Arnott: Market Hyped Up on Stimulus

Russel Kinnel: Good afternoon, I am Russel Kinnel, Director of Fund Research for Morningstar and I am joined today by Rob Arnott, who is the originator of the fundamental indexing concept and Manager of PIMCO All Asset and PIMCO All Asset/All Authority. Thanks for joining us Rob.

Rob Arnott: It's a pleasure.

Kinnel: So, it's the beginning of the year, people are always eager to talk asset allocation. So we'd love to hear what's your take, because your funds have tremendous latitude as part of the newer fund allocation style that has a much bigger tool box. So, what areas are looking attractive to you today?

Arnott: Well, Warren Buffett early in his career told his friends that the way to succeed in investing is to be greedy when others are terrified and terrified when others are greedy. Now, when was the last time people where really terrified? Two years ago. When was the best time for a 'risk on' trade? Two years ago, before the catch phrase 'risk on' became part of the public jargon.

Now you have a market that's being propped up by stimulus. I liken it to a kid with ADHD presented with a massive bowl of M&M's. The kid wolfs down the M&M's, gets a sugar rush. If the M&M's ever run out, they get a sugar crash. And we have a market that's being propped up by what might be called the Bubble Instigator In Chief, Ben Bernanke.

So what we have is a sentiment at work in the marketplace in which most investors today are much more worried about missing the last of the bull market than about downside risk. Times like that I think investors fall prey to the temptation to chase down nickels in front of a steam roller. So this is a time not to have risk on in my view. There is much more downside risk than upside opportunity from current levels. So our investment posture and my worldview is a very cautious one at the moment.

Kinnel: So, I am gathering, U.S. stocks and U.S. bonds, are you wary of both right now?

Arnott: A little wary of both, more on the stock side than the bond side. The economy is like the emperor with no clothes. It's an economic recovery relatively anemic that's built on a foundation of stimulus, and stimulus dwarfs the size of the recovery. If you add up fiscal stimulus, bailouts, quantitative easing and QE2, the aggregate size of the fiscal and monetary stimulus is on the order of $4 trillion. And the aggregate size of the run up in the national debt in the last 2.5 years is same ball park. And $4 trillion of stimulus has brought us $0.5 trillion of increased economic scale, increased GDP.

That's not a very attractive trade-off. That's a pretty bad investment if it's borrowed money that funds it. So I think stocks today are priced to reflect, one, a consensus that the economic recovery is gaining organic traction in the private sector -- that what Keynes called the animal spirits of the private sector are being reignited; two, that that economic recovery is going to gain traction and is going to accelerate; three, that there is no end in sight to quantitative easing, of which I am skeptical that QE2 can be followed by anything. So the market is pricing in expectations of not just a neutral outlook but a very robust outlook where the downside is much greater than the upside.

You can bifurcate bonds into treasury bonds and everything else. I think treasury bonds ultimately reflect inflation expectations on the long end, and those inflation expectations have been ratcheting up. So, long-term, I'd be cautious on long treasuries, a little less cautious on credit. We are getting some credit spreads that are not bad. So I think that the opportunity set out there is not bad.

The places that I love are things like PIMCO has an unconstrained bond fund that's the only one that I know that can go net short duration on a tactical basis -- that's very cool if you are worried about inflation kicking up the interest rates at the long end. And fundamental long/short -- long the fundamental index, short the cap-weighted index. If you have a defensive view on the market, what could be more interesting than something that loads up on out-of-favor value stocks -- where you could reasonably expect a good risk premium because they are seen as risky -- and shorts the most popular trendy beloved growth stocks, where why on earth should you get a risk premium for investing in something that everyone thinks is a safe heaven? So, those long/short strategies, and there is a couple of them available in the marketplace, I think are awfully interesting at a time when we want layers of alpha and don't want beta.

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Kinnel: And then what about emerging markets, what's your take there?

Arnott: Emerging markets, I think, the spreads have come in a lot. They're not as attractive as they were some months or quarters ago. But, as a long-term secular play, absolutely. And so, we'd be using them tactically anywhere from a modest allocation to a large allocation, depending on the spreads.

I think there is a very good likelihood that this economy will disappoint on the down side. Consensus seems to be in the 3%, 3.5% range for GDP growth this year. What's the likelihood of a percent higher than that? Pretty slim. What's the likelihood of a percent lower than that? Not slim at all, very plausible.

So, if it disappoints on the downside, risk markets are going to disappoint, which means that for the tactical investor who wants to buy when people are scared, you're going to have opportunities to buy.

So I think the opportunity set is marvelous to put what is called, in the lingo of the marketplace these days, the 'risk on' trade when people are scared again. Don't put it on now. And that would definitely include emerging markets, which are not as debt burdened as the developed world. The aggregate debt of the emerging markets is roughly 10% of world's total debt. The G5 -- with collectively same size of the economy as the whole of the emerging markets world -- represent 40% of world GDP. They have 70% of world debt, seven times the debt burden per unit of GDP as the emerging markets.

So the emerging markets give you a 3% yield premium, and yet maybe that risk premium in 10 years will flip. The developed world with its debt overhang that's huge ought to be priced at a premium yield, not a discounted yield, relative to the emerging economy.

So I think that represents a very powerful long-term play. Tactically short-term, I like them, I don't love them.

Kinnel: So, should investors be sitting on significant amount of cash so that they have something ready when panic comes back and assets are cheap again?

Arnott: That's where I love things like fundamental long/short and things like unconstrained bond, because if you can get layers of alpha without the beta, without the beta at a time when you think the beta could hurt you, that's a lot better than zero cash yield.

So short answer to your question is, no, I'm not a big fan of cash. I think there is always something interesting to invest in, and now is no exception to that. There are some defensive strategies that are light on beta and long on alpha that I think are really interesting these days.

Kinnel: What about Europe?

Arnott: Europe, on the bond side, not terribly interesting, the spreads have blown out quite a bit, but they reflect the likelihood of rolling sovereign defaults. Until that plays out a bit further -- I think we will see defaults -- I'd be leery on the debt side. The equity side has been savaged and the euro, of course, has come off from its historic highs.

So I think that stocks in Europe are not bad. The U.S. is expensive, Europe is not.

Kinnel: I just wanted one last question. You mentioned we'll see some defaults in Europe. Are you talking about, probably, sovereign issuers or corporate or…

Arnott: Yeah. Well, of course, there is always some corporate defaults. That's part of the nature of the corporate arena and much less worrisome because it is normal. In Europe, you have what are derisively called the PIIGS, Portugal, Ireland, Italy, Greece and Spain, and their aggregate debt as a percentage of GDP is nearly identical to the G5, and we have the temerity to call them the PIIGS. Our debt burden, especially if you count unfunded social security and Medicare, is actually as large as Greece was at its peak, and that's alarming.

So, when we look at Europe, we look at the -- let's not put euphemisms on it -- we're looking at the bankrupt countries, looking to near bankrupt countries to bail them out. Germany's debt overhang is big. France's is bigger. The so called PIIGS are bigger still, but not bigger than the G5 in aggregate. So a country like Greece with astonishingly few people on the tax rolls actually paying taxes, and with a desire to confuse consumption for prosperity if you borrow a $100,000 and buy a Mercedes, are you more prosperous because you just bought a Mercedes? Of course not. You have a cool new car, and you have $100,000 more debt that you have to pay down out of reduced future consumption. Well, a country is just a family writ large and if a country plays that game, borrowing to consume and doesn't intend to pay back or finds it can't pay back, it will default.

Now, if they're looking to other countries with severe debt overhang but a little less severe to bail them out, it's not plausible. So at some point, you will see de facto defaults. Now, you can paper them over them by kicking the retirement of the debt down the road, by lending the countries money to service their debt, but all it does is kick the can down the road -- apropos the kid with ADHD and a bunch of M&M's, you're looking at a kid with ADHD, bunch of M&M's, wolfing down the M&M's getting a sugar high. They're going to get a sugar crash. If you keep feeding them M&M's, they're going to get a bigger sugar crash when it eventually hits. When the M&M's run out and then you have to pay for the M&M's, these are expensive M&M's.

Kinnel: Right. Well, thanks a lot, Rob.