Fasanara Capital | Investment Outlook | October 7th 2013

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“Learn how to see. Realize that everything connects to everything else.” ― Leonardo da Vinci

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October 7th 2013

Fasanara Capital | Investment Outlook

1. Beware of blue-sky markets, when the only price they are prepared to pay for

uncertainty is a slowdown of the rally.

2. We maintain our view for Japan-style volatility to permeate markets in the months

to come. Artificial markets are structurally fragile. Renting rallies, while keeping

overlay hedging strategies in place against sudden adjustment to the downside,

remains our elected investment strategy. Stay long, but only tactically so. Stay over-

hedged.

3. In Europe, the tail risk of Italian elections has only been postponed. Still, we are

constructive on Europe in the short-term, especially against the US. Long-term, we

believe the case for a break-up of the EUR remains a genuine one.

4. In the US, we expect rates to drift lower going into the heat zone of Debt Ceiling.

Once new recent lows have been established in rates, we plan to try and reverse

course and position for somewhat higher rates, in more sizeable amounts.

5. Longer-term in the US, if we are right about the lack of economic growth remaining

the elephant in the room, then after tapering lies more Quantitative Easing. Perhaps,

the new entry monetary tool of 2014 will be Nominal GDP Targeting. Which means by

then the sea level of asset prices will be increased once again. Visible inflation is

better than stagflation.

6. VALUE BOOK, remains flat:, as markets are toppy, still expensive vs fundamentals, at

risk of a 10%/20% steeper correction. HEDGING BOOK, active: short S&P, long VIX,

long Credit Curve Flatteners, short EUR, Long Interbanking Spreads & Currency Pegs,

short JGB rates, short Yen, short Australian Dollar. TACTICAL BOOK, expanding: long

Europe vs US in equities (similarly to September 2012), long China-led stocks and

commodity for short term reflation to continue.

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Beware of Blue Sky Markets

In the last few weeks, in spite of several risk factors at play simultaneously, markets remained

broadly directionless, volatile within their recent range bound, across Equity and Credit. Not so

much because they are unsure as to the direction to take from here, but rather because the only

price they are prepared to pay for uncertainty is a slowdown of the rally.

Despite the specter of Italian elections in Europe and a prolonged government shutdown in the US,

leading straight into another standoff on Debt Ceiling, equity markets kept hold of their cool,

remaining optimistic about positive resolutions on all, and standing ready to grind higher.

In fairness, while such risk factors are in action mode, others have meanwhile been defused:

September tapering got postponed, possibly into next year, while Summers left the race to FED

chairmanship. Both elements speak of sustained government support to financial valuations, as the

mother-ship Central Bank keeps the gates of liquidity to Wall Street wide open.

That is, markets put dogmatic trust in the parachute offered by monetary authorities, and do

not even flinch as they look down the barrel of the gun of potential government defaults, neither

in the US nor in Europe. We could not get better indication of widespread overdose of optimism

than the one we got this past month. As fundamentals speak of a different world, markets bought

fully into the rosy picture depicted by the FED for GDP growth come 2014.

None of this is to say that we see events turning for the worst, neither in the US nor in Italy (in the

short term). However, we surely look at markets’ over-bullishness as a connotation of fragility. As we

recently argued (CNBC Interview) we maintain our view for Japan-style volatility to permeate

markets in the months to come. Artificial markets are structurally fragile.

Renting rallies, while keeping overlay hedging strategies in place against sudden adjustment to

the downside, remains our elected investment strategy.

Artificial Markets are gapping markets. Stay long, but only tactically so. Stay over-hedged.

We attach the link to the recent Investor Presentation we held in London two weeks ago, where

Charts & Data were provided for the analysis summarized in this Outlook (Artificial Markets are

Structurally Fragile | Investors Presentation | 19th September 2013).

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Short-Term Outlook For Europe:

Italian Elections Off-The-Table, But For How Long?

Let’s start with Italy, where last month we argued: ’’as per July Outlook, it is not only about German

elections, but perhaps about Italian elections too, soon enough. The political landscape in Italy is

crystal-fragile, as the governing party led by Berlusconi faces a lose-lose proposition between

political irrelevance and outright extinction. To them, returning to elections in some drama play on

anti-EUR rhetoric, might end up being the safer option to resort to. New elections in Italy are a 'fat

tail' risk, which is not even a 'tail', as its probability tops 40%. Italian bonds are well inside bubble

territory against this backdrop; Italian equities are historically cheap, but way off pricing in such risk

scenarios’’.

It ended up playing just along those lines. If not for two unexpected elements, one political and

one market related.

- Surprisingly, while we thought Berlusconi’s party was to stand by him at all costs until

the end, some of it decided instead to part ways in what they thought was going to be

his final hour. It is not for us to opine on politics and have a view on whether or not this

is game-end for Berlusconi. We suspect not, as he still commands large popularity.

However, as elections are postponed into next year, he may not be in a position to

monetize that value soon enough (for he may be banned from public office

beforehand). Surely, while the government coalition remains crystal-fragile, the

iceberg of a fully-fledged crisis has been sailed around this time.

- Surprisingly, while looking at a critical confidence vote the next day, as new

elections loomed, the reaction of the markets was just subdued.

The market resilience in the face of adversity was yet another proof of its total deafness to risk

bells. As we argued here (CNBC interview Oct.3rd), the market may have been too complacent those

days. New elections could have put chain effects in motion, such as:

- The only Rating Agency with a single A- rating on Italy is the Canadian DBRS. Last

time around, DBRS downgraded Italy upon new elections. Losing a single A rating is no

small deal, it is a trigger. When haircutting BTPs held as collateral, the ECB takes into

account the best rating of the four agencies. Should Italy lose that single A rating, the

average charge on a 5yr BTP would suddenly rise from 1.5% (where it is taxed in line

with Bunds) all the way to 9%. An higher haircut is bad news to the local banking

system, already stretched with funding, let alone capital.

- As LTROs got repaid for Eur 300 bn (on total Eur 1 trn) and some deleverage took place,

excess liquidity in the banking system in Europe compressed to ~Eur 210 bn. The

ECB estimates at Eur 200bn the threshold for tightening pressures on EUR short rates.

A new LTRO is therefore needed, or else stress in the inter-banking market is to be

expected, especially to Italian and Spanish banks. Yet again, what would have been the

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likelihood of the ECB offering a new LTRO if Italy was to go into new elections, in most

uncertain outcomes, encompassing anti-EUR parties (which accounted for 25% of the

votes last time around)? It all revolves around the independence of the Central Bank, I

guess. As Germany may not have taken the risk of handing out that cash fast enough,

arguably.

- Adding fuel to the fire, Cyprus is the blueprint for the next crisis. Bail-in is the name

of the game. Bail-in means bondholders contribute to a bank rescue by writing down

part of their bonds. Any restructuring goes through the need to haircut certain classes

of bondholders (maybe all) and certain classes of depositors too. Not only for peripheral

Europe: SNS Reaal, suffered the same fate, despite being located in core Europe,

Holland that is. The market seems to have forgotten that completely. In spite of the

European Commission confirming it as recently as in August, when saying that ‘State

aid must not be granted before equity, hybrid and sub debt have fully contributed to

offset any losses’. Rephrased, there can be no aid for any bank anywhere in Europe,

unless there have been haircuts first. The European Commission has full executive

power over State Aid rules in the EU, legally binding, no need for ratification by any of

the member states.

Once the chain effect had been ignited, there was no telling where it would stop.

Such concurring elements were defused right before hitting the wall, at the last quarter mile.

Markets held their breath, then brushed it off all too quickly, deducting it had never been a real

threat. Over-optimism reigns over blue-sky markets.

For what is worth, there was a cheap way to hedge back then, providing for heavily asymmetric

profile, which goes as simple as being long Bunds vs BTPs, just across those few hours. At a

spread of approx. 250bps, a potential positive resolution to the crisis was fully priced in (and indeed it

did not tighten much right afterwards). In contrast, were new elections to be called, the spread

widening could have been sizeable.

Such strategy may become relevant all over again when new elections are called out of Italy. We do

believe that Italian elections have only been postponed: as the government remains flaky (and

flakier than before), the economy keeps imploding (as deficit tightens only due to contracting

aggregate demand), debt/GDP worsens (to 130% at year-end), youth unemployment keeps

rising (from Weimar-style 40%), ECB remains missing in action (let alone cheap talk). Next time

around, the entry point on such hedging position might even be at a tighter spread of ~150bps,

courtesy of the ECB soft talk and market over-bullishness. We plan to use this or similar

contingency arrangements to sail through the next risk zone with a full hedging kit equipment in

place. Forewarned is forearmed.

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Long-Term Outlook For Europe:

The Case For Staying Hedged Against EUR Break-Up Risk

Talking of instability and un-sustainability of the current state of affairs of the EUR as a currency peg,

we argued in the past how difficult it would be for the rebalancing of competitiveness across the Euro

Area to take place via Internal Devaluation only, in the impossibility of resorting to any external

depreciation/currency adjustment. We argued months ago that, in spite of ~40% youth

unemployment in Italy and Portugal, ~60% in Spain and Greece, such rebalancing requires salaries to

being cut some additional 40%: difficult to imagine. Moreover, that was true when the EUR was 1.28

to the USD. How more unlikely did it get now that the EUR is 1.36 and appreciated against any other

currency globally? How much more pain is needed in Internal Deflation to fill up gaps in

competitiveness? How much more pain is tolerable before it is not?

Italy did not experience 40% Youth Unemployment during the Great Depression of 1929. It is doing

so now. While losing 10% in actual GDP in 5 years.

Again, ‘’the fact that the fear of destruction, either in the form of widespread unemployment,

civil unrest or sequential failures, is preventing the EUR currency peg from being dismantled,

must delay the final extinction of the currency, until such same destruction is to happen anyway,

under the squeeze of an overvalued currency, overleverage and current account deficits’’.

Contrary to what we hear all around, forming the consensus view, rebalancing across countries

is not taking place. It is certainly not happening at an acceptable speed, when compared to the

accumulation of total debt in the system undergoing. Let’s look at numbers. Current account surplus

for Northern Europe stands at Eur 500bn. Germany's surplus keeps expanding and now represents

7.5% of GDP, from 6% last year. This is making Southern Europe no favour: the need for looser policy

on the part of Germany fell on deaf ears. Elsewhere, the shrinking deficit in Italy and Spain is

misleading as is achieved by the contraction in the economy and a fall in domestic demand - which

only incidentally reduces imports. Critically then, France's deficit is on the rise at 3.5% of GDP. At

current rates of change, before having Italy and Spain look like Germany, we will have France

look like Italy and Spain.

Interestingly, Italy looks all too similar to Japan. Over-indebtness, declining economy,

demographic drag on GDP (at least 0.5% yearly), too strong of a currency. At least Japan has the

tools (debt monetization/currency debasement) and the willingness (political leadership for

structural reforms) to have a shot at a different future.

Again then, as repeated ad nauseam, we remind ourselves of hard data evidence from the past: ‘if

history is any guide, three conditions were met in past currency crisis and emerging market

crisis: an over-valued currency (read, the EUR to countries like Italy and Spain), over-indebtedness,

as a share of GDP or the productive economy (rephrased, too much debt and no growth against it),

and current account deficit. By any objective criteria, all three levers are met for certain countries

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in southern Europe, making the case for a reshaping of the EUR-fixed currency regime a genuine

one. In advanced economies the readjustment may be slower to occur than in emerging economies

(as we learn from the attached interesting piece looking at past banking crisis), but it may still do

occur over time, including a currency-driven one.’

Short-Term Outlook on the US:

Tactically Trading Around Government Shutdown / Debt Ceiling

The attached article on Game Theory applied to Debt Ceiling makes for a fun reading: 'If I say “Row,

or I’ll tip the boat over and drown us both,” you’ll say you don’t believe me. But if I rock the boat so

that it may tip over, you’ll be more impressed.' (read)

The market consensus is that the Government Shutdown will not produce any lasting damage, while

the Debt Ceiling risk is not for real. We agree with consensus. However, when consensus is one-way

widespread there is clearly room for volatility.

Trading tactically around the debt ceiling might provide opportunities. We will use our Tactical

Book to try and do that. We are currently positioned for lower rates going into the deadline, as risk

aversion might procure a similar environment to the one experienced in August 2011 (although less

pronounced, as it is widely anticipated, this time around, and the surprise factor is missing). If we and

the consensus are right over politicians finding a solution in extra time, then such possibly lower rates

may provide an excellent entry point for the reverse position, as we believe rates are going to be

higher come 2014. Best curve place to us to play the view is 5 years.

Thus, we expect rates to drift lower going into the heat zone of Debt Ceiling discussions. Once

new recent lows have been established in rates, we plan to try and reverse course and position

for somewhat higher rates, in more sizeable amounts. We do believe that the tree of potential

outcomes will plan out as follows, by then:

- No Debt Ceiling disarray: as soon as debt ceiling discussions are past us, we may

possibly see the FED chairmanship confirmed, and the market may start focusing again

on tapering. As we argued extensively, while delayed, tapering is taking place. That is

what matters, more than the specific month it gets initiated at. To us, tapering should

take place because QE is ineffective and comes at outsized risks and unintended

consequences, while not yielding any commensurate result in the real economy. To the

market, tapering should take place as rosy GDP prospects are round the corner, come

2014. Whatever the motives for tapering, tapering brings with it higher long-term rates.

- Debt Ceiling leads to technical default: in the unfortunate/unlikely case in which

irrational political behavior prevails over economics and common sense, bonds may get

sold for nobody likes to hold paper in the presence of a technical default (as Bill Gross

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noted). Starting with the reserve managers of the Emerging Markets, as they account

for the bulk of the $5.6 trillion of Treasuries owned by foreign entities, as of late June

(including China at 1.27trn).

It should be noted that the duration of the government shutdown/ debt ceiling impasse is a factor

too: should its duration be too long, the impact on GDP and the call for more prolonged QE cannot

be ruled out. In such instance short rates positions are more risky than otherwise.

In the equity markets, we suspect that multiple mini-rallies might take place as news of an

agreement filter in, only to be disappointed as more negotiation is needed right behind. As

volatility is cheap, especially on high strike calls, those patterns can also be played out

opportunistically. That is what we intend to do for the coming days/weeks.

Long-Term View for the US:

Tapering First within 6 months, then no tapering, then NGDP?

On June 28th

we wrote: “ if we are right about the LACK OF GROWTH being the elephant in the

room, then Bernanke will be next confirming QE and delaying tapering’’. On Sept. the 3rd

we

confirmed: “Tapering may get postponed by a few months, leading to a short-lived, relief rally. So

much for the potential nominal rally we see possible in Q4”

The reason why we expected Bernanke to delay tapering, has to do with our skepticism around the

quality of the GDP growth and the sustainability of it. We view Bernanke’s decision as

confirmation of our assumptions on real economic activity, in contrast to market consensus. The

FED seems to believe extraordinarily measures are still indeed needed. GDP growth is weak and

shallow at best, far insufficient to fund the huge funding gap created by additional debt inherited

from QEs policies. The market may realise that at some point. The market should realise that as

some point. That may lead to the steep re-pricing we see possible (benchmark for it is a 10-20%

downside on S&P, possibly digitally so).

We expect Japan-style volatility. We therefore plan to stay fully hedged (CNBC Interview).

If we are right about the lack of economic growth remaining the elephant in the room, then after

tapering lies more Quantitative Easing. Perhaps, the new entry monetary tool of 2014 will be

Nominal GDP Targeting (NGDP). Which means by then the sea level of asset prices will be

stepped up once again. Visible inflation is better than stagflation.

Fast-Forward there, and inflation might look less of a prehistoric fossil than it looks today. Fast-

forward there, and Gold could have its day again, within 2014.

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If Japan is any guide, once total debt/GDP private and public is well above 500% (UK there

already), there is little else to do but desperate debt monetization and heavy currency

debasement. You are boxed out in the corner, as higher rates are a Damoclean sword pending down

your neck, while the drag of indebtedness in real terms on economic growth is unbearable, calling for

more financial repression and negative real rates.

China’s Bumpy Road Ahead

Recent data shows that China resorted to the bad old habits of fixed investments to ring-fence

growth from an inevitable decline. August exports and industrial output came out stronger than

expected. Interestingly enough, however, construction starts fell 20% yoy. Typically, residential

housing was leading the way of Chinese GDP growth. Has china found a new way of growing through

manufacturing and industrial investments? We doubt it. To us, this is one more reason to cast

doubts over the sustainability of this short term reflation in china.

We did some research the Imperial College library in London this week end. Early Saturday morning

and 90% of the many students at work around us are Chinese. Not any significant observable sample,

obviously. But if it was just because it is week end (where commuters go home) and early morning,

then it would be even more telling. There can be little doubt that the future speaks Chinese.

Across Asia, middle-class population will increase by 1 billion people in the next 10 years. This single

statistic may say it all (article).

We convene that China is going to be the driver of growth in the next 10-20 years. However, we

expect the next two years to be problematic, as the country works out its delicate rebalancing

from export/fixed investments to a domestic demand -driven economy. The excesses in the credit

system, the sheer magnitude of Corporate China indebtedness (120% plus of GDP, well above...) will

be exposed once GDP growth falls from the diving board of unsustainable 7% GDP growth. We

discussed this at lengths last month (September Outlook).

In summary, in China we hold a barbell type of view; positive in the short-term (artificially so, as

fixed investment habits are hard to die), negative for the next two years (as credit excesses are

exposed in a rebalancing economy), positive again in the next decade (as demographic factors,

GDP quality catch up, and reserve currency status take hold).

Japan: Interesting Q4 Ahead

Not enough space and time to discuss Japan in this Outlook, although we believe the next quarter is

going to offer valuable opportunities. In this respect, good entry levels might materialize for the

hedging book re Japan. We aim to discuss more on Japan at the next investor presentation.

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Investment Strategy

During the latest Investor Presentation, we provided examples of positions over the 3 books in our

portfolio (Artificial Markets are Structurally Fragile | Investors Presentation | 19th September 2013).

Value Book

At present, our Value Book remains pretty flat, as markets remains toppy, still too expensive vs

fundamentals, especially now that rates may be on the rise and the Central Bank support shows

the first cracks. Our current small allocation to longs in the Value Book is filled with select Special

Sits which still offer asymmetric returns vs risks in our eyes. We will change our bearish positioning

once the disconnect between the real world and financial markets tighten from here, as a

consequence of market correcting further or fundamentals improving (we remain skeptical on real

growth recovery, as argued extensively, but will remain open-minded as the situation develops and

more data come in). Also, we will change that stance if markets move side-ways for long enough

(which is just another way to digest their expensiveness, arithmetically equivalent in real terms

to a declining market if inflation is above zero). As argued last month already, we have been in

bubble markets similar to the current ones multiple times in history: 1) the Credit markets are all too

remindful of 2007 (at that time it was Investment Banks inflating the bubble through leverage, this

time it is Central Banks themselves, with obviously more margin for error, but not infinitively so). 2)

The Equity markets, the Mothership US in primis, are remindful of conditions we have seen already in

2007, but also in 2000, 1987, 1929, all followed by market crashes

Tactical Book

We like tactical longs in Europe at present, fully hedged via shorts in the US. This is a tactical

position, which we expect to hold into possibly year end. Such view is independent from debt

ceiling discussions, as we expect them to have an eleventh hour fix. Such positioning follows delayed

VALUE BOOK

FLAT Remains light, as we see a risk of 10%+ correction over the medium term

TACTICAL BOOK

EXPANDING In absence of sustainable carry generation in the Value Book

Tactical Long EuroStoxx – also vs US - postponed ITA elections

Tactical Long single stocks linked to EMs / Commodities - catch up theme

L / S positions

HEDGING BOOK

ACTIVE This is where we see MOST OPPORTUNITIES

Short S&P / Long VIX Long Credit Curve

Flatteners Short EUR Long Inter-banking spreads

/ currency pegs

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Italian election, and Greece /portugal issues to arise with a time lag, thus leading to false calm in the

markets, and possibly an LTRO/rate cut by the ECB, weaker euro.

Longer term, no change in views to this day: we maintain our bearish bias in Europe, for we expect

the crisis to flare up again and the EUR-peg to be dismantled down the line. In the same vein,

hedging overlay strategies via cheap optionality and positive carry formats are to be held

throughout the period.

Elsewhere in the Tactical Book, we look at China, and the impact of short-term push into fixed

investment-led growth all over again. While not sustainable, it is not to be underestimated for the

short-term. We look at beneficiaries of such flows, tactically for the short-term, before implosion few

months from now. Commodity stocks who fell out of favour with the market to levels where a

temporary catch up reflation looks possible.

Hedging Book

Regrettably, it is impossible to call the day, the month, or even the quarter in a reality-check

correction may take place. Policymakers can indeed buy more time. Money printing might still

be in its early days, despite evident diminishing returns (tending to zero). For all intents and

purposes, we are left to rely on a sustainable multi-dimensional risk management policy,

intended to keep the guard high for long enough, being able to finance the renewal of market

protection strategies for the quarters to come.

At present, our task is made the most difficult as we have no significant carry generation within

the Value Book to rely upon in financing the cost of the hedging strategies. Ever since May, and

differently than in the last two years, we decided to keep the Value Book flat-ish, as carry strategies

would be exposed to digital downside risks in both equity and credit asset classes. When adjusted for

real risks, as opposed to deceptive historical vols, such carry strategies are a clear pass.

Consequently, the ability to fund and roll hedges and keep them alive for long enough will be the

key determinant of our ability to live to produce strong returns in the medium term.

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What I liked this month

Roubini predicts Indonesia growth to exceed China, India Read

Cashing demographic dividend: India lures foreign colleges Read

IMF chides Turkey on reckless policies as taper looms Read

W-End Readings

Fasanara Capital recent interviews available on our page: Videos

The Structure and Resilience of the European Interbank Market Working Paper

Canadian billionaire: US dollar is soon to be dethroned as the worlds 'de facto currency' Video

Jeff Bezos: What matters more than your talent. Video

Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001 E-Mail: [email protected] Twitter: https://twitter.com/francescofilia 55 Grosvenor Street London, W1K 3HY Authorised and Regulated by the Financial Conduct Authority (“FCA”) “This document has been issued by Fasanara Capital Limited, which is authorised and regulated by the Financial Conduct 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 may have, or have had, investments in these securities. The law may restrict distribution of this document i