1. October 5th 2012
Fasanara Capital | Investment Outlook
1. Short-term, we believe markets will be supported well into year-end by
open ended Central Banks activism, which we expect to outweigh the
downside risks arising from Greece, Spain and the likes.
2. Upon some concessions to the ECB over conditionality, at some point an
attempt will be made to compress spreads further for peripheral Europe
into a level which would trigger further sizeable reflation across financial
assets (e.g. to sub 300bps for spreads of 10yr BTPs vs Bunds).
3. Recent market weakness was likely driven by quarter-end profit taking,
as investors rushed to crystallize a positive performance for the period.
From here, we expect the market to be more supported on Central Bank’s
natural floor on valuations, in volatile range trading with an upward drift
bias, allowing for short-term tactical yield-enhancement strategies.
4. Longer-term, we intend to capitalize on the fictitiously sustained
valuations and rock-bottom Risk Premia to amass cheap optionality on the
six pre-identified Fat Tail scenarios we anticipate in the few years ahead,
under our Multi-Equilibria market outlook
In our last write-up we detailed the outlook over the short term, the medium term and
the long term horizon. In a nutshell, in the short-term we believe markets should be
able to reflate further on Central Banks’ liquidity or under the threat of their
intervention, which should serve as a natural floor of some sort to the markets.
Medium-term, possibly not earlier than next year, we see the fundamentally
impaired markets and economy to show vulnerability to one of two polar forces:
from the top, German taxpayers rebelling to subsidies, or from the bottom, with
peripheral Europe’s taxpayers rebelling to austerity. Longer-term, we expect the
markets to reneging on Mean Reversion, under our Multi-Equilibria theory, and a decent
probability for them to implode in either a Default Scenario (real defaults) or his
polar opposite of an Inflation Scenario (nominal defaults). For a more detailed
rendering of each scenario please refer to the link attached.

2. In this brief Outlook, we would just like to add a few elements to our short-term view.
Over the past fortnight, in our eyes, the market weakness is to be attributed to the
quarter end and investors rushing on the opportunity to close a positive period in a
rocky year. From now on, and possibly into year end, we suspect the markets might
respond to the Central Bank liquidity in reflating further, although with hiccups and
volatility along the way. The trigger for a more sustained rally might derive from
further compression of government bonds spreads for peripheral Europe,
relieving tail risk on investors’ mind. Central Bank liquidity acts from various fronts,
from the ‘top real dollars’ spent monthly by the FED to the ‘hypothetical euros’ the
ECB is willing to spend, upon concessions over conditionality and budgetary controls by
money recipients. Counter-intuitively, we would not be surprised to see ECB’s
‘expected euros’ proving to be more impactful than FED’s ‘actual dollars’, over the
short term. Not only because the FED is at his third round of a flawed intervention
policy, whose diminishing returns are more and more evident. But also due to short
term noise from elections, discussions over debt ceiling and fiscal cliff, and peak-ish
valuations (pre-Lehman levels) on record profit margins.
In Europe, we expect an agreement over conditionality to be reached, and without
the need for dramatic price action to trigger it. The ECB cannot transform ‘expected
euros’ into ‘actual euros’ whilst unleashing its OMT operations with no strings attached.
That would be the one single biggest misstep paving the way for Germany
unplugging from Europe’s assistential model, on realization that Weidmann’s stance
was indeed insightful. Draghi’s boldness in front-running inactive fiscal agents, risking
the Bundesbank’s anger in offering unlimited paper cash against troubled assets, is not
to be wasted too quickly too blatantly, as the immediate loss of credibility would be fatal
to the European fragile construct. We believe Spain, and surely Italy, know that best and
will succumb to soft brinkmanship policy by the ECB with no need for tragedy. Which
leads us to believe that the then top euros spent by the ECB will attempt first at
compressing yields and spreads to Germany quickly to a level which would likely trigger
a significant reflation over all asset classes in Europe in the few months ahead. Should
spreads of BTPs to Bunds be manipulated to below 300bps, for example, it is
likely for the markets to re-price positively in anticipation of a de facto Debt
Mutualisation across Europe. To be sure, to us, for what is worth, such interpretation
will be erroneous or premature, but we can see the market taking that view for a while,
in the short term outlook, until further notice from the real economy (for those who
have read us before, we are in what we called ‘Phase II: Reflation following new
intervention’, which is to be followed by ‘Phase III: Bursting of the Bubble’).
In the medium term, as extensively explained in previous write-ups, austerity will
press its grip on the largest economies in peripheral Europe, with evident

3. potential consequences. Such economies have so far only tasted the preliminary
flavours of austerity, but we are 6 to 12 months away from it exercising its full wrath.
Greece’s sequencing comes handy in detecting timing and inflection points for
Spain and Italy. Germany’s support itself is at risk in the medium term: if current
‘expected euros’ together with the first ’real euros’ spent were to fail to kick-start the
economy and build quickly on the positive momentum, then we can see Germany
openly opposing or unplugging outright, as we believe the numbers still support such
turnaround, as of late (please refer to previous Outlooks for our calculations over this
matter).
In the long term, after such an overdose of credit expansion, we shall look at the
patient and see if any productivity / real GDP / industrial production /real wages
and output growth was engineered out of all of it, or whether the ‘debt overhang
without growth’ is still there and way bigger than before, without any more
humanly-devisable monetary treatments to dispose of. At that point, the baseline
scenario of a Japan-style multi-year slow deleverage, could leave the stage for what we
called Multi-Equilibria markets, under which the market finds its new equilibrium in a
completely different place than where mean-reversion would suggest. Without boring
who has read us before, for easiness of understanding and at the risk of oversimplifying,
our six strategic long-term scenarios are the following: Inflation Scenario, Default
Scenario, Renewed Credit Crunch, EU Break-Up, China Hard Landing, USD
Devaluation.
Let us clarify our thoughts for the long run. We do not position for Fat Tail
events and pay for Contingency Arrangements because we expect the
European construct to surely implode and imminently so. We do it because
it may happen. Because stuff happens. That is why you take out insurance. And
we do it because, in this instance, insurance is absurdly cheap, undervalued
and mispriced, by virtue of the same Central Banks’ actions and their
desperation to compress insurance premiums themselves in an attempt to
demonstrate that tail risks have been removed outright and all bets on it are off.
It reminds us of the price of wanna-be AAA paper during the credit bubble
few years ago, under the sign-off of bullet-proof Rating Agencies
calculations. 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.
True, the deleverage which has taken place in between provides for some

4. cushion, but such leeway is rapidly evaporating and leaves us in a similar
situation to then, using the same flawed remedies whilst hoping for a different
outcome.
The by-product of their acts is a cheapening of insurance premium themselves,
to levels where it is made inexpensive to position for such tail events, in a self-
financing way, despite low yield environments on the long only side of the
portfolio. In a way, compression of risk premia, the demise of volatility, the
increase in correlation across asset classes helps counterbalance a low yield
environment and low carry at hand to finance cheap proxy options, leaving us
with heavily asymmetric profiles and large positive convexity.
The reason why we position for Fat Tail events is also because we know
that the experimental Central Bank policy has a chance of success nowhere
near par. Central Banks themselves have upped the stakes to un-precedent
levels for peacetime finance history and have no way to be in safe control of
the unintended consequences of their bold moves. Money don’t grow on
trees, balance sheet is itself a finite resource, it is not cost-free and surely
not risk-free. Rephrased: “‘none of us really know why the economy has
performed so poorly, why the tools we have been putting at work didn’t work,
and by the way none of us has ever been here before as central bankers…how we
are gonna come back…we have the theoretical tools but we have never been here
before, neither the ECB has’’. It is not us talking but the Federal Reserve Bank of
Dallas President Richard Fisher.
Opportunity Set
Certainly, the right-tail event “Inflation Scenario’, included in our list of six
scenarios (under our Fat Tail Risk Hedging Programs) is today made more probable
by the combined actions of the ECB and the FED. The firm commitment to pursue
Debt Monetization and interest rates rigging through open-ended balance-sheet
expansion and negative real rates, may result in disorderly/unsterilised actions and
provoke heavy Currency Debasement, at some point along the way.
Despite the fact that an Inflation Scenario is today made more probable, its rising
probability is all but reflected by the markets. If anything, it is price in as less
probable than the day before. The same indicators that should price and reflect it are

5. indeed compressed by CB’s activism and their objective of crushing volatility and
compressing Risk Premia (Draghi spoke of the ‘Convertibility Premium’ for Spain as if it
was a disease, instead of a fair reflection of risk). Critically, such premia are one of the
very few ways, at least in trade-able instruments, to protect oneself from the unintended
consequences of current policies. Resulting in the greatest value opportunity of all,
which is to amass such effectively Cheap Optionality to hedge (and over-hedge)
the portfolio for the years to come.
More generally, as previously argued, Risk Premia are nowhere near where they ought
to be should one factor in the even vague possibility of partially failing European policy
making. Our leit-motiv remains to take advantage of current market manipulation
and compressed Risk Premia to amass large quantities of (therefore cheap)
hedges and Contingency Arrangements , thus balancing the portfolio 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’ provided for by Central Bankers. Look no further than that, as
we believe that they represent the only truly Distressed Opportunity right now in
Europe. Timing-wise, the next 6 months may provide the most interesting window
of opportunity. Beyond that, perhaps within 18 months, that may be the next most
crowded trade.
Portfolio Update
Money printing has pushed the price of the senior secured paper we hold to
bubble levels. Thank-you Central Banks. In a way, the fundamentals of our invested
companies deteriorated less than the fundamentals of the Central Banks’ balance sheets,
resulting in higher prices for our paper. We now have almost no paper left sub-par.
The risk of MTM volatility has risen with the rise in current prices, and we consequently
now effectively face downside risks-only going forward, as any potential further
appreciation on lower discount rates is limited. We are therefore forced into taking
profits, reduce positions, and getting even more under-invested.
Getting lower in the credit quality scale is not an option. At some point that same paper
may become the best short out there. At a time where Central Banks monetize every
sovereign risk asset onto their balance sheet (reducing the amount of quality

6. collateral available), you want to short first something that has less of a chance of
being monetized, outright or in relative value, if you can minimize negative carry.
Senior paper has been a pillar of our portfolio since the beginning of the year. At
current rates, let alone few special sits, we may have to look beyond that and
move away from it, at least in part. With open-ended easy credit, also the classical
distressed opportunity executed via fire-sales of portfolio is postponed to a later
date to be defined. Should Japan be any guide to European matters, with his stagnation
and mild stagflation, then we eye certain equities and certain commodities for the
Cash Generator portion of our portfolio, together with more active yield enhancement
strategies.
But, as we repeated ad nauseam, in our eyes the real opportunity, the truly distressed
opportunity in Europe right now is FTRHPs. The classical Value investment
opportunities into long-only bonds or equities, when adjusted for risk, at such anemic
returns, is hardly a smart trade. It might still perform (and we would miss that rally),
but as a bold high-octane strategy. We try to be more prudent than that.
On the scenario of China hard landing, we took all profits and closed positions, for
the time being. Although we still believe in the idea (which is confirmed by data on
Taiwan exports, Shipping and Mining flows), and have been proven right by the markets
in the first half of 2012, we currently witness heavy money supply and China itself
restarting fixed investment to stimulate the economy (building totally nonsense
overcapacity, but nobody seems to care). In a way, recent scandals there may create
more of a case for the opportunity of additional monetary stimulus. We expect a short
term rebound there. If it materialize, 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.
Portfolio Roadmap
Our personal roadmap to successfully riding current financial markets is based on 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).

7. - 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 week
France facing double-dip recession Read
Another domino falls as Hollande pushes France into depression - Telegraph Read

8. The truth about current inflation stats. Shadow statistics reflect estimate of inflation
for today as if it were calculated the same way it was in 1990 Read
What the Fed's Historic Bet Means for You – El Erian Read
W-End Readings
Fasanara Capital Interview on CNBC Video
With Banks Skittish, Europe’s Private Equity Firms Look Elsewhere Read
Fed's policy is not going achieve projected unemployment levels Read
Defecting Iranian cameraman brings CIA priceless film of secret nuclear sites Read
Dealing with financial systemic risk: BIS Working Paper
Currency intervention and global portfolio balance effect: Japanese lessons
Working Paper
China: “Sales are down because no-one knows who to bribe.” Read
Francesco Filia
CEO & CIO of Fasanara Capital ltd

9. Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
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