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

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October 26th 2015

Fasanara Capital | Investment Outlook

1. Separating Structural Forces from Short-Term Noise

The ugly market volatility of the past months originated from various sources:

Bunds in April, Greece in June/July, China in August, Volkswagen/Glencore in

September. However, a more fundamental and durable force was visible all

throughout: Structural Deflation.

2. Our call remains for ‘Deflationary Boom Markets’

August/September volatility, while extreme, has not irreparably damaged the

bullish trend for equities and bonds of the past few years. We do not believe this

to be the beginning of a bear market.

We believe Central Banks still have the upper hand, have not run out of ammo as

yet, and therefore will succeed at remaining the main driver of asset pricing.

‘Deflationary Boom Markets’ is the name of the game. Deflation forces Central

Banks into action. Central banks to push Bonds and Equities higher, inflating

the bubble some more, although on a rougher path and with higher volatility

than we got accustomed to in recent years.

3. Longer-Term: Deflationary Bust?

If we are right about the global economy, there will be no normalization of growth

rates, just sluggish GDP growth, deflationary trends may prevail, over-

indebtedness may go uncured, un-employment may remain high in Europe.

Against such backdrop, Central Banks will continue pumping liquidity and fueling

the bubble, until their arsenal runs thin, at which point political regime changes

may provoke an unplug. In Europe, a dissolution of the currency peg (EUR break-

out) would then be a genuine option.

4. Structural Deflation explained: Secular Stagnation or Global Savings Glut

Structural deflation is the backbone of the macro outlook we endorsed for the

last few years. Here below we characterize our conceptual framework on Secular

Stagnation and Structural Deflation, and update our data finding on it.

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Separating Structural Forces from Short-Term Noise

The last several months have been characterized by ugly market volatility. A few clear catalysts can

be isolated:

1. In June/July, the Greek government breaking negotiations at the eleventh hour, the

moment before signing a life-saving deal, sending the country into capital controls, wiping

out the equity of its banks, sparking fears over unplugging from EMU, and the bad

precedent is set right ahead of elections in Spain, Portugal etc.

2. In July/August, China messing up with markets, grossly failing at manipulating them first,

engineering a small but unexpected devaluation off the USD peg later, sending equity

markets worldwide into panic mode during August the 24th

.

3. In September, the combined effect of the emission scandal at Volkswagen, debt fears for

Glencore, Hillary Clinton hitting at perilously-overvalued Biotech sector.

However, while provoking ugly market reaction, down the road such events may all prove to have

been only short-term market noise. For various reasons:

1. Greece’s economic and financial situation is broadly unchanged, yet it is now surrounded by

robust radio-silence. Markets have put on noise-cancelling headphones, and Greece did not

even get a mention at the latest ECB’s press conference.

2. Volkswagen’s scandal seems to be an isolated case, not one widespread to the industry.

Glencore is a symptom of chronically weak commodity markets, yet imminent debt rollover

fears may have been overblown.

3. China’s lack of communication makes it difficult to decipher what it is that they targeted

when devaluing their currency in August. Was it panic reaction to falling exports, deflation

or giving in to FX speculative flows, or, more likely, trying to adapt to IMF indications for

inclusion of the Renminbi into the SDR basket (incidentally published just a week before the

CNY’s widening of the band)? Truth is that China did indeed manage to domesticate

markets after a few failed attempts: equity daily volumes in equity markets fell from $600bn

to $6bn (a staggering 100x reduction), CNH short sellers got smashed on September the 10th

when China drove the CNH from 6.50 to 6.40, one morning, in a show of force. Market

forces may find it hard to combat a $3.5trn reserve manager for too long.

None of this is to downplay the potential destructive effects of short-term factors on markets.

Any one temporary factor has the potential to set off a chain reaction and domino effect leading to

far worse consequences. Yet, one cannot read too much into short-term factors without losing sight

of the bigger picture at play.

The market reaction or over-reaction to these factors is part of what we characterize as Seismic

Markets. Markets defined by thin liquidity and high leverage, prone to sudden volatility shocks.

No liquidity, low inventories, abundant leverage, crowded positioning on consensus trades, on

stretched valuations when not outright asset bubbles, make VaR shocks inevitable.

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As argued in previous Outlooks, brutal market moves, 5+ sigma events, when measured against

deceptively low levels of (daily realized) volatility, are confirmation of the dislocated markets we

live within, and join the list of numerous other recent schizophrenic episodes and sudden bouts

of volatility, what we described in the past as ‘seismic markets’ (an updated is attached here

below). One more confirmation of fat-tailed distributions (as opposed to normally-distributed),

exhibiting a tendency for outliers: low-probability high-impact events do occur (statistician David

Hand would say ‘must occur’), deep excursions from the central value do happen, and when they do

their magnitude is great. Differently than the Bunds’ VAR shock in Q2 and Greece related volatility in

June/July, August volatility showed another connotation of today’s markets: a bias for CoVaR to rise

steeply at times, sky-high cross-asset correlation to kick-in, especially in downside scenarios for

markets, pushing an idiosyncratic risk into a systemic one: equity plummeted, but also bonds tanked,

together with the safe-haven USD (against EUR and JPY), magnifying the pain.

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To us, there is a more fundamental force visible in the economic and financial landscape in the

last several months, and that is Structural Deflation. The last months offered further evidence in

confirmation of the grip of deflationary trends. Globally.

1. Inflation prints came in extremely weak in the last few months, often printing in

negative territory, US included:

i. EU Sep CPI: 0.2% mom / - 0.1% yoy

ii. GERMANY Sep CPI: -0.2% mom / 0.0% yoy

iii. US Sep CPI: -0.2% mom / 0.0% yoy

iv. JPY Aug CPI ex fresh food: -0.1% yoy

v. UK Sep CPI: -0.1% mom / -0.1% yoy

vi. CHF Sep CPI: 0.1% mom / -1.4% yoy

vii. CAD Sep CPI: -0.2% mom / 1% yoy

2. Gavekal research constructed an index of the USD against MXN, BRL, RAND, RUB, INR &

SEK and showed that this leads the movements of the US consumer price index (ex-shelter)

by three months, with a correlation of 0.90 since 2010. This leading indicator is pointing to a

negative US CPI early in 2016, with a 70% chance that US CPI inflation (ex housing) will fall

to between -1.8% and -3.6%

3. CNH tilting towards devaluation will only add to deflationary pressures globally

4. Oil failing to detach itself much from the depressed-enough 50$ line

5. Market participants getting accustomed to negative nominal yields for the next few

years, something which will affect inflation expectations. This is the list of 2yr yields in

Europe. Only three countries left at non-negative yields: UK, Portugal & Greece

Greece 7.61 France -0.26

UK 0.6 Austria -0.27

Portugal 0.25 Netherlands -0.31

Spain -0.002 Finland -0.31

Italy -0.01 Germany -0.32

Ireland -0.19 Sweden -0.45

Denmark -0.25 Switzerland -0.86

Belgium -0.26

On a longer horizon, we expect such fundamental force to have a more lasting effect on markets

than short-term noise such as the one isolated above. Reading through it should help anticipate

Central Banks’ actions, which we expect to be the dominant driver of asset pricing in the

foreseeable future, up until when they run dry of ammunition, a few years down the road.

Last week, the ECB is likely to have de facto announced QE2, and in our eyes, that was not in

response to August’s market volatility and China, but rather so in a desperate attempt to

counterbalance deflationary trends, which are growingly visible and the most worrisome locally

in Europe.

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Deflation will force the hand of Central Bankers because it is the elephant in the room,

overwhelming far and large any other factor at play. We have two equations in mind when

considering deflation:

1. Deflationary trends are both global and secular.

a. Global phenomenon. Deflation is not only visible in Japan and Europe, two old

economic blocks badly affected by demographics and over-indebtedness.

Disinflation is also now visible in China, admittedly an emerging market, despite

being already a $10trn economy. Deflation is strikingly visible in the US too, despite

6 years of quantitative easing, despite supposedly tight labor markets, strong

internal demand, US-style animal spirit, talks of GDP being on the verge of hitting

escape velocity, and despite (or maybe helped by) a disruptive technology industry.

b. Secular phenomenon: structural deflation has little to do with the Lehman-

moment and the subprime crisis. It is a long-running process which has been

unfolding for few decades. It may have started as early as with the end of Bretton

Woods in 1971, right when credit expansion started to borrow growth from the

future into the present. Pretty much since then, the ‘money multiplier’ and the

‘velocity of money’ started a relentless descent, bringing them to all-time lows.

The chart attached below at pag.15 is self-explanatory. Lehman was surely an

accelerator, but it can hardly be blamed for the phenomenon.

This argument ties into the falling productivity of credit, analyzed later on in this

Outlook on page 14. Increasingly more money chases the same level of output.

Increasingly less economic output follows the same expansion in base money and

money supply. Meanwhile, debt in the system grows larger and larger, viciously, as

the years go by.

2. Zero inflation is a death penalty to debt-laden countries. No amount of fiscal rectitude

will ever manage to outbalance the debt trap originating from zero inflation and low

growth.

a. The problem with zero inflation (or deflation) is that minuscule levels of GDP

growth are unable to prevent debt ratios from grinding higher and posing a

larger threat down the line. Mathematically, as primary budget balances are lower

than the difference between real GDP growth and real interest rates on public debt,

the debt/GDP ratio is set to rise, from already alarming levels.

b. As growth rates, primary surpluses and debt dynamics are inextricably linked to

inflation, so it happens that for a country in, say, peripheral Europe, for every 1% of

decrease in inflation, primary surplus have to increase by 1.4% so as to prevent

debt dynamics from worsening. Should a country like Italy, for example, prevent its

debt/GDP from ever-rising from an already dreadful 135%, at zero inflation, she

should be required to produce a primary surplus of 8%: clearly recessionary, clearly

self-defeating, clearly suicidal. Zero inflation is a no go.

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Deflationary Boom Markets

Our Medium-Term Baseline Scenario is one of Deflationary Boom Markets.

Going forward, we move along the following working assumptions, checking incoming data for

confirmation or denial of our thesis:

- August/September volatility, while ugly, has not irreparably damaged the bullish

trend for equities and bonds of the past few years. We do not believe this to be the

beginning of a bear market.

- We believe Central Banks still have the upper hand, have not run out of ammo as

yet, and therefore will succeed at remaining the main driver of asset pricing.

- Deflationary Boom Markets is the name of the game. Deflation forces Central Banks

into action. Central banks push Bonds and Equities higher, inflating the bubble

some more, although on a rougher path and with higher volatility than we got

accustomed to in recent years.

- Bond prices pushed higher by deflationary trends and shrinking of government

bond collateral as Central Banks hoover up the bulk of gross issuance.

- Equity markets to be pushed higher by lower yields.

o Equity in Europe and Japan are clearly expensive when compared to

fundamentals (and particularly against our bearish forecast for the

economy), but less so when measured against the backdrop of excess

liquidity and the low bar for expected returns set by minuscule yields.

o We think of a purely nominal rally. Nominal as opposed to real, when adjusted

for currency fluctuations. Nominal and not real, when compared to a

deteriorating economy. Elusive returns, but returns.

o Lower yields means higher average duration on any available set of

investments. Higher duration means that it takes longer to recover capital

investment. On longer durations, the Present Value of perpetual future cash

flows in equities rises, mechanically so. Rephrased, lower yields pump up P/E

ratios, mathematically so, without much merit for the underlying equity plays

(as long as earnings do not contract too visibly).

- Government bond spreads cross-markets in Europe to further shrink. For instance,

BTPs-OATs spreads to move below 60bps: current 85bps is too much in the medium-

term, for the same Central Bank, within the context of a deflationary environment.

- Inflation forward rates remaining low or moving lower, commodities staying weak

or weakening more from here. Further weakness in Emerging markets.

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- Oil price capped at 50$ for Brent Crude. From here it can take a temporary detour

higher to 60-70$, but it is more likely to see new lows on a detour, and visit 20$-30$.

That would reignite fears of covenant breaches for debt issued by EMs corporate and

governments, and for shale frackers and the energy sector at large.

o Critically, deflationary forces do not need oil prices any lower than 50$.

Extreme pricing, such as Oil at 20$ or so, would over time likely push shale

frackers and high-cost producers out of the markets, cutting supply and laying

the basis for a recovery in prices. As it comes out, an Oil price floating around

50$ for months may be the most deflationary outcome, keeping most

players in the game and capping energy inflation for several years ahead.

Our call for a ‘deflationary boom’ market environment goes hand in hand with, and assumes, a

bearish outlook for global economies, and especially so in Europe and Japan, and a strenuous battle

against die-hard deflation, forcing the hand of Central Bankers into continued monetary printing,

until they go closer to running out of ammunition, over the next few years. We think such

‘deflationary boom’ is to last for the foreseeable future.

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Longer Term: Deflationary Bust?

At some point, though, we expect a change in regime, once Central Banks run dry of

ammunition, and things unravel. If we are right about the global economy, there may be no

normalization of growth rates, just sluggish GDP growth, deflationary trends may prevail, over-

indebtedness may go uncured, unemployment may remain high in Europe. Against such

backdrop, Central Banks will continue pumping liquidity and fueling the bubble, until their arsenal is

running thin (which is still not the case today), at which point political regime changes may possibly

provoke an un-plug. In Europe, a dissolution of the currency peg (EUR break-out) would then be a

genuine option.

In the past six years, the FED could go from cutting rates, to zero rates, to QE1, QE2, QE3 waves in

2008 (upped in 2009), 2010, 2012, Operation Twist and all sort of other tools (US Treasury’s

preference shares, TARP etc). The ECB went from cutting rates, to moving rates to zero, to bringing

rates into negative territory, to LTROI, LTROII, to SMP, then OMT, then T-LTROs, to ABS purchases,

and now into QE1, and perhaps already into QE2 now. There might as well be a QE3 after that, if

recent history is any guide. And that can easily fill the next few years, while superficial but timidly

improving GDP/inflation/unemployment numbers make mainstream agents baptize it as successful

policymaking.

At some point though, as the arsenal go emptier, several months or few years from now, one

will have to look around, analytically, and if (i) GDP is still shallow, (ii) debt is still high and has

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grown some more, (iii) inflation is still zero / negative (taking debt ratios higher with it), (iv)

unemployment is still awfully high, down there then a new phase can open up, with political

instability forcing a change to the status quo, with bond yields rising in no inflation/growth,

equities giving back fictitious gains all too quickly.

We remind ourselves of the main risks to our long-term view: fast rising GDP, rising Inflation,

rising productivity rates, rising working population, declining indebtedness, disruptive technological

breakthrough innovation of a type we cannot foresee now (the one we see now is in line with our

current long-term view). Should we see any of these elements emerging in global economies), and

do so in a durable fashion (and especially so in Europe and Japan, the preferred spots of our asset

allocation and where we have been the most active in the last couple years), we stand ready to

change our views and throw overboard our current portfolio positioning. Veritas filia temporis.

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Structural Deflation, Secular Stagnation

Structural deflation is the backbone of the macro outlook we endorsed for the last few years.

Last year, it made us think that the ECB would have been forced into action, making us think of

upcoming Sovereign QE as a certainty. Such belief made us stay invested into European equities

and European bonds and spreads also during volatile times.

As we argued in our earlier Outlooks, deflation is a multi-years process, not a data point. It takes

years to reverse deflationary trends, absent a shock of some sort. Last year, we argued that

Deflation in Europe was just beginning (link to article can be found HERE).

The economic outlook for ‘Secular Stagnation’ we currently buy into has similarities to the one

described by Larry Summers. While disagreeing with the conclusions, Ben Bernanke speaks of a

similar state of affairs when referring to a ‘Global Savings Glut’. In the attached PRESENTATION and

VIDEO we tried to characterize our conceptual framework on Secular Stagnation and Structural

Deflation.

The basic point of our take on the subject is that the current depressed economy, with its low

inflation, low GDP growth rates, low potential GDP growth, low working population growth

rates, low interest rates, is not a consequence of the Global Financial Crisis and the Lehman

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moment, but rather the result of more structural forces, which have been at play for decades.

The GFC has at best been an accelerator, weighting on a more chronic long-running pandemic.

Indeed, it is vividly noticeable that in the years going into the GFC, from 2003 to 2008, despite what

we would today admit being bubbles levels of credit expansion and real estate expansion, definitive

and unsustainable manias, GDP growth was not impressive but rather just fine. During those boom

years, despite an unprecedentedly over-leveraged private sector, GDP growth was un-impressive,

while inflation risks were subdued.

Let’s start from defining the type of ‘depressed economy’ we have in mind:

To distinguish between causes and effects is not easy. We define some consequential connotations

for such depressed economy, although they may partially be drivers too, in a negative feedback loop:

- Low interest rates are engineered by Central Banks to combat deflationary trends and

stimulate growth.

o At the same time, though, they may reflect high savings rates, and savings

rates exceeding investment rates. As such, they may signal an increased

’savings propensity’. If there is any structural change in the propensity to save

over investing, that would bode badly for productivity.

o Also, viciously, low interest rates compress bank margins, therefore somehow

de-incentivizing bank lending, therefore leading to low loan supply.

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o Low rates may also be consequent upon low demand for loans, low Capex,

on the back of low expected returns. In this respect, they are a reflection of

stagnation, not just a policy response to it.

o Low rates may still be too high, impeding recovery. Rates are low by

historical standards, trading at multi-centuries lows. Rates are low against the

Taylor rule, when one is to account for (US) unemployment. But they are

probably not low against the Wicksellian natural rate (the rate that produces

stable inflation). If inflation is to be sub-zero for long, nominal rates are surely

too high (financial repression fails / debt-ratios rise).

o Low rates are expected to damage rentiers and push them into riskier asset

classes, including investments in the real economy. However, Central Banks

policies have inflated financial assets to a level where those rentiers have vastly

profited. Indeed, anecdotally, the return from US stocks since Mar2009 has

been 30%, vs historical average of 10%; the return from US Corporate Bonds

has been 12%, vs historical average of 6%. Capital gains have substituted the

income stream. In this respect, despite rates being at zero, rentiers prevail over

productive forces in the economy, leading to greater income inequality, lower

productivity, lower propensity to invest, and viciously then ultimately even

lower aggregate demand (in this respect a low Oil price is much more positively

impacting the odds of aggregate demand, than rates, as it affects the lower-

income households, more elastic to price).

A few drivers of Structural Deflation can be isolated:

- Falling working population. Demographics affect long-term anti-cyclical growth. An

ageing population is much of a global issue (including China), although it is clearly more

visible in countries like Japan, Italy, Germany. In Japan in particular, the depressed

economy of the 90s owed much to the combination of falling fertility rates (from 1.8

children per woman from 1980 to 1.4 from 2010) and increased life expectancy. That

coupled with Japan’s stance over no immigration, no women at work, no job cuts, no

wages cut, helped fuel 24 years of depressed economy (Japan’s‘ lost decades’).

Undoubtedly, a falling working population played a big role.

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- Over-indebtedness. As inflation moved lower, debt ratios went higher for most large

economies globally (except perhaps today’s austerity Stakhanovites in Germany). Debt

diverts resources away from productive investments into sterile debt service. Even at

minimal interest rates, such diversion is material. Over-indebtedness constraints the

wings of productivity and growth from opening up.

- Diminishing effects of monetary printing and the credit cycle. This is visible when

looking at the 40-year chart of ‘Money Multiplier’ (how many $$$ of commercial bank

money for any $ of Central Bank money, how many $$$ of money supply for any $ of

monetary base, the famous $$$ lent to the real economy) and ‘Velocity of Money’ (how

many $$$ of GDP produced for any $ of loans extended to the real economy). The end

of the Bretton Woods System triggered by Nixon’s New Economic Policy in August

1971, unleashed the full power of the fractional-reserve banking system, and the beauty

of credit expansion and its multiplier effect on growth and productivity. The falling

productivity of Credit is before everybody’s eyes. Has the credit-based expansion

now run into some kind of a dead end? Has it permanently gone into exhaustion

mode, or are there ways to reigniting the virtuous cycle? The impossibility of

exponential growth in a finite environment makes us propend to think it cannot.

Herbert Stein’s law states that ‘if something cannot go on forever, it will eventually

stop’. A cursory glance at the chart below, plotting Credit expansion vs GDP

expansion in the US, shows the point.

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- Technological advances: this is a striking difference to past occurrence of secular

stagnation. When Alvin Hansen in 1938 referred for the first time to ‘secular stagnation’

he enlisted ‘low technological advances’ as a key driver. Today, in contrast, we believe

we are in the middle of a technological revolution (Google, Apple, Amazon, 3-D printing

etc), reshaping the world we live within. However, incidentally, such technological

revolutions calls for (i) shredding jobs (Nike employed 106k less people in 2013 due to

automation, WhatsApp was a 50-employee company when it was valued as much as

Nokia, an employee- and plants-rich company), (ii) reducing unit production costs to

levels where one can live almost without working or working less (even sequencing

human genome used to cost $ 2.5bn in 1990,it now costs $ 750 to produce), (iii)

increasing income inequality and further concentrating wealth into elites, while

reducing the economy’s capital intensity. Less labor, but also less capital. Less

investments needed.

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More specifically in Europe, deflationary trends are helped by dysfunctional politics:

- As demographics are a paramount factor, it should be noted that fiscal policy only can

affect demographics, not monetary policy. As Europe’s obsession for austerity

impedes a fiscal expansion to join monetary expansion, the chances of success of

European policymaking must be lower, against the same conceptual framework they

advocate to (monetary printing alone will not kick off escape velocity; fiscal overkill will

induce structural reforms fatigue, as opposed to force structural reforms).

- At times of deficient aggregate demand, monetary expansion without fiscal expansion

and redistribution policies is ineffective in the long run. It avoids circuit breaks, but does

fail to reignite a growth / inflation cycle.

None if this is clearly conclusive but rather is a conceptual framework, one that we hope can help us

navigate our views on the economy, and the consequences for markets over time. Against these

assumptions, we will evaluate incoming data and their durable nature, so as to ascertain if the theory

gets confirmed or invalidated. Unhelpfully, such theory will take years to confirm. On the other

hand, it might quickly be invalidated. An inflation rate at even just 2% in 2016, or a European

GDP at 3%+, or a debt/ratio steep decline in peripheral Europe would all suffice to make us

rethink our view.

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Crystal Ball

We present the table unchanged since it was first published on January 2015. Here below our target

levels across markets and across asset classes 6- to 12-months out.

From our January Outlook:

- S&P closing the year at 2,100-2,200. Which means limited upside, as the market is

priced for perfection. Implied volatility VIX closer to 20% than 14% (average 2014).

Several sell-offs of 5% to 10%. Potentially a larger one along the way. Last year 5% to

10% sell-offs took place in Jan, Aug, Oct, Dec.

- Eurostoxx closing the year above 3,600, although on a rough ride too. Implied

volatility V2X closer to 25%/30% than 18% (average 2014).

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- FTSEMIB above 25,000 at some point in 2015.

- BTPs 10yr yield at ca. 1% (from 1.60% today). BTPs/OATs spread at 0.60%. Laggard.

- Bunds 10yr yield at 0.00%, from 0.40%, below Japanese JGBs, and possibly going

negative (-1%). OATs at 5 basis points over Bunds.

- Bund 10y-30y spread at 40bps (from 70bps today), possibly turning negative.

- US Treasuries 10yr at 1.00%, 30yr at below 2.00%.

o The best carry trade available globally. Strong credit risk, nice yield, no

inflation risks near term, real yield appealing when adjusted for likely

strengthening of the currency

o Scarcity value: 50% of all government bonds globally yield less than 1%

o Global supply / demand for bonds in favor.

- 5y5y UK Inflation at below 2.5%. 5y5y EUR Inflation at below 1%

- FED Fund Rates at 0.50%, FED to hike rates, but only moderately so.

- Nikkei at 20,000. Currency debasement, regulation-driven flows (GPIF and friends, in a

2trn$ pension fund industry invited to relocate to equity), and some genuine

momentum improvement in corporate profitability.

- JPY at 130 vs USD. Currency debasement, in progress (no new injection needed,

although likely).

- EURUSD at 1.05.

- Gold at above 1,400. Upside risk.

- Brent Crude at below 40$, possibly overshooting to below 30$.

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Thanks for reading us today!

For those of you who may be interested, we will soon circulate a save the date for our next

Investment Outlook call, to be held in Q4. Supporting Charts & Data will be displayed for the views

rendered here. I hope you will be able to participate.

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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