By JACK HOUGH
Round 1 of the inflation debate has seemingly been won by the doves. But Robert Arnott believes the hawks will be proved right, and soon.
The inflation rate has "an 80% chance of topping 5% within five years," says Mr. Arnott, founder of Research Affiliates, a Newport Beach , Calif. investment firm whose strategies are used to manage $100 billion worldwide.
And he has a unique prescription for investors.
The inflation rate, experienced by consumers as rising prices for goods and services, was just 1.7% during the year through June, down from 3.5% the year before, according to the Labor Department. The long-term average rate is close to 3%.
The slow price growth validates the view of those economists who have held that sluggish spending and high unemployment are greater threats to the economy than inflation, and that the Federal Reserve is justified in keeping interest rates at extraordinary lows in an attempt to boost growth.
In an interview with SmartMoney.com, Mr. Arnott explained that although the gloomy economy has held inflation down, it will jump "toward the back end of the next recession"--a recession he believes will start within a year "and may have already started."
Some economists define a recession as two or more consecutive quarters of declining "gross domestic product," a broad measure of economic activity. GDP rose 1.5% during the second quarter, down from 2% in the first quarter, estimates the Commerce Department. It will revisit its second-quarter estimate on Aug. 29 when more data are available.
Mr. Arnott believes either a rise in taxes or a reduction in government spending will trigger a recession. (Government spending is part of GDP.) He says elevated inflation is inevitable during the next recovery because America's debt is mounting too fast for dollars to retain their value.
That raises the question of how like-minded investors should prepare. One popular approach is to buy gold, but the relationship between gold and inflation isn't especially dependable (see "Why Your Portfolio Doesn't Need Gold").
Another option is to buy Treasury Inflation-Protected Securities, or TIPS, whose payoff rises with the inflation rate. But yields on those are negative for maturities of up to 20 years. An investor who buys five-year TIPS gets a yield of about negative 1.2%. If the inflation rate jumps, those notes may prove a good deal, but if it doesn't, they will offer meager returns or even lose money.
A third approach is to buy real estate investment trusts, or REITs, which pass along the income produced by property to shareholders. But yield-starved investors have pushed prices on some of them to worrisome levels (see "It's time to Get Choosier With REITs").
Mr. Arnott recommends two more tools for fighting inflation. One is emerging markets shares. If dollars lose value, currencies of emerging markets may produce gains for U.S. investors. Many such markets have healthy economic growth and moderate debt levels.
Also, the MSCI EM index has lost 17% over the past year, versus a gain of 6% for MSCI USA, meaning that emerging market shares have become a better deal relative to U.S. ones. (For ideas on how best to invest in emerging markets, see "The Problem With Emerging Markets Funds").
The second tool may come as a surprise: high-yield or "junk" corporate bonds.
If inflation roars, the Federal Reserve will likely be forced to raise interest rates to contain it. As bond investors know well, rising interest rates typically cause bond prices to slide.
But junk bond investors may also benefit from inflation if a decline in the value of dollars makes it less expensive for companies to pay what they owe. According to an analysis by Mr. Arnott, junk bonds have a higher historic correlation with inflation than TIPS, even though TIPS have a contractual link with the inflation rate. Short-term junk bonds have the highest correlation of all, he says.
Of course, the first part of Mr. Arnott's prediction--the looming recession--could send prices for emerging-market shares and junk bonds lower. Inflation hawks who get the timing right may get good deals and protection.