1. November 16th 2012
Fasanara Capital | Investment Outlook
1. Short-term, as critical levels are being tested, we cut directional
risks, moving our Beta portfolio to completely neutral, whilst
maintaining RV plays cross-markets between Europe and the US/UK
2. As we maintain our view that Spain, Greece and the US fiscal cliff
risk factors are overdone, we stand ready to promptly establish
tactical longs, as we believe there is a better chance for a 20% rally
than there is of a 20% drop in prices, within the next 3-4 months
3. The UK is a likely underperformer vs Europe in the near future,
both in Equity and Credit spaces. The catalyst may have been the
decision of the BoE to moderate QE, as a slow-down in the rate of
acceleration of credit expansion is in itself a tightening move.
4. Longer-term, we capitalize on fictitiously sustained valuations and
rock-bottom Risk Premia to amass cheap optionality on the six pre-
identified Tail Scenarios we anticipate in the few years ahead, under our
view of Multi-Equilibria markets. In particular, we here give more
thoughts to the hedging opportunity for scenarios of Credit Crunch
and China Hard Landing.
Back in September, we argued that markets would remain supported, possibly
into year end, allowing for tactical yield enhancement strategies, mainly
executed through selling the downside in optional format. We also anticipated
‘expected Euros’ of Draghi to be more effective than ‘actual Dollars’ of Bernanke,
setting the stage for an outperformance of Europe vs the US. Since then, we had
markets in Europe supported and directionless, almost soporific as they danced
in narrow trading range (2450 to 2550 for the Eurostoxx, 30 basis points range
for yields and spreads volatility), whereas European equity was indeed
outperforming the US by a decent margin (almost 400bps) over the period.
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2. Now then, as we feel we are at a crossroad and critical levels are being
tested (for the DAX and the S&P in primis), we decided to cut directional
risks on short term positioning, moving our Beta portfolio to completely
flat neutral, whilst maintaining relative value plays cross-markets between
Europe and the US/UK. We have enjoyed the ride on yield enhancement
strategies until now, but prefer to be flatter going forward into year end. Markets
in Europe moved to the low end of their trading range, and are dangerously
dangling on the cliff, giving the impression to be on the verge of a breakdown,
plagued by fears at home (Spain and Greece) and abroad (US fiscal cliff). We
maintain our view that Spain, Greece and the US fiscal cliff risk factors are
overdone, and do not have the potential to truly destabilize markets in the
short term, having the Central Banks just stepped out in offering a
backstop firewall with reckless abandon. However, we are worried about
technical levels and risk appetite abating for most active players into
thinner volumes at year end, and have therefore preferred to cut risk and
moved completely flat. Should the technical formation improve from here, we
stand ready to promptly reinstate our yield enhancement strategies and
add tactical longs to them, as we believe there is a better chance for a 20%
rally than there is of a 20% drop in prices, within the next 3-4 months. In
fact, we maintain the view that an attempt will be made, at some point, for
compression of yields and spreads of Spain/Italy vs core to levels which would
trigger the (erroneous) market perception of a de facto Debt Mutualisation
across Europe, well before the Banking Union - dreamed about by Hollande - or
the budgetary parental controls - dreamed about by Merkel (please refer to the
link attached for our thinking around a de facto Debt Mutualisation).
Reinstating yield enhancement strategies and tactical longs will not be a
one way bet. We have taken advantage of current super-compressed risk
premia and tiny inter-banking spreads to implement cheap optionality on the
hedging side of our portfolio, and we look at increasing such positioning given
current rock-bottom levels and limited downside. We believe such hedges are
best geared to provide cover against the potential true catalyst to
underperformance on the Beta portion of our portfolio.
The reason why we believe in the possibility of further reflation of asset prices
revolves around the credibility of the Central Bank, which we feel is the real
asset at stake now. Our investors and readers know how critical we are about
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3. endless monetary printing as a way to cover up unresolved structural
imbalances across Europe, and buy time in the process. However, they do
manage to achieve that: buy time. In the short to medium term, we expect
policymakers to be rationale enough not to waste their credibility all too
early, too blatantly, having promised to stand behind the European construct at
all costs (‘do whatever it takes, Euro can’t go backwards’ in Draghi’s own words
). Finger-pointing to one other is not an option either. Should Europe not unlock
a most expected/obvious funding tranche to Greece, should Spain pester around
conditionality to the point of jeopardizing a most needed 90bn recapitalization of
its banks (still dependent on the ECB), should even Draghi decide to help Spain
in the absence of such conditionality (risking Germany’s revolt), in all such cases
the loss of credibility would be heavy damage. All in all, we believe policymakers
know that all too well and will manage to avoid these obvious missteps.
Policymakers and monetary agents may be convinced that this is the time to
prove to the markets and their respective electorates that Europe is on the right
path, as the conditions at large will soon be far worse for them to try the same
exercise next year. They are confronted with a similar grim data set to the one
we currently look at, and they may come to similar conclusions as to the
importance of getting the timing right, this time around. And capitalize on the
tentative signs of stabilization that have surfaced in the markets as of late.
Not only inter-banking spreads have compressed to levels where any
potential further tightening is hard to imagine (leaving the door open to cheap
hedging, in our tail hedging programs ‘FTRHPs’). Additionally, we saw positive
developments for the first time in months in the Eurosystem, with Spain
TargetII exposure to the ECB decreasing by over 50bn (to 365bn), mainly
due to a reopening of the repo market on their securities (with Spanish banks
replacing ECB repo funding - 75bps - with cheaper private repo market funding -
approx. 30bps), but also thanks to forestalling deposit outflows and some new
bank debt issuance. Italy itself saw its exposure to the Eurosystem
decreasing by over 20bn in two months (to 270bn), possibly due to non-
domestic buying of net government bond issuance.
On the other end, policymakers cannot avoid seeing the shadow of black
clouds into next year, making the odds worse by then: (i) the law of
diminishing returns for central bank policies is ever more evident, with free-
falling monetary money multipliers (ECB is most concerned about it as it is
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4. looking for ways to repair a broken transmission system - ECB workshop on Nov
19th on excess liquidity and money market functioning), (ii) the drag on growth
can only worsen into next year, as fiscal multipliers are larger than
governments assumed in conducting austerity programs (‘sharp expenditure
cutbacks or tax increases can set off vicious cycles of falling activity and rising
debt ratios’ Underestimating Fiscal Multipliers?), resulting in tight fiscal policies
possibly worsening the same fiscal position for countries hit by austerity
measures, therefore worsening sovereign solvency itself, as opposed to
improving it, (iii) youth unemployment reaching tipping points at almost
60% in Greece, 55% in Spain, and above 35% in Italy, Portugal and Ireland
(introducing the ‘youth sacrifice ratio’) (iv) this week the Eurozone was
confirmed in recession in Q3, with deceleration of consumer spending and
headwinds from activity data all pointing further south: even German
manufacturing is in outright contraction, after weakening exports not only into
peripheral Europe but also into Latam and China (likely to worsen further with
the weakness in commodity prices).
Critically, what is way harder for policymakers to avoid is the end result of the
current crisis resolution policies, as a colossal debt overhang gripping the
economy is being treated with yet more debt, weighting even more on real GDP
prospects. It is way more difficult to treat the basic disease affecting European
(and global, in that respect) policymaking: ‘short-termism’. However, as we
argued repeatedly of late, this is a long-term scenario and we do not expect it to
materialize in the short to medium term.
A word on Greece, as we head into next week’s EU summit. Back in March, we
thought Greece’s PSI was purely priced into the next inevitable restructuring
event. However, we warned ‘’by then, the Official Sector will count for 80% of the
total debt (vs 60% today), making it an even more politically-troubled issue.
Critically, and unintentionally, Greece will thus maintain its status of key
vulnerability for Europe as a whole, long before the next event, with its
imbalances building up slowly and surely to the next tipping point.’’ All in all, we
remain bearish on Greece, and we see its exit from the Euro Area as
inevitable. However, we believe such next tipping point is no earlier than
2013/2014.
Cross-markets, we remained positioned for Europe to further outperform
the US in the near future. True, Obama victory at the elections is the relative
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5. best when compared to the increased uncertainties over inflection points in
monetary and fiscal policymaking that Romney would have entailed (in that we
probably disagree to consensus view). But the stage is set for further noise in the
US and a weak relative price action. Firstly, if the technical situation got tricky
in Europe it is far worse in the US. The US starts off from richer valuations, at
around pre-Lehman levels, and it is hard to argue that just the thin air of actual
monetary expansion engineered by the FED stands beneath such bloated levels.
Peak profit margins were in large part a reflection of it, as we previously argued.
Finally, we believe a compromise over the fiscal cliff/debt ceiling gridlock will be
reached in less than a dramatic fashion, but the timing of such compromise is
likely to be later rather than sooner, if history is any guide, at which point the
market will have taken a defensive stance. We look at it as an opportunity, as a
cheaper valuations for certain bonds and stocks in the US will help us build part
of our portfolio on the Value side (Carry Generator pool, helpful to self-finance
the Hedging portion of the portfolio and our Fat Tail Risk Hedging Programs). In
particular, we monitor the uncertainties over the taxation on dividends and
their impact on blue chips, low leverage, high dividend paying stocks: it seems
the top marginal tax rate may rise to almost 45% on dividends, and 25% on
capital gains, from 15% for both currently. Against that backdrop, a sharp slow-
down of flows into high-dividend ETFs is the foretelling data corroborating
such view. Once (and if) that re-pricing has occurred, possibly into early next
year, we stand ready to reverse the relative value between Europe and the US.
We also believe that the UK is a likely underperformer to Europe in the
near future, both in Equity and Credit space. The catalyst may be the recent
decision by the BoE to moderate QE. Truth be told, such decision is an
understandable one, as the credit expansion in the UK is way larger than that of
Europe (and even the US), on our metrics. However, as we are reminded by
history, a slow-down in the rate of acceleration of credit expansion is itself
a tightening move. When the addiction to credit is large (as in the UK), it is hard
to imagine the markets and the economy at large not reacting to that with a re-
pricing. The UK has a total debt (private and public) to GDP well above 500%
(second only to Japan, Holland and Ireland, Chart), a maximum ratio of private
debt to GDP of 450% (300% in the US), financial sector debt of 250% of GDP (hot
money flows). Lastly, but perhaps most importantly, the rich valuations
(especially in Credit) vis-à-vis core and peripheral Europe should help motivate
an underperformance in the next few months. Such valuations stand in stark
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6. contrast to credit metrics / fundamentals: next year, the UK needs a nominal
GDP growth of almost 4% to cover primary deficit plus borrowing costs (much
worse than Italy, whilst having funding costs of one third of Italy, at current
1%/2% yields). Such contrast might be exposed (and demand a re-pricing)
as the (erroneous) perception of Debt Mutualisation surfaces in Europe in
the few months ahead, depriving the UK of the most relevant
differentiating factor until now: the availability of a lender of last resort.
Most worryingly, such lender of last resort - Mervyn King - recently admitted the
limits of monetary expansion, identifying the external demand as the missing
source of pick-up of activity for the UK economy. Our transcript from his
recent testimony (Video, starts at 3.20 minute): ‘what the UK needs is more
demand in the rest of the world to buy goods from the UK, that is the key bit
missing from our attempt to rebalance, and why the challenge is so great’. But
there may be too much wishful thinking there, as net exports contribution to
UK’s GDP growth was flat and stable, at best, over the past 10 years for the UK,
with average exchange rates (whereas it improved markedly for Germany over
the same period, for example). So Mr King is hoping for nothing to change, but
export demand to be better than it has ever been in the past 10 years, and
lead to UK’s resurgence. Given what is going on globally, with clear signs of
contracting global trade, trade conflicts to debase one own’s currency and
secure a larger slice of a shrinking pie, there is more than one reason to
hold doubts about King’s hopes.
Finally, regarding another possible catalyst and a key vulnerability for the UK, let
us quote our March Outlook: ‘’Corporate Pension Deficit Widening Fast and
Solvency Models of Insurers under pressures. Given our long-term Outlook
for an unbalanced, fictitious economy in Europe (debt-laden and kept alive by
massive liquidity and currency debasement from the ECB, possibly building up
its excesses to the point of implosion), we cannot easily dismiss the dangerous
spiral underway on Corporate Pension Schemes and Insurers alike. When
Negative Real Rates are the goal of a Central Bank trying to achieve Nominal
Debt Monetization (as Debt Mutualisation was prohibited by Germany, and
Defaults were deemed to be politically unacceptable), the pension deficits
balloon. The fatal mix of falling long-term Interest Rates and simultaneous
rise in Inflation make Pension Liabilities rise indiscriminately’’.
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7. For the Long-Term outlook, allow us to be repetitive and close up today’s write-
up with the usual ritual: long-term, we have no new news to change our view of
Multi Equilibria markets in the next 4 years. We rendered out thinking in a
recent conversation with CNBC (Video). The multi-year Japan-style deleverage
is perhaps the most probable scenario, perhaps the luckiest one for Europe, but
still it is hardly a scenario we should give for granted, hardly a scenario with a
probability close to par. Absent a crystal-ball, it is arduous to determine with
certainty where else we could be heading from here, and that is why we refer to
Multi Equilibria markets, as we see more than one potential endgame for
European matters. In an attempt to simplify the tree of potential outcomes, we
see two broad destructive forces who could spoil the party and derail the Japan-
style slow deleverage, which point in exact opposite directions: Default
Scenario: Real Defaults, Haircuts & Restructuring, potential Euro break-up
as a by-product. Or Conversely, we see an equal chance of going through the
opposite scenario, an Inflation Scenario: Nominal Defaults, Debt
Monetisation, Currency Debasement. ‘The leit-motiv 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.
Within 12/18 months, that may be the next most crowded trade’.
Such undervaluation and mispricing reminds us of the price of wanna-be
AAA paper a few years ago, under the sign-off of complacent Rating
Agencies. At that time too, shorting credit was made inexpensive. Timing for the
bubble to burst was uncertain, as it is now, but inexpensive means that it did not
matter that much after all. This time around, it is not the Investment Banks
pushing credit into unsustainable territory but the Central Banks
themselves - with obviously more margin for error, but not infinitely so.
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8. Opportunity Set
We offer an update to our Opportunity Set alongside the list of pre-identified tail
scenarios we see possible in the few years ahead of us (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
Break-Up (either coming from Germany rebelling to subsidies or peripheral
Europe rebelling to austerity), China Hard Landing, USD Devaluation.
Renewed Credit Crunch
Ever since Draghi’s bold move in support of the currency union, together with
similar extraordinarily expansionary monetary policies globally, certain Risk
Premia and inter-banking spreads collapsed to new lows, from where any
potential further compression is hard to imagine. In particular, we saw the
EURUSD currency basis tightening to pre-Lehman lows (before resurging slightly
last week on recent market weakness), OIS-Libor spreads (in Europe and the US)
and Swap Spreads (especially in the US) well below pre-Lehman levels. They all
are in between 10bps and 20bps, having been single digits for a short while in
the past few weeks. In comparison, the tightening in CDS premiums, VIX
volatility and the likes is short of impressive.
China Hard Landing
This year we had a great run hedging the China Hard Landing Scenario,
expressed via shorts on the Dry Bulk segment of the shipping industry,
heavily sensitive to the Chinese economy. Back in January, we were convinced
China’s imports were slowing down, as reflected by official data and as
confirmed by data on Taiwan exports, Shipping and Mining flows. We recently
took all profits and closed positions, for the time being. Although we still
believe in the idea (in particular, South Korean’s exports to China took a dive
lately), we are on the verge of forceful money supply in China (for a change) and
abroad, and therefore became wary of a short term rebound. If such rebound
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9. materializes, 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.
Short term, in addition to money printing, there are a few reasons to be
positive about China and wary of a rebound. Xi Jinping’s appointment was a
safe choice for the country and we noticed his immediate consolidation of power
within the Party’s Standing Committee, as he assumed Military Committee
chairmanship (differently than what happened during Deng Xiaoping and Jiang
Zemin hand-overs). Also, the initial statements of the new leadership team seems
to show awareness that reforms are essential to China and the same survival of
the Communist Party. All in all, the good ground for reforms should help
markets in the short term.
Moving away from the shipping industry, which provided the hedge last
time around, our eyes are now on Australia. We believe Australia might
provide an efficient hedge against China’s hard lending, at some point next
year. The main fragilities we observe are the following: an unusual current
account deficit, heavy hot money flows (large foreign investments), overcapacity
in the mining and construction industries (key components of their economy).
Medium-term, we are bearish both on the exchange rate and the banking sector
on the equity side (a far cheaper play than the already depressed iron ore
industry), whilst we would be receiving rates in fixed income, so as to prepare
for interest rates cuts and generate premium in between.
Our long-term bearish stance on China is based mainly on decelerating
growth and overexpansion of credit embedded in their economy. For what
has now become a 7trn economy, it is fair to assume that double-digit growth
rates are long gone. Growth is not necessarily the most informative data out of
China (due to flaws in their statistical infrastructure, let alone reliability of the
data available). However measured, it is inevitable for growth to slow down
markedly, from here: it is arithmetic pure and simple, for the impossibility
of exponential growth in a finite environment. We expect growth to be
below 7% possibly already next year and below 6% within the next 5
years. Within such growth rates (still good in absolute terms), the rebalancing of
growth from state-driven fixed investment to domestic demand is going to have
an impact. Investment is almost 50% of China’s GDP, whereas Consumption is
just above 35%. Total credit is 30% of GDP. The housing bubble is greater than in
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10. Switzerland, as the country dis-incentivized foreign investments by Chinese
people, together with lowering real interest rates into negative territory. We do
not believe China will go bust, but the transition to a more balanced
aggregate demand mix should lead to pitfalls and adjustment fatigues, as
the credit bubble of indiscriminate state investments (in totally useless
projects) deflates. And in the meantime, at points, China’s sensitive assets
(home and abroad) are poised to steeply underperform as a result of it.
That is what we refer to as ‘China Hard Landing Scenario’.
Default Scenario / Euro Break Up Scenario / Inflation Scenario
Similarly to the Renewed Credit Crunch scenario, Cheap Optionality is available
here and will grow some more in the near future with regard to these scenarios.
We leave a full discussion on this topic to one of the future write-ups.
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11. What I liked this month
UK total Government pension obligation, at the end of December 2010, of
£5.01 trillion, or 342% of GDP, of which around £4.7 trillion is unfunded
obligations Read
High yield debt issuance in 2012 hits an all-time record Charts
Introducing the ‘youth sacrifice ratio’: the cost of the economic downturn is
borne in a disproportionate manner by the younger generations is, in the
short term, more socially acceptable than a “fair” distribution across all age
categories. the bulk of the population, at least initially, can still benefit from a
relatively high level of economic security which may help to keep them away
from radical politics Read
Spain has full access to the market, but ONLY because of the ECB's backstop. In
fact if Portugal qualified for the OMT program, it would immediately gain full
access to the market as well. This argument is a bit circular, isn't it? Read
W-End Readings
Bloomberg TV Interview to Fasanara Capital: В течение нескольких лет
Греция выйдет из еврозоны: Video
Greece next restructuring: ideas from past experiences with heavily indebted
poor countries Read
Is Russia the best or worst of BRICS? Video
Samsung Hikes Apple Component Price By 20% Read
How Zara Grew Into the World’s Largest Fashion Retailer Read
China's future: challenges and opportunities Read
As Giffen good, when physical Gold goes into “hiding” the demand will increase
in proportion to the increasing price Read
Austerity in pictures Pictures
Ray Kurzweil and reproducing brain Video”
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12. 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
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