1. April 13th 2012
Fasanara Capital | Investment Outlook Weekly
Investment Outlook
So far this year, our view has materialized: a risk-on rally in the first three months of the
year, namely in the ramp up to a pre-announced LTRO2 liquidity event, driven by central
planners’ money supply injection and massive balance sheet expansion, was followed by a
decisive 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, within
the next few weeks: ‘Deflating Further’. Phase (2) Medium Term, within the next few
months: ‘Reflating Back, following new intervention’, and Phase (3) Long Term, within the
next 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, whilst
progressively drifting to lower valuations under the effect of various forces at play: (i)
From a fundamental stand-point: rising unemployment, contracting GDP, debt overhang
and deleveraging pressures, oil-induced instability and increased energy bills for an already
strained peripheral Europe and an income-challenged consumer base. (ii) From a technical
stand-point, shorts are down, Hedge Funds have meanwhile gone long in an attempt to not
deviate 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 at
easing further (in the absence of a pre-announced LTRO3 or the political backing for way
more intense SMP open market purchases of govies) might already equate to tightening
financial conditions, which cannot possibly bode well for fragile markets previously pushed
to current levels by an overdose of liquidity.
In the Medium Term, especially if and when a more pronounced drop in prices was to
occur, we believe policymakers would intervene and engineer a fresh round of liquidity in

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 more
pronounced sell-off is required for the policymakers to build political consensus around a
fresh new intervention. Re-phrased, we believe that we will likely experience further
monetary 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 SMP
activity or the expectation of a LTRO3) or intensified moral suasion by fiscal agents on
firewalls (either via EFSF, ESM, IMF or other bailout funds). The ECB SMP’s activity would
currently 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 a
direct shock on government bond prices, larger than the one generated by a possible
LTRO3, as it is not diluted by Local Banks risk attitude and moral hazard. These same Local
Banks have indeed already amassed carry trades on the local government paper of the
countries they belong to, more intensely so in the days following LTRO2, at net interest rate
differentials 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 in
replenishing capital via capital gains on seemingly safe assets. Local banks have amassed
local country risk, in a double-up bet on the downside, making spreads movements on
Bonos and BTPs more catalytic than they were late last year. Consequently, a flattening of
the government credit curve, on rising short dated government yields (maybe following a
less than ideal T-bills auction in peripheral Europe, especially Spain), might be the catalyst
to look out for to detect a larger tail risk in the Medium Term, and therefore an imminent
intervention by Central Planners. Such front end yield dynamics might otherwise easily
snowball on an already impaired and shrinking sovereign collateral. Especially if coupled
with (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 on
financial assets: it is fair to assume that another round of liquidity injection/support would
therefore be accelerated, in a last attempt to preserve markets from imploding.
Spain, in particular, might provide such catalyst. With youth unemployment at close to
50%, a 92% debt on GDP ratio (way more than 60% when including regional, state
corporations and other hidden debt, some of which is already impaired), with budget
deficits adding a potential 9%/10% on it at YE 2013), a residential housing market which may
fall more than anticipated (consensus at -15%), zombie banks with unrealized losses on
massive loans to developers and homeowners, and one of the most uncompetitive labor

3. markets in Europe, Spain may see his long dated government bonds exceed 6%/7% yield
mark again soon and, at a later stage, the curve itself flattening out on upcoming
government 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 to
backfire on a Liquidity Trapped economy, inevitably exposing to Tail Events and Multiple
Equilibria Markets, sooner or later, within the next few years. Credit expansion, in the
form of cheap loans (re-hypothecation and leverage), asset purchases (debt monetization
and leverage), Euro-Bonds (wealth transfer across countries and leverage) or fiscal firewalls
(wealth transfer across countries / investor classes and leverage), helps to quell immediate
fears and to avert a disorderly deleverage, but Europe's deep rooted issues remain
unresolved. In the absence of real GDP growth, the common denominator of such policies
is still just ‘leverage’, disguised in multiple ways but still just financial engineering more
than anything else. If history is any guide, leverage has previously failed when imbalances
had 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 the
bubble. 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 considered
politically 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 to
exercise an influence.
More specifically, as we often stressed, we see Multiple Equilibria Markets mode to keep
the center stage in the years ahead: the base case Stagnant Volatile Scenario may keep its
lead on an Inflation Scenario (Nominal Defaults and Debt Monetisation) on the one hand
and a Default Scenario (Real Default and Debt Restructurings) on the other (see our March
Outlook for how we define them), as long as Central Bankers can flood the system with
enough liquidity, avoiding a disorderly deleverage and critically helped by the same
undergoing deleverage in averting Inflation, for now, until the delicate equilibrium breaks
on either sides.

4. Opportunity Set
Meanwhile, whilst we trail the effects of unprecedented monetary manufacturing into
financial assets pricing, levels have improved to a level where it is made easier and
cheaper to hedge against certain negative scenarios, both through Select Shorts or Cheap
Hedges (Fat Tail Risk Hedging Programs - more in the February Outlook). The scenarios that
may 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 Banking
industry/HY/Lev Loans, (iii) Default Scenario (sequential failures and exit from EU of certain
countries), (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 scenarios
have still low probability, all of them, in absolute terms, but such probability was never
higher than it is today. Critically, the probability of any one (or the other) of those
independent 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, and
permits you to hedged at.
Our investment philosophy is not to change delta from positive to negative at every turn of
the market, but rather to have a balanced investment portfolio, where we (i) position
ourselves 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 its
direction-less status and the sky at the horizon is clearer, whilst simultaneously (ii)
equipping ourselves with the cheapest hedging programs available, at various points in
time, which are reasonably expected to let us endure as large a number of negative
scenarios as we can expense.

5. What I liked this week
Spain: some indebted regions and hundreds of municipalities have fallen into arrears on
payments owed to suppliers and service providers, including pharmaceutical groups and
rubbish collectors. As markets continue to pressure Spanish government debt, fiscal
consolidation becomes a race against time, and austerity driven tensions have the potential
to boil over. Spain is in for some rough times. Read
Economists Roubini and Das suggest the creation of a transitory monetary framework
which would reverse the exchange rate mechanism that led to the euro, and new foreign
exchange trading corridors would be widened in steps as inflation and exchange rate risk
premia returned to normal. Read
EZ break-up stands to benefit the core. If the EZ loses its weaker members, the smaller EZ
that would result would consist of countries with a greater reputation for fiscal
responsibility, which might the strongest countries to become less opposed to issuing
Eurobonds and to finally take the necessary steps to establish a fiscal union. The result could
be a smaller but much stronger currency area. Read
Evidence of a bubble? The global high yield bond issuance hit a record during the past
quarter. With persistently low rates and tremendous demand for yield from mutual funds
and ETFs, companies lined up to get ridiculously cheap financing. Read
W-End Readings
Most Interesting: Money and Collateral, IMF Working Paper. On the Drop of Available
Collateral. Working Paper
El Erian: will investors remain sedated by the money sloshing around the system? or will
the welfare of billions of people around the world suffer greatly if central banks end up in
the unpleasant position of having to clean up after a parade of advanced nations that
headed straight into a global recession and a disorderly debt deflation Read
Jim Grant Crucifies The Fed; Why A Gold Standard Is The Best Option Read
China: Chinese property developers hold their breath… Read

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 a
misleading 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 be
used as a gauge of improving labor conditions. Read
Gary Shilling's thought-provoking interview with Bloomberg TV, his view of the S&P 500
hitting 800, as operating earnings compress to $80 per share. Video
Coral reef ecologist Jeremy Jackson: How we wrecked the Ocean. It’s not about the fish; it’s
not about the pollution; it’s not about the climate change. It’s about us and our greed and
our need for growth Video
Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
1 Berkeley Street, London
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