1. December 17th 2011
Fasanara Capital | Investment Outlook
In our last write-up before year-end, we try to make sense of the current markets
and render our view on 2012 economic landscape, fat-tail risks and investment
opportunities.
The week ending today was an important one= as it carried an answer to some of
the question marks floating around: will the un-precedent liquidity
injection/monetary base expansion put in place by the ECB and Central Banks
globally be able to boost Confidence? In fact, the ECB accepted to provide Banks
with unlimited financing against good and not-so-good collateral (whilst global
central banks pressed forward $ liquidity swaps in size), in exchange for the
Banks to hold on to their sovereign paper and, perhaps, buy some more at the
next auctions (in what would become for the bank a zero-risk-weighted carry
trade). At the same time, a prospective enlarged SMP meant that ECB could buy
government paper for 20bn/week, which is already a staggering 1trn/year. Such
move, together with a new patchwork bazooka in the doings (encompassing
EFSF / ESM / IMF / Eurobonds / BRICs help), was supposed to remove the
catalyst of a large bank failure =rom the markets, restore interbank markets and
support sovereign funding. On=the contrary, market indicators returned a bitter
verdict: OIS-Libor / TED spreads, eurusd currency basis, $libor, swap spreads,
spreads of peripheral countries to Bunds, yields on sovereigns, all rising or
stationing at alarming levels, bank stocks sinking. We moved into a Confidence
Collapse Scenario, as we called it in our previous Outlook, a scenario in which the
marginal utility/impact of subsequent measures decreases, leaving the
problems unsolved, the bleeding flowing and raising the bar exponentially on
further measures. The by-product of such scenario, is a Bank-Run Scenario.
However, despite stress in financial conditions and the interbank market,
distressed sovereign markets across Europe and battered bank stocks, such
Confidence Collapse scenario is not yet to b= seen in most private markets: in
Equity and most Credit, and neither can yet be seen in=the key macro driver of
aggregate demand, Consumer Confidence and Spending. None of them is really
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2. cheap in our eyes, as it is only mildly down when compared to the range of
possible outcomes out there: currency redenomination risk, depression and
earnings contraction, shut-down of capital markets when they are most needed,
sequential sovereign failures an= restructuring, currency debasement and mass
monetisation. That must be b=cause those markets predict one outcome most
out of all, they share an intimate, deep-rooted, religious belief: at some
point=down the line, when the risk of implosion is closer, on the very verge of
collapse or whilst it’s already unfolding, a massive wave of debt mutualisation or
monetization will deep-impact markets, mighty and forceful, falling from the sky.
Light will shine on them, saving debt-laden=Samson and all the Philistines.
Consistently, corporate earnings (at historical 60-year peak) look real and
sustainable only to the extent all the excess leverage and toxic assets in the
economy get stripped out of the current holders, swallowed by public balance-
sheet, wiped out by the printing press together with the fiat currency they are
written =n.
But who should be the architect of such mighty force? left there, maybe
Germany?
As the battle intensifies and gets ugly, Germany is left alone to fight in the field
(similarly to the last two world battles it fought in the last century, un-
successfully). With France and Spain on the verge of being downgraded (b=
kick’em-while-they-are-down Rating Agencies lagging indicators), and therefore
not being able to compute into EMSF numbers any longer, with the UK
leaving=the scene in anger (creating a dangerous precedent of open-air
animosity in the fragile political landscape, at a time when any agreement was
just difficult enough to grasp), Germany is left in solitude to do the number
crunching. <=>Germany’s robotic, disciplined, cost-conscious, depressive Buba
mentality will have to handle Europe mess a=d commit to provide un-calculable
(i.e. unlimited) funding for it. As debt mutualisation (Euro bonds) or
seigniorage/printing press (ECB) hardly changes the true implicit transfer of
resources from Germany to peripheral countries, somehow, it is still Germany
alone to call the shots.
So let’s now see their number crunching. How much should they pay and for
what. Let us try to gauge the range of the potential bill, and its key risk vectors.
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3. - Debt Flows: in systemic secular crisis like this one=Sovereign or Bank
debt burden is somehow the same thing. 2012 is a maturity cliff yea= for
Sovereigns and Banks (let alone Corporates, where we see an opportunity=-
below). Sovereigns will need 1 trillion plus in 2012, refinancing on Eur700bn
debt coming due, much of it in the first quarter.
- Debt Stock: The outstanding stock of government bond= is 3.5 trillion
plus considering peripheral countries only. 5.1 trillion including France. 8.5trn in
total. We fear there are no natural holders anymore for this debt, but only ECB-
financed (un)natural buyer on steroids = the banks – creating a vicious circle of
hyper re-hypothecation if left f=r a longer period than just the time of
emergency. As argued in previous outlooks, such volatile debt is un-sellable at a
reasonable price to any other buyer than the ECB or its lieutenants
(banks)=/span>.<=b> If you are a pensio= plan based in America, Middle East or
Asia, you should wonder why you keep hold of such digital risk for =inimal
potential upside. Even if you are an European institutional buyer you are l=ft
wondering. The average government bond buyer is one who wants to invest
100=to get a meager 103.5 next year and the year after next, quite simply. Here
he=is confronted with equity-like volatility, stormy uncharted territory
predicting fat-tail outcomes of all sorts and no diversification benefit to speak of
(=s they become positively correlated to risky asset, being their main Beta
driver). And, lets not forget, that ECB intervention means that the government
bondholders is relegated to the status of junior bondholder, all of a sudden (as
the Greek precedent proved, where ECB insisted to be made whole vis-à-vis
haircut for the private sector, being the provider of “Debtor in Possession” like
financing). Therefore, as soon as a decent bidder shows up (be it ECB or its
lieutenants banks), maybe at better prices than the market as monetary agents
try to cap yields to return debt sustainability, the average bond buyer is simply
likely to run for the exit. Especially if he runs the risk of becoming a junior
bondholder. Especially if the Central Bank is not credible enough.
- Within the liability side of the stylized bank balance sheet, one item is
dangerously liquid and promptly redeemable: deposits. In=precursor Greece,
50bn plus of Business and Household Deposits have flown in the last 18 months,
20% of the total only in 2011, and the pace has alarmingly accelerated in the last
three months according to BoG. Not surprisingly, given capital mobility these
days. The same un-expensive risk-reduction trade could happen in France and
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4. Italy. After all, French la=ger banks have 4.6trn assets vs 1.7trn of French GDP
overall. After all, BNP Paribas has 30X le=erage against Tangible Common Equity,
with deposits representing 30% of its 2trn assets (compared =o US at 50%),
depending for the rest from a disappearing wholesale market.
- Consumer Confidence and Spending are lagging indicators, these days,
showing incredible resilience. But they cou=d give in at some point, broken
down by front-loaded austerity kicking in, bringing down growth and GDP, and
the denominator of most debt/equity ratios and P/E multiples.
In a desperate attempt to try and make sense of the current markets in a
reduced-form equation, let us drop in just two more factors. Firstly, no= only
Germany is left alone in having to sort out years and years of European chronic
runaway deficits and over-leverage (with yet more debt, but of his own), but it is
about to face opposition from the same countries it might try to save: Italy, Spain,
even Greece are slowly realizing the flows in the Europe tentative solution being
offered. In the base case scenario (of Germany doing just enough to a=ert a
collapse) they are at the beginning of an indefinite period of recession =if not
depression), years-long deleverage, where all of their primary surplus =if any,
after raising taxes and cutting expenditures) will be spent to pay for=the debts,
with way more politically-unbearable social unrest than they had anticipated
(with 20-30% youth unemployment), as they can’t rely on a tru=y expansionary
policy and on the only fix that worked historically to reignit= growth, i.e.
competitive devaluation. For instance, look at Italy, where th= interest rate bill
reached a lethal 100bn/year now; compare it to the lates= 25bn Finanziaria
Straordinaria that Mr Monti is yet struggling to have green-light for. The second
blocker standing in the way of Germany is Germany itself, as Germany is called to
finance the debt-laden European construct instead of using the same resourc=s
and focus them on its own skeletons: fiscal deficit (worsening), large stock of
debt, insolvent financial institutions (Landesbanken, Commerzbank, IKB, West
LB, DB itself has leverege of 60:1 on a TCE/assets basis and $2.5 t=illion of assets
with zero capital backing).
These are the factors that lead us to believe, contrary to the market consensus,
that debt mutualisation or massive debt monetization might come too late, might
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5. be insufficient or might not come at all. Those who construct their macro
portfolios on such catalyst might be exposing themsel=es to large tail data points.
Our long term view is therefore unchanged. The Euro block is entering recession
even before austerity plans kick-in, left right and center. GDP to slow into 2012,
gripped by austerity. First test on Christmas Shopping, =o prove way worse than
Black Friday. Equity, Credit & Vol in denial on potential negative GDP quarterly
figures and EU break-up risk longer-term, grossly misaligned to its probabilty.
Uncertainty to stay, hence its probab=lity to rise, hence equity to catch up with
reality and fall in 1H12. The EU= exercise is going to be unwound in the next 3/5
years with a 50%+ probabili=y, following a restructuring and early exit of Italy
and Spain.
One industry is most at risk, as it is victim to a secular transformation: banks.
Banks to be the ghosts =f a financial services depressed industry, moving from
wanna-be hedge funds at the forefront of innovation to “in=rastructure money
centers”, left alone in swallowing un-yielding government bond =aper, able to
operate at way lower ROE and multiples, with half of their current employees,
justifying only half of their current valuations.
Opportunity Set:
1. In a debt crisis without inflation there is little alternative to defaults, or else,
anyway, a long period of sub-potential growth and painful deleverage. Longer-
term, financial depression and broad-based deleverage across the Euro Zone and
beyond is a likely outcome. Debt relief/Deleveraging is to provide the best
relative value opportunity, starting in the first half of 2012.
2. We do prefer good companies and good collaterals to shaky government risks,
macro trading and speculative positioning of any type. We target Value
companies coming under stress in the months to come on European sovereign
woes and maturity cliffs= with a long-term approach and emphasis on absolute
standards of value. Safest place in these markets is senior secured, which also
happens to offer (or is about to offer) equity like returns. Most often, this is not
available in government bonds, nor in equities.
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6. 3. Second leg of the strategy is Insurance/Hedging: value approach to be coupled
with overlay hedging strategies, name-specific and macro across the overall
portfolio (fat tail risk options), banking on market dislocations/inefficiencies to
seize cheap(er) options. Counterparty risk to be a game-changer: hedging
strategy to be re-defined in the current market conditions to reflect that; more
disclocations-based hedges as oppos=d to traded options.
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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