Arnott: Look to Alternative Investments to Battle Inflation

Saying that a “3-D Hurricane” — debt, deficits, and demographics — is lingering on the horizon for the U.S., Rob Arnott is taking several steps to prepare his portfolio for an inflationary climate.

Arnott tells that the U.S. budget deficit is worse than many think, if you include entitlement program costs like Medicare, Medicaid, and Social Security. And with an aging population that will mean a shrinking workforce, he says he sees slower growth ahead — and the distinct possibility that the government will try to inflate its way out of debt.

“If we turn to the printing press as the way to reduce the value of our debt, which I think we probably will, that creates inflation risk,” he said, though he added, “I don’t want to be seen as a prophet of doom. What I’ve described is a doomsday scenario if we harbor the illusion that we can spend the way we’ve been spending.”

In the face of potential inflation, Arnott recommends a number of portfolio changes.

One is to steer clear of the standard 60/40 stocks/bonds asset allocation approach. Investors, he says, need a third pillar besides stocks and bonds in their portfolio: “assets that can serve well in a reflationary world”. He says that means decreasing some stock holdings, particularly expensive growth stocks, and putting money into inflation-fighting investments like Treasury Inflation-Protected Securities and commodities.

Arnott also says investors should diversify through emerging market bonds. “Emerging markets have 10% of the world’s debt and 40% of world GDP,” he said. The G-5 countries (the U.S., Japan, U.K., France, and Germany) have 70% of the world’s debt and 40% of its GDP, he adds — but emerging market bonds have better yields. Emerging market stocks are also attractive because of the high growth in those regions, he says