1 | P a g e

January 7th 2012

Fasanara Capital | Investment Outlook

Multiple Equilibria Markets and the Case for

Staying Net Short

Happy New Year.

Four years of dysfunctional markets followed some two decades of over-

leverage and over-stimulation, with debt-fueled spending programs

addressing debt problems with yet more debt, and bringing us here, in the

land of Multiple Equilibria markets. As opposed to reverting to pre-crisis

mean and equilibrium, the dust in the markets could settle in diametrically

different ways and find a different equilibrium there: different combinations of

devaluations, inflation, expansion, deflation, depression, defaults are all made

plausible.

Surrounded by insolvent too-big-to-fail Sovereigns and Banks on steroids, that

would have failed in anything close to a free market (but have instead being

given electrical stimulation to keep the dead frogs moving), 2012 investors are

invited by policymakers to stay optimistic, to not drop the towel on such hostile

environment, as the bullish trend is about to resume.

Monetary-medicine and credit expansion have been the attempted solution to

the 2000 Dot-Com crisis first and then the 2008 Subprime/Banking crisis, and

now tried to fix the Eurozone Sovereigns/Banking crisis, to save the insolvents

and sustain elevated valuations. But after that much effort we awake in 2012

with the market still in a debilitated state, the medicine not sorting any visible

effect and yet more of the same medicine (debt and its surrogates) being pledged

in hope for a different result (this time is different) or just in fear of the

alternative unknowns.

2 | P a g e

In 2012, we believe the base case scenario remains one of a stagnant

market and economic environment, with anemic expected returns, volatile

range-bound trading and sudden shocks pushing them lower (Stagnant

Volatile Scenario). Such stagnant fragile economy could take, at some point, one

of two directions: 1) Inflation Scenario, money printing gets truly massive,

Draghi finds political support to implement decisive Fisher-Friedman monetary

stimulus (assets purchase programs, target high nominal GDP, zero rates) and

therefore finally manages to bring inflation in, markets inflate their way to

higher output, economy expands, employment recovers, debt returns

sustainable, confidence is restored, markets rebound, then some currency

debasement and potentially hyperinflation, orderly or disorderly. 2) Defaults

Scenario, money printing fails, few Banks in receivership /restructured /

nationalized /merged, few Sovereigns restructure / devalue / leave the Euro,

deleverage, implosion, Eur break-up or reshapes, orderly or disorderly. All

legitimate scenarios, not necessarily mutually exclusive, each with decent

probability.

However, certain scenarios assume that defiant investors will hang in there:

bond investors keeping their shaky government and bank bonds (whilst being

reduced by ECB SMP activity to the status of junior bondholders), equity

investors keeping their overvalued stocks factoring in peak margin levels (in

exchange for anemic expected returns) and their pricey bank stocks (ahead of

fairly dilutive recap exercises – Unicredit 43% discount docet), bank depositors

to keep cash at fragile banks at zero rates (as opposed to inexpensively remove

them from trouble). That is a big assumption: confronted with such

widespread binomial tree of potential outcomes, where half of the

potential exits are fat-tail events in either direction, it is not easy for the

average 2012 investor to stay in the game as opposed to run for the exit.

Nor it is rationale to expect that from him. We should be reminded of that when

attaching probability to each of those scenarios.

Analyzing now some relevant European data that came out over year-end,

we perhaps have seen further evidence of a Liquidity trap and signs of a

Keynesian Endpoint. First of all, ECB’s liquidity transmission mechanism has

failed, until now. The ECB is clearly printing money (as no sterilization is taking

place and bond purchases / repos are likely not to be temporary, neither they

are credit-risk free, we think), but the transmission to the real economy is as

3 | P a g e

weak as ever. True, monetary base has expanded almost 50% in the last year

(base money M0 aggregate ), but broad money supply is flat (M3 aggregate),

resulting in a collapse of the Euro money multiplier (which halved since its

peak in 2002). In simple terms, cash and equivalent (high-powered money) is

amassed in Central Bank reserves, where it is not fulfilling any economic

function, in a dysfunctional allocation of capital, not contributing to stimulating

the economy nor supporting Government bonds. In other words, stronger banks

are flushed with cash (courtesy of massive QE repo operations, 489bn just in the

last round) but prefer to deposit most of it in the safe haven vaults of the ECB (at

a destructive 0.25%) instead of lending it in the market, leaving weaker banks

struggling to get funding and grasping for more ECB support. Data is confirmed

by numbers on the ECB deposit facility being at historical highs. Data on falling

loans to individuals/household/consumer credit/mortgages speaks of the same

story. Without the multiplier, it is arduous to manufacture growth via

monetary engineering, as no matter how much you print the impact on the

economy is reduced.

Public sector is de facto crowding-out private credit, as banks hoard govies

or cash at the ECB, instead of turning it to the industrial or consumer debt

market. But there is a flip side to it as well, with the private sector deserting

public issues and bank recap/refi exercises too.

Moreover, interestingly, recent data shows that banks are pretty much not

buying sovereign paper anymore (steady decline from a peak of EU350bn in

2009). Bottom-line, monetary policy is currently therefore slowly turning

ineffective. Whilst monetary policy is out-of-order, non-monetary factors

are also weak, as job creators are immobilized, since they cannot budget or

manage the fiscal and regulatory uncertainty. All of this, just before austerity

measures kick-in, just before banks seek to shrink their loan books by a

whopping 1 trillion in an attempt to meet capital ratios (as capital markets are

still perilious – see Unicredit).

In such hostile environment, living through the likes of a Liquidity Trap

and a Keynesian Endpoint, the probability of bank restructurings /

receiverships / nationalizations is as decent as ever. The catalyst of a major

bank failure had been removed by the ECB via LTRO and SMP operations, but

such interventions have so far failed to restore confidence amongst banks

themselves, therefore their marginal impact is way less effective. It would seem

4 | P a g e

to us that one of a few reasons why several banks have not been

nationalized yet, is that their desperate Sovereigns would lose access to

back-door ECB funding. In other words, and thinking of Italian government-

guaranteed debt issued by banks on purpose to get collateral for new funding at

ECB, it is as if banks were already nationalized, in certain ways. No wonder we

are bearish on bank equity.

As we argued extensively in previous outlooks, the bar is being raised by the day,

and one cannot rationally be certain that Germany will keep footing the bill

unlimitedly and become joint and severally liable with a growingly worrisome,

ever more insolvent sinking bloc. As if it did not have its own issues (Deutsche

Bank, for example). Given its implicit transfer of resources from Germany to

other countries, the ECB operations in LTRO or SMP could be joined by yet

more massive Friedman-style monetary stimulus (and not just a bit more, as

the multiplier collapsed), or could just come in too late (as is already), and

deliberately so.

Some investors think the effects of past actions have not been felt yet, as

transmission requires time: eventually funding levels will come down (from

unsustainable 7% on BTPs), spreads to Germany tighten, interbank funding

resume, rights offer proceed smoothly (following an eventually successful

Unicredit deal). It is possible, and we may all hope so, but time is not an

independent variable in this equation and the longer it takes the more

likely it will be – in such fragile conditions – for any Greece defaulting /

Hungary imploding / Ireland double dipping / Japan facing 3trn

redemptions/ France, Austria losing AAA / Corporate inevitable failures…

to create shockwaves and spoil the party, accelerating the demise and

possible end/reshuffle of the Euro as we know it in the next 3 years. If

anything, we would tend to believe that the lagging missing link is more to be

detected in the transmission to the real economy of distress in the financial

sector/sovereign markets (something like what happened this week to

Petroplus PPHN, announcing that access to all credit lines had been suspended,

sending the stock down 20%). We believe that this realignment is indeed

more likely, to the downside, and we therefore stay net short / bearish /

hedged.

Our thinking follows through in determining that at current rich valuations

across most asset classes (although already lower than a month and six

5 | P a g e

months ago), you are not properly paid for the embedded risk you are

taking. In other words the risk-adjusted returns are not appealing enough to

justify long position sizing: there are better levels for you to get into the trade, or

there are lower embedded vols/risks, for the same valuation. If a rationale

investor still exists, somewhere, in such irrational dysfunctional markets, then

such assessment of risk will cap current markets and make the case for bearish

positions a compelling one.

Opportunities exist, already, by and large: in dislocated markets smart

hedges cost less. As long as the remit of the mandate allows you to roam

across asset classes, across the capital structure and across financial

instruments, you have a playground with no precedents. Dysfunctional

markets allow for cheap options trading, mis-pricings and heavily

asymmetric profiles, whilst trailing nominal benchmark returns is easier

than normal to do.

In no instance, in these markets, should a portfolio feel secure in the

absence of select shorts, in our view. Long-only portfolios, un-hedged

exposures and, more generally, classical asset allocation practice will be at risk

this year, more than in 2011, much like heading through a hurricane in a sailing

boat. Current markets come handy in that they allow for cherry picking your

most suitable shorts and hedges, and also now outside of the easy targets

(financials).

We believe hedging and fat-tails risk management is paramount in 2012

and beyond, as it will prove to be the most significant differentiating factor

in any strive for performance. As there is little similar to a perfect hedge in

finance, the moving basis has to be continuously and dynamically managed,

through which Fasanara Capital seeks to capture returns for its investors.

6 | P a g e

What I liked this month

Governments of the world’s leading economies have more than $7,6 trillions of debt

maturing in 2012, with most facing a rise in borrowing costs. Led by Japan’s $3 trn and the

U.S.’s $2,8 trn. More..

Everyone is also very focused on the maturities of sovereign debt this year. But one issue that

markets may not have fully considered is the immense amount of private debt European

banks will need to roll this year. Maturing EU bank debt may hit a wall in 2012

The M3 chart versus the monetary base (i.e. how much base money is out there versus all the

possible money-multiplying investment possibilities) is perhaps the most striking of them all.

More ..

Eurozone M3 contraction. This is troubling because if Germany's M3 continued to expand,

the periphery economies credit conditions deteriorated even faster than the euro area as a

whole. That was largely driven by a drop in loans to firms. Banks also continued to delever

outside the euro area. Their net external assets fell EUR25bn in November after a EUR60bn

drop in October More ..

Mediobanca is the largest shareholder of UniCredit (6.76%) . Unicredit is the largest holder of

Mediobanca (8.7%). Remember when CDO's all bought each other's BBB and BB tranches,

because no one else would? More ..

European Services PMI by key countries More ..

Top Three Central Banks Account For Up To 25% Of Developed World GDP. What does this

mean? It means that nearly $8 trillion in world economic growth is artificial and exists only

courtesy of central bank intervention. for everyone who feels that the global economy is fake -

you are right: up to 25% of all economic growth is what in a different day and age would have

been called "one-time and non-recurring". More ..

W-End Readings

Jeremy Grantham. Looking out a year, the overall picture seems so much worse than the

generally benign forecast of 4% global growth from the IMF. The probabilities of bad

outcomes are not as high for us today as they were in early 2008 when, I’m pleased to say, as

predictors, they looked nearly certain to us. The possibility of extremely bad and long-lasting

problems looks as bad to me now as it ever has More ..

7 | P a g e

Bill Gross. On capital markets: "real price appreciation is getting close to mathematically

improbable" More ..

Christina Romer. In the NYT: A Financial Crisis Needn’t Be a Noose

Jeff Gundlach. DoubleLine, Complete Slideshow Presentation, impressive slidedeck of raw

data, from Europe, to the US economy, to financial products. More ..

Ambrose Evans-Pritchard. 2012 could be the year Germany lets the euro die

More ..

Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001

E-Mail: francesco.filia@fasanara.com

16 Berkeley Street, London, W1J 8DZ, London

Authorised and Regulated by the Financial Services Authority

“This document has been issued by Fasanara Capital Limited, which is authorised and regulated by the

Financial Services Authority. The information in this document does not constitute, or form part of, any offer to

sell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or the

fact of its distribution form the basis of or be relied on in connection with any contract. Interests in any

investment funds 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 of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any steps

to ensure that the securities referred to in this document are suitable for any particular investor and no

8 | P a g e

assurance 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 or

analysis on which it is based, 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 observe any such restrictions.