Podcast: Jeremy Siegel on Interest Rates, the Amaranth Implosion and the Thai BahtPublished: September 20, 2006 in Knowledge@Wharton
Optimism seems to be everywhere just as the Federal Reserve's Open Market Committee gets ready once again to pass judgment on where interest rates are headed. The consensus is that Fed chairman Ben Bernanke will keep the federal funds rate unchanged. Part of the reason is that oil prices are down and inflation seems to be under control. Still, the bursting of the commodities bubble has not been a universal blessing -- as investors in the Connecticut-based hedge fund Amaranth Advisors discovered after it lost $5 billion in value. The coup in Thailand also raises questions about international business risks. In an interview with Knowledge@Wharton, finance professor Jeremy Siegel, spoke with editorial director Robbie Shell and editor-in-chief Mukul Pandya about these issues and more.
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Optimism seems to be everywhere, just as the Federal Reserve's open market committee gets ready once again to pass judgment on where interest rates are headed. The consensus is that the status quo will prevail. Meanwhile, oil prices are down and inflation seems to be coming under control. To help us make sense of these trends is Wharton finance professor Jeremy Siegel, author of the book, The Future for Investors.
Knowledge@Wharton: The question on everyone's mind of course is the FOMC meeting. Most people seem to think that the interest rates will remain unchanged. What do you think?
Siegel: Absolutely. Actually the data that we received today, on the housing starts being down more than anticipated, isn't good news. But the good news was the Producer Price Index and particularly the core Producer Price Index down 4/10ths of a percent. That is very good news. There is no question that there will not be an increase. In fact, I believe there will not even be a dissent as there was last time. We had one Fed president who wanted an increase and I don't think that is going to happen.
What is encouraging is that Bernanke's forecast, which he made a couple months ago -- that enough tightening had in fact been applied to the U.S. economy -- is proving true. That's very encouraging ... because many people thought the Fed would have to continue. This is very good news. I think it's going to be on hold. I think the statement, the press release, that comes with it is going to acknowledge the fact that we have turned the corner on commodity prices and that will lead to, I believe, no more increases at all.
In fact, what is interesting and what Wall Street is now wondering about -- and what the betting is on -- is when will the first decrease of rates be? We have not heard that for many, many years.
Knowledge@Wharton: The price of oil has come down by more than $10 a barrel. Does this spell the end of the commodities bubble that you have been warning against?
Siegel: I think that it does. You know on these podcasts I have been saying that there are two major bubbles that the Fed has to puncture. One was the housing bubble -- we know that has been punctured. I've said that for many, many months. There's absolutely no doubt now, certainly with the housing statistics that we have. The second was the commodity bubble. That proved to be much more resistant to the Fed tightening. But it has now given way also.
We see oil actually dropping down to nearly $60 a barrel. Of course we all see what's happening to gasoline. It is actually at a six-month low. Natural gas has been collapsing, which is good news for all those who are heating with gas this winter. The rates are going to be much lower than what we have seen in the last couple of years.
And we're beginning to see it in the metals, in copper, zinc and aluminum. These are important for construction. Certainly the slowdown in the housing market has influenced these. So those two fronts of pricing, the housing bubble and the commodity bubble, have popped and as a result there is no reason for any further increases. That is what the Street believes, that is what the bond market believes, and that's basically good news for consumers.
Knowledge@Wharton: To stick with what you just said about the slowness in the housing market: As interest rates remain flat, what impact do you see on the housing market? In other words, will the slowdown, slow down?
Siegel: That's a good question. You know the builders are all saying, "My God, I've never seen a slowdown without interest rates moving up much." Certainly long-term interest rates have not moved up and they have moved down recently. There's been a huge shift in psychology which for two or three years was, "I've got to buy now because it's going up; it's going to be 10% higher." That has totally faded. In fact, the reverse psychology has set in.
What people are saying is, "Don't buy now - Rent". I've been talking to some realtors who have said that they have never seen the rental market as strong as it is today. And, in fact they are bumping up rents anywhere from 5%, 10%, 15% and more. This is not just happening in Philadelphia. There have been reports of this in New York and elsewhere. People are saying that the demand for housing is there. It has just totally changed from buy now to rent. "Let me wait a year." "All of those condos that are not going to be sold are going to be cut in price." And they will be cut in price.
The question is, will the decline in prices impact the consumer? Will that so-called reverse wealth effect set in? My feeling is that it won't be as severe as many people feel. This is because there were so many equity gains and many people did realize that it was probably not permanent. So, settling back to 10-15% even in especially the hot markets: I don't think it's going to have a severe effect. The fact that interest rates will stay stable and the fact that energy prices are down will tend to offset the contraction effect of the decline in housing.
Knowledge@Wharton: What about the troubles that the auto industry is facing? What affect will that have?
Siegel: Well, the market thought that GM and Ford were on the mend. They were very disappointed, first of all in the sales and then in Ford's reforms ....The U.S. auto makers have severe problems that they have just only begun to address. The market is asking for more.
But clearly layoffs in the auto market and in the housing sector are going to be a drag on the economy going forward. Not a recession. I think that particularly housing now, which probably added about a ½% to the GDP growth over the last three to four years on a yearly basis, will probably now be a drag of about 1% and maybe even slightly more. We may be looking also at a slowdown in the U.S. auto production industry; we may be looking at GDP growth that is just in the 2% region -- sluggish but no recession.
Knowledge@Wharton: That's very interesting. So, based on all of these trends that you have referred to, what will be the impact on equities and on the dollar?
Siegel: With the equity markets, there are always two sides to the coin when there is a slow down in the economy. The bad news is the profits could be below forecast. The good news is that interest rates will be down. So what you have to ask: Is the good news enough to offset the bad news and how much of a contraction will we get? If GDP goes down to 2%, what kind of earnings increases can we get? It's unlikely that we will get the double digit increases that we have had over the last four years. They've been very, very strong. I think it's the longest double digit increase quarterly spread that we've had in history.
By the way, the long rate was down today, dramatically, as a result of housing and inflation. Short rates look like they are going to follow, especially with the expectation of the Fed's [action]. Even if earnings only go up in the single rates, you've got very favorable valuation on equities. So, it is very possible that we will see a nice rise in equities, despite the slowdown in the economy.
In other words, they feared more of a tightening of the Fed than they feared a slowdown of the economy. Actually what they feared was both at once. The Fed would have then had to tighten in the face of a sharply slowing economy. Now it looks like there may be a slowing economy to be sure, but the Fed is not going to be tightening. So that second worry is off of the equity markets.
Last Friday, it is interesting to note, even though the Standard & Poor is still 20% or so below its all time high, the Dow Jones Industrials closed at the second highest close that they have ever had in their history, only surpassed by January of 2000. We're still about 150 points or so from the all time high, but once you get away from the tech stocks and you get to more of the non-tech sectors in the economy, you really see how much strength there has been in the market.
Knowledge@Wharton: Are there international risk factors to be taken into account especially now that the Thai Army has seized control of the government?
Siegel: Right. The Thai baht took a little hit and so did the market, although the latest seems to have shown a little bit of an improvement. Back in July 1997 the Thai baht was the first Asian currency to be devalued, and many people, when they talk about the Asian currency crisis, they point to the Thai baht as the beginning of this. There was a little bit of nervousness that went through the market [today] when everyone thought, "Oh my goodness, is Thailand going to start it again?"
There is just a world of difference today. Thailand was running a huge current account deficit; it was on a fixed exchange rate with an overvalued baht relative to the dollar. We are on a floating rate system now which releases all of these pent up pressures. I do not see this as cascading into a severe or any financial crisis. Clearly the slowdown in the U.S. will have ramifications for the Asian economies, but I would say that there is virtually zero probability of this turning into another Asian crisis.
Knowledge@Wharton: What about the Middle East? Are there any risk factors there or do you see the situation getting better?
Siegel: Well, it's sort of status quo there. We got a little better news out of Iran, not so good news though in terms of negotiation. The news out of Iraq seems to be kind of universally bad. But there doesn't seem to be any major upheaval. I think the good news is that in response to the falling oil prices, OPEC is not going to reduce supply to keep it up there.
In fact, they may be happy to see oil drop to below $60 a barrel. This is because they are very nervous about the development of alternatives for fuel sources. So they would rather that be delayed by a few years and get $55 a barrel than for it to be accelerated and get for a year or less, $65 a barrel.
So I don't think that they are going to be restricting supplies. We've had even today more signs of a big downward movement in the energy prices. And what we could really begin to see now is hedge fund selling of these commodity futures that could add to downward pressure.
Knowledge@Wharton: In light of all these economic factors that you've been talking about, what would you tell someone who has just been laid off as a middle manager in the auto industry or the financial service industry or the internet sector?
Siegel: Well I don't know if I'm the best person to answer that. It's going to be tough. I don't see a recovery in certainly auto and housing any time soon. I think basically the good news is that there is still net job creation in the U.S. at the rate of around 150,000 net jobs a month. So there still is absorption and it is not anywhere near as bad as other severe auto slowdowns that have really precipitated recession.
Knowledge@Wharton: Let me ask you about Amaranth, the hedge fund that imploded last week and lost about $5 billion in value. Do you think that hedge funds will face some sort of a backlash because of that?
Siegel: This is very interesting, the Amaranth situation. They have been piling into alternative assets. I've been warning that there isn't anywhere near the depth in some of these assets as many people believe. A lot of the commodity bubble, and those who have done research seem to confirm this, is due to hedge funds moving into these commodities.
With the commodity bubble breaking we may see the reverse. In fact some of the total collapse in natural gas prices may be part of the unwinding of Amaranth's positions in natural gas. This really gives the consumer a big break, which is the good news.
I think that if commodities continue to go down -- and that is a very good possibility -- we may see some concerted selling and some very bad results from hedge funds. This will cause people to really rethink their philosophy of allocating X% of their wealth to these hedge funds. These hedge funds are very risky. They talk about controlled risk. Amaranth talked about controlling risk -- it did not. They are taking very risky positions. They're very much into alternative assets and if these alternative assets go south, they are going to be hurt dramatically.
This actually is good for the stock market because that's the traditional asset classes; these people actually left stocks to go to hedge funds. Maybe they will say, "Hey, you know what? Maybe stocks aren't so bad after all." So the ultimate upshot of this is that the traditional asset classes might actually get a benefit if we really have a severe hedge fund decline. It's possible. I'm not saying it's certain. Every hedge fund has different positions. But the feeling on Wall Street is that there are a lot of net positive commodity positions in these hedge funds. They have had huge gains.
I was looking at Harvard and you know it was interesting. They were quoting how well Harvard had done in their endowment fund. That only went through the fiscal year June 30th, when commodity prices were very high. I just wondered that if you updated that today whether things are going to be quite as rosy. But commodities have been big, they've been important, they've given huge gain for quite a few years and we're seeing a very sharp reverse that could turn into a route potentially in these commodity markets.
So the wrap up $64,000 question is what advice do you have for investors?
Well, I am still positive on the stock market, probably even more positive on the stock market given that I think that the Fed is done and that the interest rates are going to stay low. As I mentioned earlier the bottom line is that I don't think that it is a recession. I think that profits are going to slow down definitely, but they are not going to take a sudden dive. So given what profits there are and the earnings forecast and these lower interest rates, stocks I think are at good value.