[Editor’s note: In view of the most recent market volatility and devaluation in China, Knowledge at Wharton has updated this interview, which was initially conducted earlier this week.]
Despite the global upheaval as the Chinese stock market plunged this week, Wharton finance professor Jeremy Siegel is sticking with his forecast for a 10% rise in the Dow for 2016 (or around 19,000 by year-end). But he cautions that the first half of the year will suffer an economic drag caused by lower oil prices, which touched a 12-year low on January 7.
He also notes the following, regarding the most recent events in China:
“The devaluation of the yuan is the most important issue driving markets in recent weeks. China knows the circuit breaker [a mechanism allowing the forced shut-down of selling in Chinese stock markets when prices fall too far, too fast] is not a good idea as it is set up, and they are going to substantially widen the band.
“The market is oversold at this point, but there is still worry about the Chinese currency,” Siegel continues. “The Chinese want the yuan lower but, unfortunately the government’s slow adjustment causes more people to want to get out of the yuan because they feel it will go lower. That is one of the things spurring the stock sell-off and some of the destabilization.
“The result is the lower yuan is going to export more deflation into the developed world, which is going to make it even harder for the central banks to hit their inflation goals, and that will lead to a much slower rise in U.S. interest rates by the Federal Reserve.”
The other big issue is oil prices, Siegel adds: “If they break below $30, it will make the transition for energy investors more difficult. Even though net lower energy prices are good for the U.S., there is capital in that industry that must move out to find other profitable projects. That is very disrupting – it’s not enough to spark a recession, but it does slow down growth in the first half until that capital gets redirected.
“In the second half [of the year], once people see that the Fed is not going to be as aggressive as before – and outside of the oil sector — earnings are going to be fairly good. So I think my positive projection has a very good possibility of working out. The negative sentiment we see now is getting way too bearish. Don’t forget, we are not anywhere near the panic lows we were at in August. We’ll see if [today’s levels] will hold – I think they will.”
In this Knowledge at Wharton interview, Siegel also discusses U.S. labor markets, productivity and absent wage increases, problems in the junk bond market, and the risks of worldwide deflation and recession.
An edited transcript of the conversation follows.
Knowledge at Wharton: We’re speaking today with Jeremy Siegel, a Wharton finance professor, about the outlook for markets in 2016. Welcome, Jeremy. Thank you for joining us.
Jeremy Siegel: Happy to be here, and happy New Year.
Knowledge at Wharton: Happy New Year to you as well.
Siegel: Although not so happy in the stock market today [Monday, January 4, 2016].
Knowledge at Wharton: Let’s talk about a couple of things. One is that 2015 was the worst for stock markets since 2008. The Dow Jones and S&P 500 indexes … lost a little bit, but basically they were flat. That is the lowest performance in quite a while. Where [do] you see them going in 2016? We have these issues in China, [with] suspension of trading, [and] and a drop of 7% in the stock market there. These are all connected. Let’s talk about the short term, and then we can talk about the long term.
Siegel: One thing is interesting: The worst in what — six or seven years, and that’s a flat market? That’s not bad, right? It shows how many up-markets we have had over the last seven years, and the worst is a slight negative on the index. If you add the dividend return, it’s actually a very slight positive. The major reason for that is we had a tremendous drop in earnings. Unexpected, both the rise of the Dow [at the time] and the collapse of the energy prices. The earnings were way, way below estimates. It is not a bad stock market performance given the decline in earnings that we had.
Knowledge at Wharton: The projections are that earnings in the upcoming reports aren’t going to be great either, and that we have this wrinkle, large or small, with China at the moment. What do you see? It’s a tough call for 2016.
Siegel: Let’s get to the real short run. The China [aspect] — a circuit breaker at 5% for a volatile market is way too small. There [are] also fears that there is a big lockup — they prevented insiders from selling stocks for six months. That’s going to end on Friday. Whenever something bad happens [people feel], ‘Oh my God, there’s going to be millions of shares sold on Friday,’ and ‘Get out now before the circuit breakers come in.’ It’s a mess. We all know that they’ve handled the market really badly. It’s an important market of the world, and that certainly contributed to the declines we saw today.
Knowledge at Wharton: Do you think the situation in China is not quite as bad as the market suggests today, and that technical things are making it overshoot on the downside?
Siegel: The market always overreacts. How much will GDP go up? I heard on CNBC some forecaster saying it will be as low as 2-3% for this year, which would be a shock. But most of the people that I talk to … say maybe it’s 5%. That’s a comedown, but still not a disaster. We wish we could get anywhere near that figure.
Knowledge at Wharton: Let’s look in to the first quarter [and] first half.
Siegel: The whole year.
Knowledge at Wharton: The whole year. What are you seeing?
Siegel: There’s a lot of pessimism now. If you take a look at bulls and bears, there’s a lot of downbeat on the market. I don’t think it’s going to be as downbeat. First of all, I don’t think the Fed is going to tighten as much as many observers fear right now. A lot of people [are] calling for four “tightenings,” and some even think more. I don’t think so. I think it’s going to be two “tightenings” — around that level. That is going to be a positive in the market, once they realize, ‘Oh my goodness, the Fed is not going to tighten that much.’ Hey, at that particular point, you look at the valuations of stocks. Even though they’re high from a historical basis, they are not high relative to current and prospective interest rates, and that realization will bring some money back into equities this year.
“With the earnings increase, and fears being allayed on how aggressive the Fed is, we would be at the same price-earnings ratio for a 10% move in the market this year.”
Knowledge at Wharton: Where would you see the indexes at the end of the year?
Siegel: We can do 10% this year. Again, we were flat last year. I think our earnings are going to rise about 10%, [and] bounce back from about the 7% drop that we had this year. With the earnings increase, and fears being allayed on how aggressive the Fed is, we would be at the same price-earnings ratio for a 10% move in the market this year.
Knowledge at Wharton: What do you see as the major positives and the major threats to the U.S. economy for 2016?
Siegel: The positives are: I don’t think interest rates are going to be a threat. In fact, they are going to be less of a threat than many people think. That is going to turn out on the positive side. Earnings are going to recover. We had a tremendous decline in particularly energy-earning sectors, and they’re going to recover. The threats are, my goodness, there are still people calling for $20 [a barrel] oil.
A drop in oil prices is good, net for the U.S. economy, although not as good as it used to be, because we are almost balanced in terms of imports and exports, with our tremendous increase in shale oil production over the last five years. But nonetheless, the S&P 500 is not just a U.S. index. It is way more heavily weighted towards energy — the manufacturing companies that supply the energy. Companies like Caterpillar and others with all of the drilling equipment and all of that, are definitely hurt and marking down.
Also the fact that the strong dollar, although it helps us in terms of imports, it is very challenging for those companies that sell abroad and bring back euros and yen that are worth less in dollars. That is another reason for the hit in earnings. So again, oil prices [going] down is not going to be good for the earnings of the S&P 500 even though it is not going to have a big negative effect on U.S. consumers.
Knowledge at Wharton: How about places like in Europe and China? They would benefit, of course, from these lower oil prices.
Siegel: China is a net importer and India is a net importer. By the way, India is growing 7%-8% now —faster than China. It’s the oil producers in the emerging markets that have been hit the most. China is a big story about what happens on oil — unquestionably. If we get a big slowdown in China, oil will continue to be under pressure in 2016.
Knowledge at Wharton: What are the chances that the relatively positive picture for job growth in the U.S. in 2015 will finally lead to some real wage growth in the U.S., which has been lagging — some would say for decades — when you account for inflation? And connected to that [is] real investment by corporations in increasing production or in expanding in some way.
“… The S&P 500 is not just a U.S. index. It is way more heavily weighted towards energy.”
Siegel: One of the biggest disappointments over the past four or five years is that while we have had a really good increase in the number of jobs, productivity growth and GDP growth have been very poor. People say, ‘Well, it’s 2%, and 2.5%,’ but that’s the trend rate. That’s if you had no increase in jobs. We, of course, have had a net increase in number of workers — over two million a year over the last three years. We should be producing 4.5% or 5% growth rates in real GDP.
We don’t completely understand the reasons for the productivity collapse. Part of it is more regulations, part of it is maybe a mis-measurement of prices. So many things are now free because of our cell phones and our apps and everything [else]. If they’re free, they’re not in GDP, because GDP is price times quantity.
There are some people, and I am one of them, who think there is actually more deflation going on than people think when you actually take into account all of the things that have gotten free over time. [This] means we are understating real GDP, and understating the growth of real wages. So there is some measurement problem, there may be some compliance problem, and a regulation problem. It’s not completely understood. If we get a bounce-back in productivity, you will see a bounce-back in the real wages.
Knowledge at Wharton: Is this connected in any way to the labor participation rate? It’s great when you see jobs increasing and so forth. But when you compare it historically to the percentage of the workers in the U.S. who are employed, which is in a way a more long-term measure, we are still struggling back to where we were before the financial crash.
Siegel: Actually, we’re at record lows. The participation rate has continued to fall — and you’re absolutely right — fallen much more than we would have expected. We do know the participation rate will be falling because the baby boomers are going into the retirement period now. But it is falling about twice as fast as most economists say it should be falling. Why people are quitting the labor force? There is a lot of speculation. But that is one of the things that has put pressure on the unemployment rate.
We’re going to have a jobs report Friday, and of course every month we have that jobs report. If we could get the participation rate to stabilize or even move up in 2016, that would take a lot of pressure off the Fed, moderate any sort of increases they would have, and that would be a very positive development for the U.S. economy.
Knowledge at Wharton: What do you think the odds are of that happening?
Siegel: I’m not sure. It keeps on surprising us on how poor it is. With a good labor market, [an] unemployment rate of 5% — one of the lowest in the developed world — we should see more people saying, ‘Hey, you know what? There are job openings out there.’ Why aren’t they coming back in to the job market? It’s not just low-wage jobs and so on. We don’t understand all of the reasons people change in attitude about workers, and double-income families. There’s a very complicated dynamic that is going on.
Knowledge at Wharton: This unemployment rate of 5% doesn’t really capture the number of people that are outside [the formal labor force].
Siegel: The U6, which includes those, [is] good. [According to the U.S. Department of Labor, the broader U6 measure of unemployment includes those who are unemployed as defined by the International Labor Organization; “discouraged workers” or those who have stopped looking for work; “marginally attached workers” or “loosely attached workers,” or those who “would like” and are able to work but have not looked for work recently; and part-time workers who want work full time but cannot due to economic reasons.] But that’s gone down a lot, too. That fell below 10% again. So we have reduced even the discouraged workers, the marginally attached workers, the workers that are working part-time instead of full time. All of those have also seen a dramatic decline. We have done a great job there, [but] still have not been able to coax people back in to the labor force.
Knowledge at Wharton: As bad as you say things are with that number in the U.S., it is even worse in Europe.
Siegel: Many of them have a much earlier retirement age, and much more generous pension. Unemployment insurance is automatic for them, whereas for us it isn’t automatic. There are a lot of differences that make ours a much more flexible labor market than in Europe.
Knowledge at Wharton: What signals should we take from the big dip in high yield – or junk — bonds?
Siegel: Almost all of that is in the energy sector. If you take high yield off the energy sector, it is only a very modest weakening. [It has to do with] the collapse of oil prices, and there was a lot of debt associated with that. [Also, the] master limited partnerships and the disaster that occurred last year. [Master limited partnerships are essentially limited partnerships that are publicly traded. Most of them are in the business of energy transportation, and saw a one-third drop in returns last year.] People thought they had a safe income vehicle, and those prices have been crushed 70% or more. That has hurt it. I do not think that we are going to see a weakening of the high yield market this year. In fact, there are probably some good values right now in that market.
“One of the biggest disappointments over the past four or five years is that while we have had a really good increase in the number of jobs, productivity growth and GDP growth have been very poor.”
Knowledge at Wharton: You would disagree with those who say this could be the canary in the coal mine that is suggesting there is some underlying weakness in financial markets and that’s why this is showing up?
Siegel: Yes…. You can always take a look at the 2007-2008 financial crisis, but that was much more endemic. This [crash last year had to do with] just the energy credits, which by the way the banks are not in at all. This is very, very important in contrast to 2007 and 2008. The banks basically [said], ‘We’re not going to do any of this financing of this oil [business].’ There was so much money on the sidelines that went in directly [that] they didn’t have to go to the banks. The banks are very, very sound at this juncture.
Knowledge at Wharton: How big of a threat is deflation? With China’s slowdown, commodity prices have plummeted. It’s not just oil, it’s copper, [and so on].
Siegel: Everything. It’s almost everything.
Knowledge at Wharton: Almost everything. We are at the end of a major pricing cycle, but now with China doing this pull-back, it is causing a tremendous effect. So where are we with deflation? Europe seems very vulnerable, China seems vulnerable, and if they were to devalue [their currency] again, for example….
Siegel: Which they are. We saw a tremendous weakening today in the value [of the renminbi], and it looks like it wants to be weaker. And yes, that does export deflation, and yes, I think (Fed chair) Janet Yellen is going to have difficulty meeting her 2% [inflation] target. That is one of the reasons why we are going to have very moderate increases in the rate this year.
Knowledge at Wharton: But not something that is going to spin out of control?
Siegel: I don’t see [that occurring]. If oil goes down to $20, that’s another leg down. But [things could change] if we get stability in oil. If you look at the core rates of inflation, they are not quite at 2%, but they are much closer to 2%, and they don’t show a sign of substantial weakening. I still don’t think [we need to worry about] deflation per se, but hitting the 2% target might still be a challenge.
Knowledge at Wharton: If the economy in the U.S. performs — the stock market performs — the way you are suggesting it will, that is going to help the world economy in general. But there are people out there that say the world economy could already be in a recession, or certainly that one is ahead. What is your feeling on that?
Siegel: The emerging markets are the most challenged, and of course those that are producers of these commodities are the most challenged. Europe is looking better than it did a year ago, and the U.S. is not really looking weaker. Looking in to this year, I still see 2-2.5% [U.S. GDP growth]. We’ll see what happens to the labor force and the productivity. [It is] not great for good labor market growth because of that productivity feature.
In Japan, Shinzo Abe’s plan for revival has been very slow in coming off, but I don’t see a recession there. The emerging markets are the most challenged of the group, and since their internal growth rate is so much higher. A recession [in] China is 3%-4% GDP growth. India still looks very, very strong. So I don’t see [a] world recession in 2016.
