Only a Haircut Will Do in Europe

While liquidity may provide temporary relief, only debt reduction--and a creditor haircut--will put Europe back on the road to growth, says TCW's Komal Sri-Kumar

Jeremy Glaser 16 August, 2012 | 9:53AM


Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm pleased to be joined today by Komal Sri-Kumar. He's the chief global strategist and group managing director of TCW. He's also the chair of the asset allocation committee.

We're going to talk about the future of the European sovereign debt crisis, and if the United States is headed for another recession.

Sri, thanks for joining me, today.

Sri-Kumar: Good to be here, Jeremy.

Glaser: So, let's start in Europe. Certainly that's an area of interest on a lot of investors' minds. Recently there's been some excitement--as excited as anyone gets about Europe nowadays--about the European Central Bank buying bonds, trying to keep Spanish yields down.

Do you think this is a viable strategy? Can the ECB really act here to keep the crisis contained?

Sri-Kumar: Jeremy, I think it is viable only in the very short term. This is not the first rescue operation the Europeans have gone through, and even in the part of the ECB, we saw that they did two repurchase agreements, known as the LTRO, last December and again in February, totaling about €1 trillion, and you got the benefit of it in terms of lower interest rates on the bond market for two months, and then the rates went up again.

I think the same thing is going to happen again, and the basic reason is, Europe, many parts of Europe, have a solvency problem; it's not a liquidity issue. So providing them with additional liquidity is not going to get rid of the main problem, which is that they have an excess level of debt, which has to be reduced.

Glaser: So is there anything that policymakers can do, then, at this point to try to stem the crisis, or is this already so out of control that the euro is kind of doomed, and we need to just start preparing for that fallout?

Sri-Kumar: Absolutely timely question. I think what comes out of the Latin American experience in the 1980s, where I started my career, is that we had something called a Brady Plan in 1989, named after U.S. Treasury Secretary Nicholas Brady at that time. This involved a reduction in the level of debt of countries like Mexico and Brazil and Argentina. We allowed for debt-to-equity conversions. So, overall, we brought down the level of debt to a level that the countries could service, and that's what made Latin America start to grow again.

What we need to do, Jeremy, is to have the eurozone countries grow again, rather than have a more and more severe recession, and that won't happen until the debt level is reduced.

Instead of that, what we are doing is adding to the level of debt. Can you believe that? They can't pay the existing level of debt, and we are providing them more debt in the form of bailouts, so the situation gets worse, surprising only to the European powers, not to us investors.

Glaser: But is there any appetite for that debt reduction? Is it something that's politically feasible, or will it never actually happen?

Sri-Kumar: The debt reduction is never voluntarily done. It gets eventually forced on the governments. Even in the 1980s with Latin America, we tried many, many, many bailouts between 1982 and 1988, before we gave up and said they need debt reduction.

The problem with debt reduction is, somebody needs to take a haircut on the other side--they are going to be the creditors, the lenders who lent all the billions, trillions of dollars of money to the different countries, which is why they resisted. And eventually, I think that has to happen, and that's when the situation starts to improve. So that's your answer to what needs to be done. What can be done to turn the situation around.

Glaser: So if we're looking at the euro, then, can it survive this? With these debt reductions, will it survive? Or will it fall before these debt reductions are forced?

Sri-Kumar: I think if the debt reduction is done fairly soon, meaning within the next two to three months, and then you eject one country, say perhaps Greece, and then put a firewall around the remaining 16 members so that they are protected from further deterioration in the situation, you can save the euro.

But if they decide to postpone it, as they have done in the last three years, and don't deal with the problem until well into 2013, then the whole euro concept is going to be in jeopardy. And then you have to ask, not just will Greece or Portugal will leave the eurozone, but whether Germany will be better off leaving the eurozone and forming a strong currency union with a few other countries.

Glaser: So coming back to the United States, certainly the sovereign debt crisis [in Europe] could seem very distant to a lot of American investors. What impact is the European crisis going to have on the United States? Does the United States really just have its own set of problems that it needs to deal with in terms of the economy?

Sri-Kumar: U.S. has its own set of problems. We can talk about that in a minute. There are two major headwinds which come from Europe. First is, something like 18% of the bottom line of S&P 500 corporations are coming from sales made to Europe, and the European Union is the biggest economic entity in the world today--it's not the United States, but the EU is bigger.

So when the biggest part of the world is having a major crisis, that is going to have an impact on our exports into Europe, and that has a major impact on S&P 500 corporate earnings [and the] equity market in the United States.

Big as that seems, Jeremy, there's one other impact which is even more important, and that is the financial transmission. The financial transmission impact deals with the case where you have U.S. banks with a lot of loans, derivative relationships, with European banks, and we simply don't have a good concept of what the extent of exposure is. And that, I fear, could be even more of an issue than just the merchandise sales into Europe. Remember September 2008 when Lehman Brothers was allowed to go bankrupt, we did not know of all the ramifications until they actually happened.

Glaser: So turning to United States' economic problems then: There has been some very mixed economic data, jobs data was maybe a little bit better than expected [in July], but still fairly soft.

Is the United States careening toward a recession, or will the recovery be able to hold on?

Sri-Kumar: I have maintained for the last couple of years that this economic recovery cannot be self-sustained--something has to change here. I stick with it.

Specifically, I think the second half of this year appears to be the time at which a U.S. recession may well begin.

Where does it come from? One, we talked about headwinds from Europe. Second, the U.S. consumer sentiment still remains very low. If you have an unemployment rate of 8.3% for the open rate, and a very high 15% for the so-called U6 unemployment rate (which includes disgruntled workers and those working part-time because they can't find full-time jobs), that is not a happy situation to increase consumption. And consumption accounts for more than two-thirds of GDP, and that's a big weakness.

Second, we have the fiscal cliff, the uncertainty of the elections, and U.S. businesses are accumulating cash rather than spending it for new investments.

And so those two or three items are the major factors which contribute to the U.S. economy doing much worse in the next few months than it has so far.

Glaser: Could an improvement of housing help stabilize the economy at all? Or is that housing recovery just too far off?

Sri-Kumar: I think the housing recovery has begun, but don't expect a booming recovery yet. ... What I would say is housing has bottomed. You are going to have some small increase in house prices over the next 12 to 18 months, but it's nothing like a big contributor to the overall economic recovery.

If you want to look for an indicator, Jeremy, I would say go to the opposite of what textbooks tell you, which is that employment will pick up after economic growth. Here, I would say, look upon it as a leading indicator. You have to create jobs, you have to make people feel better, so they spend more, and therefore the economy will grow faster. That's going to be the sign that the economy is turning around.

Glaser: I know that deflation is something that you've been worried about in the past. Is that still a concern for you?

Sri-Kumar: Deflation is very much a concern in the short term, and I will tell you why. The two LTROs we spoke about adding €1 trillion hasn't done anything in terms of boosting inflation. Chinese inflation came out a few hours ago at 1.8% year-over-year. It's very low. On the U.S. side, while we have more than tripled the balance sheet of the Federal Reserve, inflation is still very much reduced.

I would say, if there is a European crisis, the commodity prices can further drop and that in turn could feed into short-term deflation for a few months. And yes, that is a major concern. That's the reason why these so-called risk-free interest rates--whether it is the U.S. Treasury or Germany or U.K. gilts--are trading at such low interest rates and people are willing to give money for two years to Finland or Germany at negative interest rates--that's because of the fear of deflation.

Glaser: So against this very uncertain backdrop, what should investors do then? Are there certain assets classes that could thrive in this environment, or is it a matter of just trying to be conservative and just live to play another day?

Sri-Kumar: I would say the last thing you should do is to stay all in cash. There are lots of other things you can do with your money.

First thing that you do with it, you are going to be looking in the U.S. equity side, to be very defensive: utilities, high dividend yielding stocks appear to be very attractive. That is one area that I would think of going into.

Second, because of what we have talked about Europe, I think the euro is ready to weaken significantly from current levels. In the last week, the expectations of some stabilization by the ECB has caused the euro to go from about $1.21 to $1.24. Today it's about $1.23. I would say it is likely to weaken significantly. That is one more area for your audience to be looking at.

Third, I would say keep your powder dry for distress. European distress is starting to look very, very attractive. Major European companies are unable to get loans, and so entities trying to lend to them, funds which are lending to them at very high interest rates, is a very profitable occupation. Very soon, you're going to be able to buy privatized companies, you're going to be able to look at troubled companies that you're going to buy at a discount, and I'm waiting for the day when you can use the sovereign debt or corporate debt in exchange for equity, and those are the types of opportunities that investors should be holding some of their cash for.

Sri, we really appreciate you taking the time to speak with us today.

Good to be with you, Jeremy.

For Morningstar, I'm Jeremy Glaser.

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Jeremy Glaser  is markets editor for, the sister site of