Consuelo Mack WealthTrack - October 14, 2011
CONSUELO MACK: This week on WealthTrack, Financial Thought Leader Robert Arnott predicted hurricane force winds of deficits, debt, and demographics would hit the economies of Europe and the U.S. Now that they’ve arrived, what can investors do to protect themselves? Research Affiliates Great Investor Rob Arnott is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Things are not what they seem. They are worse! That is the view of this week’s Great Investor guest. For more than two years now, Research Affiliates’ Robert Arnott has been sounding the alarm bells about what he calls the “3-D hurricanes-” deficits, debt and demographics- major headwinds facing America and the rest of the developed world. He says the storms have arrived.
Arnott, a summa cum laude graduate in economics, applied mathematics and computer sciences from the University of California, Santa Barbara, is one of those rare individuals who can reduce complex financial theories and analysis to understandable and practical investment advice. For instance, he recently wrote an essay called “Simple Truisms” to guide long term investors. We will have a link on our website for you. In it, he outlined six economic truths to invest by. Here are two of them:
“Truism: GDP growth is produced mostly by young adults in their 20s and 30s.” Arnott says think emerging markets; whereas an aging population means slower growth, think the U.S. and Europe.
“Truism: earnings and dividends cannot be expected to grow faster than GDP indefinitely…” again think of the slowing economies of the developed world. Arnott’s point: can profits be far behind?
We are delighted that Arnott’s firm Research Affiliates is a sponsor of WealthTrack, but Rob is here on his own merits as a financial innovator and thought leader. Rob has pioneered several portfolio strategies that have gone mainstream including tactical asset allocation. He created one of the first global asset allocation funds using alternative markets with PIMCO. He runs their All Asset and All Asset All Authority funds. At his firm Research Affiliates, he created fundamental indexing, replacing the traditional market cap weightings of stocks in indexes with their economic weighting measured by fundamentals such as sales, dividends, and cash flow. Overall, across multiple asset classes his RAFI Fundamental Indexes have outperformed market cap ones by substantial margins over the last five years.
I began the interview by asking Arnott about his warning on WealthTrack over a year ago, about a possible double dip in the U.S. economy.
ROB ARNOTT: I think we’re probably already in it. I think the economy probably crested in June. The problem is really simple. We have a lot of GDP that’s phony GDP.
CONSUELO MACK: So explain what’s phony about our GDP.
ROB ARNOTT: GDP consists of consumer spending, government spending, capital spending, and net exports. It’s measuring spending not prosperity. So it’s measuring something that is not as important as aggregate prosperity. Now, take a family. Suppose a family measures their GFP, Gross Family Product, and they measure it based on measuring their spending. They make 50 grand. They go out and buy a flash car and borrow 100 grand to do it.
CONSUELO MACK: Those were the old days, right?
ROB ARNOTT: Yeah. But they feel much wealthier. They aren’t. They have a flash car. They have a ton of new debt. They have debt service to face and if two years later they have to sell the car, then they don’t have the car, they still have the debt to service. A nation is very much like a large family and what we have is a country where our deficit is 10% of GDP. That means 10% of our GDP is debt finance consumption; it’s not prosperity.
CONSUELO MACK: So therefore, what do you think is the real GDP? And I don’t mean subtracting inflation. So what do you think the economy, the pace that the economy is running if you took away, as you said, the debt type finance spending that we’re seeing both in the government and in the consumer level?
ROB ARNOTT: Right. Much less so in the consumer level. Consumers have been deleveraging. But if 10% of our GDP is debt financed consumption, you can subtract that and that gives you the underlying structural GDP. Structural GDP is down 11%, maybe 12 from where it was in 2007 per capita and net of inflation and it’s bottom bouncing. It’s barely above where it was at the trough in 2009. You can also subtract all government spending and that shows you the private sector GDP. Private sector GDP is also down 11 to 12% from ’07 and it’s also bottom bouncing near 2009 levels.
CONSUELO MACK: I want to talk about the U.S. stock market because so many Americans are invested in their home market as is the case all around the world. At one point you’ve said, “Don’t buy U.S. stocks because they’re priced as if we will get through this mess unscathed.” So are you still saying, don’t buy U.S. stocks?
ROB ARNOTT: I’m softening that a bit. The market has, in fact, tanked to some extent. The market is reflecting some fears that maybe, maybe some of these challenges are real. And so am I still cautious on equities? Yes.
CONSUELO MACK: And it’s specifically U.S. equities?
ROB ARNOTT: Specifically U.S. equities. Am I cautious on all U.S. equities? Not so much. The value side of the market has been savaged again and is cheap again. The growth side of the market remains very expensive. I was asked recently what my favorite long/short bet would be, and being somebody who doesn’t mind being a little proactive, I said, “Short Apple, buy B of A.”
CONSUELO MACK: That is provocative. And seriously?
ROB ARNOTT: Oh, absolutely.
CONSUELO MACK: Not in jest? This is a serious recommendation?
ROB ARNOTT: No, absolutely. Is B of A a beautifully run company humming on from height to new height? No. Is Apple a shabby company about to fall off a cliff? No, but Apple is currently priced at the number one market capitalization on the planet.
CONSUELO MACK: Right. Bigger than Exxon Mobile.
ROB ARNOTT: So the market is basically saying this company will produce the biggest profit distributions to its shareholders in the decades ahead of any company on the planet. Could that happen? Yes. Is it likely? I don’t think so.
CONSUELO MACK: “Always something to invest in.” That’s what you’ve said many times on WealthTrack and elsewhere. So when you are looking for something to invest in what are your expectations? What do you look for, especially in this new normal environment?
ROB ARNOTT: Sure. What I look for would be yields above historic norms for an asset class.
CONSUELO MACK: For an asset class. So for instance, for stocks that would be?
ROB ARNOTT: If yields are above three, they get to be a lot more interesting than when yields are two. I like to look for investments where the headwinds aren’t going to be drastic. What about emerging economies? Most of them don’t have a problem with a deficit. If they have a deficit, it’s modest. Most of them don’t have lofty debt burdens, there are exceptions, but most don’t. Most of them don’t have a demographic headwind. Quite the contrary. Sweet spot for GDP growth is young adults age 20 to 40. Is that because folks who are past 40, not you, but me. People above 40, are we not contributing to GDP? That’s not it. It’s that our contribution to GDP isn’t growing as fast as it used to. So if you go from teens to twenties, you’re looking at being a consumer of GDP to a contributor. A huge jump. Twenties to thirties. A huge jump. Thirties to forties, a smaller jump. Forties to fifties, smaller jump or for many people a slight down tip. Fifties to sixties, usually a down tip. So the contribution to GDP growth is in the young adults.
What’s happening to our young adult population? It’s shrinking as a share of the population. What’s happening in the emerging economies? It’s soaring. You have a lot of emerging economies where birthrates used to be huge, median age was 18. Half the population, teens are younger and a modest cadre of young adults and a tiny cadre of old adults. Now with falling birthrates, you have a flood of people coming into that young adult sweet spot. So the emerging economies of the world seem to me to be poised to truly emerge in a very significant way in the years ahead.
CONSUELO MACK: And so for a long term investor that demographic trend is something that you think is very important, because that’s going to be a big determiner of GDP growth. What about Africa? I mean, so Africa has a really young population. So is that not there yet?
ROB ARNOTT: That’s not helpful. That’s not helpful. You need the 20 to 40 crowd.
CONSUELO MACK: The twenties. So that’s going to happen in another ten years maybe in Africa?
ROB ARNOTT: Yeah, it’s early for Africa. It’s primetime for most of the emerging economies of the world. So emerging market stocks aren’t cheap, but they have to be part of somebody’s toolkit if they want to think seriously about investing in the coming decades, if we are in a bear market for stocks.
CONSUELO MACK: And you think we are in a bear market for stocks?
ROB ARNOTT: I think we probably are in a U.S. and European bear market. Well, Europe, obviously, but I think we are in a bear market for stocks. I think the next leg is more likely down than up. That will create some pockets of bargains in the U.S., but it will also pull down emerging market stocks, creating some real bargains. Well, that’s interesting. Emerging markets bonds. The G5 is 40% of world GDP. Emerging markets are 40% of world GDP. The G5 has 70% of world debt. Emerging economies have 10% of world debt. So the emerging economies have seven times the debt coverage ratio of the G5 and yet relative yields, the emerging economies have 3.5% higher yield. Why on earth is that? It’s because investors think back to times when the emerging markets debt was big relative to the G5 and the defaults that ensued and they think, oh, I don’t want to be part of that. But who is to say that the G5 is immune from defaults?
CONSUELO MACK: Now we know.
ROB ARNOTT: Either explicit defaults or backdoor defaults through debasing the currency through reigniting the inflation engine. So when I look at that I think, okay, lower debt burden, better debt coverage ratio, higher yield. That’s a more interesting market. And if in the coming decade the spread disappears, you’re going to have a premium yield and capital gains on top of that. Well, that’s interesting. So I look around the world and I see pockets that are mildly to moderately interesting. Commodities have come off quite a bit. They’re now getting kind of interesting. I don’t mean gold.
CONSUELO MACK: And we’ll talk about gold. We always talk about “we”, when I say on WealthTrack, because gold is almost in a separate class of its own.
ROB ARNOTT: Right, right.
CONSUELO MACK: And your view of gold is?
ROB ARNOTT: Gold has three constituencies. There are those who like gold as an inflation hedge. There are those who like it as a hedge against geopolitical shocks. There are those who like it as a hedge against government expropriation of wealth. So all three constituencies are nervous. So all three constituencies are overpaying for their protection. Now, I’m not opposed to those who want to own gold. If it helps you sleep better at night great, go for it. If it’s profitable that will be in a context of the rest of your portfolio not doing so well. So this is an investment where you buy it, A, to sleep better at night, and, B, hoping that it’s unprofitable.
CONSUELO MACK: This is your good friend, Peter Bernstein, of course, called gold an insurance policy against extreme outcomes which is one of the three categories.
ROB ARNOTT: Which is exactly right.
CONSUELO MACK: That you mentioned. And when you think of the last 11 years, the bull market in gold, it certainly has been a terrific investment.
ROB ARNOTT: It’s been awesome.
CONSUELO MACK: Considering that other assets that we mostly invest in, at least stocks, have not done well at all.
ROB ARNOTT: Or as the gold bugs are fond of pointing out, the reciprocal of that is gold has held its value. The dollar, the stock market, the bond market has not. Fiat currencies, currencies that are not backed by anything tangible, that are just pieces of paper that are backed by trust. Trust that they have value.
CONSUELO MACK: Just about all paper currencies right now.
ROB ARNOTT: Right. Fiat currencies have never, ever succeeded on a long-term basis. Now, we’ve had a great run. We’ve had a contractual fiat currency since the gold window was closed in ’71. We’ve had a de facto fiat currency since gold ownership was denied in 1933 by FDR. So we’ve had 40 years or 80 years depending on how you count it. But the gold bugs will point out that the dollar’s purchasing power measured in ounces of gold has gone down 98% since ’71, 99% since ’33. So we’ve lost all but one to two percent of the purchasing power of the dollar during this fiat currency era.
CONSUELO MACK: That’s a pretty compelling argument for gold.
ROB ARNOTT: That’s sobering.
CONSUELO MACK: It is.
ROB ARNOTT: Now of course, gold is very near all time peaks and has outperformed most commodities. So to my way of thinking, an investor thinking about inflation protection would be better served by a basket of currencies.
CONSUELO MACK: A basket of currencies?
ROB ARNOTT: Excuse me, commodities.
CONSUELO MACK: Commodities.
ROB ARNOTT: Basket of commodities. And there are a lot of funds that do track commodity indexes. And that’s one way to deal with that particular risk.
CONSUELO MACK: Looking around the world specifically as far as if you’re looking at countries, for instance. And if you want to be in a currency that you think is going to hold up, I mean, are there any countries that you think are particularly appealing at this point for you as a global investor?
ROB ARNOTT: I think the emerging economies are likely to do very well.
CONSUELO MACK: As a class?
ROB ARNOTT: Right. And I prefer not to drill down to individual countries.
CONSUELO MACK: Right.
ROB ARNOTT: Because I want the diversification of a basket. And so when I look around the world, my inclination is to say I want to invest in assets that can shrug off the impact of inflation. There are a lot of those. It’s not just the TIPS and the commodities, but they’re certainly part of the toolkit. There are emerging market stocks and bonds. There are high yield.
CONSUELO MACK: So high yield dollar denominated bonds?
ROB ARNOTT: Surprisingly, yes.
CONSUELO MACK: Really? Alright.
ROB ARNOTT: Yeah. High yield bonds are a stealth inflation hedge.
CONSUELO MACK: Explain.
ROB ARNOTT: The way it works is very simple. If you get inflation, the debt coverage ratios improve because the real value of the debt is falling. So if the business is growing with inflation and the real value of the debt is falling, debt coverage ratios improve, which means that the spreads can collapse, which means that you have a rich starting yield and capital gains. For that reason, if you go back historically and measure the correlation of high yield bonds with inflation, you find that the correlation is higher than the correlation with TIPS.
CONSUELO MACK: Oh, fascinating.
ROB ARNOTT: So it’s a stealth inflation hedge. In the even of moderate inflation, five to ten percent inflation, it can work beautifully. In the event of hyperinflation it doesn’t, of course.
CONSUELO MACK: And talk to us about TIPS. It’s been One Investment recommendation of yours in the past. You are being dubbed an inflation hawk and is that a fair---
ROB ARNOTT: That’s a fair statement.
CONSUELO MACK: Characterization? Alright. So TIPS?
ROB ARNOTT: TIPS. Expensive, lowest yields that they’ve ever had. You get a negative yield out to ten years. You get a one percent yield if you go all the way out to 30 years. That’s not very impressive. But it’s an insurance policy against renewed inflation and in that context it’s not difficult to imagine scenarios in which it could actually go to lower yields. Let’s suppose we have ten percent inflation three years hence. If that happens what is the T bond yield going to be? It won’t be ten, but it’s going to be a lot higher than 3.25. What’s the TIPS yield going to be if the treasury yield is eight or nine and inflation is ten? It could be minus one, minus two at the long end. So I’m not suggesting that as a likely scenario. I am suggesting that if we get renewed inflation that’s significant, double digit, then the TIPS will be a go-to asset and the buyers won’t care if the TIPS carry a two handle for their yield or a one handle or a zero handle. They’re going to want it because of the contractual link with CPI.
CONSUELO MACK: Right. But your inflation expectations are not double digit?
ROB ARNOTT: Actually, I would give us 50-50 odds or a bit better than 50-50 odds that we’ll see double digit sometime in the next ten years. I think the temptation to debase the currency and reduce the real value of the debt will be politically overwhelming.
CONSUELO MACK: Rob, One Investment for a long term diversified portfolio. What is your choice today?
ROB ARNOTT: My choice today would be fundamental index for emerging markets stocks, if you’re a buy and hold investor planning to hold it at least five years; if you’re a shorter term investor, look for buying opportunities and average in over the next two or three years. The reason I say that is that fundamental index has a value tilt. It pushes you more heavily into the out of favor deep value companies. With emerging markets what we find is that emerging market stocks, cap weighted, have produced slightly better returns over the last 15 years than the developed economies. Okay. You could have had a higher return with emerging markets cash.
CONSUELO MACK: Cash being?
ROB ARNOTT: Emerging markets short maturity government debt.
CONSUELO MACK: Really?
ROB ARNOTT: And so emerging markets cash investments for the last 15 years had a higher return than emerging market stocks. Well, what’s going on there? It’s that cap weighting pulls the return down by concentrating you in the two or three companies in each country that are most well politically connected, most beloved, most well known globally, and most extravagantly expensive.
CONSUELO MACK: And the biggest market cap.
ROB ARNOTT: The fundamental index weights you into companies according to the size of the business and so it takes out of favor value companies and weights them with a nice, solid weight. If they’re out of favor and come back into favor they do awfully well. So I look on deep value emerging markets as the best opportunity for a long term investor, but I do view it as an averaging in opportunity from today.
CONSUELO MACK: So you personally, are you investing in stocks right now?
ROB ARNOTT: Indirectly in modest ways. I have 100% of my personal pension in PIMCO’s All Asset All Authority Fund. So when that fund is investing--
CONSUELO MACK: Your fund.
ROB ARNOTT: Yeah.
CONSUELO MACK: Right.
ROB ARNOTT: When that fund is investing in emerging markets stocks, I’m investing in emerging market stocks. And broadly today, we’re looking at a toolkit where most things are expensive. Yields are too low across the board on a whole sweep of asset classes so it’s a great time to hunker down and have a defensive posture, have broad diversification to tamp down our risk, use that broader toolkit to pick out individual categories that might be priced off for superior returns, and to play the game that Buffett described in his twenties. He said, “The way to succeed in investing is pretty simple. Be greedy when others are terrified, be terrified when others are greedy.” When were people last terrified? Two and a half years ago. Where are they now? They’re edgy.
CONSUELO MACK: They’re getting there.
ROB ARNOTT: They’re nervous. They’re not terrified. Where were they six months ago? Don’t want to miss that last leg of the bull market. And so that’s a perfect environment for taking risk off the table. Two and a half years ago was a wonderful environment for ramping up risk aggressively. Today we’re in between those two, closer to the peak than the trough. So I look on today’s markets as a great time to start taking a little bit of risk here and there, but mostly remain very defensive.
CONSUELO MACK: Rob Arnott, Research Affiliates, financial thought leader. It is always such a treat to have you on WealthTrack. Thank you so much for doing this.
ROB ARNOTT: Thank you very, very much.
CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point: Consider the PIMCO All Asset All Authority Fund, run by this week’s guest, Rob Arnott. As Morningstar puts it the “PIMCO All Asset All Authority Fund eats market declines for breakfast.” By investing in a number of PIMCO funds, across multiple asset classes in all parts of the world, plus having the ability to go short, Arnott has managed to beat the markets and protect shareholders against market declines since the fund’s inception in late 2003. Two other pluses- it’s nearly 7% yield and Arnott has invested 100% of his pension money in the fund. That’s a reassuring commitment.
Next week on WealthTrack, we are going to have a rare double interview with bond powerhouse PIMCO’s two investment gurus, Bill Gross and Mohamed El-Erian, together from PIMCO headquarters in Newport Beach, California. For those of you who want to see our WealthTrack interviews ahead of the pack, including an extended interview with Bill and Mohamed next week, we have a new opportunity for you. Subscribers can now see our program 48 hours in advance on our website along with timely interviews exclusive to WealthTrack web subscribers. To sign up- go to our website, wealthtrack.com. Thanks for watching and make the week ahead a profitable and a productive one.
