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November 16th 2012

Fasanara 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, possibly

into year end, allowing for tactical yield enhancement strategies, mainly

executed 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 had

markets in Europe supported and directionless, almost soporific as they danced

in narrow trading range (2450 to 2550 for the Eurostoxx, 30 basis points range

for yields and spreads volatility), whereas European equity was indeed

outperforming the US by a decent margin (almost 400bps) over the period.

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Now then, as we feel we are at a crossroad and critical levels are being

tested (for the DAX and the S&P in primis), we decided to cut directional

risks on short term positioning, moving our Beta portfolio to completely

flat neutral, whilst maintaining relative value plays cross-markets between

Europe and the US/UK. We have enjoyed the ride on yield enhancement

strategies until now, but prefer to be flatter going forward into year end. Markets

in Europe moved to the low end of their trading range, and are dangerously

dangling 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). We

maintain our view that Spain, Greece and the US fiscal cliff risk factors are

overdone, and do not have the potential to truly destabilize markets in the

short term, having the Central Banks just stepped out in offering a

backstop firewall with reckless abandon. However, we are worried about

technical levels and risk appetite abating for most active players into

thinner volumes at year end, and have therefore preferred to cut risk and

moved completely flat. Should the technical formation improve from here, we

stand ready to promptly reinstate our yield enhancement strategies and

add 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. In

fact, we maintain the view that an attempt will be made, at some point, for

compression of yields and spreads of Spain/Italy vs core to levels which would

trigger the (erroneous) market perception of a de facto Debt Mutualisation

across Europe, well before the Banking Union - dreamed about by Hollande - or

the budgetary parental controls - dreamed about by Merkel (please refer to the

link attached for our thinking around a de facto Debt Mutualisation).

Reinstating yield enhancement strategies and tactical longs will not be a

one way bet. We have taken advantage of current super-compressed risk

premia and tiny inter-banking spreads to implement cheap optionality on the

hedging side of our portfolio, and we look at increasing such positioning given

current rock-bottom levels and limited downside. We believe such hedges are

best geared to provide cover against the potential true catalyst to

underperformance on the Beta portion of our portfolio.

The reason why we believe in the possibility of further reflation of asset prices

revolves around the credibility of the Central Bank, which we feel is the real

asset at stake now. Our investors and readers know how critical we are about

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endless monetary printing as a way to cover up unresolved structural

imbalances across Europe, and buy time in the process. However, they do

manage to achieve that: buy time. In the short to medium term, we expect

policymakers to be rationale enough not to waste their credibility all too

early, too blatantly, having promised to stand behind the European construct at

all 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 unlock

a most expected/obvious funding tranche to Greece, should Spain pester around

conditionality to the point of jeopardizing a most needed 90bn recapitalization of

its banks (still dependent on the ECB), should even Draghi decide to help Spain

in the absence of such conditionality (risking Germany’s revolt), in all such cases

the loss of credibility would be heavy damage. All in all, we believe policymakers

know that all too well and will manage to avoid these obvious missteps.

Policymakers and monetary agents may be convinced that this is the time to

prove to the markets and their respective electorates that Europe is on the right

path, as the conditions at large will soon be far worse for them to try the same

exercise next year. They are confronted with a similar grim data set to the one

we currently look at, and they may come to similar conclusions as to the

importance of getting the timing right, this time around. And capitalize on the

tentative signs of stabilization that have surfaced in the markets as of late.

Not only inter-banking spreads have compressed to levels where any

potential further tightening is hard to imagine (leaving the door open to cheap

hedging, in our tail hedging programs ‘FTRHPs’). Additionally, we saw positive

developments for the first time in months in the Eurosystem, with Spain

TargetII exposure to the ECB decreasing by over 50bn (to 365bn), mainly

due to a reopening of the repo market on their securities (with Spanish banks

replacing ECB repo funding - 75bps - with cheaper private repo market funding -

approx. 30bps), but also thanks to forestalling deposit outflows and some new

bank debt issuance. Italy itself saw its exposure to the Eurosystem

decreasing 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 black

clouds into next year, making the odds worse by then: (i) the law of

diminishing returns for central bank policies is ever more evident, with free-

falling monetary money multipliers (ECB is most concerned about it as it is

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looking for ways to repair a broken transmission system - ECB workshop on Nov

19th on excess liquidity and money market functioning), (ii) the drag on growth

can only worsen into next year, as fiscal multipliers are larger than

governments assumed in conducting austerity programs (‘sharp expenditure

cutbacks or tax increases can set off vicious cycles of falling activity and rising

debt ratios’ Underestimating Fiscal Multipliers?), resulting in tight fiscal policies

possibly worsening the same fiscal position for countries hit by austerity

measures, therefore worsening sovereign solvency itself, as opposed to

improving it, (iii) youth unemployment reaching tipping points at almost

60% in Greece, 55% in Spain, and above 35% in Italy, Portugal and Ireland

(introducing the ‘youth sacrifice ratio’) (iv) this week the Eurozone was

confirmed in recession in Q3, with deceleration of consumer spending and

headwinds from activity data all pointing further south: even German

manufacturing is in outright contraction, after weakening exports not only into

peripheral Europe but also into Latam and China (likely to worsen further with

the weakness in commodity prices).

Critically, what is way harder for policymakers to avoid is the end result of the

current crisis resolution policies, as a colossal debt overhang gripping the

economy is being treated with yet more debt, weighting even more on real GDP

prospects. It is way more difficult to treat the basic disease affecting European

(and global, in that respect) policymaking: ‘short-termism’. However, as we

argued repeatedly of late, this is a long-term scenario and we do not expect it to

materialize in the short to medium term.

A word on Greece, as we head into next week’s EU summit. Back in March, we

thought Greece’s PSI was purely priced into the next inevitable restructuring

event. However, we warned ‘’by then, the Official Sector will count for 80% of the

total debt (vs 60% today), making it an even more politically-troubled issue.

Critically, and unintentionally, Greece will thus maintain its status of key

vulnerability for Europe as a whole, long before the next event, with its

imbalances building up slowly and surely to the next tipping point.’’ All in all, we

remain bearish on Greece, and we see its exit from the Euro Area as

inevitable. However, we believe such next tipping point is no earlier than

2013/2014.

Cross-markets, we remained positioned for Europe to further outperform

the US in the near future. True, Obama victory at the elections is the relative

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best when compared to the increased uncertainties over inflection points in

monetary and fiscal policymaking that Romney would have entailed (in that we

probably disagree to consensus view). But the stage is set for further noise in the

US and a weak relative price action. Firstly, if the technical situation got tricky

in Europe it is far worse in the US. The US starts off from richer valuations, at

around pre-Lehman levels, and it is hard to argue that just the thin air of actual

monetary 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 be

reached in less than a dramatic fashion, but the timing of such compromise is

likely to be later rather than sooner, if history is any guide, at which point the

market will have taken a defensive stance. We look at it as an opportunity, as a

cheaper valuations for certain bonds and stocks in the US will help us build part

of our portfolio on the Value side (Carry Generator pool, helpful to self-finance

the Hedging portion of the portfolio and our Fat Tail Risk Hedging Programs). In

particular, we monitor the uncertainties over the taxation on dividends and

their impact on blue chips, low leverage, high dividend paying stocks: it seems

the top marginal tax rate may rise to almost 45% on dividends, and 25% on

capital gains, from 15% for both currently. Against that backdrop, a sharp slow-

down of flows into high-dividend ETFs is the foretelling data corroborating

such view. Once (and if) that re-pricing has occurred, possibly into early next

year, 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 the

near future, both in Equity and Credit space. The catalyst may be the recent

decision by the BoE to moderate QE. Truth be told, such decision is an

understandable one, as the credit expansion in the UK is way larger than that of

Europe (and even the US), on our metrics. However, as we are reminded by

history, a slow-down in the rate of acceleration of credit expansion is itself

a tightening move. When the addiction to credit is large (as in the UK), it is hard

to 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 private

debt to GDP of 450% (300% in the US), financial sector debt of 250% of GDP (hot

money flows). Lastly, but perhaps most importantly, the rich valuations

(especially in Credit) vis-à-vis core and peripheral Europe should help motivate

an underperformance in the next few months. Such valuations stand in stark

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contrast to credit metrics / fundamentals: next year, the UK needs a nominal

GDP growth of almost 4% to cover primary deficit plus borrowing costs (much

worse than Italy, whilst having funding costs of one third of Italy, at current

1%/2% yields). Such contrast might be exposed (and demand a re-pricing)

as the (erroneous) perception of Debt Mutualisation surfaces in Europe in

the few months ahead, depriving the UK of the most relevant

differentiating factor until now: the availability of a lender of last resort.

Most worryingly, such lender of last resort - Mervyn King - recently admitted the

limits of monetary expansion, identifying the external demand as the missing

source of pick-up of activity for the UK economy. Our transcript from his

recent testimony (Video, starts at 3.20 minute): ‘what the UK needs is more

demand in the rest of the world to buy goods from the UK, that is the key bit

missing from our attempt to rebalance, and why the challenge is so great’. But

there may be too much wishful thinking there, as net exports contribution to

UK’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 over

the same period, for example). So Mr King is hoping for nothing to change, but

export demand to be better than it has ever been in the past 10 years, and

lead to UK’s resurgence. Given what is going on globally, with clear signs of

contracting global trade, trade conflicts to debase one own’s currency and

secure a larger slice of a shrinking pie, there is more than one reason to

hold doubts about King’s hopes.

Finally, regarding another possible catalyst and a key vulnerability for the UK, let

us quote our March Outlook: ‘’Corporate Pension Deficit Widening Fast and

Solvency Models of Insurers under pressures. Given our long-term Outlook

for an unbalanced, fictitious economy in Europe (debt-laden and kept alive by

massive liquidity and currency debasement from the ECB, possibly building up

its excesses to the point of implosion), we cannot easily dismiss the dangerous

spiral underway on Corporate Pension Schemes and Insurers alike. When

Negative Real Rates are the goal of a Central Bank trying to achieve Nominal

Debt Monetization (as Debt Mutualisation was prohibited by Germany, and

Defaults were deemed to be politically unacceptable), the pension deficits

balloon. The fatal mix of falling long-term Interest Rates and simultaneous

rise in Inflation make Pension Liabilities rise indiscriminately’’.

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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 of

Multi Equilibria markets in the next 4 years. We rendered out thinking in a

recent conversation with CNBC (Video). The multi-year Japan-style deleverage

is perhaps the most probable scenario, perhaps the luckiest one for Europe, but

still it is hardly a scenario we should give for granted, hardly a scenario with a

probability close to par. Absent a crystal-ball, it is arduous to determine with

certainty where else we could 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 an attempt to simplify the tree of potential outcomes, we

see two broad destructive forces 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. Or Conversely, we see an equal chance of going through the

opposite scenario, an Inflation Scenario: Nominal Defaults, Debt

Monetisation, Currency Debasement. ‘The leit-motiv of our Investment

Strategy remains to take advantage of current market manipulation and

compressed Risk Premia to amass large quantities of (therefore cheap)

hedges and Contingency Arrangements against the risk of hitting Fat Tail

events in the years to come. If we do not hit them, then great, it will be the

easiest catalyst to us hitting the target IRR on the value investment portion of

our portfolio (what we call Safe Haven, or Carry Generator). If we do hit one of

those pre-identified low-probability high-impact scenarios, then cheap hedges

will kick in for heavily asymmetric profiles (we typically targets long only/long

expiry positions with 10X to 100X multipliers). Such multipliers are courtesy

of market manipulation and ‘interest rate rigging’ by Central Banks. We

believe 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-be

AAA paper a few years ago, under the sign-off of complacent Rating

Agencies. At that time too, shorting credit was made inexpensive. Timing for the

bubble to burst was uncertain, as it is now, but inexpensive means that it did not

matter that much after all. This time around, it is not the Investment Banks

pushing credit into unsustainable territory but the Central Banks

themselves - with obviously more margin for error, but not infinitely so.

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Opportunity Set

We offer an update to our Opportunity Set alongside the list of pre-identified tail

scenarios we see possible in the few years ahead of us (some of which are

mutually exclusive or may happen in succession): Inflation Scenario (Currency

Debasement, Debt Monetisation, Nominal Defaults), Default Scenario (Real

Defaults, sequential failures of corporates/banks/sovereigns across Europe),

Renewed Credit Crunch (similar to end-2008, end-2011 or mid-2012), EU

Break-Up (either coming from Germany rebelling to subsidies or peripheral

Europe rebelling to austerity), China Hard Landing, USD Devaluation.

Renewed Credit Crunch

Ever since Draghi’s bold move in support of the currency union, together with

similar extraordinarily expansionary monetary policies globally, certain Risk

Premia and inter-banking spreads collapsed to new lows, from where any

potential further compression is hard to imagine. In particular, we saw the

EURUSD currency basis tightening to pre-Lehman lows (before resurging slightly

last 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 all

are in between 10bps and 20bps, having been single digits for a short while in

the past few weeks. In comparison, the tightening in CDS premiums, VIX

volatility and the likes is short of impressive.

China Hard Landing

This 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 convinced

China’s imports were slowing down, as reflected by official data and as

confirmed by data on Taiwan exports, Shipping and Mining flows. We recently

took all profits and closed positions, for the time being. Although we still

believe in the idea (in particular, South Korean’s exports to China took a dive

lately), we are on the verge of forceful money supply in China (for a change) and

abroad, and therefore became wary of a short term rebound. If such rebound

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materializes, we would like to reinstate positions, this time expanding the scope

to 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 be

positive about China and wary of a rebound. Xi Jinping’s appointment was a

safe choice for the country and we noticed his immediate consolidation of power

within the Party’s Standing Committee, as he assumed Military Committee

chairmanship (differently than what happened during Deng Xiaoping and Jiang

Zemin hand-overs). Also, the initial statements of the new leadership team seems

to show awareness that reforms are essential to China and the same survival of

the Communist Party. All in all, the good ground for reforms should help

markets in the short term.

Moving away from the shipping industry, which provided the hedge last

time around, our eyes are now on Australia. We believe Australia might

provide an efficient hedge against China’s hard lending, at some point next

year. The main fragilities we observe are the following: an unusual current

account deficit, heavy hot money flows (large foreign investments), overcapacity

in the mining and construction industries (key components of their economy).

Medium-term, we are bearish both on the exchange rate and the banking sector

on the equity side (a far cheaper play than the already depressed iron ore

industry), whilst we would be receiving rates in fixed income, so as to prepare

for interest rates cuts and generate premium in between.

Our long-term bearish stance on China is based mainly on decelerating

growth and overexpansion of credit embedded in their economy. For what

has now become a 7trn economy, it is fair to assume that double-digit growth

rates are long gone. Growth is not necessarily the most informative data out of

China (due to flaws in their statistical infrastructure, let alone reliability of the

data available). However measured, it is inevitable for growth to slow down

markedly, from here: it is arithmetic pure and simple, for the impossibility

of exponential growth in a finite environment. We expect growth to be

below 7% possibly already next year and below 6% within the next 5

years. Within such growth rates (still good in absolute terms), the rebalancing of

growth from state-driven fixed investment to domestic demand is going to have

an impact. Investment is almost 50% of China’s GDP, whereas Consumption is

just above 35%. Total credit is 30% of GDP. The housing bubble is greater than in

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Switzerland, as the country dis-incentivized foreign investments by Chinese

people, together with lowering real interest rates into negative territory. We do

not believe China will go bust, but the transition to a more balanced

aggregate demand mix should lead to pitfalls and adjustment fatigues, as

the credit bubble of indiscriminate state investments (in totally useless

projects) 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 Scenario

Similarly to the Renewed Credit Crunch scenario, Cheap Optionality is available

here 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.

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What I liked this month

UK 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 unfunded

obligations Read

High yield debt issuance in 2012 hits an all-time record Charts

Introducing the ‘youth sacrifice ratio’: the cost of the economic downturn is

borne in a disproportionate manner by the younger generations is, in the

short term, more socially acceptable than a “fair” distribution across all age

categories. the bulk of the population, at least initially, can still benefit from a

relatively high level of economic security which may help to keep them away

from radical politics Read

Spain has full access to the market, but ONLY because of the ECB's backstop. In

fact if Portugal qualified for the OMT program, it would immediately gain full

access to the market as well. This argument is a bit circular, isn't it? Read

W-End Readings

Bloomberg TV Interview to Fasanara Capital: В течение нескольких лет

Греция выйдет из еврозоны: Video

Greece next restructuring: ideas from past experiences with heavily indebted

poor countries Read

Is Russia the best or worst of BRICS? Video

Samsung Hikes Apple Component Price By 20% Read

How Zara Grew Into the World’s Largest Fashion Retailer Read

China's future: challenges and opportunities Read

As Giffen good, when physical Gold goes into “hiding” the demand will increase

in proportion to the increasing price Read

Austerity in pictures Pictures

Ray Kurzweil and reproducing brain Video”

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Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001

E-Mail: francesco.filia@fasanara.com

16 Berkeley Street, London, W1J 8DZ, London

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