Fasanara capital | Investment Outlook: October 26th 2012
October 26th 2012Fasanara Capital | Investment Outlook 1. Short-term, we maintain our view for valuations in Europe to stay supported into year-end, with the possibility to see further reflation on compression of countries’ spreads below critical levels 2. Medium-term, we believe the European crisis is likely to flare up again early on in 2013, under the drive of austerity (from the bottom) or Germany itself (from the top). France may potentially have become a catalyst too, and proving to be the casus belli next time around. 3. We observe that Central Banks desperate attempts to remove fat tail risks in the markets have the unwelcome consequence of making such events lower in probability (perhaps), more distant in time (perhaps), but ‘fatter’ in potential outcomes (surely).Markets in the month of October proved to be resilient and unvolatile to thepoint of being soporific, held up by the promise (or under the threat) of open-ended monetary base manufacturing by Central Bankers the world over. Notmuch new news was fed into the markets in the last period, leaving us toreiterate our short-term view for valuations in Europe to stay supportedinto year-end, with the possibility to see a further reflation of risky assetsshould there be a further compression of spreads across Europeangovernment bonds (our earlier Outlook is attached).The risk factors to this view are endogenous to Europe’s politics, but webelieve they carry a low potential in the very near term: (1) For one thing,Spain’s bickering with European authorities over conditionality is hardly goingto be a game changer, when Draghi’s intervention is just a call away. Nor webelieve that heavy brinkmanship will end up to be needed for triggeringadherence to conditionality. It is just fair enough for Spain to keep it as a lastresort measure, enjoying the free ride whilst it lasts, just to activate it promptly
at the first real signs of market deterioration (2) Furthermore, Greece seems tobe in no position to harm Europe’s price action in the nearest term. As it nowseems clearer to most, Greece has no chances of surviving much more austerityfrom here on, as the political backing for it is hard to imagine, and is thereforemost likely to leave the Euro Area at some point over the next few years. Thatsaid, if Greece were to exit today, a domino effect would be most certain acrossperipheral Europe, jeopardizing efforts by policymakers to ring-fence Italy andSpain and exposing early on Draghi’s great gamble, with potentially un-repairable damages to his credibility: not a scenario Europe as a whole couldcope with right now. For all these reasons, we are led to believe that Greece maybe stable to rally further in the short term, before a probable reversal of thetrend at some point down the line. (3) Lastly, recent disagreements betweenHollande and Merkel surely carry a bad omen of things to come, but are unlikelyto gain momentum in the imminent future.All in all, markets seem sedated by monetary expansion and Draghi’s boldstatement in guaranteeing an unlimited supply of paper cash againsttroubled government borrowers, should it be required. Such ‘expectedeuros’ are playing their magic and it won’t be easy in the short term to takeaway the wizardry that came with it. We see two immediate consequences ofthis market formation. Firstly, such market resilience may prove useful inimplementing yield enhancement strategies between now and the end of theyear, by implementing tactical longs on dips whilst selling downside risks.Secondly, if anything, as we mentioned in our previous Outlook, the ‘expectedeuros’ of Draghi might prove more effective than the ‘actual dollars’ of Bernanke:over there, the combination of weak technicals, rich valuations, earningsrevisions and a much debatable recovery (even in the housing sector), let aloneelections, fiscal cliff and debt ceiling hurdles, may concur to create anunderperformance of the US vs Europe in the near term.In the short term, we believe that markets could accelerate their positivemomentum if they got convinced that Debt Mutualisation had occurredacross Europe, well before the proverbial Euro Bonds (dreamed about byHollande) or the budget parental controls (dreamed about by Merkel). Wecalled it a ‘de facto Debt Mutualisation’ in previous write-ups. That is whenGermany is believed (erroneously, in our eyes) to have become jointly andseverally liable to other big economies in Europe. We believe such illusion
might spread, and be endorsed by the markets, should spreads ofperipheral Europe vs Bunds tighten further, perhaps below 250-300 bpsfor BTPs and Bonos alike. For instance, should BTPs fall below 300bps spreadto Bunds, the next stop could be 200bps spread, from which level theyskyrocketed in mid-2011 (see chart) with a 100 points jump - at which pointequity markets were 20% higher.However, we believe the calm in the markets is deceptive and temporary, itcomes at high hidden costs, downside risks and unintended consequences,and as such is paving the way for a resumption of hostilities into next year.Critically, recent macro releases globally have pointed to negative territory, inparticular new orders and activity data (charts). Medium-term, we believe theEuropean crisis is likely to flare up again early on in 2013, under theweight of one of two polar-opposite factors: (1) From the bottom, withperipheral Europe’s electorate rebelling to austerity, as we are only few monthsinto it and the full wrath of it is still to be seen, possibly six months from now, or(2) From the top, with Germany’s electorate (led by Bundesbank’s orthodoxy)rebelling to an assistential model which sees them as the ultimate solepaymasters, with no clear deal in return.Paradoxically, thinking about the ‘remote’ possibility of Germanyunplugging from Europe, we come to think that the latest developments inEurope have only made such potential exit somewhat ‘less remote’, in thelast couple of months. In fact, the ‘expected euros’ promised by Draghi, wellbefore being actually spent, have already managed to stop the hemorrhage ofGerman exposure to the Eurosystem via TargetII, one of the few truemutuality feature of monetary policy construct in the continent. A fewmonths ago, that figure presented a bold number ascenting at staggering speed,on his way to cross the 1trn mark and counting by the end of the year, and in ourOutlooks we were suspecting something somewhere would have been devised tostop that dangerous ascent (as we held doubts as to the real willingness ofGermany to become effectively and unquestionably liable to peripheral Europeall too quickly). Today, such number is down by 50bn at 700bn (after the biggestmonthly decline of his history - we could title), having bottomed up on the re-pricing of risk across peripheral Europe and related pause in deposit outflows(link). Such number is important, as it reflects the one single largest componentof German upfront loss, should it leave the currency peg at any given point in
time. It will be a different story and a different calculation when ‘expected euros’turn into ‘actual euros’ on Draghi unleashing actual bond buying, but thatmoment has yet to arrive. For now, in the last two months, German netexposure to peripheral Europe has gone down, markedly, instead of risingfurther to the point of no return. Risk sharing across Europe is now less than itwas two months ago.As far as the risks posed to the markets from peripheral Europe, we would like toobserve that France may have well joined Italy and Spain in theconsortium, and may well prove European markets’s new casus belli nexttime around. The fragility of French asset prices is a result of rich valuations tostart with (unfairly close to German levels), coupled with a still heavy foreignownership of negotiable government debt (around 65%), heaviest publicexpenditures on GDP across Europe (at 56%, well above anybody else includingGreece), a damaging fiscal tightening on his way (ill-conceived tax charges oncapital gains scaring off hot money capital), and a re-pricing of the loss ofpolitical unity to Germany. As such, for the tactical part of our portfolio, we areanalyzing ways to implement barbell strategies involving Germany-France-Italy: we believe Italy might outperform France in both a risk-on marketenvironment in the months ahead (tightening more), and a risk off-one(widening less).In the long-term, whist we witness the progressive exhaustion of policy toolsavailable to monetary and fiscal agents, we reaffirm our outlook for Multi-Equilibria markets, as we see the market diverging from mean-reversion tosettle at a different equilibrium on hitting Fat Tail scenarios in the next fiveyears. It is what we called ‘Phase III: Bursting of the Bubble’ in our write-ups inthe last few months. We observe that Central Banks desperate attempt toremove fat tail risks in the markets has the unwelcome consequence ofmaking such events lower in probability (perhaps), more distant in time(perhaps), but ‘fatter’ in potential outcomes (surely). The bubble is inflatedfurther to a level where the stakes are way larger than ever before. As such, asound risk management policy calls for Contingency Arrangements to be addedto prudent portfolios. At Fasanara Capital, we harvest such hedgingarrangements and cheap optionality methodically, for them to represent growingpercentages of the investment portfolio, through our Fat Tail Risk HedgingPrograms. We believe such arrangements are nowhere to be seen in portfolios
these days, in any meaningful amount; if they were, we would see it reflected inthe pricing of such hedges. On the contrary, some portfolios seek a defensivestance by leaning more into cash or real assets, which is just fine but fails tocapture the opportunity of cheap hedging currently offered by the markets(courtesy of Central Bankers, mainly). Also, some other portfolios misinterpret adefensive stance by leaning more than normal into government bonds, whichmay prove delusional and expose to large losses on maturity extensions shouldyields rise (as we expect) at some point down the road. The one opportunitywhich very few seem to take advantage of (otherwise we would see suchflows reflected in more expensive market pricing) is the availability ofCheap Optionality through Risk Premia. The availability of such hedges ismade possible by monetary agents themselves, as it is a direct consequenceof the financial repression environment we live in, zero-interest ratepolicy, currency manipulation and high cross-assets correlation.In particular, we see six scenarios playing out in the few years ahead of us (someof which are mutually exclusive or may happen in succession): InflationScenario (Currency Debasement, Debt Monetisation, Nominal Defaults), DefaultScenario (Real Defaults, sequential failures of corporates/banks/sovereignsacross Europe), Renewed Credit Crunch (similar to end-2008, end-2011 ormid-2012), EU Break-Up (either coming from Germany or peripheral Europe),China Hard Landing, USD Devaluation.Let us take the opportunity of this Outlook to explain our argument in furtherdetails. So far, money printing failed to re-ignite growth in the debt-ladeneconomy. The excessive level of debt in the industry, although now partlytransferred from the private to the public sector, serves as a huge drag ongrowth. Increasing the level of debt further through balance sheetexpansion – as the sole crisis intervention policy - is hardly a cure, andrisks to make the drag bigger and bigger, and the growth more and moreunlikely, in a self-defeating vicious circle. Money do not grow on trees, andthe debt is not going anywhere, it stays in the system. The IMF foreseesEuropean banks deleveraging by 4.5trn in the years to come. A staggeringamount, and one which could offset the incendiary inflation effects of the moneyprinting in the making in Europe. However, it is less obvious the price at whichthese assets will change hands. It occurs to us that very little will be achieved ifsuch stock is transferred at close to par, at current bubble levels, as it seems to
be in the intention of the selling agents (it is worthwhile reminding ourselves ofbanks having utilized all tricks at their disposal to hide the real magnitude ofNPLs on their books, under the complicity of Central Bankers and regulators).The drag on growth would stay, in that scenario, and the economy in Europe willfollow the baseline scenario of a Japan-style multi-year slow deleverage. Therebalancing would then happen purely through moderate inflation, eating slowlyinto the stock of debt (a 2% inflation YoY annihilates 70% of the level of debtover a lifetime). Also, again by the IMF, we are warned about the danger of fiscaltightening and austerity, as they point out that “fiscal multipliers” might besignificantly larger than governments assumed in conducting austerityprograms. Assumption was 0.5. Instead, multipliers up to 1.7 suggest that,counter-intuitively, fiscal tightening could even end up worsening a country’sfiscal position: ‘sharp expenditure cutbacks or tax increases can set off viciouscycles of falling activity and rising debt ratios’ (Underestimating FiscalMultipliers?). Here again, we are left with a more than proportional drag ongrowth and, consequently, a slower process of deleverage in the years to come.Now then, the multi-year Japan-style deleverage is perhaps the mostprobable scenario, perhaps the luckiest one for Europe, but still it is hardlya scenario we should give for granted, hardly a scenario with a probabilityclose to par. Absent a crystal-ball, it is arduous to determine where else wecould be heading from here, and that is why we refer to Multi Equilibria markets,as we see more than one potential endgame for European matters. In anattempt to simplify the tree of potential outcomes, we see two drivingforces who could spoil the party and derail the Japan-style slow deleverage,which point in exact opposite directions: • Default Scenario: Real Defaults, Haircuts & Restructuring, potential Euro break-up as a by-product. In this state of the world, money printing failed to achieve any result in terms of manufacturing growth in the real economy (as measured by productivity / real GDP / industrial production /real wages and output growth), and can claim victory just on removing the tail risk from the banking sector, temporarily. Temporarily.. as the political backing for austerity and debt mutualisation fades away, and with it the ability to pour more base money into the financial veins of the system. What happens is that EUR holders and taxpayers realize and rebel against the implicit transfer of wealth that money printing
represents, from producers, savers and them into the banking sectors, bondholders and the well-off. Money printing slows, or stops outright, the oxygen mask is removed and the patient dies of overleverage-induced suffocation. Amongst other potential catalysts, history teaches us that bad things happen when a “bubble economy” is held on the thin air created by Central Banks’ liquidity injections and tightening conditions result in higher rates. • Conversely, we see an equal chance of going through the opposite scenario, an Inflation Scenario: Nominal Defaults, Debt Monetisation, Currency Debasement. In this state of the world, money printing failed to achieve any result in terms of manufacturing growth in the real economy (as measured by productivity / real GDP / industrial production /real wages and output growth), and can claim victory just on removing the tail risk from the banking sector, temporarily. Temporarily.. as the heavy money printing finally erupts into higher inflation. So far, the incendiary effects of massive balance sheet expansion by Central Banks have been counterbalanced by the slow deleverage undergoing in the system, helped in the process by a broken transmission system where the ‘money multiplier’ is at his historical lows (as a result of an historical 30-year trend, which was accelerated in the last few years by banks – and corporates too - amassing excess reserves twenty times larger than historical averages), and finally the ‘velocity of money’ at rock-bottom levels. But both macroeconomics measures can quickly change their trajectory, at some point, and the ability of Central Bankers to stop them running their course then is highly overestimated. Indeed, Central Banks have lost much of their ability to implement standard anti- inflationary policies, as it transpires from looking at minimum reserves, excess short-term deposit vs short-term lending, non-sensitive assets vs excess deposits, corporates cash.In a nutshell, the base case scenario of a stagnant economy may continue tobe the most plausible scenario as Central Bankers keep flooding the systemwith enough liquidity. Under such scenario, a disorderly deleverage wouldbe avoided and inflation would not be triggered, at least for now, until thisdelicate equilibrium breaks on either sides.
Portfolio RoadmapOur personal roadmap to successfully riding current financial markets is basedon the following portfolio guidelines: - Keep the Dry Powder, on a slim and nimble liquid portfolio, heavily under-invested - Accumulate nominal returns, on safe senior-secured short-dated corporate exposure from northern Europe (Value Investment section of the portfolio). - Unload it fast on triggering target IRRs and meeting Carry Accumulation plans. We are now unloading, indeed, and reloading on select stocks with most similar characteristics to senior secured exposure. - Amass large quantities of long-only long-expiry heavily- asymmetric profiles to insure and over-hedge against pre- identified Fat Tail Scenarios. Accumulate a treasury of optionality over time, banking on system-wide dislocations and mis-pricings (across its four dimensions of Cheap Optionality, Select Shorts, Embedded Options and Dislocation Hedges) - Follow methodically and meticulously the list of pre-identified Fat Tail Scenarios and match it to the list of pre-identified Eligible Instruments (Fat Tail Risk Hedging Programs section of the portfolio)From here, on this construct, two outcomes are we prepared for: - Pitfalls in Europe on the way to restoring imbalances due to under-execution of austerity programs, and ‘adjustment fatigues’, leading to the possibility of steep market corrections and the chance for us to reload fast on the Value Investing part of the portfolio, at cheaper, safer and more sustainable valuations (acceleration of the ramp up of the portfolio) - Fast forward to Tail Events: best case scenario for our strategy
What I liked this monthFrance and Hollande: French business erupts in fury against "disastrous"Hollande ReadWhat makes this economic recovery so difficult for the US consumer:relative to previous recessions, growth in disposable income has been horribleReadChinas shale gas industry: for China, the deal offers another geopoliticalhedge—the opportunity to turn dollar-denominated treasury bills into realenergy assets. ReadMortgage REITs business case under pressure: with lower interest incomeand higher interest expense, the equity of these portfolios is expected togenerate lower returns (ROE) going forward, making these investments lessattractive ReadEurope’s Path to Disunity: Hans-Werner Sinn, President of the Ifo Institute forEconomic Research ReadW-End ReadingsSecurities lending insight: cost of short selling is top performing factor :since January 2007, the cost of shorting is the best in Europe of all factors, with ahigh and consistent return trumping conventional classics like operating cashflow ratios. This note debunks various myths surrounding short selling alpha. Asone might expect, the most expensive to short shares are the ones that fallthe most. But notice that being long or overweight the least shorted stocksalso makes money. With the exception of the second quarter of 2009 when theso called ‘junk rally’ saw a stimulus spirited fight back from highly shortedshares, the most borrowed companies have fallen in price almost every monthsince then. ReadSharp declines in equity correlations should improve alpha generation ChartInteresting Reading: so many numbers, so little time Read
Reinhart/Rogoff on the US recovery: sluggish vs most recessions. But relativeto systemic crises, it is pretty remarkable ReadU.S. Unemployment Hurdle for Housing VideoAgriculture: "Why I Learned To Trade Less And Love The Farm" VideoJapan’s very own fiscal cliff ReadDeflation vs Inflation: some educated thoughts for deleverage to prevail ReadWEIMAR: The Hyperinflation Horror Story That Haunts Europe Today ReadBundesbank slashed London gold holdings in mystery move ReadInteresting perspective on Apple and its supply chain ReadU.S. Debt Lags Only Three Government Defaults VideoThe Top 15 Economic Truth Documentaries VideoFrancesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: firstname.lastname@example.org Berkeley Street, London, W1J 8DZ, LondonAuthorised and Regulated by the Financial Services Authority
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