Asian Economy Crucial to Europe

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Global markets continue to be focused on the European sovereign debt crisis and the potential for slow growth in Europe for years to come. I'm here today with James Bristow. He's the managing director and co-portfolio manager at BlackRock International fund, and we'll talk a little bit more about this.

James, thank you so much for taking the time today.

James Bristow: It's a pleasure.

Glaser: We've heard about a lot of plans coming from a bunch of different members in the European community, from politicians to the European Central Bank. What do you think really needs to happen to solve the European debt crisis?

Bristow: Well, Jeremy, I think that's certainly a big question. I think I'd differentiate between what's needed to stabilize and support risk assets in the short term, from actually what needed to happen in the medium term to reduce the very high levels of sovereign debt in Europe.

In the near term, I think markets are nervous because they continue to see really no clear or comprehensive path mapped out by politicians in Europe. It's Europe really that in our view is most critical here. And as a basis for market stabilizing, I think we need to see at least three things.

So firstly, I think we need to see a commitment to increase, if necessary, the size of the EFSF bailout fund and that's beyond the EUR 440 billion level that should be agreed in September. Second, I think we need a lot more clarity on both the extent of open-market bond purchases by the ECB--and this is in relation to Spanish and Italian bonds--but also the duration of those bond purchases because they're really the key to keeping Spanish and Italian yields low.

Then in the medium term this environment above will really provide the backstop we think for Europe's most indebted countries really to start a longer-term debt workout that they need to do. This really requires a few additional things. It needs a combination of further austerity in countries that are not yet running a primary surplus. I think it also needs further capital raising by the banking sector in Europe, generally to give it more of a buffer in what we think is likely to remain a low-growth environment.

And then alongside this and I think this was the message that German chancellor Angela Merkel and French president Nicolas Sarkozy gave a week or so ago, Europe really has to start to build the institutions required to support euro bond at some stage in the future. So I think there are a lot of things that are needed to be done in both the short term and the medium term.

Glaser: You just mentioned a lot of different things that need to happen for the crisis to get solved, but is there any really any political will among both voters and politicians to actually implement this and to make it happen, or are they going to keep kicking the can down the road?

Bristow: Well, I think the slow-growth environment probably persists in Europe for some time given the extent of the debt workout and how long it takes economies to get out of that. I think the time for kicking the can down the road is really coming to a close now for Europe's leaders. I think they see the risks now in terms of sovereign crises spreading beyond the smaller peripheral countries to bigger countries. I think they see those risks really very close to them now, and really the time for talking and providing solutions that don't show investors a clear path to solving this, I think that time is over.

So, we'd expect really much more action from Europe, much more coordinated action from Europe in the next six months, really mainly because they have to do it, otherwise the bond markets will really force a worse outcome if Italian and Spanish yields particularly continue to blow out.

Glaser: You mentioned that banks could be at risk. What's your view of the financials sector in Europe, and do you think that those institutions are appropriately capitalized right now?

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Bristow: Well, I think in aggregate, the sector still isn't adequately capitalized in our view. We do note that some banks earlier in the year and indeed last year did raise meaningful amounts of capital. So, that statement doesn't apply to every bank out there, but I think what the banks have in mind--when they think about this minimum 7% level of Tier 1 capital that Basel III mandates or a 9% level of you deem systematically important--I think what the banks below that level are communicating to investors right now is they're saying, "We can earn our way to that stronger capital position over a period of years. We don't need to raise equity capital today."

We think the market increasingly has a problem with that viewpoint because that doesn't leave the banks a big enough margin of safety over the minimum Basel III requirements.

I think implicitly, the market is demanding probably 1 to 2 percentage points of extra Tier 1 capital above and beyond those Basel III requirements to deem a bank properly safe and solid and able to survive a low-growth environment in Europe for some years to come. It's clear that there are quite a lot of banks in Europe that don't fulfill that criteria today.

So, more to do on capital raising, though, we would also note that in terms of near-term liquidity, we think the banks really have dealt quite well with their near-term liquidity needs particularly for the rest of this year. So, the risk in that shorter-term sense, we think, is less than it was, but in terms of the capital overall, there's definitely more still to do.

Glaser: So, you're not concerned about a repeat of 2008, where liquidity dried up in the global financial system?

Bristow: We haven't seen that before. We're obviously talking a lot to our fixed-income colleagues within BlackRock, and really trying to look for early warning signs that that's happening again. We've haven't seen it thus far, but what we're not certainly out of the woods yet.

Glaser: Getting back to the idea of having slow growth in Europe for a long time. What impact do you think that's going to have on the rest of the world's economy, particularly developing markets in Asia?

Bristow: I think, it's interesting. I think we'll see some impact there, but given what we've already discussed in terms of how important Europe is, systemically in the global economy right now, actually, we're probably more worried about a slowdown in Asia really spilling over to even slower growth in the European economy and particularly, the northern core of Europe. This is because it's clear to us that countries like Germany really have been supporting European growth almost single-handedly off late, and a lot of that German growth is clearly export-dependent and dependent on strength in Asia.

So any meaningful slowdown in Asia, we're worried about that causing even more of a slowdown in core Europe, and especially Germany. But whilst we think there will be a modest slowdown in growth in Asia, we really do think the economy will hold on, and it won't be a meaningful growth slowdown. Clearly the two most important countries here are China and India. For China, we think they have enough policy tools and control of the economy to engineer a soft landing, and whilst in India, we're not yet at the end of the tightening cycle. We think we are closer to the end, maybe one or two rate rises away from the end. It's really growth in those two big emerging economies that helped the global economy continue to move along in this slower 3% to 4% global-growth environment.

That's enough to help Europe start to address its problems, but clearly we're worried if that number moves meaningfully lower.

Glaser: Finally, when you look globally, where you're seeing opportunities today?

Bristow: Well, in the BlackRock International fund in the last few months, we have been changing the composition of our portfolio quite meaningfully actually. We've really been positioned for a low-local-growth environment all year, but I'd say whereas back in May and June we had a small bias to an upside surprise from that core scenario, we've really taken that bias out of the portfolio recently given some of the risks you and I've discussed today.

I guess, there are three main areas there. The first is within the financials sector where I think this is slowing-growth environment really does make it harder for banks to earn their way to a stronger capital position, and we've really reduced holdings in stocks where we see the greatest risks there.

Secondly, we've added further to our exposure to high-yielding, high-quality stocks. So, this is a group of stocks that's done well this year already, but we think valuations in aggregate for his group are not yet stretched. And we've added to positions in the telecom sector, the cable sector, and the food, beverages, and tobacco sector just to name a few. So, yes, investors have been moving toward high-quality stocks, but we think there are still a lot of opportunities there.

Thirdly, though just to emphasize, that doesn't mean that we in BlackRock, an international fund, have been moving our portfolio is really very defensively. Because also the fall in markets has really thrown out what we think are quite interesting quality growth opportunities, as well, such as stocks that have a little bit more cyclicality. So, we've been adding to positions in some for favorite Japanese exporters. We've added in Asian technology. Even some cyclical sectors in Europe like autos and retail are really starting to throw up value opportunities here.

So, it's a mix of opportunities we're seeing, but they're very neutrally positioned now versus both a deceleration in the macro environment or a positive surprise.

Glaser: James, thank you for your insights today.

Bristow: That's very kind. Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.