October 5th 2012Fasanara Capital | Investment Outlook 1. Short-term, we believe markets will be supported well into year-end by open ended Central Banks activism, which we expect to outweigh the downside risks arising from Greece, Spain and the likes. 2. Upon some concessions to the ECB over conditionality, at some point an attempt will be made to compress spreads further for peripheral Europe into a level which would trigger further sizeable reflation across financial assets (e.g. to sub 300bps for spreads of 10yr BTPs vs Bunds). 3. Recent market weakness was likely driven by quarter-end profit taking, as investors rushed to crystallize a positive performance for the period. From here, we expect the market to be more supported on Central Bank’s natural floor on valuations, in volatile range trading with an upward drift bias, allowing for short-term tactical yield-enhancement strategies. 4. Longer-term, we intend to capitalize on the fictitiously sustained valuations and rock-bottom Risk Premia to amass cheap optionality on the six pre-identified Fat Tail scenarios we anticipate in the few years ahead, under our Multi-Equilibria market outlookIn our last write-up we detailed the outlook over the short term, the medium term andthe long term horizon. In a nutshell, in the short-term we believe markets should beable to reflate further on Central Banks’ liquidity or under the threat of theirintervention, which should serve as a natural floor of some sort to the markets.Medium-term, possibly not earlier than next year, we see the fundamentallyimpaired markets and economy to show vulnerability to one of two polar forces:from the top, German taxpayers rebelling to subsidies, or from the bottom, withperipheral Europe’s taxpayers rebelling to austerity. Longer-term, we expect themarkets to reneging on Mean Reversion, under our Multi-Equilibria theory, and a decentprobability for them to implode in either a Default Scenario (real defaults) or hispolar opposite of an Inflation Scenario (nominal defaults). For a more detailedrendering of each scenario please refer to the link attached.
In this brief Outlook, we would just like to add a few elements to our short-term view.Over the past fortnight, in our eyes, the market weakness is to be attributed to thequarter end and investors rushing on the opportunity to close a positive period in arocky year. From now on, and possibly into year end, we suspect the markets mightrespond to the Central Bank liquidity in reflating further, although with hiccups andvolatility along the way. The trigger for a more sustained rally might derive fromfurther compression of government bonds spreads for peripheral Europe,relieving tail risk on investors’ mind. Central Bank liquidity acts from various fronts,from the ‘top real dollars’ spent monthly by the FED to the ‘hypothetical euros’ theECB is willing to spend, upon concessions over conditionality and budgetary controls bymoney recipients. Counter-intuitively, we would not be surprised to see ECB’s‘expected euros’ proving to be more impactful than FED’s ‘actual dollars’, over theshort term. Not only because the FED is at his third round of a flawed interventionpolicy, whose diminishing returns are more and more evident. But also due to shortterm noise from elections, discussions over debt ceiling and fiscal cliff, and peak-ishvaluations (pre-Lehman levels) on record profit margins.In Europe, we expect an agreement over conditionality to be reached, and withoutthe need for dramatic price action to trigger it. The ECB cannot transform ‘expectedeuros’ into ‘actual euros’ whilst unleashing its OMT operations with no strings attached.That would be the one single biggest misstep paving the way for Germanyunplugging from Europe’s assistential model, on realization that Weidmann’s stancewas indeed insightful. Draghi’s boldness in front-running inactive fiscal agents, riskingthe Bundesbank’s anger in offering unlimited paper cash against troubled assets, is notto be wasted too quickly too blatantly, as the immediate loss of credibility would be fatalto the European fragile construct. We believe Spain, and surely Italy, know that best andwill succumb to soft brinkmanship policy by the ECB with no need for tragedy. Whichleads us to believe that the then top euros spent by the ECB will attempt first atcompressing yields and spreads to Germany quickly to a level which would likely triggera significant reflation over all asset classes in Europe in the few months ahead. Shouldspreads of BTPs to Bunds be manipulated to below 300bps, for example, it islikely for the markets to re-price positively in anticipation of a de facto DebtMutualisation across Europe. To be sure, to us, for what is worth, such interpretationwill be erroneous or premature, but we can see the market taking that view for a while,in the short term outlook, until further notice from the real economy (for those whohave read us before, we are in what we called ‘Phase II: Reflation following newintervention’, which is to be followed by ‘Phase III: Bursting of the Bubble’).In the medium term, as extensively explained in previous write-ups, austerity willpress its grip on the largest economies in peripheral Europe, with evident
potential consequences. Such economies have so far only tasted the preliminaryflavours of austerity, but we are 6 to 12 months away from it exercising its full wrath.Greece’s sequencing comes handy in detecting timing and inflection points forSpain and Italy. Germany’s support itself is at risk in the medium term: if current‘expected euros’ together with the first ’real euros’ spent were to fail to kick-start theeconomy and build quickly on the positive momentum, then we can see Germanyopenly opposing or unplugging outright, as we believe the numbers still support suchturnaround, as of late (please refer to previous Outlooks for our calculations over thismatter).In the long term, after such an overdose of credit expansion, we shall look at thepatient and see if any productivity / real GDP / industrial production /real wagesand output growth was engineered out of all of it, or whether the ‘debt overhangwithout growth’ is still there and way bigger than before, without any morehumanly-devisable monetary treatments to dispose of. At that point, the baselinescenario of a Japan-style multi-year slow deleverage, could leave the stage for what wecalled Multi-Equilibria markets, under which the market finds its new equilibrium in acompletely different place than where mean-reversion would suggest. Without boringwho has read us before, for easiness of understanding and at the risk of oversimplifying,our six strategic long-term scenarios are the following: Inflation Scenario, DefaultScenario, Renewed Credit Crunch, EU Break-Up, China Hard Landing, USDDevaluation.Let us clarify our thoughts for the long run. We do not position for Fat Tailevents and pay for Contingency Arrangements because we expect theEuropean construct to surely implode and imminently so. We do it becauseit may happen. Because stuff happens. That is why you take out insurance. Andwe do it because, in this instance, insurance is absurdly cheap, undervaluedand mispriced, by virtue of the same Central Banks’ actions and theirdesperation to compress insurance premiums themselves in an attempt todemonstrate that tail risks have been removed outright and all bets on it are off.It reminds us of the price of wanna-be AAA paper during the credit bubblefew years ago, under the sign-off of bullet-proof Rating Agenciescalculations. At that time too, shorting credit was made inexpensive. Timing forthe bubble to burst was uncertain, as it is now, but inexpensive means that it didnot matter that much after all. This time around, it is not the InvestmentBanks pushing credit into unsustainable territory but the Central Banksthemselves - with obviously more margin for error, but not infinitely so.True, the deleverage which has taken place in between provides for some
cushion, but such leeway is rapidly evaporating and leaves us in a similarsituation to then, using the same flawed remedies whilst hoping for a differentoutcome.The by-product of their acts is a cheapening of insurance premium themselves,to levels where it is made inexpensive to position for such tail events, in a self-financing way, despite low yield environments on the long only side of theportfolio. In a way, compression of risk premia, the demise of volatility, theincrease in correlation across asset classes helps counterbalance a low yieldenvironment and low carry at hand to finance cheap proxy options, leaving uswith heavily asymmetric profiles and large positive convexity.The reason why we position for Fat Tail events is also because we knowthat the experimental Central Bank policy has a chance of success nowherenear par. Central Banks themselves have upped the stakes to un-precedentlevels for peacetime finance history and have no way to be in safe control ofthe unintended consequences of their bold moves. Money don’t grow ontrees, balance sheet is itself a finite resource, it is not cost-free and surelynot risk-free. Rephrased: “‘none of us really know why the economy hasperformed so poorly, why the tools we have been putting at work didn’t work,and by the way none of us has ever been here before as central bankers…how weare gonna come back…we have the theoretical tools but we have never been herebefore, neither the ECB has’’. It is not us talking but the Federal Reserve Bank ofDallas President Richard Fisher.Opportunity SetCertainly, the right-tail event “Inflation Scenario’, included in our list of sixscenarios (under our Fat Tail Risk Hedging Programs) is today made more probableby the combined actions of the ECB and the FED. The firm commitment to pursueDebt Monetization and interest rates rigging through open-ended balance-sheetexpansion and negative real rates, may result in disorderly/unsterilised actions andprovoke heavy Currency Debasement, at some point along the way.Despite the fact that an Inflation Scenario is today made more probable, its risingprobability is all but reflected by the markets. If anything, it is price in as lessprobable than the day before. The same indicators that should price and reflect it are
indeed compressed by CB’s activism and their objective of crushing volatility andcompressing Risk Premia (Draghi spoke of the ‘Convertibility Premium’ for Spain as if itwas a disease, instead of a fair reflection of risk). Critically, such premia are one of thevery few ways, at least in trade-able instruments, to protect oneself from the unintendedconsequences of current policies. Resulting in the greatest value opportunity of all,which is to amass such effectively Cheap Optionality to hedge (and over-hedge)the portfolio for the years to come.More generally, as previously argued, Risk Premia are nowhere near where they oughtto be should one factor in the even vague possibility of partially failing European policymaking. Our leit-motiv remains to take advantage of current market manipulationand compressed Risk Premia to amass large quantities of (therefore cheap)hedges and Contingency Arrangements , thus balancing the portfolio against therisk of hitting Fat Tail events in the years to come. If we do not hit them, then great,it will be the easiest catalyst to us hitting the target IRR on the value investment portionof our portfolio (what we call Safe Haven, or Carry Generator). If we do hit one of thosepre-identified low-probability high-impact scenarios, then cheap hedges will kick in forheavily asymmetric profiles (we typically targets long only/long expiry positions with10X to 100X multipliers). Such multipliers are courtesy of market manipulation and‘interest rate rigging’ provided for by Central Bankers. Look no further than that, aswe believe that they represent the only truly Distressed Opportunity right now inEurope. Timing-wise, the next 6 months may provide the most interesting windowof opportunity. Beyond that, perhaps within 18 months, that may be the next mostcrowded trade.Portfolio UpdateMoney printing has pushed the price of the senior secured paper we hold tobubble levels. Thank-you Central Banks. In a way, the fundamentals of our investedcompanies deteriorated less than the fundamentals of the Central Banks’ balance sheets,resulting in higher prices for our paper. We now have almost no paper left sub-par.The risk of MTM volatility has risen with the rise in current prices, and we consequentlynow effectively face downside risks-only going forward, as any potential furtherappreciation on lower discount rates is limited. We are therefore forced into takingprofits, reduce positions, and getting even more under-invested.Getting lower in the credit quality scale is not an option. At some point that same papermay become the best short out there. At a time where Central Banks monetize everysovereign risk asset onto their balance sheet (reducing the amount of quality
collateral available), you want to short first something that has less of a chance ofbeing monetized, outright or in relative value, if you can minimize negative carry.Senior paper has been a pillar of our portfolio since the beginning of the year. Atcurrent rates, let alone few special sits, we may have to look beyond that andmove away from it, at least in part. With open-ended easy credit, also the classicaldistressed opportunity executed via fire-sales of portfolio is postponed to a laterdate to be defined. Should Japan be any guide to European matters, with his stagnationand mild stagflation, then we eye certain equities and certain commodities for theCash Generator portion of our portfolio, together with more active yield enhancementstrategies.But, as we repeated ad nauseam, in our eyes the real opportunity, the truly distressedopportunity in Europe right now is FTRHPs. The classical Value investmentopportunities into long-only bonds or equities, when adjusted for risk, at such anemicreturns, is hardly a smart trade. It might still perform (and we would miss that rally),but as a bold high-octane strategy. We try to be more prudent than that.On the scenario of China hard landing, we took all profits and closed positions, forthe time being. Although we still believe in the idea (which is confirmed by data onTaiwan exports, Shipping and Mining flows), and have been proven right by the marketsin the first half of 2012, we currently witness heavy money supply and China itselfrestarting fixed investment to stimulate the economy (building totally nonsenseovercapacity, but nobody seems to care). In a way, recent scandals there may createmore of a case for the opportunity of additional monetary stimulus. We expect a shortterm rebound there. If it materialize, we would like to reinstate positions, this timeexpanding the scope to the Australian dollar, the banking sector in Australia, and theLuxury industry, in addition to Shipping, Mining and the likes.Portfolio RoadmapOur personal roadmap to successfully riding current financial markets is based on thefollowing 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 strategyWhat I liked this weekFrance facing double-dip recession ReadAnother domino falls as Hollande pushes France into depression - Telegraph Read
The truth about current inflation stats. Shadow statistics reflect estimate of inflationfor today as if it were calculated the same way it was in 1990 ReadWhat the Feds Historic Bet Means for You – El Erian ReadW-End ReadingsFasanara Capital Interview on CNBC VideoWith Banks Skittish, Europe’s Private Equity Firms Look Elsewhere ReadFeds policy is not going achieve projected unemployment levels ReadDefecting Iranian cameraman brings CIA priceless film of secret nuclear sites ReadDealing with financial systemic risk: BIS Working PaperCurrency intervention and global portfolio balance effect: Japanese lessonsWorking PaperChina: “Sales are down because no-one knows who to bribe.” ReadFrancesco FiliaCEO & CIO of Fasanara Capital ltd
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