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2. Febraury 1st 2013Fasanara Capital | Investment Outlook 1. We remain positive on markets in the short term, as we think equitieshave 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 isnot right yet for the sizeable correction we anticipate. 2. Central Banks liquidity remains to date the chief driver of marketsperformance, thus we value the rally as built on shaky foundations andoverly sensitive to external shocks. Indeed, the markets that performedthe 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, toisolate elusive gains from reliable returns. 4. Perhaps, the name of the game in 2013 is to make sure to invest into areal rally as opposed to a fake one, or to invest deliberately into a fakerally, 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 arepast us outright. But less attention is given to the fact that we might aswell live through one of such scenarios, as we speak. We believe anInflation Scenario, played through Currency Debasement to achieve DebtMonetization might be off to his early stages. 6. On the Hedging portion of our portfolio, in Q1 2013 we intend toincrement hedging on three strategic scenarios in particular (out of ourFat Tail Risk Hedging Programs) as they still are at rock-bottomvaluations: Inflation, Credit Crunch & Euro Break-Up.2|Page 3. Since our last Outlook in mid-January, equity markets failed to move decisively into newhighs, and they are broadly unchanged over the period. In Europe, the party was spoiledby Italy (and Spain), where the market started to take issue with a weaker thananticipated government to be elected on February 24th-25th, together with spot shockson equities like MPS bank and Saipem. The US performed better, in nominal terms,before adjusting for currency movements, as corporates sailed pretty well through theearnings season and the debt ceiling hurdle was postponed.Overall, the tactical portion of our portfolio showed a mild improvement over theperiod, as Europe underperformance vs the US/UK was mitigated by our lightening upof the Italian component of it, as anticipated, and then more than offset by thedevaluation of the US Dollar vs the EUR, as also anticipated. Going forward, wemaintain our modest longs on equity markets, both in absolute value and inrelative value Europe vs UK/US. Simultaneously we increased hedgingtransactions, as we believe the rally has further to go but lies on thin ice and is to beterminated prematurely. The weakness of the last couple of weeks should serve as areminder of markets fragility, although we think the time is not right as yet forthe sizeable correction we anticipate. A combination of more retail investorsfollowing the lead of a strong corporate sector and no imminent catalyst to a set backmay signal that an overshooting market is in the cards.Cross-markets, we tend to believe that the US has the most potential to disappointin the very short term against buoyant markets expectations, whilst muddle-through Europe promised much less to over-optimistic equity bugs. The US will alsosoon have to come to terms with a postponed debt ceiling discussion (hanging on theneck of its monetary expansionisms) and automatic spending cuts / US governmentsequesters coming its way (hanging on the neck of its fiscal expansionism, which isdefinitively through peak). Thus, we remain positioned for some outperformance ofEurope (ex Italy) against the US/UK, especially as we factor in further weakness ofthe US Dollar. Such positioning is purely tactical and relates to the RV bucket of ourportfolio: 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 andnominal, as is primarily due to extraordinarily expansive monetary policies and thecurrency debasement that comes with it, we still do not want to easily dismiss asuccessful earnings season: especially in the US, shares moved higher on expandedshare 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 Corporatesector gave some legitimacy to a rally otherwise totally out-of-sync with the economicenvironment. In addition to that, a few mildly positive data emerged, like durable goodsfrom the US (before the government defense spending hit few days ago, bringing GDP to 3|Page 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 fromsuch data set a truly improved economic environment. The data pointing in the oppositedirection are still overwhelming, starting with industrial production, unemploymentand consumer spending.In fact, we believe that Central Banks liquidity remains to date the chief driver ofmarkets performance, and therefore that is where we concentrate our attention andanalysis. Consequently, we value the rally in risky assets as built on shakyfoundations and overly sensitive to external shocks. Indeed, the markets thatperformed the best in nominal terms (i.e. not adjusting for inflation and currency) arethe US and Japan. Unsurprisingly, their Central Banks are currently the most active, withthe FED anticipated at flooding the market with $85bn per month (approx. $1 trillion in2013), while the Bank of Japan inundates markets with a similar amount of papermoney (as they plan a Yen120trn expansion grand plan, 25% of Japan GDP, equivalentto 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 moremoderately than before, whilst that of the ECB is outright contracting (by possiblyEur300bn in H1). The Bank of Japan has even anticipated that they will buy expensiveEuropean 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 alsoaccompanied by devaluations of their currencies for concurrent amounts, making therally purely nominal, and not a real one, to a wide variety of non-local investors. Onemore textbook case study of a Government using its handyman Central Bank toachieve 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 yearsahead, according to our personal roadmap in Multi-Equilibria Markets (more on itbelow). It is what we refer to as Inflation Scenario, one which we define ascharacterized by Nominal Defaults, Debt Monetisation via Currency Debasement andprolonged negative real rates (i.e. Inflation, hopefully mild, hopefully not getting out ofcontrol). We suspect that, sailing throughout 2013, we may often have todifferentiate between real rallies and nominal rallies, when looking at pricedynamics and distinguishing (real) losers from (nominal) winners, elusive gainsfrom 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 hasbeen little real rally there for most investors, after adjusting for the loss on the exchange 4|Page 5. rate (or the cumulative costs of hedging it). We may easily agree to that. Market pricesseem to agree more to it now. Way less they agreed to it last month, when thecorrelation 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 opposedto a fake one, or to invest deliberately into a fake rally, after careful assessment ofthe costs of hedging it out of its fake context. We believe that paying attention tothe visible and not so visible facets of Currency Debasement cross-markets holdsthe key to safely navigating the macro picture in 2013.Actually, there is much talk about the fact that Tail Risks have receded or are pastus outright. But less attention is given to the fact that we might as well livethrough one of such scenarios, as we speak. We believe an Inflation Scenario, playedthrough Debt Monetisation via heavy Currency Debasement might be off to his earlystages. Its seeds were planted during few years of ballooning Central Banks balancesheets (from 2trn to 6trn in 5 years for G4 Central Banks). Such Inflation Scenariocarries with it Nominal Defaults as opposed to Real Defaults, to a wide range ofinvestors classes. To a fixed income investor, for instance, inflation is in many ways nodifferent than a default, as it curtails the value of your claim as surely as a default. To anequity player, it is capital destructive whenever your stocks are incapable of recoupinginflation quickly enough so as to preserve purchasing power vis--vis currencies inmore limited supply. Again, illusory gains vs reliable returns.Critically, as we argued repeatedly in past write-ups, the ability of the Central Banksto prevent inflation from getting out-of control is highly overestimated bymarkets, and especially so by the long end of the fixed income markets. Let thedebt overhang grow some more and there will not even exist any longer a Private Sectorbig enough to take on the slack of freshly printed government securities, if need be tosedate inflation. Any exit strategy would be hazardous, to say the least. In starkcontrast to this, markets seem to hold the opposite view, as they price in the possibilityof moderating inflation as easy as a walk in the park. How could you otherwise explainan holder of a 10-year Treasury being happy to be paid 1.60% (now 2.00%) nominalreturn per annum (and negative real rates) to take on that risk. And we wouldnt besurprised to see such yields back lower next month. While agency/non-agencymortgages are not that far behind.In analyzing the magnitude of potential currency debasements, it may helpthinking that once that trend is confirmed as unfolding, it can catch up speedeasily, and transform itself into a falling knife. There are $11 trillions of FXreserves owned by Central Bank reserve managers (from just $2 trillions some 10 yearsago). 60% of it is allocated to the USD (paying an useless average yield of 30bps, from5|Page 6. 4% some 5 years ago). Such is the basic theme behind our long term USD DevaluationRisk Scenario (more on it below in Multi-Equilibria Markets section below).As we argued several times, a disciplined multi-dimensional Risk Managementpolicy is therefore paramount if one is to safely navigate through visible and notso visible Fat Tail scenarios. A strong macro overlay strategy can attempt at protectingthe real value of ones portfolio, especially at a time where Contingency Arrangements(against an Inflation Scenario or its alternative Scenarios) are not only available butcheap, 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 whichimpaired the ability to mitigate risk through asset diversification, and makes itharder to stay clear of bubble risks. At the same time, if ones bothers to go the extramile, it may also help in building a multi-dimensional risk management strategy whichattempts at turning correlation to your advantage. We believe that confining a strategyinto the classical silos of equity/value/macro, exposes the portfolio to systemic risksand may equate to fail to capture the transformational markets we operate into, for highcross asset correlation is here to stay.A few quick observations on Italy to refresh our views on recent developments. TheItalian market showed the most volatility recently, as uncertainties mounted over thenew government to be formed upon elections on February the 24th-25th, and its ability todeliver 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 withthem. MPS may seem like a politically orchestrated case, naively confirming that politicsprevail over economic considerations and national interest, especially the closer you getto an election date (if anything, we wonder what the market would do in realization thatsome of MPS regulatory accounting practices are widespread across the financialindustry). On the other hand, Saipem and ENI are no random stocks, but perhaps two ofa handle of stars of the Italian stock market. All in all, more volatility in the near term, onthis basis, should not take by surprise. Strategy-wise, having lightened up our Europeanlongs from the Italian component, we now plan to try to take advantage of volatilityarising in the run up to the elections to reload selectively. 6|Page 7. Multi-Equilibria MarketsLonger-term, as our readers and investors know all too well, we remain skeptical on theeffectiveness of crisis resolution policies being implemented, wary of the sheermagnitude of the level of over-leverage built in the system and its drag on the realeconomy, conscious of the wild volatility which could be triggered by one too manyexternal or internal shocks in such crystal-fragile environment. As such, we design ourportfolio to sustain most of the states of the world we can see, and be protectedagainst new equilibria which deflect vastly from the baseline scenario currentlypriced in by markets, and which are diametrically opposite from one another. Thebaseline scenario remains one of a multi-year slow-deleverage Japan-style. But thesystem has never been as vulnerable as it currently is to shocks which may flip theequilibrium to a different set of variables than the status quo / mean reversionwould suggest.To be sure, as Central Bankers keep flooding the system with liquidity, our base casescenario 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 wouldnot be triggered at least in the short term, until such delicate equilibrium willeventually break. In the coming years, we believe that 6 scenarios might play out (someof which are mutually exclusive or may happen in succession): Inflation Scenario(Currency Debasement, Debt Monetisation, Nominal Defaults), Default Scenario (RealDefaults, sequential failures of corporates/banks/sovereigns across Europe), RenewedCredit Crunch (similar to end-2008, end-2011 or mid-2012), EU Break-Up (eithercoming from Germany rebelling to subsidies or peripheral Europe rebelling toausterity), China Hard Landing, USD Devaluation.We also believe that current market prices and compressed Risk Premia make itworthwhile / relatively inexpensive to position for fat tail events, as they are currentlyheavily mispriced by markets.7|Page 8. The OutlookOur thinking is simple. The market is underestimating the potential impact of thereal 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 inperipheral 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 andwelfare safety nets put in place by such democracies will suffice in keeping socialdiscontent at bay, and the army of unemployed in voting for yet another pro-Europeanpro-austerity government as soon as they are given another opportunity to do so overtime. As the readjustment needed to rebalance competitiveness across Europe is stillwide open (to closing the gap to German wages it would require Italian andSpanish labor costs to fall by an additional 30% to 40%), we tend to challengemarkets complacency about it. Falling real wages, perhaps falling nominal wages, inItaly and Spain by up to 40% is the baseline scenario now, one of slow deleverage multi- 8|Page 9. year Japan-style. If anything, Japan did have a choice ten years ago, to devalue thecurrency in nominal terms, which they did not go for (they are taking a different view onit only now), whereas Europe does not even have that option, as fixed-exchangecurrency system impedes it, and allows only Internal Devaluation to happen. Until thecurrency system itself implodes, as we expect down the line.And more so now, as we enter a market environment of currency debasements onecountry against another, where no mystery is held up any longer on ones intention todevalue and open wide the FX gates to its economy. More and more, evidence is in ourface of US and Japan intentions. South Korea, China, Latam, and the UK itself, mightfollow, although the tempo of their reaction functions might vary greatly. Europe itselfwill then face the choice of either catching up on the trend or split up, to allow individualcountries to opt for that route if they wish. Timing matters: the sequence of competitivedevaluations across countries might take years to materialize and be fully visible, and itmay be a stretch then to expect southern Europe to sustain multi-years of muchstronger EUR against pretty much anything else, and thus a more dramatic drop inwages and increase in unemployment needed to make up for it. Look at Japan, where aprogressively stronger nominal Yen in the last ten years was associated with an evenlarger Internal Devaluation and Price Deflation, so big that the Yen actually depreciatedin 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 heavyQE is here to stay for long enough, we have one more reason to consider the riskscenario of a EUR break-up a genuine one. Yet another one of the scenarios we seekto be hedged (and over-hedged) against. We might as well have those hedgesimplemented 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 nominalrally in the market. On the other end, if such events were to take place, we would beamongst a few ones who bothered to spend that money on a hedge, before such hedgebecame overly expensive or not available at all.Bottom-line, over the next few years, if money printing failed to restart theeconomy, we face the real chance of a multiple choice between a Default Scenario(Real Defaults, Haircuts & Restructuring; potential Euro break-up, as either peripheralEurope derails from the bottom, or Germany reconsiders it from the top) and anInflation Scenario (Nominal Default, Currency Debasement whilst engineering DebtMonetization, as money printing continued unabated, until money multipliers/velocityof money made a U-turn to fully drive it out of control). More on it in the attached. 9|Page 10. Opportunity Set for 2013As the strategy was unchanged over the last few months, let us quote freely from ourDecember Outlook (while updating some of the short dated investment positioning inhere described): In the following few lines we offer our observations on the mainthemes underlying our portfolio construction, across its three main building blocks. Ourcurrent Investment Outlook in implement into an actionable Investment Strategy alongthe following three parts:The StrategyValue InvestingOver the course of 2012, our Value Investing portion of the portfolio was staticand entirely filled by Senior Secured bonds issued by strong companies fromnorthern 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 withexposure 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 thisyear warranted to stay clear of peripheral Europe assets, clear of junior/mezzaninepaper, 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, weconcluded that such opportunity was not appealing when adjusted for the large risks itentailed. Risks did not materialize in the end, but in retrospect it is always easier toread markets.10 | P a g e 11. Now then, we are at a crossroad as High Yield valuations have reached bubblelevels. One thing is to say our senior bonds were good investments and deserved torally, another thing is to say they deserve to trade at 4% to 6% yields to worst. We donot believe such sustained valuations are justified, especially as we do not discount thetail risks out there at zero, and we believe it is only a matter of timing before thevaluations realigns to fundamentals somehow. True, liquidity is large in the system andmoney printing (especially in the US) might target corporate paper directly and drivevaluations even further and yield even lower: however, the more time goes by the morethat equated to an Inflation Scenario (Debt Monetisation achieved via CurrencyDebasement). An Inflation Scenario, where negative real rates and QE-type interventionhelps inflate ones way out of nominal debt, is effectively just another form of DefaultScenario. Whether the debt is not paid back in full or whether its real value is eroded byinflation does not make a huge difference to most investors. Inflation destroys thevalue of fixed income claims as surely as default.On the other end, should the money printing slow down or stop outright, should theoxygen mask be removed from the debilitated patient, and the reversal of the trendwould be abnormally asymmetric, leading to important capital losses across the capitalstructure. Playing for even lower yields on stretched corporate balance sheets (and evenmore on government bonds) equates to pick up dimes in front of a steamroller. Webelieve that the risk of rising interest rates is highly underestimated by themarket right now.The bubble in the credit markets is unmistakable, starting with government bonds toslide down the credit curve into High Yield markets. Valuations are so high that anyroom for further appreciation is close to exhaustion. 2013 might be the first yearearmarked with a negative return (of some dimension) for government bondsever since 1994. To continue slowly or quickly, in the following year, until it changesgear. Cracks are well visible in the High Yield and Loan markets too, as issuancevolumes reached approx. $600bn, which is 2007 record levels (another creditbubble market back then, which was going to pop a year later). More importantly, theshare of covenant-lite issuance has reached a staggering 30% of the total (in 2005it was 5%): which means less maintainance covenants in exchange for pure incurrencecovenants, which means lower protection for investors. Market players now argue thatthis is a positive development as a potential catalyst to a credit event / downperformance is outright removed, forgetting it also damages recovery values. It soundslike typical complacent bubble market commentary, ready to justify overvaluations inretrospect as the new normal and make the case for further future appreciation. To us, itmay be wishful thinking, and it is only a matter of time for the market to catch upwith reality.11 | P a g e 12. For all these reasons, in 2013 we intend to keep migrating slowly and safely fromHigh Yield territory into Equity, hedged, with similar characteristics to seniordebt. As Equity most obviously presents different characteristics of expected volatility,we apply three layers of risk management: 1) security-specific hedges (typically throughlong/shorts, but also via capital structure arbitrage), 2) macro overlay strategies and 3)Fat Tail Risk hedging programs.Fat Tail Risk Hedging ProgramsThe leit-motiv of our Investment Strategy remains to take advantage of currentmarket manipulation and compressed Risk Premia to amass large quantities of(therefore cheap) hedges and Contingency Arrangements against the risk ofhitting Fat Tail events in the years to come. If we do not hit them, then great, it will bethe easiest catalyst to us hitting the target IRR on the value investment portion of ourportfolio (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 forheavily asymmetric profiles (we typically targets long only/long expiry positions with10X to 100X multipliers). Such multipliers are courtesy of market manipulation andinterest rate rigging by Central Banks. We believe they represent the only trulyDistressed Opportunity in Europe. Timing-wise, the next months may offer aninteresting window of opportunity.Currently, thanks to Central Banks liquidity and asset value manipulation, threestrategic scenarios (out of the six strategic scenarios we have in mind) can first behedged at rock-bottom valuations. Such scenario include: Inflation, Renewed CreditCrunch & Euro Break-Up. Hedging against such scenarios is currently very cheapand as a result Fasanara aims to increment hedging on such opportunities first inQ1 2013.12 | P a g e 13. Tactical Short-Term Plays / Yield EnhancementWe will not expand on this section too much, as it is less relevant in our portfolioconstruction, which tends to be quite static and buy and hold. Short term tacticalpositioning / yield extraction strategies are currently executed via our existingpositioning (which we confirmed today for the fourth consecutive month) for theEuropean 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 eversince September. Such positioning is typically tactical and short term, for weremain prepared to adjust as information comes in.What I liked this monthSpains crisis strategy under fire as economy buckles again: Evans-Pritchard ReadWhy Expansionist Central States Inevitably Implode, via ZH ReadLBO leverage creeping up, credit not reaching smaller firms ReadW-End ReadingsHow to live in a capital superabundance environment. The rate of growth of worldoutput of goods and services has seen an extended slowdown over recent decades, whilethe volume of global financial assets has expanded at a rapid pace. By 2010, globalcapital had swollen to some $600 trillion, tripling over the past two decades,against $63 trillion of global GDP. ReadThe Great Eight: Trillion-Dollar Growth Trends to 2020 ReadWhy Chinas Credit System Looks Vulnerable Read China Hits Key DemographicCeiling As Working-Age Population Now Declining Read 13 | P a g e 14. Francesco FiliaCEO & CIO of Fasanara Capital ltdMobile: +44 7715420001E-Mail: francesco.filia@fasanara.com16 Berkeley Street, London, W1J 8DZ, LondonAuthorised and Regulated by the Financial Services AuthorityThis document has been issued by Fasanara Capital Limited, which is authorised and regulated by theFinancial Services Authority. The information in this document does not constitute, or form part of, any offer tosell or issue, or any offer to purchase or subscribe for shares, nor shall this document or any part of it or thefact of its distribution form the basis of or be relied on in connection with any contract. Interests in anyinvestment funds managed by New Co will be offered and sold only pursuant to the prospectus [offeringmemorandum] relating to such funds. An investment in any Fasanara Capital Limited investment fund carriesa high degree of risk and is not suitable for retail investors.] Fasanara Capital Limited has not taken any stepsto ensure that the securities referred to in this document are suitable for any particular investor and noassurance 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 oranalysis on which it is based, before the material is published. Fasanara Capital Limited [and its] personnelmay have, or have had, investments in these securities. The law may restrict distribution of this document incertain jurisdictions, therefore, persons into whose possession this document comes should inform themselvesabout and observe any such restrictions. 14 | P a g e