- Inflation may stay above 3% for years, Rob Arnott said in an interview with Insider.
- Tight monetary policy and high valuations make stocks vulnerable to downside risk, he said.
- Arnott also shared multiple opportunities he sees for the long-term.
Investors and central bankers who are hoping that inflation falls back to the Federal Reserve‘s 2% target in an orderly fashion may be bound for disappointment.
After letting inflation run hot, the Federal Reserve is set on bringing price stability back to US consumers by hiking interest rates and reducing the assets it holds. Since June, the Consumer Price Index has indeed been coming down, but still remains historically high at 7.1%.
Arnott, whose clients include PIMCO and Invesco, recently conducted an analysis of inflationary episodes in developed (OECD) economies over the five decades (US inflationary episodes weren’t numerous enough for a meaningful sample size, he said). He found that, since 1970, almost every time inflation rises above 8% in these 38 countries, it has taken a median of 10 years for it to fall back below 3%.
The below chart shows the 29 instances where inflation has risen higher than 8% and how long it’s taken to fall to 2%. Only two times has it fallen back to 2% in under two years.
Arnott doesn’t completely rule out the possibility of inflation falling quickly, but this shouldn’t be a base-case outlook, he said.
Given that inflation could stay elevated for longer than anticipated, and the recession implications that a hawkish Fed has, Arnott said stocks are vulnerable to further downside.
Exacerbating that downside risk is the fact that US stocks are still expensive relative to history, he said.
“It would be unsurprising to see a capitulation in the months ahead where the market goes to new lows — not necessarily deep new lows, it doesn’t have to be a monster bear — but a decent likelihood that we see new lows,” Arnott told Insider on Wednesday.
He added: “The Shiller P/E ratio for US stocks is now north of 30 again. So it took us a bear market to get us down to a 30 multiple, meanwhile the bull market that ended in 2007 peaked at 28x.”
The S&P 500 hit lows in October at around 3,577. The index currently sits at 3,878, meaning new lows would represent at least 7.7% downside.
Where to invest over the next decade
While Arnott sees potential downside in the near-future, he said he sees US stocks returning 6-7% per year over the next decade.
But there are better returns to be had around the world, he believes. Arnott highlighted two trades he thinks will deliver 15% annualized returns over the next decade because of how undervalued they currently are.
The first opportunity is in international developed market value stocks, which are represented by the EAFE Value Index. He said the index’s average Shiller P/E ratio is 16x.
The second is in emerging market value stocks, which he said have an average Shiller P/E of 10x.
“I’ve been called a perma-bear, but I’m not a bear when things are cheap,” Arnott said. “Emerging markets value, international value represent bargains. Not screaming bargains, but bargains.”
Arnott said US value stocks, by comparison, should return 10-11% annualized returns over the next decade. The Invesco S&P 500 Pure Value ETF (RPV) is one way to gain exposure to US value stocks.
He also added that it will be “a decade of diversifiers winning.” Diversifiers, he said, include assets that are lightly correlated to stocks and low-risk bonds, such as Treasury-protected inflation-backed securities (also known as TIPS), high-yield bonds, and commodities.
One example of a diversifier Arnott likes is emerging market debt, due to lower risk of default and higher yields relative to US high-yield bonds, as well as the US dollar’s still-relatively-high strength.