- Rob Arnott predicts inflation is more likely to surprise to the upside and growth to the downside.
- Value stocks, TIPS, and alternative investments are good hedges for these outcomes, he said.
- Looking long term, he said US small-caps and MLPs are among areas priced for high returns.
When it comes to future outcomes on two of the market's most crucial inputs — inflation and economic growth — Rob Arnott says investors are underappreciating asymmetrical risks.
Right now, the five-year breakeven rate for Treasury Inflation-Protected Securities (TIPS) is 2.3%, meaning investors are betting inflation will come down from its current level of 3.4%. Consensus is also that the economy will continue chugging along as is, avoiding a recession while producing run-of-the-mill growth.
These outcomes are entirely possible, says Arnott, the founder of Research Affiliates, which advises its clients on investment strategy. But both inflation and economic growth have upside and downside risks relative to consensus. Inflation could average below 2% for the next five years, just as it could prove sticky and hang above 3%. Economic growth could falter, but it could also boom.
But Arnott wants to remind investors that not all risks are created equal. At the moment, there are clearly differences in likelihoods for each potential outcome.
On inflation, Arnott believes it's far more likely that it surprises to the upside. When he asks clients what they think, 90% of them agree, he recently told Business Insider. Such a scenario would likely mean interest rates staying higher for longer, putting pressure on the economy and on certain assets like growth stocks.
As for economic growth, there's a much higher chance that the economy slows down or enters a recession than is currently being priced in, he said. He pointed to the inverted Treasury yield curve — an extremely reliable recession harbinger — as well as poor purchasing manager index data and poor inventory growth as warning signs that the economy could decelerate in the months or years ahead. He also noted that consumer spending is being supported by growing credit card debt and a wealth effect from the stock market, which may not be able to continue until inflation comes down and the Federal Reserve cuts rates.
"There's a circularity to the logic that because the economy is doing well, it will do well. That circularity is best demonstrated by the fact that there has never been a recession that didn't start with a robust economy that rolled over," Arnott said. "Do I think we're going into a recession? No, but I'd give it a decent likelihood."
Putting a number on it, Arnott said there's about a 40% to 50% chance the US economy goes into recession.
To take advantage of these asymmetries in the market, Arnott said that value stocks and TIPS are two investments that would perform well in a higher-inflation environment. In an economic slowdown, alternative investments and diversifying assets — which might include commodities and real-estate — are good places to be, he said. Value stocks also fit this bill.
One way investors can gain exposure to these assets is through funds like the iShares Core S&P U.S. Value ETF (IUSV), the Schwab U.S. TIPS ETF (SCHP), and the iMGP DBi Managed Futures Strategy ETF (DBMF).
6 cheap investments for the long-term
Outside of hedging for macro outcomes, Arnott is currently bullish on various assets he believes have cheap valuations, meaning they are set up to deliver handsome returns over the long term.
"I've been called a permabear. I'm not. I'm a bull on things that are cheap," he said. "I'm not a bear when it comes to things that are priced to give you double-digit returns, and there's a lot of them right now."
Within the US, these include real-estate investment trusts, also known as REITs; small-cap stocks, usually meaning firms that have market capitalizations under $2 billion; and master limited partnerships, or MLPs, which are publicly traded firms that retain some of the benefits of being private. The Real Estate Select Sector SPDR Fund (XLRE), the iShares Core S&P Small-Cap ETF (IJR), and the Alerian MLP ETF (AMLP) offer exposure to these trades.
But Arnott sees opportunities outside the US as well, especially in the MSCI EAFE Index, which tracks non-US developed market stocks. Emerging markets are also attractive, he said. More specifically, value stocks within both developed and emerging markets are trading in their "cheapest decile ever" compared to growth stocks, Arnott said.
Funds like the Avantis Emerging Markets Equity ETF (AVEM), the iShares MSCI EAFE ETF (EFA), and the Avantis International Large Cap Value ETF (AVIV) offer exposure to these trades.
Arnott is betting that all of these investments will deliver 7% to 14% annualized returns over the next 10 years.
