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 gross domestic product 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 ‘three-D 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 return 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.