Five money moves one inflation hawk is making now

Expert Robert Arnott see the "perfect storm" coming of deficits, debt and demographics that are surely to hurt the US economy. His big question is "Who pays this debt?" referring the large and ever increasing debt that the US economy currently hold with no way of solving it.

June 23, 2011, 12:56 p.m. EDT
By Jonathan Burton
MarketWatch

SAN FRANCISCO (MarketWatch) — QE2 is steaming into port, and Capt. Bernanke is about to broadside the S.S. United States.

That’s the view of Robert Arnott, an influential voice in the study of portfolio asset allocation, indexing and risk management, and founder of Research Affiliates, a Newport Beach, Calif.-based investment management firm.

Arnott hasn’t always been so pessimistic about the future of the U.S. economy, but nowadays he sees the dark clouds of what he calls a “3-D Hurricane” — a perfect storm of deficits, debt and demographics that Arnott said creates “serious headwinds for investors in the years ahead.”

For starters, the U.S. budget deficit is much bigger than it appears, Arnott said. When obligations for Social Security, Medicare and Medicaid are counted, the already-bloated deficit balloons. Add in state and local debt, and the national overhang exceeds 500% of U.S. GDP, Arnott said. “Think about what you made last year, multiply by five, and that’s your personal share of the national debt,” he noted.

The question, Arnott said, is who pays this debt? That becomes a demographic problem for the U.S. “Our population is aging and our working age cadre will be shrinking as a percentage of the population,” he explained.

With more retirees and fewer workers, the economy will slow, Arnott said. Declining GDP growth will pressure corporate earnings and dividend growth. Meanwhile, Arnott said, if the U.S. has trouble paying its bills, policymakers may decide to reduce the value of the debt by printing more and more money, debasing the U.S. dollar and spiking inflation.

“If we turn to the printing press as the way to reduce the value of our debt, which I think we probably will, that creates inflation risk,” he said.

“I don’t want to be seen as a prophet of doom,” Arnott added. “What I’ve described is a doomsday scenario if we harbor the illusion that we can spend the way we’ve been spending.”

With that in mind, Arnott favors investment strategies that fall outside the mainstream now, but which he said could become increasingly common if Washington tries to inflate its way out of debt:

1. Dump traditional asset allocation

Conventional advice holds that an individual investor with many years until retirement is best served with a portfolio of 60% stocks and 40% bonds. This all-purpose mix offers long-term upside from equities plus income and risk-control from less-volatile bonds.

Where this advice is lacking is in protecting investors against inflation, Arnott said. And given his sober prognosis for the developed world’s economic health, it should come as no surprise that Arnott is warning investors away from tried-and-true portfolio standards.

“The classic 60/40 is not a good place to be for the next 10 to 20 years,” he said. Investment portfolios, he said, need a “third pillar” to protect against inflation and to diversify mainstream stock and bond exposure.

What is that third category? “Assets that can serve well in a reflationary world,” Arnott said. That means lightening up on traditional stocks, starting with growth stocks, he added, because they’re the most expensive, and putting money into assets that can withstand high inflation.

“If I’m wrong, then the classic 60/40 will serve investors fine and the inflation segment will probably neither help nor hurt,” Arnott said. “If I’m right, the inflation segment of the portfolio may be the safest part of the portfolio.”

2. Buy inflation-linked bonds

Benchmark 30-year Treasury Inflation-Protected Securities (TIPS) recently sported an inflation-adjusted 1.8% yield, about equal to the average real yield (after inflation) on long U.S. government bonds for the past 100 years, Arnott said. That’s not a great yield, he added, but it’s “decent.”

Yet decency in the face of aggressive inflation is exactly the role TIPS play, Arnott said. TIPS “serve you reasonably well but unimpressively,” he noted. These bonds are tied to the U.S. inflation rate, as measured by the Consumer Price Index for All Urban Consumers (CPI-U). “It is a safe haven for your portfolio if inflation reignites,” Arnott said.

3. Stock up on commodities

Even investors who can appreciate commodities as both an inflation hedge and a long-term global investment theme are put off by the volatility and speculation of this asset class.

But if you hold commodities to cushion against inflation shocks — unexpected bouts of inflation — then the investment takes a more sophisticated role in your portfolio, Arnott points out.

The key for investors here is inflation “shock” as opposed to “expectation.” Commodity futures already reflect inflation expectations, Arnott said. Accordingly, when expectations dim, as they have recently, commodity prices decline. “That creates a buying opportunity” for investors to obtain inflation insurance on the cheap, Arnott added.

“Commodities are coverage for inflation surprise,” he said. “It’s something a lot of people don’t understand.”

As an investment vehicle, the Dow Jones UBS Commodity Index appeals to Arnott because, he said, it’s more broadly diversified and less sensitive to oil prices than other commodity indexes. Though Arnott didn’t mention it, exchange-traded products that benchmark against this index include iPath Dow Jones-UBS Commodity Index DJP -0.87% and the more thinly traded DJ-UBS Commodity Index Total Return ETN DJCI -0.03%.

4. Embrace emerging markets

Emerging markets have been hit hard this year. Stock mutual funds that invest in developing regions are down 3%; China funds have lost twice that.

To Arnott, emerging markets are still in a powerful long-term upward trajectory. Their economic growth offers investors a hedge against U.S. and developed world inflation.

“Emerging markets have 10% of the world’s debt and 40% of world GDP,” Arnott said. Meanwhile, he added, the G-5 (Group of Five) nations — the U.S., Japan, Great Britain, France and Germany — has 70% of the world’s debt and 40% of its GDP, yet investors are more handsomely compensated for owning emerging-market bonds.

Emerging-market stocks are also positioned for economic growth on the back of “demographic tailwinds,” Arnott said, adding that the working-age population in emerging markets is expanding while the situation is reversed throughout the developed world.

5. Reach for high-yield bonds

In an inflationary period, companies find it easier to cover existing high-yield debt. “So the prices of the bonds go up, on top of a starting yield that’s pretty rich,” Arnott said.

The strength of junk bonds in a climate of rising rates makes them a “stealth hedge” against inflation, he added.

What I’m arguing for is to pare back on exposure to mainstream stocks and bonds,” Arnott said. “This is a window of opportunity where stock [valuations] are high, bond yields are low, and where alternatives are still not on everyone’s radar screen, and represent powerful diversification that can help in a reflationary world.

“If inflation does come on stream, your mainstream 60/40 portfolio is not going to help you,” Arnott added. “Inflation-linked alternatives will.”

Jonathan Burton is MarketWatch's money and investing editor, based in San Francisco.

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