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Fasanara Capital | Investment Outlook | January 7th 2012
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Fasanara Capital | Investment Outlook | January 7th 2012


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  • 1. January 7th 2012Fasanara Capital | Investment OutlookMultiple Equilibria Markets and the Case forStaying Net ShortHappy New Year.Four years of dysfunctional markets followed some two decades of over-leverage and over-stimulation, with debt-fueled spending programsaddressing debt problems with yet more debt, and bringing us here, in theland of Multiple Equilibria markets. As opposed to reverting to pre-crisismean and equilibrium, the dust in the markets could settle in diametricallydifferent ways and find a different equilibrium there: different combinations ofdevaluations, inflation, expansion, deflation, depression, defaults are all madeplausible.Surrounded by insolvent too-big-to-fail Sovereigns and Banks on steroids, thatwould have failed in anything close to a free market (but have instead beinggiven electrical stimulation to keep the dead frogs moving), 2012 investors areinvited by policymakers to stay optimistic, to not drop the towel on such hostileenvironment, as the bullish trend is about to resume.Monetary-medicine and credit expansion have been the attempted solution tothe 2000 Dot-Com crisis first and then the 2008 Subprime/Banking crisis, andnow tried to fix the Eurozone Sovereigns/Banking crisis, to save the insolventsand sustain elevated valuations. But after that much effort we awake in 2012with the market still in a debilitated state, the medicine not sorting any visibleeffect and yet more of the same medicine (debt and its surrogates) being pledgedin hope for a different result (this time is different) or just in fear of thealternative unknowns. 1|Page
  • 2. In 2012, we believe the base case scenario remains one of a stagnantmarket and economic environment, with anemic expected returns, volatilerange-bound trading and sudden shocks pushing them lower (StagnantVolatile Scenario). Such stagnant fragile economy could take, at some point, oneof two directions: 1) Inflation Scenario, money printing gets truly massive,Draghi finds political support to implement decisive Fisher-Friedman monetarystimulus (assets purchase programs, target high nominal GDP, zero rates) andtherefore finally manages to bring inflation in, markets inflate their way tohigher output, economy expands, employment recovers, debt returnssustainable, confidence is restored, markets rebound, then some currencydebasement and potentially hyperinflation, orderly or disorderly. 2) DefaultsScenario, money printing fails, few Banks in receivership /restructured /nationalized /merged, few Sovereigns restructure / devalue / leave the Euro,deleverage, implosion, Eur break-up or reshapes, orderly or disorderly. Alllegitimate scenarios, not necessarily mutually exclusive, each with decentprobability.However, certain scenarios assume that defiant investors will hang in there:bond investors keeping their shaky government and bank bonds (whilst beingreduced by ECB SMP activity to the status of junior bondholders), equityinvestors keeping their overvalued stocks factoring in peak margin levels (inexchange for anemic expected returns) and their pricey bank stocks (ahead offairly dilutive recap exercises – Unicredit 43% discount docet), bank depositorsto keep cash at fragile banks at zero rates (as opposed to inexpensively removethem from trouble). That is a big assumption: confronted with suchwidespread binomial tree of potential outcomes, where half of thepotential exits are fat-tail events in either direction, it is not easy for theaverage 2012 investor to stay in the game as opposed to run for the exit.Nor it is rationale to expect that from him. We should be reminded of that whenattaching probability to each of those scenarios.Analyzing now some relevant European data that came out over year-end,we perhaps have seen further evidence of a Liquidity trap and signs of aKeynesian Endpoint. First of all, ECB’s liquidity transmission mechanism hasfailed, until now. The ECB is clearly printing money (as no sterilization is takingplace and bond purchases / repos are likely not to be temporary, neither theyare credit-risk free, we think), but the transmission to the real economy is as 2|Page
  • 3. weak as ever. True, monetary base has expanded almost 50% in the last year(base money M0 aggregate ), but broad money supply is flat (M3 aggregate),resulting in a collapse of the Euro money multiplier (which halved since itspeak in 2002). In simple terms, cash and equivalent (high-powered money) isamassed in Central Bank reserves, where it is not fulfilling any economicfunction, in a dysfunctional allocation of capital, not contributing to stimulatingthe economy nor supporting Government bonds. In other words, stronger banksare flushed with cash (courtesy of massive QE repo operations, 489bn just in thelast round) but prefer to deposit most of it in the safe haven vaults of the ECB (ata destructive 0.25%) instead of lending it in the market, leaving weaker banksstruggling to get funding and grasping for more ECB support. Data is confirmedby numbers on the ECB deposit facility being at historical highs. Data on fallingloans to individuals/household/consumer credit/mortgages speaks of the samestory. Without the multiplier, it is arduous to manufacture growth viamonetary engineering, as no matter how much you print the impact on theeconomy is reduced.Public sector is de facto crowding-out private credit, as banks hoard goviesor cash at the ECB, instead of turning it to the industrial or consumer debtmarket. But there is a flip side to it as well, with the private sector desertingpublic issues and bank recap/refi exercises too.Moreover, interestingly, recent data shows that banks are pretty much notbuying sovereign paper anymore (steady decline from a peak of EU350bn in2009). Bottom-line, monetary policy is currently therefore slowly turningineffective. Whilst monetary policy is out-of-order, non-monetary factorsare also weak, as job creators are immobilized, since they cannot budget ormanage the fiscal and regulatory uncertainty. All of this, just before austeritymeasures kick-in, just before banks seek to shrink their loan books by awhopping 1 trillion in an attempt to meet capital ratios (as capital markets arestill perilious – see Unicredit).In such hostile environment, living through the likes of a Liquidity Trapand a Keynesian Endpoint, the probability of bank restructurings /receiverships / nationalizations is as decent as ever. The catalyst of a majorbank failure had been removed by the ECB via LTRO and SMP operations, butsuch interventions have so far failed to restore confidence amongst banksthemselves, therefore their marginal impact is way less effective. It would seem 3|Page
  • 4. to us that one of a few reasons why several banks have not beennationalized yet, is that their desperate Sovereigns would lose access toback-door ECB funding. In other words, and thinking of Italian government-guaranteed debt issued by banks on purpose to get collateral for new funding atECB, it is as if banks were already nationalized, in certain ways. No wonder weare bearish on bank equity.As we argued extensively in previous outlooks, the bar is being raised by the day,and one cannot rationally be certain that Germany will keep footing the billunlimitedly and become joint and severally liable with a growingly worrisome,ever more insolvent sinking bloc. As if it did not have its own issues (DeutscheBank, for example). Given its implicit transfer of resources from Germany toother countries, the ECB operations in LTRO or SMP could be joined by yetmore massive Friedman-style monetary stimulus (and not just a bit more, asthe multiplier collapsed), or could just come in too late (as is already), anddeliberately so.Some investors think the effects of past actions have not been felt yet, astransmission requires time: eventually funding levels will come down (fromunsustainable 7% on BTPs), spreads to Germany tighten, interbank fundingresume, rights offer proceed smoothly (following an eventually successfulUnicredit deal). It is possible, and we may all hope so, but time is not anindependent variable in this equation and the longer it takes the morelikely it will be – in such fragile conditions – for any Greece defaulting /Hungary imploding / Ireland double dipping / Japan facing 3trnredemptions/ France, Austria losing AAA / Corporate inevitable failures…to create shockwaves and spoil the party, accelerating the demise andpossible end/reshuffle of the Euro as we know it in the next 3 years. Ifanything, we would tend to believe that the lagging missing link is more to bedetected in the transmission to the real economy of distress in the financialsector/sovereign markets (something like what happened this week toPetroplus PPHN, announcing that access to all credit lines had been suspended,sending the stock down 20%). We believe that this realignment is indeedmore likely, to the downside, and we therefore stay net short / bearish /hedged.Our thinking follows through in determining that at current rich valuationsacross most asset classes (although already lower than a month and six 4|Page
  • 5. months ago), you are not properly paid for the embedded risk you aretaking. In other words the risk-adjusted returns are not appealing enough tojustify long position sizing: there are better levels for you to get into the trade, orthere are lower embedded vols/risks, for the same valuation. If a rationaleinvestor still exists, somewhere, in such irrational dysfunctional markets, thensuch assessment of risk will cap current markets and make the case for bearishpositions a compelling one.Opportunities exist, already, by and large: in dislocated markets smarthedges cost less. As long as the remit of the mandate allows you to roamacross asset classes, across the capital structure and across financialinstruments, you have a playground with no precedents. Dysfunctionalmarkets allow for cheap options trading, mis-pricings and heavilyasymmetric profiles, whilst trailing nominal benchmark returns is easierthan normal to do.In no instance, in these markets, should a portfolio feel secure in theabsence of select shorts, in our view. Long-only portfolios, un-hedgedexposures and, more generally, classical asset allocation practice will be at riskthis year, more than in 2011, much like heading through a hurricane in a sailingboat. Current markets come handy in that they allow for cherry picking yourmost suitable shorts and hedges, and also now outside of the easy targets(financials).We believe hedging and fat-tails risk management is paramount in 2012and beyond, as it will prove to be the most significant differentiating factorin any strive for performance. As there is little similar to a perfect hedge infinance, the moving basis has to be continuously and dynamically managed,through which Fasanara Capital seeks to capture returns for its investors. 5|Page
  • 6. What I liked this monthGovernments of the world’s leading economies have more than $7,6 trillions of debtmaturing in 2012, with most facing a rise in borrowing costs. Led by Japan’s $3 trn and theU.S.’s $2,8 trn. More..Everyone is also very focused on the maturities of sovereign debt this year. But one issue thatmarkets may not have fully considered is the immense amount of private debt Europeanbanks will need to roll this year. Maturing EU bank debt may hit a wall in 2012The M3 chart versus the monetary base (i.e. how much base money is out there versus all thepossible money-multiplying investment possibilities) is perhaps the most striking of them all.More ..Eurozone M3 contraction. This is troubling because if Germanys M3 continued to expand,the periphery economies credit conditions deteriorated even faster than the euro area as awhole. That was largely driven by a drop in loans to firms. Banks also continued to deleveroutside the euro area. Their net external assets fell EUR25bn in November after a EUR60bndrop in October More ..Mediobanca is the largest shareholder of UniCredit (6.76%) . Unicredit is the largest holder ofMediobanca (8.7%). Remember when CDOs all bought each others BBB and BB tranches,because no one else would? More ..European Services PMI by key countries More ..Top Three Central Banks Account For Up To 25% Of Developed World GDP. What does thismean? It means that nearly $8 trillion in world economic growth is artificial and exists onlycourtesy of central bank intervention. for everyone who feels that the global economy is fake -you are right: up to 25% of all economic growth is what in a different day and age would havebeen called "one-time and non-recurring". More ..W-End ReadingsJeremy Grantham. Looking out a year, the overall picture seems so much worse than thegenerally benign forecast of 4% global growth from the IMF. The probabilities of badoutcomes are not as high for us today as they were in early 2008 when, I’m pleased to say, aspredictors, they looked nearly certain to us. The possibility of extremely bad and long-lastingproblems looks as bad to me now as it ever has More .. 6|Page
  • 7. Bill Gross. On capital markets: "real price appreciation is getting close to mathematicallyimprobable" More ..Christina Romer. In the NYT: A Financial Crisis Needn’t Be a NooseJeff Gundlach. DoubleLine, Complete Slideshow Presentation, impressive slidedeck of rawdata, from Europe, to the US economy, to financial products. More ..Ambrose Evans-Pritchard. 2012 could be the year Germany lets the euro dieMore ..Francesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: francesco.filia@fasanara.com16 Berkeley Street, London, W1J 8DZ, LondonAuthorised and Regulated by the Financial Services Authority“This document has been issued by Fasanara Capital Limited, which is authorised and regulated by theFinancial Services 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 no 7|Page
  • 8. 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 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. 8|Page