1. March 2nd 2012
Fasanara Capital | March Investment Outlook
Investment Outlook
With a €530bn ($700bn) of liquidity injection, the LTRO2 came out on the safe side of
expectations and at a powerful enough level to not command an immediate setback of
the market risk rally. Such credit expansion equated to more than €300bn of fresh new
liquidity, after deducting roll-overs of old shorter-dated loans (and €500bn in total adding
up LTRO1). As anticipated, we believe the current rally will likely be tested in the next few
weeks, now that LTRO2 is past us, maybe sometime around option expiry in mid-March
(which would somehow coincide with the 20th March Greek maturity and its residual risk).
The guesswork plan of the ECB is clear and moving along steadily and dangerously: buying
time for an insolvent banking industry, who in turn can support over-levered Sovereigns
with contracting economies (indeed, the funding gap of European banks is now effectively
pre-funded to 2014, who can now then dial up their risk tolerance on carry trades on
government bonds, amassing local country risk), in an attempt to inflate their way out of the
crisis via nominal debt monetization (as Sterilization is debatable) and extremely
accommodative monetary stance over an extended period of time (artificially driving Real
Rates to negative territory). Meanwhile, in the hopes of the ECB, banks will have engineered
an orderly deleverage, will have resumed lending to each other and to the real economy,
whilst fiscal agents will have provided for fiscal firewalls (recent policymakers’ talks of ESM
combined with EFSF, and more), and will have imposed austerity on peripheral countries so
as to determine Internal Devaluation and Deflation, restoration of competitiveness,
realignment of External Imbalances within Europe within the next five years or so (assuming
that multi-year economic contraction is politically acceptable and does not derail against
social unrest). But the policy plan comes at a massive price tag, unheard of for a
peacetime economy: past LTRO2 (and before a possible LTRO3), the ECB owns already some
€1.3trn of peripheral bonds or loans (if one combines asset purchases and repos) and a total
balance sheet of over €3trn (more than 30% of GDP).
Our long-term view remains on course, as we believe the case for being (i) broadly
defensive, (ii) for preferring collateralized or secured exposures to any expendable degree,

2. (iii) and macro hedges all along (select shorts and cheap hedges) is a genuine one, even
more so now that the stake has been raised on the ECB’s gamble. We have argued
extensively on that in previous Outlooks so we won’t go into details. Suffice it to say that
money multiplier is still contracting (past LTRO2 deposits at the ECB are now almost 300bn
higher at close to 780bn, where we fear they might station), money aggregate M1 deposits
in peripheral countries is compressing fast (at current rates, it might top 25% in Greece, and
16% in Italy, 18% in Ireland and Portugal, annualized), private sector loans and consumer
credit in a downward spiral, household deposit on a steep rise.
To clarify our thinking, we may differentiate between three scenarios for the next few years,
in what we called earlier on 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. (1) 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 over the course of 2012 or beyond,
one of two directions: (2) Inflation Scenario, money printing gets truly massive, Draghi finds
political support to implement decisive Fisher-Friedman monetary stimulus (beyond LTRO3,
more direct assets purchase programs, target high nominal GDP, Zero Nominal Rates, more
negative Real 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, then possibly currency debasement and potentially high/hyper
inflation, orderly or disorderly. (3) Defaults Scenario, money printing fails, few Banks in
receivership/restructured/nationalized/merged, few Sovereigns restructure/devalue,
possibly Eur break-up or reshapes, orderly or disorderly. All legitimate scenarios, not
necessarily mutually exclusive, each with decent probability (although the last two
scenarios are far from being priced in, therefore relatively cheaply hedge-able).’’
Critically, in ten years from now, looking back at Europe’s multiple choice and its
attempted solutions, such scenarios may not look so far apart, in forward value terms. 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. The attached BIS paper gives a clear illustration of the illusion of unlimited
intervention.

3. Opportunity Set
The current risk on rally pushed levels to a point where it is made easier and cheaper to
hedge against select negative scenarios, both through Select Shorts or Cheap Hedges (Fat
Tail Risk Hedging Programs). The scenarios that may be targeted, at different probabilities
(for how low they may be) 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, (vi) US Dollar Devaluation. Such scenarios have still low
probability, all of them, in absolute terms, but such probability was never higher than it is
today.
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), until the market emerge from its
direction-less status and the sky at the horizon is clearer, whilst simultaneously (ii)
equipping 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.

4. What I liked this week
ECB's Draghi raises the stakes with trillion euro gamble More
Greece: CDS trigger More. Will the Greece CDS auction be ‘fair’? More. Juncker Says There Is
A "Plan B" If Greek Debt Swap Fails More
China Dumps $100+ Billion In USTs In December More and More
Spain's public deficit was 8.51% of GDP... 2.5% higher than the target agreed with the
European Commission More
W-End Readings
Google Search trends: (i) German people are becoming increasingly aware of and likely
concerned with TARGET2 imbalances More (ii) The public and the markets have dismissed
the Greece related risks, focusing instead on Iran, oil, and gasoline prices More
Quantitative Easing and Money Growth: Potential for Higher Inflation? Federal Reserve
Bank of St. Louis Economic Synopses. More
BIS database banking statistics gather quarterly data on international financial claims and
liabilities of bank offices More
Diamandis makes a case for optimism -- that we'll invent, innovate and create ways to solve
the challenges that loom over us Video

5. 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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