Rob Arnott, the author of numerous published academic papers on quantitative investing and tactical asset allocation, is chairman and founder of U.S. firm Research Affiliates. Here he talks to Morningstar about building diversified inflation protection and areas of opportunity among the universe of real return assets.
1. We've seen inflation heat up in 2011, but we also see continued high unemployment and a sluggish economy, which would tend to keep a lid on rampant price increases. What expectations about inflation are you incorporating into your investment process?
Inflation is already a problem today across many emerging markets. The most apparent cause of this inflation is the rapid pace of growth in the BRIC economies that exerts upward pressure on commodities prices. Rising commodity prices are a more serious concern for emerging-market countries relative to developed because commodities comprise a greater share of both industrial inputs and a family's consumption basket in emerging countries.
The more fundamental cause of inflation is monetary and currency policy. By preventing the currency appreciation implied by their rapid productivity growth, emerging-market countries must adjust to their trade surpluses through wage and asset price inflation. Emerging-market inflation is importantly facilitated by the easy money of our Fed, which is a reaction to the weak currency policies of the emerging-market countries. Recall, that the U.S. housing bubble was in large part caused by excessively cheap credit provided by huge accumulation of U.S. government debt by the central banks of emerging-market countries precisely to prevent their currencies from appreciating.
The flip side of the emerging-market trade surplus coin is our trade and budget deficits. We should not, however, attribute our deficits primarily to excess savings of the emerging markets. We should have been saving aggressively to fund our coming retirement in recognition of the easy-to-forecast decline in demographic support ratios caused by the ageing of the baby boom. Instead we went on a several-decade, credit-fuelled spending binge. Reducing our debt, which means increasing savings by reducing consumption and thereby measured GDP, seems to be the exact opposite goal of our policymakers. The political pressure to reduce the real value of our enormous explicit debt and much larger unfunded off-balance sheet liabilities through inflation and currency depreciation seems nearly irresistible.
The stalled recovery may delay the transmission from monetary stimulus to observed inflation. With some luck, we may have some time yet to buy inflation hedges at cheaper prices before the arrival of the 3-D hurricane (debt, deficits, and demographics).
2. In 2009 you wrote a paper asserting that investors should broaden their toolkit for fighting inflation. What types of assets are investors overlooking that could help them outpace inflation?
Investors should assemble a diversified portfolio of inflation hedges to provide a third pillar to their traditional allocations to stocks and bonds. The fixed-income markets offer a wide array of inflation hedging asset classes beyond the obvious foundation of [inflation-linked government bonds]. Short duration credit, floating-rate bonds, high yield, and bank loans all provide inflation protection. Local currency emerging-market bonds and commodities provide protection against both inflation and dollar depreciation.
Beyond defensive strategies, rising inflation can be part of an investor's offensive portfolio. The heightened volatility that will accompany an inflation shock provides greater opportunity for total return oriented strategies, including tactical asset allocation, long/short equity, and unconstrained bond management.
3. When looking across the universe of real return assets, which areas are currently looking attractively priced and which are you avoiding?
Emerging-market bonds carry a 3% yield above [U.S.] Treasuries despite having a more favourable debt profile. They represent 35%/40% of the world's GDP yet only have debt outstanding of 10%. Absent political risk, there are few reasons they should carry such a hefty premium. When we add in the local currency, these can be a very efficient stealth inflation fighter for [developed-world] investors.
REITs on the other hand currently sport yields almost identical to the pre-crisis days in early 2007 despite a considerably murkier macro picture. This asset class has provided some wonderful tactical opportunities over the past 20 years. Today is not one of them.
In addition, volatility will create favourable entry points. Investors should opportunistically accumulate their diversified portfolio of inflation hedges. A stall in global growth provides the opportunity to buy commodity futures at attractive prices. A flight-to-quality induced rally of the dollar provides the opportunity to increase local currency emerging-market bonds.
4. At a portfolio level, what should investors think about when combining inflation-beating assets into an effective package? For example, do they need to worry about correlations in building these stakes? Can younger investors--who are likelier to hold more higher-risk assets, such as stocks--rely on equity returns to keep them ahead of inflation?
Richly priced [developed world] equities will not provide the inflation protection that some hope for. In theory, pricing power should allow companies to pass on their rising costs through rising prices thereby maintaining the real value of dividends and stock prices. In the real world, history teaches us that materially higher inflation is accompanied by increased volatility of inflation, interest rates, and stock prices. High volatility spooks businesses and investors. The first reaction of equity markets to an inflation shock will be higher discount rates and lower P/E multiples. Only from the resulting depressed stock prices will equities provide an effective inflation hedge.
Correlations are important but must be forward looking. During the disinflationary period of the last two decades, bonds had low or negative correlation with equities, thereby providing an effective diversifier. As we learned in the inflationary 1970s and 1980s, high and volatile inflation changes the correlation of equities and bonds. When inflation volatility is the dominate driver of capital market risk, then equities and bonds become more highly correlated. To protect against the coming 3-D hurricane, investors should build that crucial inflation protection third pillar of their asset allocation.
Special thanks to Joel Chernoff, Chris Brightman, and John West, members of the Research Affiliates Senior Management Team, for their contributions to these answers.
An extended version of this article first appeared on Morningstar.com.
