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Fasanara Capital | Investment Outlook | November 16th 2012


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Fasanara Capital | Investment Outlook | November 16th 2012

  1. 1. November 16th 2012Fasanara Capital | Investment Outlook 1. Short-term, as critical levels are being tested, we cut directional risks, moving our Beta portfolio to completely neutral, whilst maintaining RV plays cross-markets between Europe and the US/UK 2. As we maintain our view that Spain, Greece and the US fiscal cliff risk factors are overdone, we stand ready to promptly establish tactical longs, as we believe there is a better chance for a 20% rally than there is of a 20% drop in prices, within the next 3-4 months 3. The UK is a likely underperformer vs Europe in the near future, both in Equity and Credit spaces. The catalyst may have been the decision of the BoE to moderate QE, as a slow-down in the rate of acceleration of credit expansion is in itself a tightening move. 4. Longer-term, we capitalize on fictitiously sustained valuations and rock-bottom Risk Premia to amass cheap optionality on the six pre- identified Tail Scenarios we anticipate in the few years ahead, under our view of Multi-Equilibria markets. In particular, we here give more thoughts to the hedging opportunity for scenarios of Credit Crunch and China Hard Landing.Back in September, we argued that markets would remain supported, possiblyinto year end, allowing for tactical yield enhancement strategies, mainlyexecuted through selling the downside in optional format. We also anticipated‘expected Euros’ of Draghi to be more effective than ‘actual Dollars’ of Bernanke,setting the stage for an outperformance of Europe vs the US. Since then, we hadmarkets in Europe supported and directionless, almost soporific as they dancedin narrow trading range (2450 to 2550 for the Eurostoxx, 30 basis points rangefor yields and spreads volatility), whereas European equity was indeedoutperforming the US by a decent margin (almost 400bps) over the period. 1|Page
  2. 2. Now then, as we feel we are at a crossroad and critical levels are beingtested (for the DAX and the S&P in primis), we decided to cut directionalrisks on short term positioning, moving our Beta portfolio to completelyflat neutral, whilst maintaining relative value plays cross-markets betweenEurope and the US/UK. We have enjoyed the ride on yield enhancementstrategies until now, but prefer to be flatter going forward into year end. Marketsin Europe moved to the low end of their trading range, and are dangerouslydangling on the cliff, giving the impression to be on the verge of a breakdown,plagued by fears at home (Spain and Greece) and abroad (US fiscal cliff). Wemaintain our view that Spain, Greece and the US fiscal cliff risk factors areoverdone, and do not have the potential to truly destabilize markets in theshort term, having the Central Banks just stepped out in offering abackstop firewall with reckless abandon. However, we are worried abouttechnical levels and risk appetite abating for most active players intothinner volumes at year end, and have therefore preferred to cut risk andmoved completely flat. Should the technical formation improve from here, westand ready to promptly reinstate our yield enhancement strategies andadd tactical longs to them, as we believe there is a better chance for a 20%rally than there is of a 20% drop in prices, within the next 3-4 months. Infact, we maintain the view that an attempt will be made, at some point, forcompression of yields and spreads of Spain/Italy vs core to levels which wouldtrigger the (erroneous) market perception of a de facto Debt Mutualisationacross Europe, well before the Banking Union - dreamed about by Hollande - orthe budgetary parental controls - dreamed about by Merkel (please refer to thelink attached for our thinking around a de facto Debt Mutualisation).Reinstating yield enhancement strategies and tactical longs will not be aone way bet. We have taken advantage of current super-compressed riskpremia and tiny inter-banking spreads to implement cheap optionality on thehedging side of our portfolio, and we look at increasing such positioning givencurrent rock-bottom levels and limited downside. We believe such hedges arebest geared to provide cover against the potential true catalyst tounderperformance on the Beta portion of our portfolio.The reason why we believe in the possibility of further reflation of asset pricesrevolves around the credibility of the Central Bank, which we feel is the realasset at stake now. Our investors and readers know how critical we are about 2|Page
  3. 3. endless monetary printing as a way to cover up unresolved structuralimbalances across Europe, and buy time in the process. However, they domanage to achieve that: buy time. In the short to medium term, we expectpolicymakers to be rationale enough not to waste their credibility all tooearly, too blatantly, having promised to stand behind the European construct atall costs (‘do whatever it takes, Euro can’t go backwards’ in Draghi’s own words). Finger-pointing to one other is not an option either. Should Europe not unlocka most expected/obvious funding tranche to Greece, should Spain pester aroundconditionality to the point of jeopardizing a most needed 90bn recapitalization ofits banks (still dependent on the ECB), should even Draghi decide to help Spainin the absence of such conditionality (risking Germany’s revolt), in all such casesthe loss of credibility would be heavy damage. All in all, we believe policymakersknow that all too well and will manage to avoid these obvious missteps.Policymakers and monetary agents may be convinced that this is the time toprove to the markets and their respective electorates that Europe is on the rightpath, as the conditions at large will soon be far worse for them to try the sameexercise next year. They are confronted with a similar grim data set to the onewe currently look at, and they may come to similar conclusions as to theimportance of getting the timing right, this time around. And capitalize on thetentative signs of stabilization that have surfaced in the markets as of late.Not only inter-banking spreads have compressed to levels where anypotential further tightening is hard to imagine (leaving the door open to cheaphedging, in our tail hedging programs ‘FTRHPs’). Additionally, we saw positivedevelopments for the first time in months in the Eurosystem, with SpainTargetII exposure to the ECB decreasing by over 50bn (to 365bn), mainlydue to a reopening of the repo market on their securities (with Spanish banksreplacing ECB repo funding - 75bps - with cheaper private repo market funding -approx. 30bps), but also thanks to forestalling deposit outflows and some newbank debt issuance. Italy itself saw its exposure to the Eurosystemdecreasing by over 20bn in two months (to 270bn), possibly due to non-domestic buying of net government bond issuance.On the other end, policymakers cannot avoid seeing the shadow of blackclouds into next year, making the odds worse by then: (i) the law ofdiminishing returns for central bank policies is ever more evident, with free-falling monetary money multipliers (ECB is most concerned about it as it is 3|Page
  4. 4. looking for ways to repair a broken transmission system - ECB workshop on Nov19th on excess liquidity and money market functioning), (ii) the drag on growthcan only worsen into next year, as fiscal multipliers are larger thangovernments assumed in conducting austerity programs (‘sharp expenditurecutbacks or tax increases can set off vicious cycles of falling activity and risingdebt ratios’ Underestimating Fiscal Multipliers?), resulting in tight fiscal policiespossibly worsening the same fiscal position for countries hit by austeritymeasures, therefore worsening sovereign solvency itself, as opposed toimproving it, (iii) youth unemployment reaching tipping points at almost60% in Greece, 55% in Spain, and above 35% in Italy, Portugal and Ireland(introducing the ‘youth sacrifice ratio’) (iv) this week the Eurozone wasconfirmed in recession in Q3, with deceleration of consumer spending andheadwinds from activity data all pointing further south: even Germanmanufacturing is in outright contraction, after weakening exports not only intoperipheral Europe but also into Latam and China (likely to worsen further withthe weakness in commodity prices).Critically, what is way harder for policymakers to avoid is the end result of thecurrent crisis resolution policies, as a colossal debt overhang gripping theeconomy is being treated with yet more debt, weighting even more on real GDPprospects. It is way more difficult to treat the basic disease affecting European(and global, in that respect) policymaking: ‘short-termism’. However, as weargued repeatedly of late, this is a long-term scenario and we do not expect it tomaterialize in the short to medium term.A word on Greece, as we head into next week’s EU summit. Back in March, wethought Greece’s PSI was purely priced into the next inevitable restructuringevent. However, we warned ‘’by then, the Official Sector will count for 80% of thetotal debt (vs 60% today), making it an even more politically-troubled issue.Critically, and unintentionally, Greece will thus maintain its status of keyvulnerability for Europe as a whole, long before the next event, with itsimbalances building up slowly and surely to the next tipping point.’’ All in all, weremain bearish on Greece, and we see its exit from the Euro Area asinevitable. However, we believe such next tipping point is no earlier than2013/2014.Cross-markets, we remained positioned for Europe to further outperformthe US in the near future. True, Obama victory at the elections is the relative 4|Page
  5. 5. best when compared to the increased uncertainties over inflection points inmonetary and fiscal policymaking that Romney would have entailed (in that weprobably disagree to consensus view). But the stage is set for further noise in theUS and a weak relative price action. Firstly, if the technical situation got trickyin Europe it is far worse in the US. The US starts off from richer valuations, ataround pre-Lehman levels, and it is hard to argue that just the thin air of actualmonetary expansion engineered by the FED stands beneath such bloated levels.Peak profit margins were in large part a reflection of it, as we previously argued.Finally, we believe a compromise over the fiscal cliff/debt ceiling gridlock will bereached in less than a dramatic fashion, but the timing of such compromise islikely to be later rather than sooner, if history is any guide, at which point themarket will have taken a defensive stance. We look at it as an opportunity, as acheaper valuations for certain bonds and stocks in the US will help us build partof our portfolio on the Value side (Carry Generator pool, helpful to self-financethe Hedging portion of the portfolio and our Fat Tail Risk Hedging Programs). Inparticular, we monitor the uncertainties over the taxation on dividends andtheir impact on blue chips, low leverage, high dividend paying stocks: it seemsthe top marginal tax rate may rise to almost 45% on dividends, and 25% oncapital gains, from 15% for both currently. Against that backdrop, a sharp slow-down of flows into high-dividend ETFs is the foretelling data corroboratingsuch view. Once (and if) that re-pricing has occurred, possibly into early nextyear, we stand ready to reverse the relative value between Europe and the US.We also believe that the UK is a likely underperformer to Europe in thenear future, both in Equity and Credit space. The catalyst may be the recentdecision by the BoE to moderate QE. Truth be told, such decision is anunderstandable one, as the credit expansion in the UK is way larger than that ofEurope (and even the US), on our metrics. However, as we are reminded byhistory, a slow-down in the rate of acceleration of credit expansion is itselfa tightening move. When the addiction to credit is large (as in the UK), it is hardto imagine the markets and the economy at large not reacting to that with a re-pricing. The UK has a total debt (private and public) to GDP well above 500%(second only to Japan, Holland and Ireland, Chart), a maximum ratio of privatedebt to GDP of 450% (300% in the US), financial sector debt of 250% of GDP (hotmoney flows). Lastly, but perhaps most importantly, the rich valuations(especially in Credit) vis-à-vis core and peripheral Europe should help motivatean underperformance in the next few months. Such valuations stand in stark 5|Page
  6. 6. contrast to credit metrics / fundamentals: next year, the UK needs a nominalGDP growth of almost 4% to cover primary deficit plus borrowing costs (muchworse than Italy, whilst having funding costs of one third of Italy, at current1%/2% yields). Such contrast might be exposed (and demand a re-pricing)as the (erroneous) perception of Debt Mutualisation surfaces in Europe inthe few months ahead, depriving the UK of the most relevantdifferentiating factor until now: the availability of a lender of last resort.Most worryingly, such lender of last resort - Mervyn King - recently admitted thelimits of monetary expansion, identifying the external demand as the missingsource of pick-up of activity for the UK economy. Our transcript from hisrecent testimony (Video, starts at 3.20 minute): ‘what the UK needs is moredemand in the rest of the world to buy goods from the UK, that is the key bitmissing from our attempt to rebalance, and why the challenge is so great’. Butthere may be too much wishful thinking there, as net exports contribution toUK’s GDP growth was flat and stable, at best, over the past 10 years for the UK,with average exchange rates (whereas it improved markedly for Germany overthe same period, for example). So Mr King is hoping for nothing to change, butexport demand to be better than it has ever been in the past 10 years, andlead to UK’s resurgence. Given what is going on globally, with clear signs ofcontracting global trade, trade conflicts to debase one own’s currency andsecure a larger slice of a shrinking pie, there is more than one reason tohold doubts about King’s hopes.Finally, regarding another possible catalyst and a key vulnerability for the UK, letus quote our March Outlook: ‘’Corporate Pension Deficit Widening Fast andSolvency Models of Insurers under pressures. Given our long-term Outlookfor an unbalanced, fictitious economy in Europe (debt-laden and kept alive bymassive liquidity and currency debasement from the ECB, possibly building upits excesses to the point of implosion), we cannot easily dismiss the dangerousspiral underway on Corporate Pension Schemes and Insurers alike. WhenNegative Real Rates are the goal of a Central Bank trying to achieve NominalDebt Monetization (as Debt Mutualisation was prohibited by Germany, andDefaults were deemed to be politically unacceptable), the pension deficitsballoon. The fatal mix of falling long-term Interest Rates and simultaneousrise in Inflation make Pension Liabilities rise indiscriminately’’. 6|Page
  7. 7. For the Long-Term outlook, allow us to be repetitive and close up today’s write-up with the usual ritual: long-term, we have no new news to change our view ofMulti Equilibria markets in the next 4 years. We rendered out thinking in arecent conversation with CNBC (Video). The multi-year Japan-style deleverageis perhaps the most probable scenario, perhaps the luckiest one for Europe, butstill it is hardly a scenario we should give for granted, hardly a scenario with aprobability close to par. Absent a crystal-ball, it is arduous to determine withcertainty where else we could be heading from here, and that is why we refer toMulti Equilibria markets, as we see more than one potential endgame forEuropean matters. In an attempt to simplify the tree of potential outcomes, wesee two broad destructive forces who could spoil the party and derail the Japan-style slow deleverage, which point in exact opposite directions: DefaultScenario: Real Defaults, Haircuts & Restructuring, potential Euro break-upas a by-product. Or Conversely, we see an equal chance of going through theopposite scenario, an Inflation Scenario: Nominal Defaults, DebtMonetisation, Currency Debasement. ‘The leit-motiv of our InvestmentStrategy remains to take advantage of current market manipulation andcompressed Risk Premia to amass large quantities of (therefore cheap)hedges and Contingency Arrangements against the risk of hitting Fat Tailevents in the years to come. If we do not hit them, then great, it will be theeasiest catalyst to us hitting the target IRR on the value investment portion ofour portfolio (what we call Safe Haven, or Carry Generator). If we do hit one ofthose pre-identified low-probability high-impact scenarios, then cheap hedgeswill kick in for heavily asymmetric profiles (we typically targets long only/longexpiry positions with 10X to 100X multipliers). Such multipliers are courtesyof market manipulation and ‘interest rate rigging’ by Central Banks. Webelieve they represent the only truly Distressed Opportunity in Europe.Timing-wise, the next months may offer an interesting window of opportunity.Within 12/18 months, that may be the next most crowded trade’.Such undervaluation and mispricing reminds us of the price of wanna-beAAA paper a few years ago, under the sign-off of complacent RatingAgencies. At that time too, shorting credit was made inexpensive. Timing for thebubble to burst was uncertain, as it is now, but inexpensive means that it did notmatter that much after all. This time around, it is not the Investment Bankspushing credit into unsustainable territory but the Central Banksthemselves - with obviously more margin for error, but not infinitely so. 7|Page
  8. 8. Opportunity SetWe offer an update to our Opportunity Set alongside the list of pre-identified tailscenarios we see possible in the few years ahead of us (some of which aremutually exclusive or may happen in succession): Inflation Scenario (CurrencyDebasement, Debt Monetisation, Nominal Defaults), Default Scenario (RealDefaults, sequential failures of corporates/banks/sovereigns across Europe),Renewed Credit Crunch (similar to end-2008, end-2011 or mid-2012), EUBreak-Up (either coming from Germany rebelling to subsidies or peripheralEurope rebelling to austerity), China Hard Landing, USD Devaluation.Renewed Credit CrunchEver since Draghi’s bold move in support of the currency union, together withsimilar extraordinarily expansionary monetary policies globally, certain RiskPremia and inter-banking spreads collapsed to new lows, from where anypotential further compression is hard to imagine. In particular, we saw theEURUSD currency basis tightening to pre-Lehman lows (before resurging slightlylast week on recent market weakness), OIS-Libor spreads (in Europe and the US)and Swap Spreads (especially in the US) well below pre-Lehman levels. They allare in between 10bps and 20bps, having been single digits for a short while inthe past few weeks. In comparison, the tightening in CDS premiums, VIXvolatility and the likes is short of impressive.China Hard LandingThis year we had a great run hedging the China Hard Landing Scenario,expressed via shorts on the Dry Bulk segment of the shipping industry,heavily sensitive to the Chinese economy. Back in January, we were convincedChina’s imports were slowing down, as reflected by official data and asconfirmed by data on Taiwan exports, Shipping and Mining flows. We recentlytook all profits and closed positions, for the time being. Although we stillbelieve in the idea (in particular, South Korean’s exports to China took a divelately), we are on the verge of forceful money supply in China (for a change) andabroad, and therefore became wary of a short term rebound. If such rebound 8|Page
  9. 9. materializes, we would like to reinstate positions, this time expanding the scopeto the Australian dollar, the banking sector in Australia, and the Luxury industry,in addition to Shipping, Mining and the likes.Short term, in addition to money printing, there are a few reasons to bepositive about China and wary of a rebound. Xi Jinping’s appointment was asafe choice for the country and we noticed his immediate consolidation of powerwithin the Party’s Standing Committee, as he assumed Military Committeechairmanship (differently than what happened during Deng Xiaoping and JiangZemin hand-overs). Also, the initial statements of the new leadership team seemsto show awareness that reforms are essential to China and the same survival ofthe Communist Party. All in all, the good ground for reforms should helpmarkets in the short term.Moving away from the shipping industry, which provided the hedge lasttime around, our eyes are now on Australia. We believe Australia mightprovide an efficient hedge against China’s hard lending, at some point nextyear. The main fragilities we observe are the following: an unusual currentaccount deficit, heavy hot money flows (large foreign investments), overcapacityin the mining and construction industries (key components of their economy).Medium-term, we are bearish both on the exchange rate and the banking sectoron the equity side (a far cheaper play than the already depressed iron oreindustry), whilst we would be receiving rates in fixed income, so as to preparefor interest rates cuts and generate premium in between.Our long-term bearish stance on China is based mainly on deceleratinggrowth and overexpansion of credit embedded in their economy. For whathas now become a 7trn economy, it is fair to assume that double-digit growthrates are long gone. Growth is not necessarily the most informative data out ofChina (due to flaws in their statistical infrastructure, let alone reliability of thedata available). However measured, it is inevitable for growth to slow downmarkedly, from here: it is arithmetic pure and simple, for the impossibilityof exponential growth in a finite environment. We expect growth to bebelow 7% possibly already next year and below 6% within the next 5years. Within such growth rates (still good in absolute terms), the rebalancing ofgrowth from state-driven fixed investment to domestic demand is going to havean impact. Investment is almost 50% of China’s GDP, whereas Consumption isjust above 35%. Total credit is 30% of GDP. The housing bubble is greater than in 9|Page
  10. 10. Switzerland, as the country dis-incentivized foreign investments by Chinesepeople, together with lowering real interest rates into negative territory. We donot believe China will go bust, but the transition to a more balancedaggregate demand mix should lead to pitfalls and adjustment fatigues, asthe credit bubble of indiscriminate state investments (in totally uselessprojects) deflates. And in the meantime, at points, China’s sensitive assets(home and abroad) are poised to steeply underperform as a result of it.That is what we refer to as ‘China Hard Landing Scenario’.Default Scenario / Euro Break Up Scenario / Inflation ScenarioSimilarly to the Renewed Credit Crunch scenario, Cheap Optionality is availablehere and will grow some more in the near future with regard to these scenarios.We leave a full discussion on this topic to one of the future write-ups. 10 | P a g e
  11. 11. What I liked this monthUK total Government pension obligation, at the end of December 2010, of£5.01 trillion, or 342% of GDP, of which around £4.7 trillion is unfundedobligations ReadHigh yield debt issuance in 2012 hits an all-time record ChartsIntroducing the ‘youth sacrifice ratio’: the cost of the economic downturn isborne in a disproportionate manner by the younger generations is, in theshort term, more socially acceptable than a “fair” distribution across all agecategories. the bulk of the population, at least initially, can still benefit from arelatively high level of economic security which may help to keep them awayfrom radical politics ReadSpain has full access to the market, but ONLY because of the ECBs backstop. Infact if Portugal qualified for the OMT program, it would immediately gain fullaccess to the market as well. This argument is a bit circular, isnt it? ReadW-End ReadingsBloomberg TV Interview to Fasanara Capital: В течение нескольких летГреция выйдет из еврозоны: VideoGreece next restructuring: ideas from past experiences with heavily indebtedpoor countries ReadIs Russia the best or worst of BRICS? VideoSamsung Hikes Apple Component Price By 20% ReadHow Zara Grew Into the World’s Largest Fashion Retailer ReadChinas future: challenges and opportunities ReadAs Giffen good, when physical Gold goes into “hiding” the demand will increasein proportion to the increasing price ReadAusterity in pictures PicturesRay Kurzweil and reproducing brain Video” 11 | P a g e
  12. 12. 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. 12 | P a g e