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Younes: Europe Taking Easy Medicine First

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Global markets continued to be rocked by fears of slowing European growth and the ongoing European sovereign debt crisis. I'm here today with Rudolph-Riad Younes. He is a portfolio manager at Artio, and he will provide an update on the situation.

Riad, thank you so much for joining me.

Rudolph-Riad Younes: Thank you, Jeremy. Thank you for having me.

Glaser: So, my first question is, do you really see Europe careening toward recession or do you think that there's going to be a some more resilience there?

Younes: Definitely, we feel during the next five to 10 years, Europe as well as the United States will be in a very low-growth environment, much lower than they had in the past.

Glaser: Is that the same across, the entire continent? I mean, there was some the hope that maybe strength in Germany would be able carry some of the slower-growth countries, but we're seeing at least the gross domestic product numbers indicating slowing growth in Germany. Is that something that concerns you?

Younes: So far, Germany has been able to offset a lot of the weaknesses of its weaker partners in the eurozone, but ultimately it will affect them.

Glaser: So, let's turn our sights to the eurozone then. There is lot of talk about if it can remain stable, or if it will be able to continue in its current form. Do you think, there'll need to be major structural changes to the eurozone or to the European Union in order to secure growth in Europe or will they be able to muddle through with their current system?

Younes: Definitely, the eurozone needs a serious reengineering. The current status quo is not an equilibrium, and that's what the financial market is telling the policymakers. That's also how the policymakers, little by little, are acknowledging the problem, but the solutions are not easy. Therefore, there is this resistance, and it is difficult to tell what kind of outcome it's going to be. But definitely, the current situation is unsustainable.

Glaser: Do you think they are moving fast enough to make these structural changes? Or is there a chance that the government won't be able to act quickly enough to kind of stave off an even slower-growth or negative-growth scenario?

Younes: I mean, the situation is very dynamic. Definitely, the market is moving too fast. The market was to slow, and now the market is too fast. And there is this dynamism between the market and fundamentals because even if market prices do not reflect fundamentals, they affect them anyway. So, there is a dynamic relationship between pricing and the situation. If you look at the current situation today, the eurozone is kind of like a currency board in reality but you have a zero fluctuation in currency. Instead of a currency band, what you really have is an interest rate brand. And like any currency board system, for it to work you need very little deviation. For the eurozone to work you need the sovereign spread versus Germany to be, on average, within 50 basis points.

If we get to that, then we know the eurozone is working. If we don't get there, which we are far away from that, then we know that the system is not working, and little by little, the fundamentals are getting worse for all the weak members.

Glaser: So we look at the European banks, obviously they are very exposed to both growth in Europe and also just some of the sovereign debt problems. Do you think the banks are appropriately capitalized; will they be able to ride out any storm in Europe? Or are you worried about those institutions?

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Younes: Well, again it's dynamic. It's funny too because it depends on the solutions that European policymakers decide to do. So with the new equilibrium, I would say there are several possibilities. One, we should call a positive equilibrium which is good for the banks; this is if you have an overt or a covert, German backstop to the fiscal problems in Europe. The overt German backstop means a euro bond issuance which basically implies German taxpayers are directly backing other government issuances. And the other solution, which is a covert solution, is having the European Central Bank buy in the markets and ultimately the Germans bail out the ECB. So this kind of scenario would be very positive for the banks because the banks hold a lot of sovereign debt on their balance sheets and are not taking haircuts because the German taxpayer generosity will definitely improve the book value of these banks. And you will see a tremendous rally in them.

A second equilibrium would be negative for the banking sector. This is possible if we were to force a default or exit on many of the weaker members that will force haircuts on the banks, which will require a huge decapitalization of many, many, many banks in the continent.

The third option is to remain in this lack of equilibrium, which means kicking the can down the road. In this situation, I think the banks would be bleeding slowly, making them not investable.

And with the fourth solution, which governments have always surprised me how creative they can be, instead of kicking the can down the road, they may kick the road down the can. In this situation, I do not know what will happen.

Glaser: So given those four scenarios that you've laid out. Do you have a sense of which one you think is more likely and which is less likely at this time?

Younes: Well, I mean I am not an expert in politics; if anything, in the last two years, I would get a grade of F-. But if I were to listen to what advisors and politicians are saying, they are trying to find a hybrid between the two between selective default or exit for the weakest ones and kind of like covert/overt German backup for the more important ones. I think it is kind of like a hybrid solution. So, in Greece and Portugal, maybe that will cause some default,t and maybe on the Spaniards and Italians they maybe will find some kind of covert/overt German backstop.

But again, I think, there aren't any big decisions, yet. I think the policymakers up to today don't know what to do. They always hope to take the easiest medicine first, and the easiest medicine is over the small thing--Let's have the ECB buy some bonds that have this European System of Financial Supervisors oversight, which is like a fund that is funded by the European Governments to buy bonds from weaker members.

So, they're hoping for these easy solutions, first. But to have the German taxpayer more exposed to the problems, it's very difficult for Berlin to decide upon and causing a haircut and default is very easy. It's very difficult for the policymakers because any serious default is going to create another problem for the governments which is how to decapitalize their own banks.

So that's also a very tough medicine for them. And it's not just the private sector will take the losses. There is the boomerang effect which is you have a situation where your main banks are insolvent, and basically the whole economy would collapse. So that's why for now the easiest road is to find a way to support and minimize the pain as opposed to having surgery.

Glaser: And finally looking across the European equity space, where are you finding value? Where do you think the opportunities lie today?

Younes: In today's environment you need to differentiate between the short term and medium term. In the short term, of course, there is lot of trading involved and a lot of money is hiding in what's perceived to be defensive, high-yielding stocks, such as a pharmaceutical firm, a food producer, and what have you. But in reality, in the medium term to long term what you really want to have are sectors and companies that are either global leaders or highly exposed to the Chinese consumers as we expect for the next decade China to become even larger than the U.S. economy.

Glaser: Riad, thank you so much for taking the time today.

Younes: Thank you, my pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser.