Fasanara Capital investment outlook for the month of January 2017.
1. The Future Is Wide Open: Avoid The ‘Illusion Of Knowledge’ Trap
The single most dangerous thinking trap / optical illusion for investors today is to look at Trump, Brexit and Italy Referendum as non-events, buried in the past. We believe that 2017 may likely be driven by the same factors that failed to shape 2016. The non-events of 2016 are likely to be the drivers of 2017. Finally, we will get to find out if Brexit means Brexit, if Trump means Trump, if a failed Italian referendum means early elections and a membership of the EMU in jeopardy down the line.
2. Structural Shift: These Are Transformational Times
The macro outlook of the next years will be influenced the most by these structural trends:
- Protectionism, De-Globalization & De-Dollarization. In Pursuit of Inclusive Growth
- End of ‘Pax Americana’. The ascent of China. Geopolitical risks on the rise
- End of ‘Pax QE’. Markets without steroids, but still delusional.
- 4th Industrial Revolution: labor participation rate falling from 63% to 40% in 10 years?
3. Our Baseline Scenario: Bubble Unwind, Equities and Bonds Down
Starting this 2017, our major macro convictions are as follows:
- Global Tapering to progress
- US Dollar to keep grinding higher
- European Political Instability to worsen
- US Equities to weaken
The Future Is Wide Open: Avoid The ‘Illusion Of Knowledge’ Trap
2016 saw few different watershed moments taking place, in order of importance: Trump, Brexit, a failed Italian referendum. None of them managed to deflate the bubble in equities: if anything, markets moved higher by heroically climbing the wall of worry. We look at it as the single most hazardous thinking trap / optical illusion for investors today. Having averted ‘disaster’ should not necessarily imply that a ‘disaster’ was not warranted, nor that it is not now overdue. Having experienced a rapid shift in narrative and a blue-sky scenario on such catalysts, does not equate to say that those events were market positives all along. Meanwhile, though, investors have gotten longer and longer, leverage has gone bigger, expectations higher. We recall Bertrand Russell’s metaphor for rejection of the cause-effect relationship: as they get fed day in day out, chickens start inducting that life is good and humans are kind and caring beings – until the one day when they suddenly get slaughtered.
Human minds are naturally biased to reach conclusions too fast, and are then changing those ideas too slowly: the urge to explain is such that a new narrative is formed to make sense of what happened – the reflation / ‘Trumpinflation’ in this instance, and the mind subsequently walls itself off from new information threatening the view. Two common cognitive traps come to mind: the confirmation bias (narrow focus on just what comes through in confirmation of the view) and the hindsight bias (‘we knew it all along’).
The mental setting described above was visibly at play across the second part of 2016. It is part of the more general market psychosis of indiscriminate ‘buy the dip’, which dominated the years since Lehman. We described it in a previous Outlook, linking its root causes to a structure of the market growingly dominated by passive investment vehicles (ETFs/ETPs, index funds, risk parity, trend-chasing algos), amounting to up to $8tn global firepower, often for 90% plus of daily equity flows.
To us, 2017 may instead be driven by the same factors that failed to shape 2016. The non-events of 2016 are likely to be the drivers of 2017. Finally, we will get to find out if Brexit means Brexit, if Trump means Trump, if a failed Italy referendum means early elections and a membership of the EMU in jeopardy. At present, nobody knows anything but empty headlines: the future is wide open. As Linton Wells once quipped: “all of which is to say that I’m not sure what 2010 will look like, but I’m sure that it will be very little like what we expect, so we should plan accordingly”.
Moving on from the symptoms to the causes, nowadays, the world rightfully debates hot unknowns: is globalization going in reverse, is 30’s-type protectionism reborn, is the US disengaging from Asia and the Middle East the beginning of inflated geopolitical risks (end of ‘Pax Americana’), is this the end of Quantitative Easing after 5-7 years of narcotized markets (end of ‘Pax QE’), how quickly the 4th Industrial Revolution will discard the economic fabric and workforce as we know them. It will not take longer than 2017 to find meaning to most of these excruciating question marks. In this vein, 2017 has the potential to be a pivotal year in economic and political history, shaping the conceptual framework for the years to come. Lenin once said that “there are decades when nothing happens; and there are weeks when decades happen”. As far as financial markets are concerned, it is hardly an environment to be traded as ‘business as usual’ and tackled with a traditional asset allocation (read: long-only, long-everything balanced portfolios), we think.
The stakes are high. After almost 10 years of loose policy generated minuscule yields and extreme P/E multiples, the residual scope for inflating the bubble some more is limited. Conversely, tight money (especially Dollars), capacity constraints and unintended consequences now pave the way for a big pullback. Critically, not knowing the fallout to any of those hot unknowns complicates things and the possible volatility. A disruption of the status quo is no gentle environment for market bubbles. More so if bubble markets, as is often the case across financial history, bring about high levels of complacency: rising points of tension in the system go unnoticed, visible cracks ignored. When volatility spikes on bubble markets, the asymmetry in payoffs goes wild. So does risk, that becomes gap risk. A bubble being a bubble, the bubble in markets – both equities and bonds – is at risk of deflating, crashing against benevolent market complacency, in acrimony.
We positively look at such downside gap risk as a great unchecked opportunity of today’s markets, asymmetrically profiled against little marginal upside from current levels, at a time when very few investors are left standing in the bearish camp.
At a minimum, 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).
For instance, the US equity market – to speak of the best in class – may not be able to be stronger today than it was when rates were at rock-bottom lows, the USD was weak, and oil was cheap. Expectations of recovery pre-emptively pushed rates up, the USD stronger, oil up, thus implicitly undermining its own true chances of revival. Valuation-wise, it is priced to perfection, at almost 28x P/E Shiller ratios (adjusted for cycle/inflation). Not to mention the monetary tightening all too visible in the money markets. Tellingly,