Thu, 9 Aug 2012
With U.S. stocks facing anemic growth in the years ahead, investors banking on 10% returns from equities should rethink their assumptions, says Research Affiliates' Rob Arnott.
Paul Justice: Hi there. I'm Paul Justice, director of passive fund research at Morningstar. Today I'm joined by Rob Arnott, chairman of Research Affiliates, manager of the PIMCO All Asset fund, and many other funds that are run by different companies such as Charles Schwab and PowerShares that follow some of his fundamental indexing concepts. Rob, thanks so much for joining me today.
Rob Arnott: Thank you very much for the invitation.
Justice: Now, you've got some interesting takes on the market today. I wouldn't put you in the bear camp, but you’re certainly not a bull of the decades passed. Could you give us a little bit of your outlook on what you think the market has in store for investors over the next 10 years and some of the major hurdles that they are going to encounter?
Arnott: Well the big hurdles relate to what we refer to as the 3-D hurricane: the interconnected influence of deficit, debt, and demography. Deficits are a lot bigger than they seem because we have a lot of off-balance-sheet spending and a lot of unfunded prospective obligations. That means the debts are bigger than they seem. National debt crossed 100% of gross domestic product, but under generally accepted accounting principles, the correct number is already north of 600% of GDP. That runs headlong into demography. As the baby boomers slide off into the retirement sunset, the support ratios soar just as the debt burden has already soared. So it creates dangerous headwinds.
I'm cautious near term because we’re facing the fiscal cliff. The worrisome part is not the cut in spending; that's probably reasonably benign. It's the rise in taxes on the affluent. If the affluent see their aftertax income tumble, they’re going to cut spending. And if they cut spending, who is going to spend in their place. So I think that sets the stage for a recession. I think there's a decent chance, 50-50 anyway, that we may already be in recession; that the start of the recession could be pegged as second quarter; that's a dangerous situation. We're also facing the debt limit, and both the debt limit and the fiscal cliff are going to hit total gridlock until after the election. Neither has any reasonable chance of a resulting compromise. So this leaves us in a vulnerable spot.
Why doesn't that mean that I'm terrified of stocks and think we should prepare for another market crash? My hesitation there is very, very simple. If the affluent stop spending because of higher taxes, until the taxes actually go up, what are they going to do with their money? They are going to be squirreling it away in the liquid markets. So you actually have this possibility that can cushion some of that downside risk. We also have very rich yields in Europe and moderately rich yields in emerging markets. If you can get a higher yield in emerging markets and faster GDP growth, that seems to us to be a pretty good layup for better stock market returns in emerging markets than in the U.S.
Justice: It sounds to me like you’re saying people should moderate their expectations going forward for what the equity risk premium or the returns on the market might be, but there are some alternatives. It's not Armageddon that's coming upon us. You like some of the other areas.
Arnott: That's exactly right. We don't like U.S. bonds. I mean a yield of less than the rate of inflation is not very interesting. We don't like U.S. stocks; they are the most expensive in the world because they are the safe haven to which people channel resources when they are afraid about Europe or Japan or uncertainties in China or other emerging markets.
We do like a spectrum of alternatives. Emerging-markets bonds have a premium yield despite debt levels that are very low relative to the developed world. Emerging-markets stocks have a higher yield than U.S. [stocks] by almost a 1%. Are they going to have slower growth than the U.S., I don't think so. So that represents an interesting choice. High-yield bonds are richer than historical norms in terms of their spreads relative to Treasuries. The yields aren’t great, but their spreads are pretty darn good. So there are some interesting places to invest. A lot of folks think I'm a perma-bear. I guess over the last decade I’ve often seemed to be because I’ve been bullish fairly rarely.
Justice: I guess it's a good decade to be a bear.
Arnott: But I'm not a perma-bear. I like markets that are cheap, and looking around the world now, we see some markets that are moderately interesting.
Justice: Now it's interesting to me that you’d find some interest in European equities right now. Obviously, the fiscal cliff is grabbing a lot headlines, but the collapse in Europe is as well. But you’ve got some exposure there. Could you talk about how you’ve adapted to that market?
Arnott: Well, Europe is a slow-motion train wreck; it's a mess. It's an extremely simple problem, masquerading as something nuanced, complex, and subtle. It’s not nuanced, complex, or subtle at all. It's the spending stupid, if I can borrow from President Clinton's campaign tagline back in the ‘90s. If you spend materially more than you take in taxes, you are going towards a cliff, and until the spending is cut, it will continue to look like a slow-motion train wreck. At some stage the spending will be cut, either by choice or by the markets forcing that solution on them.
So I view the Europe situation as emblematic of the problems across the developed world, but investors are terrified enough in Europe that the dividend yield of European stocks is 4%; [in the United States] it's 2%. That means valuation multiples there are half of what they are here. If you look at the value under the spectrum or fundamental index in Europe, the yield is 5%. If you can get a 5% dividend yield, that's a big step in the direction of earning very respectable real returns. So I'm cautious on European stocks. If they enter a new round of bear market, I'd start to be an aggressive buyer at that stage. We're not there yet, but averaging in, taking a modest allocation to us makes some sense, and emerging markets look to us to be entirely fairly priced.
Justice: So, really it's from a valuation approach that you like Europe at this point in time compared with U.S. equities.
Arnott: That's exactly right. For U.S. equities we have anemic growth in the years ahead. We have a relatively anemic dividend yield of 2%. That's not a formula for great returns. Our estimate is that during the next 10 to 20 years, stocks will give us 4% to 6%. OK, 4% to 6% is not a bad rate of return unless you expect 8% or 10%. And the problem is not a dearth of investment opportunities, it's unrealistic expectations. Investors broadly, all over the world, harbor this illusion that stocks should give them a 10% return. It's not going to happen. If you ratchet down your expectations, what are you going to do? You'll spend more cautiously, you'll save more aggressively, and you'll be fine. Most investors won't pursue that course.