No Easy Answers: Decoding the Economy's Mixed MessagesPublished: February 16, 2011 in Knowledge@Wharton
Corporate earnings have surged and stocks have soared, but the housing market is still weak. Interest rates remain low, but are rising. Many countries' economies are perking up, but a jump in commodities prices is producing inflation. Governments in the United States and Europe are wrestling with huge budget deficits and debt problems. Knowledge@Wharton asks Wharton finance professors Jeremy Siegel and Franklin Allen and real estate professor Susan Wachter for their views on the global economy.
An edited transcript of the conversation follows.
Knowledge@Wharton: Welcome everybody and thank you for being with us today. I want to start asking the same question of each of you -- we'll just answer in turn. And that is, if you look at the economy and the financial markets in the U.S. and abroad today, what are the key factors that are driving things, both for the positive and the negative? Professor Wachter?
Susan Wachter: Job growth is, of course, the key factor in recovery and in the fact that it's a slow recovery. Profits have certainly been strong and that usually is a precursor to job growth, but job growth is slow. From the negative side, in many recessions, housing is the power driver to recovery. And of course, it's missing in action in this recovery.
Knowledge@Wharton: We'll come back to housing in a minute. Professor Allen, what do you see?
Franklin Allen: I think one of the key factors is what's happening in China and in the Middle East. The inflation numbers came out in China [this week] -- 4.9%. It's a bit below 5.5%, which was the consensus forecast, so that's good news. But it's still a high number and [higher] than last month. The big problem there is food price inflation -- China is even higher. The [Chinese] government has a big decision to make as to whether to try and calm things down and cool the overheating economy. Normally that would be something they would think hard about. But at the present time with what's happening in the Middle East -- particularly what just happened in Egypt and now looks to play out again in Bahrain and maybe even Iran -- they have a lot of nervousness because last time we saw events like that was Tiananmen Square [in 1989]. They've done a good job, so far, I hear from my friends in China, of not showing pictures of what happened in the Square and so on, but I think they are aware that this is a big issue. So, I think they'll be very careful. And they have to decide: Do we let things go on, inflation go on, maybe with a lot of food inflation, which is going to hurt many poor people in China, or do we start clamping down and trying to control the overheating?
Knowledge@Wharton: Professor Siegel, what do you see are the big factors overhanging today?
Siegel: I see some hopeful signs. We're getting a little better signals in the labor market on jobless claims, on slowing the unemployment rate, that I think are going to be a precursor to better job growth. Certainly, as Franklin mentioned, corporate profits have been doing very well and are expected to hit record highs this year. That's why you've had such a strong recovery in the stock market to about 15% below ... the all-time high reached in October of 2007.
But I also would like to reinforce what Franklin was saying about the food inflation. We're getting tremendous inflation in commodities and it's not just oil coming back, but food at exceeding records. Even such staples as cotton have just skyrocketed 200%. Now fortunately, for the U.S., I think only 9% of our budget is on food, but for the poor countries it's much, much greater. With these prices going up, that could [lead to] unrest, although I would suggest that if China wanted to [try and] solve it, revaluing the renminbi would be one way of doing that, [in addition to] reducing the cost of imported goods. But nonetheless, very few developing countries now have the same choice there that China does in terms of setting the exchange rate.
Knowledge@Wharton: Professor Wachter, let's talk a little about the housing market. Occasionally, we see signs of hope and then we get new data that shows prices are continuing to fall. What does all this mean? Are we near the bottom or not?
Wachter: Housing at this point is absolutely at the mercy of the overall economy. If job growth does pick up, then we'll start seeing some recovery. Right now, we're looking at continuing bouncing on the bottom, even sliding down. The consensus is prices declining another 5%, but that's with interest rates maintaining their current level. Indeed, if we do see interest rates going up in the rest of the world, inflation heating up, that may, in fact, lead us to an increase in interest rates in the U.S....
For the 30-year fixed rate mortgage, costs are going up, and that is now in the cards, in part, because of a policy decision that Fannie and Freddie will pull back, start raising their fees. There are simply slight increases in disparity, 30-year-fix over ten-year treasuries, which they usually track quite closely. So we've hit 5%. Five percent is, of course, historically, very low. But if we go up another hundred bases points, and we could, that would have significant impact over and above a 5% slide.
And then of course we've got a potential disequilibrium condition again because right now, 25% of home borrowers, mortgage holders, are under water. If we had 10% plus down, we would have 50% of borrowers under water, which triggers all sorts of potential strategic default issues. So where we are, it's on the bottom. It's not destabilized. We're not in a vicious cycle as we were a year ago. But potentially, we're there again, and then of course, that feeds into the rest of the economy -- no growth in construction, either in the residential sector or construction jobs, and that slows down the overall recovery, which again, feeds back to the housing. But the greatest concern is on the interest rate front.
Knowledge@Wharton: And the interest rates -- the higher the rate is, the more it costs to borrow a given amount of money. So fewer people can qualify, which affects prices. Is that basically how the process works?
Wachter: Right, and it is also simply this: People who are on the sidelines, who are thinking about buying into the housing market, becoming an owner versus a renter, were actually looking forward to what's going to happen to prices. As the threat of price depreciation increases, you'll find more people sitting on the sidelines [because] it becomes reinforcement [not to buy a home]. Expectations are extremely important in this market and so interest rates have a double impact. People are aware, especially investors, that as interest rates go up, prices will go down and that future expectation will pull people back from investing in housing. We see that happening right now.
Knowledge@Wharton: It often seems that the realtors will argue sort of the opposite. They'll say, "Well, if interest rates are going rise, you need to race out and buy right now."
Wachter: There is some of that.... Also, Fannie's and Freddie's fees are going to increase and there may be an attempt to get in while we still have these historically low mortgage rates. But for the longer run, it's a negative.
Knowledge@Wharton: There was a really interesting story in The New York Times just the other day saying that some evidence now shows that some of the more stable markets, like Seattle, are seeing price drops. They are suggesting that there's a kind of delayed reaction in some of these markets that we really hadn't anticipated. Do you see that?
Wachter: To call Seattle stable is really a misnomer. All of the West Coast markets are not stable, but nonetheless, Seattle was not a subprime heavy market and the initial decrease was due to this sharp volatility of flows in and then out of the subprime market.... That entire sector, the entire private, non-prime mortgage market is out of business, imploded. That's not Seattle's problem. Seattle's problem is an overhang of inventory relative to job growth and that's where we're seeing problems. Those are the markets that we're seeing problems in today.
Knowledge@Wharton: You mentioned underwater mortgages, which are people who owe more than their homes are currently worth. There was a statistic just the other day from Zillow saying that this had gone up to, I think, about 27% from just over 23% in the previous quarter. You mentioned if you go much higher, if interest rates go up and depress prices -- is this a surprise? Were you [surprised by] this much underwater mortgage ... and would you have expected the rate of underwater mortgages to go down by now?
Wachter: No. This is a fundamental failure, the consequences of which are going to be with us for many, many years. And no, it's absolutely not a surprise. It's trackable. The fundamentals are, in fact, what are driving housing markets as they always have. On top of the fundamentals, of course, we have this extreme volatility in capital flows into and out of the housing market, which came with the subprime crisis and the procyclical supply of credit. Now we're seeing the other side -- a procyclical tightening of credit....
Knowledge@Wharton: And finally, is there any benefit at all to lower housing prices? I mean, some people must benefit if they're entering the market for the first time.
Wachter: Sure, if they are stabily at bottom without a potential cycle of anticipating depreciating housing prices.
Knowledge@Wharton: Is there an optimum level of home price appreciation that we would find desirable?
Wachter: It's more the question of the dynamics -- clearly, we want inexpensive houses for affordability, but the dynamics are what are fearful at the moment, getting in, again, to housing price declines that feed expectations of further housing price declines. We ... went way above fundamentals in the period of the bubble, and we could also easily go way under fundamentals and in fact, we're not there. It's not happening for sure. I don't want to overemphasize this. I predict we'll continue to bounce along a bottom, maybe a sliding bottom....
Knowledge@Wharton: Professor Allen, you mentioned the new inflation numbers from China. I wonder if you could add to your comments a moment ago and explain how this ripples out and affects the rest of us. Obviously, it matters to the Chinese, but why would it matter to people in Europe and the U.S. and elsewhere?
Allen: Well, China is the second-largest economy in the world if you measure across the exchange rates. I think it's actually much bigger than that -- if you use purchasing power parity, or a number of other ways of measuring economies. For example, China has the largest automobile market now in the world. General Motors sells more cars in China than it does in the U.S. These kinds of things indicate just how important China is to the world economy now.
They have a tremendous effect on many of the global prices. Jeremy was mentioning earlier about commodity prices. I think many would agree the reason commodities are going through the roof is because of Chinese demand, and also, of course, Indian and Brazilian demand. It's not just the Chinese. But they're a major factor in that. If they raise their interest rates more, significantly more, then if their economy slows down, that's going to have a big effect on commodity prices and on many other things. That will have global effects. If they don't slow down their economy, then prices may continue to go up and that's also going to affect all these kinds of increases.
The price of oil is already above a hundred dollars a barrel. It could go up to where it was at the peak -- and it could go beyond that in the longer run. The basic problem is we've got about 750 million, 800 million people who live in Western-style lifestyles, but there are many billions of other people who are aspiring to that. It's going to [create] very large pressures on commodity prices and so on as we go forward. This is going to affect all of us.
Knowledge@Wharton: In the past when we've talked, you've expressed concerns about deficits. Is that still a major problem? Is it getting worse? Is it getting better?
Allen: My view is that deficits are a big problem. I think if you compare what the U.K. is doing compared to what the U.S. is doing from basically somewhat similar positions, you see two very different views of the world. In the U.S., we have yet to even really address what we need to do, let alone start to plan it in a significant way. This is a major issue. I think one of the interesting factors in recent weeks has been that the Japanese got downgraded by the S&P on their sovereign debt because they don't have a credible deficit reduction plan. For some reason, we're still Triple A and S&P hasn't downgraded us. That may have something to do with the fact that they probably would be regulated if they started being aggressive to the government.
But we really do have big holes in our public finance in many ways, and we need to start thinking about how we're going to address them. Because if we don't, then it's going to get into long-term interest rates as foreign investors and domestic investors start to worry about how we're going to deal with this problem. Are we going to inflate it away as many countries have done in the past? Are we going to tax it away? How are we going to deal with it? That uncertainty is one of the reasons long-term rates are going up, as Susan just mentioned. And of course, if we see, she was talking about 5%, but if we saw long-term normal kinds of rates - 6%, 7%, 8%, 9% -- or as we all remember from the 1980s, much higher rates, this is going to have very damaging effects on the economy.
Knowledge@Wharton: I won't ask you to take sides in a political fight, but we do have a new budget proposal from President Obama. Do you think it deals with this problem of balancing the budget or is it a good start?
Allen: I don't think either side has yet made a serious proposal because there are four big spending items - defense, Medicare, Medicaid and Social Security. You have to deal with those problems. Nobody is willing to deal with those problems yet. Perhaps, when we see the U.S. hit the debt ceiling in a few months time, we'll see some proposals. I think the Tea Party must come up with some serious numbers about what they're going to do, and we've got to cut one of those [four areas] or many of those things.
Knowledge@Wharton: It seems like everybody in this discussion is talking about cuts, where to cut and how deep to cut. Nobody is really talking seriously about tax increases. Do you think it's possible to balance the federal budget eventually without tax increases?
Allen: I think it's possible. Whether I think it would be desirable is another thing. I don't think we want to do it that way, so my own view is that we are going to have significant tax increases over the next decade to two decades.
Knowledge@Wharton: Now the European debt crisis seems to have fallen off the front pages. But is that really an issue that's behind us?
Allen: No, it's not behind us. It's still there. Portuguese rates have reached new records. I think we're going to see a problem in Portugal in the next two or three months. I think they will have to go to the [European Financial Stability Facility (EFSF), the euro zone's temporary bailout mechanism]. Their last bond issue was at 7.3%, which is generally recognized as being unstable. They can't keep borrowing at those kinds of rates.
I think there's wide agreement that Greece will default in some way or another; they won't, of course, call it that, but they'll have some kind of restructuring. That's going to cause a lot of problems psychologically in the markets.
And then, we've still got this problem that the European governments keep saying they're going to come up with some solution and a permanent mechanism, but when it comes to the details, they simply can't agree on them. This has all been exacerbated by the problems with the next president of the [European Central Bank]. I think many people had thought it would be [German economist] Axel Weber, who is currently president of the Deutsche Bundesbank, but he has now withdrawn effectively from that race. [Last week, Weber unexpectedly announced that he would step down from Bundesbank at the end of April.] The most obvious and most talented candidate is [Bank of Italy governor] Mario Draghi, but I think many people have worries about having an Italian at the head of the central bank, given all the problems with [Italian Prime Minister Silvio] Berlusconi and the potential instability if long-term rates go up, and the affect that that would have on Italy with about 120% of GDP in debt....
But there is a great deal of uncertainty about who's going to head the central bank. This is particularly worrying for the Germans who are very nervous about this whole process forward. So I would say we still have a long way to go in Europe.
Knowledge@Wharton: Professor Siegel, the stock market has done quite well in the last couple of years, as you said earlier. Just explain a little more why you're optimistic. I take it you're optimistic about the future?
Siegel: I can still see it go higher. There are three major factors that influence stock prices. First of all, earnings, the interest rates at which those earnings get discounted in, and the appetite for risk. There was very little appetite for risk a couple of years ago when the market hit the low, but I think that is increasing again.
But on the first two factors, it looks very, very good. The all-time high earnings for the S&P 500 ... were in the 12 months ending in June of 2007 at the peak of the market, at the peak of the economy -- was 91 dollars and 50 cents. Current estimates for operating earnings this year are 95 to 96. Back then, the S&P was at 1575. Now it's just over 1300. So we're much lower in price, we have higher earnings and we have lower interest rates.... Long-term rates are still very, very low. So the rates at which we're discounting those earnings are low.
Right now, if you look at operating earnings and I will agree, operating earnings are more generous than the gap earnings or reported earnings, although that margin has shrunk quite significantly. But we're selling around 13, 13 and a half times expected earnings here in 2011. If you go back and look at historical periods in post-World War II where interest rates, long-term interest rates, have been below like 7% or 8%, the average PE ratio has actually been 18 or 19. So we are below the long run, which is sort of quoted as 15 and we're even more below it if you take a wider look.
Now those interest rates will probably be increasing ... I do think inflation's heating up. So I think there's risk on bonds, but they'll be in the low category from a longer-term perspective. So in the early stages of a cycle, rising interest rates don't seem to restrict the stock market as much as later in the cycle. So we will have rising rates, but I still think we can have a rising stock market. There are threats, of course -- there always are, and the inflation threats that we see are in commodities and oil, which is particularly important to the U.S. We're a net exporter of agricultural goods, so we gain on the export side what we might lose in terms of prices, but we're, of course, a huge importer of oil. So as oil goes up, that increases our bill a lot and certainly depresses the U.S. economy.
Knowledge@Wharton: One of the concerns I've seen out there is a question about what is the nature of these earnings? So much of it seems to be tied to greater efficiency or productivity, rather than increased revenues. Is this a worry or not?
Siegel: Well, in the early stages, the last six or seven quarters, you were absolutely right. Wall Street was missing its revenue estimates, but exceeding its earnings estimates and cost cutting was important. What I think was very interesting -- we're about 80% to 90% done with the earnings for the fourth quarter [of 2010] and this was the first quarter, the fourth quarter, where a clear majority of firms actually beat the revenue estimates. It was the biggest margin in over three or four years. Bloomberg has been taking a reading on this particular thing. So we're beginning to do that, but it certainly does mean most of the ... cost reductions have been taken to continue to increase bottom lines.
We're going to have to get increases in the top line. You're going to have to have the nominal GDP go up, real GDP to go up, and have both of those rise in terms of revenues of the corporation. We should also realize, as we've said many times before, that of the S&P 500, 40% to 45% of their earnings now come from sales abroad. The strength of the emerging markets is something that is very positive. There are big problems in Europe and I agree completely with Franklin that this story's not over, that there's going to be a lot more crises and rescheduling of debt that is really a default one way or the other. But JP Morgan actually sharply raised its estimates of GDP growth in Europe, the euro area, for 2011, just two days ago. They were pessimistically thinking about a one and a half percent increase and they said we're just looking at our surveys and the data on the ground, and they boosted it to two and a half to three [percent]. Now that's still not robust, but it's certainly better than the near quasi recession level that they had before.
Knowledge@Wharton: I don't want to pick the market apart sector by sector, but I do want to ask about Internet stocks. There's a little bit of talk about whether there's sort of a boom brewing there. Everybody's very excited about Facebook and all of this -- what's going on?
Siegel: Well, it's the IPO, not so much the traded ones. Facebook is the big one and Twitter. We all remember Google, which was IPOed at around 86 and now is what, 600? And that was just a few years ago. So people are looking forward to that and people say, "I want a piece of it." It was interesting because I saw the movie The Social Network and of course, have heard about Facebook. When the movie came out, they said a value of $25 billion. Now they're talking about $50 billion for Facebook. I asked someone else, "How are they getting their revenue? They still don't pop up ads on there." We were trying to figure out, well, how do they get to $50 billion then in terms of the valuation? There's still a lot of questions over here. But really, outside of Twitter and Facebook and maybe a few other potentials, in the market themselves, we don't really see anything like the speculation we had in 1999 and 2000.
Knowledge@Wharton: Now let's turn to the bond market. What do you see happening there?
Siegel: It did well until October. I think that may be the turning point, as years later we'll look back at October 2010 as being -- my God, how did rates get so low? I think long-term and short-term interest rates, short-term interests being mostly a policy instrument of central banks than longer-term interest rates, are really built on economic growth and inflation, both of which are rising, which means long-term interest rates are rising. Real economic growth on a purchasing power basis, if you average emerging markets even with the slower growing developed markets, is four and a half percent. And inflation is going to go up. So it's hard to see how you're going to get long-term treasuries, three and a half, four, well, in the 30-year four and a half to five, but even in that range given the huge deficits that are going to continue to mount going forward. They're going to shrink in the next two years because of the recovery. And then they're going to remain at a barely tolerable level until all the baby boomers start retiring and then Medicare is just going to blow the lid off of everything unless that gets under control. It's hard to think about what bond prices might be at that time.
Knowledge@Wharton: So rising interest rates push down the prices of existing bonds because they're stingy?
Siegel: People who have long-term bond funds and certainly, they had done very well for very many years, have to really be careful and beware now of the pitfalls of those rising rates.
Knowledge@Wharton: Does that mean that investors should be reassessing their asset allocation?
Siegel: I think so. Some people tell me, "I'm in treasury bonds [because] they can't default." But the trouble is these bond funds are in long-term bonds and as they get shorter, they're not held to maturity. So they sell them and buy another long-term bond. So yes, you can, you know, permanently lose on government bonds in long-term government bond funds, even when no one defaults a penny worth on those bonds. I think some of those things are just not always well understood by some of the investors in those bond funds.
Knowledge@Wharton: And finally, your latest book talked about the need for investors to diversify internationally. How do you see that now? Is that still where the opportunity is? Is it still important?
Siegel: Well, there's been a bit of a pull back on emerging markets, which have done, you know, extraordinary well. Emerging markets from the peak before the crisis were down 70%. They're now within 10% or 15% of their all-time high. People backed off recently because of the inflation and it's hitting all of them, the food prices and all the rest. I do grant that that is a potential problem, but I think still that that's where you want to be ... Certainly not all your assets should be there by any means, but you should not ignore them.... I still think there's going to be a very rewarding investment for investors looking forward.