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2. March 1st 2013
Fasanara Capital | Investment Outlook
1. European markets vulnerability amid Italian political unknowns is to
extend for weeks. However, on balance, we remain broadly positive in
the medium term, as we do not expect as bad a scenario as in Q2 2012
2. Strategy‐wise, hence, we plan to continue to take advantage of market
dips to establish modest and/or optional long positions, renting the
rally, primarily in Equity space. Hedging programs run in parallel
3. We would not be surprised to see Germany ultimately loosening its
stance on austerity, in principle and on the surface. Talk is cheap, Euros
are expensive: and yet talk is more effective than Euros
4. The real catalyst to a disastrous market environment: a failed OMT
intervention. It would lead to fully­fledged implosion tail scenario.
OMTs failed already in the past: at the time, they were called SMPs
5. We believe we are nowhere near the end of FED expansionary policies
and talks of an exit are premature/pretextual. As the housing recovery
nastily depends on ultra‐low mortgage rates, rising rates expectations could
easily choke off the rebound underway. Let alone the Student Loans mess
6. French banks led LTRO repayments. Are they overly reliant on USD
funding all over again as they were at the end of 2011? Crisis struck then
7. Japan to lead the game of illusory returns. Heavy currency debasement
and nominal equity rally in the doings. Timeframe is the only unknown.
8. UK has few Damoclean’s swords pending down its neck this year, while
nasty bargaining negotiations with the EU progress. Downside risks on
overvalued bonds and currency. Rally is nominal at best in Equity space
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3. Inconclusive elections in Italy delivered the surprising result of a hung
parliament, and fears of un‐governability for the third largest economy in the Euro
Area. Democratic Party’s Bersani won by too narrow a margin to both resurgent
Berlusconi and to new‐entry anti‐euro Grillo. A big draw. Which means a big mess for
months to come. In so much as we expected volatility in the run up to Italian elections,
and we anticipated the complacent markets to have to re‐price decisively on a weaker
than expected government to be formed, the magnitude of such weakness is beyond
expectations. We are therefore brought to spend some time in reassessing the shape
and tempo of our long­term views, particularly with reference to the Euro Break­
Up Scenario we included in our roadmap of must­hedge tail risks.
Surely, European market vulnerability amid Italian political unknowns is to
extend for weeks, as parties’ bargaining evolves, whilst desperately trying to form any
coalition possible. No formal decision can be taken until the new parliament
convenes on 15th March. During this period, we have to discount the possibility of
political headlines driving prices in volatile market activity. However, on balance, we
remain broadly positive in the medium term, as do not expect such volatility to be
as bad as in the summer of 2012 and as bad as the one provoked by the first Greek
elections. Consequently, we plan to continue to take advantage of market dips to
establish modest and/or optional long positions, renting the subsequent rally,
primarily in Equity space.
Grotesque Italian elections may fail to provide the catalyst to the Euro break‐up scenario
we anticipate for the years ahead of us (with decent probability), while they may be
showing the early signs of it. Actually, we may see the possibility for markets to be
positively surprised next time around, as and when a grand coalition / national
unity government is established, so as to avoid new elections to take place
anytime soon. This is our baseline scenario, at present.
Why Italy may determine to settle for a grand coalition, and end of hostilities
A few arguments are backing our positive tone for the medium term. Firstly, differently
than in the failed Greek elections, most parties in Italy have no willingness to go
back into new elections anytime soon. If a new government failed to be
established, new elections would be called. On new elections, Grillo’s party would
be up for a landslide victory. Nobody wants Grillo to win (including possibly Grillo
himself, still unprepared for the top job). Hence, new elections should be avoided.
Berlusconi may have no real interest in returning to power either, as his main target of
getting a blocking minority is achieved (together with the legal and political safety net
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4. that comes with it). Bersani, and the group of long‐running career politicians fiercely
supporting his candidacy while sharing his fate in full, are frightened at the idea of going
into new elections, as defeat to Grillo would be one of only two options, the second being
a defeat to alternative party candidate Renzi (which made no mistery of his intention to
similarly swipe away the long‐standing political elite of the party).
Why Germany may determine to settle for less austerity, and end of hostilities
Secondly, despite public appearances hinting to the opposite, Germany itself might
ultimately support such mixed‐bag grand coalition, even if uneasy Berlusconi
substitutes synergetic Monti in the team. Kissing Berlusconi’s comeback, indirectly as
part of the coalition, represents the least evil to Ms Merkel. Such seal of approval comes
at a price: Germany will have to accept the most obvious rebalancing in the mix of
austerity vs growth that comes with it. The Italian vote was not against Europe
(differently than the Greek vote perhaps), but surely it was against austerity (for some
50% of total votes). It may be a stretch, but we would not be surprised to see
Germany ultimately loosening its stance on austerity, in principle and on the
surface. Talk is cheap. If anything, history has clearly proven that Draghi moral
suasion (in publicly standing behind the euro in late July 2012) was more effective than
Draghi actual money spending (during SMP1 and SMP2 operations, the antecedents of
OMT). An act of faith was more effective than paper Euros of actual money, in
driving inside spreads and yields from unsustainable levels. Germany may realize
that, and settle for it, for lack of better alternatives (as political concessions on the road
to fiscal union are out of reach in the near term under such new weak government).
True, softening austerity might require a redrafting of OMT’s rules, but we suspect
markets could be sedated by just soft talks / gentlemen agreement as opposed to
contractual arrangements, if recent history is any guide.
Talk is cheap, Euros are expensive: and yet talk is more effective than Euros
In retrospect, moral suasion helped not only yields/spreads for peripheral
Europe, but coincidentally helped Germany in reducing its true counterparty risk
exposure to it. As we argued in previous Outlooks, one of the largest single items
computing Germany’s exposure to the rest of Europe are Target II claims under the
Eurosystem. We look at such exposure as one of the few true de facto debt mutuality
feature of the Eurozone, well before the dream of a banking union or Eurobonds. It kind
of represents risk sharing across European countries. Such exposure rose forcefully all
through 2012, before stopping suddenly in July/August at approx Eur 740bn, thanks to
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5. Mr Draghi and the moral suasion elixir he was able to domesticate the markets with.
Absent such elixir, Germany’s exposure was projected to cross the Eur 1trn mark
by year­end (following bank runs and securities markets outflows from
peripheral Europe), a level at which any political brinkmanship would have been
jeopardized, as counterproductive and a double­edged sword in the eyes of most
market participants. Such wizardry came at no costs, as talk is cheap. Perhaps,
Germany will resort to ‘cheap talk’ strategy again, in publicly opening to a
different mix of austerity vs growth, and a different timeframe to the readjustment
process across Europe. OMTs are definitively more tangible and expensive as an
alternative route (especially in the context of little political gains to be snatched in the
near term).
The real catalyst to market implosion: OMTs triggered, but failing
ECB’s OMT operations are also tricky and not without downside risks, as they
could fail. The real catalyst to a disastrous market environment might be just that:
a failed OMT intervention. If OMT intervention was to be applied without enough
energy and determination (due to a less than fully‐hearted German backing for them),
they could fail. On paper they are open‐ended, in practice there are caveats (starting
with austerity‐linked covenants). For all intents and purposes, OMTs failed already
in the past. At the time they were called differently, SMPs. While fully covering the
gross issuance of countries like Spain and Italy, SMPs did not succeed in preventing
yields from going to 7% yield danger zone. It was only when Draghi resorted to moral
suasion and cheap talk (‘we stand behind the Euro at all costs, there is no way
backward’) that yields came in. A replay of a similar pattern would be catastrophic
next time around, sending markets in short­circuit and paving the way for fully­
fledged implosion tail scenario (the so‐called ‘Default Scenario’, in our roadmap, one
of disorderly deleverage/sequential restructurings).
To be sure, whilst we remain broadly positive in the medium term, we also retain
our conviction that the Euro crisis is to flare up again in the months ahead, and the
European construct is ultimately doomed in the long­run: reasons for it being heavy
structural imbalances, unsustainable competitive gaps, the impossibility of
readjustment via Internal Devaluations only, the un‐likelywood of kick‐starting real
growth/real productivity/industrial production in an overleveraged economy as is. We
simply suspect the timing is possibly not imminently right for the potentially
heavy readjustments we anticipate.
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6. On the EUR strength over G4 currencies
One important implication for our investment strategy after recent events relates
to the dynamics of the EUR vs other G4 currencies. We expected EUR strength
against USD, JPY, GBP, as the relative domestic monetary policy dynamics of the
respective central banks were to be the main driver of performance (as the other chief
driver of relative performance ‐ current account deficit – is a common denominator
across G4 regions at present). In essence, the ECB balance sheet might have tightened by
Eur 300bn (it was only approx Eur 210bn in the end), whereas the BoE, FED, BoJ would
be expanding by $0.5trn, $1trn and $1.3trn. We now have to revise the timing of that
view, as the Italian crisis provokes slower repayment of LTROs’ money, together with
the possibility of OMT being activated, which would mean credit expansion (although
the latter is not our baseline scenario).
Whilst we maintain our basic views, we expect the EUR relative performance to be
modest in the near term and go hand in hand with the political headlines coming
out of Italy. It will take some time for the trend to resume on the Euro. If it takes
too long it might not resume at all.
On the Exit Strategy of the Federal Reserve: not anytime soon
To this same point, as of late markets have been debating over a potential ‘exit strategy’
by the FED, which is supposedly discussing internally the end of its quantitative easing
and progressive withdrawal from the markets. In our eyes, we are nowhere near the
end of FED expansionary policies and such possibility is not on the table for the
near future. Tentative signs of recovery in the markets are materializing, but we believe
they are mainly a fictitious causality of excess liquidity and money printing, Thus, the
FED won’t act to remove the oxygen mask until such recovery is visible in the real
economy, and not confined to financial asset prices. M&A activity in the US (24% up
year‐to date, via large branded transactions) is testimony to the strength of the
corporate sector, already shown during a successful earnings season, but it is still
confined in financial markets and corporate investors behavior. Down from there, in the
real economy, GDP and unemployment data are still depicting a parallel reality.
The one single most promising element in between the real world and the financial
world is the housing market, where asset prices have been on the rise, pushing market’s
sentiment to ecstasy mood. However, the housing market recovery heavily depends
on super low mortgage rates ­ existentially ­ and a rise in rates expectations could
easily choke off the rebound underway.
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7. In fact, the real estate market looks relatively cheap when looked at from the viewpoint
of the NAR house affordability index, at a 40‐years low. Such index incorporates the
three basic ingredients of housing affordability: house prices, median incomes and
mortgages rates. Critically, if the effect of mortgage rates is excluded, house prices
relative to median income are now become less affordable than in 90s (as real
incomes are lagging behind in the US real economy, while house prices rebounded).
Rephrased, take cheap credit away by hiking rates, and the recovery is gone. Bad
things happen when rates rise on a bubble economy held on the thin air of central
bank liquidity.
Let alone the hot issue of Student Loans outstanding balances, which increased
further in the fourth quarter to reach a total of USD 996bn. The 90+ day delinquency
rate on it continues to rise, and now stands at 11.7%. Again, bad things happen
when…
Bernanke surely knows this all too well and may avoid interrupting the money supply,
rightly or wrongly. Strategy­wise, referring to our Inflation Scenario (Nominal
Default and Currency Debasement), we still hedge long­dated rates now on multi­
year tenors (on the USD, JPY and GBP curves), as they are ultra­cheap to do so,
whilst we hold no expectations of our views materializing anytime soon.
On France, fragile whilst expensive
LTROs repayments may have been smaller than expected amid a disastrous
Italian election, in all countries except France. At the last round, French banks
accounted for a big chunk of total LTRO repayments. Given the fragile state of Europe
(although we are mildly positive in the near term), such excess optimism might have
taken place without merit. Interestingly, we have recently noticed a spike in USD
Commercial Paper issuance by non‐US financial institutions. We would not be surprised
if French banks too had overly re‐approached USD wholesale financing. Which would
put French banks back to where they were in the autumn of 2011, just before the
Sovereign crisis hit hard on the back of a shutdown of USD financing, on which
financing French banks were (are) awfully reliant. At the time, the FED was forced
into launching unlimited USD swap lines to other Central Banks, in emergency mode,
and shortly afterwards the ECB had to invent the LTROs. We await to see if the future
holds a replay of market events, should the situation in Italy deteriorate for any reason.
With yet another steep widening of rock‐bottom inter‐banking spreads, led by the
EURUSD currency basis, most sensitive to such funding mismatch and ready to over‐
react.
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8. Moreover, as we observed last year, we like to remind ourselves of a few data points
on France: the fragility of French asset prices is a result of rich valuations to start with
(unfairly close to German levels), coupled with a still heavy foreign ownership of
negotiable government debt (around 65%), heaviest public expenditures on GDP across
Europe (at 56%, well above anybody else including Greece), a damaging fiscal tightening
being threatened (ill‐conceived tax charges on capital gains scaring off hot money
capital), and a re‐pricing of the loss of political unity to Germany.
On Nominal Rallies vs Real Rallies: Japan lead illusionist
With the appointment of Kuroda as BoJ governor, the toolkit of Abe is now complete in
its grand implementation plan of bold reflationary strategies. As argued in previous
Outlooks and in a recent interview (Video CNBC), we think Abe has good chances of
manufacturing a strong nominal rally in the equity markets, which is incidentally
totally fake when measured against a much debased currency. Illusory gains versus
reliable returns. Higher levels of the Nikkei should be feasible, together with higher
(weaker) levels for the Yen against pretty much anything else. Particularly the Euro,
once and if Italian woes were to abate.
We believe Abe may succeed in engineering such asset bubbles which his
predecessors failed to inflate, as this time around Japan enforces currency
debasement policies through heavy­handed monetary and fiscal expansion. A
fundamental decision has been taken. In the last ten years, actual financial conditions
were tight and getting tighter, on balance, despite large money printing, due to a
nominally appreciating Yen (while depreciating in real terms, when factoring in
deflation). This time around, we believe the Government and his handyman Central
Bank might hit the target. For three reasons in particular:
i) There is great enough frustration amongst Japanese people for the
blatant lack of success of crisis resolution policies implemented in the
last 10/20 years, against the background of the US supposedly resurging
from death in just 5/6 years
ii) Differently than in the past 20 years, Japan is now in current account
deficit territory. Current account deficit coupled with extraordinary
monetary expansion calls for a currency weaker than the currencies of
countries with similar deficits but softer monetary expansions (Japan is a
third of the US, but may expand by more in absolute terms, $1trn in the
US vs $1.3trn in Japan)
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9. iii) Japan needs to get it right fast, as China meanwhile grew as an economic
and territorial threat. Nationalistic arguments prevail on pretty much
anything in a country like Japan
iv) As the debt is truly unsustainable and demographic trends run fast to
expose it, currency debasement in epic proportions may be
unavoidable, to achieve debt monetization, before it is too late. As 99%
of the debt is owned by Japanese, no obvious drawback seems to stand in
between this policy and its forceful implementation.
For the records, typically, a 10% trade­weighted weakening of the Yen leads to a
0.3% increase in inflation expectations. The target inflation rate is now 2%.
Such target is to be achieved in two years, in the opinion of Kuroda and Iwata, governor
and deputy governor of the BoJ. The time horizon for reaching the target is the only left
contentious point, amongst members at the BoJ (current members would currently
prefer a ‘flexible inflation target’), whilst the need for massive easing is consensus. More
clarity on the timing is to be given by April 4th when the BoJ might publish the Outlook
Report, and in between by speeches of key members.
The Central Bank is allowed to buy into JGBs (they will prefer maturities longer than 5
years – the 10yr yield had already moved lower to tiny 0.66%), but also index bonds
and.. stocks. Plus obviously foreign bonds (like ESM/EFSF), so as to make some surer a
devaluation vs Euro, as if it was needed (which incidentally is less of a domestic policy,
and more un‐controversially a direct FX intervention ‐ food for thoughts for the next
G20).
We plan to rent the Nikkei rally here too, whilst implementing overlay strategies
aimed at hedging such rally out of its fake context. Cross­asset correlation helped
us do that cheaply last time around.
Distressed Opportunity in Europe? Flights cancelled, again
As Italy complicates the activation of ECB’s OMTs, and surely delays it as the political
bargaining of Germany gets correspondingly more complicated, so it is delayed the de­
linkage of the Sovereign and Banking sector risks, and so it is de facto delayed a
most needed recapitalization of the banks. Without it, we have less of an opportunity
to see the asset disposals (stressed or distressed) everybody is waiting for and has
raised meaningful money to snatch. Money raised/on the sidelines are outsized vis‐à‐vis
the opportunity. Hence, viciously, even less of a chance of asset value discounts to below
fair value.
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10. Without deleveraging banks’ balance sheets, without freeing them up from having to
lend to their own government so as to absorb gross issuance, we have less of a chance
to see them lending to the real economy, hence less of a chance to see real GDP
growth in Europe (ex Germany) anytime soon.
With less chances of real GDP recovery, the debt overhang will weight more,
exacerbating the unemployment picture in peripheral Europe and their tolerance for
further austerity and subordination to Brussel’s directives.
In the near term, therefore, the GDP and Equity gap with the US may be widening,
not only nominally but in real terms. Until the situation in Italy is resolved, or some
creative financial engineering is imagined in between by the ECB. Together with it, the
gap in GDP and Equity between Germany and peripheral Europe may be widening
too.
On Nominal Rallies vs Real Rallies: few Damoclean swords on UK’s neck
Few days ago, we learnt of EU officials agreeing to introduce a cap on bonuses (flat
on salary) as early as next year. The implications for the GBP currency / economy would
be material. Especially, when coupled with recent ECB’s regulations over Clearing
Houses, another potent blow to the business in the City of London. We watch
developments as they unfold here, but see the potential for long­term trends to
create downside risks. Should GDP projections be downgraded, the implications are
material: the debt overhang is higher in the UK than it is anywhere else, at well over
500% total debt (public and private) on GDP (second only to Japan, Holland and
Ireland). The sector under attack, the Financial sector, has a total debt on GDP of 250%
(hot money flows). The bond market all but reflects that, at tiny 50bps Gilt spreads
over Bunds. Equity­side, this means a nominal rally at best, for a real loss when
adjusted for FX, with the potential for a nominal and real loss altogether.
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11. Appendix
In the next few pages, we re‐present the long‐term Outlook and the current Strategy of
Fasanara Capital, quoting freely from previous write‐ups.
Multi­Equilibria Markets
Longer‐term, as our readers and investors know all too well, we remain skeptical on the
effectiveness of crisis resolution policies being implemented, wary of the sheer
magnitude of the level of over‐leverage built in the system and its drag on the real
economy, conscious of the wild volatility which could be triggered by one too many
external or internal shocks in such crystal‐fragile environment. As such, we design our
portfolio to sustain most of the states of the world we can see, and be protected
against new equilibria which deflect vastly from the baseline scenario currently
priced in by markets, and which are diametrically opposite from one another. The
baseline scenario remains one of a multi‐year slow‐deleverage Japan‐style. But the
system has never been as vulnerable as it currently is to shocks which may flip the
equilibrium to a different set of variables than the status quo / mean reversion
would suggest.
To be sure, as Central Bankers keep flooding the system with liquidity, our base case
scenario is one of a stagnant economy and of a multi­year Japan­style deleverage.
Under such a scenario, a disorderly deleverage would be avoided and inflation would
not be triggered… at least in the short term, until such delicate equilibrium will
eventually break. In the coming years, we believe that 6 scenarios might play out (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 Break­Up (either
coming from Germany rebelling to subsidies or peripheral Europe rebelling to
austerity), China Hard Landing, USD Devaluation.
We also believe that current market prices and compressed Risk Premia make it
worthwhile / relatively inexpensive to position for fat tail events, as they are currently
heavily mispriced by markets.
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12. The Outlook
Our thinking is simple. The market is underestimating the potential impact of the
real economy not picking up despite unprecedented liquidity being thrown at it,
by extraordinarily expansive monetary policies, for too long a period of time. In doing it,
the market underestimates the impact that a fast increasing level of unemployment in
peripheral Europe can have on price dynamics in the second half of 2013 and beyond
(youth unemployment at approx 60% in Greece/Spain, and 36% in Italy/Portugal).
Here the market seems to be sedated to the flawed idea that the social compact and
welfare safety nets put in place by such democracies will suffice in keeping social
discontent at bay, and the army of unemployed in voting for yet another pro‐European
pro‐austerity government as soon as they are given another opportunity to do so over
time. As the readjustment needed to rebalance competitiveness across Europe is still
wide open (to closing the gap to German wages it would require Italian and
Spanish labor costs to fall by an additional 30% to 40%), we tend to challenge
market’s complacency about it. Falling real wages, perhaps falling nominal wages, in
Italy and Spain by up to 40% is the baseline scenario now, one of slow deleverage multi‐
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13. year Japan‐style. If anything, Japan did have a choice ten years ago, to devalue the
currency in nominal terms, which they did not go for (they are taking a different view on
it only now), whereas Europe does not even have that option, as fixed‐exchange
currency system impedes it, and allows only Internal Devaluation to happen. Until the
currency system itself implodes, as we expect down the line.
And more so now, as we enter a market environment of currency debasements one
country against another, where no mystery is held up any longer on one’s intention to
devalue and open wide the FX gates to its economy. More and more, evidence is in our
face of US and Japan intentions. South Korea, China, Latam, and the UK itself, might
follow, although the tempo of their reaction functions might vary greatly. Europe itself
will then face the choice of either catching up on the trend or split up, to allow individual
countries to opt for that route if they wish. Timing matters: the sequence of competitive
devaluations across countries might take years to materialize and be fully visible, and it
may be a stretch then to expect southern Europe to sustain multi‐years of much
stronger EUR against pretty much anything else, and thus a more dramatic drop in
wages and increase in unemployment needed to make up for it. Look at Japan, where a
progressively stronger nominal Yen in the last ten years was associated with an even
larger Internal Devaluation and Price Deflation, so big that the Yen actually depreciated
in real terms by 35%/40% against EUR and USD over the past 15 years, counter‐
intuitively, whilst appreciating in nominal terms by 75%.
All told, if the political gridlock over ECB OMT activities and other forms of heavy
QE is here to stay for long enough, we have one more reason to consider the risk
scenario of a EUR break­up a genuine one. Yet another one of the scenarios we seek
to be hedged (and over‐hedged) against. We might as well have those hedges
implemented now, for it is still inexpensive to do so. If such tail events do not take place,
then great, as our Value portfolio will not be impaired, and we will enjoy the nominal
rally in the market. On the other end, if such events were to take place, we would be
amongst a few ones who bothered to spend that money on a hedge, before such hedge
became overly expensive or not available at all.
Bottom­line, over the next few years, if money printing failed to restart the
economy, we face the real chance of a multiple choice between a Default Scenario
(Real Defaults, Haircuts & Restructuring; potential Euro break‐up, as either peripheral
Europe derails from the bottom, or Germany reconsiders it from the top) and an
Inflation Scenario (Nominal Default, Currency Debasement whilst engineering Debt
Monetization, as money printing continued unabated, until money multipliers/velocity
of money made a U‐turn to fully drive it out of control). More on it in the attached.
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14. Opportunity Set for 2013
As the strategy was unchanged over the last few months, let us quote freely from our
December Outlook (while updating some of the short dated investment positioning in
here described): ‘’In the following few lines we offer our observations on the main
themes underlying our portfolio construction, across its three main building blocks. Our
current Investment Outlook in implement into an actionable Investment Strategy along
the following three parts:
The Strategy
Value Investing
Over the course of 2012, our Value Investing portion of the portfolio was static
and entirely filled by Senior Secured bonds issued by strong companies from
northern Europe and the US (i.e. countries with their own domestic currencies –UK,
US – or on the right side of a foreign currency – Germany, Holland), export champs with
exposure to EM flows, high but affordable leverage, running yields of 5%‐10% area,
target IRR at inception of 10%‐15%. We thought the tail risks underneath markets this
year warranted to stay clear of peripheral Europe assets, clear of junior/mezzanine
paper, and clear of equity markets altogether. As we performed strongly into above 20%
returns, we still clearly lost the opportunity for even bigger gains: however, we
concluded that such opportunity was not appealing when adjusted for the large risks it
entailed. Risks did not materialize in the end, but in retrospect it is always easier to
read markets.
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15. Now then, we are at a crossroad as High Yield valuations have reached bubble
levels. One thing is to say our senior bonds were good investments and deserved to
rally, another thing is to say they deserve to trade at 4% to 6% yields to worst. We do
not believe such sustained valuations are justified, especially as we do not discount the
tail risks out there at zero, and we believe it is only a matter of timing before the
valuations realigns to fundamentals somehow. True, liquidity is large in the system and
money printing (especially in the US) might target corporate paper directly and drive
valuations even further and yield even lower: however, the more time goes by the more
that equated to an Inflation Scenario (Debt Monetisation achieved via Currency
Debasement). An Inflation Scenario, where negative real rates and QE‐type intervention
helps inflate one’s way out of nominal debt, is effectively just another form of Default
Scenario. Whether the debt is not paid back in full or whether its real value is eroded by
inflation does not make a huge difference to most investors. Inflation destroys the
value of fixed income claims as surely as default.
On the other end, should the money printing slow down or stop outright, should the
oxygen mask be removed from the debilitated patient, and the reversal of the trend
would be abnormally asymmetric, leading to important capital losses across the capital
structure. Playing for even lower yields on stretched corporate balance sheets (and even
more on government bonds) equates to pick up dimes in front of a steamroller. We
believe that the risk of rising interest rates is highly underestimated by the
market right now.
The bubble in the credit markets is unmistakable, starting with government bonds to
slide down the credit curve into High Yield markets. Valuations are so high that any
room for further appreciation is close to exhaustion. 2013 might be the first year
earmarked with a negative return (of some dimension) for government bonds
ever since 1994. To continue slowly or quickly, in the following year, until it changes
gear. Cracks are well visible in the High Yield and Loan markets too, as issuance
volumes reached approx. $600bn, which is 2007 record levels (another credit
bubble market back then, which was going to pop a year later). More importantly, the
share of covenant­lite issuance has reached a staggering 30% of the total (in 2005
it was 5%): which means less maintainance covenants in exchange for pure incurrence
covenants, which means lower protection for investors. Market players now argue that
this is a positive development as a potential catalyst to a credit event / down
performance is outright removed, forgetting it also damages recovery values. It sounds
like typical complacent bubble market commentary, ready to justify overvaluations in
retrospect as the new normal and make the case for further future appreciation. To us, it
may be wishful thinking, and it is only a matter of time for the market to catch up
with reality.
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16.
For all these reasons, in 2013 we intend to keep migrating slowly and safely from
High Yield territory into Equity, hedged, with similar characteristics to senior
debt. As Equity most obviously presents different characteristics of expected volatility,
we apply three layers of risk management: 1) security‐specific hedges (typically through
long/shorts, but also via capital structure arbitrage), 2) macro overlay strategies and 3)
Fat Tail Risk hedging programs.
Fat Tail Risk Hedging Programs
The leit­motiv 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.
Currently, thanks to Central Banks’ liquidity and asset value manipulation, three
strategic scenarios (out of the six strategic scenarios we have in mind) can first be
hedged at rock­bottom valuations. Such scenario include: Inflation, Renewed Credit
Crunch & Euro Break­Up. Hedging against such scenarios is currently very cheap
and as a result Fasanara aims to increment hedging on such opportunities first in
Q1 2013.
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17. Tactical Short­Term Plays / Yield Enhancement
We will not expand on this section too much, as it is less relevant in our portfolio
construction, which tends to be quite static and ‘buy and hold’. Short term tactical
positioning / yield extraction strategies. Such positioning is typically tactical and
short term, for we remain prepared to adjust as information comes in.
What I liked this month
The Fed to face challenges as it ultimately exits the unprecedented monetary
expansion Read
Is the US facing a housing shortage? Inventory has contracted to its lowest level since
December 1999, more than 13 years ago Read
Trade protectionism looms next as central banks exhaust QE Read
An interesting (and optimistic) view of Fat Tail Scenarios over history from NY Life
CFO Read
France, 1789: a monarchy out of touch with reality and experiments of currency
debasament Read
W­End Readings
FASANARA CAPITAL recent interview with CNBC: Nominal Rally vs Real Rally, the
Nikkei, etc Video
FASANARA OPPORTUNITIES FUND profile on Hedge Funds Review: ‘Fasanara
Capital has bleak view of global markets’ Read
Sustained real growth should be the number one priority. Austerity policies must
stop, now. Growth will not return unless bank lending is adequately available. The ECB
may act as lender in last resort to banks and governments, but who will bear the
residual costs? The only remaining option is public debt restructuring, a purging of the
legacy. Read
The correlation between austerity measures and spreads in 2011 Read
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18. 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
“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.
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