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

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September 1st 2014

Fasanara Capital | Investment Outlook

1. TENSIONS WITH RUSSIA ARE TRANSITORY FACTOR FOR MARKETS. 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.

2. DEFLATION IS STRUCTURAL FACTOR. 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.

3. WE EXPECT THE ECB TO FOLLOW THREE STEPS PROCESS:

a. Enhancing already generous terms for T-LTROs to maximize take-up, while

stepping up rhetoric over QE

b. Finalizing a benign AQR / stress test, and putting it behind us

c. Delivering ECB’s own version of QE

4. WE SEE THREE TOP VALUE OPPORTUNITIES IN CURRENT MARKETS

a. EUROPEAN DEFLATION TRADES: ECB’s activism and deflation are two

weapons firing in same direction. Rates to move lower, credit spreads to

narrow, risk premia to implode, interest rate curves to flatten. Bund yields

moving flat to below JGBs, Italian 10yr BTPs at 2% yield by year end, below

100bps spread over Bunds and 60bps over OATs; Greek 10yr GGBs at below 5%

b. OPTIONALITY ON PERIPHERAL EUROPE EQUITY UPSIDE. ECB will step up

its game, further inflating the bubble. Most upside materializing in the equity

of Italy and Greece, primarily in the financial sector. Record levels of implied

vol and availability of option-type instruments allow 2x to 3x payout ratios

c. JAPAN SECOND PHASE OF ABENOMICS: activism to be stepped up, further

inflating the bubble in equity. Yen to weaken. Private-sector credit spreads at

rock-bottom levels offer outsized payout ratios to hedge failure of Abenomics

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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).

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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.

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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.

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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.

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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.

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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

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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.

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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.

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- 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.

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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.

Opportunity-Set: Greece, Italy, Japan

We see three main opportunities in the current market environment:

- Optionality on Peripheral Europe Equity Upside

- European Deflation Trades

- Japan Second Phase of Abenomics

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(1) Optionality on Peripheral Europe Equity Upside

Our one liner on Europe could read as follows: European policymaking may fail (too little too late),

the EUR may break few years from now, but before that happens the ECB will step up its game,

further inflating the bubble across European debt and equity markets.

For the next 1 to 2 years we see the most upside materializing in the equity of Italy and Greece,

primarily in the financial sector.

Record low levels of implied volatility (even lower than realized) and the availability of option-

type instruments offer the opportunity to play this upside in optional format, with potential for

2x to 3x payout ratios.

Greece

Greek banks are the most interesting they have been in 10 years. They have never been cheaper

than they are today, yet they have not been better capitalized and transparent about the true

value of their assets in many years. Despite raising some 11bn$ new equity, despite narrowing their

funding gap by re-accessing debt capital markets at record-low cost levels, their stocks fell to levels

not even seen during the Lehman-moment or the Greek sovereign crisis in 2010-2011.

Few specters drove such bloodbath:

- Banco Espiritu Santo sudden bankruptcy, a month after a blue-sky equity

offering, sent tremors across the European financial sector, raising concerns over

the opacity of banks in peripheral Europe and the possibility for new BES-type

discoveries during the AQR process. Weakness across the board, special

emphasis given to peripheral Europe: Greece looks the most like Portugal for

location and size.

- AQR examination looming ahead and fast approaching, at a time where

banks are battered globally by litigation risks (Barclays, BNP, DB etc.), are hit

by profit warnings (Erste etc.), are jumping to default (BES). Greek banks

currently already discounting the need for further capital action.

- Geopolitical tensions in Russia/Ukraine, and their impact on already-anemic

European growth, let alone chance for global conflict

- Political uncertainty in Greece ahead of February elections.

- ECB’s intervention in early June judged by markets as insufficient, leading to

strong underperformance of banks over the rest of the market ever since.

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We expect such factors to work in reverse between now and year-end and drive a powerful

recovery in Greek banks:

- We expect Greek banks to be in small to no need of capital after AQR is

completed. They currently discount the need to return to the markets for

sizeable amounts. NBG, Piraeus, Alpha have just release numbers: all good,

exceeding expectations. NBG, for example, shows Capital Adequacy Tier I ratios

of 16.2% (double the 8% regulatory capital requirement), positive net operating

profit (and rising above expectations), loan-to-deposit ratio of 83%, provision

coverage at 56%, new NPLs rolling off (new +90days loans are 30% lower than

last quarter, pace of new credit impairments slowed, 75% lower formations than

in 2012). JPMorgan estimates Basel3 CET1 2014E of 18.3%, and 19.5% in 2016E,

B3CET1 ratio post stress test of 13.6% vs 5.5% capital minimum. Sure, AQR can

disclose not as good an asset side as these banks believe they have (especially

when it comes to residential mortgages recovery assumptions, restructured

loans’ marking, SME’s NPLs). Nevertheless, the buffer is now substantial and

we believe that any new capital exercise will be limited. Investors’ fears are

overdone.

- BES is an isolated case. One of a handful of family-ran banks left in Europe. It

won’t be able to cap the sector for long, no more than Enron and Lehman were

able to, at their time.

- We expect the ECB to have a vested interest in a less-than-disruptive AQR,

especially in Greece, for the reasons given earlier in this Outlook.

- We expect the Russia/Ukraine stand off to ease over the next few months, as

Russia will want avert default, for the reasons given earlier in this Outlook

- ECB’s T-LTROs are more effective than the market is currently considering them;

more generous terms, if granted, will benefit banks first. Plus, the ECB will be

forced into stepping up its game.

- Greek GDP was the outlier in Europe these days, together with Spain,

exceeding expectations for two consecutive quarters, trending to show a positive

Greek GDP growth number for Q3 (and a positive annual 2015 number for the

first time in six years).

We can only hope the weakness lasts longer to be able to pick up the pieces at even more distressed

levels in the last month left before AQR, as a consequence of Russia’s noise or the SPX correcting,

but we sense that we may have seen the bottom already. Our view is that, within the next six

months, as the AQR is past us, as Russia/Ukraine crisis eases off or stabilizes in gridlock, as the

ECB steps up its game, Greek banks will adjust upward. Optionality plays target up to 3x

multiplier here (we will expand on specific terms at our Investor Presentation later this month).

15 | P a g e

Italy

Italy disappointed as of late, well beyond market’s or our expectations. GDP contracted in Q2,

leaving the country in technical triple-dip recession. Stocks corrected as investors fled the country. If

one were to project the trajectory from here, Italy would be bankrupt in less than two years. A

debt crisis is all it takes to tip the balance, as the a lethal mix is served: Debt/GDP hitting 140% by

year-end, a debt denominated in foreign currency (the Euro), GDP contracting again after falling 10%

in absolute levels in six years (being now where it was in 2000), Industrial Production falling 26% in

six years, youth unemployment at 43%, implementation of structural reform agenda lagging behind

on shameful resistance by hard-to-die political establishment, Renzi’s popularity just starting to

wane.

However, we believe the days of reckoning for Italy are to be postponed. Italy is the key to the

European project, and the European authorities have at their disposal the tools to engineer such

postponement. Now that Germany’s economy itself is contracting, now that outright deflation is

about to enter the stage, now that Russia refreshes the old fears that once brought Europe together,

now that ruling parties across Europe are the best subjugates Germany can ever aspire to, the time is

right to fire what is in the arsenal and try to fix it. The ECB is the main player here, together with a

large fiscal program, as explained earlier on in this Outlook.

Against this backdrop, we see large catch-up upside on Italian stocks and bonds within the next

6-12 months. Again, optional formats are both preferable and available to play the view.

Catalyst to be the same as presented above: ECB’s policy, AQR’s cloud dissipating, Russia easing

off its stance, spreads compressing further.

Fixed income wise, we see BTPs ending the year at 2% absolute yield on the 10yr tenor, for a

spread of 100bps over Bunds and 60bps over OATs. Catalyst to be the same as presented above:

ECB’s policy, deflation biting.

16 | P a g e

(2) European Deflation Trades

Disinflation is just about to turn into outright Deflation in Europe. The ECB is active but most likely

already late in the game, behind the curve, and unable to prevent deflation from kicking in. There are

important consequences for rates and spreads in Europe, together with the level of the EUR itself:

- Rates to reach new lows, especially in the far end of the interest rate curve,

especially in Germany. Bunds 10yr yields moving flat to JGBs, Bunds’ 30yr yields

below JGBs

- Spreads to compress, both between peripheral debt and core European debt,

and across the curve. Italian 10yr BTPs at 2% yield by year end, and at below

100bps spread over Bunds, below 60bps over French OATs; Greek 10yr GGBs at

below 5%

- Risk premia to implode, interest rate curves to flatten. Curve spreads to

tighten, volatility spreads to compress, cross-spreads to narrow.

(3) Japan Second Phase of Abenomics

Our recap views on Japan could read as follows:

- Abenomics may likely fail, eventually, but before that efforts will be stepped

up, further inflating the bubble in the equity markets. BoJ may be close to

confirming its QE operations for 2015 and even increasing their magnitude from

already monumental levels.

- Two years from now, the Yen is significantly weaker than it is today in both a

Abenomics’ failure scenario and a more benign scenario. Currency

debasement is either the result of a successful laboratory experiment of the

BoJ or the poster child of its failure.

- Private-sector credit spreads are at rock-bottom levels and offer the best

payout ratios to hedge failure of Abenomics in the years to come. We start an

accumulation program here, as spreads can hit bottom in the next six months.

Position-wise, our baseline for Japan scenario is two-phased:

- First phase: Short Yen, Long Equity, Tighter Credit Spreads

- Second phase: Short Yen, Lower Equity, Higher Rates / Credit Spreads

As we run out of space here, we will expand on actual portfolio trades’ terms and conditions and

execution strategy in our Investor Presentation.

17 | P a g e

Cross-Markets Recap

Before we go, to recap, our current and expected positioning for the few weeks to come is

formed against such convictions as:

- US: neutral on real economy, neutral to bearish on equity, bullish on bonds short term but

bearish medium term

- Europe: bearish on real economy, bullish on equities and bonds

- Within Europe, long Italian equities, long Greek banks, long Disinflation

- Japan: bearish on real economy, long equities for nominal rally, short yen, hedged on

tightness of rates/credit spreads

- China: bearish on economy, inevitable GDP slow down exposing imbalances, but market has

priced it in for the short term. Thus, tactically long segments of the market there

- Emerging Markets – neutral on real economy, neutral to bearish on equity, open eyes on

Argentina, Eastern Europe buying tactically on possible dips

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

18 | P a g e

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.

Francesco Filia

CEO & CIO of Fasanara Capital ltd

Mobile: +44 7715420001 E-Mail: francesco.filia@fasanara.com Twitter: https://twitter.com/francescofilia 25 Savile Row London, W1S 2ER

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