Fasanara Capital | Bi-Weekly Notes | September 14th 2012
1. September 14th 2012
Fasanara Capital | Bi-Weekly Notes
1. Pax Romana in the markets is brought in by Central Bankers. Monetary
creation is open-ended and can support markets in the short term,
possibly into year-end. It eases up potential troubles over the next few months,
puts to sleep imminent catalysts and downside risks. But only temporarily so.
2. The threat to the Pax Romana induced by balance sheet expansion
comes from both ends of the spectrum: from the top, with German taxpayers
rebelling to subsidies, or from the bottom, with peripheral Europe’s
taxpayers rebelling to austerity. These two basic drivers (more than Greece,
heavy government supply in October, or Italy and Spain pestering the ECB over
conditionality terms) may defuse monetary expansion in the medium term.
3. The greatest opportunity we see is to load up optional-style Contingency
Arrangements, which are made the cheapest ever by Central Banker’s
activism and interest rate manipulation.
Over the past few weeks, financial assets reflated markedly on the back of coordinated
balance sheet expansion across major Central Banks. We entered what we called, in
previous write-ups, ‘Phase II: Reflation Back, following new intervention’. Truth be
told, markets had rallied already in anticipation of such move, and Central Bankers
(differently than in the recent past) did not even wait for conditions to deteriorate, so as
to justify such intervention, but rather stepped in boldly to match markets’ expectations.
The monetary injection is un-precedent, even when compared to LTROI, LTROII, QE1,
QE2 and Operation Twist I and II. In Europe, Draghi made up his mind and took the
lead on un-decisive policymakers, and without waiting for Germany’s Supreme
Court to decide over Euro bailout funds first, he effectively made such resolution
less relevant by promising the markets unlimited direct supply of fiat paper cash
against troubled government bonds. He had not even waited for his own ECB’s
meeting on the 6th, having rushed to pre-announce it in the days before. The OMT
programs, just a by-product of the SMP operations in disguise, rebranded ad hoc for
the day, are unlimited in size and designed to compress spreads (or evil ‘convertibility
premium’, to use Draghi’s terminology) and reduce the risk of government and bank
2. runs in Spain and Italy. As we anticipated, SMP-style measures were the best bang for
the buck, and they were elected as the instrument of choice of monetary policymaking
this time around: having seen the unlikeliness of a banking license for the ESM fund,
considering the unfeasibility of further LTROs for lack of eligible collateral, OMTs (or
SMPs) operations had remained the only possible solution to attempt. The government
bond curve, dangerously flat as of late, steepened strongly in response to the
announcement, and is likely to stay steep for the time being. Such bold move was then
boosted by the Supreme Court giving green light to the ESM (although with a few
caveats, which we analyze below). On top of it, the FED decided to grant the markets
with QE3 or QE-Cosmic, as this time the intervention of the FED is open-ended,
unlimited in size (for the first time it does not give a financial cap for the overall
amount), and scope and timing (for the first time it does not say when it ends). It has
been estimated at being worth over $2trn over the next two years.
We believe the current environment, especially in the US, hardly justified such
unlimited balance sheet expansion. Critically, Central Bankers must have been truly
concerned of the fragility of the economy and the markets, well and beyond the data we
could dispose of at the time, and well and beyond the markets themselves seemed to be
worried about (in Europe markets were nowhere near their lows, in the US equity
markets were at pre-Lehman highs, labor market was weak but not much weaker than it
had been as of late, volatility measures at theirs lows). Considering the diminishing
returns of their policies, round after round and failure after failure, it is all the
more disconcerting to see them embarking in ‘unlimited’ interventions. At a
minimum, it represents an admission of desperation, a last attempt at stimulating
growth and bring the economy and the markets away from the cliff.
One thing seems certain, now Central Banks are closer to the end of their potential
activisms, as there is little more you can do than promise the markets to fire
unlimited direct purchases of assets over an unlimited timeframe. In so much as
we expected them to have more bullets at their disposal, as per the Outlooks of the past
few months, we now expect them to have moved significantly closer to the end of their
journey: a few months from now, the diminishing returns of their policies may
have transformed into close-to-zero marginal impact. At the expenses of further
fatally discrediting fiat paper money standards, in general, and making the case for the
unintended consequences to get traction. In other words, either it works this time, or
the loss of confidence will be over-whelming and their magic on the markets will be
seriously impaired. A Keynesian End-Point and Liquidity-trapped markets would
then be joined by a complete drop in Confidence, the last man standing.
3. Short Term
For those who followed our previous notes, we are in Phase II of a three-phased
outlook. Let us now divide it in two: short-term and medium-term. In the short term,
asset prices should be allowed to enjoy the ride and reflate further, possibly for
the next few months into year-end (although at a slower pace than in previous QEs).
This is not to say there will not be pitfalls and ‘adjustment fatigues’: volatility could arise
from a heavy European government calendar in October, Greece being in need of a third
bailout (Portugal of a second, Cyprus and Slovenia of a first), Spain and Italy delaying
their formal request for aid (whilst negotiating for the conditionality needed to
unleashing the ECB’s actual intervention). But all in all, such market gyrations look
easier to handle when you have unlimited supply of paper cash to otherwise
insolvent market players.
Medium Term
Central Banks may well have bought few months for now. That is the reasons why we
kept repeating that any hedges, to be effective, in this market , has to be multi-year (we
ourselves put the threshold at the 4 years horizon, thinking a final resolution to the
current state of affairs may take at least that long to materialize). In the medium-term,
we see two main catalysts with the potential to destabilize markets all over again:
1. Germany
Draghi set the trajectory for Debt Mutualisation across Europe and Debt
Monetisation, but it may be too early to deem it a done deal. In spite of
Merkel current stance and the Supreme Court’s ruling, we believe it is
premature to consider Germany as de facto joint and severally liable to
other European countries, as yet. That time has still to come, on our count. Up
until then, we believe Germany could still opt to unplug, in one of many
ways, including cutting the lifeline to select peripheral countries, or deciding to
step out of the EUR currency-peg herself. As of now, the Bundesbanks
indicates its exosure to the Eurosystem at 751bn (link), having risen
approx. 25bn in August only. Still, the number incorporates more repatriation
of funds by the German private sector. The exposure is still being transferred
from the private sector to the public sector (Banks alone have sold peripheral
Europe debt for more than 500bn in the last 4 years), making the net increase in
German exposure impressive, but not at the face value of the headline figure. We
monitor carefully the flows here as they unfold, as clearly at some point it may
cross the limit. At that point you could call it a de facto Debt Mutualisation, but
4. not as yet in our eyes. We arbitrarily put that threshold at 1.3/1.5trn (following
an reasoning we rendered in previous Outlooks). If anything, you may flip the
case and argue that, with all chips held by the National Central Bank, it is
made easier for Germany to leave the peg (and the PIIGS), in so far as the
risk of contagion to banks, household and businesses within the Germany
micro-system is somehow reduced.
Moreover, interestingly enough, we believe the Supreme Court’s
ruling contains the seeds of execution risks at a later stage. Upon careful
reading of the ruling, now both houses of the Bundestag (including the euro-
adverse Bundesrat) “must individually approve” every large scale rescue package
(a run on Italy/Spain would surely need more than the 190bn current cap for
Germany) and are “prohibited from establishing permanent mechanisms based on
international treaties which are tantamount to accepting liability for decisions by
free will of other states, above all if they entail consequences which are hard to
calculate”. Such ruling clarifies the illegality of Eurobonds and Fiscal Union
under the current law. For such reforms (which would really attempt to tackle
the root causes of the European malaise and cronic imbalances) you need a new
Constitution and a referendum.
In other words, the German Supreme Court has made the distance
shorter between policymaking and the German electorate. Not irrelevant,
considering that it is the German taxpayers who are ultimately footing the
bulk of the bill to Europe’s Debt Monetisation and Debt Mutualisation.
2. Austerity
Nominal default (via inflation) is preferred to real defaults (via
restructurings/haircuts). The debt overhang is handled through the more
invisible way of inflation, which weighs on EUR holders and EUR taxpayers.
Which helps the well-off and financial debtors (banks in primis and their largest
shareholders/bondholders), at the expenses of entrepreneurs, savers and
producers. As always, we play within finite resources in a zero-sum game,
making any policy, including this one, only a transfer of wealth and ‘confiscation’
of sort.
Until one segment of the industry breaks out, under the unsustainable burden of
austerity, which has only just started to hit the electorate (the first real taxes in
Italy, for instance, were levied no earlier than two months ago only). The
5. massive Youth Unemployment (52% Spain, Greece, 36% Italy, Portugal) may
be the detonating fuse to watch in this respect.
Long Term
A few months from now, after such 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.
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
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.
6. 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 Construct
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
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
7. 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.
What I liked this week
This time we group interesting readings by some of the six scenarios we have in mind.
Renewed Credit Crunch Scenario
Gary Shilling on US Economy Video
Inflation Scenario
Is QE3 justified? Comparing current conditions with 2010 Charts
Gross: Gold a Better Investment Than Bonds, Stocks Video
Prior QEs and market reaction analyzed Charts
Longer-term inflation expectations spike in reaction to the Fed Charts
Default Scenario
8. $648 Trillion Derivatives Market Faces New Collateral Concentration
Risks. Last time it was the 'fair-value' of housing, now it is the 'fair-value' of
'transformed' collateral that is pledged at par and is really worth nickels on the
dollar Read
Ray Dalio and Deleveraging Cycles explained Video
China Hard Landing
China's Revolution Risk. ‘The Bo Xilai affair has lifted the lid on a hornet's nest.
I had not realised quite how serious the situation has become until listening to
China expert. China's economic hard-landing is intertwined with a leadership
crisis. Read
W-End Readings
Fasanara Capital Interview on CNBC Video
End to ‘alpha’ a stress for fund managers Read
BIS Paper: whether exchange rate fluctuations can really insulate economies against
contagion: whether global bond markets are isolated or integrated, and whether
fallacies of composition characterise monetary policymaking Read
9. 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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