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By Paul Justice, CFA | 08-09-2012 01:00 PM

Arnott: Investors Have Unrealistic Expectations

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.

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