2. Febraury 1st 2013
Fasanara Capital | Investment Outlook
1. We remain positive on markets in the short term, as we think equities
have further to go, both in absolute value and in spread Europe vs US,
especially as we factor in more US Dollar weakness. We think the time is
not right yet for the sizeable correction we anticipate.
2. Central Bank’s liquidity remains to date the chief driver of markets’
performance, thus we value the rally as built on shaky foundations and
overly sensitive to external shocks. Indeed, the markets that performed
the best, nominally, are those printing the most: US and Japan.
3. As countries engage actively in Currency Debasement policies in 2013,
we seek to differentiate between ‘real rallies’ and ‘nominal rallies’, to
isolate elusive gains from reliable returns.
4. Perhaps, the name of the game in 2013 is to make sure to invest into a
real rally as opposed to a fake one, or to invest deliberately into a fake
rally, after assessment of the costs of hedging it out of its fake context.
5. There is much talk about the fact that Tail Risks have receded or are
past us outright. But less attention is given to the fact that we might as
well live through one of such scenarios, as we speak. We believe an
Inflation Scenario, played through Currency Debasement to achieve Debt
Monetization might be off to his early stages.
6. On the Hedging portion of our portfolio, in Q1 2013 we intend to
increment hedging on three strategic scenarios in particular (out of our
Fat Tail Risk Hedging Programs) as they still are at rock-bottom
valuations: Inflation, Credit Crunch & Euro Break-Up.
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3. Since our last Outlook in mid-January, equity markets failed to move decisively into new
highs, and they are broadly unchanged over the period. In Europe, the party was spoiled
by Italy (and Spain), where the market started to take issue with a weaker than
anticipated government to be elected on February 24th-25th, together with spot shocks
on equities like MPS bank and Saipem. The US performed better, in nominal terms,
before adjusting for currency movements, as corporates sailed pretty well through the
earnings season and the debt ceiling hurdle was postponed.
Overall, the tactical portion of our portfolio showed a mild improvement over the
period, as Europe underperformance vs the US/UK was mitigated by our lightening up
of the Italian component of it, as anticipated, and then more than offset by the
devaluation of the US Dollar vs the EUR, as also anticipated. Going forward, we
maintain our modest longs on equity markets, both in absolute value and in
relative value Europe vs UK/US. Simultaneously we increased hedging
transactions, as we believe the rally has further to go but lies on thin ice and is to be
terminated prematurely. The weakness of the last couple of weeks should serve as a
reminder of market’s fragility, although we think the time is not right as yet for
the sizeable correction we anticipate. A combination of more retail investors
following the lead of a strong corporate sector and no imminent catalyst to a set back
may signal that an overshooting market is in the cards.
Cross-markets, we tend to believe that the US has the most potential to disappoint
in the very short term against buoyant markets’ expectations, whilst muddle-
through Europe promised much less to over-optimistic equity bugs. The US will also
soon have to come to terms with a postponed debt ceiling discussion (hanging on the
neck of its monetary expansionisms) and automatic spending cuts / US government
sequesters coming its way (hanging on the neck of its fiscal expansionism, which is
definitively through peak). Thus, we remain positioned for some outperformance of
Europe (ex Italy) against the US/UK, especially as we factor in further weakness of
the US Dollar. Such positioning is purely tactical and relates to the RV bucket of our
portfolio: we stand ready to close it outright or even reverse it as information comes in.
While we maintain our conviction that the current rally is mostly fictitious and
‘nominal’, as is primarily due to extraordinarily expansive monetary policies and the
currency debasement that comes with it, we still do not want to easily dismiss a
successful earnings season: especially in the US, shares moved higher on expanded
share multiples but also on somewhat incremented earnings. That came to our surprise,
and we are therefore brought to reflect on it some longer. The strength in the Corporate
sector gave some legitimacy to a rally otherwise totally out-of-sync with the economic
environment. In addition to that, a few mildly positive data emerged, like durable goods
from the US (before the government defense spending hit few days ago, bringing GDP to
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4. negative territory for the fourth quarter), US housing, US weekly job claims drop,
German IFO, Europe flash PMIs surveys. We believe it is too early to interpolate from
such data set a truly improved economic environment. The data pointing in the opposite
direction are still overwhelming, starting with industrial production, unemployment
and consumer spending.
In fact, we believe that Central Bank’s liquidity remains to date the chief driver of
markets’ performance, and therefore that is where we concentrate our attention and
analysis. Consequently, we value the rally in risky assets as built on shaky
foundations and overly sensitive to external shocks. Indeed, the markets that
performed the best in nominal terms (i.e. not adjusting for inflation and currency) are
the US and Japan. Unsurprisingly, their Central Banks are currently the most active, with
the FED anticipated at flooding the market with $85bn per month (approx. $1 trillion in
2013), while the Bank of Japan inundates markets with a similar amount of paper
money (as they plan a Yen120trn expansion grand plan, 25% of Japan GDP, equivalent
to more than $1trn, for an economy which is 35% only of the US).
Conversely, at current rates, the balance sheet of the Bank of England is growing more
moderately than before, whilst that of the ECB is outright contracting (by possibly
Eur300bn in H1). The Bank of Japan has even anticipated that they will buy expensive
European Stability Mechanism’ bonds, to make a weaker Yen vs EUR a surer thing.
Consequently, in both instances, the rallies of the S&P and the Nikkei were also
accompanied by devaluations of their currencies for concurrent amounts, making the
rally purely nominal, and not a real one, to a wide variety of non-local investors. One
more textbook case study of a Government using its handyman Central Bank to
achieve Debt Monetisation of an otherwise unbearable level of over-indebtness
(unbearable as a % of real GDP and output growth), via Currency Debasement.
Indeed, such environment is one of our six pre-identified Risk Scenarios for the years
ahead, according to our personal roadmap in Multi-Equilibria Markets (more on it
below). It is what we refer to as ‘Inflation Scenario’, one which we define as
characterized by Nominal Defaults, Debt Monetisation via Currency Debasement and
prolonged negative real rates (i.e. Inflation, hopefully mild, hopefully not getting out of
control). We suspect that, sailing throughout 2013, we may often have to
differentiate between ‘real rallies’ and ‘nominal rallies’, when looking at price
dynamics and distinguishing (real) losers from (nominal) winners, elusive gains
from reliable returns.
Let us use Japan as an example. In the likely scenario that the Nikkei grows to 20,000
(from 11,000 currently), but meanwhile the YEN moves to 160 to the USD, there has
been little real rally there for most investors, after adjusting for the loss on the exchange
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5. rate (or the cumulative costs of hedging it). We may easily agree to that. Market prices
seem to agree more to it now. Way less they agreed to it last month, when the
correlation between FX and Equity was much smaller (possibly mispriced). Perhaps,
the name of the game in 2013 is to make sure to invest into a real rally as opposed
to a fake one, or to invest deliberately into a fake rally, after careful assessment of
the costs of hedging it out of its fake context. We believe that paying attention to
the visible and not so visible facets of Currency Debasement cross-markets holds
the key to safely navigating the macro picture in 2013.
Actually, there is much talk about the fact that Tail Risks have receded or are past
us outright. But less attention is given to the fact that we might as well live
through one of such scenarios, as we speak. We believe an Inflation Scenario, played
through Debt Monetisation via heavy Currency Debasement might be off to his early
stages. Its seeds were planted during few years of ballooning Central Banks’ balance
sheets (from 2trn to 6trn in 5 years for G4 Central Banks). Such Inflation Scenario
carries with it Nominal Defaults as opposed to Real Defaults, to a wide range of
investors’ classes. To a fixed income investor, for instance, inflation is in many ways no
different than a default, as it curtails the value of your claim as surely as a default. To an
equity player, it is capital destructive whenever your stocks are incapable of recouping
inflation quickly enough so as to preserve purchasing power vis-à-vis currencies in
more limited supply. Again, illusory gains vs reliable returns.
Critically, as we argued repeatedly in past write-ups, the ability of the Central Banks
to prevent inflation from getting out-of control is highly overestimated by
markets, and especially so by the long end of the fixed income markets. Let the
debt overhang grow some more and there will not even exist any longer a Private Sector
big enough to take on the slack of freshly printed government securities, if need be to
sedate inflation. Any ‘exit strategy’ would be hazardous, to say the least. In stark
contrast to this, markets seem to hold the opposite view, as they price in the possibility
of moderating inflation as easy as a walk in the park. How could you otherwise explain
an holder of a 10-year Treasury being happy to be paid 1.60% (now 2.00%) nominal
return per annum (and negative real rates) to take on that risk. And we wouldn’t be
surprised to see such yields back lower next month. While agency/non-agency
mortgages are not that far behind.
In analyzing the magnitude of potential currency debasements, it may help
thinking that once that trend is confirmed as unfolding, it can catch up speed
easily, and transform itself into a falling knife. There are $11 trillions of FX
reserves owned by Central Bank reserve managers (from just $2 trillions some 10 years
ago). 60% of it is allocated to the USD (paying an useless average yield of 30bps, from
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6. 4% some 5 years ago). Such is the basic theme behind our long term USD Devaluation
Risk Scenario (more on it below in Multi-Equilibria Markets section below).
As we argued several times, a disciplined multi-dimensional Risk Management
policy is therefore paramount if one is to safely navigate through visible and not
so visible Fat Tail scenarios. A strong macro overlay strategy can attempt at protecting
the real value of one’s portfolio, especially at a time where Contingency Arrangements
(against an Inflation Scenario or its alternative Scenarios) are not only available but
cheap, at rock bottom historical valuations, courtesy of Central Banks’ activisms,
financial repression and high cross-asset correlation.
For all intents and purposes, high cross-asset correlation is the demon which
impaired the ability to mitigate risk through asset diversification, and makes it
harder to stay clear of bubble risks. At the same time, if one’s bothers to go the extra
mile, it may also help in building a multi-dimensional risk management strategy which
attempts at turning correlation to your advantage. We believe that confining a strategy
into the classical silos of equity/value/macro, exposes the portfolio to systemic risks
and may equate to fail to capture the transformational markets we operate into, for high
cross asset correlation is here to stay.
A few quick observations on Italy to refresh our views on recent developments. The
Italian market showed the most volatility recently, as uncertainties mounted over the
new government to be formed upon elections on February the 24th-25th, and its ability to
deliver on structural reforms. Moreover, external shocks on stocks like MPS, Saipem
(partially owned by ENI) helped scaring off some of the bullish market participants.
Such shocks are not to be underestimated, as they carry some valuable information with
them. MPS may seem like a politically orchestrated case, naively confirming that politics
prevail over economic considerations and national interest, especially the closer you get
to an election date (if anything, we wonder what the market would do in realization that
some of MPS’ regulatory accounting practices are widespread across the financial
industry). On the other hand, Saipem and ENI are no random stocks, but perhaps two of
a handle of stars of the Italian stock market. All in all, more volatility in the near term, on
this basis, should not take by surprise. Strategy-wise, having lightened up our European
longs from the Italian component, we now plan to try to take advantage of volatility
arising in the run up to the elections to reload selectively.
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7. Multi-Equilibria 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 multi-year Japan-style 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 Break-Up (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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8. 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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9. 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 break-up 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.
Bottom-line, 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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10. 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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11. 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 covenant-lite 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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12. 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 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.
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 rock-bottom valuations. Such scenario include: Inflation, Renewed Credit
Crunch & Euro Break-Up. 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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13. Tactical Short-Term 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 are currently executed via our existing
positioning (which we confirmed today for the fourth consecutive month) for the
European markets to stay sustained and possibly squeeze further to the upside,
while outperforming the US/UK/Italy, in $ terms, as they have managed to do ever
since September. Such positioning is typically tactical and short term, for we
remain prepared to adjust as information comes in.
What I liked this month
Spain's crisis strategy under fire as economy buckles again: Evans-Pritchard Read
Why Expansionist Central States Inevitably Implode, via ZH Read
LBO leverage creeping up, credit not reaching smaller firms Read
W-End Readings
How to live in a capital superabundance environment. The rate of growth of world
output of goods and services has seen an extended slowdown over recent decades, while
the volume of global financial assets has expanded at a rapid pace. By 2010, global
capital had swollen to some $600 trillion, tripling over the past two decades,
against $63 trillion of global GDP. Read
The Great Eight: Trillion-Dollar Growth Trends to 2020 Read
Why China's Credit System Looks Vulnerable Read China Hits Key Demographic
Ceiling As Working-Age Population Now Declining Read
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14. 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
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certain jurisdictions, therefore, persons into whose possession this document comes should inform themselves
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