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April 5th 2013Fasanara Capital | Investment Outlook      1. Cyprus and Italy are two major political debacles that bear im...
Since our last write-up a month ago, two major European political debacles havetaken center-stage and bear important ramif...
contemplated (so much on the road of a banking union to forestall bank runs pandemiccrisis), capital controls sine die wer...
resolution of the crisis, its duration and its scope (amongst others, with opposite    outcomes: Great Depression, Weimar ...
pushing Europe over the cliff. Rephrased, more diplomatically, it is becoming       evident that the goal of Europe’s surv...
Short Term Strategy: downside risks are so evident that we should prepare for areflation trade in optional format, no cash...
European Long-Term Outlook & Strategy: the need for hedging against aEuro Break-Up scenarioBack in September 2011 we start...
Capital controls done, custom duties next? Why having a currency union and a marketcommonplace in the first place if there...
not a real one. One that can be captured only as long as you can hedge it out of its       fake context. Elusive gains vs ...
The OutlookFor more data points on our Strategy positioning, and how it is derived from ouroutlook, please refer to the at...
What I liked this monthFrench Stocks To Drop 33% On Macro Recoupling ChartWhen Interest Rates Rise. Martin Feldstein, Harv...
Francesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: francesco.filia@fasanara.com55 Grosvenor Str...
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Fasanara Capital | Investment Outlook | April 5th 2013

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Fasanara Capital | Investment Outlook | April 5th 2013

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  2. 2. April 5th 2013Fasanara Capital | Investment Outlook 1. Cyprus and Italy are two major political debacles that bear important ramifications for the market at large in the months ahead. Policymaking resembling a dancing elephant in a crystal store 2. Irrationality in political behavior took center-stage and is perhaps here to stay. With it, the scope for policy mistakes is today bigger than before 3. We may be past the peak of political cohesiveness and coordinated actions. Things complicate from here, on the back of offensive competitive devaluations globally and policy mistakes regionally 4. Strategy-wise, realised volatility in politics and markets alike may be set to rise from here, from the rock-bottom levels where it has been confined so far by political cohesiveness and financial repression 5. Short Term Strategy: downside risks are so evident that we should prepare for a reflation trade in optional format, no cash longs 6. European Long-Term Strategy: the need for hedging against a Euro Break-Up scenario 7. Global Long-Term Strategy: the need for adapting to and hedging against Multi Equilibria Markets 8. Paradigm shift in the markets and the need for unconventional portfolio management tools 2|Page
  3. 3. Since our last write-up a month ago, two major European political debacles havetaken center-stage and bear important ramifications for the market at large in themonths ahead: (i) the inglorious handling of the political stalemate in Italy, and(ii) the disastrous handling of the anticipated Cyprus restructuring. We will look ateach one briefly, highlighting what we see as the critical elements that emerged fromeach, as they bear consequences for our Outlook and Strategy further down.Italy provided first for some self-inflicted pain. The inconclusive elections of 24h-25th of February were a shocking political result, but pain and panic could have beensedated in short order by pursuing the one and only logical solution to the impasse: theelections delivered three winners in roughly equal amounts (which equates to threeequally losers), two of which are conservative parties and one is a revolutionary party.In no rocket science, the two conservatives parties were supposed to find a compromiseof sort, to preserve the political activity - and themselves from extinction in between. Ascoming back to elections would pose the risk of landslide victory for the revolutionaryparty. And indeed a compromise is what they reached already a year ago or so when aclosure of funding markets was driving the country head on into a liquidity crunch.Logic would have led to such conclusion, although still after a few weeks of bargainingand volatility. Logic was dismissed outright, however, as political deadlines have goneby and a compromise is still to be found, whilst playing Russian roulette with themarkets and risking to crash test into yet another turmoil. Such compromise might stillmaterialize, and a relief rally might spur out of it, but the road to such resolution wasand is reckless and irrational. All in all, the handling of the impasse was irrational andemotional, and not one driven by logical assessment of benefits vs costs, neithereconomical nor political ones.Cyprus provided then for some more illogical behavior. Whereas Italy was astumbling block taking policymakers by surprise, Cyprus’ restructuring was oneverybody’s calendar. Cyprus was in the cards ever since Greece re-restructured lastyear, by means of heavy PSI, thus devastating the asset side of most banks on the Island(for an amount equivalent to 25% of Cyprus’ GDP), which were overleveraged to thetune of 700% of GDP, most of which relied critically on hot money flows of wealthyforeigners. Given the troublesome economic landscape in Europe, the crystal-fragilefinancial conditions across the continent, and the addendum of uncertainties in Italy oflate, Cyprus’ restructuring was supposed to be something short of a walk in the park. Toput things into context, Cyprus is a tiny rock in the Mediterranean, population of 1mnpeople, counting for 0.3% of Europe’s GDP, and the capital shortfall was just Eur5.8bn: Cyprus was no place to create volatility, animosity, and most importantlybad precedents for Europe at large. Yet still, it took 10 days to come to a resolution,and in between we learned that imposing losses to insured deposit was 3|Page
  4. 4. contemplated (so much on the road of a banking union to forestall bank runs pandemiccrisis), capital controls sine die were imposed (so much for a market commonplaceand a currency union without barriers), and the negative loop between governmentrisk and banking sector was reaffirmed loud and clear (so much for finding ways forbanks to lend to the real economy). A true disaster outcome, a dancing elephant in acrystal store.It does not matter too much how we got to such an outcome. It could be due to a numberof different elements we all understand. (i) Could be political calculations in Germany onthe ramp up to September’s elections, as Merkel’s new opposition – Lucke’s AfD - callsfor stopping fiscal bailouts draining money from German taxpayers, especially whenbailing out richer un-taxed Russians. (ii) Could be political calculations to send a Mafia-style message to peripheral Europe, ahead of new potential negotiations overconditionality of any sort. After all, before promptly retracting, new Euro Grouppresident Dijsselbloem ventilated that this format (insured deposit haircuts and capitalcontrols?) should be a blueprint for future rescue plans.. (iii) Could be a message to tax-havens, yet another one (Luxembourg is warned, as their banking system is 2500% ofGDP). (iv) Could be a message to the finance industry at large, including the shadowbanking system, yet another one.Whatever the basic driver was, it is still illogical for tiny Cyprus in the context of thecurrent widespread fragility, to provide the stage for the show. Tiny upside vs massivedownside. Especially in the context of the dangerous precedents it set: thePandora’s box in our story. Undue risk was taken in creating a Cyprus precedent,which resulted in mishandling the situation altogether. Irrational behavior prevailed.As it stands, we are led to question why we got into such unnecessary trouble acrossItaly and Cyprus over a few weeks of schizophrenic disconnect, and if there is anybasic virus at play we should isolate. A few take-aways seem inevitable whenassessing market risks for the months ahead: - Irrationality in political behavior took center-stage and is perhaps here to stay. With it, the potential for policy mistakes or political miscalculation is today bigger than it was before. Such new entry factor complicates behavioral finance-type analysis and game theory when applied to infer the tree of potential outcomes. Noted. Policy mistakes matter: looking through past crisis over financial history, they counted as key determinants of the magnitude, longevity and scale of such crisis: crisis are created by imbalances building up over time, leading to excessive leverage and bubbles in coveted assets, before deleverage and collateral implosion kicks-in. But it is policy mistakes that often defined the difference between an orderly or disorderly 4|Page
  5. 5. resolution of the crisis, its duration and its scope (amongst others, with opposite outcomes: Great Depression, Weimar Republic, DotCom aftermath leading into Subprime crisis, etc). In the case of Italy, the mess might have been due to adjustment fatigue on the side of policymakers, once you have been too long into the crisis and lose the plot. Again, if tomorrow a new government gets formed around the two main conservative parties (as it should have been the case in the first place), avoiding going straight into new elections, then the damage will have been limited in scope, for the time being. In the case of Cyprus, implications are more far-reaching, as bad precedents have now been set. Slovenia is running fast into a similar crisis to the one Cyprus was buried under: over-levered banking system (130% of GDP), NPLs for 20% of the total, quadrupled funding costs, contracting economy under the weight of debt and fiscal consolidation. If it reaches cooking stage quickly enough, we can be sure that the Cyprus format will be copy-pasted, under the eyes of the few who still thought it was not a blueprint for future crisis. After Cyprus and Slovenia, how likely would it be for Italy to be treated any differently? What conclusion should then 9-trillions depositors and savers in Italy (500% of GDP) reach from all that? Is a large- scale bank run really just a theoretical text-book case study, or can it really get to, say, Italy?- Even more worryingly, and raising the scope for policy mis-steps, it looks like European technocrats have gone blindly complacent of market resilience as they carry out power plots over Europe. The über-aggressive behavior they undertake, the arrogance they use in delivering their firm (ever changing) resolutions, is gathering momentum on the back of two factors: (i) the market resilience, as the market corrected somewhat but was able to brush off the most dangerous news of the last month, possibly under the threat of Draghi’s printing machine (although the market might be just late in adjusting to it), and (ii) the absence of a clear political resistance from peripheral Europe, where political parties are in disarray, decimated by inconclusive elections, unable to close ranks within their domestic place, let alone to form a common block amongst themselves and with France. The (possibly unintended) consequence is to increase the divide across Europeans, planting the seeds for public anger to foster and reaching tipping points.- We said we deem such policy behavior as irrational, as unnecessarily heightening potential risk scenarios (bank runs across Europe) without a commensurate gain in return (less fiscal transfers, at present for Eur 5.8bn to Cyprus island). However, some more logic would be there on the part of northern European countries if such actions were aimed at deliberately 5|Page
  6. 6. pushing Europe over the cliff. Rephrased, more diplomatically, it is becoming evident that the goal of Europe’s survival in the short term is second to the goal of Europe shaping out alongside their grand plan in the long term. This would be included in the ‘Default Scenario’ under our strategic long-term Outlook, and it is still a possibility to contemplate and seek hedges for. If anything, Cyprus created the scare of insured deposits haircut, but also the one of decisive capital controls. Both of them were taboos the day before. Capital controls could slow down bank runs and, concurrently, the exposure for Germany, Holland and Finland under the Target II Euro-system (the biggest single item in their counterparty risk upon Eur break-up). - For all intents and purposes, we believe we may be past the peak of political cohesiveness and coordinated actions, in Europe and beyond. For Europe, Martin Feldstain said it best in 1997 when he argued that, for how counterintuitive that might be, the Eur fixed-rate exchange system might have jeopardized political cohesiveness across the EU as opposed to foster it. Six years into the financial and economic crisis, two years into the sovereign crisis in Europe, we may have seen the best of global coordination, whilst cracks emerge and things complicate from here, on the back of competitive devaluations worldwide (with G4 Central Banks racing to debase to inflate, one against another, under the cover of domestic policies) and policy mistakes regionally (Europe took the lead). Let alone geopolitical risk, as North Korea takes the microphone, Russia meditates on retaliating on tough northern Europeans, and the usual suspects on a long list of potential catalysts.Strategy-wise, Where does all of this leave us? Mixed in the short term, bearish inthe long term (in nominal or real terms).Surely, realised volatility in politics and markets alike may be set to rise fromhere, from the rock-bottom levels where it has been confined so far by politicalcohesiveness and financial repression. 6|Page
  7. 7. Short Term Strategy: downside risks are so evident that we should prepare for areflation trade in optional format, no cash longsIn the short term, anything can happen. Still though, Draghi is in the waiting roomand ‘stands ready to act’, as the market consensus discounts. The bad precedents ofCyprus, the total mess in Italy and the expansionary policies of other Central Banks allaround, might convince him to step up his game at the first signs of market’s frailty(which is the only mandate he has got, vis-à-vis the FED which also targetsunemployment directly). On any given day, he might walk down one of a few avenues:(i) unexpected interest rate cut, to the point where they are eventually taken tonegative territory, off ECB formal meeting dates, (ii) announcement of BoE-styleFunding for Lending programs at national central banks’ level, (iii) LTRO3 or (iv)OMT, for example on Ireland, which has recently re-gained market access by issuing a10yr bond.We do not buy into Draghi’s talking of ‘empty toolbox’ yesterday at the ECB pressconference, interpreted by part of the market as the inability to intervene further andpromptly from here should the situation deteriorate. He may just try to not interfere inthe political debate. To the contrary, ECB’s balance sheet was the only one in the worldto shrink outright in the first quarter of 2013, as LTROs were partially paid back (forEur220bn), helping the ECB to keep its gunpowder dry. A new LTRO would be thefaster route, if a fast tool is needed, and possibly also somehow a cost-effectiveone as markets would react positively to it well before any actual euro is spent (cheaptalk more effective than actual euros, once again).Such an intervention might spark a short-term relief rally, especially if coupled with agrand coalition government in Italy of any duration. In our eyes, we think suchscenario is best played in an optional format, as volatility is tight and the marketupside is priced cheaply vis-à-vis the downside. Longs outright are risky asmarket might adjust to Cyprus precedents with a delay (especially if Italy callsnew elections) and gap down in size.Conversely, for the same reasons, we do not feel comfortable in going outright short, atpresent. Should Italy fall and call for fresh elections, together with evidence of apotential stalemate at the ECB, then and only then we would turn the portfolio around.Meanwhile, the longer-term hedging programs we run in parallel to the Value bookshould help compensate for such correction. 7|Page
  8. 8. European Long-Term Outlook & Strategy: the need for hedging against aEuro Break-Up scenarioBack in September 2011 we started writing: ‘the European construct is structurallyflawed and going to be unwound within the next 3-5 years with a 50% probability’. Backin early 2012 we wrote: it may either come ‘from the bottom, with peripheral Europe’selectorate rebelling to austerity (as we are only few months into it and the full wrath ofit is still to be seen), or from the top, with Germany’s electorate (led by Bundesbank’sorthodoxy) rebelling to an assistential model which sees them as the ultimate solepaymasters, with no clear deal in return’.In a nutshell, we argued, the basic disease infecting Europe is a cancerous excess levelof debt. The real problem with that is the lack of economic growth, the elephant in theroom, exasperated by fiscal austerity. The most visible vulnerability where it may reachtipping point is unemployment (particularly youth unemployment). The stage fordebt, no growth and high unemployment to kick-start a European meltdown may beItaly or Spain, the two economies in the Euro-zone which are too large to fail, too largeto save, and also too frail to recover.It now looks like we are slowly adding stepping stones in that direction, one afteranother, as that idea is less far-fetched now than it used to be, although is still nowhereto be seen in market’s prices (if anything, less so now than before). - From the bottom: electorate from peripheral Europe might rebel to austerity measures and close ranks to force an exit. In the face of a few trillions poured into the market, unemployment increased (approx. 60% youth unemployment in Spain & Greece, 38% in Italy & Portugal), growth failed to be reignited (outright contraction for France, Italy, Spain), tax receipts decreased on lower GDP, debt ratios sickened, no banking union whatsoever, no deposit guarantee to be given for granted (if anything, we almost hit the meteor of insured deposit haircut in Cyprus), capital controls (under which it is fair to discount even lower GDP projections, as the currency is fixed). Absent a currency readjustment, Internal Devaluation to close competitiveness gaps demands further cuts of Italian/Spanish salaries by 30%-40%. Self-explanatory. - From the top: electorate in Germany rebelling to fiscal subsidies to peripheral Europe, with no clear parental controls in exchange. German taxpayer woke up this year, and do not want to foot the bill any further. Severing fiscal transfers, whilst imposing capital controls to impede deposit outflows and a corresponding increase of Germany’s exposure to the rest of Europe via Target II Euro-system, equates to taking steps to dissolving the union itself. 8|Page
  9. 9. Capital controls done, custom duties next? Why having a currency union and a marketcommonplace in the first place if there are capital controls and silos within it. How muchmore artificial can this Frankestein economy look like, and how many mirrors to breakto avoid looking through it?The fact that the fear of destruction, either in the form of widespreadunemployment, civil unrest or sequential failures, is preventing the EUR currencypeg from being dismantled, must delay the final extinction of the currency, untilsuch same destruction is to happen anyway under the squeeze of the overvaluedcurrency, overleverage and current account deficits.It could and should end up being an orderly dismantling of the Eur currency peg, as itmight take dissolving the currency union to save the European Union.Global Long-Term Outlook & Strategy: the need for adapting to and hedgingagainst Multi Equilibria MarketsHedging a EUR Break-Up scenario is paramount, and so is incorporating it into ourportfolio strategy when it comes down to allocating risk across countries, industries andsectors. Beyond Europe (as argued extensively in previous Outlooks Nov 2012 and Jan2012), we have the strong conviction that we live in Multi-Equilibria Markets, wherethe final outcome is hard to anticipate as it may divert markedly from classical meanreversion: diametrically opposite scenarios are made equally possible, whichdeflect vastly from the baseline scenario currently priced in by markets.We live through the end of a Keynesian state, as the level of over-leverage isunable to be dealt with by pure growth. Four decades of credit expansion whichfollowed the end of Bretton Woods are now coming to an end, as debt metrics areunsustainable and growth is gripped down by such debt overhang. The debt as a %of productive GDP/real output growth is just too high. Policymakers and handy centralbanks are confronted by unconventional hard choices between one of two evils: - Inflation Scenario (Currency Debasement, Debt Monetisation, Nominal Defaults). It seems the route followed by Japan, the US, the UK. This is a Nominal Default, but still a default (as it curtails the value of a fixed income claim as surely as a default). As we previously argued (March Outlook and CNBC interview), Japan is the lead illusionist here, printing more than the US in absolute terms, whilst having a third of its economic output. Of course the financial assets get bloated up, at present. It is purely a nominal rally, though, 9|Page
  10. 10. not a real one. One that can be captured only as long as you can hedge it out of its fake context. Elusive gains vs reliable returns. - Default Scenario (Real Defaults, sequential failures of corporates/banks/sovereigns across Europe). Let deleverage unravels, Europe flirted with this option, last month.The good part of the story is that hedge constructs and contingency arrangementsabound, courtesy of Central Banks’ activism, interest rate rigging via ZIRP policies,and financial repression compressing implied volatility and spreads of all sorts. Also, thesteer levels of cross-assets correlation help in implementing cheap hedges andproxy hedges: as there are lower boundaries between nearby asset classes, the chanceis there to hedge with one another for minimizing costs.Paradigm shift in the markets and the need for a unconventional portfoliomanagement toolsAll in all, to us, the paradigm shift in the markets calls for a decisive shift in portfoliomanagement, along the following key guidelines: - Portfolio should account for tail scenarios to stay with us for the foreseeable future, bubble-prone markets on excess liquidity, vulnerable to downside shock scares. In our world, this is implemented via our proprietary methodology for Fat Tail Risk Hedging Programs - Thus, the need for a truly multi-dimensional risk management policy, Hedging Book, running in parallel to the Value book, whereas this typically belonged to different silos of the asset management industry (and still is). Hedging means bothering to spend the cash needed in expensing such overlay. - Use cross-asset correlation to your advantage , at a time when diversification (a’ la Markowitz) no longer helps as everything is correlated to everything else, and on top of things rates can’t fall no more, mathematically, as they did for the best part of the last 40 years, complicating things for the most widely held asset class – Credit – and its use within a portfolio. - Fully invested portfolios are no longer optimal. The Value book can at times be heavily underinvested so as to adapt to unstable and gapping markets, whilst replacing cash positions with optional positions and synthetics on low volatility. 10 | P a g e
  11. 11. The OutlookFor more data points on our Strategy positioning, and how it is derived from ouroutlook, please refer to the attached Appendix (Portfolio Buckets).Finally, for those of you who enquired about it, let me clarify that we will send out thesewrite-ups on a monthly basis only (which has been the case ever since Feb 2013, asopposed to weekly or biweekly as previously was the case). For any intra-month updateon the views/positionings please feel free to get in touch. 11 | P a g e
  12. 12. What I liked this monthFrench Stocks To Drop 33% On Macro Recoupling ChartWhen Interest Rates Rise. Martin Feldstein, Harvard University ReadMarkets Fear Loose Cannon Yellen at Fed: "a client said to me a few weeks ago thatif Karl Marx was in charge of the world, hed have Yellen as his CB governor’ ReadUnderstanding North Korea ReadChina: Rising Risks of Financial Crisis. Nomura. What matters is not so muchDomestic Credit to GDP ratios, where China lags behind Japan, US (at 150% vs 250%),but rather the speed of acceleration of credit expansion. Using Total Social Financing(overall credit supply to the economy), leverage built up by 60% of GDP in the last 5years (to 207% of GDP). ReadYen Selling May Become an Avalanche: Soros VideoW-End ReadingsThe private wealth discrepancy at the heart of Europe. Consider Italy, which has thehighest ratio of private wealth to public debt of any G7 country, and is 40% higherthan in Germany. Italy and France share a ratio of 500%. By contrast, the ratio inGermany is only 350%. This discrepancy is at the heart of the question: shouldtaxpayers in debtor countries expect "solidarity" – money – from taxpayers in creditorcountries? Why should they take responsibility, when high ratios may result from lowtax revenues over time, while lower ratios may reflect higher tax revenues? ReadIf EMU does come into existence, as now seems increasingly likely, it will changethe political character of Europe in ways that could lead to conflicts in Europe ….Indeed, there is no doubt that the real rationale for EMU is political and not economic.Indeed, the adverse economic effects of a single currency on unemployment andinflation would outweigh any gains from facilitating trade and capital flows among theEMU members. Martin Feldstein, Professor of Economics at Harvard University Read‘PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter Lynch’s epoch, all occurred or haveoccurred within an epoch of credit expansion – a period where those that reached forcarry, that sold volatility, that tilted towards yield and more credit risk.. What if anepoch changes?’ Read 12 | P a g e
  13. 13. Francesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: francesco.filia@fasanara.com55 Grosvenor StreetLondon, W1K 3HYAuthorised and Regulated by the Financial Conduct Authority (“FCA”)“This document has been issued by Fasanara Capital Limited, which is authorised and regulated by theFinancial Conduct Authority. The information in this document does not constitute, or form part of, any offer tosell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or thefact of its distribution form the basis of or be relied on in connection with any contract. Interests in anyinvestment funds managed by New Co will be offered and sold only pursuant to the prospectus [offeringmemorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carriesa high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any stepsto ensure that the securities referred to in this document are suitable for any particular investor and noassurance 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 oranalysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnelmay have, or have had, investments in these securities. The law may restrict distribution of this document incertain jurisdictions, therefore, persons into whose possession this document comes should inform themselvesabout and observe any such restrictions. 13 | P a g e

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