Fasanara Capital | Investment Outlook | June 28th 2013
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“Learn how to see. Realize that everything connects to everything else.”
― Leonardo da Vinci
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Fasanara Capital | Investment Outlook
1. Bernanke clarified that the double win for the financial markets of both QE and
potential GDP recovery has now vanished. It will be either one or the other from
2. Until then, we then believe any potential upside is capped and the risk is to the
downside, as the froth is skimmed from the markets, investors take profits on upticks
(as opposed to buy on dips) lightening up books ahead of the summer-time, and as EMs
/ Commodities exert gravitational forces. Thus, we plan to remain flat to short
markets over the summer-time, and potentially go long sometimes after that
3. Again, rates are the biggest catalyst to equity underperformance. Should rates rise
decisively, equity are most likely to tumble in size, no matter how much nominal
growth stands behind it. So much as this observation sounds obvious, it still stands in
stark contrast to market forwards.
4. Japan: weaker Currency seems the safest bet in town. Higher Rates seems the
cheapest bet in town. Higher Equity seems to require the boldest view to take.
However, we have now added a tactical long Equity, as we believe July will be a
positive month for stocks in Japan.
5. China: vulnerability is unmistakable and may call for more expansionary policies, on
par with Japanese contenders. Trigger may be the labor market. China may play
hard ball with banking system and may be willing to tolerate short term pain, but is
less likely to tolerate pain in unemployment. Last time it intervened in size (end 2008,
start 2012), PMI unemployment had just fallen below critical threshold.
6. Europe: not only do we believe the EUR break-up is a real possibility, but we think
the process of dismantling the peg is already unfolding. Europe may soon re-enter
the news headlines.
7. VALUE BOOK: at present our Value Book remains pretty flat to short, as markets
are toppy, still expensive vs fundamentals, at risk of a 10%/20% steeper correction.
We currently see most of the opportunities in the HEDGING BOOK: short JGB rates
& Yen, short Australian Dollar, Long Interbanking/Swap Spreads, long Currency Pegs.
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US Equities: What we learned from Bernanke’s remarks
A key event this month was Bernanke specifying his expected timing for a tapering to take place
(Q4 2013) and for the end of QE (mid 2014). It all depends on GDP and Unemployment, as before,
but now we have his precise expected timetable around it. It does not mean hikes in interest rates, it
does not mean FED’s balance sheet shrinking, but it still holds relevant information as we moved
from open-ended mode to a precise timetable.
Truth be told, so much as we can only applaud a return to fundamentally priced stocks and bonds,
and an end to the virtual reality generated by QE, we can only welcome his decision. So much as we
can only hope for the price of money to return in the hands of the market and be freed up from
Central Bankers’ manipulation, we can only welcome a normalization of rates to 3% on the 10yr in
2013 and 4%-5% in 2014, in the presence of GDP recovery without Inflation. Also, in fairness, it is
positive to notice that the FED’s hand was not forced by rising inflation expectations, which would
have provided a totally different playground.
However, we do remain less optimistic than the FED on GDP prospects in such debt-laden
economy, and in an environment of rising rates in particular. As we argued in the past (US Equities
have entered bubble territory), interest rates are the bubble within the bubble, as they provided the
foundations for 70-year high corporate profits, 30-year high in house affordability (NAHB index) and
related housing market recovery, as they provided a lifeline to a still over-levered private sector
(gripping down consumer demand), as they helped US deficits built up, as they soften student loans
loss ratios. And the list goes on. Take super-low interest rates and ultra-low mortgage rates out of
the equation and the recovery may melt down like snow in the sun.
Critically, the latest GDP report held some piece of information more valuable than the simple drop
in growth over the first quarter: real per capita disposable income fell at annualized rate of 9.2% (a
similar drop took place in Q3 2008). As the personal savings rates are already super low at 3.2% of
disposable income (and ticking higher now), this is not boding well for consumer demand/consumer
growth/corporate profits in the medium term.
To be sure, Bernanke focused minds on GDP/unemployment prospects over the coming months. The
double win for the financial markets of both QE tailwind AND potential recovery of GDP tailwind
has now vanished. It will be either one OR the other from September onwards. Which also means
that any potential upside is capped from here, until a confirmation of the GDP/employment picture
is provided over the coming months. Further upside would then be more likely in Q4 rather than
Q3, as the data may take time to depict a clear trend. Until then, we believe the risk is to the
downside, as the froth is skimmed from the markets, investors take profits on upticks (as
opposed to buy on dips) lightening up books ahead of the summer-time, and as Emerging
Markets / Commodities exert gravitational forces.
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The potential for a steeper correction in the near term is there. A further 10%-20% loss would be all
but unjustified. Gold suffered of such heart attack, as liquidity comes and goes, and buying on
borrowed money has no mercy for mild fluctuations, making steep correction steeper.
Therefore, we believe markets will trade range-bound to move lower during Q3. After that, two
things may happen:
1. Confirmation of GDP recovery / confirmation of improving employment picture
2. Weakness in the economy and employment picture re-pricing of QE vs current
expectations of tapering in Q4 markets up
For what is worth, if we are right about the lack of growth being the elephant in the
room, then Bernanke will be next confirming QE and delaying tapering, with Equity
markets going up on inflationary policies resuming beyond current expectations of
tapering by Q3 and exiting by mid-2014.
In conclusion, we plan to remain flat to short markets over the summer-time, and potentially go
long sometimes after that.
Why Bernanke did what he did
In terms of the motives behind Bernanke’s move, one would think that an optimistic view over the
US economy is the key underpinning. We would add to that that Bernanke may also have wanted
to take the froth away from a market running ahead of itself: talking of tapering conditional on
the economy as opposed to actually implementing tapering may have been an efficient way to
achieve that goal. We can only suspect that he had grown concerned of excess volatility in Japan.
At the same time, he may have wanted to reload its bullets too. It is better to take the markets
by surprise with a resumption of QE activities, if need be, as opposed to have it disappointed by
their ineffectiveness on diminishing returns.
He was clearly way less concerned of the concurrent fragility in Emerging Markets, which were on
the verge of capitulation that day, and the tight liquidity conditions in China, where Shibor rates
were skyrocketing. Also, the next day was option expiry, with huge Gamma in the markets which
could have had destabilizing effects. Unsurprisingly then, Bernanke’s words had indeed a lethal
effect on markets at large in the following days.
True, it cannot be his mandate of worrying about the world. However, tightening the spigot of global
dollar liquidity right at the same time as EMs are on the verge of collapse could have been timed
somewhat differently. Surely, this may be yet another proof that domestic policies and domestic
goals come first and form a competitive landscape, these days. So much as Japan’s QE is intended
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to debase the Yen in a competitive devaluation, US’s QE is intended to lift local markets first
(differently than past expansionary credit policies), reallocating capital globally (repatriation of US
manufacturing activities comes along). Domestic policies are growingly confrontational cross-
countries, at present. One more reason to think that volatility is to stay high.
Bubble Chain vs Deleverage Chain
Our framework for attempting to make sense of market chaos isolates too opposing forces: Bubble
Chain and Deleverage Chain. The players for the two chains are displayed in the Chart below (for a
full description of the timeline of the two chains please refer to page 2 of the attached: Timeline of
Bubble Chain and Deleverage Chain). The Bubble Chain reacts to Central Bank’s liquidity and puts
dogmatic trust into the holy promise of open-ended Quantitative Easing, in spite of
fundamentals being foretellers of a parallel universe. Here, chasing the yield (income stream) in the
markets has become chasing the rally (capital gains), which is turn has become chasing the next
bubble. The Deleverage Chain speaks of the real universe, and still tries to price itself against real
GDP, against the unfortunate reality of an end-of–journey Keynesian economy gripped by 40 years
of over-leverage with no growth to support it.
We believe that Japan is an important driver of the Bubble Chain, as its fate will affect the perceived
effectiveness of QE policies globally. On the Deleverage Chain, China is the chief catalyst, and
understanding what happens to China’s credit markets may help understand what happens next to
the Deleverage Chain.
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In the last couple of weeks, we saw equity markets in the US and Europe giving up to the
gravitational forces of the Deleverage Chain and moving down, in what could be the start of a
more sizeable correction. Emerging Markets, their currencies and commodities showed further
weakness. No recoupling in sight, as yet, but the two chains started moving more in sync. On a
longer term, we believe re-coupling is most likely: the virtual reality manufactured by Central
Banks can deflect from the physical world of real GDP/real Industrial Production for only that long.
As we suspected, volatility resurrected to the lows it was confined to by Central Banks activism,
rebelling to it, as they run into exhaustion mode: after years of ripping the easy benefits, the law of
diminishing returns is kicking in, and the underlying patient, treated with huge doses of morphine,
starts to cough out of breath again. In shorthand, ‘toppy markets’ are ‘gapping markets’.
Should we position in the area of carnage and go long Delevearge Chain against Bubble Chain?
Perhaps, but not as yet. We do have that trade in mind for the months ahead (Russia & China).
On Bubble Markets, cracks were visible across the chain, particularly on govies, corporate credit
and High Yield markets. Lightening of positions has kicked off. Back in January we thought that
‘2013 might be the first year earmarked with a negative return (of some dimension) for
government bonds ever since 1994’: we hold to that view.
Gold proved way weaker than we had expected, moving down with the market, moving down
without the market. We were wrong on Gold. Rising rates was a powerful blow, coupled with one
of his best fan, China, going through a rough moment. So much as we still like it for the long term,
we trimmed down residual positions as the momentum is nasty, and we feared capitulation of large
holders at some stage. We plan to re-enter this market, as we think its investment case remains valid
in the long term.
We are monitoring quite a few stories in the credit space, although an attractive entry point is still far
from current pricing, in our opinion. We salute the ongoing sell-off as a positive for the markets.
From here, let alone short term volatility, we believe Credit can weaken further, with the shape
and tempo of such weakening depending on the magnitude of the move. Should the adjustment
be severe in liquidation fashion, it may take few months only. Should the adjustment be slower
and milder, it may take years. In our eyes, the uncertainty is about the shape and tempo of the
move, more than the magnitude of the move itself.
Whether the adjustment will be wild or mild, may depend on whether QE policies get unplugged as
recovery kicks in or as inflation expectations rise. Inflation does not seem a concern now, but
Inflation Scenario remains one of our key Fat Tail Scenarios.
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Causality&Correlation Value Opportunity: Equity vs Rates
Last month, we stressed that equity markets would be most vulnerable to interest rates in the
months to come:
‘Rates are the biggest catalyst to equity underperformance. Should rates rise decisively,
equity are most likely to tumble in size, no matter how much nominal growth stands
So much as this observation sounds obvious, it stands in stark contrast to market
forwards. Decades of data corroborating portfolio diversification theories (à la Markovitz)
have shown that when equity goes up, rates tend to go up (and bonds down), more often
rather than not. Currently, consistently with such historical dogma, the correlation between
equity and bonds is priced in by the market at approx - 20%. We disagree with the market
pricing of correlation here as we believe it might soon turn out to be +50%. And on the way
down! Bonds and equity could fall simultaneously. And not only because rates have hit
their zero bound (if anything, the ECB starts contemplating negative nominal rates, for
example). Such misalignment between our forecast and the market forwards highlights
a valuable opportunity for our strategy: it helps build cheap hedges against Equity going
down, or helps cheapening up good hedges against Rates going up.
Despite rates went up and equity down, the correlation between the two moved only mildly, surely
not as much as we think it can move over the next several months. As such, we believe there is more
upside in the trade, and we plan to increase our positioning on lower equities / higher rates
conditional optional hedges.
Japan: we hold the line on Short Yen & Rates, we now added Long Equity
Last month we argued that, weaker JPY seems the safest bet in town (beyond any short term
rebound). Higher Japanese rates seems the cheapest bet in town. Higher Nikkei seems to require
the boldest view to take, as it is digital volatile and two-sided fat-tailed market outcome from now
on (rising higher, gapping down; up the stairs, down the elevator).
We now change our positioning on Equity, tactically for the next few weeks, as we think July
may be positive for stocks in Japan:
1. On July 21
Upper House election, Abe’s party is expected to win a majority, paving
the way for a smoother execution of its policy, namely in regard to the second and third
pillars of his strategy: fiscal intervention and structural reforms.
2. In late July, second quarter earnings start to come out, and we expect them to reflect
the preliminary benefit of a much weaker Yen. Earnings season should be positive.
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Japanese exports jumped 10.1% in May from a year earlier, best annual gain since
Dec10. Earnings season should be positive.
We have been long Japanese equity already as of last December/January into March, as we
thought the change in policy was structural, and equity would have rallied more than the
currency depreciated (Outlook and our CNBC interview). Such 'nominal rally', as we called it then,
was hedge-able into hard currency at cheap costs. So we could rent a 'illusory rally', by hedging it out
of its fake context. We have now re-established the same trade as then, by entering a tactical
long equity position, for the short term, while shorting the currency.
Shorting the Yen remains our single largest position in Japan. Indeed, as we noted last month,
‘’we believe that it is hard to imagine a state of the world where the Yen is not significantly
weaker than it is today.
- Rates could be higher, which means equity would be lower, as debt crisis may
snowball abruptly, and JPY weaker in reflection of such calamity.
- Or rates could be managed down successfully, anchored at zero across the curve
via more monumental money printing, and equity up, just nominally so, as JPY
weakens further, and rapidly so.
The one scenario where the JPY goes back to its highs (around 75 vs USD) seems at present the most
unlikely. The dynamics that the BoJ has set in motion are irreversible. By promising to print so
much, they now can print so much or much more than that. By having selected such an overdose
of monetary expansion, the more bonds sell-off the quicker they might have to step-up their printing
presses. The more they crowd out the private sector on JGBs, the more they will eventually have to
print. The more the market flies on liquidity-havens, the more it will be addicted to such printing.
Samurai-Japan’s policy is remindful of the ‘burning the bridges behind’ war strategy of Sun Tzu.
General Sun Tzu (from China, actually), in its “The Art of War”, explains that one technique for
success in war is burning boats or bridges for escape. The tactic is basically this, taking an army
across a river, burning all their boats, the only routes of escape. Left with two choices when facing
the enemy army, to win or to die, people will do super human feats to survive. Similarly, Abe and
Kuroda today, have put themselves in a corner where they are confronted with one of two
options: print, and buy bonds only, hoping for the market to grow before inflation kicks in; or
print more, and buy all bond and some equity, if inflation kicks in and/or the market does not
grow. Stop printing and you die.
Fight like a samurai, or die as a kamikaze’’
Another factor can drive the Yen weaker, in the short term: real rates differentials. After real rates in
Japan plummeted below US real rates for the first time in years during May, the divide between
them has widened further since then. 5yr real rates are at a new super low beyond -1.5% in Japan
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(as nominal yields rose less than inflation expectations), whereas they moved up from -1.5% to -0%
in the US (as break even inflation rates lowered and nominal rates rose). Declining inflation
expectations in the US, possibly on the back of the Deleveraging Chain shown above (whilst Japan
seems kamikaze-committed to 2% percent inflation) are at the basis of such increase in real rates in
Incidentally then, local Japanese money managers (especially the VAR-shock sensitive ones like
banks, broker dealers, regional and Shinkin banks) should be compelled to divest from shaky JGBs
and sinking Yen, and move to USD cash, pure and simple cash, for a real yield pick-up.
Finally, on Japanese interest rates, we plan to take advantage of potentially lower yields in the
months to come in order to increase our short Japanese rates positions. As the market has started
questioning the credibility of the Bank of Japan, we believe that samurai-Japan will manage to
close ranks and fight back, bringing rates lower. At the speed it opted for, Abenomics cannot
possibly last for several years: still, it is at his infant stage now. More money can be poured into the
market, open-endedly. The revisions to its expected size may come as early as October.
China: fake liquidity crunch or true credit exhaustion
Last month, we left the conversation on China asking ourselves the following question: Can credit
expansion resumes despite clear signs of diminishing returns and credit exhaustion? True, china
stock of debt is not outrageous when compared to Developed Markets. However, what matters is
not so much Domestic 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), total leverage built up by 60% of GDP in the last 5 years, to 207% of GDP
(research). Will it continue now after watching the monumental policy experiment in Japan?
This month, we experienced the impact of a decelerating credit expansion on asset pricing, as Shibor
rates (Chinese inter-banking rates) and Repo rates skyrocketed ahead of Dragon Boat holidays in
spectacular fashion: up to 29% and 10% intraday respectively.
It has been argued that the panic in Libor rates is likely to be the result of a stand-off between the
Central Bank of China (PBoC) and the shadow banking system. The shadow banking system
allowed the Total Social Financing in China (broadest measure of credit growth) to rise well in excess
on PBoC’s intentions. The liquidity crunch (in the form of a delayed injection of liquidity in the inter-
banking market) was then used to defuse an out-of-control credit system. Target of the policy was
the plethora of trust ($ 1.4 trn) and wealth management products ($ 2 trn) engineered by non-bank
financial institutions. Beyond that, the reverse repos utilized by small banks with large banks to get
short term financing so as to reduce capital requirements by nearly 75% (bypassing risk ratings on
corporate bonds) may have been a target too.
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Whatever the real motives there, it is surely dangerous for liquidity to dry up in a highly
leveraged economy. Hot money capital outflows can take place on a large scale and force sequential
failures across the industry. Unintended consequences can be triggered.
A recent Fitch report indicates that signs of credit exhaustion are evident in China. Overall credit
jumped from $ 9 trn to $ 23 trn in the last 5 years.
Critically, China holds the key to what the market has in store in the near term for a variety of
levers: the dollar index strength, equity markets in EM, and our shorts on JPYUSD and AUDUSD.
For all intents and purposes, it suffices to say that despite all the noise about China rebalancing its
growth model to internal consumption, the growth prospects of China are heavily reliant on exports
and aggregate foreign demand. At 50% Investment on GDP, and Private Consumption now below
35%, China is way more dependent on the external world than ever before. The remarkable
resilience it showed during the 2009 crisis and the 2011 crisis is history (when its two most important
trade partners imploded - US and Europe respectively). China's instability now is unmistakable and
might call for more expansionary policies, on par with Japanese contenders. It is key to
understand that over the coming months, as policymakers make up their mind.
The trigger to such reflation policies might be the labor market. China may play hard ball with
the banking system and may be willing to tolerate short term pain there, but is less likely to
tolerate pain in unemployment. Last time it intervened in size (end of 2008 and beginning of
2012), manufacturing unemployment had just fallen below critical threshold. That is an important
lever to watch to understand China’s sensitivities, likely policy shifts, and its implications for the
Deleverage Chain at large.
The case for being short the Australian Dollar
We believe the weakening in the Australian Dollar has further to go in the months to come (save
for a short term rebound, which we now expect for the short term), following further weakness
from China, tightening rate differentials to the US (impairing the carry trade that made the AUD
strong in the first place), a weakening business cycle, a sizeable current account deficit.
Particularly, Australia’s vulnerability to US interest rates is higher than in other markets. This is
primarily due to position concentration in local bond markets: 60% of bonds are owned by
foreigners (similarly to Norway and New Zealand), where bonds are 20% of GDP.
As we previously argued, the Australian Dollar could possibly be a loser in more than one possible
- Deleverage Chain risk. GDP scare on more China Hard Landing evidence. AUD
will be next in the Deleverage Chain we have shown above: from Gold and Miners,
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to Commodity Markets, to Emerging Markets, to a breakage point on fast-
weakening Australian economy
- Bubble Chain risk. Money printing machine gets activated following allegedly
'successful' Japanese experience. Nominal Rally would follow in the equity
markets, through AUD Currency Debasement exercise (not so much for the same
reasons as for Japan, where the currency is debased to achieve Debt Monetisation,
as Australia has low debt/GDP ratios). Inflation risk is high in Australia.
- Bubble Chain implosion, volatility-induced sell-off in a VAR-shock, globally out of
Japan or the US (not so much a resumption of hostilities in Europe, which has last
drove money into Australia, crowding out their govies, which at some point were
80% held by foreigners). A global risk off mode could possible drive AUD down
this time around, much like it did on Lehman-moment, when AUD was 30%
weaker than today vs the Dollar. To be true, these days a slightly weaker S&P is
driving up AUD (and JPY) vs USD: but it is the digital adjustment we fear, a steeper
correction, which we believe could invert the sign of the recent correlation.
Euro Crisis to flare-up again
In the last few months, Europe was left out of the news headlines, despite worrying trends
unfolding, as investors’ attention was captured by rates in the US, volatility in Japan, the credit
squeeze in China, the weakness of the Emerging Markets. We believe Europe may soon return to
the scene, as the fundamentals have further deteriorated for some large countries within the
block. Markets may currently be underestimating/mispricing such vulnerability.
Markets may be giving too much credit to the positives in the market. Take Italy, for example.
Consumer confidence rose from 86.4 to 95.7 in June, the highest in more than a year. However, retail
sales fell for an eighth consecutive month. However, NPLs on banks’ balance sheets increased some
more. However, subsidies to unemployed increased, together with unemployment. However, the
government is much weaker than it was before as Berlusconi just went through another adverse
court ruling which may force a radical shift in his political strategy.
The current levels on BTPs and Bonos have decoupled from both the Target II flows and NPLs
trends, with which they used to correlate quite tightly. Spreads to Germany are too tight, when
valued against those fundamentals. Clearly, the ECB’s put has sedated markets, thus far.
This month we learned that Italian gross non-performing loans rose 22.3% in April versus the
previous year, to Eur 133bn. Net of impairments, they grew by 33% to Eur 66bn.
This month, the Italian government flatly admitted that the Eur 8 bn needed to cover the promised
lightening of value added tax (IVA) and property tax (IMU) is impossible to find. If the government
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cannot find the Eur 8 bn for that, how do they plan to retrieve the Eur 90 bn needed to refund
arrears to corporations? Companies are defaulting at an alarming speed in the country, on the back
of a weakening business cycle but also after failure to receive what is owed to them by the
government. In the first quarter, 4200 companies went bust. Default run rate is 43 companies per
Italy has youth unemployment of almost 40%, like in Portugal (whereas in Spain and Greece it is
already 60%). In spite of that, absent adjustment to the currency, the rebalancing across European
countries for Italy to return to a competitive status implies Internal Devaluation in the form of lower
salaries by 30% to 40%. We do not see this happening quietly.
And the internal devaluation might have to be more severe than that, as in the meantime the
EUR has appreciated or remained strong against pretty much any other currency globally: so
much for the ECB balance sheet shrinking in stark contrast to heavily expansionary policies in the US,
Japan and the UK, so much for direct currency manipulation in Switzerland, Denmark, Norway..
Yesterday, after debating for hours, EU finance ministers proved to be aware of the issue by granting
Eur 8 bn for initiatives for Youth Unemployment (much more than initially planned, Van Rompuy
stressed). Considering that there is roughly 5.6 millions of them, that makes 1,429 euros each. Make
no trouble in the streets, go have some fun kids ..
Last week, Berlusconi was sentenced to 7 years in prison and barred from public office for life (the
court of Cassazione has to uphold the conviction for it to become effective). Another key ruling on
tax fraud charges is to be held later in the year. Berlusconi is the supreme leader of one of the two
parties forming the crystal-fragile government grand coalition. He runs the party undisputedly:
without him, there is no party. The party knows this all too well, and is expected to stand by him at all
costs, until the end. Last time around, in December 2012, Berlusconi’s personal affairs upsized the
Monti’s government and sent the country to new elections and market turmoil. Strategically,
Berlusconi may be thinking of shifting gear on EUR-skepticism and become the new Grillo.
Germany must be considering that any deal they cut with Italy on parental controls (fiscal and
budgetary) in exchange for a potential bailout is as durable as the government who signs it off.
Cash now in exchange for commitments later. Germany may not buy into that, neither before the
German elections, nor after that. Surely, Germany has not bought into it thus far, as their exposure
to Target II Eurosystem decreased some Eur 200 bn in the past 9 months, together with lower BTPs
holdings for their private sector. Incidentally, the German supreme court is asked to rule again over
OMTs, which they have never been utilized, before they may be ever utilized.
We see most commentators looking at declining Target II exposure as a sign that tail risks have
receded. We hold the opposite view. Target II is de facto a mutuality feature across the Eurozone,
bundling countries together in risk sharing. It is the equivalent of marital assets in a divorce: take
those away and the breakage costs are lower, way lower. If it was a positive, why then has foreign
ownership of government bonds in Italy and Spain not restarted at all? It stands at less than 30%
now, versus 55% two years ago. Again, less risk sharing than ever before equals lower break costs.
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The market may have forgotten Cyprus. Cyprus laid out the blueprint for the next bail-out/bail-in
of a country in Europe. Contrary to previous statements, yesterday EU finance ministers have
confirmed that Cyprus is indeed a model to be applied to future bailouts: ‘insured deposits under
€100,000 are exempt and uninsured deposits of individuals and small companies are given
preferential status in the bail-in pecking order’. The Eur 1.2 trn depositors in Italy (which actually
complacently increased 7.3% on the year) may realize at some point that they are looking at
Cyprus as their end game, should a crisis arise which demanded a bailout.
A recent must-read Mediobanca research, speaks of a déjà vu of 1992, when a political and macro
crisis forced it to devalue the Lira and exit the EMS.
In summary, not only do we believe the EUR break-up is a real possibility, but we think the
process of dismantling the peg is already unfolding. It may not happen if things change, we need a
catalyst for it not to happen, as opposed to the other way round.
Short-Term Outlook for the Euro
One of the implications of a potential resumption of hostilities in Europe is a strengthening of the
USD vs the EUR in the second half of the year. So far this year, the EUR showed resilience against
most currencies, including the Dollar, for two main factors:
1. The ECB balance sheet was outright shrinking by some Eur 300 bn on repayment of
LTROs, while the money of the OMT operations never really left the vaults of the ECB
(Germany). In stark contrast to the ballooning balance sheets of the BoJ, FED and BoE.
2. Emerging Markets proximity to capitulation forced large repatriation flows into the
Euro, similarly to what happened during the 1997 Asian crisis. The European fund
industry alone is estimated as having placed approx 1trn into Emerging Markets as of
the end of March (versus Eur 400bn in mid 2008). Some of these flows returned home in
tears, driving the EUR stronger in the process.
Going forward, we may finally see a stronger USD over the EUR, as the EUR crisis might flare-up
again , as the recovery may be comparatively stronger in the US, as rates are re-priced higher in
the US while the ECB is still seen debating the possibility for negative nominal rates, as the USD
index is strengthening on commodity weakness.
Euro Break-Up scenario
Back in September 2011 we started writing: ‘the European construct is structurally flawed and going
to be unwound within the next 3-5 years with a 50% probability’. Back in early 2012 we wrote: it may
either come ‘from the bottom, with peripheral Europe’s electorate rebelling to austerity (as we are
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only few months into it and the full wrath of it is still to be seen), or from the top, with Germany’s
electorate (led by Bundesbank’s orthodoxy) rebelling to an assistential model which sees them as the
ultimate sole paymasters, with no clear deal in return’.
In a nutshell, we argued, the basic disease infecting Europe is a cancerous excess level of debt. The
real problem with that is the lack of economic growth, the elephant in the room, exasperated by
fiscal austerity. The most visible vulnerability where it may reach tipping point is unemployment
(particularly youth unemployment). The stage for debt, no growth and high unemployment to kick-
start a European meltdown may be Italy or Spain, the two economies in the Euro-zone which are
too large to fail, too large to save, and also too frail to recover.
The fact that the fear of destruction, either in the form of widespread unemployment, civil
unrest or sequential failures, is preventing the EUR currency peg from being dismantled, must
delay the final extinction of the currency, until such same destruction is to happen anyway under
the squeeze of the overvalued currency, overleverage and current account deficits.
It could and should end up being an orderly dismantling of the Eur currency peg, as it might take
dissolving the currency union to save the European Union.
Multi Equilibria Markets
Euro Break-Up, China Hard Landing, Credit Crunch, Inflation, Default, USD Devaluation are six
strategic scenarios in our road-map for Multi-Equilibria Markets (where the final outcome is hard
to anticipate as it may divert markedly from classical mean reversion: diametrically opposite
scenarios are made equally possible, which deflect vastly from the baseline scenario currently
priced in by markets. As argued extensively in previous Outlooks Nov 2012 and Jan 2012).
“We live through the end of a Keynesian state, as the level of over-leverage is unable to
be dealt with by pure growth. Four decades of credit expansion which followed the end
of Bretton Woods are now coming to an end, as debt metrics are unsustainable 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 central banks 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, 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.
15 | P a g e
- Default Scenario (Real Defaults, sequential failures of corporates/banks/sovereigns across
Europe). Let deleverage unravels, Europe flirts with this option, still.
Opportunity Set: Value Book still flat, Hedging Book active
Our positioning in the portfolio remains broadly unchanged to last month:
1) VALUE BOOK: at present, our Value Book remains pretty flat, as markets remains
toppy despite their recent correction, still too expensive vs fundamentals,
especially now that rates may be on the rise and the Central Bank support shows
the first cracks. The risk of a steeper correction over the summer is there. Our
current small allocation to longs in the Value Book is filled with select Special Sits which
still offer asymmetric returns vs risks in our eyes. We will change our bearish
positioning once the disconnect between the real world and financial markets
tighten from here, as a consequence of market correcting further or fundamentals
improving (we remain skeptical on real growth recovery, as argued extensively, but will
remain open-minded as the situation develops and more data come in). Also, we will
change that stance if markets move side-ways for long enough (which is just
another way to digest their expensiveness, arithmetically equivalent in real terms
to a declining market if inflation is above zero). As argued last month already, we
have been in bubble markets similar to the current ones multiple times in history: 1) the
Credit markets are all too remindful of 2007 (at that time it was Investment Banks
inflating the bubble through leverage, this time it is Central Banks themselves, with
obviously more margin for error, but not infinitively so). 2) The Equity markets, the
Mothership US in primis, are remindful of conditions we have seen already in 2007, but
also in 2000, 1987, 1973, 1929, all followed by market crashes (we gave our take on
technicals/fundamentals for the US market in our previous Outlook on page 11: US
Equities have entered bubble territory). Let alone a sound risk/return policy, as we
observe that there has never been so much risk for so little return, over the last century
(long–only funds and Sharpe Ratio-driven allocators should feel the discomfort). We
suspect that the time for us to reload on long positions might be sometimes in Q4, as by
then the fundamentals might have improved to a level where they are visible, or they
will have stalled (as we suspect) thus forcing the hand of the FED to delay tapering and
a concurrent re-pricing of expectations around it.
2) HEDGING BOOK: on the other end, we currently see most of the opportunities in the
Hedging Book, and we banked on them in the month just past. As the market
misprices the potential for realized volatility to pick up from here and for ‘toppy
markets’ to be ‘gapping markets’ (Gold’s heart attack, Nikkei flash crash, next?). It
makes sense to us to be long volatility in such uncertain markets where rates cannot
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possibly rally any further (and Credit can’t either in any meaningful way), where
investors go long on large margin, where shorts are cleaned out, and where silly talks of
the ‘bondification of equity’ spread around. As early as September 2012, we were early
to say that equities would have been more ‘defensive’ than bonds (‘‘European Equities
Will Jump’ Video), as we migrated our book from High Yields into Equities; riding the
bubble of catch up rallies first (Europe), and Nominal Rallies later in December
2011/January 2012 (US and Japan, currency hedged). We now dump that train too, until
further notice. Our methodology for Fat Tail Risk Hedging Programs should cover
our – currently small - exposure to the Value Book, and over-hedge us enough to
deliver a positive return in the second half of the year, while waiting for better
valuations before we reassess re-loading on longs. Amongst hedging strategies, on
the list of pre-identified scenarios in our Multi-Equilibria Markets roadmap, our top
picks are as follows: short Japanese rates (Inflation & Default Scenario), short Yen
(Inflation & Default Scenario), short Australian Dollar (China Hard Landing Scenario),
Long Interbanking Spreads and Swap Spreads(Renewed Credit Crunch Scenario),
long Currency Pegs (EUR Break-Up Scenario). In terms of instrument selection, we
follow our methodology for eligible instruments with target multipliers on exit higher
than 10X (and as high as 100X): Cheap Optionality first, but also Select Shorts,
Embedded Optionality and Dislocation Hedges.
Finally, we will hold our Monthly Outlook Presentation on the 10
of July in 55 Grosvenor street,
London, where supporting Charts & Data will be displayed for the views rendered here. Please do get
in touch if you wish to participate.
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
55 Grosvenor Street
London, W1K 3HY
Authorised and Regulated by the Financial Conduct Authority (“FCA”)
17 | P a g e
What I liked this month
ITALY: deja’ vu of 1992, when political/macro crisis forced it to devalue Lira and exit EMS Read
CHINA Gambles That A Credit Crunch Can Rein In Shadow Banking Read | Is Shibor Shock Part
Of A Political Battle In China? Read | Chinese monetary policy, with Maoist characteristics Read
Which countries are running the largest government deficits? Japan by far the largest, UK number
4 on the list, US 9. Norway has the largest surplus at 13% of GDP. Read
The Big Picture: Francesco Filia: Japan is a catalyst for other economies – Opalesque Read
Asia's rise -- how and when. Hans Rosling graphs global economic growth since 1858 and predicts the
exact date that India and China will outstrip the US Video
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