2. April 5th 2013
Fasanara Capital | Investment Outlook
1. Cyprus and Italy are two major political debacles that bear important
ramifications for the market at large in the months ahead. Policymaking
resembling a dancing elephant in a crystal store
2. Irrationality in political behavior took center-stage and is perhaps here to
stay. With it, the scope for policy mistakes is today bigger than before
3. We may be past the peak of political cohesiveness and coordinated
actions. Things complicate from here, on the back of offensive competitive
devaluations globally and policy mistakes regionally
4. Strategy-wise, realised volatility in politics and markets alike may be set
to rise from here, from the rock-bottom levels where it has been confined
so far by political cohesiveness and financial repression
5. Short Term Strategy: downside risks are so evident that we should
prepare for a reflation trade in optional format, no cash longs
6. European Long-Term Strategy: the need for hedging against a Euro
Break-Up scenario
7. Global Long-Term Strategy: the need for adapting to and hedging against
Multi Equilibria Markets
8. Paradigm shift in the markets and the need for unconventional portfolio
management tools
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3. Since our last write-up a month ago, two major European political debacles have
taken center-stage and bear important ramifications for the market at large in the
months ahead: (i) the inglorious handling of the political stalemate in Italy, and
(ii) the disastrous handling of the anticipated Cyprus restructuring. We will look at
each one briefly, highlighting what we see as the critical elements that emerged from
each, as they bear consequences for our Outlook and Strategy further down.
Italy provided first for some self-inflicted pain. The inconclusive elections of 24h-
25th of February were a shocking political result, but pain and panic could have been
sedated in short order by pursuing the one and only logical solution to the impasse: the
elections delivered three winners in roughly equal amounts (which equates to three
equally losers), two of which are conservative parties and one is a revolutionary party.
In no rocket science, the two conservatives parties were supposed to find a compromise
of sort, to preserve the political activity - and themselves from extinction in between. As
coming back to elections would pose the risk of landslide victory for the revolutionary
party. And indeed a compromise is what they reached already a year ago or so when a
closure of funding markets was driving the country head on into a liquidity crunch.
Logic would have led to such conclusion, although still after a few weeks of bargaining
and volatility. Logic was dismissed outright, however, as political deadlines have gone
by and a compromise is still to be found, whilst playing Russian roulette with the
markets and risking to crash test into yet another turmoil. Such compromise might still
materialize, and a relief rally might spur out of it, but the road to such resolution was
and is reckless and irrational. All in all, the handling of the impasse was irrational and
emotional, and not one driven by logical assessment of benefits vs costs, neither
economical nor political ones.
Cyprus provided then for some more illogical behavior. Whereas Italy was a
stumbling block taking policymakers by surprise, Cyprus’ restructuring was on
everybody’s calendar. Cyprus was in the cards ever since Greece re-restructured last
year, by means of heavy PSI, thus devastating the asset side of most banks on the Island
(for an amount equivalent to 25% of Cyprus’ GDP), which were overleveraged to the
tune of 700% of GDP, most of which relied critically on hot money flows of wealthy
foreigners. Given the troublesome economic landscape in Europe, the crystal-fragile
financial conditions across the continent, and the addendum of uncertainties in Italy of
late, Cyprus’ restructuring was supposed to be something short of a walk in the park. To
put things into context, Cyprus is a tiny rock in the Mediterranean, population of 1mn
people, counting for 0.3% of Europe’s GDP, and the capital shortfall was just Eur
5.8bn: Cyprus was no place to create volatility, animosity, and most importantly
bad precedents for Europe at large. Yet still, it took 10 days to come to a resolution,
and in between we learned that imposing losses to insured deposit was
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4. contemplated (so much on the road of a banking union to forestall bank runs pandemic
crisis), capital controls sine die were imposed (so much for a market commonplace
and a currency union without barriers), and the negative loop between government
risk and banking sector was reaffirmed loud and clear (so much for finding ways for
banks to lend to the real economy). A true disaster outcome, a dancing elephant in a
crystal store.
It does not matter too much how we got to such an outcome. It could be due to a number
of different elements we all understand. (i) Could be political calculations in Germany on
the ramp up to September’s elections, as Merkel’s new opposition – Lucke’s AfD - calls
for stopping fiscal bailouts draining money from German taxpayers, especially when
bailing out richer un-taxed Russians. (ii) Could be political calculations to send a Mafia-
style message to peripheral Europe, ahead of new potential negotiations over
conditionality of any sort. After all, before promptly retracting, new Euro Group
president Dijsselbloem ventilated that this format (insured deposit haircuts and capital
controls?) should be a blueprint for future rescue plans.. (iii) Could be a message to tax-
havens, yet another one (Luxembourg is warned, as their banking system is 2500% of
GDP). (iv) Could be a message to the finance industry at large, including the shadow
banking system, yet another one.
Whatever the basic driver was, it is still illogical for tiny Cyprus in the context of the
current widespread fragility, to provide the stage for the show. Tiny upside vs massive
downside. Especially in the context of the dangerous precedents it set: the
Pandora’s box in our story. Undue risk was taken in creating a Cyprus precedent,
which resulted in mishandling the situation altogether. Irrational behavior prevailed.
As it stands, we are led to question why we got into such unnecessary trouble across
Italy and Cyprus over a few weeks of schizophrenic disconnect, and if there is any
basic virus at play we should isolate. A few take-aways seem inevitable when
assessing market risks for the months ahead:
- Irrationality in political behavior took center-stage and is perhaps here to
stay. With it, the potential for policy mistakes or political miscalculation is
today bigger than it was before. Such new entry factor complicates
behavioral finance-type analysis and game theory when applied to infer the
tree of potential outcomes. Noted. Policy mistakes matter: looking through
past crisis over financial history, they counted as key determinants of the
magnitude, longevity and scale of such crisis: crisis are created by imbalances
building up over time, leading to excessive leverage and bubbles in coveted
assets, before deleverage and collateral implosion kicks-in. But it is policy
mistakes that often defined the difference between an orderly or disorderly
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5. resolution of the crisis, its duration and its scope (amongst others, with opposite
outcomes: Great Depression, Weimar Republic, DotCom aftermath leading into
Subprime crisis, etc). In the case of Italy, the mess might have been due to
adjustment fatigue on the side of policymakers, once you have been too long into
the crisis and lose the plot. Again, if tomorrow a new government gets formed
around the two main conservative parties (as it should have been the case in the
first place), avoiding going straight into new elections, then the damage will have
been limited in scope, for the time being. In the case of Cyprus, implications are
more far-reaching, as bad precedents have now been set. Slovenia is running
fast into a similar crisis to the one Cyprus was buried under: over-levered
banking system (130% of GDP), NPLs for 20% of the total, quadrupled funding
costs, contracting economy under the weight of debt and fiscal consolidation. If
it reaches cooking stage quickly enough, we can be sure that the Cyprus format
will be copy-pasted, under the eyes of the few who still thought it was not a
blueprint for future crisis. After Cyprus and Slovenia, how likely would it be for
Italy to be treated any differently? What conclusion should then 9-trillions
depositors and savers in Italy (500% of GDP) reach from all that? Is a large-
scale bank run really just a theoretical text-book case study, or can it really get
to, say, Italy?
- Even more worryingly, and raising the scope for policy mis-steps, it looks
like European technocrats have gone blindly complacent of market
resilience as they carry out power plots over Europe. The über-aggressive
behavior they undertake, the arrogance they use in delivering their firm (ever
changing) resolutions, is gathering momentum on the back of two factors: (i) the
market resilience, as the market corrected somewhat but was able to brush off
the most dangerous news of the last month, possibly under the threat of Draghi’s
printing machine (although the market might be just late in adjusting to it), and
(ii) the absence of a clear political resistance from peripheral Europe,
where political parties are in disarray, decimated by inconclusive elections,
unable to close ranks within their domestic place, let alone to form a common
block amongst themselves and with France. The (possibly unintended)
consequence is to increase the divide across Europeans, planting the seeds for
public anger to foster and reaching tipping points.
- We said we deem such policy behavior as irrational, as unnecessarily
heightening potential risk scenarios (bank runs across Europe) without a
commensurate gain in return (less fiscal transfers, at present for Eur 5.8bn
to Cyprus island). However, some more logic would be there on the part of
northern European countries if such actions were aimed at deliberately
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6. pushing Europe over the cliff. Rephrased, more diplomatically, it is becoming
evident that the goal of Europe’s survival in the short term is second to the goal
of Europe shaping out alongside their grand plan in the long term. This would be
included in the ‘Default Scenario’ under our strategic long-term Outlook, and it is
still a possibility to contemplate and seek hedges for. If anything, Cyprus created
the scare of insured deposits haircut, but also the one of decisive capital
controls. Both of them were taboos the day before. Capital controls could slow
down bank runs and, concurrently, the exposure for Germany, Holland and
Finland under the Target II Euro-system (the biggest single item in their
counterparty risk upon Eur break-up).
- For all intents and purposes, we believe we may be past the peak of political
cohesiveness and coordinated actions, in Europe and beyond. For Europe,
Martin Feldstain said it best in 1997 when he argued that, for how
counterintuitive that might be, the Eur fixed-rate exchange system might have
jeopardized political cohesiveness across the EU as opposed to foster it. Six
years into the financial and economic crisis, two years into the sovereign
crisis in Europe, we may have seen the best of global coordination, whilst
cracks emerge and things complicate from here, on the back of competitive
devaluations worldwide (with G4 Central Banks racing to debase to inflate,
one against another, under the cover of domestic policies) and policy
mistakes regionally (Europe took the lead). Let alone geopolitical risk, as
North Korea takes the microphone, Russia meditates on retaliating on tough
northern Europeans, and the usual suspects on a long list of potential catalysts.
Strategy-wise, Where does all of this leave us? Mixed in the short term, bearish in
the long term (in nominal or real terms).
Surely, realised volatility in politics and markets alike may be set to rise from
here, from the rock-bottom levels where it has been confined so far by political
cohesiveness and financial repression.
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7. Short Term Strategy: downside risks are so evident that we should prepare for a
reflation trade in optional format, no cash longs
In the short term, anything can happen. Still though, Draghi is in the waiting room
and ‘stands ready to act’, as the market consensus discounts. The bad precedents of
Cyprus, the total mess in Italy and the expansionary policies of other Central Banks all
around, might convince him to step up his game at the first signs of market’s frailty
(which is the only mandate he has got, vis-à-vis the FED which also targets
unemployment directly). On any given day, he might walk down one of a few avenues:
(i) unexpected interest rate cut, to the point where they are eventually taken to
negative territory, off ECB formal meeting dates, (ii) announcement of BoE-style
Funding for Lending programs at national central banks’ level, (iii) LTRO3 or (iv)
OMT, for example on Ireland, which has recently re-gained market access by issuing a
10yr bond.
We do not buy into Draghi’s talking of ‘empty toolbox’ yesterday at the ECB press
conference, interpreted by part of the market as the inability to intervene further and
promptly from here should the situation deteriorate. He may just try to not interfere in
the political debate. To the contrary, ECB’s balance sheet was the only one in the world
to shrink outright in the first quarter of 2013, as LTROs were partially paid back (for
Eur220bn), helping the ECB to keep its gunpowder dry. A new LTRO would be the
faster route, if a fast tool is needed, and possibly also somehow a cost-effective
one as markets would react positively to it well before any actual euro is spent (cheap
talk more effective than actual euros, once again).
Such an intervention might spark a short-term relief rally, especially if coupled with a
grand coalition government in Italy of any duration. In our eyes, we think such
scenario is best played in an optional format, as volatility is tight and the market
upside is priced cheaply vis-à-vis the downside. Longs outright are risky as
market might adjust to Cyprus precedents with a delay (especially if Italy calls
new elections) and gap down in size.
Conversely, for the same reasons, we do not feel comfortable in going outright short, at
present. Should Italy fall and call for fresh elections, together with evidence of a
potential stalemate at the ECB, then and only then we would turn the portfolio around.
Meanwhile, the longer-term hedging programs we run in parallel to the Value book
should help compensate for such correction.
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8. European Long-Term Outlook & Strategy: the need for hedging against a
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 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.
It now looks like we are slowly adding stepping stones in that direction, one after
another, as that idea is less far-fetched now than it used to be, although is still nowhere
to be seen in market’s prices (if anything, less so now than before).
- From the bottom: electorate from peripheral Europe might rebel to
austerity measures and close ranks to force an exit. In the face of a few
trillions poured into the market, unemployment increased (approx. 60% youth
unemployment in Spain & Greece, 38% in Italy & Portugal), growth failed to be
reignited (outright contraction for France, Italy, Spain), tax receipts decreased
on lower GDP, debt ratios sickened, no banking union whatsoever, no deposit
guarantee to be given for granted (if anything, we almost hit the meteor of
insured deposit haircut in Cyprus), capital controls (under which it is fair to
discount even lower GDP projections, as the currency is fixed). Absent a
currency readjustment, Internal Devaluation to close competitiveness gaps
demands further cuts of Italian/Spanish salaries by 30%-40%. Self-explanatory.
- From the top: electorate in Germany rebelling to fiscal subsidies to
peripheral Europe, with no clear parental controls in exchange. German
taxpayer woke up this year, and do not want to foot the bill any further. Severing
fiscal transfers, whilst imposing capital controls to impede deposit outflows and
a corresponding increase of Germany’s exposure to the rest of Europe via Target
II Euro-system, equates to taking steps to dissolving the union itself.
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9. Capital controls done, custom duties next? Why having a currency union and a market
commonplace in the first place if there are capital controls and silos within it. How much
more artificial can this Frankestein economy look like, and how many mirrors to break
to avoid looking through it?
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.
Global Long-Term Outlook & Strategy: the need for adapting to and hedging
against Multi Equilibria Markets
Hedging a EUR Break-Up scenario is paramount, and so is incorporating it into our
portfolio strategy when it comes down to allocating risk across countries, industries and
sectors. Beyond Europe (as argued extensively in previous Outlooks Nov 2012 and Jan
2012), we have the strong conviction that we live in 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.
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,
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10. 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.
- Default Scenario (Real Defaults, sequential failures of
corporates/banks/sovereigns across Europe). Let deleverage unravels, Europe
flirted with this option, last month.
The good part of the story is that hedge constructs and contingency arrangements
abound, courtesy of Central Banks’ activism, interest rate rigging via ZIRP policies,
and financial repression compressing implied volatility and spreads of all sorts. Also, the
steer levels of cross-assets correlation help in implementing cheap hedges and
proxy hedges: as there are lower boundaries between nearby asset classes, the chance
is there to hedge with one another for minimizing costs.
Paradigm shift in the markets and the need for a unconventional portfolio
management tools
All in all, to us, the paradigm shift in the markets calls for a decisive shift in portfolio
management, along the following key guidelines:
- Portfolio should account for tail scenarios to stay with us for the foreseeable
future, bubble-prone markets on excess liquidity, vulnerable to downside shock
scares. In our world, this is implemented via our proprietary methodology for
Fat Tail Risk Hedging Programs
- Thus, the need for a truly multi-dimensional risk management policy, Hedging
Book, running in parallel to the Value book, whereas this typically belonged to
different silos of the asset management industry (and still is). Hedging means
bothering to spend the cash needed in expensing such overlay.
- Use cross-asset correlation to your advantage , at a time when diversification
(a’ la Markowitz) no longer helps as everything is correlated to everything else,
and on top of things rates can’t fall no more, mathematically, as they did for the
best part of the last 40 years, complicating things for the most widely held
asset class – Credit – and its use within a portfolio.
- Fully invested portfolios are no longer optimal. The Value book can at times
be heavily underinvested so as to adapt to unstable and gapping markets,
whilst replacing cash positions with optional positions and synthetics on low
volatility.
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11. The Outlook
For more data points on our Strategy positioning, and how it is derived from our
outlook, please refer to the attached Appendix (Portfolio Buckets).
Finally, for those of you who enquired about it, let me clarify that we will send out these
write-ups on a monthly basis only (which has been the case ever since Feb 2013, as
opposed to weekly or biweekly as previously was the case). For any intra-month update
on the views/positionings please feel free to get in touch.
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12. What I liked this month
French Stocks To Drop 33% On Macro Recoupling Chart
When Interest Rates Rise. Martin Feldstein, Harvard University Read
Markets Fear 'Loose Cannon' Yellen at Fed: "a client said to me a few weeks ago that
if Karl Marx was in charge of the world, he'd have Yellen as his CB governor’ Read
Understanding North Korea Read
China: Rising Risks of Financial Crisis. Nomura. 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), leverage built up by 60% of GDP in the last 5
years (to 207% of GDP). Read
Yen Selling May Become an 'Avalanche': Soros Video
W-End Readings
The private wealth discrepancy at the heart of Europe. Consider Italy, which has the
highest ratio of private wealth to public debt of any G7 country, and is 40% higher
than in Germany. Italy and France share a ratio of 500%. By contrast, the ratio in
Germany is only 350%. This discrepancy is at the heart of the question: should
taxpayers in debtor countries expect "solidarity" – money – from taxpayers in creditor
countries? Why should they take responsibility, when high ratios may result from low
tax revenues over time, while lower ratios may reflect higher tax revenues? Read
If EMU does come into existence, as now seems increasingly likely, it will change
the political character of Europe in ways that could lead to conflicts in Europe ….
Indeed, there is no doubt that the real rationale for EMU is political and not economic.
Indeed, the adverse economic effects of a single currency on unemployment and
inflation would outweigh any gains from facilitating trade and capital flows among the
EMU members. Martin Feldstein, Professor of Economics at Harvard University Read
‘PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter Lynch’s epoch, all occurred or have
occurred within an epoch of credit expansion – a period where those that reached for
carry, that sold volatility, that tilted towards yield and more credit risk.. What if an
epoch changes?’ Read
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13. Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
55 Grosvenor Street
London, W1K 3HY
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