Rob Arnott: Tried and True Strategies (Transcript)

ROB ARNOTT: No, no. The seeds that delivered that crop, the global financial crisis, there’s more of those seeds than ever. They’re bigger than ever.

CONSUELO MACK: So Rob, what are the bigger seeds that have been planted that you think we’re going to have to face at some point?

ROB ARNOTT: Last fall we wrote a piece entitled “the 3-D hurricane.” It talked about deficit, debt and demographics. We’re spending more than we produce as nation, which is leading to a buildup of debt to be paid for by whom, a shrinking population of workforce as a percentage of the population. So how bad are each of these problems? Deficit: 10% of GDP last year. There are those who say, don’t worry about it. It’s a one-off. We have a global financial crisis; we need to spend this money to spend our way out of this mess. I could almost buy that if I believed that it was a one-off. Simple fact is that the 10% was tip of the iceberg. The accounting that got us there would have made Enron execs blush. You have off-balance sheet spending, that’s the pre-funding of social security and Medicare trust funds and a few other items. They’re off balance sheet, but they’re prefunding future obligations. They are legitimate spending. That takes you to 14% of GDP. You have the GSEs, government-sponsored entities: Fannie Mae, Freddie Mac and several others. Those take us to 17% of GDP. They’re now backed by full faith and credit of the U.S. government.

CONSUELO MACK: So there are obligations.

ROB ARNOTT: They are our obligations. A year and a half ago at midst of the financial crisis, the government said we’ll backstop these organizations. We’ll backstop them to a limit of $200 billion. February, they lifted that limit and said, no, backstop to an unlimited extent, infinite extent all by full faith and credit of the U.S. government. And oh, by the way, one of the provisions of the bill, this will not be counted as part of the national debt.

CONSUELO MACK: And they’re underwriting the entire mortgage market right now, right?

ROB ARNOTT: Corporate execs would go to jail for that, but if you write the laws, you don’t. That took us to 17% of GDP as a deficit. Then there’s unfunded social security and Medicare. We’re getting older, there’s more people, the debts are growing. That takes us to 18%. The average of the last quarter century officially has been 2.5% of GDP; unofficially with correct gap accounting, it’s been just under 10% of GDP per annum per quarter century. So this 10% deficit is not abnormal at all. We have a government and a society addicted to debt-financed consumption. That leads to the debt level. The debt level for the national debt officially is approaching 90%. That doesn’t include state and local and it doesn’t include GSEs.

CONSUELO MACK: 90% of total output.

ROB ARNOTT: Of GDP. And if you include state and local and GSEs, you’re now up to 143%. Greece, as the crisis has been blowing up there, has been in the 120% range. We’re above 140%. If you add in the unfunded portion of social security and Medicare, we’re at 420% of GDP. The corporate debt is 320%. Household debt is 100% of GDP. Combined private debt is another 420%, the largest in the world. So we have aggregate debt and unfunded future obligations eight times our annual income. If you borrowed eight times your annual income, how comfortable would you feel about your ability to service that debt in the years ahead?

CONSUELO MACK: So what do you do with that information? I mean, how does it change your view, number one, of the U.S. stock market and bond market and certainly government debt market? And how do you adjust to that as an investor so that that doesn’t destroy you?

ROB ARNOTT: Well, we’ve been talking about a lot of depressing stuff. The not-so-depressing part is that there’s always something interesting to invest in, always. The aggregate size of our debt I think almost guarantees some inflationary burst that will be daunting sooner and larger than we expect in the years ahead. I think we’ll see at least one major inflationary shock in the coming decade, two or three in the next 20 years. And by major, I do mean double-digit. I’m hoping I don’t mean hyperinflation, but I don’t think it’s impossible. The inflationary shocks mean preposition your portfolio for inflation.

CONSUELO MACK: Now?

ROB ARNOTT: Do it before inflation becomes obvious because inflation protection, protecting against anything, insuring anything is cheapest when people don’t expect it. Buy auto insurance when you have a clean record. The notion of buying tips, inflation-linked government bonds, they’re currently priced at a level that suggests 2.5% lower yield than corresponding government bonds. Okay, 2.5% means that if inflation averages over 2.5% over the next 20 years, you’re better off in TIPS. Okay, so that’s your defensive reserve.

CONSUELO MACK: Sounds like a pretty good bet.

ROB ARNOTT: It’s a pretty good bet. I think the likelihood of us managing the next 20 years with 2.5% inflation is somewhere between slim to none. Commodities, when they have their occasional 20% and 30% drops, use them, buy them. I don’t think commodities are cheap right now. I think they will be in the next recession, which I don’t think is that far off. So I think if there’s a second dip to this recession in the coming year or two, and I think there will be, that will create a buying opportunity.

CONSUELO MACK: Why do you think there is going to be a double dip?

ROB ARNOTT: Two things. Firstly, to outward appearance, the economy seems to be rebounding. It’s not showing up in the tax figures. Government tax receipts year to date are about 6% below where they were year to date in ‘09 at this time. 6% down and this is a recovery? If taxes are down, then doesn’t that mean incomes are down? If incomes are down, doesn’t that mean that we don’t really have a strong recovery yet? The recovery seems to be mostly restocking inventory, not actual demand for product.
The second big issue is taxes. Taxes will go up at the end of the year if for no other reason than the Bush tax cuts lapsing. The path of least resistance for Congress is to do nothing. It’s always the path of least resistance, and to do nothing means taxes go up 2% of GDP in one fell swoop; history suggests a three-to-one multiplier, that 1% higher taxes means 3% smaller GDP. So 2% higher means six. 6% drop in GDP, that’s a recession.

CONSUELO MACK: You created the first global asset allocation product that makes active use of alternative markets beyond stocks, bonds, and cash- I was reading from your website, which was launched at PIMCO initially So an all-asset fund that is broadly diversified across all different alternative asset classes. What are the kinds of alternative asset classes that we all should be invested in, and why is it so important to be that broadly diversified?