Rob Arnott, founder and chairman of the board at Research Affiliates, was the driving force behind the smart beta wave of ETFs that first hit the markets in the early years of the 21st century. The fundamentally weighted approach he pioneered fell out of favor as value struggled, but now the economist’s belief in value is looking appealing as the U.S. economy flirts with recession and inflation rages on.
ETF.com spoke with him about how the U.S. came to find itself in its current state, what lies ahead and what investors can do to navigate the turmoil.
ETF.com: What are your expectations around inflation and the potential for recession?
Rob Arnott: Ben Bernanke about 10 years ago famously said economic expansions don't die of old age, they're murdered by the central bank. And there's a lot of truth to that. We have inflation. It's created by a massive stimulus spending, by supply chain disruptions closely related to the disruptions, the war in Ukraine.
And which of these does the Fed have any control over? None.
The old cliche is, to a person with a hammer, everything looks like a nail. If the only tool at your disposal is monetary tightening, shrinking the money supply or raising the cost of short-term capital, or reducing the Fed's balance sheet, any of these things has the effect of hurting the economy, so they can rein in inflation by crashing the economy. They can't rein it in by fixing supply chain disruptions by ending the war in Ukraine or by telling the Treasury to stop spending money.
Can they rein in inflation? Yes, but through the wrong set of tools. One of my colleagues, Chris Brightman, is fond of describing [Fed Chairman] Jerome Powell’s situation through the analogy of someone who's lost. A person wandering the countryside of Scotland asks a local, “How do I get to Dundee?” And the local replies, “Well, firstly, I wouldn't start from here.”
ETF.com: Would you elaborate on that?
Arnott: Starting from a position of free money was a horrible mistake. It created asset bubbles, it created economic dislocations of the wrong kind in the form of propping up zombie companies encouraging mal-investment and misallocation of resources at the personal level, the corporate level and the government level. If money is free, people will take it and use it for whatever comes to mind.
I liken interest rates to a speed bump to discourage reckless spending. If the speed bump is too high, you don't get anywhere. The economy winds up having no resources to fund innovation, to fund entrepreneurial capitalism, to fund new enterprise creation. If the interest rates are too low, those who have access to the free money will use it for all sorts of stupid things. And that's where we've been seeing for the last 14 years. So this is not a good starting point.
Should rates have been higher? Yes. Should they be higher now? Yes. Will the Fed stop before creating a recession? I doubt it. Recessions don't naturally start with twice as many job openings as job seekers. Absent Fed intervention, this economy would continue to do just fine. With that intervention, they can crush inflation through the back door by crushing demand.
A more appropriate response is to increase supply. But they can't do that. They can't control that. The short answer on inflation is it's going higher before it goes lower. I say that with high confidence.
We're expecting inflation at the end of the third quarter to be in the mid-9's. We're expecting at the end of the year for it to be 10-ish, probably a little higher.
This is going to have huge political implications. I've observed that in October, inflation will go from being the No. 1 item on the political landscape to the only item. And it's due to an illusion of an inflation breakout. Even if inflation is moderating a little bit, it'll look like it's breaking out to the upside, so that's an interesting nuance. As for next year, sure, it could moderate; it could finally start to settle back down.
ETF.com: How does housing fit into the inflation print?
Arnott: A third of inflation is shelter. Back in the ’70s and early ’80s, they defined shelter inflation by rate of change of rents for renters and home prices for homeowners. [Then] they were horrified at inflation breaking out above 14%.
So they reasoned—and it was self-serving reasoning, because they really didn't like the high numbers that they had to print—a homeowner doesn't feel the rise in the price of the house as inflation, their costs aren't going up unless they’re new buyers. Why don't we calculate what the home would rent for and treat the rising cost of an imputed estimated rent as the inflation that a homeowner would actually feel?
That's an artificial construct. It's, by definition and by design, smoothed and slowed and behind the curve. When home prices soar, you have home prices that are up almost 40% in the last 28 months. That's an enormous rise. And owners’ equivalent rent in the last 2 1/2 years is up just about 8%. That's all just under 4% annualized.
So what happens to that difference, that 30 percentage point difference? It shows up over the next decade, with about half of it showing up in the next three years. That means we're going to see inflation run hot for the next three years by about 5% a year. So that means owners’ equivalent rent is going to be running in the 6-10% range per year for the next three years.
You've got a third of the Consumer Price Index baked in to run hot unless the Fed is so tight that home prices crash. And so they can wind up wrecking the economy, wrecking home prices. But I don't think they're going to go that far. I don't think they're going to create a housing crash. I think they will create a recession most likely.
If housing prices stabilize right where they are, you're still going to get s6-10% [operating expense ratio] inflation for the next two, three years. This is a long way of saying I think inflation will run to high single digits through end of next year and perhaps into 2024. The consensus is a lot more benign than that. I hope the consensus is right. I don't think [it is].
ETF.com: What does that mean for investors?
Arnott: If inflation is running hot, what do you do with your investments? Firstly, value beats growth when inflation is rising. [So consider value.] Secondly, stocks face head winds during inflationary shocks. So invest outside the U.S. where the inflationary shocks are likely to be milder, not necessarily but likely.
The simple reality is this 8.6% inflation in the last 12 months was really way higher than that, because OER and rent inflation were smoothed and lagged. And because of that, inflation probably was more like 12%. We're just going to see a catch-up. [Even] if underlying inflation falls down to 6%, that's not good enough—you're still going to be playing catch-up.
ETF.com: You just suggested investing internationally, but aren’t other countries seeing inflation?
Arnott: They are, but they're cheap. If you look at [price-earnings] ratios in Europe, in Japan, they're about two-thirds of U.S. multiples. In emerging markets, they're half U.S. multiples.
What they call the “BAT” stocks—Baidu, Alibaba and Tencent—are still very expensive. Take those out, and emerging markets are two-thirds off. You can buy an emerging markets value strategy for less than 10 times earnings.
ETF.com: Fixed income isn't what one would consider a refuge right now. Is it simply that it’s disconnected from how it traditionally behaved?
Arnott: Yes. If long bonds are yielding 3%and change, and inflation is running at 8% and change, unless inflation settles way back down pretty darn fast, those yields aren't going down. The only bond markets that I think are attractive at current levels are emerging markets debt, which currently yields more than junk bonds.
U.S. junk bonds have a moderate spread relative to U.S. Treasuries and investment grade, but emerging markets bonds—many of which are investment grade—are priced to offer a higher yield than U.S. junk bonds.
Emerging markets generally benefit from U.S. inflation. If their economies benefit, their interest rates could actually go down, not up—creating an opportunity. Furthermore, their currencies are very cheap at the moment.
I look on emerging market stocks and bonds as the best place to invest for the long-term investor—emphasis on long term, because emerging markets are volatile, and getting in at the bottom isn’t very easy to do. You're going to look and feel stupid from time to time, and you have to be ready to accept that.
International stocks in the developed economies are almost as cheap. A value portfolio [such as] EAFE Value, we're estimating will produce about a 9% return per annum for the next 10 years. For U.S. stocks [we estimate] about a 4% per annum return. Are people going to be happy with 4%? I don't think so. Especially not if inflation is running 8%, 9%.
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