Fasanara Capital | Investment Outlook | January 11th 2013


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Fasanara Capital | Investment Outlook | January 11th 2013

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  2. 2. January 11th 2013Fasanara Capital | Investment Outlook 1. Outlook-wise, we expect markets to build up on their positive momentum into the short term, beating current resistances and reaching new highs, to then correct markedly over the course of the next few months once the EMU crisis flares up again. 2. Strategy-wise, we hold onto our long positions in Europe, both in absolute value and relative to the UK/US, whilst incrementing hedging transactions, as we believe the rally lies on false assumptions and is to be exposed and terminated prematurely. 3. Country-wise, Italy may provide an opportunity in the near term, as we expect volatility to rise in the run-up to the national elections on February the 24th-25th. We plan to progressively lighten up our European longs from the Italian component, while we stand ready to reload on volatility arising from the market realization of a weaker than expected government to be established. 4. Country-wise, Greece may be up for new restructuring already in 2013, as NPLs and Unemployment are rising at the speed of light. 5. Cross-markets, we expect Monetary Policies to diverge, while Fiscal Policies to converge, over G4 Countries in 2013 6. Currency-wise, we expect Stress Tests to occur on European Currency Pegs, possibly even by 2013: DKK, CHF and the EUR itself. 7. On the Hedging portion of our portfolio, in Q1 2013 we intend to increment hedging on three strategic scenarios in particular (out of our Fat Tail Risk Hedging Programs) as they still are at rock- bottom valuations: Inflation, Credit Crunch & Euro Break-Up. 2|Page
  3. 3. In the weeks since our last write-up, markets moved along the path of expectedoutcomes. European Equity markets jumped ahead (with the Eurostoxxbreaching 2700 level and now flirting with an important resistance at 2717),while outperforming both the US and the UK.Going forward, for the short term, we expect more of the same marketenvironment, as we believe the rally in risk assets has further to go. Wethus stay put on all positions, although we expect markets to retractbetween Q1 and Q2, and therefore stand ready to offload and reversepositions by then.When we last reported in November, equity markets were on the low end oftheir trading range (around support at 2450) and seemed to be on the verge of abreakdown. As reflected by flow and skewness data points, shorts and protectionstrategies were then implemented, which had to be unwound as the marketpointed higher, spurring a short squeeze that fuelled the rally. In our eyes, themajor compression of spreads below psychological levels (below 300bps forBTPs vs Bunds, currently at ~250) helped drive the rally, together with a late(partial) resolution of the fiscal cliff hurdle in the US. Later on, relaxation ofLiquidity Coverage Ratio (and more generally Basel III and Solvency II rules)pushed some more. Retail flows also emerged, as of late, joining the party andadding to its momentum.Once again, as repeatedly was the case in 2012, no major economic data canclaim a role in the upswing. Financial markets have outperformed the stateof the economy all through 2012. For 2013, we expect a similar pattern toplan out, as a similar model of behavior for policymakers and investors islikely: we see policymakers keeping on trying to manipulate markets higherthrough interest rate rigging and direct intervention in nearby asset classes(including equity, indirectly), so as to augment the ‘Portfolio Balance Channel’theorized by Bernanke (explanation), whilst hoping and praying for spilloversinto the real economy and aggregate demand.Likewise, we see investors willing to diligently follow policymakers andmonetary agents, and buy where and when they buy, not so much as they areconvinced about the merit of the investment, but forced into it by the LiquidityTrap, financial repression and zero-interest rate policies. Not so much a vote of 3|Page
  4. 4. confidence in policymakers, but under the threat of their sudden intervention inthe markets in reckless amounts.One more emotional element, perhaps, is now worryingly at play, as Retail andInstitutional money seem to be chasing the rally in risk assets, having movedfrom being concerned about tail events into being fearful of missing out onflamboyant markets. Complacency in financial markets has emerged in size,and seems set to grow bigger in the short-term, as more investors have putto rest any concerns to fly into the rally in pursuit of securing a piece of it.One more alarming reason to be skeptical about the foundations of the currentpositive tone in the market, and stand ready to abandon it promptly.Signs of bubble markets held on the thin air of Central Bank’s liquidity andcomplacency amongst market participants (at a time when fundamentaldata has deteriorated, if anything, as falling Industrial Production data isthere to show), are visible. Evidence includes: - Prudential launched a Perpetual Tier1 transaction for a maximum of $700mn: initially marketed with a 6% coupon, guidance tightened quickly to 5.25-5.375% after receiving orders for $15bn (20x oversubscribed) - Turkey local bonds: government selling TRL800mn, getting $41bn demand (51x oversubscribed) - New CLOs are starting to re-emerge, to manufacture high yields from ultra-tight building blocks levels, remindful of pre-Lehman happy days - LBOs with 30% only of equity, asset-backed financing with 30% only of equity are starting to re-emerge, pairing with ratios from pre-Lehman happy days too - The share of covenant-lite issuance has reached a staggering 30% of the total (in 2005 it was 5%): which means less maintenance covenants in exchange for pure incurrence covenants, which means lower protection for investors. And issuance volumes themselves for HY and Loans exceeded $600bn in 2012, which is above 2007 record levels (another credit bubble market back then, which was to pop up a year later). 4|Page
  5. 5. - In contrast, Itraxx skewness inverted quite remarkably in the last 10 days, as sophisticated investors favored buying protectionOutlook-wise, therefore, we expect markets to build up on their positivemomentum into the short term, beating current resistances and reachingnew highs, to then correct markedly over the course of the next few monthsonce the EMU crisis flares up again. Well into next year, the elephant in theroom may well be proven to be the lack of economic growth. We arguedaround such theme on a recent interview with CNBC (video attached). For all theliquidity poured into the veins of the financial system may achieve little inmanufacturing real GDP, industrial production and productivity, desperatelyneeded to make the debt overhang sustainable and softening its sickening dragon the economy.Strategy-wise, we hold onto our long positions in Europe, both in absolutevalue and relative to the UK/US, whilst adding on to our recurrent tools ofContingency Arrangements and hedging transactions, as we believe therally lies on false assumptions and as such is going to be exposed andterminated prematurely.Country-wise, Italy may provide an opportunity in the near term, asvolatility is expected to rise in the run-up to the national elections onFebruary the 24th-25th. Judging from the neat outperformance of Italianssecurities over pretty much anything in Europe, international marketparticipants seem sedated to the idea of a re-edition of a Monti government ofsome sort (with Monti as either Prime Minister, Minister or President), with asimilar power grip to the previous Monti-led government. Excessive market’scomplacency may be at play here, too. Although a Monti-bis remains ourbaseline scenario, markets may soon have to realize that the new governmentwill be formed of heterogeneous enough parties as to be way weaker than themarket currently anticipates (with the added spin of having Berlusconi at theopposition). Let alone the possibility (still open) of a Left government leavingMonti aside, or the possibility of outright victory by Berlusconi. For all intentsand purposes, Monti (and the European technocrats to that extent) mayhave lived through their best days in 2012, with no greener light waiting 5|Page
  6. 6. their reforms in 2013, under any new government formations. All in all, thelikely volatility on Italian securities which would arise in any of those scenariosmay offer new attractive entry points. As such, we plan to lighten up ourEuropean longs from the Italian component in the near future, while westand ready to reload on volatility arising from the market realization of aweaker than expected government to be established. Perhaps, as spreadcompression pushed Italian equity higher, spreads widening could be sending itlower, next time around.Country-wise, Greece may well be up for a new restructuring round alreadyin 2013, possibly even before German elections in September. Few days ago,we learned that Non-Performing Loans on Greek banks’ balance sheets (despitebeing booked at farcical levels and not yielding more than the few penniesneeded to justify mispricing them) had risen to some 55bn Euros, whichrepresents 24% of the total book, which is a steep 50% increase year-on-year. Ifyou consider that the total funds made available for Greek banks is 50bn, acapital shortfall in the next few months for Greek banks is easy to contemplate.Most likely, an attempt will be made for the electorate in Germany to notrealize that before Merkel runs for re-election in September. However,given the speed of the increase in NPLs, and the staggering levels ofunemployment (60% youth unemployment, 27% total) inevitablyweighting down on economic output and default rates, we cannot be toooptimistic about it. Given that the Official Sector now represents close to 80%of the outstanding debt, the political repercussions and market implications arepotentially heavy.Quoting freely from previous Outlooks: ‘we believe the growing evidence oflack of growth will take issue with price dynamics already in 2013, leadingto downside risks for asset pricing. The catalyst might be the labor market.As adjustment through exchange rates is not feasible under the EUR currencypeg, structural imbalances across European countries are to be shock absorbedby Internal Devaluation, primarily via compression of unit labor costsdifferentials and contraction of aggregate demand (which tightens trade deficitsby definition, so much as it may sound a paradox to think of falling GDP as thetargeted outcome of policymakers to restore balance across the continent).Closing the gap to German wages would require Italian and Spanish laborcosts to fall by an additional 30% to 40% in the years ahead. With youth 6|Page
  7. 7. unemployment at respectively 36% and 55% already, such scenario ishardly bearable. If austerity is not a catalyst to a major roadblock as yet, itwill soon become one in the years ahead of us. If austerity is heavy now, wecan imagine how it is going to be handled with salaries up to 50% lower. Webelieve such day of reckoning might be 9 to 12 months away, if Greece’ssequencing of events is any guide.Longer term, in the few years ahead, if money printing failed to restart theeconomy, we face the real chance of a multiple choice between a DefaultScenario (Real Defaults, Haircuts & Restructuring, potential Euro break-up as aby-product, as either peripheral Europe derails the crisis resolution policiesfrom the bottom, or Germany might reconsider it from the top) and an InflationScenario (Nominal Default, Currency Debasement whilst engineering DebtMonetization, as money printing continued unabated, until moneymultipliers/velocity of money made a U-turn to drive it out of control). We willnot expand on it as we have done extensively so in previous write-ups (Multi-Equilibria long-term market outlook).’Monetary Policies to diverge, Fiscal Policies to converge,over G4 Countries in 2013As we analyze the effects of unprecedented monetary expansion on financialmarkets and manipulated asset values, we note that 2013 might markdefining differences between the monetary policies pursued by the G4Central Banks, which may help detect possible cross-markets divergencesin performance.In aggregate, a recent JPM paper shows that the G4 Official Sector is expected tobuy $1.7trn worth of bonds in 2013, from around $600bn in 2012 (including$500bn from FX reserve managers): this represents 80% of 2013’s net bondsupply.Numbers are staggering and gathering further momentum, if one’s consider thatG4 countries have already engaged in approx $4trn balance sheet expansionbetween 2008 and the end of 2012, to a total of $6trn (Charts). 7|Page
  8. 8. Most of the actual buying and balance sheet expansion is expected to comefrom the Federal Reserve ($1trn) and the Bank of Japan ($200bn), whereasthe ECB and the Bank of England are expected to pursue more targetedmeasures as they are (perhaps rightly) more concerned about thediminishing returns of their policies and thus try to tackle theireffectiveness as opposed to their magnitude. The balance sheet of the ECB isactually shrinking by some degree as we speak. The ‘Funding for Lending’scheme, for example, initiated by the BoE might be followed by the ECB at somepoint over the course of the year. In the case of the ECB, there is one more toolwhich may get utilized if markets were to violently deteriorate along the way:aggressive interest rates cuts. We could even imagine a situation where theECB decides to bring nominal rates to negative territory, quiteextraordinarily. Indeed, negative rates would likely spur repayments of LTROmoney by banks in core Europe (from the 30th of January onwards, loans can beearly redeemed), thus further compressing ECB’s balance sheet, in favor ofperipheral Europe. Liquidity would float more efficiently where it is mostneeded, leading to a better use of capital from the viewpoint of the Central Bank.As the issue has been to date one of Liquidity Trap and falling Money Multipliers(the difference between base money printed by the Central Bank and M2/M3aggregate/money supply actually injected into the economy by CommercialBanks loans to household and businesses and other means) this may well be atool being discussed in the closed rooms of the ECB. Destroying the cost ofcapital to the extremes might manage to kick start not only loan supply butalso loan demand, which is now minimal, as the private sector fails to find areason to borrow money at even low rates. As the capital is scarce and theissue is to incentivate (read forcing) banks to lend more to the real economy andthe real economy to take the money and spend it, in the pursuit of inflation, thismay be seen by the ECB as a possible (desperate) step in the ‘right’ direction.Negative nominal rates may sound like heresy today, but should market returnto full crisis mood, we believe they are a real possibility. For once, we havecomfortably lived through negative real yields for a good year now. Moreover,Denmark and Switzerland have already implemented them, in a desperateattempt to preserve their undervalued currencies. Additionally, after all, thecurrent marketplace has become the largest policy experiment of modernfinancial history, where new records are registered by the day, and no 8|Page
  9. 9. clear economic theory within Modern Capitalism is left to relate to (be itKeynesian or monetarist).In terms of Fiscal Policies, and contrary to the divergence we expect forMonetary Policies, we can imagine the gap partially closing between G4countries as 2013 runs its course. Up until now, the US led the way to fiscalexpansion, whilst Europe was focused on austerity and fiscal tightening. We seethe possibility for the gap to close to some degree, as the mix of austerity versusgrowth gets affected and rebalanced across southern Europe by weakergovernments and unbearable unemployment figures, gradually over time, onecountry after another.An interesting BCA Research study remind us of a simple cornerstone DebtSustainability function: nominal GDP growth should be higher than DebtServicing Costs minus Primary Surplus. Bond markets tend to focus primarilyon interest rates levels when assessing sovereign solvency. However, the abilityof an economy to generate growth and deliver Primary Surplus is as important.Performance is here widespread between different countries. The US deliveredgrowth above debt servicing costs, but incurred into massive Primary Deficit:result, their debt/GDP ratio worsened. In reverse order, Italy delivered largePrimary Surplus but its growth is well below interest servicing costs: result, theirdebt/GDP ratio worsened. Germany has primary surplus and also GDP above itsinterest expenses. Japan has the worst mix of all, negative on both counts. TheUK too is negative on both counts, although less so than Japan.Europe (including Germany) may be slowly realizing that fiscal tightening andausterity backfires when fiscal multipliers are underestimated (IMF Research),as austerity reduces growth more than it reduces the deficit, thus worseninginstead of improving the debt sustainability / solvency ratio for that one country.For all these reasons, a fiscal policy convergence seems reasonable cross-markets over the course of the year, especially between the US/UK and Europe.Perhaps, a few investment implications can be drawn from the above: - Weakening of the USD versus the EUR. As the FED confirms its extraordinarily aggressive credit expansion, and does it more indiscriminately than others, we would not be surprised to see the Dollar depreciating first, which in turn helps the States 9|Page
  10. 10. achieve better trade flows for a bigger slice of a shrinking global trading pie, rebalancing against China and repatriating some portion of manufacturing in between, selling their low-yielding expensive debt to foreign investors, keeping rates low to attempt inflating the housing market (which shows the first signs of life) etc.. while officially justified by the need to support the recovery and the job market. The FED currently seems more desperate than others to get the economy off its zero bound early on whilst it still has some residual effectiveness (Bernanke’s own words: focus on the Q&A session). - Counter-intuitively, possibility for Govies and Credit in the Euro area to outperform their US equivalents on more aggressive rates cuts (counterbalancing a slower balance sheet expansion at the Central Bank level) - If you couple what above with technicals and the valuation gap still outstanding, a further outperformance of Europe over the US/UK in the equity markets is also a plausible outcome early in 2013.Stress Tests in European Currency PegsHow much more maneuvering room can be left there to defend theirundervalued currencies for the SNB and the Nationalbanken ? Swiss Francand Danish Krone may come under pressure already in 2013. Longer term,the other currency peg under stress, most obviously, is the EUR itself. Ifhistory is any guide, three conditions were met in past currency crisis andemerging market crisis: an over-valued currency (read, the EUR to countrieslike Italy and Spain), over-indebtedness, as a share of GDP or the productiveeconomy (rephrased, too much debt and no growth against it), and currentaccount deficit. By any objective criteria, all three levers are met for certaincountries in southern Europe, making the case for a reshaping of the EUR-fixed currency regime a genuine one. In advanced economies thereadjustment may be slower to occur than in emerging economies (as we learnfrom the attached interesting piece looking at past banking crisis), but it may stilldo occur over time, including a currency-driven one. 10 | P a g e
  11. 11. Opportunity Set for 2013In the previous write-up we had offered our observations on the main themesunderlying our portfolio construction, across its three main building blocks. Ourcurrent Investment Outlook for 2013 is implemented into an actionableInvestment Strategy along the following three parts:  Value Investing / Carry Generator portion of the portfolio  Hedging / Fat Tail Risk Hedging Programs  Cash and Cash alternatives / Tactical Short-Term Plays / Yield EnhancementWhat I liked this monthSterling crisis looms as UK current account deficit balloons ReadGermany hurt by the Eurozones massive demand shock, but has the economybottomed? ChartsDE central banks balance sheets approaching $6 trillion; expected to growanother $1 trillion in 2013 ChartsInteresting Charts for 2012 from JPMorgan ChartsHoward Marks: "There Are Times For Aggressiveness; Now Is Time For Caution"ReadThe appreciating Renminbi ReadIron Ore Seen Set for Bear Market as Restocking Rally Fades ReadThe Chinese are running away with thorium energy, sharpening a global race forthe prize of clean, cheap, and safe nuclear power ReadBasel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools Read 11 | P a g e
  12. 12. W-End ReadingsFasanara Capital November interview with CNBC on our outlook andstrategy: CNBC Interview Part 1, CNBC Interview Part 2Given the wide interest it raised, we re-present this interesting study. MustRead | FSB Report: “shadow banking system”: can also become a source ofsystemic risk, especially when they are structured to perform bank-likefunctions. Global shadow banking system, as conservatively proxied by “OtherFinancial Intermediaries” grew rapidly before the crisis, rising from $26 trillionin 2002 to $62 trillion in 2007. The size of the total system declined slightly in2008 but increased then to $67 trillion in 2011 (i.e. 111% of the aggregatedGDP of all jurisdictions). This represents 50% of banking system assets, and 25%of total financial intermediaries (including banks, pension funds/insurance,central banks, public financial institutions). The US has the largest shadowbanking system, at $23 trillion in 2011, then Europe ($22 trillion) and UK ($9trillion). Holland (45%) and the US (35%) are the two jurisdictions where NBFIsare the largest sector relative to other financial institutions. The share ofNBFIs is also relatively large in Hong Kong (around 35%), the euro area (30%),Switzerland, the UK, Singapore, and Korea (all around 25%). Jurisdictions whereNBFIs are the largest relative to GDP are Hong Kong (520%), the Netherlands(490%), the UK (370%), Singapore (260%) and Switzerland (210%). After thecrisis (2008-2011), the shadow banking system continued to grow although at aslower pace. Interconnectedness risk tends to be higher for shadow bankingentities than for banks ReadMust Read | BIS Report: Total notional amounts outstanding of OTCderivatives amounted to $639 trillion at end-June 2012, down 1% from end-2011. Gross market values, which measure the cost of replacing existingcontracts, dropped by 7% to $25 trillion ReadThe Empirical Implications of the Interest-Rate Lower Bound WorkingPaper Have We Underestimated the Likelihood and Severity of Zero LowerBound Events? Working PaperIs Modern Capitalism Sustainable? Kenneth Rogoff, Nov 2011 Read 12 | P a g e
  13. 13. Finally, let us take the opportunity of this first write-up of the year to thank-youfor following us in 2012 and to wish you all the best for 2013.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 thefact of its distribution form the basis of or be relied on in connection with any contract. Interests in anyinvestment funds managed by New Co will be offered and sold only pursuant to the prospectus [offeringmemorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carriesa high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any stepsto ensure that the securities referred to in this document are suitable for any particular investor and noassurance can be given that the stated investment objectives will be achieved. Fasanara Capital Limited may,to the extent permitted by law, act upon or use the information or opinions presented herein, or the research oranalysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnelmay have, or have had, investments in these securities. The law may restrict distribution of this document incertain jurisdictions, therefore, persons into whose possession this document comes should inform themselvesabout and observe any such restrictions. 13 | P a g e