IMF blog
post . Read
Solar Energy Revolution: A Massive Opportunity. Peter Diamandis Read

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Rockefeller Family Fund will divest from fossil fuels 'makes little sense to invest in companies like
Exxon' Read
The cost of power generated by solar has plummeted to the point where, in many parts of the
world, it is now close to coal or gas generated electricity. The more solar grows, the cheaper it
becomes to manufacture solar panels, and the virtuous cycle continues. But it's not just that solar is
becoming cheaper – it's also that fossil fuel generation is becoming more expensive. That's
because once a solar or wind project is built, the marginal cost of the electricity it produces is almost
nothing, whereas coal and gas plants require more fuel for every new watt produced []. As more
renewables are installed, coal and natural gas plants are used less. As coal and gas are used less, the
cost of using them to generate electricity goes up. As the cost of coal and gas power rises, more
renewables will be installed. WEF. Read
Fossil Fuels Losing Cost Advantage Over Solar, Wind. Renewable technologies no longer cost
outliers. No single technology is cheapest under all circumstances. IAE Report. Read.
Bill Gates: Follow the Money: The Role of Innovation in Climate Finance, December 2, 2015 Read
Bill Gates: Without access to energy, the poor are denied all of the benefits that come with
power. Poverty is not just about a lack of money. It’s about the absence of the resources the poor
need to realize their potential. Two critical ones are time and energy. More than one billion people
today live without access to energy. No electricity to light and heat their homes, power hospitals and
factories, and improve their lives in thousands of ways. Read
The Clean Energy Revolution. Fighting Climate Change With Innovation. Developing countries
should not choose between powering economic growth and phasing out dirty fossil fuels. As long as
this tradeoff persists, diplomats will come to climate conferences with their hands tied. Foreign
Affairs. Read
Bill Gates recently unveiled the Breakthrough Energy Coalition, a group of more than two dozen
wealthy sponsors that plan to pool investments in early stage clean energy technology companies.
Read
Banks vs Fintech. The critical role banks play in protecting the par value of the monetary float
(usually with collateral), and why it’s not that easy or even advisable to provide payment services
without the support of such a scheme. Read.
The influence of monetary policy on bank profitability, by Claudio Borio, Leonardo Gambacorta
and Boris Hofmann. BIS Working Papers No 514. Read
Unless real growth/inflation is raised, then south instead of north is logical direction for markets.
Bill Gross Read