July 27th 2012Fasanara Capital | Investment Outlook We hold onto the contents of our three-‐phased market view, as we position for the market to (i) remain into volatile range trading, before (ii) drifting lower on renewed market pressures, possibly seeing new lows, and (iii) being then re-‐flated back by policymakers’ fresh intervention. In the long run, under our Multi-‐Equilibria market theory, we give it a decent chance for the bubble to bust in one of several possible ways, potentially leading to an Inflation Scenario (Nominal Defaults) or a Default Scenario (Real Defaults) and their various possible declinations. Phase I: ‘Deflating Further’ In the near term, on Phase I, we expect the market to give in to its downside risks. The catalyst could be Spain, its banks’ recapitalization needs (as the EU has deliberately delayed to assess), it may be its illiquid and insolvent Regions, its tumbling Real Estate, its capital flights or its street riots. As we monitor capital flows closely, for example, in the last fortnight we sensed the first serious capital outflows away from Spain by some of the large Corporates in the country. Up until very recently, no real outflows had really been triggered by local household, local banks and local corporates. To the end of June, most of the 350bn rise in Target2 liabilities held by the Bank of Spain with the Eurosystem would account for foreigners only, leaving Spain through either repatriating deposits, selling Spanish equities/bonds or foreign banks redeeming loans. No more than 10% of it was driven by local players rundowns (to be precise, in the previous 12 months, Spanish Corporates’ deposits fell by just 16%, Spanish Household by tiny 4%). It will be interesting to read through July data for Target 2 exposure, as soon as they are available. However, it seems the case that locals have proven quite resilient up until now, keeping the systemic risk on their books unabated. The rising risk of bank runs in Spain is therefore not priced in, and one of the key vulnerabilities, as data shows that it has not even began as yet.
Likewise, Italy and Greece are dangling on a string, for some of the same reasons. This week, we record a most concerning bearish flattening of the government bond curve, one of the indicators we had on our checklist for spotting dangerous market momentum: 2yr yield in Spain (and Italy to a lesser extent) closed much of the gap to 10yr yield, with both reaching to new highs. Not surprisingly, yesterday Mr Draghi deemed it opportune to come out with an unusually bullish statement, for he would ’do whatever it takes to save the Euro’. Maliciously, yesterday was also the first day of holiday for Ms Merkel, as Draghi may have timed his outing wisely, capitalizing un-‐disturbed on his window of opportunity.. Phase II: ‘Reflating Back, following new intervention’ We believe that such market capitulation will lead into a fresh new intervention, on Phase II, as it will manage to build enough political consensus around such policy move. In other words, we believe that further market weakness and street riots are needed to trigger the intervention. Such intervention is likely to be shaped in one of two different ways: (i) SMP direct purchases of government paper by the ECB (possibly leading to a more widespread TARP-‐like program of asset purchases in the next 12 months, despite Draghi’s current reluctance), or (ii) providing the ESM with a banking license (despite Germany’s current reluctance), so that it can increment its firepower from Eur 500bn to infinity, having access to ECB’s liquidity operations. Such bimodal outcomes are the two faces of the same coin: the ECB is prevented from giving unlimited financing to governments, under the limitations of its founding treaty, but it can give unlimited financing to a bank (and so it has done with LTROs and MROs). ESM would therefore become the Trojan horse of the ECM’s SMP operations, with yet another layer of complex financial engineering thrown in. On the other hand, we believe that alternative interventions are not realistic: (i) Eurobond would take ages to implement, as multiple treaty changes are required, and the necessary referendums that go with it; (ii) LTROs would be ineffective, as the lack of eligible collateral is a major constraint, let alone the concentration of local risks it has morphed into (exacerbating the negative feedback loop between Sovereigns and Banks). Both interventions deliver some sort of Debt Mutualisation across the Euro-‐area, filling the void of unsustainable imbalances across the region, buying some more time to the Euro, delaying the day of reckoning for ‘debt saturation without growth’ in peripheral Europe,
effectively inflating the bubble even further, adding new debt and new leverage to the existing unsustainable debt overhang, so as to attempt to keep the whole system afloat. Debt Mutualisation, if properly and timely implemented, could potentially set the basis for a more sustainable Europe. We hold doubts, but definitively quite a bit of time can be bought through that. Germany is key, as it has the most to lose in that framework. The next six months are key in assessing this probability. On our count, even if such forms of Debt Mutualisation were to occur, their chances of success are nowhere near par. We rendered some of the reasoning on it in our latest Outlook. Essentially, we argue, the fundamentally flawed Euro construct meets a dangerously high level of over-‐indebtedness in the system, on a near global scale. The fragile Eur fixed-‐exchange system is all the more inherently unstable when measured against a level of leverage by major economies which grows increasingly unbearable as a percentage of GDP, real productivity and industrial production (the latter stripping out the borrowing factor from GDP aggregate numbers). And the denominator of the troubled ‘global Debt/productive GDP ratio’ receded some more recently. In the last fortnight, we had more evidence of China hard landing and US slowing down. In the US in particular, latest GDP numbers were not only retrenching, but also dependant for most part on personal consumption expenditure, where (i) half of it was due to a drawdown of savings rates as opposed to real output growth or real wages and (ii) the rest was perhaps due to the boost in disposable income provided for by the extended transfer payments and tax cuts (cumulatively a whopping 1.4trn in the last year). Now, as the ‘fiscal cliff’ approaches and the savings rate accelerates its rise, the fairy tale of a strong recovery in the US might just be about to dissipate. And with it, so it will delusional peak profit margins of American corporations, lying on the thin ice of an unsustainably debt-‐laden economy. Overall, the global framework we operate into does not help the Euro cause in the long term, even before accounting for Europe’s negative externalities abroad. Phase III: Busting of the Bubble. To us, the same fact that the current level of 10yr government yields in the US has not been seen for 220-‐years, in Japan for 140years, in Germany for 200 (and in Holland for 500 years), speaks for itself and calls for abnormal market conditions on abnormally long historical
evidence and time series. Our outlook for Multi-‐Equilibria Markets means just that. As opposed to simple mean reversion, the dust in the markets could settle in diametrically opposite ways and the system might find its new equilibrium in there. The expectation that things will be sorted out and the old trend on the old framework will resume might not only prove delusional but also preclude one’s strategy from capturing amazing value in the current context, namely what we refer to as Fat Tail Risk Hedging Programs. We suspect Europe cannot manage to paddle forever in the middle of the distribution curve and avoid the edges of these cliffs. As per Herbert Steins Law: "If something cannot go on forever, it will eventually stop’’. The base case of a stagnant Japan-‐style slow deleverage could lead into Fat Tail Risk Scenarios at any time over the next 4 years. Scenarios include: Inflation Scenario ((Nominal Defaults, Debt Monetization and Currency Debasement), Default Scenario (Real Default and Debt Rescheduling/Haircut), Renewed Credit Crunch, EU Break-‐Up, China Hard Landing, USD Devaluation. Opportunity-‐Set In opportunity land, we believe the most interesting value investment right now in Europe is to take advantage of such market resilience to provide one’s portfolio with your own home-‐made backstop facilities and firewalls. In fact, Risk Premia are nowhere near where they ought to be should one factor in the even vague possibility of partially failing European policy making. Our leit-‐motiv remains to take advantage of current market manipulation and compressed Risk Premia to amass large quantities of (therefore cheap) hedges and Contingency Arrangements , thus balancing the portfolio against the risk of hitting Fat Tail events in the years to come. If we do not hit them, then great, it will be the easiest catalyst to us hitting the target IRR on the value investment portion of our portfolio (what we call Safe Haven, or Carry Generator). If we do hit one of those pre-‐identified low-‐probability high-‐impact scenarios, then cheap hedges will kick in for heavily asymmetric profiles (we typically targets long only/long expiry positions with 10X to 100X multipliers). Such multipliers are courtesy of market manipulation and ‘interest rate rigging’ provided for by Central Bankers. Look no further than that, as we believe that they represent the only truly Distressed Opportunity right now in Europe. Timing-‐wise, the next 6 months may provide the most interesting window of opportunity. Beyond that, perhaps within 18 months, it may be the next most crowded trade.
Portfolio Construct Our personal roadmap to successfully riding current financial markets is based on the following portfolio guidelines: -‐ Keep the Dry Powder, on a slim and nimble liquid portfolio, heavily under-‐investe -‐ Accumulate nominal returns, on safe senior-‐secured short-‐dated corporate exposure from northern Europe (Value Investment section of the portfolio) -‐ Unload it fast on triggering target IRRs and meeting Carry Accumulation plans -‐ Amass large quantities of long-‐only long-‐expiry heavily-‐asymmetric profiles to insure and over-‐hedge against pre-‐identified Fat Tail Scenarios. Accumulate a treasury of optionality over time, banking on system-‐wide dislocations and mis-‐ pricings (leading us into Cheap Optionality, Select Shorts, Embedded Options and Dislocation Hedges) -‐ Follow methodically and meticulously the list of pre-‐identified Fat Tail Scenarios and match it to the list of pre-‐identified Eligible Instruments (Fat Tail Risk Hedging Programs section of the portfolio) From here, on this construct, two outcomes are we prepared for: -‐ Pitfalls in Europe on the way to restoring imbalances due to under-‐execution of austerity programs, and ‘adjustment fatigues’, leading to the possibility of steep market corrections and the chance for us to reload fast on the Value Investing part of the portfolio, at cheaper, safer and more sustainable valuations (acceleration of the ramp up of the portfolio) -‐ Fast forward to Tail Events: best case scenario for our strategy
What I liked this week Ray Dalio: Dont Assume Germany Will Bail EU Out; "Fat Tail" A Real Possibility Read Swiss base money spikes as the SNB defends the peg Read End of game? Don’t bet on it Read Natural gas up 44% from the lows Charts W-‐End Readings Former Reagan’s Budget Director David Stockman: ‘This market isnt real. The 2% on the ten-‐year.. those are medicated rates created by the Fed and which fast-‐money traders trade against as long as they are confident the Fed can keep the whole market rigged’ Video How things change, China FX manipulation. The renminbi’s weakness appears to stem from the actions of market participants rather than those of policymakers Read Francesco FiliaCEO & CIO of Fasanara Capital ltd Mobile: +44 7715420001 E-‐Mail: firstname.lastname@example.org 16 Berkeley Street, London, W1J 8DZ, London Authorised and Regulated by the Financial Services Authority “This document has been issued by Fasanara Capital Limited, which is authorised and regulated by the Financial Services Authority. The information in this document does not constitute, or form part of, any offer to sell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or the fact of its distribution form the basis of or be relied on in connection with any contract. Interests in any investment funds managed by New Co will be offered and sold only pursuant to the prospectus [offering memorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carries a high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any steps to ensure that the securities referred to in this document are suitable for any particular investor and no assurance can be given that the stated investment objectives will be achieved. Fasanara Capital Limited may, to the extent permitted by law, act upon or use the information or opinions presented herein, or the research or analysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnel may have, or have had, investments in these securities. The law may restrict distribution of this document in certain jurisdictions, therefore, persons into whose possession this document comes should inform themselves about and observe any such restrictions.