Fasanara Capital | Weekly Investment Outlook | December 17th 2011


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Fasanara Capital | Weekly Investment Outlook | December 17th 2011

  1. 1. December 17th 2011Fasanara Capital | Investment OutlookIn our last write-up before year-end, we try to make sense of the current marketsand render our view on 2012 economic landscape, fat-tail risks and investmentopportunities.The week ending today was an important one= as it carried an answer to some ofthe question marks floating around: will the un-precedent liquidityinjection/monetary base expansion put in place by the ECB and Central Banksglobally be able to boost Confidence? In fact, the ECB accepted to provide Bankswith unlimited financing against good and not-so-good collateral (whilst globalcentral banks pressed forward $ liquidity swaps in size), in exchange for theBanks to hold on to their sovereign paper and, perhaps, buy some more at thenext auctions (in what would become for the bank a zero-risk-weighted carrytrade). At the same time, a prospective enlarged SMP meant that ECB could buygovernment paper for 20bn/week, which is already a staggering 1trn/year. Suchmove, together with a new patchwork bazooka in the doings (encompassingEFSF / ESM / IMF / Eurobonds / BRICs help), was supposed to remove thecatalyst of a large bank failure =rom the markets, restore interbank markets andsupport sovereign funding. On=the contrary, market indicators returned a bitterverdict: OIS-Libor / TED spreads, eurusd currency basis, $libor, swap spreads,spreads of peripheral countries to Bunds, yields on sovereigns, all rising orstationing at alarming levels, bank stocks sinking. We moved into a ConfidenceCollapse Scenario, as we called it in our previous Outlook, a scenario in which themarginal utility/impact of subsequent measures decreases, leaving theproblems unsolved, the bleeding flowing and raising the bar exponentially onfurther measures. The by-product of such scenario, is a Bank-Run Scenario.However, despite stress in financial conditions and the interbank market,distressed sovereign markets across Europe and battered bank stocks, suchConfidence Collapse scenario is not yet to b= seen in most private markets: inEquity and most Credit, and neither can yet be seen in=the key macro driver ofaggregate demand, Consumer Confidence and Spending. None of them is really 1|Page
  2. 2. cheap in our eyes, as it is only mildly down when compared to the range ofpossible outcomes out there: currency redenomination risk, depression andearnings contraction, shut-down of capital markets when they are most needed,sequential sovereign failures an= restructuring, currency debasement and massmonetisation. That must be b=cause those markets predict one outcome mostout of all, they share an intimate, deep-rooted, religious belief: at somepoint=down the line, when the risk of implosion is closer, on the very verge ofcollapse or whilst it’s already unfolding, a massive wave of debt mutualisation ormonetization will deep-impact markets, mighty and forceful, falling from the sky.Light will shine on them, saving debt-laden=Samson and all the Philistines.Consistently, corporate earnings (at historical 60-year peak) look real andsustainable only to the extent all the excess leverage and toxic assets in theeconomy get stripped out of the current holders, swallowed by public balance-sheet, wiped out by the printing press together with the fiat currency they arewritten =n.But who should be the architect of such mighty force? left there, maybeGermany?As the battle intensifies and gets ugly, Germany is left alone to fight in the field(similarly to the last two world battles it fought in the last century, un-successfully). With France and Spain on the verge of being downgraded (b=kick’em-while-they-are-down Rating Agencies lagging indicators), and thereforenot being able to compute into EMSF numbers any longer, with the UKleaving=the scene in anger (creating a dangerous precedent of open-airanimosity in the fragile political landscape, at a time when any agreement wasjust difficult enough to grasp), Germany is left in solitude to do the numbercrunching. <=>Germany’s robotic, disciplined, cost-conscious, depressive Bubamentality will have to handle Europe mess a=d commit to provide un-calculable(i.e. unlimited) funding for it. As debt mutualisation (Euro bonds) orseigniorage/printing press (ECB) hardly changes the true implicit transfer ofresources from Germany to peripheral countries, somehow, it is still Germanyalone to call the shots.So let’s now see their number crunching. How much should they pay and forwhat. Let us try to gauge the range of the potential bill, and its key risk vectors. 2|Page
  3. 3. - Debt Flows: in systemic secular crisis like this one=Sovereign or Bankdebt burden is somehow the same thing. 2012 is a maturity cliff yea= forSovereigns and Banks (let alone Corporates, where we see an opportunity=-below). Sovereigns will need 1 trillion plus in 2012, refinancing on Eur700bndebt coming due, much of it in the first quarter. - Debt Stock: The outstanding stock of government bond= is 3.5 trillionplus considering peripheral countries only. 5.1 trillion including France. 8.5trn intotal. We fear there are no natural holders anymore for this debt, but only ECB-financed (un)natural buyer on steroids = the banks – creating a vicious circle ofhyper re-hypothecation if left f=r a longer period than just the time ofemergency. As argued in previous outlooks, such volatile debt is un-sellable at areasonable price to any other buyer than the ECB or its lieutenants(banks)=/span>.<=b> If you are a pensio= plan based in America, Middle East orAsia, you should wonder why you keep hold of such digital risk for =inimalpotential upside. Even if you are an European institutional buyer you are l=ftwondering. The average government bond buyer is one who wants to invest100=to get a meager 103.5 next year and the year after next, quite simply. Herehe=is confronted with equity-like volatility, stormy uncharted territorypredicting fat-tail outcomes of all sorts and no diversification benefit to speak of(=s they become positively correlated to risky asset, being their main Betadriver). And, lets not forget, that ECB intervention means that the governmentbondholders is relegated to the status of junior bondholder, all of a sudden (asthe Greek precedent proved, where ECB insisted to be made whole vis-à-vishaircut for the private sector, being the provider of “Debtor in Possession” likefinancing). Therefore, as soon as a decent bidder shows up (be it ECB or itslieutenants banks), maybe at better prices than the market as monetary agentstry to cap yields to return debt sustainability, the average bond buyer is simplylikely to run for the exit. Especially if he runs the risk of becoming a juniorbondholder. Especially if the Central Bank is not credible enough. - Within the liability side of the stylized bank balance sheet, one item isdangerously liquid and promptly redeemable: deposits. In=precursor Greece,50bn plus of Business and Household Deposits have flown in the last 18 months,20% of the total only in 2011, and the pace has alarmingly accelerated in the lastthree months according to BoG. Not surprisingly, given capital mobility thesedays. The same un-expensive risk-reduction trade could happen in France and 3|Page
  4. 4. Italy. After all, French la=ger banks have 4.6trn assets vs 1.7trn of French GDPoverall. After all, BNP Paribas has 30X le=erage against Tangible Common Equity,with deposits representing 30% of its 2trn assets (compared =o US at 50%),depending for the rest from a disappearing wholesale market. - Consumer Confidence and Spending are lagging indicators, these days,showing incredible resilience. But they cou=d give in at some point, brokendown by front-loaded austerity kicking in, bringing down growth and GDP, andthe denominator of most debt/equity ratios and P/E multiples.In a desperate attempt to try and make sense of the current markets in areduced-form equation, let us drop in just two more factors. Firstly, no= onlyGermany is left alone in having to sort out years and years of European chronicrunaway deficits and over-leverage (with yet more debt, but of his own), but it isabout to face opposition from the same countries it might try to save: Italy, Spain,even Greece are slowly realizing the flows in the Europe tentative solution beingoffered. In the base case scenario (of Germany doing just enough to a=ert acollapse) they are at the beginning of an indefinite period of recession =if notdepression), years-long deleverage, where all of their primary surplus =if any,after raising taxes and cutting expenditures) will be spent to pay for=the debts,with way more politically-unbearable social unrest than they had anticipated(with 20-30% youth unemployment), as they can’t rely on a tru=y expansionarypolicy and on the only fix that worked historically to reignit= growth, i.e.competitive devaluation. For instance, look at Italy, where th= interest rate billreached a lethal 100bn/year now; compare it to the lates= 25bn FinanziariaStraordinaria that Mr Monti is yet struggling to have green-light for. The secondblocker standing in the way of Germany is Germany itself, as Germany is called tofinance the debt-laden European construct instead of using the same resourc=sand focus them on its own skeletons: fiscal deficit (worsening), large stock ofdebt, insolvent financial institutions (Landesbanken, Commerzbank, IKB, WestLB, DB itself has leverege of 60:1 on a TCE/assets basis and $2.5 t=illion of assetswith zero capital backing).These are the factors that lead us to believe, contrary to the market consensus,that debt mutualisation or massive debt monetization might come too late, might 4|Page
  5. 5. be insufficient or might not come at all. Those who construct their macroportfolios on such catalyst might be exposing themsel=es to large tail data points.Our long term view is therefore unchanged. The Euro block is entering recessioneven before austerity plans kick-in, left right and center. GDP to slow into 2012,gripped by austerity. First test on Christmas Shopping, =o prove way worse thanBlack Friday. Equity, Credit & Vol in denial on potential negative GDP quarterlyfigures and EU break-up risk longer-term, grossly misaligned to its probabilty.Uncertainty to stay, hence its probab=lity to rise, hence equity to catch up withreality and fall in 1H12. The EU= exercise is going to be unwound in the next 3/5years with a 50%+ probabili=y, following a restructuring and early exit of Italyand Spain.One industry is most at risk, as it is victim to a secular transformation: banks.Banks to be the ghosts =f a financial services depressed industry, moving fromwanna-be hedge funds at the forefront of innovation to “in=rastructure moneycenters”, left alone in swallowing un-yielding government bond =aper, able tooperate at way lower ROE and multiples, with half of their current employees,justifying only half of their current valuations.Opportunity Set:1. In a debt crisis without inflation there is little alternative to defaults, or else,anyway, a long period of sub-potential growth and painful deleverage. Longer-term, financial depression and broad-based deleverage across the Euro Zone andbeyond is a likely outcome. Debt relief/Deleveraging is to provide the bestrelative value opportunity, starting in the first half of 2012.2. We do prefer good companies and good collaterals to shaky government risks,macro trading and speculative positioning of any type. We target Valuecompanies coming under stress in the months to come on European sovereignwoes and maturity cliffs= with a long-term approach and emphasis on absolutestandards of value. Safest place in these markets is senior secured, which alsohappens to offer (or is about to offer) equity like returns. Most often, this is notavailable in government bonds, nor in equities. 5|Page
  6. 6. 3. Second leg of the strategy is Insurance/Hedging: value approach to be coupledwith overlay hedging strategies, name-specific and macro across the overallportfolio (fat tail risk options), banking on market dislocations/inefficiencies toseize cheap(er) options. Counterparty risk to be a game-changer: hedgingstrategy to be re-defined in the current market conditions to reflect that; moredisclocations-based hedges as oppos=d to traded options.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. 6|Page