First he convinced some of us that cap-weighted indexing doesn’t work, now Rob Arnott, the founder of Research Affiliates, is back with more bombshells – that the equity risk premium, as we came to know it, is gone and not hurrying back; and that emerging market debt is “objectively a better credit risk” than US Treasuries, at a higher yield to boot.
Combine these two controversial thoughts, and it’s no surprise to learn that Arnott has been turning his attention to fixed income, with RAFI recently launching a bond business.
Research Affiliates has sought to reshape global sovereign fixed-interest benchmarks like it did traditional equity benchmarks, where it ignored price in favour of ranking companies based on their sales, book value, dividends, earnings and number of employees.
According to Arnott, established benchmarks which weight sovereign bonds according to the amount on issue are over-representing the countries least able to service their debts.
“Bond investors are lenders. Why should we deliberately choose to lend more to those who are most deeply in debt?” he asks, echoing sentiments in a recent note to RAFI investors entitled ‘Debt Be Not Proud’ (with apologies to John Donne).
Arnott’s team has come up with a way of measuring a sovereign’s capacity to service its debt, which compares the level of that outstanding debt to the country’s economic size.
RAFI measures economic size using four factors: gross domestic product, population (as a simple gauge of labour force size), land mass (as an even simpler gauge of its access to resources), and aggregate energy consumption.
The factors aren’t quite as straightforward as they sound.
The square root of the land mass number was used, as Arnott explains, “to avoid grossly rewarding big, sparsely populated countries like Russia, Australia, and Canada, or penalising small, crowded countries like Hong Kong and Singapore.”
He also placed a caveat on the energy consumption factor – that a country’s needs may partly be met through petroleum imports.
Country weights for each of the four factors were calculated separately, then equally weighted to arrive at an overall weight within the RAFI sovereign bond index.
As the attached graph shows, most of the countries with the best debt-burden-to-economic-size ratio, and thus most able to service their debts, were in the emerging markets.
He said the reversal of market weights to RAFI weights would be even more pronounced if the benchmark were able to include debt that was not publicly traded, such as that of government-sponsored enterprises (Fannie Mae etc), state and local debt, off-balance sheet debt and unfunded entitlements – some of which Arnott said could be very large, particularly in the case of the US.
Arnott admitted there were “pockets of discipline” in the developed world, anointing a ‘Prudent Nine’ including Australia, Poland, Slovakia, Canada, Finland, New Zealand, Norway, Slovenia and Sweden which collectively spoke for less than 4 per cent of world sovereign bond debt, yet totalled 6 per cent of world GDP, 18 per cent of world land mass, and 8 per cent of world RAFI weight.
Overall, however, developed markets account for 62 per cent of the world’s GDP and owe 90 per cent of the world’s sovereign bond debt. Meanwhile emerging markets collectively produce 38 per cent of the world’s GDP and owe just 10 per cent of world sovereign bond debt.
“Does hidden debt and off-balance-sheet debt change this picture? Yes. In the wrong direction!” Arnott exclaims.
“The emerging markets have, for the most part, little off-balance-sheet debt. The developed economies have, in many instances, vast off-balance-sheet debt. One might reasonably argue that — absent political risk — emerging markets are collectively more creditworthy than US Treasuries. Which invites a provocative question: when will US Treasuries be priced to offer a risk premium – a higher yield – more than the most stable and solvent sovereign debt that money can buy: emerging markets?”
Arnott is predicting a ‘3D hurricane’ – of debt, deficit and demographics – will suppress equity returns for years to come, particularly as baby boomers sell down their assets into markets with fewer buyers.
He says investors need to recalibrate.
“A 5 per cent returns isn’t a problem if you’re expecting a 5 per cent return. You’re only affected if you shoot for a higher return, spend accordingly, but then only get the more modest result.”
Straitened times suit Arnott and RAFI to some degree. He claims fundamental equity indexing outperforms the cap-weighted approach in about half of all bull market years, 80 per cent of single-digit return years, and 90 per cent of negative years.