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April 5th 2013

Fasanara Capital | Investment Outlook

1. Cyprus and Italy are two major political debacles that bear important

ramifications for the market at large in the months ahead. Policymaking

resembling a dancing elephant in a crystal store

2. Irrationality in political behavior took center-stage and is perhaps here to

stay. With it, the scope for policy mistakes is today bigger than before

3. We may be past the peak of political cohesiveness and coordinated

actions. Things complicate from here, on the back of offensive competitive

devaluations globally and policy mistakes regionally

4. Strategy-wise, realised volatility in politics and markets alike may be set

to rise from here, from the rock-bottom levels where it has been confined

so far by political cohesiveness and financial repression

5. Short Term Strategy: downside risks are so evident that we should

prepare for a reflation trade in optional format, no cash longs

6. European Long-Term Strategy: the need for hedging against a Euro

Break-Up scenario

7. Global Long-Term Strategy: the need for adapting to and hedging against

Multi Equilibria Markets

8. Paradigm shift in the markets and the need for unconventional portfolio

management tools

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Since our last write-up a month ago, two major European political debacles have

taken center-stage and bear important ramifications for the market at large in the

months ahead: (i) the inglorious handling of the political stalemate in Italy, and

(ii) the disastrous handling of the anticipated Cyprus restructuring. We will look at

each one briefly, highlighting what we see as the critical elements that emerged from

each, as they bear consequences for our Outlook and Strategy further down.

Italy provided first for some self-inflicted pain. The inconclusive elections of 24h-

25th of February were a shocking political result, but pain and panic could have been

sedated in short order by pursuing the one and only logical solution to the impasse: the

elections delivered three winners in roughly equal amounts (which equates to three

equally losers), two of which are conservative parties and one is a revolutionary party.

In no rocket science, the two conservatives parties were supposed to find a compromise

of sort, to preserve the political activity - and themselves from extinction in between. As

coming back to elections would pose the risk of landslide victory for the revolutionary

party. And indeed a compromise is what they reached already a year ago or so when a

closure of funding markets was driving the country head on into a liquidity crunch.

Logic would have led to such conclusion, although still after a few weeks of bargaining

and volatility. Logic was dismissed outright, however, as political deadlines have gone

by and a compromise is still to be found, whilst playing Russian roulette with the

markets and risking to crash test into yet another turmoil. Such compromise might still

materialize, and a relief rally might spur out of it, but the road to such resolution was

and is reckless and irrational. All in all, the handling of the impasse was irrational and

emotional, and not one driven by logical assessment of benefits vs costs, neither

economical nor political ones.

Cyprus provided then for some more illogical behavior. Whereas Italy was a

stumbling block taking policymakers by surprise, Cyprus’ restructuring was on

everybody’s calendar. Cyprus was in the cards ever since Greece re-restructured last

year, by means of heavy PSI, thus devastating the asset side of most banks on the Island

(for an amount equivalent to 25% of Cyprus’ GDP), which were overleveraged to the

tune of 700% of GDP, most of which relied critically on hot money flows of wealthy

foreigners. Given the troublesome economic landscape in Europe, the crystal-fragile

financial conditions across the continent, and the addendum of uncertainties in Italy of

late, Cyprus’ restructuring was supposed to be something short of a walk in the park. To

put things into context, Cyprus is a tiny rock in the Mediterranean, population of 1mn

people, counting for 0.3% of Europe’s GDP, and the capital shortfall was just Eur

5.8bn: Cyprus was no place to create volatility, animosity, and most importantly

bad precedents for Europe at large. Yet still, it took 10 days to come to a resolution,

and in between we learned that imposing losses to insured deposit was

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contemplated (so much on the road of a banking union to forestall bank runs pandemic

crisis), capital controls sine die were imposed (so much for a market commonplace

and a currency union without barriers), and the negative loop between government

risk and banking sector was reaffirmed loud and clear (so much for finding ways for

banks to lend to the real economy). A true disaster outcome, a dancing elephant in a

crystal store.

It does not matter too much how we got to such an outcome. It could be due to a number

of different elements we all understand. (i) Could be political calculations in Germany on

the ramp up to September’s elections, as Merkel’s new opposition – Lucke’s AfD - calls

for stopping fiscal bailouts draining money from German taxpayers, especially when

bailing out richer un-taxed Russians. (ii) Could be political calculations to send a Mafia-

style message to peripheral Europe, ahead of new potential negotiations over

conditionality of any sort. After all, before promptly retracting, new Euro Group

president Dijsselbloem ventilated that this format (insured deposit haircuts and capital

controls?) should be a blueprint for future rescue plans.. (iii) Could be a message to tax-

havens, yet another one (Luxembourg is warned, as their banking system is 2500% of

GDP). (iv) Could be a message to the finance industry at large, including the shadow

banking system, yet another one.

Whatever the basic driver was, it is still illogical for tiny Cyprus in the context of the

current widespread fragility, to provide the stage for the show. Tiny upside vs massive

downside. Especially in the context of the dangerous precedents it set: the

Pandora’s box in our story. Undue risk was taken in creating a Cyprus precedent,

which resulted in mishandling the situation altogether. Irrational behavior prevailed.

As it stands, we are led to question why we got into such unnecessary trouble across

Italy and Cyprus over a few weeks of schizophrenic disconnect, and if there is any

basic virus at play we should isolate. A few take-aways seem inevitable when

assessing market risks for the months ahead:

- Irrationality in political behavior took center-stage and is perhaps here to

stay. With it, the potential for policy mistakes or political miscalculation is

today bigger than it was before. Such new entry factor complicates

behavioral finance-type analysis and game theory when applied to infer the

tree of potential outcomes. Noted. Policy mistakes matter: looking through

past crisis over financial history, they counted as key determinants of the

magnitude, longevity and scale of such crisis: crisis are created by imbalances

building up over time, leading to excessive leverage and bubbles in coveted

assets, before deleverage and collateral implosion kicks-in. But it is policy

mistakes that often defined the difference between an orderly or disorderly

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resolution of the crisis, its duration and its scope (amongst others, with opposite

outcomes: Great Depression, Weimar Republic, DotCom aftermath leading into

Subprime crisis, etc). In the case of Italy, the mess might have been due to

adjustment fatigue on the side of policymakers, once you have been too long into

the crisis and lose the plot. Again, if tomorrow a new government gets formed

around the two main conservative parties (as it should have been the case in the

first place), avoiding going straight into new elections, then the damage will have

been limited in scope, for the time being. In the case of Cyprus, implications are

more far-reaching, as bad precedents have now been set. Slovenia is running

fast into a similar crisis to the one Cyprus was buried under: over-levered

banking system (130% of GDP), NPLs for 20% of the total, quadrupled funding

costs, contracting economy under the weight of debt and fiscal consolidation. If

it reaches cooking stage quickly enough, we can be sure that the Cyprus format

will be copy-pasted, under the eyes of the few who still thought it was not a

blueprint for future crisis. After Cyprus and Slovenia, how likely would it be for

Italy to be treated any differently? What conclusion should then 9-trillions

depositors and savers in Italy (500% of GDP) reach from all that? Is a large-

scale bank run really just a theoretical text-book case study, or can it really get

to, say, Italy?

- Even more worryingly, and raising the scope for policy mis-steps, it looks

like European technocrats have gone blindly complacent of market

resilience as they carry out power plots over Europe. The über-aggressive

behavior they undertake, the arrogance they use in delivering their firm (ever

changing) resolutions, is gathering momentum on the back of two factors: (i) the

market resilience, as the market corrected somewhat but was able to brush off

the most dangerous news of the last month, possibly under the threat of Draghi’s

printing machine (although the market might be just late in adjusting to it), and

(ii) the absence of a clear political resistance from peripheral Europe,

where political parties are in disarray, decimated by inconclusive elections,

unable to close ranks within their domestic place, let alone to form a common

block amongst themselves and with France. The (possibly unintended)

consequence is to increase the divide across Europeans, planting the seeds for

public anger to foster and reaching tipping points.

- We said we deem such policy behavior as irrational, as unnecessarily

heightening potential risk scenarios (bank runs across Europe) without a

commensurate gain in return (less fiscal transfers, at present for Eur 5.8bn

to Cyprus island). However, some more logic would be there on the part of

northern European countries if such actions were aimed at deliberately

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pushing Europe over the cliff. Rephrased, more diplomatically, it is becoming

evident that the goal of Europe’s survival in the short term is second to the goal

of Europe shaping out alongside their grand plan in the long term. This would be

included in the ‘Default Scenario’ under our strategic long-term Outlook, and it is

still a possibility to contemplate and seek hedges for. If anything, Cyprus created

the scare of insured deposits haircut, but also the one of decisive capital

controls. Both of them were taboos the day before. Capital controls could slow

down bank runs and, concurrently, the exposure for Germany, Holland and

Finland under the Target II Euro-system (the biggest single item in their

counterparty risk upon Eur break-up).

- For all intents and purposes, we believe we may be past the peak of political

cohesiveness and coordinated actions, in Europe and beyond. For Europe,

Martin Feldstain said it best in 1997 when he argued that, for how

counterintuitive that might be, the Eur fixed-rate exchange system might have

jeopardized political cohesiveness across the EU as opposed to foster it. Six

years into the financial and economic crisis, two years into the sovereign

crisis in Europe, we may have seen the best of global coordination, whilst

cracks emerge and things complicate from here, on the back of competitive

devaluations worldwide (with G4 Central Banks racing to debase to inflate,

one against another, under the cover of domestic policies) and policy

mistakes regionally (Europe took the lead). Let alone geopolitical risk, as

North Korea takes the microphone, Russia meditates on retaliating on tough

northern Europeans, and the usual suspects on a long list of potential catalysts.

Strategy-wise, Where does all of this leave us? Mixed in the short term, bearish in

the long term (in nominal or real terms).

Surely, realised volatility in politics and markets alike may be set to rise from

here, from the rock-bottom levels where it has been confined so far by political

cohesiveness and financial repression.

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Short Term Strategy: downside risks are so evident that we should prepare for a

reflation trade in optional format, no cash longs

In the short term, anything can happen. Still though, Draghi is in the waiting room

and ‘stands ready to act’, as the market consensus discounts. The bad precedents of

Cyprus, the total mess in Italy and the expansionary policies of other Central Banks all

around, might convince him to step up his game at the first signs of market’s frailty

(which is the only mandate he has got, vis-à-vis the FED which also targets

unemployment directly). On any given day, he might walk down one of a few avenues:

(i) unexpected interest rate cut, to the point where they are eventually taken to

negative territory, off ECB formal meeting dates, (ii) announcement of BoE-style

Funding for Lending programs at national central banks’ level, (iii) LTRO3 or (iv)

OMT, for example on Ireland, which has recently re-gained market access by issuing a

10yr bond.

We do not buy into Draghi’s talking of ‘empty toolbox’ yesterday at the ECB press

conference, interpreted by part of the market as the inability to intervene further and

promptly from here should the situation deteriorate. He may just try to not interfere in

the political debate. To the contrary, ECB’s balance sheet was the only one in the world

to shrink outright in the first quarter of 2013, as LTROs were partially paid back (for

Eur220bn), helping the ECB to keep its gunpowder dry. A new LTRO would be the

faster route, if a fast tool is needed, and possibly also somehow a cost-effective

one as markets would react positively to it well before any actual euro is spent (cheap

talk more effective than actual euros, once again).

Such an intervention might spark a short-term relief rally, especially if coupled with a

grand coalition government in Italy of any duration. In our eyes, we think such

scenario is best played in an optional format, as volatility is tight and the market

upside is priced cheaply vis-à-vis the downside. Longs outright are risky as

market might adjust to Cyprus precedents with a delay (especially if Italy calls

new elections) and gap down in size.

Conversely, for the same reasons, we do not feel comfortable in going outright short, at

present. Should Italy fall and call for fresh elections, together with evidence of a

potential stalemate at the ECB, then and only then we would turn the portfolio around.

Meanwhile, the longer-term hedging programs we run in parallel to the Value book

should help compensate for such correction.

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European Long-Term Outlook & Strategy: the need for hedging against a

Euro Break-Up scenario

Back in September 2011 we started writing: ‘the European construct is structurally

flawed and going to be unwound within the next 3-5 years with a 50% probability’. Back

in early 2012 we wrote: it may either come ‘from the bottom, with peripheral Europe’s

electorate rebelling to austerity (as we are only few months into it and the full wrath of

it is still to be seen), or from the top, with Germany’s electorate (led by Bundesbank’s

orthodoxy) rebelling to an assistential model which sees them as the ultimate sole

paymasters, with no clear deal in return’.

In a nutshell, we argued, the basic disease infecting Europe is a cancerous excess level

of debt. The real problem with that is the lack of economic growth, the elephant in the

room, exasperated by fiscal austerity. The most visible vulnerability where it may reach

tipping point is unemployment (particularly youth unemployment). The stage for

debt, no growth and high unemployment to kick-start a European meltdown may be

Italy or Spain, the two economies in the Euro-zone which are too large to fail, too large

to save, and also too frail to recover.

It now looks like we are slowly adding stepping stones in that direction, one after

another, as that idea is less far-fetched now than it used to be, although is still nowhere

to be seen in market’s prices (if anything, less so now than before).

- From the bottom: electorate from peripheral Europe might rebel to

austerity measures and close ranks to force an exit. In the face of a few

trillions poured into the market, unemployment increased (approx. 60% youth

unemployment in Spain & Greece, 38% in Italy & Portugal), growth failed to be

reignited (outright contraction for France, Italy, Spain), tax receipts decreased

on lower GDP, debt ratios sickened, no banking union whatsoever, no deposit

guarantee to be given for granted (if anything, we almost hit the meteor of

insured deposit haircut in Cyprus), capital controls (under which it is fair to

discount even lower GDP projections, as the currency is fixed). Absent a

currency readjustment, Internal Devaluation to close competitiveness gaps

demands further cuts of Italian/Spanish salaries by 30%-40%. Self-explanatory.

- From the top: electorate in Germany rebelling to fiscal subsidies to

peripheral Europe, with no clear parental controls in exchange. German

taxpayer woke up this year, and do not want to foot the bill any further. Severing

fiscal transfers, whilst imposing capital controls to impede deposit outflows and

a corresponding increase of Germany’s exposure to the rest of Europe via Target

II Euro-system, equates to taking steps to dissolving the union itself.

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Capital controls done, custom duties next? Why having a currency union and a market

commonplace in the first place if there are capital controls and silos within it. How much

more artificial can this Frankestein economy look like, and how many mirrors to break

to avoid looking through it?

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 the overvalued

currency, overleverage and current account deficits.

It could and should end up being an orderly dismantling of the Eur currency peg, as it

might take dissolving the currency union to save the European Union.

Global Long-Term Outlook & Strategy: the need for adapting to and hedging

against Multi Equilibria Markets

Hedging a EUR Break-Up scenario is paramount, and so is incorporating it into our

portfolio strategy when it comes down to allocating risk across countries, industries and

sectors. Beyond Europe (as argued extensively in previous Outlooks Nov 2012 and Jan

2012), we have the strong conviction that we live in Multi-Equilibria Markets, where

the final outcome is hard to anticipate as it may divert markedly from classical mean

reversion: diametrically opposite scenarios are made equally possible, which

deflect vastly from the baseline scenario currently priced in by markets.

We live through the end of a Keynesian state, as the level of over-leverage is

unable to be dealt with by pure growth. Four decades of credit expansion which

followed the end of Bretton Woods are now coming to an end, as debt metrics are

unsustainable and growth is gripped down by such debt overhang. The debt as a %

of productive GDP/real output growth is just too high. Policymakers and handy central

banks are confronted by unconventional hard choices between one of two evils:

- Inflation Scenario (Currency Debasement, Debt Monetisation, Nominal

Defaults). It seems the route followed by Japan, the US, the UK. This is a

Nominal Default, but still a default (as it curtails the value of a fixed income claim

as surely as a default). As we previously argued (March Outlook and CNBC

interview), Japan is the lead illusionist here, printing more than the US in

absolute terms, whilst having a third of its economic output. Of course the

financial assets get bloated up, at present. It is purely a nominal rally, though,

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not a real one. One that can be captured only as long as you can hedge it out of its

fake context. Elusive gains vs reliable returns.

- Default Scenario (Real Defaults, sequential failures of

corporates/banks/sovereigns across Europe). Let deleverage unravels, Europe

flirted with this option, last month.

The good part of the story is that hedge constructs and contingency arrangements

abound, courtesy of Central Banks’ activism, interest rate rigging via ZIRP policies,

and financial repression compressing implied volatility and spreads of all sorts. Also, the

steer levels of cross-assets correlation help in implementing cheap hedges and

proxy hedges: as there are lower boundaries between nearby asset classes, the chance

is there to hedge with one another for minimizing costs.

Paradigm shift in the markets and the need for a unconventional portfolio

management tools

All in all, to us, the paradigm shift in the markets calls for a decisive shift in portfolio

management, along the following key guidelines:

- Portfolio should account for tail scenarios to stay with us for the foreseeable

future, bubble-prone markets on excess liquidity, vulnerable to downside shock

scares. In our world, this is implemented via our proprietary methodology for

Fat Tail Risk Hedging Programs

- Thus, the need for a truly multi-dimensional risk management policy, Hedging

Book, running in parallel to the Value book, whereas this typically belonged to

different silos of the asset management industry (and still is). Hedging means

bothering to spend the cash needed in expensing such overlay.

- Use cross-asset correlation to your advantage , at a time when diversification

(a’ la Markowitz) no longer helps as everything is correlated to everything else,

and on top of things rates can’t fall no more, mathematically, as they did for the

best part of the last 40 years, complicating things for the most widely held

asset class – Credit – and its use within a portfolio.

- Fully invested portfolios are no longer optimal. The Value book can at times

be heavily underinvested so as to adapt to unstable and gapping markets,

whilst replacing cash positions with optional positions and synthetics on low

volatility.

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The Outlook

For more data points on our Strategy positioning, and how it is derived from our

outlook, please refer to the attached Appendix (Portfolio Buckets).

Finally, for those of you who enquired about it, let me clarify that we will send out these

write-ups on a monthly basis only (which has been the case ever since Feb 2013, as

opposed to weekly or biweekly as previously was the case). For any intra-month update

on the views/positionings please feel free to get in touch.

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What I liked this month

French Stocks To Drop 33% On Macro Recoupling Chart

When Interest Rates Rise. Martin Feldstein, Harvard University Read

Markets Fear 'Loose Cannon' Yellen at Fed: "a client said to me a few weeks ago that

if Karl Marx was in charge of the world, he'd have Yellen as his CB governor’ Read

Understanding North Korea Read

China: Rising Risks of Financial Crisis. Nomura. What matters is not so much

Domestic Credit to GDP ratios, where China lags behind Japan, US (at 150% vs 250%),

but rather the speed of acceleration of credit expansion. Using Total Social Financing

(overall credit supply to the economy), leverage built up by 60% of GDP in the last 5

years (to 207% of GDP). Read

Yen Selling May Become an 'Avalanche': Soros Video

W-End Readings

The private wealth discrepancy at the heart of Europe. Consider Italy, which has the

highest ratio of private wealth to public debt of any G7 country, and is 40% higher

than in Germany. Italy and France share a ratio of 500%. By contrast, the ratio in

Germany is only 350%. This discrepancy is at the heart of the question: should

taxpayers in debtor countries expect "solidarity" – money – from taxpayers in creditor

countries? Why should they take responsibility, when high ratios may result from low

tax revenues over time, while lower ratios may reflect higher tax revenues? Read

If EMU does come into existence, as now seems increasingly likely, it will change

the political character of Europe in ways that could lead to conflicts in Europe ….

Indeed, there is no doubt that the real rationale for EMU is political and not economic.

Indeed, the adverse economic effects of a single currency on unemployment and

inflation would outweigh any gains from facilitating trade and capital flows among the

EMU members. Martin Feldstein, Professor of Economics at Harvard University Read

‘PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter Lynch’s epoch, all occurred or have

occurred within an epoch of credit expansion – a period where those that reached for

carry, that sold volatility, that tilted towards yield and more credit risk.. What if an

epoch changes?’ Read

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Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001 E-Mail: francesco.filia@fasanara.com 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 in certain jurisdictions, therefore, persons into whose possession this document comes should inform themselves about and observe any such restrictions.