Fasanara Capital | Investment Outlook June 2012 (published May 25th)
May 25th 2012Fasanara Capital | Investment OutlookIn the last fortnight, we saw Germany financing itself at 0% yield on 2yr bonds (vs 0.10% forJapan’s JGBs and 0.28% for US Treasuries), we saw simultaneous weakness (but withoutpanic) in Equity (together with Oil and Gold), and pressures (but resilience) in Credit andGovies. All in all, in our eyes, the market seems to maintain his confidence on a renewedgovernment intervention, putting faith in Central bankers and fiscal agents to apply newbandages on the structural deficiencies of Europe and buy more time, critically ring-fencingGreece to counterbalance the rising probability of its contagion. As it stands, the marketallegedly elected the Japanese scenario as the luckiest of all for Europe, and one for whichthe market would sign-off.Although we share the market expectation for a fresh new intervention avoiding the worstand reflating asset values once more, we tend to disagree on timing and on the pre-condition for such event to take place. We think a more pronounced sell-off is indeedrequired to concentrate minds and build the political support needed for a coordinatedaction. Absent such intervention, we believe the market should manage to make freshnew lows, although in a volatile range (Phase I of our earlier Outlook).Catalysts for such accelerated downside might be, in order of appearance: (i) theantagonistic chatter between Merkel and Hollande/Monti on the right course of action, (ii)survey polls for Greece pre-elections showing continued confusion or the election itself onthe 17th of June, (iii) more bad data on Real Estate valuations in Spain.Few effects might follow such catalysts, and provide a precursor of the accelerateddownturn to come, possibly: (i) more concrete signs emerging of bank runs, velocity ofmoney picking up, spreading from Greece to nearby countries, (ii) renewed pressures onUSD funding, as reflected this month by 1yr EURUSD currency basis, and (iii) new highs onyields and spreads vs Bunds or, worse, a bearish flattening of the government bond curveof peripheral Europe on rising short-dated rates.
The topology of various government interventions was discussed in previous Outlooks.Perhaps, this week we have added to the list of shock absorbers a legendary Eurobond anda Pan-European Deposit Guarantee (FIDC-style). We hold to our belief that ECB’s SMPoperations would be most effective measure in the short-term (biggest bang for the buck),if utilised with resolve and if duly pre-announced so as to affect expectations, moreeffective than LTROIII and fiscal bailouts, despite the side-effects of subordination imposedon existing private government bondholders. Importantly, driving yields and spreadsdecisively lower on risky governments can hardly decouple more from nearby assetclasses, and would therefore likely trigger positive relief performances, including a positivefallout on market confidence and a temporary re-pricing of tail risks.Critically, US dynamics (and their decisive monetary policy) are unlikely to come to therescue either, this time around. Next Friday non-farm payrolls might spread some light onthe timing of QE3, as we have little doubt it will take place at some point. Ironically, anegative economic number there would be positive news for the markets and financialassets, increasing the odds of QE3 being announced, possibly when the FED meets next onthe 20th of June. However, timing-wise, it might be too long to wait until then for Europe’sown events to unfold. To be sure, in the absence of such clarity over QE3, US markets mightwell weaken further too (looking at past monetary expansion phases, seeing a mark of1100/1150 for the S&P500 would seem plausible, from the current value of 1320).Consequently, we maintain our shorts/hedges in place, with the idea of revisit them, andpossibly flipping them over, once and if an acceleration of the market decline is visible(through the list of Catalysts and Effects enumerated above) and may trigger a fresh newmonetary or fiscal injection by policymakers (Phase II: ‘Reflating Back, following newintervention’).Clearly, the biggest risk to a coordinated intervention is Germany. Germany may have lostsome shine on monetary policymaking (and rightfully so, in so far as its rigid call for austerityover growth is exposed), but they still call the shots. The paymasters may be proven wrongon their theories, but they still hold the wallet. And the more so now than at the beginningof the crisis. Should Germany opt to slow-down and dis-engage itself, or leave the tableoutright, the scenario would most obviously dramatically change. However, for now, webelieve they might stick to the European project, renewing markets’ hopes for a debtunion (and internal inflation in Germany), as it should make sense to them not onlypolitically but also economically, still. If anything, over the last decade the common
currency led them to accumulate 1.8 trillions in surpluses (vs 1.5trn deficits for peripheralEurope altogether). Surely, so far they are exposed for 657bn under Target2 system with theECB/Eurosystem and their lion share of the 390bn in aid pledges forGreece/Ireland/Portugal. In some ways, they are getting closer and closer to breaking evenon a decade’s wealth of gains. And recent early signs of bank runs inevitably getGermany’s compensating exposure to the Eurosystem rising fast. In Martin Wolfe’s words,‘export surpluses are of no real value if they translate into claims vis-à-vis countries whichultimately cannot pay their debts (Bundesbank vis-à-vis the ECB: Target Claims). Such figuresmay or may not help figure out when a tipping point for Germany gets reached. Overall, anyinvestor would have an hard time accepting potential losses wiping out 10 years of capitalgains. Such price could be just too high for any non-economical goal. On balance, they maystick in this time but, by the same token, they might decide differently at the next round,on overwhelming economical calculations over political ones.On a Long-Term horizon, we repeat our mantra of equipping our portfolio for what wecalled ‘’Bursting of the Bubble Phase’, as we advocate for such renewed governmentintervention (maybe the last one, maybe not) to inflate the bubble even more and set thestage for one of two events under our Multi-Equilibria Markets theory: Inflation Outcome(Nominal Defaults, Debt Monetization and Currency Debasement) or Default Outcome (RealDefault and Debt Rescheduling/Haircut). We still doubt Europe can manage to paddleforever in the middle of the distribution curve and avoid the edges of these cliffs.The base scenario may keep its lead as long as Central Bankers can flood the system withenough trillions of liquidity, avoiding a disorderly deleverage and critically helped by thesame undergoing deleverage in avoiding triggering Inflation, for now, until the delicateequilibrium breaks on either sides. 1. Inflation Scenario is as much a self-explanatory outcome as it is mispriced in the current markets, across asset classes. Even Germany has recently accommodated to the possibility for inflation to ratchet higher than the 2% ceiling normally contemplated. Unleashing inflation does not come without potential risks and unintended consequences (the attached funny video can help visualize Currency Debasement, more effectively than a macro-economic essay). 2. Default scenario is one where money printing fails to counterbalance the safe de- levering of the debt-laden parts of the economy, pushing select Banks in receivership /restructuring /nationalization /merge, select Sovereigns to restructure/devalue/
leave the Euro, the Euro to break-up or reshape. Orderly or disorderly. Credit is the most exposed asset class here, but not the only one. Equity may be priced inexpensively against history (on P/E multiples) and against interest rates (especially after underperforming over the last month): but definitively not as much against left- sided tail events.The structural issues of an over-leveraged European economy generating too little growthare at the roots of our bearish long term view: GDP, Unemployment, Productivity,Imbalances across Europe continue to paint a growingly disconcerting reality. With YouthUnemployment at 36% in Italy and Portugal, and 52% in Greece and Spain, there is onlynegative convexity there. To such debilitated state, austerity is hardly the right medicine.Churchill put it best when he said: ‘we contend that for a nation to try to tax itself intoprosperity is like a man standing in a bucket and trying to lift himself up by the handle’.Certainly, doing so at the mercy of still unaware (although growingly less so) EU taxpayersand, more generally, EUR holders.The huge divergence in costs, trade balances and productivity across European countries isthe next big thing, as it still reigns unabated 6 months after the outburst of the sovereigncrisis, with no evidence of easing in sight. Germany, on their side, refused to engineer areversal of its trade surplus, through Internal Inflation via boosting disposable householdincome and household consumption (by cutting income and consumption taxes), orstepping up infrastructure spending. On the other end, peripheral Europe is trapped in itsimplementation of Internal Devaluation, in the absence of any possibility for NominalExternal Depreciation, and a still-overvalued Euro currency. In accordance to theBundesbank’s vision, Europeans are attempting at reducing an unsustainable chronic levelof debt by driving aggregate demand to grow less than income and productivity for manyyears to come. Put simply, we are doubtful that such large imbalances can (and should) bedealt with in a Fixed Exchange Rate system, like the Euro. Thus, our grim outlook for themarket to re-price the rising probability of select countries leaving the Currency Regime(but not necessarily the European Union for that purpose), over the next 4/5 years.
Opportunity SetMeanwhile, whilst we trail the effects (and side-effects) of unprecedented monetarymanufacturing into financial assets pricing, market levels and market depth forpositioning on Tail Scenarios are available and cheap, both through Select Shorts or CheapHedges (what we call Fat Tail Risk Hedging Programs). Dysfunctional markets allow forcheap options trading, mis-pricings and heavily asymmetric profiles, whilst trailingnominal benchmark returns is easier than normal to do. The market does not price in asyet such extreme outcomes, in what we believe is a replica of an hard-to-die irrationalexuberance, except for VIX and most celebrated ‘fear factors’ which are therefore over-crowded and over-priced. As long as you can look beyond the VIX, which does not representa viable instrument at current rates in our eyes, into what we call Embedded Options andDislocation Hedges, you are off to a successful hunting season on Tail Risk Hedging.The shock scenarios that may be targeted, at different probabilities and costs, range from:(i) Renewed Sovereign woes, (ii) renewed Credit Crunch and stress in the Bankingindustry/HY/Lev Loans, (iii) Default Scenario (sequential failures and exit from EU of certaincountries), (iv) Inflation Scenario (as a result of monetary expansion getting out of control,or even Defaults and derailing fiscal train wreck), (v) China hard landing. Such scenarioshave still low probability, all of them, in absolute terms, but such probability was neverhigher than it is today. Critically, the probability of any one of those independent eventstaking place is not as low as each single probability would indicate, and definitively higherthan what the market prices-in currently (and permits you to hedged at).In no instance, in these markets, should a portfolio feel secure in the absence of selectshorts/hedges, in our view. Long-only portfolios, un-hedged exposures and, more generally,classical asset allocation practice will be at risk this year, more than in 2011, much likeheading through a hurricane in a sailing boat.Our investment philosophy is not to change delta from positive to negative at every turn ofthe market, but rather to have a balanced investment portfolio, where we (i) positionourselves on what we believe are the safest asset classes/capital structures (strong cash-flow generative companies, from countries who still dispose of a domestic currency,preferably senior positions or collateralised positions), whilst simultaneously (ii) loadingourselves with the cheapest hedging programs available, at various points in time, whichare reasonably expected to let us endure as large a number of negative scenarios as we canexpense.
What I liked this weekGermany should quit the euro. Clyde Prestowitz - Foreign policy ReadSecret Central Bank Aid Props Up Greek Banks. Greece’s banking system is being proppedup by an estimated €100 billion or so of emergency liquidity provided by the country’scentral bank — approved secretly by the ECB in Frankfurt ReadConcentrated Risk: 226 Hedge Funds Owned Apple As Of March 31. But what happens ifthe Fed continues to push off the NEW QE announcement: just how much of a generalcollateral redemption onslaught can the said group withstand before they all scramble toleave at the very same time? ReadRay Dalio sees a 30% chance Europe will stumble badly. What is happening in Europe nowis essentially the same to what happened in the U.S. in 1789. In 1776, the coloniesdeclared independence from Great Britain. We didnt have a country. It wasnt until 13years later, 1789, that those states started to form a central government, largely because oftheir debt problems ReadW-End ReadingsShipping Focus: China Buyers Defer Raw Material Cargos Read; Pimco Bullish Analysis ReadJapan Focus: In Historic Move, Japanese Pension Fund Switches To Gold For First Time EverReadJapan Last resort? Japan hires top girlband AKB48 to sell government bonds ReadUS Focus: Renewed Fight Over the Debt Ceiling ReadUS Focus: Treasury Secretary Timothy Geithner, speaking at a meeting of the PetersonFoundation in Washington DC on May 15, reflects on the economy ReadECB propaganda: Inflation Island Game. GameGreat Expectations and the End of the Depression, by, Gauti B. Eggertsson. This papersuggests that the US recovery from the Great Depression was driven by a shift in
expectations. This shift was caused by President Franklin Delano Roosevelt’s policy actions.The key to the recovery was the successful management of expectations about futurepolicy. On the monetary policy side, Roosevelt abolished the gold standard and—even moreimportantly—announced the explicit objective of inflating the price level to pre-Depressionlevels. On the fiscal policy side, Roosevelt expanded real and deficit spending, which madehis policy objective credible. These actions violated prevailing policy dogmas and initiated apolicy regime change. Working PaperBank Runs, Deposit Insurance, and Liquidity, by Federal Reserve Bank of Minneapolis.Traditional demand deposit contracts which provide liquidity have multiple equilibria, oneof which is a bank run. Contracts which can prevent runs are studied, and the analysis showsthat there are circumstances when government provision of deposit insurance can producesuperior contracts. Working PaperFrancesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: email@example.com Berkeley Street, London, W1J 8DZ, LondonAuthorised and Regulated by the Financial Services Authority
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