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By Samuel Lee

From the title of Rob Arnott's talk, "RAFI Strategies: Five Years Later," I was expecting an overly long (and frankly premature) victory lap for fundamental indexing. There was some of that, but the meat of the talk was on the "3D hurricane"--deficits, debts, and demographics. He laid out a powerful case that the United States and other rich-world nations are in deep trouble. Certainly the black to Brian Wesbury's white.

On deficits, Arnott said U.S. government deficits have been understated for decades: Under GAAP accounting, the kind applied to corporations, the U.S. has been running yearly deficits of 10% of GDP over the past several decades. He likened the U.S. government's accounting to Enron's. Zing.

On debts, the picture gets scary. Almost every developed nation has run up massive debts. Emerging markets are creditors. In the U.S., Social Security, Medicare, and Medicaid liabilities bring up government liabilities to over 500% of GDP, a point made by Laurence Kotlikoff and Scott Burns in 2004. Of course, long-run projections are imprecise, and small changes in assumptions can result in huge changes in the results spit out by net present value equations. Arnott does acknowledge that Social Security, Medicare, and Medicaid aren't real debts in that they can be cut without defaulting. In fact, he thinks they will be dramatically pared down in the coming decade, and major political battles will revolve around it. One reason why liabilities are so high is because lots of Americans are going to hit retirement age soon--an issue of demographics, the final leg of his doomsday trinity.

Arnott argues age distribution strongly affects GDP growth, drawing upon a paper he published with Denis Chaves. The rich world is losing its most productive workers as baby boomers retire. The sweet spot for GDP growth is when the share of 20- to 40-year-olds increases, as they go from GDP consumers to increasingly productive workers. Brazil and India are hitting their sweet spots; China is going to run into a demographic wave of elderly because of the one-child policy, but it's a ways off and not as bad as the United States.

Politicians take a lot of heat from Arnott. They probably won't rise up to the challenge of tackling these problems head-on. We'll probably default by hook or crook, via inflation and straight-up abrogation. He pegs the risk of double-digit inflation over the next 10 years at 50%. Implicit in his argument is that he thinks the endgame won't play out as long as it has for Japan. His record on inflation forecasting isn't great; he was calling for inflation protection three years ago, while the break-even rate has fallen. I think this is the biggest bone of contention between Arnott and me.

His recommendations for this aging, debt-ridden world? Get inflation protection. Expect asset prices to come under pressure as retirees begin selling them en masse to a relatively small pool of buyers. Look for opportunities in emerging markets. These are all reasonable, but very long-run projections.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Rob Arnott And The '3D Hurricane'