Dump growth stocks as 'illusion of tumbling inflation' and AI hype start to fade, investing legend Rob Arnott says

• Investors should dump growth stocks and buy value stocks as inflation will rebound, Rob Arnott said.
• Meanwhile, hype around the "AI miracle" is also starting to fade, he told Bloomberg TV.
• The legendary investor also warned a recession is likely if the Fed keeps rates high.

Investors should turn to value equities as a pick-up in inflation will make growth stocks a bad call, Research Affiliates founder Rob Arnott said.

"That illusion of tumbling inflation helped to fuel the surge in growth relative to value; now we're experiencing the reverse of that," he told Bloomberg TV on Tuesday. "Plus, people are starting to ask, is the AI miracle as miraculous as commonly perceived? Markets are driven by narratives, and that narrative is starting to get some questions."

This year's AI hype pushed investors into pricier tech shares, with seven companies leading the rally. Meanwhile, inflation largely trended downwards, encouraging shareholders to tilt toward growth stocks.

But by year-end, inflation will re-accelerate to 4.5%-5%, Arnott said. The latest reading of the consumer price index showed headline inflation was at 3.7% with core inflation at 4.3%.

Other analysts have also warned of a looming rebound, with BlackRock recently pointing to a 2024 inflation resurgence.

Against these headwinds, value stocks will win out, given their "abnormally cheap" levels, Arnott said. Apart from inflation, investors may also want to add value to their portfolio in case of higher interest rates, or coming instability in the economy. 

"Instability works to the detriment of growth because you wind up having people seeking a margin of safety. They want the underlying earnings. They want the dividends," he said.

To that end, Arnott predicted that a hard landing is likely if the Federal Reserve does not loosen monetary policy. In his view, the central bank is not paying enough attention to bond yields, with an inversion between short- and long-duration rates signaling a recession.

As to the tech sector, Arnott thinks AI can change the world, but said that these developments would be much more gradual than investors would hope. In a recent paper, he warned that AI-led investing has formed a tech bubble that will bring down the market when it pops.