Fasanara Capital’s investment outlook for the year 2016 full of short ideas.
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.
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.
Fasanara Capital – 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.
Our assessment of the underlying risks is as follows:
- 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$. Unsurprisingly, you cannot borrow 10% of GDP per quarter for long without a currency adjustment, whether desired or not. And generally, what is the point in selling reserves to defend the peg, thus doing monetary tightening, when you seek so desperately monetary expansion. From here, at some point, one of two outcomes seems plausible:
- China determines that 1 trillion dollars per quarter is too high a cost for printing GDP, and lets the currency devalue. An illusion of demand exchanged for another. A bad habit exchanged for another, but at least cheaper. CNH devaluation is a clear risk-off factor for global markets.
- China keeps going printing recklessly, debt increases further into the stratosphere and drags down GDP growth anyway, leading to currency outflows and a weaker CNH. Total debt on GDP at almost 250% is already record-breaking for both emerging and advanced markets. Especially so as the ratio doubled up in a short 10-year period, making a productive use of proceeds unlikely. As debt ratios rise further, then, a slowdown in growth is a textbook outcome that cannot take by surprise. Weak China GDP numbers are a clear risk-off factor for global markets.
- Oil Price Risk. The price of Oil moved from 27$ 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$.
- In the medium term, we expect global aggregate demand to stay anemic, constrained by the structural drivers of secular stagnation (Read), and we expect supply to surprise on the upside, inventories to grow, due to technological trends in the US and due to the reaction function of Oil producers now that Oil has re-priced. Incidentally, in 2015 the same pattern was followed, as Oil rose ca. 50% to 60$ 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.
- Longer term, we expect Oil to follow the path of natural gas and coal.