1. October 26th 2012
Fasanara Capital | Investment Outlook
1. Short-term, we maintain our view for valuations in Europe to stay
supported into year-end, with the possibility to see further reflation
on compression of countries’ spreads below critical levels
2. Medium-term, we believe the European crisis is likely to flare up
again early on in 2013, under the drive of austerity (from the bottom) or
Germany itself (from the top). France may potentially have become a
catalyst too, and proving to be the casus belli next time around.
3. We observe that Central Banks desperate attempts to remove fat
tail risks in the markets have the unwelcome consequence of making
such events lower in probability (perhaps), more distant in time
(perhaps), but ‘fatter’ in potential outcomes (surely).
Markets in the month of October proved to be resilient and unvolatile to the
point of being soporific, held up by the promise (or under the threat) of open-
ended monetary base manufacturing by Central Bankers the world over. Not
much new news was fed into the markets in the last period, leaving us to
reiterate our short-term view for valuations in Europe to stay supported
into year-end, with the possibility to see a further reflation of risky assets
should there be a further compression of spreads across European
government bonds (our earlier Outlook is attached).
The risk factors to this view are endogenous to Europe’s politics, but we
believe they carry a low potential in the very near term: (1) For one thing,
Spain’s bickering with European authorities over conditionality is hardly going
to be a game changer, when Draghi’s intervention is just a call away. Nor we
believe that heavy brinkmanship will end up to be needed for triggering
adherence to conditionality. It is just fair enough for Spain to keep it as a last
resort measure, enjoying the free ride whilst it lasts, just to activate it promptly

2. at the first real signs of market deterioration (2) Furthermore, Greece seems to
be in no position to harm Europe’s price action in the nearest term. As it now
seems clearer to most, Greece has no chances of surviving much more austerity
from here on, as the political backing for it is hard to imagine, and is therefore
most likely to leave the Euro Area at some point over the next few years. That
said, if Greece were to exit today, a domino effect would be most certain across
peripheral Europe, jeopardizing efforts by policymakers to ring-fence Italy and
Spain and exposing early on Draghi’s great gamble, with potentially un-
repairable damages to his credibility: not a scenario Europe as a whole could
cope with right now. For all these reasons, we are led to believe that Greece may
be stable to rally further in the short term, before a probable reversal of the
trend at some point down the line. (3) Lastly, recent disagreements between
Hollande and Merkel surely carry a bad omen of things to come, but are unlikely
to gain momentum in the imminent future.
All in all, markets seem sedated by monetary expansion and Draghi’s bold
statement in guaranteeing an unlimited supply of paper cash against
troubled government borrowers, should it be required. Such ‘expected
euros’ are playing their magic and it won’t be easy in the short term to take
away the wizardry that came with it. We see two immediate consequences of
this market formation. Firstly, such market resilience may prove useful in
implementing yield enhancement strategies between now and the end of the
year, by implementing tactical longs on dips whilst selling downside risks.
Secondly, if anything, as we mentioned in our previous Outlook, the ‘expected
euros’ of Draghi might prove more effective than the ‘actual dollars’ of Bernanke:
over there, the combination of weak technicals, rich valuations, earnings
revisions and a much debatable recovery (even in the housing sector), let alone
elections, fiscal cliff and debt ceiling hurdles, may concur to create an
underperformance of the US vs Europe in the near term.
In the short term, we believe that markets could accelerate their positive
momentum if they got convinced that Debt Mutualisation had occurred
across Europe, well before the proverbial Euro Bonds (dreamed about by
Hollande) or the budget parental controls (dreamed about by Merkel). We
called it a ‘de facto Debt Mutualisation’ in previous write-ups. That is when
Germany is believed (erroneously, in our eyes) to have become jointly and
severally liable to other big economies in Europe. We believe such illusion

3. might spread, and be endorsed by the markets, should spreads of
peripheral Europe vs Bunds tighten further, perhaps below 250-300 bps
for BTPs and Bonos alike. For instance, should BTPs fall below 300bps spread
to Bunds, the next stop could be 200bps spread, from which level they
skyrocketed in mid-2011 (see chart) with a 100 points jump - at which point
equity markets were 20% higher.
However, we believe the calm in the markets is deceptive and temporary, it
comes at high hidden costs, downside risks and unintended consequences,
and as such is paving the way for a resumption of hostilities into next year.
Critically, recent macro releases globally have pointed to negative territory, in
particular new orders and activity data (charts). Medium-term, we believe the
European crisis is likely to flare up again early on in 2013, under the
weight of one of two polar-opposite factors: (1) From the bottom, with
peripheral Europe’s electorate rebelling to austerity, as we are only few months
into it and the full wrath of it is still to be seen, possibly six months from now, or
(2) 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.
Paradoxically, thinking about the ‘remote’ possibility of Germany
unplugging from Europe, we come to think that the latest developments in
Europe have only made such potential exit somewhat ‘less remote’, in the
last couple of months. In fact, the ‘expected euros’ promised by Draghi, well
before being actually spent, have already managed to stop the hemorrhage of
German exposure to the Eurosystem via TargetII, one of the few true
mutuality feature of monetary policy construct in the continent. A few
months ago, that figure presented a bold number ascenting at staggering speed,
on his way to cross the 1trn mark and counting by the end of the year, and in our
Outlooks we were suspecting something somewhere would have been devised to
stop that dangerous ascent (as we held doubts as to the real willingness of
Germany to become effectively and unquestionably liable to peripheral Europe
all too quickly). Today, such number is down by 50bn at 700bn (after the biggest
monthly decline of his history - we could title), having bottomed up on the re-
pricing of risk across peripheral Europe and related pause in deposit outflows
(link). Such number is important, as it reflects the one single largest component
of German upfront loss, should it leave the currency peg at any given point in

4. time. It will be a different story and a different calculation when ‘expected euros’
turn into ‘actual euros’ on Draghi unleashing actual bond buying, but that
moment has yet to arrive. For now, in the last two months, German net
exposure to peripheral Europe has gone down, markedly, instead of rising
further to the point of no return. Risk sharing across Europe is now less than it
was two months ago.
As far as the risks posed to the markets from peripheral Europe, we would like to
observe that France may have well joined Italy and Spain in the
consortium, and may well prove European markets’s new casus belli next
time around. The fragility of French asset prices is a result of rich valuations to
start with (unfairly close to German levels), coupled with a still heavy foreign
ownership of negotiable government debt (around 65%), heaviest public
expenditures on GDP across Europe (at 56%, well above anybody else including
Greece), a damaging fiscal tightening on his way (ill-conceived tax charges on
capital gains scaring off hot money capital), and a re-pricing of the loss of
political unity to Germany. As such, for the tactical part of our portfolio, we are
analyzing ways to implement barbell strategies involving Germany-France-
Italy: we believe Italy might outperform France in both a risk-on market
environment in the months ahead (tightening more), and a risk off-one
(widening less).
In the long-term, whist we witness the progressive exhaustion of policy tools
available to monetary and fiscal agents, we reaffirm our outlook for Multi-
Equilibria markets, as we see the market diverging from mean-reversion to
settle at a different equilibrium on hitting Fat Tail scenarios in the next five
years. It is what we called ‘Phase III: Bursting of the Bubble’ in our write-ups in
the last few months. We observe that Central Banks desperate attempt to
remove fat tail risks in the markets has the unwelcome consequence of
making such events lower in probability (perhaps), more distant in time
(perhaps), but ‘fatter’ in potential outcomes (surely). The bubble is inflated
further to a level where the stakes are way larger than ever before. As such, a
sound risk management policy calls for Contingency Arrangements to be added
to prudent portfolios. At Fasanara Capital, we harvest such hedging
arrangements and cheap optionality methodically, for them to represent growing
percentages of the investment portfolio, through our Fat Tail Risk Hedging
Programs. We believe such arrangements are nowhere to be seen in portfolios

5. these days, in any meaningful amount; if they were, we would see it reflected in
the pricing of such hedges. On the contrary, some portfolios seek a defensive
stance by leaning more into cash or real assets, which is just fine but fails to
capture the opportunity of cheap hedging currently offered by the markets
(courtesy of Central Bankers, mainly). Also, some other portfolios misinterpret a
defensive stance by leaning more than normal into government bonds, which
may prove delusional and expose to large losses on maturity extensions should
yields rise (as we expect) at some point down the road. The one opportunity
which very few seem to take advantage of (otherwise we would see such
flows reflected in more expensive market pricing) is the availability of
Cheap Optionality through Risk Premia. The availability of such hedges is
made possible by monetary agents themselves, as it is a direct consequence
of the financial repression environment we live in, zero-interest rate
policy, currency manipulation and high cross-assets correlation.
In particular, we see six scenarios playing out in the few years ahead of us (some
of which are mutually exclusive or may happen in succession): Inflation
Scenario (Currency Debasement, Debt Monetisation, Nominal Defaults), Default
Scenario (Real Defaults, sequential failures of corporates/banks/sovereigns
across Europe), Renewed Credit Crunch (similar to end-2008, end-2011 or
mid-2012), EU Break-Up (either coming from Germany or peripheral Europe),
China Hard Landing, USD Devaluation.
Let us take the opportunity of this Outlook to explain our argument in further
details. So far, money printing failed to re-ignite growth in the debt-laden
economy. The excessive level of debt in the industry, although now partly
transferred from the private to the public sector, serves as a huge drag on
growth. Increasing the level of debt further through balance sheet
expansion – as the sole crisis intervention policy - is hardly a cure, and
risks to make the drag bigger and bigger, and the growth more and more
unlikely, in a self-defeating vicious circle. Money do not grow on trees, and
the debt is not going anywhere, it stays in the system. The IMF foresees
European banks deleveraging by 4.5trn in the years to come. A staggering
amount, and one which could offset the incendiary inflation effects of the money
printing in the making in Europe. However, it is less obvious the price at which
these assets will change hands. It occurs to us that very little will be achieved if
such stock is transferred at close to par, at current bubble levels, as it seems to

6. be in the intention of the selling agents (it is worthwhile reminding ourselves of
banks having utilized all tricks at their disposal to hide the real magnitude of
NPLs on their books, under the complicity of Central Bankers and regulators).
The drag on growth would stay, in that scenario, and the economy in Europe will
follow the baseline scenario of a Japan-style multi-year slow deleverage. The
rebalancing would then happen purely through moderate inflation, eating slowly
into the stock of debt (a 2% inflation YoY annihilates 70% of the level of debt
over a lifetime). Also, again by the IMF, we are warned about the danger of fiscal
tightening and austerity, as they point out that “fiscal multipliers” might be
significantly larger than governments assumed in conducting austerity
programs. Assumption was 0.5. Instead, multipliers up to 1.7 suggest that,
counter-intuitively, fiscal tightening could even end up worsening a country’s
fiscal position: ‘sharp expenditure cutbacks or tax increases can set off vicious
cycles of falling activity and rising debt ratios’ (Underestimating Fiscal
Multipliers?). Here again, we are left with a more than proportional drag on
growth and, consequently, a slower process of deleverage in the years to come.
Now then, the multi-year Japan-style deleverage is perhaps the most
probable scenario, perhaps the luckiest one for Europe, but still it is hardly
a scenario we should give for granted, hardly a scenario with a probability
close to par. Absent a crystal-ball, it is arduous to determine where else we
could be heading from here, and that is why we refer to Multi Equilibria markets,
as we see more than one potential endgame for European matters. In an
attempt to simplify the tree of potential outcomes, we see two driving
forces who could spoil the party and derail the Japan-style slow deleverage,
which point in exact opposite directions:
• Default Scenario: Real Defaults, Haircuts & Restructuring, potential
Euro break-up as a by-product. In this state of the world, money
printing failed to achieve any result in terms of manufacturing growth in
the real economy (as measured by productivity / real GDP / industrial
production /real wages and output growth), and can claim victory just on
removing the tail risk from the banking sector, temporarily. Temporarily..
as the political backing for austerity and debt mutualisation fades away,
and with it the ability to pour more base money into the financial veins of
the system. What happens is that EUR holders and taxpayers realize and
rebel against the implicit transfer of wealth that money printing

7. represents, from producers, savers and them into the banking sectors,
bondholders and the well-off. Money printing slows, or stops outright,
the oxygen mask is removed and the patient dies of overleverage-induced
suffocation. Amongst other potential catalysts, history teaches us that bad
things happen when a “bubble economy” is held on the thin air created by
Central Banks’ liquidity injections and tightening conditions result in
higher rates.
• Conversely, we see an equal chance of going through the opposite
scenario, an Inflation Scenario: Nominal Defaults, Debt Monetisation,
Currency Debasement. In this state of the world, money printing failed
to achieve any result in terms of manufacturing growth in the real
economy (as measured by productivity / real GDP / industrial production
/real wages and output growth), and can claim victory just on removing
the tail risk from the banking sector, temporarily. Temporarily.. as the
heavy money printing finally erupts into higher inflation. So far, the
incendiary effects of massive balance sheet expansion by Central Banks
have been counterbalanced by the slow deleverage undergoing in the
system, helped in the process by a broken transmission system where the
‘money multiplier’ is at his historical lows (as a result of an historical
30-year trend, which was accelerated in the last few years by banks – and
corporates too - amassing excess reserves twenty times larger than
historical averages), and finally the ‘velocity of money’ at rock-bottom
levels. But both macroeconomics measures can quickly change their
trajectory, at some point, and the ability of Central Bankers to stop
them running their course then is highly overestimated. Indeed,
Central Banks have lost much of their ability to implement standard anti-
inflationary policies, as it transpires from looking at minimum reserves,
excess short-term deposit vs short-term lending, non-sensitive assets vs
excess deposits, corporates cash.
In a nutshell, the base case scenario of a stagnant economy may continue to
be the most plausible scenario as Central Bankers keep flooding the system
with enough liquidity. Under such scenario, a disorderly deleverage would
be avoided and inflation would not be triggered, at least for now, until this
delicate equilibrium breaks on either sides.

8. Portfolio Roadmap
Our personal roadmap to successfully riding current financial markets is based
on the following portfolio guidelines:
- Keep the Dry Powder, on a slim and nimble liquid portfolio,
heavily under-invested
- Accumulate nominal returns, on safe senior-secured short-dated
corporate exposure from northern Europe (Value Investment
section of the portfolio).
- Unload it fast on triggering target IRRs and meeting Carry
Accumulation plans. We are now unloading, indeed, and reloading
on select stocks with most similar characteristics to senior secured
exposure.
- Amass large quantities of long-only long-expiry heavily-
asymmetric profiles to insure and over-hedge against pre-
identified Fat Tail Scenarios. Accumulate a treasury of optionality
over time, banking on system-wide dislocations and mis-pricings
(across its four dimensions of Cheap Optionality, Select Shorts,
Embedded Options and Dislocation Hedges)
- Follow methodically and meticulously the list of pre-identified Fat
Tail Scenarios and match it to the list of pre-identified Eligible
Instruments (Fat Tail Risk Hedging Programs section of the
portfolio)
From here, on this construct, two outcomes are we prepared for:
- Pitfalls in Europe on the way to restoring imbalances due to
under-execution of austerity programs, and ‘adjustment fatigues’,
leading to the possibility of steep market corrections and the
chance for us to reload fast on the Value Investing part of the
portfolio, at cheaper, safer and more sustainable valuations
(acceleration of the ramp up of the portfolio)
- Fast forward to Tail Events: best case scenario for our strategy

9. What I liked this month
France and Hollande: French business erupts in fury against "disastrous"
Hollande Read
What makes this economic recovery so difficult for the US consumer:
relative to previous recessions, growth in disposable income has been horrible
Read
China's shale gas industry: for China, the deal offers another geopolitical
hedge—the opportunity to turn dollar-denominated treasury bills into real
energy assets. Read
Mortgage REITs business case under pressure: with lower interest income
and higher interest expense, the equity of these portfolios is expected to
generate lower returns (ROE) going forward, making these investments less
attractive Read
Europe’s Path to Disunity: Hans-Werner Sinn, President of the Ifo Institute for
Economic Research Read
W-End Readings
Securities lending insight: cost of short selling is top performing factor :
since January 2007, the cost of shorting is the best in Europe of all factors, with a
high and consistent return trumping conventional classics like operating cash
flow ratios. This note debunks various myths surrounding short selling alpha. As
one might expect, the most expensive to short shares are the ones that fall
the most. But notice that being long or overweight the least shorted stocks
also makes money. With the exception of the second quarter of 2009 when the
so called ‘junk rally’ saw a stimulus spirited fight back from highly shorted
shares, the most borrowed companies have fallen in price almost every month
since then. Read
Sharp declines in equity correlations should improve alpha generation Chart
Interesting Reading: so many numbers, so little time Read

10. Reinhart/Rogoff on the US recovery: sluggish vs most recessions. But relative
to systemic crises, it is pretty remarkable Read
U.S. Unemployment Hurdle for Housing Video
Agriculture: "Why I Learned To Trade Less And Love The Farm" Video
Japan’s very own fiscal cliff Read
Deflation vs Inflation: some educated thoughts for deleverage to prevail Read
WEIMAR: The Hyperinflation Horror Story That Haunts Europe Today Read
Bundesbank slashed London gold holdings in mystery move Read
Interesting perspective on Apple and its supply chain Read
U.S. Debt Lags Only Three Government Defaults Video
The Top 15 Economic 'Truth' Documentaries Video
Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
16 Berkeley Street, London, W1J 8DZ, London
Authorised and Regulated by the Financial Services Authority

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