Fasanara Capital November 2016 investment outlook on Transitioning From ‘Full QE’ To ‘Some Fiscal Stimulus’

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1. Delusions: Reflation/Growth or QE Bubble Unwind?

What if consensus is wrong: what if rates are rising due to the end of Quantitative Easing and not because of reflation/escape velocity on growth? Rates then rise without growth, perhaps even without much inflation. Indeed, rates started rising back in August, on momentous shifts in policy by BoJ (forced by capacity constraints and collateral damage). Such scenario is not good for equities, contrary to what currently believed by markets.

2. Transitioning from ‘Full QE’ to ‘Some Fiscal Stimulus’: Bumpy Road

2016 will likely be remembered for the paradigm shift brought by the interconnection of Trump / Brexit / populism / protectionism / end of Full QE. Critically, the transition from ‘Full QE mode’ into ‘Some Fiscal Expansion mode’ will be no smooth ride for markets. There is nothing as good as ‘Full QE’ for bonds and equities. Full QE mechanically boosts equities and bonds higher, although with diminishing efficacy over time. Fiscal expansion, instead, has (i) execution risks (longer time to delivery, uncertainties over resource (mis)-allocation across industries & population cohorts), (ii) headwinds as rates and wages rise (thus squeezing corporate margins from all-time highs). Safe to assume volatility will rise / may spike. Possible to see large potential downside gap risks on bonds and equity.

3. Regime Changes Happening On A Dangerous Market Structure

Amid such policy shifts, the potential downside is exacerbated by the thin ice of a dangerous market structure, dominated by rule-based / passive-aggressive investment strategies. Close to 90% of equity flows (from 7% 15 years ago) can today be attributed to either passive index funds or ETFs, Risk-Parity funds or Volatility-driven strategies, trend-chasing algos. Altogether, they now represent close to $8 trillion of AUM in firepower (rate of acceleration in recent years is staggering).

No wonder buy-the-dip is the strategy-elect these days. No wonder anything short of ‘buy-and-hold, fully invested’ underperformed in recent years. There is no way to know when and if such powerful forces may set in reverse motion at once, following a market downturn – nor, though, could one ever be surprised if that happens. Whether it does or not, off any catalyst or off no catalyst at all, will define the difference between a crash and a flash crash, a mild correction or a violent enduring re-pricing, a January 2016-type wacky market or a Lehman-moment.

4. Positioning for QE Bubble Unwind, Populism/EU Disorder

At Fasanara Capital, we think it pays to be positioned for disorder from here. The asymmetry of payout profiles and risk-adjusted returns, let alone our macro assessment of where things stand, calls to position for an unwind of the QE bubble trade, which means bonds and equity down together, the polar opposite of Risk Parity funds or, more generally, balance portfolios (long equities, long bonds).

In a nutshell, the black clouds of regime changes has filled the horizon (full QE in retreat, Trump / Brexit / EU populism and political un-predictability, Dollar strength). It started raining already (rates spiking) and the illusion of knowledge bias / buy-the-dip mind-frames work as a thinking trap setting the stage for the next downfall. A market structure dominated by rule-based passive-aggressive machines make such downfall potentially way larger than it could have otherwise been.

The worst downside is for the EU, where (i) populism has built up over the years, now reaching a tipping point after the boost of Trump/Brexit and (ii) the transition out of ‘full QE mode’ is a bridge to nowhere. Willingness / capacity to fiscal stimulate in the EU is underwhelming. To adequately fiscal expand and drop money from helicopters you must be in need of your own currency: exit EUR.

QE Bubble

Delusions: Rates Rising on Reflation/Growth or QE Bubble Unwind?

With Trump rising to power against all the odds of bookies, pollsters, a militant press, a reflexive army of pundits and an all-guns-out establishment, it is all too clear who are the big losers of these elections. After the supposed shocks of Brexit and Amerexit, you may imagine less and less market participants to pay attention next to pollsters, bookies and analysts in informing investment decisions at the next check point.

But there is a bigger loser, and that is the Efficient Market Hypothesis itself, a cornerstone of modern financial theory, which states that all relevant information are embedded in prices, making them fair prices. Going into the event a win by Trump was widely perceived to be an outright disaster. Coming off the event, after an initial shock, equity markets staged one of the most impressive rebounds in history. Clearly, this is not an example of rationale investment behaviour. From Armageddon to Paradise on Earth in just few hours. The market had known full well what the aftermath of a Trump win looked like, had been given plenty time to strategize on that, and yet it all seemed really new news. Ex-post, narratives of cash on the sidelines, retail coming in, fiscal expansion /reflation reality sinking in, are all handy but unconvincing scapegoats.

Earlier on this year, we rather elect to believe in what we termed as ‘random and violent markets’. A wacky, random walking environment, driven by outsized market flows from juggernaut market participants – mostly passive – in shallow liquidity, white whales manoeuvring in a street pond, together with what’s left of an investment community uncertain of the fundamental analysis surrounding the investment process and all too ready to follow the flow, abruptly and violently.

Signs of such market behavior were evident before Trump, while they may now have become even more frequent as an opinionated, short-fused Dominus takes the helm of the world’s biggest economy (25% of total), the world’s dominant equity market (37% of total) as well as the world’s biggest military. Ante-Trump, we saw bouts of excess volatility at several points: August 2015, recovered in few weeks; January/February 2016, recovered in few weeks; Brexit June 2016, recovered in just few days. Now the Trump-moment, recovered in just few hours. Post-Trump, if Trump means Trump, it seems like market crashes and flash-crashes have no reason to abate, while ‘buy-the-dip’ remains the constant winner. But is it truly warranted? And should it continue to be the best strategy-elect from here?

Markets are in belief that Brexit was not a disaster after all, but rather provided a window of opportunity to go long. And even Trump proved a valuable buy-the-dip opportunity, although you had to be quick (and awake at night). Markets even seem to be wishful for a sudden 10%-15% correction as the Christmas gift, giving them a chance to engage more: more longs, more leverage.

We look at this as the thinking trap setting the stage for the next moment of market volatility, which may be more violent and damaging as it would have otherwise been – even in the absence of fundamentals further deteriorating to a point where the need for re-pricing would be self-evident. The market structure of large passive investors (index funds and ETFs / ETPs at ca. $4tn), mechanical trend-chasing algo strategies (the bulk of

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