Europe can avoid Japan errors, says Rob Arnott of Research Affiliates

Rob Arnott, founder of Research Affiliates, warns that Europe looks increasingly like Japan.

Lukas Sustala: You warn about the three Ds: Debt, Deficits and Demography. Do we need to be afraid?

Rob Arnott (pictured): No, just prepared. Our economies have lived through a demographic sweet spot thanks to the baby boomers. That has supported growth and capital markets for decades. People in their 30s and 40s invest and save and thus support asset prices, whereas older societies divest. Today, Europe looks increasingly like Japan in the 1990s. This is not a catastrophe, but you need to be prepared for it.

LS: Will European capital markets repeat Japan’s experience?

RA: That need not be the case. Japan started with dividend yields that were a lot lower than the ones of European companies. At the top of the stock market bubble in Japan the dividend yield amounted to just 0.4%. In Europe it is currently a multiple of that. That helps a lot.

But it is likely that GDP growth will be disappointing going forward, so the 3% yield we see today will be expected return. That will double your money every 20 years, in real terms. That is not bad.

LS: In this lower yield environment, will costs of investment products matter more than ever?

RA: We are seeing growing fee pressure on aggregate fees from the growing role of indexation. If people just want to buy the market, and not buy hope or a perception of skill of a manager, they will get an index.

Remember, when people buy an investment product, they are not buying performance. Performance is the past. The future returns are unknown. So they are buying hope.

LS: How much hope do investors need to invest in fundamental indices?

RA: (laughs) Only a bit. It is a very inexpensive way to earn, what was, historically of course, a very strong alpha. It is true, people are buying hope, but they are not paying a lot extra for it. Fundamental indexes don’t weight companies by their market capitalisation, but by how big their business is.
With cap-weighting, the more expensive a company is, the more you own. We try to avoid these shifting speculations in the market.

LS: How inefficient is the indexation of bond portfolios?

RA: The notion of cap-weighting of bond indices is patently ridiculous. Greece, before its default, had four times the debt of Australia, while Australia had four times the GDP of Greece. This is absurd even before considering the fictitious accounting of governments.

LS: You don’t trust their numbers?

RA: US data, for example, excludes the debt of the government-sponsored entities like Fannie and Freddie, or entitlements obligations. With these included, the debt would be much higher.

LS: Is the over-reliance on Frankfurt and Washington clouding investment decisions?

RA: It is a very dangerous process. People invest less based on fundamentals and care more about the expectation of liquidity. The Fed officially has had a dual mandate for the past 30 years, of full employment and moderate inflation.

Ben Bernanke adopted a third mandate: keep the markets from falling. That will not work because they distort the capital allocation process in a very serious way. The negative real yields on treasury bonds will prove to be especially destructive. The central banks are destroying the savers, but savings are the key driver of any healthy economy.

LS: Stocks have done poorly over the past 15 years compared to bonds. Will this revert?

RA: Relative to government bonds, yes. High-quality sovereign debtors in the developed world will give you a negative real yield. Stocks are priced to give you a positive real return, albeit a small one. But certain segments in the bond markets look very attractive.

It is important not to view bonds as a monolithic asset class. Company debt is more attractive in industrial economies. Emerging market debt is one of the few places that look interesting for long-term investors.  


Robert Arnott is the founder and chairman of Research Affiliates.

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