Planning for inflation, before the fact

Market Beat

Rob Arnott is betting that investors in 2011 will become a lot more terrified about the prospect of deflation.

He’s also betting that they’ll wind up being wrong and that the real bogeyman lurking in the not- too-distant future is old-fashioned inflation — the kind that can be ruinous for investment portfolios that aren’t protected against it.

Arnott is a veteran money manager who heads Research Affiliates in Newport Beach. In 2002, he struck a deal with bond fund giant Pimco to oversee a mutual fund the firm wanted to launch.

Rather than pick individual securities, the Pimco All Asset portfolio would be a “fund of funds”: It would invest in shares of other Pimco funds, offering small investors a one-stop way to get global diversification among not just bonds and stocks but also commodities and real estate.

The idea wasn’t to have a static mix of assets, but to actively shift the fund’s investments depending on the economic backdrop and which markets looked like relative bargains.

Arnott has since built All Asset into one of Pimco’s biggest funds, with $17 billion in assets invested in shares of more than 30 of Pimco’s individual funds. Over the last five years the portfolio has gained an average of 5.2% a year, beating 98% of its peers in the so-called asset-allocation fund category and trouncing the woeful stock market.

This year the fund is up 10.2%, in a market starved for double-digit returns.

“He’s done a very good job of assessing which markets are truly undervalued,” said Russ Kinnel, director of fund research at Morningstar Inc. in Chicago.

Still, over the last five years the All Asset fund has taken a back seat in the performance race to Pimco’s flagship bond fund, Total Return. Who needed to diversify beyond bonds with Total Return racking up gains averaging 7.5% a year?

But with bonds now America’s hands-down favorite investment, and with interest rates so low, the question is whether pure bond funds can generate anywhere near the returns of the last five years in the next five.

And if there’s any significant revival of inflation — the great scourge of bonds because it eats away at their fixed-rate returns — people heavily invested in that market could be in for a painful shock.

For the moment, the inflation picture remains largely benign. The government reported Friday that the consumer price index rose 0.3% in August, but that was mostly because of a jump in energy prices. Excluding energy and food prices, the “core” rate of inflation showed no change. And the year-over-year rise in the core rate has been running at a mere 0.9% for the last five months, the smallest increase in 44 years.

With the economy still struggling, the low core inflation rate has fanned fears that the U.S. could fall into a 1930s-style deflation, meaning a broad-based, sustained decline in prices that would drag down wages as well.

Yet even as the CPI crawls along at less than 1%, inflation worries have bubbled up in some markets. A broad index of commodity prices has risen 8.2% since the end of June. Gold ended this week at a record high of $1,275.60 an ounce. And Treasury bond yields have bounced up modestly from 19-month lows at the end of August.

Arnott, however, thinks that deflation fears will soon mushroom. As federal stimulus spending dries up, he said, “We think there’s a pretty good likelihood of another recession” next year.

But another downturn also could force the government to pull out all the stops (again) to try to revive growth. That, to Arnott, would set the scene for a rise in inflation — in part a result of the huge sums of money sloshing around the financial system, with more likely to come.

Indeed, Federal Reserve policymakers, who meet Tuesday, are expected to continue to debate the need for another round of credit-easing. That probably would take the form of a massive increase in Fed purchases of Treasury bonds.

If he’s right about another recession in the near term, Arnott figures that many investors will bail out of classic inflation hedges on the assumption that deflation is the real risk. He thinks that could fuel widespread dumping of inflation-indexed Treasury bonds, for example, along with commodities and real-estate-related securities.

For the All Asset fund, that would be the signal to aggressively boost holdings in Pimco funds that target those kinds of investments, Arnott said.

“I expect to see a generational opportunity to load up on inflation hedges in the next 12 to 24 months,” he said.

At midyear, All Asset’s stakes in various Pimco funds that focus on inflation-indexed Treasuries, commodities and real estate accounted for about 22% of the fund. Now they’re down to 13% as Arnott has trimmed his positions.

He’s also hoping for a heavy sell-off in stocks and bonds of emerging-market countries in 2011 in tandem with any U.S. market slide, to give All Asset a chance to boost its holdings in those securities. He believes that emerging markets also will be a great way to offset higher inflation in this decade and the potential damage that could do to U.S. high-quality bonds.

One camp on Wall Street has been warning for the last 18 months that the government’s efforts to save the economy via unprecedented deficit spending and ultra-loose Fed monetary policy will eventually lead to hyperinflation — double-digit, or worse, annual increases in the CPI.

Arnott says that overstates the risk. But he believes that inflation could periodically spike from single-digit to double-digit territory in this decade because he thinks the Fed won’t be willing to throttle back fast enough on the trillions it has pumped into the financial system. Once that money begins to find its way into the real economy, inflation risks will rise, Arnott says.

A second source of U.S. inflation pressures could come from the robust growth of many emerging-market economies, which could fuel shortages of key commodities, he said.

But his forecast for the return of inflation assumes that there’s no horrendous economic crash that could easily push the country into deflation by destroying consumer demand for goods and services.

“Protracted deflation is something I just don’t see is possible,” Arnott said. He notes that the country’s heavy debt burden gives the Fed every incentive to boost inflation because that would in effect reduce borrowers’ debt loads: They’d be repaying debt with devalued dollars.

Arnott invests his own money with his fund shareholders: He says his 401(k) retirement account is fully invested in All Asset’s sister fund, All Asset All Authority, which largely replicates the holdings of All Asset but also can make riskier bets, including via Pimco funds that “short” the stock market — a bet on falling prices.

Asset-allocation funds like All Asset aren’t a panacea. Their management fees aren’t cheap compared with building a diversified portfolio of individual sector funds on your own using, say, Vanguard portfolios or exchange-traded funds. But that assumes you have the time and the discipline to monitor your holdings.

The asset-allocation-fund route also avoids the standard risk that investors will simply chase performance, buying more of whatever’s hot at the moment.

As Arnott put it: “How many people, when they’re investing their 401(k) money, go down the list of options and look for what has done well over the last one, three or five years?”

“We say, ‘What has really done badly over the last one, three and five years, and is it cheap now?’ ”