Seek Value Stock by Stock, Not Region by Region

Neel Kashkari: Thanks for having me. It's great to be here.

Stipp: So, you had a, I would call it, a ringside seat for the financial crisis. You had a major role in helping to craft the response and manage the response to that crisis. Today at Morningstar, you said that the U.S. economy, you likened it to a patient that was saved from a heart attack, but is still on the gurney. When you pick up the medical chart for the U.S. economy right now, what do you see?

Kashkari: We see a long hard adjustment period. It is several more years of private sector deleveraging, consumers are paying down their debt, but they've got a long way to go. Corporations have largely paid down their debt, but the U.S. government is still ballooning their debt.

And so, this is debt-induced crisis, a debt-induced heart attack, and until we get to a more sustainable debt level, we're not going to see the U.S. economy growing at the kind of levels that we've been used to. So, it's a multi-year painful adjustment.

Stipp: So, given that we're still basically in the sick ward, what are some of the implications? What should we expect during this recovery period, while this deleveraging is going on?

Kashkari: So, low economic growth, low asset price returns than we have been used to, much lower. Stronger growth abroad in the emerging markets. We talk about at PIMCO a multispeed world, with the developed world growing very slowly, if at all, and the emerging markets growing more quickly. So, we think, for investors, you should be positioned globally to take advantage of what these growth dynamics are offering.

Stipp: So, I want to talk to you a bit about the growth. So we do see a lot of the fundamentals especially in the emerging markets are better than the U.S., but at the same time we also know that economics doesn't necessarily guarantee that you'll see those investment results--valuation is a big piece of it.

So, when you're looking at valuations overseas given that the fundamentals are stronger, is that priced in already or do we still expect to see that valuations have a lot of upside given that fundamental strength?

Kashkari: We think it depends on a stock-by-stock basis. So, you're right. Take Brazil as an example. We think Brazil is a very attractive country. Low debt levels at the country level. Healthy economic growth, positive real interest rates, robust political system. But we think their stocks are not attractively valued today because a lot of that is already priced in.

So, we go all around the world company by company, stock by stock, evaluating that stock in the context of the economic environment that it's operating in. In our view, you have to get both of those factors right to be successful in managing global equity portfolios.

Stipp: So, it sounds like you're saying, it's not as simple as just investing in the emerging markets. You really have to have more active management in those areas to uncover where those opportunities exist?

Kashkari: Absolutely, and to be able to manage downside risk, right? In this "new normal" environment, in this multispeed world of heightened volatility, heightened volatility is here to stay. Emerging markets have always been volatile. Now you're adding on top of that European volatility, U.S. volatility, those are amplifying one another.

So, getting the company analysis right is important, getting the macro factors right is important, and managing downside risk is important. Those are the three legs of the stool.

Stipp: You mentioned Europe there in your response, and you also mentioned in the presentation today that the news out of Europe is just swinging the markets around day-by-day, that everything is focused on that macro environment.

As you're looking at Europe and the potential risk that could come out of it, it's still an unfolding story. What are you seeing? How are you managing around all the uncertainty there?

Kashkari: Well, a few things we're doing. One is, we're avoiding certain countries. We're avoiding the peripherals--Greece, Portugal, Ireland--because we don't know when and how they ultimately be resolved. We feel very confident that Greece will restructure. We don't know if it's going to be orderly or disorderly. We don't know if it's going to be tomorrow, next week, next month or next year, and so we just are avoiding those, first of all.

Second of all, we are also looking at how are individual companies exposed to Europe? Are they directly selling into Europe? Do they own European debt? Or are they just exposed to the global economy?

Europe is a huge trading partner for the U.S. If Europe goes through a disorderly restructuring or a dissolution of the eurozone, that will have profound implications for the U.S. economy and would certainly tip the U.S. economy back into recession.

So, we are paying a lot of attention to what's happening in Europe. We are also paying a lot of attention to what's happening, or not happening, in Washington. Those are two huge drivers that are whipsawing the markets today.

Stipp: So you mentioned as you're looking out there some things that you might avoid. Where are you finding opportunity? Where are you thinking that right now is a good place to put money to work globally?

Kashkari: Well, again, we're not putting money to work in stocks based on regions. We're not saying let's go buy China. We are finding individual companies in China. We are finding some individual companies in Russia. So, in China, AIA is an insurance company, a large insurance company, that's selling to the growing middle classes in Asia. It's an industry leader. It's well-known. We think it's well positioned for strong growth going forward.

In Russia, SpareBank is their largest depository, again well-positioned for organic growth in the Russian marketplace.

So, many times in the emerging markets, we're finding champions, the industry champions that are best positioned to take advantage of their own domestic organic growth. So in many cases, those are the companies we are buying.

Stipp: Meanwhile, given that economic and macro environments can swing stocks around and can lead to crises, you're managing that as well through the tail-risk management that you are doing?

Kashkari: Absolutely. So ... to manage downside risk, we want to buy stocks at an attractive price. We generally are buying higher-quality companies, and we are at the portfolio level buying active tail-risk hedging to ensure the portfolios against catastrophic events, major tail-risk events, which, frankly, seem to be happening more often these days, and they are less tail-risk events and more part of the normal environment that we are operating in.

Stipp: So speaking of tail-risk events, I want to bring the discussion back and close by touching on the U.S. policy responses that we've seen and the risks that still might be there.

So, we have seen several stimulus packages coming out, but we still are seeing very slow growth. We are seeing very slow improvement in the job market. You spoke a bit about policy responses today. Can you talk a little bit about why some of the policy responses haven't had the impact that we would have hoped, and what we need to do potentially on the policy front to get some improvement?

Kashkari: Sure. The policy responses today: fiscal stimulus, Cash for Clunkers, homebuyer tax credits, quantitative easing 1, quantitative easing 2 have all been short-term cyclical responses that would have been effective if we had a cyclical recession, which is a temporary reduction in demand. We have a multiyear, major realignment, reduction in private-sector consumption, paying down debt. There is no amount of short-term government stimulus that can make up for a five- or 10-year reduction in private sector demand.

So, instead of short-term stimulative policies that have not worked, we should be focused on long-term pro-growth structural reforms that make the economy more competitive, that make us grow faster by investing in our economy. So, pro-growth tax reform, investing in infrastructure, investing in education--these types of things can make the economic capacity of the U.S. grow and become larger and more competitive globally.

Stipp: What about on the liability side and trying to manage the debt that we have? What do you think policy can do to help us there?

Kashkari: I think it can do a lot. I think that if the super committee were actually to get its act together and pass major reforms to get the U.S.'s fiscal balance, bring it back, in the medium term, and give investors confidence that our political system is functioning, that would be a real boost for risk-taking and give businesses confidence.

Right now, the debt situation is so messed up, it is giving people a lack of confidence in the U.S. political process. We need to regain that confidence, so we can actually make tough choices. If we can regain that confidence, businesses who have a lot of cash to invest, I think will step back in and start making investments.

Stipp: Neel Kashkari, some very compelling insights. Thanks for sitting down today and offering us your forecast and your analysis on the markets and economy today.

Kashkari: Thanks for having me. It's been great to be here.

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