1. January 7th 2012
Fasanara Capital | Investment Outlook
Multiple Equilibria Markets and the Case for
Staying Net Short
Happy New Year.
Four years of dysfunctional markets followed some two decades of over-
leverage and over-stimulation, with debt-fueled spending programs
addressing debt problems with yet more debt, and bringing us here, in the
land of Multiple Equilibria markets. As opposed to reverting to pre-crisis
mean and equilibrium, the dust in the markets could settle in diametrically
different ways and find a different equilibrium there: different combinations of
devaluations, inflation, expansion, deflation, depression, defaults are all made
plausible.
Surrounded by insolvent too-big-to-fail Sovereigns and Banks on steroids, that
would have failed in anything close to a free market (but have instead being
given electrical stimulation to keep the dead frogs moving), 2012 investors are
invited by policymakers to stay optimistic, to not drop the towel on such hostile
environment, as the bullish trend is about to resume.
Monetary-medicine and credit expansion have been the attempted solution to
the 2000 Dot-Com crisis first and then the 2008 Subprime/Banking crisis, and
now tried to fix the Eurozone Sovereigns/Banking crisis, to save the insolvents
and sustain elevated valuations. But after that much effort we awake in 2012
with the market still in a debilitated state, the medicine not sorting any visible
effect and yet more of the same medicine (debt and its surrogates) being pledged
in hope for a different result (this time is different) or just in fear of the
alternative unknowns.
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2. In 2012, we believe the base case scenario remains one of a stagnant
market and economic environment, with anemic expected returns, volatile
range-bound trading and sudden shocks pushing them lower (Stagnant
Volatile Scenario). Such stagnant fragile economy could take, at some point, one
of two directions: 1) Inflation Scenario, money printing gets truly massive,
Draghi finds political support to implement decisive Fisher-Friedman monetary
stimulus (assets purchase programs, target high nominal GDP, zero rates) and
therefore finally manages to bring inflation in, markets inflate their way to
higher output, economy expands, employment recovers, debt returns
sustainable, confidence is restored, markets rebound, then some currency
debasement and potentially hyperinflation, orderly or disorderly. 2) Defaults
Scenario, money printing fails, few Banks in receivership /restructured /
nationalized /merged, few Sovereigns restructure / devalue / leave the Euro,
deleverage, implosion, Eur break-up or reshapes, orderly or disorderly. All
legitimate scenarios, not necessarily mutually exclusive, each with decent
probability.
However, certain scenarios assume that defiant investors will hang in there:
bond investors keeping their shaky government and bank bonds (whilst being
reduced by ECB SMP activity to the status of junior bondholders), equity
investors keeping their overvalued stocks factoring in peak margin levels (in
exchange for anemic expected returns) and their pricey bank stocks (ahead of
fairly dilutive recap exercises – Unicredit 43% discount docet), bank depositors
to keep cash at fragile banks at zero rates (as opposed to inexpensively remove
them from trouble). That is a big assumption: confronted with such
widespread binomial tree of potential outcomes, where half of the
potential exits are fat-tail events in either direction, it is not easy for the
average 2012 investor to stay in the game as opposed to run for the exit.
Nor it is rationale to expect that from him. We should be reminded of that when
attaching probability to each of those scenarios.
Analyzing now some relevant European data that came out over year-end,
we perhaps have seen further evidence of a Liquidity trap and signs of a
Keynesian Endpoint. First of all, ECB’s liquidity transmission mechanism has
failed, until now. The ECB is clearly printing money (as no sterilization is taking
place and bond purchases / repos are likely not to be temporary, neither they
are credit-risk free, we think), but the transmission to the real economy is as
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3. weak as ever. True, monetary base has expanded almost 50% in the last year
(base money M0 aggregate ), but broad money supply is flat (M3 aggregate),
resulting in a collapse of the Euro money multiplier (which halved since its
peak in 2002). In simple terms, cash and equivalent (high-powered money) is
amassed in Central Bank reserves, where it is not fulfilling any economic
function, in a dysfunctional allocation of capital, not contributing to stimulating
the economy nor supporting Government bonds. In other words, stronger banks
are flushed with cash (courtesy of massive QE repo operations, 489bn just in the
last round) but prefer to deposit most of it in the safe haven vaults of the ECB (at
a destructive 0.25%) instead of lending it in the market, leaving weaker banks
struggling to get funding and grasping for more ECB support. Data is confirmed
by numbers on the ECB deposit facility being at historical highs. Data on falling
loans to individuals/household/consumer credit/mortgages speaks of the same
story. Without the multiplier, it is arduous to manufacture growth via
monetary engineering, as no matter how much you print the impact on the
economy is reduced.
Public sector is de facto crowding-out private credit, as banks hoard govies
or cash at the ECB, instead of turning it to the industrial or consumer debt
market. But there is a flip side to it as well, with the private sector deserting
public issues and bank recap/refi exercises too.
Moreover, interestingly, recent data shows that banks are pretty much not
buying sovereign paper anymore (steady decline from a peak of EU350bn in
2009). Bottom-line, monetary policy is currently therefore slowly turning
ineffective. Whilst monetary policy is out-of-order, non-monetary factors
are also weak, as job creators are immobilized, since they cannot budget or
manage the fiscal and regulatory uncertainty. All of this, just before austerity
measures kick-in, just before banks seek to shrink their loan books by a
whopping 1 trillion in an attempt to meet capital ratios (as capital markets are
still perilious – see Unicredit).
In such hostile environment, living through the likes of a Liquidity Trap
and a Keynesian Endpoint, the probability of bank restructurings /
receiverships / nationalizations is as decent as ever. The catalyst of a major
bank failure had been removed by the ECB via LTRO and SMP operations, but
such interventions have so far failed to restore confidence amongst banks
themselves, therefore their marginal impact is way less effective. It would seem
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4. to us that one of a few reasons why several banks have not been
nationalized yet, is that their desperate Sovereigns would lose access to
back-door ECB funding. In other words, and thinking of Italian government-
guaranteed debt issued by banks on purpose to get collateral for new funding at
ECB, it is as if banks were already nationalized, in certain ways. No wonder we
are bearish on bank equity.
As we argued extensively in previous outlooks, the bar is being raised by the day,
and one cannot rationally be certain that Germany will keep footing the bill
unlimitedly and become joint and severally liable with a growingly worrisome,
ever more insolvent sinking bloc. As if it did not have its own issues (Deutsche
Bank, for example). Given its implicit transfer of resources from Germany to
other countries, the ECB operations in LTRO or SMP could be joined by yet
more massive Friedman-style monetary stimulus (and not just a bit more, as
the multiplier collapsed), or could just come in too late (as is already), and
deliberately so.
Some investors think the effects of past actions have not been felt yet, as
transmission requires time: eventually funding levels will come down (from
unsustainable 7% on BTPs), spreads to Germany tighten, interbank funding
resume, rights offer proceed smoothly (following an eventually successful
Unicredit deal). It is possible, and we may all hope so, but time is not an
independent variable in this equation and the longer it takes the more
likely it will be – in such fragile conditions – for any Greece defaulting /
Hungary imploding / Ireland double dipping / Japan facing 3trn
redemptions/ France, Austria losing AAA / Corporate inevitable failures…
to create shockwaves and spoil the party, accelerating the demise and
possible end/reshuffle of the Euro as we know it in the next 3 years. If
anything, we would tend to believe that the lagging missing link is more to be
detected in the transmission to the real economy of distress in the financial
sector/sovereign markets (something like what happened this week to
Petroplus PPHN, announcing that access to all credit lines had been suspended,
sending the stock down 20%). We believe that this realignment is indeed
more likely, to the downside, and we therefore stay net short / bearish /
hedged.
Our thinking follows through in determining that at current rich valuations
across most asset classes (although already lower than a month and six
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5. months ago), you are not properly paid for the embedded risk you are
taking. In other words the risk-adjusted returns are not appealing enough to
justify long position sizing: there are better levels for you to get into the trade, or
there are lower embedded vols/risks, for the same valuation. If a rationale
investor still exists, somewhere, in such irrational dysfunctional markets, then
such assessment of risk will cap current markets and make the case for bearish
positions a compelling one.
Opportunities exist, already, by and large: in dislocated markets smart
hedges cost less. As long as the remit of the mandate allows you to roam
across asset classes, across the capital structure and across financial
instruments, you have a playground with no precedents. Dysfunctional
markets allow for cheap options trading, mis-pricings and heavily
asymmetric profiles, whilst trailing nominal benchmark returns is easier
than normal to do.
In no instance, in these markets, should a portfolio feel secure in the
absence of select shorts, 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. Current markets come handy in that they allow for cherry picking your
most suitable shorts and hedges, and also now outside of the easy targets
(financials).
We believe hedging and fat-tails risk management is paramount in 2012
and beyond, as it will prove to be the most significant differentiating factor
in any strive for performance. As there is little similar to a perfect hedge in
finance, the moving basis has to be continuously and dynamically managed,
through which Fasanara Capital seeks to capture returns for its investors.
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6. What I liked this month
Governments of the world’s leading economies have more than $7,6 trillions of debt
maturing in 2012, with most facing a rise in borrowing costs. Led by Japan’s $3 trn and the
U.S.’s $2,8 trn. More..
Everyone is also very focused on the maturities of sovereign debt this year. But one issue that
markets may not have fully considered is the immense amount of private debt European
banks will need to roll this year. Maturing EU bank debt may hit a wall in 2012
The M3 chart versus the monetary base (i.e. how much base money is out there versus all the
possible money-multiplying investment possibilities) is perhaps the most striking of them all.
More ..
Eurozone M3 contraction. This is troubling because if Germany's M3 continued to expand,
the periphery economies credit conditions deteriorated even faster than the euro area as a
whole. That was largely driven by a drop in loans to firms. Banks also continued to delever
outside the euro area. Their net external assets fell EUR25bn in November after a EUR60bn
drop in October More ..
Mediobanca is the largest shareholder of UniCredit (6.76%) . Unicredit is the largest holder of
Mediobanca (8.7%). Remember when CDO's all bought each other's BBB and BB tranches,
because no one else would? More ..
European Services PMI by key countries More ..
Top Three Central Banks Account For Up To 25% Of Developed World GDP. What does this
mean? It means that nearly $8 trillion in world economic growth is artificial and exists only
courtesy of central bank intervention. for everyone who feels that the global economy is fake -
you are right: up to 25% of all economic growth is what in a different day and age would have
been called "one-time and non-recurring". More ..
W-End Readings
Jeremy Grantham. Looking out a year, the overall picture seems so much worse than the
generally benign forecast of 4% global growth from the IMF. The probabilities of bad
outcomes are not as high for us today as they were in early 2008 when, I’m pleased to say, as
predictors, they looked nearly certain to us. The possibility of extremely bad and long-lasting
problems looks as bad to me now as it ever has More ..
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7. Bill Gross. On capital markets: "real price appreciation is getting close to mathematically
improbable" More ..
Christina Romer. In the NYT: A Financial Crisis Needn’t Be a Noose
Jeff Gundlach. DoubleLine, Complete Slideshow Presentation, impressive slidedeck of raw
data, from Europe, to the US economy, to financial products. More ..
Ambrose Evans-Pritchard. 2012 could be the year Germany lets the euro die
More ..
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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