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Fasanara Capital | Weekly | April 13th 2012


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Fasanara Capital | Weekly | April 13th 2012

  1. 1. April 13th 2012Fasanara Capital | Investment Outlook WeeklyInvestment OutlookSo far this year, our view has materialized: a risk-on rally in the first three months of theyear, namely in the ramp up to a pre-announced LTRO2 liquidity event, driven by centralplanners’ money supply injection and massive balance sheet expansion, was followed by adecisive set back in the last fortnight, ever since option expiry around mid-March.Going forward, we suspect a similar pattern is waiting to play out ahead of us. Put simply,our tactical view can be split into three consequential phases: Phase (1) Short Term, withinthe next few weeks: ‘Deflating Further’. Phase (2) Medium Term, within the next fewmonths: ‘Reflating Back, following new intervention’, and Phase (3) Long Term, within thenext few years: ‘Busting of the Bubble, to the left tail (Defaults) or to the right tail (Inflation)of the distribution curve’.In the Short Term, we expect the market to range trade in a broad band, whilstprogressively drifting to lower valuations under the effect of various forces at play: (i)From a fundamental stand-point: rising unemployment, contracting GDP, debt overhangand deleveraging pressures, oil-induced instability and increased energy bills for an alreadystrained peripheral Europe and an income-challenged consumer base. (ii) From a technicalstand-point, shorts are down, Hedge Funds have meanwhile gone long in an attempt to notdeviate excessively from buoyant benchmarks, overbought conditions can still be detected.Also, maybe more significantly in the short run, a pausing ECB who does not clearly allude ateasing further (in the absence of a pre-announced LTRO3 or the political backing for waymore intense SMP open market purchases of govies) might already equate to tighteningfinancial conditions, which cannot possibly bode well for fragile markets previously pushedto current levels by an overdose of liquidity.In the Medium Term, especially if and when a more pronounced drop in prices was tooccur, we believe policymakers would intervene and engineer a fresh round of liquidity in
  2. 2. the financial veins of the bubble markets we live in, pushing the market to resume its risk-on status. Not only a fresh new intervention would push the market higher, but a morepronounced sell-off is required for the policymakers to build political consensus around afresh new intervention. Re-phrased, we believe that we will likely experience furthermonetary expansion, and its associated risk-on rallies, before the bubble busts.Such intervention may take the form of increased ECB action (either via more intense SMPactivity or the expectation of a LTRO3) or intensified moral suasion by fiscal agents onfirewalls (either via EFSF, ESM, IMF or other bailout funds). The ECB SMP’s activity wouldcurrently be the most effective tool, in our eyes, and therefore the most likely to be used:on the one hand it has the strongest marginal impact and highest multiplier. It exercises adirect shock on government bond prices, larger than the one generated by a possibleLTRO3, as it is not diluted by Local Banks risk attitude and moral hazard. These same LocalBanks have indeed already amassed carry trades on the local government paper of thecountries they belong to, more intensely so in the days following LTRO2, at net interest ratedifferentials not too far from current valuations. That means that they may be soon out-of-the-money on the bulk of their carry trades, jeopardizing the very target of those trades inreplenishing capital via capital gains on seemingly safe assets. Local banks have amassedlocal country risk, in a double-up bet on the downside, making spreads movements onBonos and BTPs more catalytic than they were late last year. Consequently, a flattening ofthe government credit curve, on rising short dated government yields (maybe following aless than ideal T-bills auction in peripheral Europe, especially Spain), might be the catalystto look out for to detect a larger tail risk in the Medium Term, and therefore an imminentintervention by Central Planners. Such front end yield dynamics might otherwise easilysnowball on an already impaired and shrinking sovereign collateral. Especially if coupledwith (i) social unrest (Spain), (ii) spiking oil prices and (iii) China tumbling further. By-products of such scenario would likely be a renewed Credit Crunch and Risk-Off mode onfinancial assets: it is fair to assume that another round of liquidity injection/support wouldtherefore be accelerated, in a last attempt to preserve markets from imploding.Spain, in particular, might provide such catalyst. With youth unemployment at close to50%, a 92% debt on GDP ratio (way more than 60% when including regional, statecorporations and other hidden debt, some of which is already impaired), with budgetdeficits adding a potential 9%/10% on it at YE 2013), a residential housing market which mayfall more than anticipated (consensus at -15%), zombie banks with unrealized losses onmassive loans to developers and homeowners, and one of the most uncompetitive labor
  3. 3. markets in Europe, Spain may see his long dated government bonds exceed 6%/7% yieldmark again soon and, at a later stage, the curve itself flattening out on upcominggovernment roll-overs (having to refinance Eur 180bn more into this year alone).In the Long Term, we expect the thin air pumped into the veins of the financial system tobackfire on a Liquidity Trapped economy, inevitably exposing to Tail Events and MultipleEquilibria Markets, sooner or later, within the next few years. Credit expansion, in theform of cheap loans (re-hypothecation and leverage), asset purchases (debt monetizationand leverage), Euro-Bonds (wealth transfer across countries and leverage) or fiscal firewalls(wealth transfer across countries / investor classes and leverage), helps to quell immediatefears and to avert a disorderly deleverage, but Europes deep rooted issues remainunresolved. In the absence of real GDP growth, the common denominator of such policiesis still just ‘leverage’, disguised in multiple ways but still just financial engineering morethan anything else. If history is any guide, leverage has previously failed when imbalanceshad compounded to a level where they became unsustainable for the system as a whole,or unbearable to specific classes of market participants who then triggered the bust of thebubble. Critically, for example, policymakers’ attempts at preserving a bubble market by re-flating it even further (as the unknown consequences of seeing it bursting are consideredpolitically unacceptable) come at the expense of still unaware EUR holders and taxpayers:multiple elections this year may provide more than one opportunity for such classes toexercise an influence.More specifically, as we often stressed, we see Multiple Equilibria Markets mode to keepthe center stage in the years ahead: the base case Stagnant Volatile Scenario may keep itslead on an Inflation Scenario (Nominal Defaults and Debt Monetisation) on the one handand a Default Scenario (Real Default and Debt Restructurings) on the other (see our MarchOutlook for how we define them), as long as Central Bankers can flood the system withenough liquidity, avoiding a disorderly deleverage and critically helped by the sameundergoing deleverage in averting Inflation, for now, until the delicate equilibrium breakson either sides.
  4. 4. Opportunity SetMeanwhile, whilst we trail the effects of unprecedented monetary manufacturing intofinancial assets pricing, levels have improved to a level where it is made easier andcheaper to hedge against certain negative scenarios, both through Select Shorts or CheapHedges (Fat Tail Risk Hedging Programs - more in the February Outlook). The scenarios thatmay be targeted, at different probabilities (for how low they may be) and costs, range from(i) Renewed Sovereign woes, (ii) renewed Credit Crunch and stress in the Bankingindustry/HY/Lev Loans, (iii) Default Scenario (sequential failures and exit from EU of certaincountries), (iv) Inflation Scenario (as a result of monetary expansion getting out of control,or even Defaults and derailing fiscal train wreck), (v) China hard landing. Such scenarioshave still low probability, all of them, in absolute terms, but such probability was neverhigher than it is today. Critically, the probability of any one (or the other) of thoseindependent events taking place is not as low as each single probability would indicate,and our sense is that it is definitively higher than what the market prices in currently, andpermits you to hedged at.Our investment philosophy is not to change delta from positive to negative at every turn ofthe market, but rather to have a balanced investment portfolio, where we (i) positionourselves on what we believe are the safest asset classes/capital structures (strong cash-flow generative companies, from countries who still dispose of a domestic currency,preferably senior positions or collateralised positions), until the market emerge from itsdirection-less status and the sky at the horizon is clearer, whilst simultaneously (ii)equipping ourselves with the cheapest hedging programs available, at various points intime, which are reasonably expected to let us endure as large a number of negativescenarios as we can expense.
  5. 5. What I liked this weekSpain: some indebted regions and hundreds of municipalities have fallen into arrears onpayments owed to suppliers and service providers, including pharmaceutical groups andrubbish collectors. As markets continue to pressure Spanish government debt, fiscalconsolidation becomes a race against time, and austerity driven tensions have the potentialto boil over. Spain is in for some rough times. ReadEconomists Roubini and Das suggest the creation of a transitory monetary frameworkwhich would reverse the exchange rate mechanism that led to the euro, and new foreignexchange trading corridors would be widened in steps as inflation and exchange rate riskpremia returned to normal. ReadEZ break-up stands to benefit the core. If the EZ loses its weaker members, the smaller EZthat would result would consist of countries with a greater reputation for fiscalresponsibility, which might the strongest countries to become less opposed to issuingEurobonds and to finally take the necessary steps to establish a fiscal union. The result couldbe a smaller but much stronger currency area. ReadEvidence of a bubble? The global high yield bond issuance hit a record during the pastquarter. With persistently low rates and tremendous demand for yield from mutual fundsand ETFs, companies lined up to get ridiculously cheap financing. ReadW-End ReadingsMost Interesting: Money and Collateral, IMF Working Paper. On the Drop of AvailableCollateral. Working PaperEl Erian: will investors remain sedated by the money sloshing around the system? or willthe welfare of billions of people around the world suffer greatly if central banks end up inthe unpleasant position of having to clean up after a parade of advanced nations thatheaded straight into a global recession and a disorderly debt deflation ReadJim Grant Crucifies The Fed; Why A Gold Standard Is The Best Option ReadChina: Chinese property developers hold their breath… Read
  6. 6. Interesting data from the US: In spite of the abysmally low number of jobs created (120K vs.205K expected), the unemployment rate continues to decline. The unemployment rate is amisleading indicator however….as it is measured against an increasingly smaller labor force.For now the headline unemployment rate number is not meaningful and should not beused as a gauge of improving labor conditions. ReadGary Shillings thought-provoking interview with Bloomberg TV, his view of the S&P 500hitting 800, as operating earnings compress to $80 per share. VideoCoral reef ecologist Jeremy Jackson: How we wrecked the Ocean. It’s not about the fish; it’snot about the pollution; it’s not about the climate change. It’s about us and our greed andour need for growth VideoFrancesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: francesco.filia@fasanara.com1 Berkeley Street, 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 the factof its distribution form the basis of or be relied on in connection with any contract. Interests in any investmentfunds managed by New Co will be offered and sold only pursuant to the prospectus [offering memorandum]relating to such funds. An investment in any Fasanara Capital Limited investment fund carries a high degree ofrisk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any steps to ensure that thesecurities referred to in this document are suitable for any particular investor and no assurance can be giventhat the stated investment objectives will be achieved. Fasanara Capital Limited may, to the extent permittedby law, act upon or use the information or opinions presented herein, or the research or analysis on which it isbased, before the material is published. Fasanara Capital Limited [and its] personnel may have, or have had,investments in these securities. The law may restrict distribution of this document in certain jurisdictions,therefore, persons into whose possession this document comes should inform themselves about and observeany such restrictions.”