Fasanara Capital | Bi-Weekly Notes | September 14th 2012
September 14th 2012Fasanara Capital | Bi-Weekly Notes 1. Pax Romana in the markets is brought in by Central Bankers. Monetary creation is open-ended and can support markets in the short term, possibly into year-end. It eases up potential troubles over the next few months, puts to sleep imminent catalysts and downside risks. But only temporarily so. 2. The threat to the Pax Romana induced by balance sheet expansion comes from both ends of the spectrum: from the top, with German taxpayers rebelling to subsidies, or from the bottom, with peripheral Europe’s taxpayers rebelling to austerity. These two basic drivers (more than Greece, heavy government supply in October, or Italy and Spain pestering the ECB over conditionality terms) may defuse monetary expansion in the medium term. 3. The greatest opportunity we see is to load up optional-style Contingency Arrangements, which are made the cheapest ever by Central Banker’s activism and interest rate manipulation.Over the past few weeks, financial assets reflated markedly on the back of coordinatedbalance sheet expansion across major Central Banks. We entered what we called, inprevious write-ups, ‘Phase II: Reflation Back, following new intervention’. Truth betold, markets had rallied already in anticipation of such move, and Central Bankers(differently than in the recent past) did not even wait for conditions to deteriorate, so asto justify such intervention, but rather stepped in boldly to match markets’ expectations.The monetary injection is un-precedent, even when compared to LTROI, LTROII, QE1,QE2 and Operation Twist I and II. In Europe, Draghi made up his mind and took thelead on un-decisive policymakers, and without waiting for Germany’s SupremeCourt to decide over Euro bailout funds first, he effectively made such resolutionless relevant by promising the markets unlimited direct supply of fiat paper cashagainst troubled government bonds. He had not even waited for his own ECB’smeeting on the 6th, having rushed to pre-announce it in the days before. The OMTprograms, just a by-product of the SMP operations in disguise, rebranded ad hoc forthe day, are unlimited in size and designed to compress spreads (or evil ‘convertibilitypremium’, to use Draghi’s terminology) and reduce the risk of government and bank
runs in Spain and Italy. As we anticipated, SMP-style measures were the best bang forthe buck, and they were elected as the instrument of choice of monetary policymakingthis time around: having seen the unlikeliness of a banking license for the ESM fund,considering the unfeasibility of further LTROs for lack of eligible collateral, OMTs (orSMPs) operations had remained the only possible solution to attempt. The governmentbond curve, dangerously flat as of late, steepened strongly in response to theannouncement, and is likely to stay steep for the time being. Such bold move was thenboosted by the Supreme Court giving green light to the ESM (although with a fewcaveats, which we analyze below). On top of it, the FED decided to grant the marketswith QE3 or QE-Cosmic, as this time the intervention of the FED is open-ended,unlimited in size (for the first time it does not give a financial cap for the overallamount), and scope and timing (for the first time it does not say when it ends). It hasbeen estimated at being worth over $2trn over the next two years.We believe the current environment, especially in the US, hardly justified suchunlimited balance sheet expansion. Critically, Central Bankers must have been trulyconcerned of the fragility of the economy and the markets, well and beyond the data wecould dispose of at the time, and well and beyond the markets themselves seemed to beworried about (in Europe markets were nowhere near their lows, in the US equitymarkets were at pre-Lehman highs, labor market was weak but not much weaker than ithad been as of late, volatility measures at theirs lows). Considering the diminishingreturns of their policies, round after round and failure after failure, it is all themore disconcerting to see them embarking in ‘unlimited’ interventions. At aminimum, it represents an admission of desperation, a last attempt at stimulatinggrowth and bring the economy and the markets away from the cliff.One thing seems certain, now Central Banks are closer to the end of their potentialactivisms, as there is little more you can do than promise the markets to fireunlimited direct purchases of assets over an unlimited timeframe. In so much aswe expected them to have more bullets at their disposal, as per the Outlooks of the pastfew months, we now expect them to have moved significantly closer to the end of theirjourney: a few months from now, the diminishing returns of their policies mayhave transformed into close-to-zero marginal impact. At the expenses of furtherfatally discrediting fiat paper money standards, in general, and making the case for theunintended consequences to get traction. In other words, either it works this time, orthe loss of confidence will be over-whelming and their magic on the markets will beseriously impaired. A Keynesian End-Point and Liquidity-trapped markets wouldthen be joined by a complete drop in Confidence, the last man standing.
Short TermFor those who followed our previous notes, we are in Phase II of a three-phasedoutlook. Let us now divide it in two: short-term and medium-term. In the short term,asset prices should be allowed to enjoy the ride and reflate further, possibly forthe next few months into year-end (although at a slower pace than in previous QEs).This is not to say there will not be pitfalls and ‘adjustment fatigues’: volatility could arisefrom a heavy European government calendar in October, Greece being in need of a thirdbailout (Portugal of a second, Cyprus and Slovenia of a first), Spain and Italy delayingtheir formal request for aid (whilst negotiating for the conditionality needed tounleashing the ECB’s actual intervention). But all in all, such market gyrations lookeasier to handle when you have unlimited supply of paper cash to otherwiseinsolvent market players.Medium TermCentral Banks may well have bought few months for now. That is the reasons why wekept repeating that any hedges, to be effective, in this market , has to be multi-year (weourselves put the threshold at the 4 years horizon, thinking a final resolution to thecurrent state of affairs may take at least that long to materialize). In the medium-term,we see two main catalysts with the potential to destabilize markets all over again: 1. Germany Draghi set the trajectory for Debt Mutualisation across Europe and Debt Monetisation, but it may be too early to deem it a done deal. In spite of Merkel current stance and the Supreme Court’s ruling, we believe it is premature to consider Germany as de facto joint and severally liable to other European countries, as yet. That time has still to come, on our count. Up until then, we believe Germany could still opt to unplug, in one of many ways, including cutting the lifeline to select peripheral countries, or deciding to step out of the EUR currency-peg herself. As of now, the Bundesbanks indicates its exosure to the Eurosystem at 751bn (link), having risen approx. 25bn in August only. Still, the number incorporates more repatriation of funds by the German private sector. The exposure is still being transferred from the private sector to the public sector (Banks alone have sold peripheral Europe debt for more than 500bn in the last 4 years), making the net increase in German exposure impressive, but not at the face value of the headline figure. We monitor carefully the flows here as they unfold, as clearly at some point it may cross the limit. At that point you could call it a de facto Debt Mutualisation, but
not as yet in our eyes. We arbitrarily put that threshold at 1.3/1.5trn (followingan reasoning we rendered in previous Outlooks). If anything, you may flip thecase and argue that, with all chips held by the National Central Bank, it ismade easier for Germany to leave the peg (and the PIIGS), in so far as therisk of contagion to banks, household and businesses within the Germanymicro-system is somehow reduced. Moreover, interestingly enough, we believe the Supreme Court’sruling contains the seeds of execution risks at a later stage. Upon carefulreading of the ruling, now both houses of the Bundestag (including the euro-adverse Bundesrat) “must individually approve” every large scale rescue package(a run on Italy/Spain would surely need more than the 190bn current cap forGermany) and are “prohibited from establishing permanent mechanisms based oninternational treaties which are tantamount to accepting liability for decisions byfree will of other states, above all if they entail consequences which are hard tocalculate”. Such ruling clarifies the illegality of Eurobonds and Fiscal Unionunder the current law. For such reforms (which would really attempt to tacklethe root causes of the European malaise and cronic imbalances) you need a newConstitution and a referendum. In other words, the German Supreme Court has made the distanceshorter between policymaking and the German electorate. Not irrelevant,considering that it is the German taxpayers who are ultimately footing thebulk of the bill to Europe’s Debt Monetisation and Debt Mutualisation.2. AusterityNominal default (via inflation) is preferred to real defaults (viarestructurings/haircuts). The debt overhang is handled through the moreinvisible way of inflation, which weighs on EUR holders and EUR taxpayers.Which helps the well-off and financial debtors (banks in primis and their largestshareholders/bondholders), at the expenses of entrepreneurs, savers andproducers. As always, we play within finite resources in a zero-sum game,making any policy, including this one, only a transfer of wealth and ‘confiscation’of sort.Until one segment of the industry breaks out, under the unsustainable burden ofausterity, which has only just started to hit the electorate (the first real taxes inItaly, for instance, were levied no earlier than two months ago only). The
massive Youth Unemployment (52% Spain, Greece, 36% Italy, Portugal) may be the detonating fuse to watch in this respect.Long TermA few months from now, after such overdose of credit expansion, we shall look atthe patient and see if any productivity / real GDP / industrial production /realwages and output growth was engineered out of all of it, or whether the ‘debtoverhang without growth’ is still there and way bigger than before, without anymore humanly-devisable monetary treatments to dispose of. At that point, the baselinescenario of a Japan-style multi-year slow deleverage, could leave the stage for what wecalled Multi-Equilibria markets, under which the market finds its new equilibrium in acompletely different place than where mean-reversion would suggest. Without boringwho has read us before, for easiness of understanding and at the risk of oversimplifying,our six strategic long-term scenarios are the following: Inflation Scenario, DefaultScenario, Renewed Credit Crunch, EU Break-Up, China Hard Landing, USDDevaluation.Opportunity SetCertainly, the right-tail event “Inflation Scenario’, included in our list of sixscenarios (under our Fat Tail Risk Hedging Programs) is today made more probableby the combined actions of the ECB and the FED. The firm commitment to pursueDebt Monetization and interest rates rigging through open-ended balance-sheetexpansion and negative real rates, may result in disorderly/unsterilised actions andprovoke heavy Currency Debasement, at some point along the way.Despite the fact that an Inflation Scenario is today made more probable, its risingprobability is all but reflected by the markets. If anything, it is price in as lessprobable than the day before. The same indicators that should price and reflect it areindeed compressed by CB’s activism and their objective of crushing volatility andcompressing Risk Premia (Draghi spoke of the ‘Convertibility Premium’ for Spain as if itwas a disease, instead of a fair reflection of risk). Critically, such premia are one of thevery few ways, at least in trade-able instruments, to protect oneself from the unintendedconsequences of current policies. Resulting in the greatest value opportunity of all,which is to amass such effectively Cheap Optionality to hedge (and over-hedge)the portfolio for the years to come.
More generally, as previously argued, Risk Premia are nowhere near where they oughtto be should one factor in the even vague possibility of partially failing European policymaking. Our leit-motiv remains to take advantage of current market manipulationand compressed Risk Premia to amass large quantities of (therefore cheap)hedges and Contingency Arrangements , thus balancing the portfolio against therisk 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 portionof our portfolio (what we call Safe Haven, or Carry Generator). If we do hit one of thosepre-identified low-probability high-impact scenarios, then cheap hedges will kick in forheavily asymmetric profiles (we typically targets long only/long expiry positions with10X to 100X multipliers). Such multipliers are courtesy of market manipulation and‘interest rate rigging’ provided for by Central Bankers. Look no further than that, aswe believe that they represent the only truly Distressed Opportunity right now inEurope. Timing-wise, the next 6 months may provide the most interesting windowof opportunity. Beyond that, perhaps within 18 months, that may be the next mostcrowded trade.Portfolio ConstructMoney printing has pushed the price of the senior secured paper we hold tobubble levels. Thank-you Central Banks. In a way, the fundamentals of our investedcompanies deteriorated less than the fundamentals of the Central Banks’ balance sheets,resulting in higher prices for our paper. We now have almost no paper left sub-par.The risk of MTM volatility has risen with the rise in current prices, and we consequentlynow effectively face downside risks-only going forward, as any potential furtherappreciation on lower discount rates is limited. We are therefore forced into takingprofits, reduce positions, and getting even more under-invested.Getting lower in the credit quality scale is not an option. At some point that same papermay become the best short out there. At a time where Central Banks monetize everysovereign risk asset onto their balance sheet (reducing the amount of qualitycollateral available), you want to short first something that has less of a chance ofbeing monetized, outright or in relative value, if you can minimize negative carry.Senior paper has been a pillar of our portfolio since the beginning of the year. Atcurrent rates, let alone few special sits, we may have to look beyond that andmove away from it, at least in part. With open-ended easy credit, also the classicaldistressed opportunity executed via fire-sales of portfolio is postponed to a laterdate to be defined. Should Japan be any guide to European matters, with his stagnation
and mild stagflation, then we eye certain equities and certain commodities for theCash Generator portion of our portfolio, together with more active yield enhancementstrategies.But, as we repeated ad nauseam, in our eyes the real opportunity, the truly distressedopportunity in Europe right now is FTRHPs. The classical Value investmentopportunities into long-only bonds or equities, when adjusted for risk, at such anemicreturns, is hardly a smart trade. It might still perform (and we would miss that rally),but as a bold high-octane strategy. We try to be more prudent than that.On the scenario of China hard landing, we took all profits and closed positions, forthe time being. Although we still believe in the idea (which is confirmed by data onTaiwan exports, Shipping and Mining flows), and have been proven right by the marketsin the first half of 2012, we currently witness heavy money supply and China itselfrestarting fixed investment to stimulate the economy (building totally nonsenseovercapacity, but nobody seems to care). In a way, recent scandals there may createmore of a case for the opportunity of additional monetary stimulus. We expect a shortterm rebound there. If it materialize, we would like to reinstate positions, this timeexpanding the scope to the Australian dollar, the banking sector in Australia, and theLuxury industry, in addition to Shipping, Mining and the likes.What I liked this weekThis time we group interesting readings by some of the six scenarios we have in mind.Renewed Credit Crunch Scenario Gary Shilling on US Economy VideoInflation Scenario Is QE3 justified? Comparing current conditions with 2010 Charts Gross: Gold a Better Investment Than Bonds, Stocks Video Prior QEs and market reaction analyzed Charts Longer-term inflation expectations spike in reaction to the Fed ChartsDefault Scenario
$648 Trillion Derivatives Market Faces New Collateral Concentration Risks. Last time it was the fair-value of housing, now it is the fair-value of transformed collateral that is pledged at par and is really worth nickels on the dollar Read Ray Dalio and Deleveraging Cycles explained VideoChina Hard Landing Chinas Revolution Risk. ‘The Bo Xilai affair has lifted the lid on a hornets nest. I had not realised quite how serious the situation has become until listening to China expert. Chinas economic hard-landing is intertwined with a leadership crisis. ReadW-End ReadingsFasanara Capital Interview on CNBC VideoEnd to ‘alpha’ a stress for fund managers ReadBIS Paper: whether exchange rate fluctuations can really insulate economies againstcontagion: whether global bond markets are isolated or integrated, and whetherfallacies of composition characterise monetary policymaking Read
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