Weathering An Inflationary Storm

Research Affiliates' Rob Arnott tells Morningstar's director of personal finance, Christine Benz, why investors owe it to themselves to ramp up exposure to inflation protection assets that can help them weather an inflationary storm. Now is not the time to load up on them, Arnott says, but over the next two to three years, investors should find such opportunities. The full transcript is available below the video.

Christine Benz: Hi, I'm Christine Benz. I'm here at the Investment News Retirement Income symposium. I'm here today with Rob Arnott. Rob is the chairman of Research Affiliates, and he's also the former editor of the Financial Analysts Journal. Rob, thanks so much for being here.

Robert Arnott: Thank you very much.

Benz: So Rob, you talked this morning, and one might have come away with the sense that you have a pretty gloomy outlook for traditional asset classes overall. You think conventional bonds, stocks are pretty expensive right now. Is that a correct assessment?

Arnott: I think that's accurate. What people will often do is shape their expectations on what's happened in the past, rather than looking at current yields.

And yields on stocks--they've doubled in the last 10 years, because it was such a horrific decade. They're still half what they've been historically.

So the yields on stocks are low. The yields on bonds, and an array of other asset classes, are low. People need to ratchet down their return expectations. If you're expecting double-digit returns on your investments, then I'm a bear. I think you're not going to get there.

If you're expecting 5% return on your investments and you're well diversified and you're taking advantage of an array of alternative markets--yeah, that's not just achievable, but reasonably easily achievable. 6% or 8% is possible.

Benz: So this is a conference focussed on retirement income. One idea you talked about this morning is just looking at TIPS [Treasury Inflation-Protected Securities backed by the US government, similar to inflation-linked gilts in the UK] for the conservative sleeve of a retiree portfolio. Can you talk about how you're thinking about inflation and why you think TIPS are relatively attractive?

Arnott: Well, inflation is the big risk that threatens people's retirements in the years ahead. Capital market returns have hurt them, but severe inflation would be crippling.

So that's the big risk, and unfortunately right now, with debt at unprecedented levels in US history, we have a problem. We're borrowing from future generations, and then we're wanting those future generations to fund our retirements through Social Security and Medicare.

The deal is going to change. It will change. It'll change because society can't afford the deal that's currently on the table.

So, as a consequence of that, looking to protect yourself from inflation, TIPS are a great vehicle. When they have their occasional corrections and become cheap, the opportunity to add to our allocations to commodities, to emerging markets debt, to REITs.

These all represent very, very interesting diversifications away from an over-reliance on mainstream stocks and bonds--neither of which serves us well in a reflationary world.

The risk is that the reflation could potentially be pretty severe.

Benz: So it's hard to argue that any asset classes you just enumerated are particularly cheap now. Correct?

Arnott: Correct.

Benz: So what should you do, if you're someone sitting there with maybe cash?

Arnott: If you want to be tactical, take a lot of risk off the table. Warren Buffett has been quoted as saying, "Be greedy when others are terrified. Be terrified when others are greedy."

A year ago, people were terrified. It was a great time to take risk, because it was so frightening to do so.

Today, quality spreads on high yield are approaching where they were in 2007. Same with investment grade. The same holds true for emerging markets bonds. The P/E ratios for stocks are approaching where they were two years ago.

This is not a time to get greedy. This is a time to take some of that risk off of the table and say, "Thank you very much for those wonderful returns in the last year."

With so many people thinking the global financial crisis is past, not prologue, the risks are to the downside. We have a tax hike coming at the end of the year.

The likelihood that high-net-worth investors, affluent consumers--will ramp down their spending as early as Q4 in anticipation of those higher taxes, to brace themselves for it. Very real possibility. What would be the consequences? A second dip in the recession. I think that's better than a 50-50 chance. The markets are priced to say that's not happening; that's not going to be the eventuality.

And so if the market is saying "no recession" and if we get a recession, then the markets will be hit. And in so doing, you will have bargains in some of these inflation protection strategies.

Benz: You had mentioned this morning that you actually thought, possibly within the next six to 12 months, there could actually be a buying opportunity in some of these assets.

Arnott: Yes. Now is not the time to load up on them, but over the course of the next two to three years, investors really owe it to themselves to ramp up their investment in inflation protection assets that can help them weather an inflationary storm.

Benz: OK. Well, thanks Rob. Not necessarily a sunny outlook, but helpful.

Arnott: There's always something interesting to invest in. Always.

Benz: Thanks Rob. Thanks for being here.

Arnott: Thanks.

Benz: Thanks for watching. I'm Christine Benz.