It's a Bird...It's a Plane...It's a Recession, or Is It?Published: January 23, 2008 in Knowledge@Wharton
It's been quite a week. Stock markets around the world showed sharp declines on Monday; on Tuesday, the Federal Reserve cut its benchmark interest rate by three-quarters of a percentage point. The rate cut helped stem the losses on some indexes, but by January 23, the volatility had returned. The obvious fear is one of recession -- a possibility that the White House and Congress are trying to avert by coming up with a stimulus package that will keep the economy off life support. Are we headed into a recession? How effective will the Fed's interest rate cut be, and what is the outlook for the Asian and European economies? Knowledge@Wharton asked finance professors Jeremy Siegel and Franklin Allen to comment on these issues.
Knowledge@Wharton: We'd like to begin by asking you whether the Fed overreacted to the upheavals in the global markets. What do you think?
Siegel: No,I think that they acted appropriately. If you look at where investors were expecting interest rates, by looking at the term structure, it was very downward sloping over the next couple of years, which means that investors expected short term interest rates to go down. We don't like inverted term structures. Bernanke has talked about that. They don't signal good times. You want to get that short rate below the long rate. I think that they went a long distance in doing that. What will be of interest, of course, is to see what they are going to do next week. The market surprisingly is expecting another 50-basis-point cut at their January 30th meeting, and this might be difficult to get.
Allen: I guess that I would agree with Jeremy. I don't think that they overreacted. But I'm not sure that it's going to do much good because I think that the problems out there are such that interest rate cuts won't help that much. And, even if there is another 50-basis-point cut, I think again it's not clear that it will have that much affect -- because the basic problem is still in the property market.
The problem is that both sides of the market are waiting. Until we find out what the property prices are going to settle at, we're not going to get too much of a resolution to these problems. This doesn't help that that much because the problem is that the people who can get credit are not necessarily going to be the people who are going to be affecting the property market.
Knowledge@Wharton: How likely is there to be a recession? Or are we, in fact, already in one?
Siegel: As you know, I've been one of the optimists saying that we were going to avoid a recession. I would say that professional economists are almost split down the middle now, maybe now a little bit more than 50% thinking that we are going to have a recession. But I'm much more optimistic than Franklin. Yes, I think that real estate is going to remain bad and prices are not going to recover for a long time and that there is still a huge overhang of housing, but that does not necessarily mean recession.
One of the other big problems that we saw was a disruption in the short term credit market, with very high risk premiums. Those risk premiums are going down and with the Fed lowering the benchmark rate, it actually means that the all-important LIBOR [London Interbank Offered Rate], upon which trillions of dollars of loans are based, is now almost a point-and-a-half lower than it was in early December. So, there are still problems in the credit market, I agree, but I think that the Fed can offset those to some degree. And I think that they are doing the right thing in lowering rates.
Knowledge@Wharton: How do you find the way that Ben Bernanke is handling the situation and how does that compare with the way, say, Alan Greenspan might have done it?
Siegel: Actually, this was a much more aggressive move than I think Greenspan might have made. This move surprised me and pleased me, but I didn't expect it. W e did see that Bill Poole dissented and Bill is known to all of us economists because he was an academic who taught at Brown and did a lot of great work. To paraphrase, he said that he didn't see the urgency and thought it could wait one more week.
The last time that such a deep rate cut happened was 9/11 -- just before the markets would re-open following the attacks. They orchestrated a discount and Fed funds rate cut just before that openingbut they only lowered a half-point then and today it was three-quarters of a point. So, this was very aggressive -- more aggressive than I think we would have seen from Greenspan.
Franklin: I differ from Jeremy. I think that we probably are in a recession already. I think that it's going to be a while before we know that but I think that there are a lot of indications that we are. I think that it's going to be a while before we reverse that. I agree with Jeremy in that this is very aggressive and that maybe it's worth a try. But as I say, I don't think that it's going to help that much.
If you look back at what happened in Japan -- they took interest rates right down to zero, they flooded the markets with liquidity, probably prices kept on falling for many, many years still and it just didn't stop the basic problem. This is a different kind of situation than we've had because it's very unique at least, in recent U.S. experience, to have falling property prices across the whole economy. In economies where this has happened, in other parts of the world, it's quite a negative.
Knowledge@Wharton: What do you think would be the right thing to do?
Franklin: I think that they should try this because it may work. But it's interesting to contrast what is happening in the rest of the world. There were rumors, yesterday or this morning, that there would be a joint ECB [European Central Bank] Fed and Bank of England rate cut,but that doesn't seem to have materialized.My guess is that the ECB won't cut rates. If they do, they won't do it nearly as aggressively. That is an interesting contrast to what is going on here.
Siegel: Franklin is bringing up an interesting point about Japan, but Japan was in much worse of a bubble, both on the property side and on the stock market side in the 1980s than the US. Japan had the double bubble of stock prices and property prices. Recently we did have a bubble in real estate prices but not in stock prices. We did have a stock market bubble seven years ago, but not now. So, one of those major markets wasn't in a bubble in the US and the property market was not as severely over-inflated, in my opinion, as Japan's was. One of the criticisms of Japan is that the Bank of Japan reacted too slowly to that deflationary situation. It's hopeful that the Fed, by acting faster, can prevent what happened in Japan.
Franklin: Jeremy, I agree with you that the bubble in Japan was much bigger. On the other hand, your good friend Bob Shiller predicts... I believe the last one that I heard was that the S&P Case-Shiller Home Price Indices is going to drop 50%....
What's your prediction?
Siegel: [I agree with] Bob -- property prices went too high, but I don't think that they are coming all the way back down to some historical mean. First of all, real interest rates are low. I think that we have maybe another 10% to 15% to go in property prices and not the 50% that Bob thinks is going to happen.
Knowledge@Wharton: President Bush has proposed a $150 billion stimulus plan that would include tax cuts for individuals and businesses. Will this be enough to encourage consumer and corporate spending, or is this more of a band-aid?
Franklin: I guess, in my view, that it's more of a political move than anything. I don't think that it will have that much affect; they just want to be seen as doing something.
Siegel: I think it is of minor impact. I think the Fed lowering rates is much more important than this boost of short-term purchasing power. But, don't forget, the money has to come from somewhere and it's coming by increasing the national debt. So, we're all going to pay for it eventually. We're sort of loaning the money to ourselves, so to speak, and this tries to encourage us to spend. I don't know that if this weren't a presidential year whether we would have everyone eager to give money back like this. I think that what the Fed does -- and I'm not saying that they can prevent every recession -- but they can make it milder. What the Fed does is going to be far more important in cushioning us from whatever decline we're going to have.
Knowledge@Wharton: Do these recent events bear any relation to the Asian crisis in the late 1990s, when stock markets around the world tanked because of credit problems in Southeast Asia?
Siegel: I don't think so. I actually think that the interesting comparison is the one that Franklin brought out about whether this is a minor version of Japan in the 1990s in how it's different and how it is not. Don't forget, in the 1990s we had a credit crisis affecting the emerging markets; this isn't as severe there.
Also, emerging market went from a fixed exchange rate system, holding the exchange rate way too high and borrowing too much. Then all of a sudden, they let it go and the currency devalued extremely [quickly] producing very high inflation and shocked their economies. There were very different causes and dynamics than what is happening now. The interesting comparison is: Are we in a mild form of what Japan experienced in the 1990s? I think that that will be debated over the next months and maybe years.
Allen: I agree with Jeremy. I think that the basic problem with the Asian crisis was that they had a lot of dollar denominated debt and they had an exchange rate crisis -- that's very different from what we have. But it is interesting that in places like Hong Kong, they had a very severe drop in property prices and that also led to a severe recession again.
Knowledge@Wharton: One of the interesting things about the subprime crisis is that one never knows when the next shoe is going to drop. One of the things that people are starting to worry about now is what might be the affect of the Monoline insurers and their defaults on the market. Could you help assess what that risk might be and what impact that might have?
Siegel: The problem is that the insurers who used to insure the municipal bonds went outside their area of expertise and started insuring CDOs, collateralized debt obligations and other instruments. That it is a serious problem. I've always been worried about this because insurance is effective when you don't have a "macro" event. But when you do have a macro event -- such as we have now-- the whole idea of an insurance on individual debt issues becomes problematical. That is something that has to be sorted out.
Recently we saw Warren Buffett moving into insurance and saying, "Hey, now I can provide the insurance with all of my cash."
I think that the banks and most of the investment houses have written down the lion's share of what could go wrong. It's in their interest to get that out of the way and I think that we do have new leaders in these firms, and they obviously want as much of that behind them as possible.
There is still the question of credit defaults and default swaps. There's nervousness out there about how these instruments are going to react. So far, it's okay and I think that what's really encouraging is that the term auction facility of the central banks has actually worked well. They brought that LIBOR rate down and some of those risk premiums down. But, to the extent that there are some of these other swaps and derivatives that might blow up - it is all a source of concern.
Allen: I guess I would be more pessimistic, and again it comes back to the property price issue. Everything is going to be driven by what happens to property prices and as long as they don't go down too much more, I agree with Jeremy about what's going to happen. I think though, that there's a significant chance that they will fall more and once that happens, we get back into a world where the next tranche of credit of mortgages will start defaulting in significant numbers.
And then we'll be back where we were in August, with a lot of uncertainties of where the defaults are. That will cause a lot of problems because, as Jeremy says, "Insurance isn't good for a macro event." We get back into what was the real problem in terms of the symptoms, which is the freezing up of the inter-bank markets. Jeremy is right; that's a lot better now, but it could happen again at any time because I don't think that anybody understands why it froze in quite the way that it did. This is because one would expect that banks which are well capitalized should be trading with each other because they know a lot about each other, but they were not and we don't really understand why that happened.
Siegel: I think that one of the things about our modern financial world is that traders are almost alike everywhere. We saw big declines in China. They don't have a subprime lending system there. We saw around the world, in every market a sharp decline. It's very correlated now. Everyone is on the phone with everyone else, everyone is emailing everyone else and so any fears or anxieties spread like wildfire, including true and false rumors.
You don't get the diversification that we often talked about from international investing, at least in the short run. In the longer run, I think that you do. One thing that I would like to say in terms of how much more property prices have to fall. The lowering of interest rates will lower mortgage rates. For conventional mortgages, rates are now near the low again, which is very important for first time buyers.
The short-term rate is going down upon which adjustables are based and everyone is worried about the jump in payment of those adjustables. Well, by bringing the short-term rates down, adjustable rates are not going to jump as much..... So, there is going to be less pressure from financing real estate which I think could help cushion the price decline. To that extent, what the Fed is doing can be helpful in the property markets.
Allen: I agree with that except the problem is that prices are falling. The optimal thing, even if you have cheap financing, is to wait until it hits the bottom. I think that that's the problem -- the market is frozen because both sides are waiting and we don't get good price discovery. It's not like stock markets where you get very quick priced discovery. It just takes a long time and that's the problem.
Knowledge@Wharton: What impact will these events have on the M&A market, in terms of deals being contemplated and those that are in the works?
Siegel: Asset-backed used to be the golden word that enabled you to sell anything that you want. Now, it's the poison word. You mention "asset backed" and no one wants to buy it. To some extent, that will bring the banks, who have access directly to the Fed, back into the picture. The Fed is showing its willingness to feed that liquidity. Borrowers will be going to the banks more often and getting funds.
My feeling is that there are a lot of smart people looking around now and just waiting for this type of environment to snag the deals at the prices that they think are decent. But it certainly won't be financed by the asset-backed commercial paper market anywhere as near as easily as before. And, because of the environment, everyone is going to scrutinize the deals much more closely.
Allen: I think that we may start seeing a lot of Sovereign Wealth Fund acquisitions, and that that will be a big change over what's happened before. This is because they have enormous amounts of cash, the dollar is low at the moment and it's easier for them to acquire. There are a lot of strategic acquisitions in particular. People talk a lot about China, but I think that particularly Indian firms will start making a lot of acquisitions. The usual problem is these political constraints that they worry about. [But] I think that in this environment they're going to find that those are loosened a lot because of this problem. Otherwise the market will dry up.
Knowledge@Wharton: Are you concerned about the growingclout of Sovereign Wealth funds and the kind of positions they are taking in institutions like Citigroup?
Siegel: Well, I've been predicting that for many years. In my book, The Future for Investors, I talk about how foreign capital is going to be huge and it's going to come not only from the Sovereign Wealth Funds but also from private investors abroad. We are just beginning to see that and they are becoming important by putting up some stakes here. We in the U.S. have to get used to this in order to support our markets. If we try to push those funds away, we are going to suffer dramatically. So, I think that it's a part of a broader process that would have happened even without the subprime crisis that we have found ourselves in.
Allen: I guess that I'm a little more negative about Sovereign Wealth funds in the sense, particularly, that some of the political issues are a little bit thorny. Although they don't have control rights at the moment, my expectation is that at the next tranche they will get them. This is part of a process where they will contain a lot of control rights.
The worrisome thing is that these entities, particularly in China but also in a number of other countries, are not independent. They are government controlled and there are security issues there. So, if there were some extreme events -- the obvious one was that there was some problem in Taiwan -- they could use this kind of power in a way that would not be good for us. Now, of course, they already have a lot of power because they own so many treasuries. But, this is additional ones which I think is of some concern.
Siegel: We are going to have to get used to that. We're going to have to get used to a greater and greater proportion of the multi-national corporations that are going to be owned by foreign investors, by either the governments or the private investors. I just don't see any way to avoid that trend. We have to think about how we can handle it, but I think we have to learn to live with that.
Allen: But you don't think that if we put our savings rate up into a positive range, Jeremy, that we could actually maybe prevent this trend and start owning our assets again?
Siegel: Owning our own assets?.... I guess I try to deal with things the way that they are. We're not there yet.
Allen: Maybe with property prices falling and the stock market falling, people will realize that they need to save for their old age.
Siegel: They will have to start saving again.
Knowledge@Wharton: Given everything that you have been saying, what's the best strategy for investors?
Siegel: You know I believe that stocks are "attractive" and relative to bonds, I think that they are extraordinarily attractive. There was something that used to be called the Fed Model which compared earnings yields on stocks with interest rates on bonds. There was an article in the Wall Street Journal earlier this week that said that this valuation is at an extreme, stocks very much more favorable vs. bonds. Safe bonds, such as triple-A's and governments, are down to 3.6% to 3.7% for 10 years maturities. I saw the inflation protected bonds selling today at 1.4% for 10 years. I think that broke through the previous low or extremely near it....
Allen: The real yield...
Siegel: The real yield -- 1.4%. Historically on stocks it's between 6% and 7%, and even if you think that it's only 5% or 6%; or even 4% or 5%, you're way above what bonds are -- and by margins that I think would even satisfy those more risk adverse investors.
I still don't find real estate assets particularly attractive although REITS [Real Estate Investment Trusts] rallied today with the lowering of interest rates. Actually, REITS were one of the only assets that was up when we came down here this morning. I agree with Franklin, there's a lot there yet to work out on the downside in the real estate area.
Allen: I guess I would take a somewhat different position than Jeremy, which is given that I am more pessimistic in terms of the recession; I think stocks are probably not as good as Jeremy does. Also, going back to the Japanese experience again, JGB [Japanese Government Bonds] at 10 years were at about 1.4%, which is about where the real yield is. So I would not be surprised if bond yields went lower than they are now, particularly in the middle of a curve.
Siegel: The JGB's actually went down to almost one-half a percent back in 2003. When we saw the 10-year U.S. Treasury down to 3.1%, which was in June of 2003, I said that we'll never see it that low again. Well....
Allen: Probably next week.
Siegel I hope not. That would mean another bad fall in the stock market.
Allen: I have a bet with Frank Diebold about whether we're going to be closer on the 10 year in the U.S. to 6% or 2%...
Siegel: By what time?
Allen: March 24th. We made this bet about five years ago and I had kind of written it off. And then a few weeks ago, he wrote to me and said, "My goodness, the 10 years are at 3.99%, and when I came down here at about 3.51%. So, it may be quicker.
Siegel: Looks like you won this bet. Well, I always say that when things are bad in the headlines, that doing nothing is often the best thing. This is because when you act when the market is extreme, either bullish or bearish, you do the wrong thing. It's also my feeling that long-term investors would be rewarded if they have some cash to put it into the market today. Maybe not by next week or next month, and even if we do have a recession, as Franklin suggests. Recessions are temporary - and if you ride those out you are rewarded.
Allen: So, currently the Nikkeiis trading at 12,500 and peaked at 40,000. That was 17 or 18 years ago though.... Again, I agree with you Jeremy that we're not nearly as extreme as Japan, but I think it may take a while before we get back up, if we do indeed have a recession and prices go down significantly. I guess my view is: I agree with Jeremy. It's not a good idea to do things in a panic, but there is a lot of risk in the next few months because we don't know what is happening. Government securities look like a good deal to me.