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U.S. Downgrade Making Euro Crisis Harder to Solve

Fidelity's William Kennedy believes that fears of a debt downgrade are behind European leaders' timid response to the sovereign crisis.


Christopher Davis: Hello. I'm Christopher Davis. I'm a senior mutual fund analyst with Morningstar and editor of Morningstar's Fidelity Funds newsletter. Today, we're joined by Bill Kennedy, the longtime and successful manager of Fidelity International Discovery fund.

Thanks for joining us, Bill.

William Kennedy: Thank you for having me.

Davis: In recent weeks, we have seen fears surrounding the European debt crisis spread. Discussions always surrounded sort of the usual suspects such as Greece, Spain, and Portugal. But more recently investors have worried Italy, even France, might be joining the fray as troubled countries.

This week, on Wednesday, German chancellor, Angela Merkel and the president of France, Nicolas Sarkozy, got together. They hatched the deal that would allow for more integrated Europe, but from a fiscal situation the market really wasn't impressed. Bill, what's your take?

Kennedy: Well, my take is that a lot of the things put out by the governments in Europe, Sarkozy and Merkel, in particular, were little bit vague in nature. The challenge is facing a lot of European countries that need aggressive policymakers making aggressive policy decisions. Merkel's reluctance to issue euro bonds has been troubling for the markets, and really the nature of the European Central Bank, in general, is quite constrained in what it can do to deal with the problem.

So, you have government officials that have not been as aggressive as they should, and you have an ECB that doesn't have the flexibility necessary to offset some of the policy and decisions that are coming out of the eurozone right now.

Davis: I know, Bill, you've been very skeptical of European banks for a long while now, and I can't imagine your skepticism is ebbing. But are there banks out there that investors are just painting with the same brush, that they're painting the more troubled financial institutions in Europe?

Kennedy: Yeah, of course. I mean, if you look at the Nordic banks, for instance, the Nordic countries have great sovereigns; they are in great sovereign situations. You look at the wealth and the fiscal situation of Norway and of Sweden, these countries have really repaired themselves during the last 20 years, since they had a crisis back in the early '90s. Norway, for instance, is blessed with lot of oil, so that country has a very, very strong fiscal situation.

However, the Nordic and the Swedish banks have significantly underperformed major European indexes and global indexes, as a result of the fact that they are banks and they are in Europe. However, they tend to trade at big discounts to where they have historically, and the fundamentals in general tend to be pretty good because those economies have been in pretty good shape. The big issue for them is they have to wholesale fund themselves and the wholesale funding markets in Europe are drying up pretty quickly, given the sovereign crisis further in Southern European countries.

Davis: I know, Bill, you've been able to somewhat escape from European financials by investing in industrial companies, such as BMW and luxury-goods makers, and these companies benefit from global growth, especially in emerging markets such as China. With growth slowing in China and elsewhere really does this leg in the stool kind of fall away, as well?


Kennedy: I mean, we are seeing growth slow a little bit in China, but consumption still remains pretty robust and those markets tend to be consumption stories. One of the reasons for growth slowing in China is just due to the government trying to quiet the property market down a little bit. But incomes in China are still growing comfortably in the double digits. They are buying more cars, and they are buying more luxury goods.

So, short term some of these issues may affect some of the big exporters in Europe, but the reality of it is that the consumer still remains fairly strong in big countries like China and the rest of Asia for that matter.

Davis: I know, Bill, you mainly are looking at international markets as part of your daily work ,but you certainly have a great understanding of what's going on in the United States. What's your understanding and your expectation for the impact the events in Europe will have on the U.S. and U.S. markets?

Kennedy: I think they are very related. I think it heightens the sovereign issue; the sovereign problem is an issue all over the world. We've seen clearly Japan has had a sovereign problem for quite a long time, and now United States and Europe have similar problems. How are they related? The situation in Europe is certainly affecting the situation in the United States with regard to just overall levels of confidence seen with global investors.

If you put a balance sheet of a European country in line with that of the U.S., they tend to look similar and they are going to similar direction. In other words, you see a heavy indebtedness coupled with governments that continue to borrow way too much money.

The encouraging thing in Europe, if you look at place like in the United Kingdom where I live, the government has been very aggressive in terms of trying to reduce the budget deficits. As for other places where austerity measures are starting to take place, even in Southern Europe, hopefully we will start to see at least the spirit of those taking place in the United States.

I think one of the big issues affecting Europe is the downgrade of the United States because it's quite clear that with the downgrade of the U.S. debt recently, a lot of European leaders are looking across the Atlantic Ocean and saying, "Wow, we really do not want to be in that situation." So, that's why you have France and Germany, in particular, very reluctant to put more money aggressively to build the European stability fund or to put more money into the ECB just because they don't want to stretch their own balance sheets. So, all of these are very, very related with one another.

Davis: I guess, one of the risks of austerity, though, is that it could damp economic growth. I know in the U.K., economic growth has been pretty sluggish, and I know that prime minister David Cameron's budget is just beginning to be implemented. So the real pain hasn't even been seen yet. So, I guess, there is a certain balance there that has to be achieved, and the European stability fund seems to be a necessity to some extent, as well.

Kennedy: That is correct, yes. You need a good mix of austerity with some monetary stimulus, and that's why in the U.K. they are talking about potentially doing some type of new quantitative easing given the growth numbers that they saw. But the reality of it is that these countries really do have to go through a long period of austerity in order to balance their books because the books are right now in a state of disarray. In order for them to have more sustainable growth in the future they are going to need to start cutting expenditures and/or start raising taxes.

Davis: One of Warren Buffett's very famous pieces of advices to investors is that they shouldn't spend a lot of time thinking about big-picture macroeconomic concerns because it's mostly a waste of time. And I think we've seen in recent years, macroeconomic issues have loomed large and really have driven the markets both in the U.S. and Europe. You are a bottom-up stock-picker, and you look at things company-by-company. What's your advice to investors as to how they can navigate the markets and look at investments from a fundamental perspective but still be able to keep this big-picture environment in mind?

Kennedy: I think it's important to keep the big-picture environment in mind because clearly a lot of what's happening on the sovereign front in Europe and the United States is clearly creating a lot of volatility in markets. However, at the end of the day it's all about picking stocks and just finding good companies with good business models that are going to be able to grow, despite any economic environment.

However, one needs to be aware of what's happening around them because that will create inevitable volatilities but also will create opportunities for investors as good companies get beaten up excessively.

Davis: Well, Bill, thank you very much for your time.

Kennedy: You are certainly welcome. Thank you very much for listening.

Davis. I am Christopher Davis with

Christopher Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.