Fasanara Capital | Investment Outlook March 2012

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  • 1. March 2nd 2012Fasanara Capital | March Investment OutlookInvestment OutlookWith a €530bn ($700bn) of liquidity injection, the LTRO2 came out on the safe side ofexpectations and at a powerful enough level to not command an immediate setback ofthe market risk rally. Such credit expansion equated to more than €300bn of fresh newliquidity, after deducting roll-overs of old shorter-dated loans (and €500bn in total addingup LTRO1). As anticipated, we believe the current rally will likely be tested in the next fewweeks, now that LTRO2 is past us, maybe sometime around option expiry in mid-March(which would somehow coincide with the 20th March Greek maturity and its residual risk).The guesswork plan of the ECB is clear and moving along steadily and dangerously: buyingtime for an insolvent banking industry, who in turn can support over-levered Sovereignswith contracting economies (indeed, the funding gap of European banks is now effectivelypre-funded to 2014, who can now then dial up their risk tolerance on carry trades ongovernment bonds, amassing local country risk), in an attempt to inflate their way out of thecrisis via nominal debt monetization (as Sterilization is debatable) and extremelyaccommodative monetary stance over an extended period of time (artificially driving RealRates to negative territory). Meanwhile, in the hopes of the ECB, banks will have engineeredan orderly deleverage, will have resumed lending to each other and to the real economy,whilst fiscal agents will have provided for fiscal firewalls (recent policymakers’ talks of ESMcombined with EFSF, and more), and will have imposed austerity on peripheral countries soas to determine Internal Devaluation and Deflation, restoration of competitiveness,realignment of External Imbalances within Europe within the next five years or so (assumingthat multi-year economic contraction is politically acceptable and does not derail againstsocial unrest). But the policy plan comes at a massive price tag, unheard of for apeacetime economy: past LTRO2 (and before a possible LTRO3), the ECB owns already some€1.3trn of peripheral bonds or loans (if one combines asset purchases and repos) and a totalbalance sheet of over €3trn (more than 30% of GDP).Our long-term view remains on course, as we believe the case for being (i) broadlydefensive, (ii) for preferring collateralized or secured exposures to any expendable degree,
  • 2. (iii) and macro hedges all along (select shorts and cheap hedges) is a genuine one, evenmore so now that the stake has been raised on the ECB’s gamble. We have arguedextensively on that in previous Outlooks so we won’t go into details. Suffice it to say thatmoney multiplier is still contracting (past LTRO2 deposits at the ECB are now almost 300bnhigher at close to 780bn, where we fear they might station), money aggregate M1 depositsin peripheral countries is compressing fast (at current rates, it might top 25% in Greece, and16% in Italy, 18% in Ireland and Portugal, annualized), private sector loans and consumercredit in a downward spiral, household deposit on a steep rise.To clarify our thinking, we may differentiate between three scenarios for the next few years,in what we called earlier on Multiple Equilibria markets: ‘’as opposed to reverting to pre-crisis mean and equilibrium, the dust in the markets could settle in diametrically differentways and find a different equilibrium there. (1) The base case scenario remains one of astagnant market and economic environment, with anemic expected returns, volatilerange-bound trading and sudden shocks pushing them lower (Stagnant Volatile Scenario).Such stagnant fragile economy could take, at some point over the course of 2012 or beyond,one of two directions: (2) Inflation Scenario, money printing gets truly massive, Draghi findspolitical support to implement decisive Fisher-Friedman monetary stimulus (beyond LTRO3,more direct assets purchase programs, target high nominal GDP, Zero Nominal Rates, morenegative Real Rates) and therefore finally manages to bring inflation in, markets inflate theirway to higher output, economy expands, employment recovers, debt returns sustainable,confidence is restored, then possibly currency debasement and potentially high/hyperinflation, orderly or disorderly. (3) Defaults Scenario, money printing fails, few Banks inreceivership/restructured/nationalized/merged, few Sovereigns restructure/devalue,possibly Eur break-up or reshapes, orderly or disorderly. All legitimate scenarios, notnecessarily mutually exclusive, each with decent probability (although the last twoscenarios are far from being priced in, therefore relatively cheaply hedge-able).’’Critically, in ten years from now, looking back at Europe’s multiple choice and itsattempted solutions, such scenarios may not look so far apart, in forward value terms. AnInflation Scenario, where negative real rates and QE-type intervention helps inflate one’sway out of nominal debt, is effectively just another form of Default Scenario. Whether thedebt is not paid back in full or whether its real value is eroded by inflation does not make ahuge difference to most investors. Inflation destroys the value of fixed income claims assurely as default. The attached BIS paper gives a clear illustration of the illusion of unlimitedintervention.
  • 3. Opportunity SetThe current risk on rally pushed levels to a point where it is made easier and cheaper tohedge against select negative scenarios, both through Select Shorts or Cheap Hedges (FatTail Risk Hedging Programs). The scenarios that may be targeted, at different probabilities(for how low they may be) and costs, range from (i) Renewed Sovereign woes, (ii) RenewedCredit Crunch and stress in the Banking industry/HY/Lev Loans, (iii) Default Scenario(sequential failures and exit from EU of certain countries), (iv) Inflation Scenario (as a resultof monetary expansion getting out of control, or even Defaults and derailing fiscal trainwreck), (v) China hard landing, (vi) US Dollar Devaluation. Such scenarios have still lowprobability, all of them, in absolute terms, but such probability was never higher than it istoday.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), until the market emerge from itsdirection-less status and the sky at the horizon is clearer, whilst simultaneously (ii)equipping ourselves with the cheapest hedging programs available, at various points intime, which are reasonably expected to let us endure as large a number of negativescenarios as we can expense.
  • 4. What I liked this weekECBs Draghi raises the stakes with trillion euro gamble MoreGreece: CDS trigger More. Will the Greece CDS auction be ‘fair’? More. Juncker Says There IsA "Plan B" If Greek Debt Swap Fails MoreChina Dumps $100+ Billion In USTs In December More and MoreSpains public deficit was 8.51% of GDP... 2.5% higher than the target agreed with theEuropean Commission MoreW-End ReadingsGoogle Search trends: (i) German people are becoming increasingly aware of and likelyconcerned with TARGET2 imbalances More (ii) The public and the markets have dismissedthe Greece related risks, focusing instead on Iran, oil, and gasoline prices MoreQuantitative Easing and Money Growth: Potential for Higher Inflation? Federal ReserveBank of St. Louis Economic Synopses. MoreBIS database banking statistics gather quarterly data on international financial claims andliabilities of bank offices MoreDiamandis makes a case for optimism -- that well invent, innovate and create ways to solvethe challenges that loom over us Video
  • 5. 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 the factof its distribution form the basis of or be relied on in connection with any contract. Interests in any investmentfunds managed by New Co will be offered and sold only pursuant to the prospectus [offering memorandum]relating to such funds. An investment in any Fasanara Capital Limited investment fund carries a high degree ofrisk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any steps to ensure that thesecurities referred to in this document are suitable for any particular investor and no assurance can be giventhat the stated investment objectives will be achieved. Fasanara Capital Limited may, to the extent permittedby law, act upon or use the information or opinions presented herein, or the research or analysis on which it isbased, before the material is published. Fasanara Capital Limited [and its] personnel may have, or have had,investments in these securities. The law may restrict distribution of this document in certain jurisdictions,therefore, persons into whose possession this document comes should inform themselves about and observeany such restrictions.”