Latest / The Capitalism and Freedom in the Twenty-First Century Podcast / Quantitative Investing, Inflation and the Macroeconomy

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Quantitative Investing, Inflation and the Macroeconomy · The Capitalism and Freedom in the Twenty-First Century Podcast

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>> Jon Hartley: My name is John Hartley, I'm chair of the Economic Club of Miami.
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We got started just over a year ago, and
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I know a number of you have been to our events so far.
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We just had an event last month with Ken Griffin and Mayor Francis Suarez,
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which was a very popular and well attended event.
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I'm the chair of the Economic Club of Miami, and as that would suggest,
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we highly encourage you to come to our website, economicclubmiami.org.
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with completing a membership application and saying that to us.
1:13
Without any further ado, I have the pleasure today,
1:16
the very special pleasure of introducing in interviewing Rob Arnott.
1:21
Rob is the founder and
1:22
chairman of the board of research affiliates NASA management firm.
1:26
Research affiliates develops investment strategies for other firms like
1:31
the famous research affiliate fundamental indices that are value tilted indices.
1:38
And research affiliates oversees 166 billion in
1:43
asset under management using their strategies and
1:48
their indices, which other asset managers manage to.
1:55
In addition, Rob has also served as a visiting professor of finance at
1:58
the UCLA Anderson School of Management.
2:00
He's also on the editorial board of several finance journals,
2:04
including the journal portfolio management.
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He's also served on the product advisory boards of the Chicago Mercantile Exchange,
2:12
the Chicago Board options Exchange, and to say the least,
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Rob is one of the most prominent quantitative investors in the world.
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And I say this having worked in quantitative asset management for
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quite some time.
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Thank you so much Rob, for joining us.
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>> Rob Arnott: Thank you [COUGH].
2:26
>> Jon Hartley: All right, so I think we'll just dive into it here.
2:29
So let's get into inflation here.
2:32
What has the Fed been missing here?
2:35
What a policy been makers been missing?
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How do you think inflation came about?
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>> Rob Arnott: Well, inflation is just a matter of supply and demand.
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If the supply of goods and services is constricted and demand for goods and
2:49
services is elevated, you're gonna get inflation, it's really that simple.
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And during the pandemic of course, we had lockdowns.
3:00
Many people continue to work from home.
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Many of those who work from home continue to pretend to work from home,
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meaning supply of goods and services is diminished.
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Supply chain disruptions are widespread.
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No real light at the end of the tunnel for that.
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And in addition to all of that,
3:22
money's been helicoptered into people's bank accounts,
3:27
creating a step up in demand, and [COUGH] we're at full employment.
3:33
So stimulus checks really shouldn't be needed.
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But anytime you have aggressively stimulative fiscal and
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monetary policy and exogenous shocks that reduce supply,
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you're going to have inflation.
3:53
I was shocked when Jerome Powell coined the expression
3:58
transitory inflation back, I believe it was April of 2021.
4:07
Inflation was already 4%, and half of that inflation had
4:12
happened in just 3 months, so that it was 4% over a year,
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8 annualized over 3 months, and he says transitory.
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I wondered what he'd been smoking.
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In November, he decided to retire the term transitory,
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although they still talk about it as if it's transitory.
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And at that point it was already 6%.
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So one of the things I found just fascinating was in December of 2021,
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with inflation already above 6%.
4:52
The Fed dot plot, which shows what Fed governors believe the Fed funds
4:56
rate should be at year end of the next year, end of the next year, and
5:01
as a permanent equilibrium.
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The forecast then was that Fed governors thought that inflation,
5:10
that Fed funds rate should be 0.8%, that was last December.
5:17
They were saying 0.8% for this year end, and inflation was already over 6%-
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>> Jon Hartley: [INAUDIBLE] 7% at
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that point.
5:22
>> Rob Arnott: Was already over 6, it might have been 7 by then.
5:27
It's astounding how far behind the curve they are.
5:31
And I'm fascinated at the obsession with listening to their forecasts for
5:37
the macro economy or for inflation, when their track record is unbelievably bad.
5:44
>> Jon Hartley: Yeah, I mean, it's fascinating just how quickly the Fed is
5:49
pivoted just beginning somewhat later this year in around March,
5:54
when they started tightening, and they've tightened very, very quickly.
6:01
So it seems like a very about face from the Fed of 2021 that was very
6:05
resistant to start increasing rates amidst what seemingly became
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entrenched inflation after October.
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When became more than just a story about used car prices going up, but
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really also about housing, which is 30 or 40% or so of the CPI basket.
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I'm curious, pivoting this a little bit to forecasting and
6:27
capital markets, how do you think sustained inflation in this
6:32
5 to 10% range over the next 2, 3 years?
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How does that, in your mind, affect the economy and capital markets?
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>> Rob Arnott: Let me break that into two questions.
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5 to 10% over the next several years is inflation that's not transitory.
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We did a study, we published it about a month ago,
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in which we took the 14 OECD countries that have
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been developed economies for the last 50 years.
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I mean, there's a lot of newcomers, leave those out, they're not our peer group.
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Focus on the ones that have been developed economies going back to 1970.
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And we then ask the question, how transitory is inflation?
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What we found was that if you get 4% inflation, half the time it's transitory,
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which by our definition means it goes below 2% within 2 years.
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Half the time it's not.
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So basically, when you get an exogenous shock that creates
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a small burst of inflation, then as soon as the shock passes,
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so does the inflation, which is great.
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When it goes above 6%, you start to have more daunting odds.
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Only about 30% of the time, is inflation transitory above 6%.
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Only about 15% of the time above 8%, less than 10% above 10 or higher.
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And this is based on surprisingly large numbers of cases,
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cuz we're looking at 14 economies spanning 60 years.
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And what we find is that there have been 28 times that one
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of these economies has seen inflation above 8%.
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Now 8 of those 28 are underway right now, so
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we don't know how they're gonna play out.
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The other 20, only 2 came back down in reasonably short order.
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18 lingered for anywhere from 2.5 to 26.5 years, median of 13 years.
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So this is not to say we're forecasting a long bout of inflation.
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What it is to say is anyone who uses transitory
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return to normal within 2 years,
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as their central expectation is being very naive.
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That is well within the realm of possibility,
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that's the optimal best quintile.
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The worst quintile is 10 years and beyond.
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Back to the second part of the question.
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What does this mean for investments?
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Right now, breakeven inflation, which is the difference between the tips yield and
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the treasury bond yield, stands at 2.3% for 10 years.
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What that means is that if inflation is less than 2.3%,
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you're better off holding treasuries.
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If it's more than 2.3%, you're better off holding tips.
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So one immediate takeaway that's very simple is do you really
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believe it's gonna be 2.3% from now for the next 10 years,
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or do you believe it'll go 7, 6, 5, 4, 3?
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Our forecast is 4% inflation for the decade, 5% inflation for 5 years.
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And if you get 4%, then tips will produce 1.7% more return per annum,
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working out to 17% more wealth after 10 years than if you used treasury bonds.
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That, to me, is a slam dunk.
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That's a simple strategic bet that, for
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the patient investors should work out beautifully.
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>> Jon Hartley: Wow, so in your mind, likely entrenched inflation or
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good potential for entrenched inflation averaging about 4% over the next 10 years.
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I'm curious, sort of pivoting to investing specifically here,
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what asset classes do you think investors should consider to help them
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amidst this sort of potentially sustained period of inflation in the coming years?
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I know some people talk about I bonds, there's sort of a 10,000 limit per person
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on that, so you can't really scale that up.
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But things like tips or treasury inflation protected securities, real estate,
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short-term interest rates, what asset classes do you think should be
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part of an investor's portfolio in this new era of inflation?
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>> Rob Arnott: Well, I've been called a perma bear for
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the simple reason that I don't things that are fully priced or expensive.
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I like holding things that are cheap.
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And that created some difficulty in the late 2010s
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because value was having its worst drawdown ever.
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But viewed within equities, the spread between growth and
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value is still the largest quintile of spread ever.
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It's no longer the largest percentile, as it was in the summer of 2020,
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but the largest quintile.
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That's pretty good.
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So for starters, if you're gonna hold stocks, hold value stocks.
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If you're going to hold stocks,
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don't be focused on US trading at Shiller PE
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ratio price relative to 10 year smooth earnings of 30 times.
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>> Jon Hartley: That's a CAPE ratio?
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>> Rob Arnott: That's the CAPE ratio.
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Where was it at the peak in 2007 and 8?
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It was 28 times.
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So it took a 6 year bull market to get to
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28 times back in the mid 2000s, and
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it's taken a bear market to get it down to 30 now.
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Now, what about Europe?
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Europe's at 14 times, AIFA is at 15 times,
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emerging markets are at 14 times, they're half off.
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Are their prospects for growth worse than the US?
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Of course they are, prices are set based on narratives, and
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those narratives have the wonderful advantage of usually being true.
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They also have the daunting disadvantage of being utterly useless because they're
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already reflected in share prices.
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So you want to figure out where the narrative may be exaggerated or
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may have room to change.
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The 2.3 breakeven inflation rate is beautiful example.
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The notion that, AIFA and
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emerging markets deserve to be half off relative
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to the US is one where there's ample room for change.
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Emerging markets local currency debt [COUGH] currently yields more
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than us junk bonds, and the default rate historically is much, much lower.
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So there are pockets of opportunity out there, and
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the backdrop on all of this is the inflation surge.
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Inflation is wonderful for value.
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If you go back historically and look at decades over the last 100 years,
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anytime you had inflation above 4% for a decade,
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value beat growth by 6 to 10 percentage points per annum during those decades.
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Why should that be?
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Very, very simple, firstly, high inflation usually means a higher discount rate.
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Higher discount rate hurts growth relative to value because most of
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the value in owning a growth stock is the distant future,
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and that distant future becomes less valuable with a high discount rate.
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Secondly, there is absolutely no such thing as high but
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stable inflation, it doesn't exist.
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Which means that if you have elevated and turbulent inflation,
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you have elevated economic uncertainty.
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Isn't it nice, if you're in a period of elevated uncertainty,
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to have a low P E ratio, low price to sales ratio, and so forth?
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So a foundation of underlying fundamentals that can sustain the value of the assets.
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So this is an opportunity rich environment,
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it's just not the opportunities people are mostly looking at.
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>> Jon Hartley: That's good to know, so value stocks, so high book to value type,
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Warren Buffett type investing works well, historically has worked well,
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in these sorts of inflationary environments.
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It's very helpful and good to know.
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So I guess jumping a little bit deeper into macroeconomics and
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microeconomic narratives, which you're alluding to.
15:48
I'm curious, how should investors think about things like rising deficits,
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national debt, aging demographics in this sort of post-COVID world?
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This has become seemingly a very important issues when thinking about
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whether it's inflation or thinking about capital market returns in general.
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How do you think these issues are gonna weigh on both
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figures like GDP as well as long term real returns?
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>> Rob Arnott: I wrote a paper in 2009 called the 3D hurricane,
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the interconnected influence of deficits, debt and demographics.
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And the point of the paper wasn't that any of these play out fast,
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but that they represent a strong current going through the macroeconomy.
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If you're wanting to swim across the Mississippi river,
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it's useful to know which direction the water is flowing
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in order to not wind up too many miles downstream.
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The same applies for things like deficit spending.
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John Maldon likes to say there's a bang moment
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when things go along just fine and then bang,
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you suddenly realize your wile coyote running off of a cliff.
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And that kind of situation happens again,
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and again in macroeconomy.
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Deficits, of course, create debt and
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the debt burden of the US.
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Interesting, if you think of the country
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as an individual family is 100,000 and
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if they have debt of 500,000,
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they're probably in trouble.
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The income that the federal government has to work with is just under 20% of GDP.
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The debt is ballpark of 120, 130% of GDP, depending how you measure it.
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That's like the family with 100,000 income having 600,000 debt.
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But there's hidden debt,
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there's off balance sheet spending and off balance sheet debt.
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There's unacknowledged debt,
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the unfunded portion of Social Security and Medicare and
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Medicaid are enormous, they dwarfed and the national debt.
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Include those and you're looking at hidden government
18:43
debt that takes you to 80% of GDP as the income for
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the government to service those obligations.
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All right, well, that's more akin to having $6
19:00
million of debt on $100,000 of income.
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What can't happen won't happen, and so I don't worry about this.
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There will be a reset, and the reset can take any of a number of forms.
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Default is theoretically possible.
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But why default when you can do the back door
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default of reducing the real value of the debt?
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Inflation, demographics then enters into the picture
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as a very slow moving macroeconomy and for the future.
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Because [INAUDIBLE] 30 years an extraordinarily
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large roster of mature adults, the baby boom generation,
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at a stage in life when they are valuation
19:59
indifferent buyers of financial assets.
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What do I mean by that?
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Those who think ahead and are worried about their future
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golden years are likely to be saying I need to set aside money.
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And setting aside money means you've got to put it into capital markets.
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And putting it into capital markets, you're not gonna ask the question,
20:27
is this too expensive or is this too cheap?
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Except perhaps on a tactical basis, you're going to set money aside.
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And this creates a dynamic that permits [INAUDIBLE],
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>> Rob Arnott: Inflation.
20:42
Roll the clock forward 20 years, even 10 years, and
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you're looking at an environment where you have an enormous roster,
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the largest ever evaluation in different sellers.
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If you have assets aside and you want to convert those assets into goods and
21:01
services during retirement, you're going to sell.
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And you won't be somebody who can choose whether to sell based on whether
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it's expensive or not.
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The result is valuation, indifferent sellers, rates go up, markets come down.
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And so I think we will have those headwinds over the coming 10 to 20 years.
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For people, that 3D hurricane is
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only a serious issue into a mindset.
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Today's economy is what things are gonna look like for the next 20 years.
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For those with a more flexible mindset,
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all you have to do is boost your savings 10, 20% per year.
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Extend your expected work span by 2 or 3 years, and
21:54
reduce your expected expenditures in retirement by 10 or 20%.
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And if you make that mental transition saying I'm gonna work a little longer,
22:04
I'm gonna save a little more, and I'll spend a little less in retirement,
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it all of a sudden becomes very manageable.
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Most people won't do that.
22:14
And the economics profession in our policy elite are complicit
22:19
in encouraging them not to think about those things.
22:23
>> Jon Hartley: Fantastic, I love that 3D hurricane
22:28
deficits nest and aging demographics.
22:32
I feel like we're very much in the eye of that hurricane.
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Or maybe the eye, I guess, is more peaceful, but
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I guess it's the edges that are the miller.
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We know a lot about hurricanes in Miami, and
22:44
you wrote this paper before you moved to Miami or?
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>> Rob Arnott: I did, I moved to Miami in 2018 when federal tax law made state
22:53
income tax no longer deductible, so that my state tax burden went from 7% to 14%.
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>> Jon Hartley: Well, fantastic, not only are you predicting capital market returns,
23:03
but you're also predicting your own future location as well, it's fantastic.
23:08
I wanna get more, a little bit into the stock markets, specifically here.
23:14
I know that you've had some pretty famous disagreements with
23:18
clip as Ness about AQR on the topic of market timing.
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And I think he's sort of the opinion that you can't really time the market well and
23:27
I think your opinion is somewhat different from that.
23:30
I'm curious, how should investors set their expectations for the future,
23:35
given where we're at now?
23:36
Are there any sort of compelling bargains today for a long term patient investor?
23:42
The S&P 500 is down 15% year to date.
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We've been sort of in this range this year to date range of anywhere between 25%,
23:52
15% for a while.
23:53
And I think there's some people out there that say now's a great time to get in if
23:58
you have dry powder on the side or.
24:00
Maybe even if you're fully invested, to lever up a little bit and
24:04
take a position that has an equity market beta greater than one.
24:08
I'm curious, what do you think about this kind of reasoning around market timing?
24:15
Do you think now is a good time to lever up a little bit and
24:18
get some more equity exposure to harness that long run risk premium?
24:23
>> Rob Arnott: First, just a quick observation on the controversies
24:26
with Cliff.
24:27
He and I agree on about 90% of everything, and
24:32
I think what's going on is he gets annoyed that we agree on so
24:37
much that what we disagree on suddenly matters more to him than it ought to.
24:46
It is what it is, the paper that got him really angry
24:51
was a paper in 2016 called How Can Smart Beta Go Horribly Wrong?
24:59
Fundamental index, which we invented back in 2004,
25:03
was actually the original inspiration for the label smart beta,
25:08
which was coined by Towers Watson back in 2007.
25:12
>> Jon Hartley: These are the research affiliates fundamental indices, which,
25:15
if you own an equity fund at Pimco or several other asset managers,
25:19
you're actually invested in exactly what Rob is telling you to be invested.
25:23
>> Rob Arnott: That's most of our 100 plus billion.
25:28
And the performance since 2016 for
25:33
multifactor was terrible.
25:36
For fundamental index was terrible unless you correctly used a benchmark
25:41
of value indexes relative to value indexes, we did really, really well.
25:49
But the essence of the paper was really simple.
25:53
If you have a stock and its price has soared and its underlying fundamentals
25:58
haven't, so its valuation multiples have soared, its past return will be brilliant.
26:03
And if there's any mean reversion, its future return is going to disappoint.
26:07
We said the same dynamic holds true for strategies and factors.
26:12
The value factor, the spread in valuation between growth and
26:16
value widens and contracts.
26:19
And when it widens, you have rising relative valuation of growth,
26:26
and you have a lousy performance for the value factor.
26:33
But it's a revaluation alpha.
26:35
It's from the valuation tumbling, not from the underlying fundamentals softening.
26:41
And what we observed was, [COUGH] that every single factor and
26:45
every single strategy out there goes through these cycles.
26:49
People are drawn into strategies when they've performed well,
26:53
without doing the added homework of asking.
26:55
Did it perform well because it got more expensive or
26:58
because it has structural benefits embedded in it?
27:02
And 2016, most factors were expensive.
27:07
Value was the one, outlier and in 2016, sure enough, value did well.
27:14
Low volume momentum, quality did badly.
27:19
And so the point of the paper was, when factor or
27:24
strategy valuations are abnormally high,
27:29
you might want to go easy on using them.
27:33
I would agree with Cliff that you don't wanna make heroic,
27:37
huge bets on factors and strategies.
27:40
You want broad diversification, but just at the margin.
27:44
If one factor is dirt cheap and the others are expensive, you want a tilt.
27:49
I'm working on a paper called That Was Then This Is Now,
27:54
which points out that the situation's changed.
27:58
Most factors are trading cheap now, most factors are trading abnormally cheap now.
28:05
So the fact that multifactor had a dismal 5 years
28:10
is part of the reason that they're trading cheap now.
28:16
And so while money was pouring into factor and
28:20
multifactor and smart beta strategies in 2016,
28:24
at a time when the valuations for most of these factors was high.
28:30
That's just common sense.
28:32
That, excuse me, that's just human nature.
28:36
That people will pile into what's given them great joy and
28:39
profit without necessarily thinking about did that profit come because of
28:43
a structural advantage of the strategy?
28:45
Or because it just got more expensive?
28:48
Today we're in the opposite situation today, money's pouring out of smart beta,
28:54
out of multifactor, and they're poised to perform beautifully the next 5 years.
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>> Jon Hartley: Fantastic, so factors are cheap?
29:03
>> Rob Arnott: [INAUDIBLE] I think is great, value investing, I think is great.
29:08
Diversification outside the US, I think is great.
29:12
Particular pockets of opportunity would be emerging markets,
29:17
value developed ex US value.
29:19
If you got own US stocks, make sure it's with a value tilt.
29:23
And in bonds, yields are still inadequate most of the world,
29:29
except the emerging markets,
29:32
where local currency debt is yielding more than US junk bonds.
29:37
And those currencies are now cheap because the dollar has been so remarkably strong.
29:42
>> Jon Hartley: Fantastic, so it'd be a good time to get in the market if
29:46
you're not already in it and tilting toward these sorts of factors,
29:51
I think that's a great, very compelling thesis to me.
29:54
And perhaps the bottom isn't already.
29:56
So you may want to act soon if you're totally cash still.
29:58
>> Rob Arnott: Well, I like to buy at a period of peak fear,
30:02
I think in Europe we may be there.
30:05
You have people terrified that good German citizens will freeze
30:11
to death this winter because of the difficulties getting oil and
30:16
natural gas at a time of great need.
30:20
There's a worry of the European economies cratering because
30:25
the industries also need energy to function.
30:30
Usually, when you have elevated fear, the subsequent reality validates that fear,
30:37
but isn't as bad as the fear would have suggested.
30:42
And so if it's not as bad, the narrative shifts and things are pretty bad,
30:48
but not as bad as I feared, which means that the markets will rise handily.
30:53
So I think the US probably will have another leg down.
30:59
This doesn't feel like peak fear,
31:01
it doesn't feel like we have had a capitulation.
31:05
Non US stocks, if US stocks go another leg down, non US will test their lows.
31:11
But [COUGH] if I'm wrong about the US having another leg down,
31:16
you wanna be risk on in the markets that are cheap.
31:20
And so averaging in now makes sense.
31:25
Keeping some dry powder now makes sense.
31:30
I'm often asked if you think there's another leg down, should I be getting out?
31:35
My response is, you should have been getting out a year ago.
31:39
The market was a lot higher then.
31:41
Now you should be thinking about entry points.
31:44
>> Jon Hartley: Fantastic, I know just yesterday the EU
31:47
announced this new price cap on energy prices.
31:52
Very, very interesting to see, it's very much-
31:54
>> Rob Arnott: How enforceable
31:55
will that be?
31:55
>> Jon Hartley: Yeah, exactly [LAUGH].
31:57
>> Rob Arnott: [LAUGH].
31:57
>> Jon Hartley: It's amazing, just this perfect storm of a war in Ukraine
32:02
at the same time as this biggest inflationary burst since the 1980s.
32:09
The timing is- >> Rob Arnott: Latest NATO estimates
32:11
are that Putin's killed 100,000 of his own citizens already by
32:16
sending them to be cannon fodder.
32:18
>> Jon Hartley: So tragic, my thoughts and prayers are with everyone in Ukraine and
32:23
affected by this conflict.
32:24
I just wanna get into shift here to tech, cuz I know when we talk about value,
32:31
I feel we're implicitly talking about growth.
32:35
And usually, when we're talking about growth,
32:37
we're usually talking about tech, these days.
32:38
>> Rob Arnott: These days.
32:40
>> Jon Hartley: These days or at least the past decade.
32:42
And so I wanna talk just a little bit about Bubbles.
32:46
And so what's been happening to tech scene?
32:48
There's been a lot of announcement about tech layoffs recently,
32:52
something really, really we haven't seen in over 20 years.
32:55
It seems like we're almost potentially at the end of this second TechBubble,
33:01
the last being ending in the early 2000s.
33:05
We've had these acronyms over the past decade that I feel like have really
33:09
emerged.
33:10
FAANGs, Facebook, Amazon, Netflix, Google.
33:15
I'm curious, given that some of these companies now, Facebook,
33:19
Netflix, have seen 70% more sell-offs in their stocks,
33:24
how can one identify Bubbles or maybe anti-bubbles in real-time?
33:28
Is that a possible thing?
33:30
There's a huge debate, folks like Robert Shiller have a very certain view on one
33:35
side, and I know efficient market folks like Eugene Fama have a very different
33:40
view on the other side.
33:41
I'm curious, what your thoughts are on the sort of behavioral economics and
33:45
behavioral finance question of being able to identify bubbles.
33:48
>> Rob Arnott: Yeah, [COUGH] people bandy around the term Bubble very liberally,
33:54
usually without defining their terms and usually in retrospect.
34:01
TechBubble.com bubble 2000, FAANG Bubble.
34:05
I'm starting to hear people say FAANG Bubble.
34:10
In 2018 we thought, wouldn't it be nice if there's a workable definition for
34:15
the term Bubble that can be used in real-time?
34:19
We came up with one that I think makes good sense, and that is,
34:23
if you're using a standard valuation tool like discounted cash flow,
34:28
you have to make implausible assumptions for
34:32
the future growth in order to justify today's price.
34:36
And as a quality check on that part of the definition,
34:40
the marginal buyer doesn't care about valuation models at all.
34:46
And if you use that definition, then for quite some time,
34:50
FAANG stocks have been Bubble stocks.
34:53
I was debating Cathie Woods a year and
34:58
a quarter ago at Big Morningstar Conference.
35:03
And at one point I briefly described that definition and
35:10
I said so, given your fondness for Tesla,
35:15
what justifies a $3,000 target
35:19
price in terms of actual future growth?
35:24
And she said [COUGH] it's gonna grow 89% a year the next 5 years, and
35:27
then it'll be priced pari-passu with today's FAANGs stocks.
35:31
And I had been asked to play nice.
35:35
>> Jon Hartley: [LAUGH].
35:36
>> Rob Arnott: So I bit my tongue, what I wanted to say is 89% growth for
35:42
5 years is 25 fold growth.
35:46
So you're saying, Tesla will be 25 times as large in 5 years?
35:51
Amazon over the last 10 years has grown 25 fold.
35:57
You're saying it'll have, excuse me,
36:02
yeah, has grown 12 fold.
36:06
So you're saying that Tesla will have twice as much growth in half as
36:10
many years as Amazon?
36:13
I bit my tongue and I said, well, that just sounds pretty impossible.
36:17
Anything's possible, but that sounds impossible, and let it go at that.
36:21
But using that definition, there's plenty of Bubble stocks out there even now.
36:28
So I view this as a deflating Bubble,
36:32
much like the 2000 to 2003 unwind of the TechBubble.
36:38
>> Jon Hartley: Well, I mean,
36:39
I've watched some of that interview with Cathie Wood from over a year ago.
36:44
I feel very prescient, and I mean,
36:47
it's fascinating just to see this tech collapse.
36:52
And it feels very much like the end of a Bubble too,
36:56
seeing all these issues around fraud and FTX.
36:59
I don't think it's quite a coincidence that perhaps the Enron scandal of
37:04
the early 2000s sort of coincided with the end of the last TechBubble.
37:09
And the fact that we see these both frothiness and
37:13
sort of arguably fraudulent things going on at the same time, and
37:18
crypto controversies, and things of that nature.
37:22
It's interesting that the timing of these things seem to occur together and
37:27
that's not in a way that's coincidental.
37:30
Maybe mania sort of comes and drives in a sense.
37:36
We talked a little bit about growth in tech stocks.
37:38
Let's get back to the value side of things here.
37:43
The idea that investors should invest like Warren Buffett,
37:47
finding good deals like stocks that are high book-to-market values,
37:51
what gives you confidence in the long-term prospects of value investing.
37:56
Value investing has had a really difficult past 15 years or so
38:01
that I think has been humbling for a lot of value managers and
38:07
a lot of quants that are big into value investing.
38:12
What's the thinking and the evidence behind your outlook?
38:15
I think you're very bullish on value.
38:18
And how have I know you spoke a little bit before about how value
38:22
stocks have have fared fairly well in inflationary times, but
38:27
say maybe we are end up able to get out of inflation over the next few years or
38:32
so and the Fed is effective in achieving that goal.
38:37
I'm curious, what's driving your thesis behind value investing being a big
38:42
winner in the coming years?
38:44
>> Rob Arnott: Well, firstly, value has two main sources of alpha long-term.
38:52
One is what Fama and French call migration [COUGH] growth stocks,
38:58
high valuation multiple companies.
39:01
One or another of them falls out of favor,
39:05
drops off the list and is replaced with a new high flyer.
39:11
So that means something with a more moderate valuation
39:14
multiple is replaced with a higher valuation model multiple company.
39:18
Which means that with every rebalancing, there's less and
39:23
less earnings, dividends, sales for every hundred dollars you invest.
39:28
The value side has the other opposite happen.
39:32
Stocks percolate up out of value, come back into favor and
39:36
are replaced with new, unloved, deep-value names.
39:40
So you get this constant rebalancing out of companies that
39:45
are no longer cheap into companies that are deeply cheap.
39:49
And in so doing, you get more earnings, dividends and book value for
39:55
every hundred dollars you invest with every rebalance.
39:59
Now this Matters because growth stocks do grow faster than value stocks.
40:06
That difference historically has been about 12 to 13% per annum, pretty big.
40:12
The migration effect has been about 18% per annum,
40:16
enough to swamp that with room to spare.
40:19
In addition to that, you have a yield difference.
40:22
And so yield is an important part of returns for value stocks.
40:27
And that yield kicker is real.
40:29
So the advantages of value
40:34
are structural and powerful.
40:39
The disadvantage is that there's a cycle, it falls out of favor.
40:46
We wrote a paper, reports of value's death may be greatly exaggerated,
40:51
which came out at the beginning of 2021.
40:56
And that paper won Graham and
40:57
Dodd recognition as one of the two best papers of the year.
41:01
So I was really pleased with that.
41:02
>> Jon Hartley: It's one of the biggest finance practitioner
41:06
journal awards out there.
41:08
>> Rob Arnott: Yeah, Graham.
41:09
>> Jon Hartley: Named after two founders of value investing for
41:13
the big Warren Buffett aficionados here.
41:16
>> Rob Arnott: Yeah. >> Jon Hartley: It's actually Ben Graham
41:18
was Warren Buffett's sort of professor at Columbia, grandfather value investing.
41:24
>> Rob Arnott: Right, so in any event, in that paper,
41:28
we made two points, one minor, one major.
41:32
The minor one, although it's not all that minor,
41:34
is that book value is an antiquated measure of a company's assets.
41:38
If I spend $1,000 on a desk, the book value of my company goes up 1,000.
41:44
If I spend 1 million on R&D, it doesn't.
41:47
And I wouldn't spend 1 million on R&D if I didn't think I was gonna get it back
41:52
in reasonably short order over, let's say, a 5 year span or something like that.
41:58
So it turns out that if you use price to book value,
42:01
if you just add in R&D to the book value and then amortize it out over 10 years,
42:07
you have about twice as much efficacy as conventional price to book.
42:12
So that was an interesting finding.
42:14
The more important one was that,
42:18
value becomes cheap or expensive over time.
42:24
And when it's expensive, it often doesn't perform very well.
42:29
People are paying as much for value as they ought to, and
42:33
they're not pricing growth stocks at frothy extremes.
42:38
Then you get to a point where values dirt cheap.
42:40
Summer of 2020, the spread between growth and
42:44
value was 13 to one on a price to book value basis.
42:49
Peak of the TechBubble, it was 10 to 1, The norm is 5 to 1.
42:56
So we were saying,
42:58
we've just seen the most extreme relative valuation for value ever.
43:03
How much of it was because the value companies were doing badly?
43:09
None, that wasn't a contributing factor at all.
43:12
The value companies were doing as well relative to growth as they historically
43:17
normally have, they were just out of favor.
43:20
People thought the narrative again that the COVID lockdowns would lead to rolling
43:26
bankruptcies across the macro-economy, and those of course would be the value stocks.
43:32
So a lot of these companies wouldn't exist.
43:35
Well, trillions of stimulus made sure that didn't happen.
43:37
Bankruptcies in 2020 were only modestly above 2019, shockingly little change.
43:44
And as people began to realize that the value cycle turned,
43:48
people stopped pricing value stocks as an option on their future survival and
43:53
started pricing them as going concerns.
43:57
That's all it took to have that first massive leg up.
44:00
So I'm a believer in value structurally because of the migration effect and
44:06
the yield difference.
44:08
I'm a believer in value when value is cheap,
44:12
which it was extremely cheap summer of 2020.
44:18
Here's a fun factoid, Russell value underperformed Russell
44:24
growth by 4,000 basis points in the first 8 months of this decade.
44:31
It's now within 2% per annum of being in the black decade to date.
44:39
To recover a 4,000 basis point drop, you got to outperform by 6,700 basis points,
44:44
we're almost there.
44:46
And the Fama French value factor is already in the black decade to date, and
44:52
fundamental index is already ahead of the cap weighted markets decade to date.
44:59
So when things change, they can change very fast.
45:02
I'm often asked, did I miss my opportunity?
45:06
Is it too late?
45:07
My answer is for now, no, it's not too late because the gap between growth and
45:13
value, while it's come in considerably, is still in the cheapest quintile ever.
45:19
And there's still 4,000 basis points needed for
45:24
value to recover relative to growth in order to just get back to historic norms,
45:30
4,000 basis points is worth making the trade.
45:35
>> Jon Hartley: Well, I know that despite this not so great period for value and
45:41
starting maybe from around the time the global financial crisis to just 2021.
45:48
I know this year, especially early in the year,
45:52
was just a huge rebound for value and I think that may bode particularly
45:57
well in an inflationary environment for the reasons you've outlined.
46:02
It's very interesting to hear your thesis and
46:05
thinking behind why value investing is great prospects in the long run.
46:11
I wanna pivot next a little bit more toward your business and
46:15
kind of what makes research affiliates
46:18
different from even other quantitative investment managers, and
46:23
that you're all about indexing and creating thoughtful indices.
46:28
And what I think is so
46:29
interesting is we've seen this massive shift over the past really 40, 50 years
46:35
in investment management away from active management toward passive management.
46:41
And we have things like index funds and ETF's.
46:44
Now what I think is so interesting about your business is that,
46:49
you have a slightly different take on the pure market cap weights of,
46:53
say, the blackrocks and vanguards out there that are just
46:58
weighing every stock by their market capitalization weight.
47:02
And you're using things like value weights and accounting and
47:06
book value type weights.
47:07
And I think that's a very different way to try and capture value than,
47:12
say, traditional hedge fund equity long short stock pickers who
47:16
are picking value names that they, it's very different.
47:20
And also just from a format perspective, you're able to offer your
47:25
investment products through things like ETF's and index funds.
47:31
I'm curious, what do you think is right about index investing in general,
47:36
investing through ETF's rather than sort of do it at home yourself,
47:41
finding value names in the newspaper and so forth, or doing your own homework?
47:47
And what do you think are some of the also underappreciated travails that
47:52
indexers may face?
47:53
What ideas going forward might improve index fund management going forward?
47:57
>> Rob Arnott: Absolutely, well firstly, two answers to your question,
48:02
each of which deserves some discussion.
48:05
One is RAFI versus cap-weight, and the other is can you do cap-weight better?
48:11
Let's take the first one first.
48:14
>> Jon Hartley: And RAFI is Research Affiliates Fundamental Indexing.
48:16
>> Rob Arnott: Correct,
48:17
fundamental index basically means you look at each company and you ask,
48:22
what are its sales as a percentage of all publicly traded companies?
48:28
What are its profits as a percentage of all publicly traded companies?
48:32
What are its dividends plus buybacks as a percentage of all publicly traded
48:37
companies?
48:38
What's its book value plus intangibles R&D as
48:42
a percentage of all publicly traded businesses.
48:47
So ExxonMobil might be 2% of all sales and
48:52
2.5% of all profits and 2% of all book value and
48:59
one and a half percent of all dividends plus buybacks.
49:06
You can argue endlessly about whether it's 1.52 or 2.5% of the economy,
49:10
or you could just take an average of those.
49:13
And if you take an average of those, you get accrued approximate measure of
49:17
the footprint the company has in the macroeconomy our footprint on the beach
49:21
has multiple measures, length, width, depth of the footprint.
49:25
Same thing can be said about companies in the macro economy.
49:29
>> Jon Hartley: 3D footprint, like the 3D hurricane.
49:31
>> Rob Arnott: Yes, yes, except this is 4D because we're using 4 measure [LAUGH].
49:36
>> Jon Hartley: [LAUGH]. >> Rob Arnott: Anyway,
49:37
if you weight companies by their fundamental footprint,
49:42
a growth stock will be reweighted down to to its economic footprint,
49:47
a value company will be reweighted up to its economic footprint.
49:52
And the market loves the growth stocks, pays a premium,
49:56
hates the value stocks, prices them at a discount.
49:59
The market is shockingly prescient in determining which companies deserve
50:04
a premium multiple and which don't.
50:06
There's a 50% correlation between the premium paid for
50:12
a stock and its subsequent future growth.
50:16
That's cool, except the market overpays for these and underpays for these.
50:21
So there's a minus 50% correlation between the premium that's paid and
50:26
the subsequent IRR of the stock.
50:28
So the market does a good job of picking the companies and
50:33
a lousy job of picking the same stocks.
50:35
The implication of that is the value tilt of fundamental index is structural and
50:41
large.
50:42
The average value tilt is very similar to that of the value indexes.
50:45
It differs from the value indexes because it includes the growth stocks,
50:51
it includes the value stocks and the deep value it overweights a lot and
50:56
the extreme growth it underweights a lot.
51:00
It also contra-trades against the markets constantly changing opinion.
51:05
So as the market is changing its mind on what a company is worth you're gonna
51:09
concentrate against those largest moves unless they're ratified by changes
51:14
in the underlying fundamentals.
51:17
Now what this means is that you have a rebalancing alpha,
51:22
a value tilt alpha, and an index.
51:25
An index that studiously mirrors the look and composition of the macroeconomy,
51:29
much like cap-weighting mirrors the look and
51:32
composition of the stock market itself, because it is cap-weighted.
51:36
So when we first thought of this idea in 2003 and
51:41
back tested it, we first did it with book value and
51:46
with sales, both of which more or less can't go negative.
51:52
And by using those measures, we found that over the prior 30 years,
51:57
choosing the companies by fundamental size of the business and
52:02
weighting them by fundamental size of the business would give you,
52:07
historically, a 2.5% alpha per annum.
52:11
1% of that came from the value tilt, one and a half from the rebalancing alpha.
52:17
>> Jon Hartley: 2.5, that's a lot.
52:18
>> Rob Arnott: Yeah, now, since we went live, values underperformed, but
52:23
we've continued to beat the value indexes by about 1.5% a year,
52:28
2 in the more volatile markets, like emerging markets and small companies.
52:34
And that's been persistent,
52:39
7 out of 10 years, we win.
52:43
8 out of every 10, 3 year spans, we win,
52:47
95% of all 5-year spans we win, relative to the value indexes.
52:52
So it's a powerful concept.
52:55
But I like to think of it as indexing to mirror the look and
53:01
composition of the economy.
53:04
So you have an economy weighted index, and you have a market weighted index.
53:09
Both represent perfectly reasonable core holdings.
53:13
Now that brings us to the second issue, can cap-weighting be smarter?
53:19
Cap-weighting has two Achilles heels, one, which RAFI addresses.
53:26
Cap-weighting guarantees that any stock that's above its future fair value,
53:32
is weighted too heavily, the majority of your holdings will be in
53:37
overvalued companies, minority will be in undervalued companies.
53:43
RAFI fixes that not by knowing what the fair value is, but
53:46
by randomizing the errors.
53:48
A stock that's big in RAFI could be over or underpriced.
53:52
The errors cancel, instead of being systematically overweight,
53:55
the overvalued and underweight the undervalued.
53:57
The second Achilles heel of cap-weighting is the way they add and delete stocks.
54:03
Stocks are added cuz they've soared, they're dropped because they've tanked.
54:09
And so you're magnifying that effect of overweighting the overvalued
54:15
by adding stocks when they are extravagantly expensive.
54:20
We went back historically and found that stocks that were added were quite
54:24
literally at 4 times the valuation multiples of the stocks that were dropped.
54:29
What if you neutralize that?
54:32
You can do that in a lot of ways, you can do that by not
54:37
adding a stock until it has let's take S&P 500 until
54:42
it's been in the top 500 for 3 years back to back, okay?
54:48
By then it's no longer necessarily on a tear and
54:51
you'll have missed turnarounds, companies that soared and crashed.
54:56
Don't drop a company until it's been out of
55:01
the top 500 for 3 years back to back.
55:05
It will no longer be in freefall and
55:07
you'll not have dropped companies that cratered and bounced back.
55:12
So you reduce the turnover,
55:14
you reduce the sensitivity to price on your additions and deletions.
55:18
And by the way, even though you're still cap-weighting,
55:23
even though Tesla is still one of your 5 largest holdings.
55:28
You add 50 to 60 basis points per annum to conventional
55:33
cap-weighted indexes because you're not chasing
55:37
the latest frothy fad and fleeing the latest unloved stock.
55:42
So we're coming out with a paper I hope FHA will accept it
55:47
should hear in a few days or weeks in which we basically say,
55:52
hey, indexers, get smart about how you add and
55:57
delete stocks, you can make a better index.
56:00
And give your customers a better experience.
56:05
And if they won't, we will.
56:08
>> Jon Hartley: I like that, so we're gonna open it up to questions now.
56:11
I think we're gonna pass around a microphone.
56:16
If you could state your name and a brief question.
56:23
More questions than comments are preferred, but
56:26
also understand that folks need some background as well.
56:29
I think we have a question from Greg over here, you'd like to?
56:34
>> Greg Ferreira: Thanks, Jon, thank you again for being here,
56:37
my name is Greg Ferreira.
56:39
So there's a little bit of a debate going on right now to where the Fed's going and
56:44
how high they're going to raise rates.
56:46
So they get to what they call and how long they're going to rate this.
56:54
My question to you would be, if you were chairman of the Fed, and based on what you
56:59
said earlier about inflation and how you think, how you studied it in the past,
57:04
what do you think you would do in terms of how high you raise the rate and how long
57:08
you keep it there, and what tends to be more effective in fighting inflation?
57:13
Is it going higher in the shorter term, or is it going up to a maybe more
57:18
moderate levels of keeping it there for a longer period of time?
57:22
>> Jon Hartley: Yeah, so I think, just to repeat the question,
57:25
I think the question is, if you were chairman of the Fed.
57:28
>> Rob Arnott: What would I do?
57:29
>> Jon Hartley: What would you do [LAUGH]?
57:34
>> Rob Arnott: [LAUGH] Believed that during the good times,
57:37
you run surpluses and get the debt reduced, he'd be shunned.
57:45
A fellow named Ian McDougall was wandering the countryside in Scotland and
57:50
goes up to a local and says, how do I get from here to Inverness?
57:55
And the local says, well, if I were you, I wouldn't start here.
58:01
You don't start with a decade of free money.
58:05
That was a catastrophic mistake and a catastrophically failed experiment.
58:11
We're gonna be paying the piper for that for 2, 3 decades to come.
58:19
They claim to be data dependent, but
58:21
the data that they focus on changes from one meeting to the next.
58:25
It's whatever is the latest hot data point that they find interesting,
58:29
the data point that they pay no attention to.
58:32
That should be the central and
58:34
most important data point that they look at is the long bond yield.
58:38
Long bond yield is still set by the market, not set by the Fed.
58:42
And the long bond yield tells all of us what a market clearing price is for
58:48
those who want to borrow at a risk free rate, for
58:53
those who are truly risk free borrowers, or for
58:57
those who wanna defer consumption and get paid for
59:02
it by deferring consumption, by providing capital.
59:07
And viewed from that perspective,
59:09
the idiocy of negative real rates becomes self evident.
59:16
Why should they pay attention to that?
59:18
Cam Harvey is an advisor to our firm,
59:21
he was the first to notice that an inverted yield curve predicts a recession.
59:27
He published it in his 1988 PhD dissertation.
59:32
And I would argue that an inverted yield curve
59:36
doesn't predict a recession, it creates one.
59:42
Because what you're doing is saying to those who are willing to defer
59:45
consumption, defer consumption for a long time,
59:48
you're gonna get paid less than deferring consumption for a short time.
59:52
Or conversely, if you're a borrower, you wanna borrow money long-term
59:58
will charge you less than if you want to borrow money short-term,
1:00:03
which means, shut down new initiatives that are remotely questionable.
1:00:11
The result is that whenever the yield curve inverts, growth is stifled.
1:00:19
Now to a person with a hammer, everything looks like a nail.
1:00:24
The inflation is caused by elevated demand, diminished supply.
1:00:29
Fed can do nothing about supply.
1:00:33
So their view is, and they're very explicit about this,
1:00:37
crush the demand until it equals the supply.
1:00:41
All right, what does crushing the demand look like?
1:00:45
A recession, Australia was called the lucky country because for
1:00:50
30 years it had no recessions.
1:00:53
What was the central bank policy during most of those 30 years?
1:00:57
Was to have short term rates pegged, whether deliberately or
1:01:03
just by happenstance, at about one to 2% below the long rate.
1:01:08
And they had no recessions.
1:01:10
And they grew from being half the per capita GDP of the US
1:01:16
to being about 80% the per capita GDP of the US, cool.
1:01:21
So I think if I were chairman of the Fed,
1:01:25
I would set the Fed funds rate at 1% below the long yield,
1:01:30
adjusted every meeting to keep it about 1% below the long rate,
1:01:35
and go spend time with my family.
1:01:40
>> Jon Hartley: So I guess, follow up on that.
1:01:43
Do you think like a soft landing is possible that we could potentially,
1:01:48
I guess that the Fed is, potentially wouldn't have a Fed induced recession.
1:01:54
>> Rob Arnott: If the Fed is not determined to crush demand, yeah,
1:01:58
if it's not determined to crush demand, then, yeah, we could have a soft landing.
1:02:06
But they are determined to crush demand.
1:02:08
So I think the likelihood of a soft landing is remote.
1:02:13
I think we're in the early stages of a recession.
1:02:18
If you look at GDP growth,
1:02:20
we had two negative GDP prints in a row that used to be defined as a recession.
1:02:26
They changed the definition of recession to say falling GDP and
1:02:30
rising unemployment.
1:02:32
When you have two job openings for every job seeker,
1:02:35
rising unemployment is difficult.
1:02:37
But they're gonna do it, they're gonna make sure it happens.
1:02:40
And with that determination,
1:02:42
it creates very high likelihood that we have a recession next year.
1:02:47
It doesn't have to be a bad recession, it doesn't have to be a deep recession,
1:02:53
but it's very highly likely that we have a recession and
1:02:56
businesses have to act accordingly.
1:03:00
>> Jon Hartley: Well, it's fascinating, and there's, I think in general,
1:03:03
there's sort of three different causes of recessions over the past 100 years.
1:03:08
The three most popular causes have been pandemics, financial asset Bubbles,
1:03:14
like the TechBubble or housing crisis of 2008.
1:03:18
And then I think the most popular one, I think people tend to forget this is
1:03:21
actually Fed induced or central bank induced recessions.
1:03:23
And these are, I guess, coming back in vogue now that we have inflation back.
1:03:27
Well, it's very interesting to know what a potentially future
1:03:31
Fed chair Arnott would do.
1:03:33
>> Rob Arnott: It's never gonna happen [LAUGH].
1:03:35
>> Jon Hartley: Well, yeah,
1:03:36
a lot of people said the same thing about president Trump and I'm not sure.
1:03:42
>> Rob Arnott: Okay, let's not go there [LAUGH].
1:03:46
>> Jon Hartley: [LAUGH] Not a wise.
1:03:46
>> Rob Arnott: I liked his policies, but I think he's a lousy human being [LAUGH].
1:03:50
>> Jon Hartley: This would be Rob's last interview with the Economic Club Miami.
1:03:54
We've got a question here from Adam, feel free to yeah, just shoot it.
1:03:59
>> Adam: We've just come to the end of a 30 year period of
1:04:04
massive disinflationary macro trends.
1:04:07
So globalization, outsourcing, technology impact,
1:04:12
that has basically come to an end.
1:04:15
Globalization has ended, outsourcing has ended, or it's now at a static level.
1:04:21
So going forward, and we've seen at the same time interest rates coming
1:04:25
down systematically throughout that 30-year period.
1:04:29
So what is going forward?
1:04:32
What do you think is stable state or the equilibrium ten-year yield?
1:04:37
And what is the corresponding equilibrium P/E multiple for the S&P 500 as a result?
1:04:45
Because they should be related to one another, right?
1:04:48
So it's been 17 and a half times over that period.
1:04:53
Should that contract 15 and a half times on the forward basis?
1:04:58
>> Jon Hartley: So just to repeat the question for our friends online in
1:05:01
the microphone here, the comment, globalization seems to have ended.
1:05:06
What is the long-term equilibrium ten-year yield and P/E ratio?
1:05:17
>> Rob Arnott: Let's start with real yields, because the 10 year yield
1:05:23
will be real yield plus ten-year expected inflation.
1:05:28
Let's assume that the economics
1:05:33
profession consensus settles
1:05:38
in at 2.5% inflation.
1:05:42
I don't think a breakeven inflation rate of 2.3 today makes any sense at all.
1:05:48
But 5 years from now, hopefully it does.
1:05:52
I wish they would aim for price stability, meaning zero inflation,
1:05:57
but that's an outlier view.
1:05:58
It's very out of favor these days.
1:06:03
So if inflation is in the 2 to 3% range and the real yield is in
1:06:08
the one to one and a half percent range, then you're looking at,
1:06:14
let's say about a 4% yield right about where it is now.
1:06:20
So that's a good end point.
1:06:22
If you have 2% real yields on treasury bonds,
1:06:26
then a valuation multiple, I don't like using PE, I like using CAPE.
1:06:33
The price relative to 10 year smoothed earnings,
1:06:37
because PE, based on trailing earnings,
1:06:40
is often extraordinarily high just because earnings are depressed,
1:06:46
or extraordinarily low because earnings are peak earnings.
1:06:50
So the 17 times that you're alluding to is 17 times peak earnings.
1:06:56
The CAPE ratio right now is about 30.
1:06:59
And historically, when you get real yields of around one to 2%,
1:07:06
you find that the natural CAPE ratio is pretty good, it's about 20 times.
1:07:14
Well, that's a third off from today.
1:07:17
And so I think yields,
1:07:20
the Fed will push rates higher.
1:07:26
So treasury yields will rise from current levels,
1:07:30
though not necessarily very much and not necessarily very long.
1:07:36
But the eventual equilibrium level would be not dissimilar to today.
1:07:41
Equity valuations would be lower and
1:07:44
real yields would be in the one and a half range.
1:07:51
What that means is that,
1:07:53
we're not that far from equilibrium except on equity valuations.
1:07:58
With the important caveat that between now and then,
1:08:02
the Fed is determined to create a recession.
1:08:07
>> Adam: So get used to 6% mortgage rates.
1:08:11
>> Rob Arnott: Yeah, which makes sense on a long-term basis.
1:08:21
Blowing housing Bubbles by creating an environment of 2 and
1:08:25
a half percent mortgage rates really doesn't make good macroeconomic sense.
1:08:33
>> Jon Hartley: Getting used to 6% mortgage rates sounds horrifying to
1:08:37
a young prospective homebuyer going forward.
1:08:40
But I agree with you, maybe we've been in this period of 0% interest rates for so
1:08:45
long that we've all become so accustomed to it.
1:08:48
>> Rob Arnott: Exactly, it was aberrantly low rates.
1:08:52
>> Jon Hartley: All right, do you have any more questions, gentleman upfront?
1:08:55
And please speak loudly if you can.
1:09:04
>> David: Okay, my name is David [INAUDIBLE], from your comments,
1:09:07
it would seem like a stagflation scenario is very likely in your view.
1:09:11
You could expand a little bit on that.
1:09:12
And also, what are your thoughts on China for the next decade or
1:09:17
so [INAUDIBLE] >> Jon Hartley: Sounds like about an hour.
1:09:21
The question is thoughts on inflation on China.
1:09:28
Okay, safe, sorry, thoughts on stagflation.
1:09:32
So GDP contracting, economy contracting, and inflation at the same time.
1:09:37
And what Rob thinks about China?
1:09:39
>> Rob Arnott: Well, firstly, our work on inflation suggests that there's
1:09:44
reasonably good odds that the burst of inflation we've had is only
1:09:49
the start of an inflationary episode, not the end of it.
1:09:54
There's a 20% chance that it recedes over the next 2 years, but
1:09:59
there's also a 20% chance that it lasts a decade or more.
1:10:05
I don't like those odds.
1:10:07
That sounds like a formula for stagflation.
1:10:11
If we wind up with a short, mild recession and
1:10:17
the Fed backs off and Fed funds are back down to 3,
1:10:22
and the 10 years back at 4, and
1:10:26
equity valuations are a healthy multiple,
1:10:31
but not a lofty multiple, then we can
1:10:35
entertain a period of relative tranquility.
1:10:41
But I would say stagflation is
1:10:45
kind of the 30% bad news case.
1:10:50
With Fed ineptitude it's not unlikely.
1:10:56
And the Goldilocks scenario is a 20 or
1:10:59
30% benign case, in which case you really want to be
1:11:04
getting back invested outside the US in particular.
1:11:09
Now not wait, the China question,
1:11:14
I feel for the people in China,
1:11:18
you've got an autocrat at the top.
1:11:23
He's unreconstructed monolist.
1:11:28
He believes in absolute control.
1:11:32
His having Hu Jintao, his predecessor, marched off at the end
1:11:37
of the party congress suggests how far he's willing to take things.
1:11:45
The zero COVID policy.
1:11:49
I'm sorry, everyone in China will be exposed to COVID, it's gonna happen.
1:11:56
Show of hands, how many people in this room think that they have had COVID?
1:12:00
Or know that they have had COVID?
1:12:02
Okay, that's about 80%,
1:12:05
I'm guessing half of the rest of you didn't have any symptoms.
1:12:10
My wife's had it twice, no symptoms either time.
1:12:14
She was tested because of travel, in both cases, and found, I have COVID.
1:12:20
[COUGH] So zero COVID policy is stupid from the get go.
1:12:28
It's gonna spread, you want to protect the vulnerable and
1:12:32
just recognize that everyone's gonna get it.
1:12:36
Let's not blow up the economy over this.
1:12:39
[COUGH] In China, isn't it interesting how every time there's a massive protest,
1:12:46
they find a COVID case somewhere nearby and lock them down?
1:12:50
It's about control, it's not about COVID.
1:12:54
It's about punishing enemies, it's not about COVID.
1:12:59
And so I hope China has more enlightened leadership within the next decade.
1:13:08
The current leadership is scary.
1:13:12
>> Jon Hartley: Any other questions from the audience?
1:13:15
We've got one from Michael, yep, we can hear you.
1:13:19
>> Michael Corkery: Michael Corkery, my question is about,
1:13:21
what do you advise investors who are making their investment decisions
1:13:25
based upon information from a sort of neoclassical or
1:13:28
Keynesian theoretical approach or evaluation approach?
1:13:31
But you're seeing an administration which has fiscal monetary policies that
1:13:35
are being more and more dominated by modern monetary theory?
1:13:38
And how that continues if there's a reelection and those policies continue to
1:13:42
ramp up over the next 4 years, how will those models reflect reality?
1:13:46
And if they will, and then what advice do you give to counteract that, or
1:13:51
at least [INAUDIBLE] certain time?
1:13:53
>> Jon Hartley: So to repeat the question, I think the question is,
1:13:58
how does neoclassical and Keynesian sort of thinking around economics and
1:14:04
some degree that that influence on investing,
1:14:08
how does that work in an era of MMT, modern monetary theory?
1:14:14
Seemingly inspired- >> Michael Corkery: Okay, so,
1:14:16
if you're using the wrong map [INAUDIBLE]
1:14:22
there's lots of inflation happening,
1:14:27
but yes, it's COVID.
1:14:30
But a lot of it is that they believe that they can print as much money as they want
1:14:33
to as long as they can control their short term interest rates.
1:14:36
[INAUDIBLE] It may not be universal yet, but
1:14:38
you have a system where all of us were trained in neoclassical or
1:14:42
Keynesian economic theories and things of that nature.
1:14:46
And you see the world through that perspective, but they don't.
1:14:49
And so what they're doing doesn't make sense.
1:14:51
And if you're an investor looking at financial protection or
1:14:54
a model that is based upon neoclassical economics, and you are in a regime change
1:14:59
that is now modern monetary theory, whether we like it or not.
1:15:02
Then how does that, 5 years from now,
1:15:04
what's that return on investment going to look like?
1:15:07
What's the real value of the returns that you've got,
1:15:10
based upon the fact that if they continue this for the next 2 to 6 years?
1:15:14
What is the economic reality for the average investor [INAUDIBLE]?
1:15:18
>> Jon Hartley: Got it, so, I think the question is,
1:15:21
living in a paradigm where sort of policy has sort of shifted away
1:15:26
from sort of neoclassical, long-term structural growth,
1:15:32
pro-growth policy, or Keynesian demand management.
1:15:36
But where you're running deficits in bad times and
1:15:40
surpluses in good times, maybe like in the 90s, in the Clinton era.
1:15:45
How does shifting away from those traditional paradigms to one where we're
1:15:50
just always running deficits and presumably always having very
1:15:53
accommodative monetary policy, that's maybe changed a little bit recently.
1:15:58
How does that sort of regime shift weigh on investing going forward?
1:16:05
>> Rob Arnott: [COUGH] I view geopolitical shocks,
1:16:10
stupid policies, which is another form of shock,
1:16:18
as a means by which mispricing is
1:16:23
introduced into the markets.
1:16:27
And those willing to countertrade against them will usually win,
1:16:32
though it can take a while.
1:16:34
So MMT, one of the premises of MMT is when you do start to see inflation,
1:16:40
you'd better raise your taxes to rein in inflation.
1:16:46
And that's an area where I would actually agree with the MMT crowd,
1:16:52
that if you are determined to keep spending and
1:16:57
you've got inflation and you're not willing to
1:17:02
cut spending, that you have to raise taxes.
1:17:07
Or as Milton Friedman famously said, the correct measure
1:17:10
of the level of taxes is the level of spending, because if it's not-.
1:17:14
>> Michael Corkery: What does it mean for the investor, though, [INAUDIBLE]?
1:17:18
>> Rob Arnott: What it does for the investor is create disruption and
1:17:22
dislocations.
1:17:23
So you get stupid policy leading to 0 interest rates for multiple years.
1:17:31
Betting on rates normalizing upward
1:17:36
eventually wins, and did win.
1:17:41
Betting on equity valuations faltering wins, and did win.
1:17:48
And so, geopolitical shocks [COUGH] likewise create opportunity.
1:17:56
And so I would say, be nimble, look for opportunities.
1:18:01
And when you see a shock, ask the question,
1:18:04
is this still gonna matter in 5 years?
1:18:08
Is COVID still gonna matter in 5 years?
1:18:11
No, COVID will still be around, it's endemic, not pandemic.
1:18:17
But while COVID's not done with us,
1:18:21
we're done with COVID as a driver of policy [COUGH].
1:18:27
>> Jon Hartley: We have a question from Rodolfo here.
1:18:29
Would you mind saying your name?
1:18:32
>> Rodolfo Milani: Yes, my name is Rodolfo Milani, and
1:18:34
I just have a question about energy stocks.
1:18:37
There's no question that 12 to 18 months ago,
1:18:40
many of these stocks were definitely in the value camp.
1:18:44
Now with many of them having doubled or tripled, I mean,
1:18:48
they still may have low PEs and they still may have decent dividends.
1:18:53
I mean, is an Exxon or
1:18:54
a Chevron still a value stock to you after the kinds of movement they've had?
1:18:59
>> Jon Hartley: So the question is energy stocks,
1:19:02
which not so long ago were thought of as value stocks.
1:19:06
With the recent run up that they've had,
1:19:08
should they still be considered value stocks?
1:19:11
Or maybe should they be thought more of as growth stocks?
1:19:15
>> Rob Arnott: I view them still in the value camp.
1:19:20
Firstly, I'm a believer in global warming and climate change,
1:19:24
I'm a believer that it's human-generated.
1:19:27
I'm also a believer that it will change the world
1:19:33
very gradually, that it will take a long time.
1:19:39
I've been asked, why did you buy a house on the water in Miami Beach?
1:19:43
And my response is, I'm 8 feet above high water mark, or high tide mark.
1:19:52
And with sea levels rising about one inch every 5 years,
1:19:57
as is the current apparent pace, I may have to move in the next 150 years.
1:20:04
[COUGH] It's gonna take time.
1:20:07
And those who want to deal with it, with multi trillion dollar transfers and
1:20:13
with multi trillion dollar spending programs,
1:20:17
they're overlooking a very important reality.
1:20:21
And that is fossil fuels [COUGH] are currently, for
1:20:26
now, and for at least 2 or 3 generations to come,
1:20:31
central to a well functioning global economy.
1:20:38
83% of energy used worldwide is from fossil fuels.
1:20:43
The most optimistic projection I've seen is that that drops to 60% by mid century.
1:20:49
But the 60% is on a larger global economy, so the actual extraction of
1:20:53
fossil fuels in mid century would be the same as it is today.
1:20:59
At PIMCO's Secular Forum, they had a climate person speak,
1:21:06
and it was more moderate than most.
1:21:11
But I asked him the question, if this is the trajectory for
1:21:16
fossil fuel consumption, without collapsing the global economy,
1:21:21
how do you get to zero fossil fuel use by mid century?
1:21:26
And he didn't have an answer.
1:21:28
So you don't, without killing the world economy, killing billions of people,
1:21:35
and creating a world war unlike any we've seen in the past.
1:21:40
I view this as just and
1:21:43
is, we have no choice.
1:21:48
We're gonna continue using fossil fuels for decades to come.
1:21:52
In that context, yes, these stocks are still value stocks.
1:21:58
No, they don't have stranded assets, the assets will be used.
1:22:04
And I'm also a big believer in technology.
1:22:09
We will find technological solutions to global warming in the coming century.
1:22:14
Look at how the world is different today from a hundred years ago.
1:22:18
It is breathtaking, people a hundred years ago could not
1:22:23
imagine many elements of our current life.
1:22:27
The notion of asking Siri your probing question and
1:22:33
having this little handheld thing tell you the answer.
1:22:38
>> Jon Hartley: Let alone commercial air travel or air conditioning too,
1:22:41
I think are 2- >> Rob Arnott: Yeah, absolutely.
1:22:43
>> Jon Hartley: Of my favorites, you didn't have a 100 years ago.
1:22:46
>> Rob Arnott: So at the end of this century, I'm a believer, and
1:22:51
this is based on zero knowledge of what technologies will be developed.
1:22:58
I'm a believer that technology will answer the climate change problem,
1:23:03
but it'll take generations, not decades.
1:23:07
>> Jon Hartley: One last question from the gentleman over here.
1:23:11
>> Jones Torres: Jose Torres, Interactive Brokers, one thing the Fed talks a lot
1:23:15
about is long-term inflation expectations remaining anchored.
1:23:19
At what point do you think inflation expectations become unanchored?
1:23:24
>> Jon Hartley: So the question is, at what point do you think that inflation
1:23:28
expectations will become, re-anchored?
1:23:32
>> Rob Arnott: Unanchored.
1:23:32
>> Jon Hartley: Unanchored, aren't they kind of somewhat unanchored right now?
1:23:37
>> Rob Arnott: No, they're very anchored.
1:23:39
>> Jon Hartley: So it's long-term, okay, sorry.
1:23:40
>> Rob Arnott: Yeah, break-even and inflation rates are still 2.3%.
1:23:43
>> Jon Hartley: Yes, so the question is,
1:23:45
at what point will long-term inflation expectations become unanchored?
1:23:50
>> Rob Arnott: I think BEI very high odds can't stay
1:23:55
below 3 until this inflation cycle winds down.
1:24:02
>> Jon Hartley: Break-even inflation?
1:24:03
>> Rob Arnott: Break-even inflation.
1:24:04
>> Jon Hartley: At the 10 year or 30 year?
1:24:06
>> Rob Arnott: That's the 10 year.
1:24:07
>> Jon Hartley: Okay.
1:24:08
>> Rob Arnott: And if I'm right about that, I would say we've got 80,
1:24:12
20 odds that a bet that inflation expectations become less anchored.
1:24:17
I wouldn't say unanchored, less anchored in the coming year is highly likely.
1:24:25
>> Jon Hartley: Okay, Rob,
1:24:26
thank you so much for joining us, if you could please give Rob a round of applause.
1:24:29
>> [APPLAUSE]