2. January 11th 2013
Fasanara Capital | Investment Outlook
1. Outlook-wise, we expect markets to build up on their positive
momentum into the short term, beating current resistances and
reaching new highs, to then correct markedly over the course of
the next few months once the EMU crisis flares up again.
2. Strategy-wise, we hold onto our long positions in Europe, both in
absolute value and relative to the UK/US, whilst incrementing
hedging transactions, as we believe the rally lies on false
assumptions and is to be exposed and terminated prematurely.
3. Country-wise, Italy may provide an opportunity in the near term,
as we expect volatility to rise in the run-up to the national
elections on February the 24th-25th. We plan to progressively
lighten up our European longs from the Italian component, while we
stand ready to reload on volatility arising from the market realization
of a weaker than expected government to be established.
4. Country-wise, Greece may be up for new restructuring already in
2013, as NPLs and Unemployment are rising at the speed of light.
5. Cross-markets, we expect Monetary Policies to diverge, while
Fiscal Policies to converge, over G4 Countries in 2013
6. Currency-wise, we expect Stress Tests to occur on European
Currency Pegs, possibly even by 2013: DKK, CHF and the EUR itself.
7. On the Hedging portion of our portfolio, in Q1 2013 we intend to
increment hedging on three strategic scenarios in particular (out
of our Fat Tail Risk Hedging Programs) as they still are at rock-
bottom valuations: Inflation, Credit Crunch & Euro Break-Up.
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3. In the weeks since our last write-up, markets moved along the path of expected
outcomes. European Equity markets jumped ahead (with the Eurostoxx
breaching 2700 level and now flirting with an important resistance at 2717),
while outperforming both the US and the UK.
Going forward, for the short term, we expect more of the same market
environment, as we believe the rally in risk assets has further to go. We
thus stay put on all positions, although we expect markets to retract
between Q1 and Q2, and therefore stand ready to offload and reverse
positions by then.
When we last reported in November, equity markets were on the low end of
their trading range (around support at 2450) and seemed to be on the verge of a
breakdown. As reflected by flow and skewness data points, shorts and protection
strategies were then implemented, which had to be unwound as the market
pointed higher, spurring a short squeeze that fuelled the rally. In our eyes, the
major compression of spreads below psychological levels (below 300bps for
BTPs vs Bunds, currently at ~250) helped drive the rally, together with a late
(partial) resolution of the fiscal cliff hurdle in the US. Later on, relaxation of
Liquidity Coverage Ratio (and more generally Basel III and Solvency II rules)
pushed some more. Retail flows also emerged, as of late, joining the party and
adding to its momentum.
Once again, as repeatedly was the case in 2012, no major economic data can
claim a role in the upswing. Financial markets have outperformed the state
of the economy all through 2012. For 2013, we expect a similar pattern to
plan out, as a similar model of behavior for policymakers and investors is
likely: we see policymakers keeping on trying to manipulate markets higher
through interest rate rigging and direct intervention in nearby asset classes
(including equity, indirectly), so as to augment the ‘Portfolio Balance Channel’
theorized by Bernanke (explanation), whilst hoping and praying for spillovers
into the real economy and aggregate demand.
Likewise, we see investors willing to diligently follow policymakers and
monetary agents, and buy where and when they buy, not so much as they are
convinced about the merit of the investment, but forced into it by the Liquidity
Trap, financial repression and zero-interest rate policies. Not so much a vote of
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4. confidence in policymakers, but under the threat of their sudden intervention in
the markets in reckless amounts.
One more emotional element, perhaps, is now worryingly at play, as Retail and
Institutional money seem to be chasing the rally in risk assets, having moved
from being concerned about tail events into being fearful of missing out on
flamboyant markets. Complacency in financial markets has emerged in size,
and seems set to grow bigger in the short-term, as more investors have put
to rest any concerns to fly into the rally in pursuit of securing a piece of it.
One more alarming reason to be skeptical about the foundations of the current
positive tone in the market, and stand ready to abandon it promptly.
Signs of bubble markets held on the thin air of Central Bank’s liquidity and
complacency amongst market participants (at a time when fundamental
data has deteriorated, if anything, as falling Industrial Production data is
there to show), are visible. Evidence includes:
- Prudential launched a Perpetual Tier1 transaction for a
maximum of $700mn: initially marketed with a 6% coupon,
guidance tightened quickly to 5.25-5.375% after receiving orders
for $15bn (20x oversubscribed)
- Turkey local bonds: government selling TRL800mn, getting
$41bn demand (51x oversubscribed)
- New CLOs are starting to re-emerge, to manufacture high yields
from ultra-tight building blocks levels, remindful of pre-Lehman
happy days
- LBOs with 30% only of equity, asset-backed financing with
30% only of equity are starting to re-emerge, pairing with ratios
from pre-Lehman happy days too
- The share of covenant-lite issuance has reached a staggering
30% of the total (in 2005 it was 5%): which means less
maintenance covenants in exchange for pure incurrence
covenants, which means lower protection for investors. And
issuance volumes themselves for HY and Loans exceeded
$600bn in 2012, which is above 2007 record levels (another
credit bubble market back then, which was to pop up a year later).
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5. - In contrast, Itraxx skewness inverted quite remarkably in the
last 10 days, as sophisticated investors favored buying
protection
Outlook-wise, therefore, we expect markets to build up on their positive
momentum into the short term, beating current resistances and reaching
new highs, to then correct markedly over the course of the next few months
once the EMU crisis flares up again. Well into next year, the elephant in the
room may well be proven to be the lack of economic growth. We argued
around such theme on a recent interview with CNBC (video attached). For all the
liquidity poured into the veins of the financial system may achieve little in
manufacturing real GDP, industrial production and productivity, desperately
needed to make the debt overhang sustainable and softening its sickening drag
on the economy.
Strategy-wise, we hold onto our long positions in Europe, both in absolute
value and relative to the UK/US, whilst adding on to our recurrent tools of
Contingency Arrangements and hedging transactions, as we believe the
rally lies on false assumptions and as such is going to be exposed and
terminated prematurely.
Country-wise, Italy may provide an opportunity in the near term, as
volatility is expected to rise in the run-up to the national elections on
February the 24th-25th. Judging from the neat outperformance of Italians
securities over pretty much anything in Europe, international market
participants seem sedated to the idea of a re-edition of a Monti government of
some sort (with Monti as either Prime Minister, Minister or President), with a
similar power grip to the previous Monti-led government. Excessive market’s
complacency may be at play here, too. Although a Monti-bis remains our
baseline scenario, markets may soon have to realize that the new government
will be formed of heterogeneous enough parties as to be way weaker than the
market currently anticipates (with the added spin of having Berlusconi at the
opposition). Let alone the possibility (still open) of a Left government leaving
Monti aside, or the possibility of outright victory by Berlusconi. For all intents
and purposes, Monti (and the European technocrats to that extent) may
have lived through their best days in 2012, with no greener light waiting
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6. their reforms in 2013, under any new government formations. All in all, the
likely volatility on Italian securities which would arise in any of those scenarios
may offer new attractive entry points. As such, we plan to lighten up our
European longs from the Italian component in the near future, while we
stand ready to reload on volatility arising from the market realization of a
weaker than expected government to be established. Perhaps, as spread
compression pushed Italian equity higher, spreads widening could be sending it
lower, next time around.
Country-wise, Greece may well be up for a new restructuring round already
in 2013, possibly even before German elections in September. Few days ago,
we learned that Non-Performing Loans on Greek banks’ balance sheets (despite
being booked at farcical levels and not yielding more than the few pennies
needed to justify mispricing them) had risen to some 55bn Euros, which
represents 24% of the total book, which is a steep 50% increase year-on-year. If
you consider that the total funds made available for Greek banks is 50bn, a
capital shortfall in the next few months for Greek banks is easy to contemplate.
Most likely, an attempt will be made for the electorate in Germany to not
realize that before Merkel runs for re-election in September. However,
given the speed of the increase in NPLs, and the staggering levels of
unemployment (60% youth unemployment, 27% total) inevitably
weighting down on economic output and default rates, we cannot be too
optimistic about it. Given that the Official Sector now represents close to 80%
of the outstanding debt, the political repercussions and market implications are
potentially heavy.
Quoting freely from previous Outlooks: ‘we believe the growing evidence of
lack of growth will take issue with price dynamics already in 2013, leading
to downside risks for asset pricing. The catalyst might be the labor market.
As adjustment through exchange rates is not feasible under the EUR currency
peg, structural imbalances across European countries are to be shock absorbed
by Internal Devaluation, primarily via compression of unit labor costs
differentials and contraction of aggregate demand (which tightens trade deficits
by definition, so much as it may sound a paradox to think of falling GDP as the
targeted outcome of policymakers to restore balance across the continent).
Closing the gap to German wages would require Italian and Spanish labor
costs to fall by an additional 30% to 40% in the years ahead. With youth
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7. unemployment at respectively 36% and 55% already, such scenario is
hardly bearable. If austerity is not a catalyst to a major roadblock as yet, it
will soon become one in the years ahead of us. If austerity is heavy now, we
can imagine how it is going to be handled with salaries up to 50% lower. We
believe such day of reckoning might be 9 to 12 months away, if Greece’s
sequencing of events is any guide.
Longer term, in the few years ahead, if money printing failed to restart the
economy, we face the real chance of a multiple choice between a Default
Scenario (Real Defaults, Haircuts & Restructuring, potential Euro break-up as a
by-product, as either peripheral Europe derails the crisis resolution policies
from the bottom, or Germany might reconsider it from the top) and an Inflation
Scenario (Nominal Default, Currency Debasement whilst engineering Debt
Monetization, as money printing continued unabated, until money
multipliers/velocity of money made a U-turn to drive it out of control). We will
not expand on it as we have done extensively so in previous write-ups (Multi-
Equilibria long-term market outlook).’
Monetary Policies to diverge, Fiscal Policies to converge,
over G4 Countries in 2013
As we analyze the effects of unprecedented monetary expansion on financial
markets and manipulated asset values, we note that 2013 might mark
defining differences between the monetary policies pursued by the G4
Central Banks, which may help detect possible cross-markets divergences
in performance.
In aggregate, a recent JPM paper shows that the G4 Official Sector is expected to
buy $1.7trn worth of bonds in 2013, from around $600bn in 2012 (including
$500bn from FX reserve managers): this represents 80% of 2013’s net bond
supply.
Numbers are staggering and gathering further momentum, if one’s consider that
G4 countries have already engaged in approx $4trn balance sheet expansion
between 2008 and the end of 2012, to a total of $6trn (Charts).
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8. Most of the actual buying and balance sheet expansion is expected to come
from the Federal Reserve ($1trn) and the Bank of Japan ($200bn), whereas
the ECB and the Bank of England are expected to pursue more targeted
measures as they are (perhaps rightly) more concerned about the
diminishing returns of their policies and thus try to tackle their
effectiveness as opposed to their magnitude. The balance sheet of the ECB is
actually shrinking by some degree as we speak. The ‘Funding for Lending’
scheme, for example, initiated by the BoE might be followed by the ECB at some
point over the course of the year. In the case of the ECB, there is one more tool
which may get utilized if markets were to violently deteriorate along the way:
aggressive interest rates cuts. We could even imagine a situation where the
ECB decides to bring nominal rates to negative territory, quite
extraordinarily. Indeed, negative rates would likely spur repayments of LTRO
money by banks in core Europe (from the 30th of January onwards, loans can be
early redeemed), thus further compressing ECB’s balance sheet, in favor of
peripheral Europe. Liquidity would float more efficiently where it is most
needed, leading to a better use of capital from the viewpoint of the Central Bank.
As the issue has been to date one of Liquidity Trap and falling Money Multipliers
(the difference between base money printed by the Central Bank and M2/M3
aggregate/money supply actually injected into the economy by Commercial
Banks loans to household and businesses and other means) this may well be a
tool being discussed in the closed rooms of the ECB. Destroying the cost of
capital to the extremes might manage to kick start not only loan supply but
also loan demand, which is now minimal, as the private sector fails to find a
reason to borrow money at even low rates. As the capital is scarce and the
issue is to incentivate (read forcing) banks to lend more to the real economy and
the real economy to take the money and spend it, in the pursuit of inflation, this
may be seen by the ECB as a possible (desperate) step in the ‘right’ direction.
Negative nominal rates may sound like heresy today, but should market return
to full crisis mood, we believe they are a real possibility. For once, we have
comfortably lived through negative real yields for a good year now. Moreover,
Denmark and Switzerland have already implemented them, in a desperate
attempt to preserve their undervalued currencies. Additionally, after all, the
current marketplace has become the largest policy experiment of modern
financial history, where new records are registered by the day, and no
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9. clear economic theory within Modern Capitalism is left to relate to (be it
Keynesian or monetarist).
In terms of Fiscal Policies, and contrary to the divergence we expect for
Monetary Policies, we can imagine the gap partially closing between G4
countries as 2013 runs its course. Up until now, the US led the way to fiscal
expansion, whilst Europe was focused on austerity and fiscal tightening. We see
the possibility for the gap to close to some degree, as the mix of austerity versus
growth gets affected and rebalanced across southern Europe by weaker
governments and unbearable unemployment figures, gradually over time, one
country after another.
An interesting BCA Research study remind us of a simple cornerstone Debt
Sustainability function: nominal GDP growth should be higher than Debt
Servicing Costs minus Primary Surplus. Bond markets tend to focus primarily
on interest rates levels when assessing sovereign solvency. However, the ability
of an economy to generate growth and deliver Primary Surplus is as important.
Performance is here widespread between different countries. The US delivered
growth above debt servicing costs, but incurred into massive Primary Deficit:
result, their debt/GDP ratio worsened. In reverse order, Italy delivered large
Primary Surplus but its growth is well below interest servicing costs: result, their
debt/GDP ratio worsened. Germany has primary surplus and also GDP above its
interest expenses. Japan has the worst mix of all, negative on both counts. The
UK too is negative on both counts, although less so than Japan.
Europe (including Germany) may be slowly realizing that fiscal tightening and
austerity backfires when fiscal multipliers are underestimated (IMF Research),
as austerity reduces growth more than it reduces the deficit, thus worsening
instead of improving the debt sustainability / solvency ratio for that one country.
For all these reasons, a fiscal policy convergence seems reasonable cross-
markets over the course of the year, especially between the US/UK and Europe.
Perhaps, a few investment implications can be drawn from the above:
- Weakening of the USD versus the EUR. As the FED confirms its
extraordinarily aggressive credit expansion, and does it more
indiscriminately than others, we would not be surprised to see
the Dollar depreciating first, which in turn helps the States
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10. achieve better trade flows for a bigger slice of a shrinking global
trading pie, rebalancing against China and repatriating some
portion of manufacturing in between, selling their low-yielding
expensive debt to foreign investors, keeping rates low to attempt
inflating the housing market (which shows the first signs of life)
etc.. while officially justified by the need to support the recovery
and the job market. The FED currently seems more desperate
than others to get the economy off its zero bound early on
whilst it still has some residual effectiveness (Bernanke’s own
words: focus on the Q&A session).
- Counter-intuitively, possibility for Govies and Credit in the Euro
area to outperform their US equivalents on more aggressive rates
cuts (counterbalancing a slower balance sheet expansion at the
Central Bank level)
- If you couple what above with technicals and the valuation gap still
outstanding, a further outperformance of Europe over the US/UK
in the equity markets is also a plausible outcome early in 2013.
Stress Tests in European Currency Pegs
How much more maneuvering room can be left there to defend their
undervalued currencies for the SNB and the Nationalbanken ? Swiss Franc
and Danish Krone may come under pressure already in 2013. Longer term,
the other currency peg under stress, most obviously, is the EUR itself. If
history is any guide, three conditions were met in past currency crisis and
emerging market crisis: an over-valued currency (read, the EUR to countries
like Italy and Spain), over-indebtedness, as a share of GDP or the productive
economy (rephrased, too much debt and no growth against it), and current
account deficit. By any objective criteria, all three levers are met for certain
countries in southern Europe, making the case for a reshaping of the EUR-
fixed currency regime a genuine one. In advanced economies the
readjustment may be slower to occur than in emerging economies (as we learn
from the attached interesting piece looking at past banking crisis), but it may still
do occur over time, including a currency-driven one.
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11. Opportunity Set for 2013
In the previous write-up we had offered our observations on the main themes
underlying our portfolio construction, across its three main building blocks. Our
current Investment Outlook for 2013 is implemented into an actionable
Investment Strategy along the following three parts:
Value Investing / Carry Generator portion of the portfolio
Hedging / Fat Tail Risk Hedging Programs
Cash and Cash alternatives / Tactical Short-Term Plays / Yield
Enhancement
What I liked this month
Sterling crisis looms as UK current account deficit balloons Read
Germany hurt by the Eurozone's massive demand shock, but has the economy
bottomed? Charts
DE central banks' balance sheets approaching $6 trillion; expected to grow
another $1 trillion in 2013 Charts
Interesting Charts for 2012 from JPMorgan Charts
Howard Marks: "There Are Times For Aggressiveness; Now Is Time For Caution"
Read
The appreciating Renminbi Read
Iron Ore Seen Set for Bear Market as Restocking Rally Fades Read
The Chinese are running away with thorium energy, sharpening a global race for
the prize of clean, cheap, and safe nuclear power Read
Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools Read
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12. W-End Readings
Fasanara Capital November interview with CNBC on our outlook and
strategy: CNBC Interview Part 1, CNBC Interview Part 2
Given the wide interest it raised, we re-present this interesting study. Must
Read | FSB Report: “shadow banking system”: can also become a source of
systemic risk, especially when they are structured to perform bank-like
functions. Global shadow banking system, as conservatively proxied by “Other
Financial Intermediaries” grew rapidly before the crisis, rising from $26 trillion
in 2002 to $62 trillion in 2007. The size of the total system declined slightly in
2008 but increased then to $67 trillion in 2011 (i.e. 111% of the aggregated
GDP of all jurisdictions). This represents 50% of banking system assets, and 25%
of total financial intermediaries (including banks, pension funds/insurance,
central banks, public financial institutions). The US has the largest shadow
banking system, at $23 trillion in 2011, then Europe ($22 trillion) and UK ($9
trillion). Holland (45%) and the US (35%) are the two jurisdictions where NBFIs
are the largest sector relative to other financial institutions. The share of
NBFIs is also relatively large in Hong Kong (around 35%), the euro area (30%),
Switzerland, the UK, Singapore, and Korea (all around 25%). Jurisdictions where
NBFIs are the largest relative to GDP are Hong Kong (520%), the Netherlands
(490%), the UK (370%), Singapore (260%) and Switzerland (210%). After the
crisis (2008-2011), the shadow banking system continued to grow although at a
slower pace. Interconnectedness risk tends to be higher for shadow banking
entities than for banks Read
Must Read | BIS Report: Total notional amounts outstanding of OTC
derivatives amounted to $639 trillion at end-June 2012, down 1% from end-
2011. Gross market values, which measure the cost of replacing existing
contracts, dropped by 7% to $25 trillion Read
The Empirical Implications of the Interest-Rate Lower Bound Working
Paper Have We Underestimated the Likelihood and Severity of Zero Lower
Bound Events? Working Paper
Is Modern Capitalism Sustainable? Kenneth Rogoff, Nov 2011 Read
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13. Finally, let us take the opportunity of this first write-up of the year to thank-you
for following us in 2012 and to wish you all the best for 2013.
Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
16 Berkeley Street, London, W1J 8DZ, London
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