1) The document provides an investment outlook from Fasanara Capital discussing recent market movements and their views on the European sovereign debt crisis. 2) They expect further market declines are needed to motivate coordinated policy intervention, but maintain shorts as catalysts like political tensions could accelerate declines and trigger action. 3) Long-term structural issues in Europe like high unemployment and economic imbalances remain unresolved and increase the risks of scenarios like inflation, defaults or countries leaving the Euro.

1. May 25th 2012
Fasanara Capital | Investment Outlook
In the last fortnight, we saw Germany financing itself at 0% yield on 2yr bonds (vs 0.10% for
Japan’s JGBs and 0.28% for US Treasuries), we saw simultaneous weakness (but without
panic) in Equity (together with Oil and Gold), and pressures (but resilience) in Credit and
Govies. All in all, in our eyes, the market seems to maintain his confidence on a renewed
government intervention, putting faith in Central bankers and fiscal agents to apply new
bandages on the structural deficiencies of Europe and buy more time, critically ring-fencing
Greece to counterbalance the rising probability of its contagion. As it stands, the market
allegedly elected the Japanese scenario as the luckiest of all for Europe, and one for which
the market would sign-off.
Although we share the market expectation for a fresh new intervention avoiding the worst
and reflating asset values once more, we tend to disagree on timing and on the pre-
condition for such event to take place. We think a more pronounced sell-off is indeed
required to concentrate minds and build the political support needed for a coordinated
action. Absent such intervention, we believe the market should manage to make fresh
new lows, although in a volatile range (Phase I of our earlier Outlook).
Catalysts for such accelerated downside might be, in order of appearance: (i) the
antagonistic chatter between Merkel and Hollande/Monti on the right course of action, (ii)
survey polls for Greece pre-elections showing continued confusion or the election itself on
the 17th of June, (iii) more bad data on Real Estate valuations in Spain.
Few effects might follow such catalysts, and provide a precursor of the accelerated
downturn to come, possibly: (i) more concrete signs emerging of bank runs, velocity of
money picking up, spreading from Greece to nearby countries, (ii) renewed pressures on
USD funding, as reflected this month by 1yr EURUSD currency basis, and (iii) new highs on
yields and spreads vs Bunds or, worse, a bearish flattening of the government bond curve
of peripheral Europe on rising short-dated rates.

2. The topology of various government interventions was discussed in previous Outlooks.
Perhaps, this week we have added to the list of shock absorbers a legendary Eurobond and
a Pan-European Deposit Guarantee (FIDC-style). We hold to our belief that ECB’s SMP
operations would be most effective measure in the short-term (biggest bang for the buck),
if utilised with resolve and if duly pre-announced so as to affect expectations, more
effective than LTROIII and fiscal bailouts, despite the side-effects of subordination imposed
on existing private government bondholders. Importantly, driving yields and spreads
decisively lower on risky governments can hardly decouple more from nearby asset
classes, and would therefore likely trigger positive relief performances, including a positive
fallout on market confidence and a temporary re-pricing of tail risks.
Critically, US dynamics (and their decisive monetary policy) are unlikely to come to the
rescue either, this time around. Next Friday non-farm payrolls might spread some light on
the timing of QE3, as we have little doubt it will take place at some point. Ironically, a
negative economic number there would be positive news for the markets and financial
assets, increasing the odds of QE3 being announced, possibly when the FED meets next on
the 20th of June. However, timing-wise, it might be too long to wait until then for Europe’s
own events to unfold. To be sure, in the absence of such clarity over QE3, US markets might
well weaken further too (looking at past monetary expansion phases, seeing a mark of
1100/1150 for the S&P500 would seem plausible, from the current value of 1320).
Consequently, we maintain our shorts/hedges in place, with the idea of revisit them, and
possibly flipping them over, once and if an acceleration of the market decline is visible
(through the list of Catalysts and Effects enumerated above) and may trigger a fresh new
monetary or fiscal injection by policymakers (Phase II: ‘Reflating Back, following new
intervention’).
Clearly, the biggest risk to a coordinated intervention is Germany. Germany may have lost
some shine on monetary policymaking (and rightfully so, in so far as its rigid call for austerity
over growth is exposed), but they still call the shots. The paymasters may be proven wrong
on their theories, but they still hold the wallet. And the more so now than at the beginning
of the crisis. Should Germany opt to slow-down and dis-engage itself, or leave the table
outright, the scenario would most obviously dramatically change. However, for now, we
believe they might stick to the European project, renewing markets’ hopes for a debt
union (and internal inflation in Germany), as it should make sense to them not only
politically but also economically, still. If anything, over the last decade the common

3. currency led them to accumulate 1.8 trillions in surpluses (vs 1.5trn deficits for peripheral
Europe altogether). Surely, so far they are exposed for 657bn under Target2 system with the
ECB/Eurosystem and their lion share of the 390bn in aid pledges for
Greece/Ireland/Portugal. In some ways, they are getting closer and closer to breaking even
on a decade’s wealth of gains. And recent early signs of bank runs inevitably get
Germany’s compensating exposure to the Eurosystem rising fast. In Martin Wolfe’s words,
‘export surpluses are of no real value if they translate into claims vis-à-vis countries which
ultimately cannot pay their debts (Bundesbank vis-à-vis the ECB: Target Claims). Such figures
may or may not help figure out when a tipping point for Germany gets reached. Overall, any
investor would have an hard time accepting potential losses wiping out 10 years of capital
gains. Such price could be just too high for any non-economical goal. On balance, they may
stick in this time but, by the same token, they might decide differently at the next round,
on overwhelming economical calculations over political ones.
On a Long-Term horizon, we repeat our mantra of equipping our portfolio for what we
called ‘’Bursting of the Bubble Phase’, as we advocate for such renewed government
intervention (maybe the last one, maybe not) to inflate the bubble even more and set the
stage for one of two events under our Multi-Equilibria Markets theory: Inflation Outcome
(Nominal Defaults, Debt Monetization and Currency Debasement) or Default Outcome (Real
Default and Debt Rescheduling/Haircut). We still doubt Europe can manage to paddle
forever in the middle of the distribution curve and avoid the edges of these cliffs.
The base scenario may keep its lead as long as Central Bankers can flood the system with
enough trillions of liquidity, avoiding a disorderly deleverage and critically helped by the
same undergoing deleverage in avoiding triggering Inflation, for now, until the delicate
equilibrium breaks on either sides.
1. Inflation Scenario is as much a self-explanatory outcome as it is mispriced in the
current markets, across asset classes. Even Germany has recently accommodated to
the possibility for inflation to ratchet higher than the 2% ceiling normally
contemplated. Unleashing inflation does not come without potential risks and
unintended consequences (the attached funny video can help visualize Currency
Debasement, more effectively than a macro-economic essay).
2. Default scenario is one where money printing fails to counterbalance the safe de-
levering of the debt-laden parts of the economy, pushing select Banks in receivership
/restructuring /nationalization /merge, select Sovereigns to restructure/devalue/

4. leave the Euro, the Euro to break-up or reshape. Orderly or disorderly. Credit is the
most exposed asset class here, but not the only one. Equity may be priced
inexpensively against history (on P/E multiples) and against interest rates (especially
after underperforming over the last month): but definitively not as much against left-
sided tail events.
The structural issues of an over-leveraged European economy generating too little growth
are at the roots of our bearish long term view: GDP, Unemployment, Productivity,
Imbalances across Europe continue to paint a growingly disconcerting reality. With Youth
Unemployment at 36% in Italy and Portugal, and 52% in Greece and Spain, there is only
negative convexity there. To such debilitated state, austerity is hardly the right medicine.
Churchill put it best when he said: ‘we contend that for a nation to try to tax itself into
prosperity is like a man standing in a bucket and trying to lift himself up by the handle’.
Certainly, doing so at the mercy of still unaware (although growingly less so) EU taxpayers
and, more generally, EUR holders.
The huge divergence in costs, trade balances and productivity across European countries is
the next big thing, as it still reigns unabated 6 months after the outburst of the sovereign
crisis, with no evidence of easing in sight. Germany, on their side, refused to engineer a
reversal of its trade surplus, through Internal Inflation via boosting disposable household
income and household consumption (by cutting income and consumption taxes), or
stepping up infrastructure spending. On the other end, peripheral Europe is trapped in its
implementation of Internal Devaluation, in the absence of any possibility for Nominal
External Depreciation, and a still-overvalued Euro currency. In accordance to the
Bundesbank’s vision, Europeans are attempting at reducing an unsustainable chronic level
of debt by driving aggregate demand to grow less than income and productivity for many
years to come. Put simply, we are doubtful that such large imbalances can (and should) be
dealt with in a Fixed Exchange Rate system, like the Euro. Thus, our grim outlook for the
market to re-price the rising probability of select countries leaving the Currency Regime
(but not necessarily the European Union for that purpose), over the next 4/5 years.

5. Opportunity Set
Meanwhile, whilst we trail the effects (and side-effects) of unprecedented monetary
manufacturing into financial assets pricing, market levels and market depth for
positioning on Tail Scenarios are available and cheap, both through Select Shorts or Cheap
Hedges (what we call Fat Tail Risk Hedging Programs). Dysfunctional markets allow for
cheap options trading, mis-pricings and heavily asymmetric profiles, whilst trailing
nominal benchmark returns is easier than normal to do. The market does not price in as
yet such extreme outcomes, in what we believe is a replica of an hard-to-die irrational
exuberance, except for VIX and most celebrated ‘fear factors’ which are therefore over-
crowded and over-priced. As long as you can look beyond the VIX, which does not represent
a viable instrument at current rates in our eyes, into what we call Embedded Options and
Dislocation Hedges, you are off to a successful hunting season on Tail Risk Hedging.
The shock scenarios that may be targeted, at different probabilities 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 of those independent events
taking place is not as low as each single probability would indicate, and definitively higher
than what the market prices-in currently (and permits you to hedged at).
In no instance, in these markets, should a portfolio feel secure in the absence of select
shorts/hedges, 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.
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), whilst simultaneously (ii) loading
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.

6. What I liked this week
Germany should quit the euro. Clyde Prestowitz - Foreign policy Read
Secret Central Bank Aid Props Up Greek Banks. Greece’s banking system is being propped
up by an estimated €100 billion or so of emergency liquidity provided by the country’s
central bank — approved secretly by the ECB in Frankfurt Read
Concentrated Risk: 226 Hedge Funds Owned Apple As Of March 31. But what happens if
the Fed continues to push off the NEW QE announcement: just how much of a general
collateral redemption onslaught can the said group withstand before they all scramble to
leave at the very same time? Read
Ray Dalio sees a 30% chance Europe will stumble badly. What is happening in Europe now
is essentially the same to what happened in the U.S. in 1789. In 1776, the colonies
declared independence from Great Britain. We didn't have a country. It wasn't until 13
years later, 1789, that those states started to form a central government, largely because of
their debt problems Read
W-End Readings
Shipping Focus: China Buyers Defer Raw Material Cargos Read; Pimco Bullish Analysis Read
Japan Focus: In Historic Move, Japanese Pension Fund Switches To Gold For First Time Ever
Read
Japan Last resort? Japan hires top girlband AKB48 to sell government bonds Read
US Focus: Renewed Fight Over the Debt Ceiling Read
US Focus: Treasury Secretary Timothy Geithner, speaking at a meeting of the Peterson
Foundation in Washington DC on May 15, reflects on the economy Read
ECB propaganda: Inflation Island Game. Game
Great Expectations and the End of the Depression, by, Gauti B. Eggertsson. This paper
suggests that the US recovery from the Great Depression was driven by a shift in

7. expectations. This shift was caused by President Franklin Delano Roosevelt’s policy actions.
The key to the recovery was the successful management of expectations about future
policy. On the monetary policy side, Roosevelt abolished the gold standard and—even more
importantly—announced the explicit objective of inflating the price level to pre-Depression
levels. On the fiscal policy side, Roosevelt expanded real and deficit spending, which made
his policy objective credible. These actions violated prevailing policy dogmas and initiated a
policy regime change. Working Paper
Bank Runs, Deposit Insurance, and Liquidity, by Federal Reserve Bank of Minneapolis.
Traditional demand deposit contracts which provide liquidity have multiple equilibria, one
of which is a bank run. Contracts which can prevent runs are studied, and the analysis shows
that there are circumstances when government provision of deposit insurance can produce
superior contracts. Working Paper
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

8. “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 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.”