Europe Resolution Not as Close as Markets Think

Komal Sri-Kumar: Good to be here, Christine.

Benz: So we talked several months, Sri, about the crisis, and I think, we are a little further from resolution at that point. I'd like to know whether you think this crisis, which has been unfolding, is getting closer to a resolution finally?

Sri-Kumar: I think we are getting close to a resolution, Christine, but not as close as the markets would have us believe with the rally that we have had in Europe and the United States last week. The reason we are a bit further than the markets seem to suggest is that, I call it the €2 trillion gap. That's the amount of money many people think needs to be done in terms of bailing out the entire banking system, plus some of the other countries that may have difficulties, not only Greece, Portugal, or Ireland, but Spain and Italy as well. But who is going to provide the $2 trillion? Where is the money going to come from? So, there are various other means of resolving the crisis, and clearly Chancellor Merkel and President Sarkozy from France, they were not going to resolve it all on one Sunday afternoon meeting.

Benz: So, you think there's more work to do, and there has recently been talk about whether Germany and France would impose shock-and-awe tactics to resolve the crisis. What do you think it will take to bring the crisis to a resolution over the months ahead?

Sri-Kumar: First of all, referring to your shock-and-awe point, the Europeans have shown they are not capable of doing that. We have gone through with just muddling through, rather than a shock-and-awe over the last year and a half. So, I don't think that's going to take place.

What do we need to do for a resolution? So first, we begin with significant haircuts, not only in the case of Greek debt to creditors, but I think other countries as well. July 21, we talked about a 21% haircut for Greek creditors. I don't think that is enough. ... The German finance minister came out and said that was not possible.

Then I think we are looking at significant haircuts as well with respect to other countries. Portugal is one of them, and the thing you don't even want to think about is Italy, with €1.9 trillion in debt, and 120% debt to GDP ratio--that requires a significant reduction as well.

On the other side of the ledger, Christine, that means the banks need to recapitalize. Now, I estimate, along with the International Monetary Fund, that you are looking at a €200 billion recapitalization. Imagine, all of these banks go to the private markets trying to raise €200 billion at the same time, when the reception is pretty hostile from the investment community. Then what happens? Then the governments have to come and provide some of that money--what you call forced recapitalization--and that means a dilution of existing shareholders, some amount of more hit on the prices, and concerns about depositors staying with some of those banks. So all of those are, I think, further ahead, and they are going to be part of the resolution we are talking about.

Benz: OK, so debt holders taking a haircut, some recapitalizations. In terms European markets, both stock and bond, what do you foresee will be the implications of these efforts?

Sri-Kumar: I think the first half of 2012 is my estimate of the bottom for European debt and equity markets. It is going to be a phenomenal future investment for investors beyond that. Right now, I would say to the investors who are watching, who want to buy and hold, unless you think you're going to buy today and leave a week later at an opportune moment, this is not the time for you. Wait for it to get significantly worse, and then you're going to have a nice five-, seven-year run along with it, much as what I found was the case with Latin America in the 1980s.

So, I think that's what we are looking at. Before that, it has negative ramifications for European growth and for U.S. growth. I think, those are slowly going to get incorporated in market expectations. So, once it's all done, the uncertainty will be gone, it will be good for global investments, but we just are not there yet.

Benz: When we spoke a couple of months back, Sri, you mentioned that you thought that Europe was heading for a recession, and your time horizon for that was six months. Do you still stand by that view that that will unfold?

Sri-Kumar: I still believe that. I think even core eurozone is slowing down, and as the European debt resolution takes place, that is going to put downward pressure on economic growth as well, and first half of 2012 is my expectation for negative growth in GDP for the eurozone. Some amount of vitality so far is with Germany, the others have slowed down. We saw that in the case of France, the second-biggest economy, the third quarter looks like it's zero growth after near-zero growth in the second quarter. France gets its big stimulus from domestic consumption, which is not doing very well. Germany gets the push-up from exports, and there with China slowing down and the U.S., in my opinion, headed to recession, it doesn't look good. So, I feel stronger about eurozone recession to come.

Benz: Okay. So let's follow-up on the comment about the U.S. Obviously, people are concerned and watching all of the unfolding economic statistics about U.S. growth. You do think the U.S. economy is headed for another recession, or possibly a continuation of the previous one?

Sri-Kumar: I think we are headed for a recession. I've said repeatedly, it's very tough to put an exact date when the recession begins. Even the National Bureau of Economic Research has difficulty doing it. But I have consistently said that the economic recovery begun with the Obama administration was simply not going to last. The components were such that we had to get a downward move again. So, we have a hard time even going to the pre-recession level of GDP, despite some growth that we have had in recent quarters.

My expectation is that before you go significantly up anywhere, you're going to go down again. The reason is a combination of the impact of the European debt crisis, a Chinese slowdown, and domestically we have the concern with the consumers who account for 70% of GDP, and the high unemployment rate continues to be a negative influence from the domestic side as well.

Benz: Absolutely. Well, I would like to talk about what you see the repercussions of that are for U.S. investors in both stocks and bonds. What do you think will be the impact?

Sri-Kumar: I think the impact in the short term is going to be that investors should be defensive. They should be looking at areas like consumer staples. They should be looking at utilities. To some extent technology, because that is often recession-proof, but you're going to stay away from consumer discretionary, which is not an area which is going to do well.

I think, externally, I've started to say ... I was negative on emerging-market equities for many, many months, but now that they've fallen a lot, I would say don't look for the bottom point, start slowing getting your toes wet and come back, because emerging-market equities are likely to come back the fastest.

Japan continues to look like a very nice value play, and I think that is a place where you can't lose money. It provides you downside protection.

Lastly, again based on what we've discussed, Christine, Europe would be my least preferred area today. So from an investor viewpoint, they want to postpone investments until that's clarified.

Benz: Okay. Well, thank you so much for sharing those insights, Sri. We really appreciate you taking the time to talk.

Sri-Kumar: Thank you. Good to talk with you, Christine.

Benz: Thank you. Thanks for watching, I'm Christine Benz for Morningstar.com.