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Fasanara Capital Bi-Weekly Notes - July 27th 2012

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  • 1. 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.    
  • 2. 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,  
  • 3. 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  
  • 4. 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.  
  • 5. 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            
  • 6. 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:  francesco.filia@fasanara.com  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.