Steve Forbes Interview: Fundamental Index Pioneer Rob Arnott (2) ~ MAKE MONEY BLOG$

Buy U.S. Treasurys?

Forbes: Would you buy U.S. Treasury bonds?

Arnott: Short term tactical play, yes. I think any time you have a crisis there’s a flight to safety. And whether we’re AAA or AA, we’re still the safe haven for a flight to safety. On a long-term basis I’m deeply alarmed at what’s going on. Washington seems singularly fixated on the debt limit. That’s the wrong thing to focus on. AAA versus AA matters hugely more long-term. Because how can we be the world’s reserve currency with a AA?

The Three Ds and the Third Pillar

Forbes: This gets to how you allocate assets – the old rule of thumb. Jack Bogle and others use it. If you’re 60, 60% bonds; if you’re 30, 30%, give or take. You say there’s a third element. You say in addition to stocks and bonds, there’s a third pillar we have to be aware of in this environment. Explain your third pillar and the three Ds.

Arnott: Sure. Well, let’s start with the three Ds. The three Ds are deficit, debt, and demographics. We wrote a white paper entitled The 3-D Hurricane. Deficits are 11% of GDP this year, but that’s based on phony accounting. If you add in off balance sheet spending; if you add in GSEs, which are now backed by full faith in credit; if you add in net new unfunded social security and Medicare, collectively we’re approaching 20% of GDP.

Okay. Well, if our deficit is bigger than it seems then maybe our debt is bigger than it seems, and indeed it is. National debt is poised across 100% of GDP this fall, probably within weeks of the debt limit rising, and so that’s bad.

Reinhart and Rogoff said that there’s a line of demarcation above 90% of GDP countries do not recover. Okay, we’re at 100%. Add in the GSEs, add in state and local debt, it’s legitimate public debt, and you’re at 170%. Add in un-funded social security and Medicare, you’re at 450%. Add in un-funded Medicaid and you’re north of 550%. If we owe or have committed to future spending five times what we produce as a nation, that’s an untenable position.

What must change will change, and of course what that means is that the softer parts of the debt, the social security and Medicare, must go away – at least in the form that we’re accustomed to thinking of it. So the 3-D Hurricane is very big and it has profound impact on where we’re going to be ten years from now.

Now, what does that mean for the classic 60/40 investor or the classic age-based, stock-bond blend investor? Well, we know stocks are brilliant in a disinflationary economic expansion. We know bonds are brilliant in a disinflationary economic contraction. So the balanced portfolio is great in a disinflationary world. We’ve had that for the last 30 years. We’ve gone from double digit inflation to low single digit. What if you’re not in a disinflationary world? What if we turn to monetizing our debt, debasing our currency, reducing the real value of our debt through inflation in the years ahead?

Forbes: Can’t you just buy gold?

Arnott: Gold produces no income. If it helps people sleep better at night to have a tin Krugerrands buried in the back yard, go for it. As an investment – to the extent that I have any gold, which is very limited – it’s an investment that I hope I never make money on.

But the third pillar is really simple. Don’t you need something in your portfolio that can serve you well in a reflationary world? Don’t you need some diversification away from mainstream stock and bond risk? Don’t you need a wider tool kit to position your portfolio tactically to take advantage of market opportunities around the world? It seems to me that building your portfolio on two pillars, stocks to participate in macroeconomic growth, bonds to provide sensible income and down your portfolio volatility, those are two pillars that crumble in a reflationary world.

Forbes: So give us the five things of you that make five parts of your third pillar.

Arnott: Well, TIPS are an obvious choice, the inflation-linked bonds. Commodities are an obvious choice. Emerging market stocks and bonds, less obvious, but it’s a diversification away from the dollar and into assets that are lightly correlated with U.S. stocks and bonds. Okay, that’s pretty interesting.

Forbes: Well, in terms of emerging markets, everyone’s talking about them. Is there a bubble there?

Arnott: I don’t think so.

Forbes: Emerging markets encompass everything from Russia, Brazil –

Arnott: Yeah. The notion of trading emerging markets as a unified entity doesn’t make a lot of sense. The BRICs: Brazil, Russia, India, China. Three of them even share a border, and yet any two of them are more different than any two developed economies in the world.

And so treating them as one entity is dangerous. But today we’re in a world where the emerging markets are a fringe component for most investors and as such, for now you can comfortably view them as one diversification. Now, emerging markets stocks are priced at premium multiples to Europe and discounted multiples relative to the U.S. Okay, but they don’t have a 3-D Hurricane. Their deficits are under control, their debt is manageable. Now, there are exceptions, obviously and their demographics are relatively benign compared with U.S., Japan and Western Europe.

So shouldn’t they be priced at a premium? Perhaps. Same thing on the bond side. They have higher yields, about 3% higher than the G5, and their debt-coverage ratios, the ratio of aggregate to GDP, is one seventh as large as the aggregate debt-to-GDP for the G5.

Forbes: So Indonesia’s better than Germany?

Arnott: I would actually go so far as to say that could very well be true. Very speculative to say that.

Forbes: In addition to that, France or Italy?

Arnott: Germany is seen as the safe bastion in Europe. Germany’s demographics are awful and Germany’s debt burden is much higher than most people think, especially if you add in the pay-as-you-go entitlement programs. So Germany’s debt burden is not benign, and their demographics are assuredly not benign.

Forbes: Now, in terms of another part of your pillar, is high-yield bonds.

Arnott: That’s a provocative one.

Why High Yield Bonds Are Better Than TIPS During Inflation

Forbes: Which are utterly counter-intuitive in the sense that if you have inflation, if you have a sluggish economy – sluggish economy means junk companies really get in trouble and high inflation means even the junk yield today will look like a triple-A tomorrow.

Arnott: Right. Here’s the startling fact: High-yield bonds, junk bonds, have a higher correlation with CPI [Consumer Price Index] than TIPS do. Hardly anyone in the investment community has noticed that. There’s a higher correlation to CPI than TIPS. Why? Because when inflation comes into the picture, the high-yield bond issuers, their debt is diminishing in real terms.

The debt coverage ratios improve, the quality spreads narrow, so you get a rich starting yield and capital gains on top of that rich starting yield as the spreads collapse. It’s very useful in an inflationary regime. It does not help you in a hyper inflationary regime, so it depends on the magnitude of the inflation. If we come into 5% inflation, high-yield bonds are going to have served us very well.

Forbes: Even at today’s yields?

Arnott: At today’s yields relative to other bonds, yes.

Forbes: So they won’t take as much of a hit is what you’re saying?

Arnott: Right. Now, I do think that we face very high odds of a double dip. And in a double dip, the buying opportunity for high-yield is probably six to 12 months out, not right now. So I don’t not think buying high-yield right now is a bargain. Tactically you might want to be underweight.

But having it in your tool kit, having it as something that you are happy, indeed eager, to use when it’s cheap? Boy, then you pile in when people are scared. It’s the old Warren Buffet adage early in his career. The way to succeed in investing is to be greedy when others are terrified and terrified when others are greedy. When were people last terrified? Two and a half years ago. When was the last time the risk on trade was massively profitable? Two and a half years ago. When was the expression “risk on” invented? A year after it was useful.

Forbes: So we’ve mentioned four. Are there any parts of your third pillar? You’ve got TIPS, inflation-linked bonds, commodities, emerging market bonds and stocks.

Arnott: Stocks and bonds.

Forbes: And high yield bonds.

Arnott: I would say real estate and REITs would be another right now.

Forbes: Even though REITs have done so well since March of 2009?

Arnott: Again, there’s a difference between viewing it as a key part of our tool kit and viewing it as a tactical choice today. I would say that real estate and REITs are likely to disappoint in the coming year. I think that we have a manipulated real estate market with all of these government interventions that is propping things up artificially.

And until the market has a chance to clear, until the foreclosures have a chance to be sold, until the upside down owners have a chance to get out and move on, that market is not going to recover. But when it does, again, you want it in your tool kit. You want to be willing to use it in size. Most people aren’t. Most people would think, “A 5% allocation to REITs? Wow.” What about a 20% allocation if they’re cheap?

How Much In The Third Pillar?

Forbes: So on the third pillar, you’ve been quoted as saying it should be anywhere from 20% to 50% of your portfolio.

Arnott: I think that hinges on the individual investor. If an investor is sanguine about our ability to build on the recent recovery and the ability of that recovery to gain organic traction and to see the animal spirits of the private sector rise up, then you don’t worry too much about inflation and maybe that third pillar is a 10% to 20% allocation that is merely an insurance policy against, “What if you’re wrong?”

If you’re as concerned as I am about the potential for seeking to monetize the debt, the potential for the debt burden to get out of hand, the potential for economic weakness to lead to lower valuations for stocks, then maybe this should be the biggest of your three pillars, 40% or 50%. It depends on the investor. But it’s hard for me to imagine any investor who should have as little in the third pillar as the average investor does, which is 0% to a few percent. It doesn’t make sense to have so little diversified away from mainstream stocks and bonds.

Forbes: Still riding motorcycles?

Arnott: I do. Less often than I used to, slower than I used to. But I still love it.

Forbes: Terrific. Rob, thank you.

Arnott: Thank you very much. I enjoyed this.

Source: forbes.com

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