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Fasanara Capital


1st September 2014

Abstr act:

We believe that a late face-saving de-escalation is still likely, as it is in the best economic interest of both parties, most importantly Russia’s: Europe faces recession risk, while Russia faces default risk, a replay of 1998.

We believe deflation is structural in Europe and likely to affect market dynamics for long. Europe is entangled in secular stagnation, resembles Japan in the early 90’s. Here then, the role that the ECB will choose to play holds the key to market action in the foreseeable future.
  1. Enhancing already generous terms for T-LTROs to maximize take-up, while stepping up rhetoric over QE
  2. Finalizing a benign AQR / stress test, and putting it behind us
  3. Delivering ECB’s own version of QE


ECB at the Center Stage

Over the course of the summer period thus far, European shares and European yields tumbled on the double push of (i) geopolitical tensions out of Ukraine and (ii) new evidence of deflation and weakness in aggregate demand emerging distinctively.

  • How tensions with Russia can evolve from here is impossible to call. However, we tend to believe that a slow face-saving de-escalation is still likely, as it is in the best economic interest of both parties, most importantly Russia’s. Politics should trump economics for only that long, until the ugly face of economic implications shows up.
  • On the other hand, we believe deflation is structural in Europe and likely to affect market dynamics for months to come. Europe is entangled in secular stagnation, which has just started to show up in deflation terms, helped by a flawed fixed currency regime. Here then, the role that the ECB will choose to play holds the key to market action in the foreseeable future.

Russia/West Tensions: Late De-Escalation Our Baseline Scenario

Contrary to our expectations, the stand-off between Russia and the West over Ukraine failed to de-escalate, as political and personal considerations prevailed over economic interests. To us, Russia has the most to lose in the confrontation, as the risk of outright default looms ahead. It was not long ago in 1998 when Russia experienced its last default, only few years before Putin rose to power.

Dangerously, the Russian economy looks similar enough to the economy of 1998, having failed to progress much on other sectors of the economy beyond energy and power / metal and mining. A disappointing outcome, considering Russia had one of the fastest rising middle classes globally. Its dependence on the gyrations of oil pricing remains the same as back then. Critically, oil is in secular decline, as global demand lags, energy efficiency progresses, alternative sources of energy are made available (from shale to renewables). A steady influx of technological advances can only maintain such trend, while any breakthrough discovery is set to accelerate oil implosion, at some point down the road. Quite tellingly, not even geopolitical tensions spanning all the way from Ukraine to the Middle East to most of North Africa managed to spur a sustained recovery in oil prices.

True, there was an unsustainable fixed currency regime back in 1998 (followed by a 70%+ devaluation of the Ruble in one month), an economy still transforming itself from Soviet-era format. But differences between now and then do not go enough beyond that. Inflation is not much lower today than it was in 1998 before the crisis: single-digit trending lower in 1998, single-digit trending higher in 2014. International reserves are higher today than they were in 1998 ( table ), but External Debt is also much higher today than it was back then (4 times over).

Russia debt/GDP is less than 10% if you take into account pure public debt, a misleading metric. Relevantly, Russia’s total indebtedness denominated in foreign currency stands at 715bn$, mostly from the private sector ( CBR’s numbers ). Compares with 30bn$ non-public foreign debt in 1998, 464bn$ in 2008. It is 36% of GDP, and the highest in absolute value of any emerging markets except China. Such debt needs rolling, for in excess of 10bn$ every month. That is staggering when compared to 375bn$ of public FX reserves (which could be just 324$ if one were to deduct the Yukos settlement), at a time when Russia is under embargo-like conditions with most other advanced nations in the world.

Back in 1998, Russia experienced a sharp contraction in GDP at -5.3% and high unemployment rates, followed by three years of strong pent-up recovery (+6.4%, +10%, +5.3%). Back then, Russia recovered strongly on the back of (i) strong commodity cycle, (ii) IMF/World Bank rescue loans (iii) access to international capital markets. Compared to today’s (i) large-scale economic isolation, (ii) weak commodity cycle and (iii) war expenses.

On the other hand, it is estimated that Europe risks approx. 0.5% of GDP knocked off 2015 numbers were the tensions with Russia to escalate from here, resulting in further sanctions. Not a rosy scenario, given a Europe-wide near-zero growth. It means recession. Still, not a default scenario.

Dependence over gas supply is at ca. 30% for Europe overall (close to 100% for select Eastern European countries). Not a great situation for Europe to be in, surely. Still, that incidentally luckily coincides with Europe being Russia’s largest client. Surely a better client than the best alternative available, China, when it comes to price negotiations. At some point, Russia may decide that dealing with the soft Europe’s energy commissioner is more convenient than having to deal with China’s energy minister, after all, especially once the latter knows he is the sole off-taker left out there.

The lackluster performance this May of Gazprom after signing a 400bn$ behemoth 30yr gas deal with China may serve as a stark reminder: it is price too, not just quantity.

Number crunching make us believe that a resolution to the Ukraine crisis should be manageable, as it is in the best interest of parties, and most relevantly in the best interest of Russia, making such de-escalation possible and probable. We factor that in our assumptions over the remainder of 2014.

Critically though, de-escalation might take weeks/months, not days. Seasonally, Russia may feel its bargaining power is enhanced by the incoming winter period and trading of gas supplies into Europe, possibly making de-escalation slow to materialize and more noise possible in the near term. Ukraine’s President Poroshenko called for early parliamentary elections at the end of October, and is unlikely to blink just before that (an interesting analysis on that can be found here ). Again, more noise in the short-term cannot surprise.

Deflation in Europe is Just Beginning

Differently than Russia/West crisis, the problem of deflation in Europe is far more structural of an issue, likely to hold the stage for the foreseeable future.

As often stated, we believe Europe looks like Japan in the early 90’s. Similarly to Japan, Europe has few unmistakable connotations at interplay:

  • High level of indebtedness, drawing resources away from productive investments into sterile debt service.
  • Overvalued currency, especially to peripheral European countries (30% overvalued against D-Mark, 40%+ overvalued against the rest of the world). Peripheral Europe is experiencing a currency crisis as if they borrowed in foreign hard currency.
  • Secular trend of falling working population mixed with falling productivity rates.

The data released in the past few weeks provided evidence of European growth having grounded to a halt for most countries, including Germany. Italy dipped in triple-dip technical recession, while France slowed down concerningly and even Germany contracted in Q2. All the while, inflation averaged 0.3% for the Euro Area as a whole, well below the ECB target and on a clear downtrend.

In Japan in the early 90’s, it took four years for disinflation to become deflation, under the push of a strong Yen and with the help of an inactive Central Bank dismissing such risk until late.

Likewise in Europe, the EUR is far too strong when measured against GDP growth prospects and productivity trends. A misleading current account surplus of 200bn only managed to make it stronger (overshadowing imbalances across countries in Europe), together with a shrinking balance sheet of the ECB for almost Eur 1 trn on deleverage flows and LTROs repayments.

In crafting crisis resolution management, European policymakers blamed the lack of reforms for the low levels of productivity, whereas Europe was suffering from a structural lack of demand. A much more dominant problem. Given that, the ECB balance sheet was allowed to shrink for almost two years now, the EUR was allowed to strengthen against most currencies around the world (which were actively engaging in the opposite effort, one of bold currency debasement, ranging from the US, to the UK, to Japan.. including even Switzerland and Norway), and austerity was imposed to shrink fiscal deficits. The candidly stated goal was to drive Internal Devaluation across peripheral European countries, so as to close the competitiveness gap to northern Europe: output contractions, wage declines, fall in prices. Almost the opposite of what should have happened if the problem was diagnosed as one of deficient demand. Tightening fiscal and monetary policies took place in Europe for two consecutive years, all the while as most other large economies were engaging in the polar opposite.​

​​Nomen omen. Internal Devaluation in Southern Europe is itself an intentional form of deflation. It should have been confined there where it mattered to level off imbalances across nations in Europe. Instead, the laboratory experiment failed as it metastasized around.

Globally, other structural forces were inductive of deflation, from robotics and technological advances shedding jobs and depressing input prices (the Amazon effect), to low energy prices (on shale gas revolutionary discoveries and the end of the Commodity super-cycle), to weaker than potential growth, slack in the labor market, weaker dollar on ZIRP policies, Yen devaluation exporting deflation, China slowing down, etc.

The result is that Germany’s GDP itself is in tatters, even before considering the damage to be from trade wars with Russia. Deflation took hold and derailed the improvement in the soft data and surveys projected earlier on.

The problem with deflation is that minuscule levels of GDP growth are unable to drive unemployment lower and unable to prevent debt ratios from grinding higher and posing a larger threat down the line. Mathematically, as primary budget balances are lower than the difference between real GDP growth and real interest rates on public debt, the debt/GDP ratio is set to rise, from already alarming levels.

Italy, is the main vulnerability here, as a debt/GDP ratio might reach 140% by the end of this year, thanks to disinflation and GDP contraction, and despite austerity and a 2% primary surplus on GDP. By the same token, thanks to zero inflation rates, real rates are too high in Italy, standing at over 200bps above France and 250bps above Germany.

Zero inflation is like death penalty to debt-laden countries. It has been estimated that Italy would need a primary surplus of ~8% if it wanted to stabilize its debt/GDP at zero inflation, which means just stopping it from moving even higher. Spain would need a primary surplus of 2%+, instead of current negative 1.44%. Which means more austerity and more contractionary policies, to cause more internal devaluation than it is currently the case, more declines in unit labor costs, more salary cuts, more unemployment, less consumer spending, less corporate investments. In Italy, for example, average salary would have to be cut by an additional 30%/40% before closing the competitive gap to Germany. This does not account for the fact that inflation in Germany is itself on the verge of becoming negative, making the necessary adjustment even more painful than that.

The good side of the story is that we believe that the ECB and fiscal authority will be forced into further action from here, in an attempt to avoid a fully-fledged debt crisis and a long period of Japan-style depression.

Germany is the key determinant of European policymaking, all too obviously, and we believe they might be about to give in to request for expansionary policies, both fiscal and monetary.

Few reasons for it:
  • The German economy itself is contracting, hardly a satisfactory result after many years of implementation of their policy recipe.
  • German inflation itself is borderline negative. Europe-wide inflation expectations have dis-anchored from 2% desired line, falling off 20bps in August alone (both 10y and 5y5y forward inflation swap curve). Any concern about price stability and Weimar-style inflation risk should have been put to rest by now.
  • German concerns with moral hazard on the side of weaker European member states should have abated by now, as most political parties have embraced structural reforms as essential, and married their political agendas to it. Government in France, Greece and Spain have already spent their political capital embracing the German agenda, being now certain to lose in future elections, while the Italian government is close to do the same, having credibly committed itself to reforms. Germany faces the best mainstream political parties in Europe they can aspire to; any future coalition is most certain to be less receptive of German’s diktat than these ones. The calendar of national elections across Europe next year and beyond should serve as a countdown. Thus, we believe Germany should be prepared now for a relaxation of austerity policies and spreading the adjustment process of fiscal consolidation over a longer time horizon, while opening up to real monetary stimulus.
  • Confrontation with Russia, while it may ease over time, surely highlights the urgent need for a common defense policy / energy policy across Europe, helping the case for integration in Europe in the short-term, softening German resistance to more expansionary policies.

In summary, we believe the ECB will be allowed to engage in non-conventional monetary policies, their version of QE, pushing equity and bonds higher in Europe, compressing spreads and yields further, within the next 6/12 months.

Whether it is going to be enough to avert a currency/debt crisis in Europe in the long run is a different matter. We think that there is a genuine case to be made for seeing dissolution of the currency union down the line, in an attempt to save the European Union. Early days to visualize that, though. What matters to the financial markets is the next twelve months - the foreseeable future - and we believe the next twelve months to be highly supporting of financial assets in Europe, both bonds and equity.

Incidentally, we have for European assets and the ECB the same feeling we have for Japan and the BoJ. Abenomics has a high chance of failure, in the long term. Nevertheless, on the road to perdition, chances are that efforts will be stepped up and more bullets shot in an attempt to avert the end game. As stakes are raised, financial assets will be supported and melt-up in bubble territory, doing so at the expenses of a more turbulent end-game in the years ahead.

Deflation to worsen from here, ECB behind the curve but active, to be forced into stepping up its game

We believe that the ECB has already been preparing ground for its game plan.
Draghi has likely front-ran its committee when he released a more dovish Jackson Hole speech than expected by most, opening up to his dissatisfaction for inflation expectations to have started a dangerous descent. From here, we expect the ECB to eye a three-step process:
  • Enhancing already generous terms for T-LTROs to maximize take-up, while stepping up rhetoric over QE-type policies
  • Finalising a benign AQR / stress test, and putting it behind us
  • Delivering on ECB’s own version of QE

1) Enhancing TLTROs, while visualizing ECB’s own version of QE
The easiest step to implement would be a further enhancement of T-LTROs conditions, which could be delivered as early as this week and before the first take-up of it in September (the second one will be in December). Increasing the generosity of terms attached to TLTROs might increase their take-up, a key measure of success for the T-LTROs’ programs.

It should be clarified that T-LTROs are not necessarily leading to an expansion of the ECB’s balance sheet, which is so important if one want to see the EUR devaluing and inflation ticking some higher. Indeed, new T-LTROs allocations coincide with earlier LTROs repayments. The balance sheet of the ECB will expand as a consequence of T-LTROs only if take-up is large enough ad in excess of LTROs residual redemptions. Thus, the need to relax further the terms of the LTROs, while ramping up the rhetoric about fully-fledged QE.

TLROs terms and conditions could be relaxed in various ways: for instance, (i) costs-wise, by eliminating the 10bps spread over the refi rate and (ii) quantity-wise, by increasing the initial allowance above 7% of banks’ real economy loan books. As argued in past Outlooks, Draghi was a master of war when war was fought via ‘cheap talks’ only (‘whatever it takes’ language proved more effective than first LTROs hard cash): he can legitimately be expected to be more effective now that he provided himself with plenty of levers to play with.

Rhetoric over QE has started already with the shift in commentary at Jackson Hole. Preconditions to QE have been met, as expectations have come down: 10y, 5y and 5y5y forward inflation break-evens have all come down, and decisively so in August alone. 10y inflation swaps have fallen to below 1.50%, 100bps below US. 5yr inflation forwards are below 1%. 5y5y forwards are now below 2%. Spot inflation is 0.3% in Europe (from 2.5% in mid-2012). All of this happening in a global disinflationary environment, where 70% of the 32 OECD countries have domestic inflation rates below 1%. Zero inflation. The pretext of price stability is available here like never before for Draghi to grab and front-run its Committee.

On the other hand, conditions to avoid QE are hard to see anytime soon. It would take a sizeable uptick in activity data (Industrial Production in primis), a rebound in soft data / surveys, a spike in inflation expectations, a spike in the oil price, a speedy devaluation of the EUR (which is only too slowly materializing). Waiting for such conditions to come into play is costly. It could amount to gambling, on the side of Draghi and policymakers in northern Europe.

2) Finalising AQR / Stress Tests with a benign outcome

Here, our working assumptions are as follows:

  • AQR to be a catalyst event for European markets at large. Results released at end of October. Come the end of October, and the European banking system will be judged clean by market participants. No more uncertainty holding off investors from pouring capital in equities trading at a fraction of their tangible book value.
  • AQR to be pretty much of a non-event, in so far as it will lead to no need for massive capital actions on the side of relevant banks.

In the last months, worrisome expectations around AQR and the possibility of certain banks to be in major need of capital, have exerted a powerful cap over the banking sector. Ever since the 5th of June ECB’s meeting, the underperformance of banks vis-à-vis the overall market has been staggering, driving the overall European market in a downward spiral. A commonsensical reading of events saw the ECB’s announcement over T-LTROs falling short of expectations, while geopolitical tensions in Ukraine and a string of bad data releases helped accentuate the weakness of European equities: meanwhile, the black cloud of AQR’s uncertain outcome was looming ahead and coming due.

As the AQR is put behind us by late October, uncertainties over banks’ capital needs will fade away, and the upside potential break free.

We believe that the AQR will prove to be a smooth and benign process for most relevant banks out there, owing to (i) large capital raising in the last couple of years (not just equity but hybrids too) and owing to (ii) the vested interests of the ECB itself, skating on the slippery slope of disinflation.

  • Importantly, several if not most banks have strengthened their capital base meaningfully in preparation of AQR, by means of new issues of equity and contingent convertible debt, and by means of deleverage through asset sales and declining loans to household and businesses.
  • AQR was designed to make sure the health of banks’ balance sheet was certified by a more credible authority than the banks’ own internal ratings, so as to clear off uncertainties, restore credibility, and prepare banks for increasing lending to the real economy, thus expanding the money supply.
  • Incidentally, however, a prolonged AQR period is proving to be counter-productive enough already. While proposed with good intentions, it entailed unintended consequences. By pushing banks into capital replenishment, banks have cut on new lending, thus pushing so many businesses to the edge, especially in peripheral Europe. Net bank lending to the private sector in Europe fell again in July by 1.6%, mainly due to Italy and Spain. Such outcome has hardly helped real GDP formation, new investments in Capex, hiring plans. In Italy 75% of total employment is provided for by small and medium sized businesses, similarly to Spain: as they historically relied almost exclusively on banks’ funding, cutting their largest source of capital at a time when (i) taxes are raised on austerity programs, (ii) labor market rigidities are slow to reform and (iii) economy is outright contracting, is the most certain way to make sure unemployment grinds higher. No wonder that consumer spending and retail sales went on free fall. Internal devaluation, unemployment, economic contraction and disinflation within peripheral Europe were given a definitive help by the vacuum created by the period leading up to the AQR/stress tests.
  • Successfully overcoming the AQR will prove cathartic for the banking sector in Europe and the European equity markets at large. A positive and smooth outcome of AQR is most important to banks in Europe but is as important to the ECB itself, we believe.
  • A gross failure of AQR would entail massive self-inflicted pain, with repercussions difficult for the ECB to project. Including the possibility of a fresh debt crisis in Europe, where local banks own the bulk of government bonds. Take Italy, for example, where some Eur 500 bn are owned by local banks, which might be forced into further deleverage.
  • Finally, consider that T-LTROs are going to be successful if their take-up is substantial. But that viciously depends on AQR too. Their take-up on T-LTROs can only increase banks’ borrowing, therefore affecting leverage ratios, therefore somewhat impacting AQR results themselves, inevitably. AQR is expected to be completed by October/November this year. T-LTROs bids are submitted for September’s or December’s take-up. December’s take-up should be more substantial than September, as banks borrow / bid for liquidity with clarity of mind over AQRs. Unless, of course, AQR itself is severe enough to decide for them.

If the AQR outcome might have been uncertain before, it should be less uncertain now: economic contraction, deflation and weak capital markets are a potent mix helping the odds of a benign AQR, as its vested interests go viral.

3) ECB’s own version of QE, Together With Fiscal Program

The ECB has accelerated its investigation on ABS direct purchased by appointing Blackrock as adviser on the matter.

Sovereign QE should be determined to be part of it too,
although not as effectively as it has been in the US. Still, as we argued earlier on, real rates in Italy are still 200bps higher than in France and 250bps higher than in Germany. That is 2 times the full yield of a 10yr duration risk on Bunds: too much to live with, in a deflationary world, at ~140% debt/GDP. In case of some sort of Sovereign QE, we would expect Bund yields to set even lower than JGBs in Japan across the curve (JGBs have been as low as 0.50% on 10years and 1.50% on 30years govies).

Private assets, including equities, could be included in some part. Caveats will need to apply to minimize risks of moral hazard for peripheral European countries engaged in structural reforms. Other caveats will need to apply to attach conditionality to QE policies, and hand-over of parts of sovereignty.

Monetary policy could run in parallel with a large ECB-financed Europe-wide fiscal program, traded against structural reforms, targeting underinvested European public goods. Infrastructure projects across the energy sector (where a energy plan for Europe is badly needed), energy savings/efficiency and telecoms could be a start. The Bruegel think tank offers few ideas here .

Implications of Deflation + ECB’s Activism: Yields & Spreads to Compress to Minuscule Levels, Equity Melt-Up First

As discussed in our previous Outlook, ECB policies and deflationary forces are two weapons firing in the same direction. From here, odds are high for European rates to move lower, credit spreads to narrow, risk premia to implode, interest rate curves to go flatter. That is financial repression at its best, with the added help of deflationary forces, putting any sort of risk premia and rate differentials under attack.

Without the ECB policy move, such process was less obvious. In the absence of an active ECB, such deflationary forces could have failed to drive rates lower and spreads narrower, as credit and risk spreads could have widened massively on fears of a replay of the sovereign and liquidity crisis of late-2011, mid 2012. Credit spreads could have widened out well in excess of base rates moving lower. An active ECB, moving decisively and unanimously (including Weidmann), helps generate the expectation of mutuality across Europe, rendering deflationary expectations even across European countries.

From our June Outlook: ‘’Pushing lower a 10year German bund yield of 1.35% might be difficult (although Japan shows the downside is still wide), but forcing lower a 2.75% yield on a BTP is easier, as it offers twice the yield of a Bund, for the same Central Bank. So it is easier to push down a 6% yield on a Greek govie (and its CDS at 450bps over), on the presumption of mutuality and ECB backstop. For the time being, until further notice’. Fixed income-wise, we expect yields to plummet, spreads to narrow further: Italian BTPs at 2%, and at 100bps spread over Bunds, 60bps over French OATs; 10year Greek yield at 5% and below, soon enough’’.

The impact on equity we expect is one of melt-up, at least in a first phase, pushing them into bubble levels, not supported by fundamentals but rather by the mix of lower yields, zero inflation rates, modest economic growth. Against this backdrop, we believe that the activism of the ECB can lead into 20%/30% upside for equities in Southern Europe, especially in the financial industry. Our favorite markets are Italy and Greece, which we think have the potential of being best performers in the next 12 months, although with heavy (realized) volatility along the way.

What I liked this month

The Russian Crisis in 1998 - Radobank Read
A Case Study of a Currency Crisis: The Russian Default Read
Grieving Russians begin to question secret Ukrainian war – FT Read
Europe needs new investments, not new rules – Bruegel Read

Sharp decline in intra-EU trade over the past 4 years - divergence between the Euro Area and the European Union as a whole is almost non-existent Read

W-End Readings

Japan and the EU in the global economy Read
Understanding the challenges for infrastructure finance Read
Argentina – Sliding Down A Slippery Slope Read
South Korea will reach zero inhabitants by 2750 Read ​​


Thanks for reading us today. For those of you who may be interested, we will offer an update on our portfolio positioning to existing and potential investors during our Bi-Monthly Outlook Presentation to be held on Tuesday September the 23rd at 5.00PM. Supporting Charts & Data will be displayed for the views rendered here. Specific value investments and hedging transactions will be analyzed. Please do get in touch if you wish to participate.