Younes: Investing in an Overleveraged World

Jason Stipp: I'm Jason Stipp for Morningstar. We're reporting from the 2010 Morningstar Investment Conference. And I'm here with Rudolph-Riad Younes. He is with Artio Investments and he runs Artio International and International Equity II.

And he is here to tell us a little bit about his take on the markets today, where he is seeing the situation with the sovereign debt crises in Europe, and now he is positioning his portfolio.

Riad, thanks for joining me again.

Rudolph-Riad Younes: Thank you, Jason.

Stipp: The first question for you, we spoke as, sort of, the European crisis was reaching ahead a few weeks ago. I'd like to hear your take on your thesis from when we spoke before how that's played out and the confidence that you have in how the situation is unfolding as you understood it when the crisis really became apparent to investors?

Younes: Well, our thesis is basically the adjustment of the global imbalance is not going to be easy and is not going to be as smooth as governments around the world hope for it.

Basically, all the efforts today are channeled toward encouraging consumption in emerging markets to allow the developed world to get their house in order.

It's not going to be as easy, although in theory the thesis is very compelling, but the size of the emerging-market consumer is so small compared to the size of the indebtedness and the overleveraging we have today in the developed world.

And we are making the problem worse because if you have a patient that is sick, and you're trying to diagnose him or her the wrong way, you're just making the disease getting worse and worse, instead of directly attacking it from day one.

And I think this is the problem we have today is we are chasing a dream that's not going to – it's not feasible. And therefore, we feel like the correction is going to be painful, but later on.

Stipp: So, certainly, with emerging markets I think there have been a lot of hopes pinned on them to be engines for the growth, to be the savior. What are you seeing as far as the developed world then? And what do you think is the potential impact for growth in the developed world? Growth in developed world hasn't – especially, in Europe, for example -- there weren't great expectations for it before. Should expectations be even lower for growth in these areas now?

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Younes: I mean, how can we get growth when the number one priority is the need to deleverage. If you look at many countries in developed world, total debt-to-GDP is about 400%, 450%, 350%. So the numbers are like all-time high for almost every nation in developed world. So, therefore, its deleveraging is unescapable and getting growth is going to be mainly driven by government spending, which is very unhealthy because it is, basically, kicking the can down the road and just make this a big problem much bigger tomorrow.

Stipp: So from a portfolio perspective, I mean, given that we have these issues and given that emerging markets may not be what we think that they could be for the global economy, how do you position a portfolio? I mean it seems like that you have a somewhat pessimistic view of some of the prospects out there. So how are you thinking about that as you are building the portfolio and your positions?

Younes: One position is you are getting insurance against this huge government build-up in debt. You see it increasing everywhere at an alarming pace because many government have budget deficit of 8%, 10%, 14%, 15% of GDP.

So you buy gold or gold mines as an insurance policy. In case the – the dream case, I'll call it the dream case scenario -- of combination of a little bit of tax hike, little bit of spending cuts, and some economic growth will gradually get the developed world out of its problem in a painless way, plus of course, a consumption boom in emerging market. So, if that experiment fails then you're going to see a gap up in gold and that's your insurance. And because we think there is a significant probability that the current experiment would fail, therefore we have a mid- to high single-digit in gold and gold mines in our mutual fund. This is one.

Two is, during the last 10 years there has been undeniable transfer of wealth and intellectual property from the developed world to the developing world. So definitely – so therefore, the income and the wealth in those regions have dramatically increased. Also, the rise in commodity prices have made this region richer.

And you add to that there is a lot of pressure from the developed world on the developing economies and government of those economies to stimulate domestic spending. And they have to [take heed] to those advices, and that's why we saw the Chinese government, for example, de-peg the yuan from the dollar. So these efforts will be done and therefore you are going to see some structural tailwind to the consumer spending, especially non-discretionary spending in emerging market.

Although that spending will not save the old world from its problems, but still you are going to see growth, and therefore as an investor it would be interesting to us, which we are, to invest and get exposure to like food retailers, food producers, pharmaceutical companies in those big markets like Brazil, like China, India, even Africa who will be – where we're going see above, way above growth, in earnings as well as in the demand.

Stipp: In the developed world, you could say that certainly, the stock market has responded to a lot of the issues out there. Do you think that the sell-off for some of the names in the developed world or specifically in Europe, has been overdone? So from a valuation perspective even though the prospects for the region economically may not be that great, is there a chance to pick up securities – undervalued securities -- that have perhaps been taken down too far?

Younes: The market is a bit more efficient than what you see on the surface. They are relatively easy picks. For example, exporters, who were benefiting from weaker euro and who has no problem with balance sheet, you would see them – many of them are up or if they are down, they are much less down than the broader indices.

Banks, financial companies ... are the ones who have driven a lot – who have brought down the indices. And these ones are very binary outcome. For example, would you buy a French – one of these French banks today, A) you need to know exactly what they hold on their books and B) you need to know what the French government will decide to do with these banks.

In the case of the U.S., I think it's a wrong lesson to learn because in the U.S., in our opinion anyway, we believe the government made the wrong decision. They did socialize the losses of these banks. Many of these banks basically had negative equity and basically, they give them a new license of life by letting them earn their way out of the trouble and maybe nationalizing them was the most rational solution.

So in Europe, we don't know basically what the governments would do. Would they follow the U.S. model and basically socialize the losses of these banks or would they do what the Swedes have done and nationalize the big banks, support them with funding from the government then a couple of years later privatize them once again. So it's a difficult game to play.

Stipp: Riad, thanks so much for joining me again today. It's always great to hear your insights.

Younes: Thank you very much, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.