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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 Mobile: +44 7715420001 E-Mail: francesco.filia@fasanara.com Twitter: https://twitter.com/francescofilia 25 Savile Row London, W1S 2ER

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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