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By Ben Johnson, CFA | 10-03-2013 01:00 PM

Arnott: Challenges of the 'New Abnormal'

Investors who don't realign their expectations and savings plan for changing U.S. demographics and slower growth are in for a jarring experience, says Research Affiliates' Rob Arnott.

Ben Johnson: I'm Ben Johnson, director of passive funds research with Morningstar, on the sidelines of our ETF Invest 2013 Conference, and I am joined by Rob Arnott, chairman of Research Affiliates.

Rob and I are going to cover a number of topics today, starting with an update on the 3D hurricane five years later.

What do you see happening with these three key central issues that we're trying to work through?

Rob Arnott: The 3D hurricane relates to the interconnected influence of deficits, debt, and demography. And it's really just the flipside of what PIMCO refers to as "the new normal," a world of lower yields, lower returns, and slower growth, and those three headwinds interconnect and magnify the impact of one another.

We're seeing Washington play out the first two pieces of that--deficits and debt--in a very big way this year. Notably, you're seeing really a battle for the soul of what this country is as a nation, and we've had deficits go through the roof. If you use generally accepted accounting principles, the deficits have been above 20% of GDP every single year since 2009. The debt crossed 100% of GDP a year-and-a-half ago, but under generally accepted accounting principles, it crossed 600% of GDP earlier this year. OK, these are big numbers. $100 trillion in debt in a country that takes in $2.7 trillion in tax revenues, so that's about 37 years' worth of taxes that we owe. That's a problem.

This runs headlong into demography, and the demography piece is subtle, but very powerful. We have a labor force that in the coming 20 years will be growing 0.5% a year. The last 40 years, it was growing 1.5% a year. That's a big difference. There goes 1% of GDP growth.

We also have a labor force that's older. Now, people reach peak productivity typically in their 50s. That means that their contribution to GDP is maxing out, not in their 20s or 30s, but in their 50s. People in their 20s and 30s are rapidly ratcheting up their productivity. They're wonderful for productivity growth. People in their 50s are great for GDP, but their growth in productivity is stalled, so their contribution to GDP growth is negligible. So, you've got an older labor force that's growing slower. Those combine to mean much slower GDP growth.

So, if we're accustomed to the notion that low yields mean lower returns, and that a slower-growing labor force that's older means slower GDP growth, if we embrace and accept that as a simple reality, a simple fact, we're going to be fine. If we fight it and say, "Oh, I refuse to believe it. I want to believe that the old normal is something we should aspire to return to," we can choose to embrace that pipe dream, but then we set ourselves up for our plans to be destroyed.

Johnson: So it sounds like we're set up for really what might be a very painful period of transition, or just trying to arrive at acceptance that what we've been through over the course of the past few decades has really been abnormal. So in PIMCO's view of the world, maybe the new normal is just normal.

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