Now that it’s clear the recession will not turn into a depression, stocks are poised for a recovery, says Wharton finance professor Jeremy J. Siegel. In an interview with Knowledge@Wharton, he said last week’s market decline in response to rising commodity prices — especially for energy — and fear of the ever-growing federal deficit was no more than a short-term setback.
An edited transcript follows:
Knowledge@Wharton: Thanks for joining us today, Professor Siegel.
Jeremy Siegel: Thank you.
Knowledge@Wharton: The market just had its first weekly [decline] in a number of weeks. What was driving that?
Siegel: I think there are two principal concerns in the market. One is the rising commodity prices — particularly energy prices and oil. And the other is the rising interest rates, which are in turn caused by fears of huge deficits, as well as rising commodity prices. My feeling is, the market would have been up last week, too, if it didn’t have to contend with those. And now, it’s concerned that those [factors] might push the economy down. Today [June 22], we had a decline in energy prices and in the market. But … energy prices and interest rates [are] our main concerns.
Knowledge@Wharton: Are the energy prices being driven by demand?
Siegel: Demand in China is rebounding very rapidly, although there are some experts who say that there’s still a lot of speculation in it, and that the price … has run a little bit ahead of itself. But China and India are recovering quickly. There are a record number of applications for new cars in China, and those generally use gasoline and oil. So, looking forward, over the next couple of years, those bulls in oil are saying there’s going to be a big increase in [consumption].
Knowledge@Wharton: Doesn’t the rise in demand [indicate] an improving economy overall?
Siegel: Certainly … a good part of the rebound in oil and in interest rates is because the depression scenario has basically been taken off the record. It’s now considered an extraordinarily low probability. So, we’re dealing with a severe recession, and [the question of] how fast we are going to improve from that. And once you’re into that mode, you don’t accept 2% to 3% bond rates any more, and oil won’t stay down at $35 a barrel. But I think some of [the movement has occurred] in anticipation of strong demand from China, particularly for oil, and, on the bond side, from the huge deficits, trillion-dollar-plus deficits that are going to cascade down on the market.
Knowledge@Wharton: The Fed is trying to keep interest rates to an acceptable level by buying a lot of those Treasury bonds. What are the mechanics of that strategy?
Siegel: In their last several meetings, they said that they are going to purchase or authorize [the] purchase of up to $100 billion of long-term Treasuries. The amount of Treasuries that they are buying is still small, very small, compared to the size of the deficit this year, because our deficit is going to be over $1 trillion. This year and next year, [the deficit will amount to] almost $3 trillion. It’s going to really overwhelm what the Fed can buy.
We have a very important meeting this week. The statement will come out at 2:15 on Wednesday [June 24]. We will see whether [the Fed is] going to continue these purchases, whether they’re concerned about this rise in these long-term rates. One of the dangers is that the Fed has nowhere near as good control over long-term rates as short-term rates. One of the dangers is to suggest [that they are] going to bring those long-term rates down, and then find that the market … could overwhelm them. And that’s not good, either — to claim you’re going to do something, and find out you can’t do it. So, the Fed has to walk very gingerly in this area, and be very, very cautious. My preference would be that they don’t overemphasize the long-term rate, because it could be something that is somewhat beyond their control.
Knowledge@Wharton: Nevertheless, the government is essentially borrowing money with one hand, and then buying that debt with another.
Siegel: But that’s actually the way that monetary policy is run. All our money is basically created by buying government debt. And the Fed, up until the crisis, held about $800 billion worth of government bonds. It now holds more, and the rest of the money it has created is just through lending to the banks. Basically, that process has been the monetary process, over 60, 70 years. As I mentioned, the deficits now overwhelm what the Federal Reserve has said it’s going to buy in the long-term Treasury area, so it’s not going to be what we call excess monetization of the debt, which could lead to inflation. Some people have talked about that, but the truth of the matter is, that is not occurring. The extra money the Fed has created is really through lending to the banks…. Bernanke claims that once the banks decide that they don’t need all this extra money, as some of them have, they will be repaying it, and that money will be withdrawn.
Knowledge@Wharton: It should be any time now — and we’ve been saying it for a while — that we might have a health care plan that has some costs attached to it. Is Wall Street holding its breath over that?
Siegel: Well, they’re watching the negotiations. There are going to be a tremendous amount of negotiations. The insurance companies and the drug companies [will all be] in that. I don’t have any special insight into what finally is going to be the result. There will be a lot of horse trading at the end. There probably will be a government plan, even though the insurance companies are against it. But my feeling is the insurance companies can still do very, very well, even with a government plan. There will be a lot of interest in additions and enhancements on that plan. So, it is a threat. I think it’s been discounted in the price of a lot of the insurers already. We’ll just have to see what the final bill turns out to be.
Knowledge@Wharton: There are some sectors that are doing well, perhaps because of their role in the economy. What are the sectors that you think are going to be showing improvement first, in terms of, hopefully, the coming recovery in the early part of 2010?
Siegel: First of all, we have the sectors that have done well through the recession. And basically, health care is one of them. Hiring has still been positive. That’s still expanding. Of course, in the long run, that’s somewhat of an indication of a problem, because our health care spending keeps on going up relative to the size of our economy. But it does support employment.
More and more forecasters are saying that this is the bottom [of the recession]. We will see [if it was May, or will be] June, maybe July. One of those three months, definitely, we would call the bottom. As we recover, those sectors that have been absolutely the weakest will show some increase. Home building has been battered down, and … there are some signs that area might show some improvement…. Automobiles have been really battered down. Obviously, there’s a lot of adjustment here. But there have been a lot of layoffs already in that area. So, that might be coming back. The strong areas, when the recession ends, will not be the leaders in terms of building new jobs in the economy. It will be those sectors that have lost the most jobs in this cyclical downturn. I don’t think they are going to gain back anything like what they had. We had too many people in the housing industry, and we had too many malls out there, and too much retailing. But there will be some rebound, as the economy comes around, in employment. And in fact, there are some economists who think that the June figures, which will be announced the first week of July, will show a loss of employment only of 275,000. This is less than half of what we’ve been seeing in monthly losses over the last six months.
Knowledge@Wharton: A lot of the people who are losing their jobs during this recession are people who are well along in their careers. They’re over 50. What are their prospects for employment when the recovery comes? As you just said, employment will rise again. Some industries will pick up, even the ones that were hard hit. But they won’t come back to what they were. What are the prospects for those people?
Siegel: Well, it’s going to be very, very difficult. I mean, as those old jobs disappear, they will probably be getting new jobs, but at lower wages than what they had before. One also has to remember that this has been a trend for many, many years — many, many decades. It accelerates whenever we have a recession, and it particularly accelerated in this recession, with the automobile slowdown being so severe.
But again, there will be some bounce back [in the auto industry], because the automobile sales recently are well below what’s called the “scrapping value” of automobiles. Cash for clunkers has passed. There will be some rebound there. And we just have to rebound just to replenish those [vehicles] that are getting older. Particularly now that oil prices and gasoline prices are going back up, there might be a little bit more demand for more fuel-efficient automobiles.
Knowledge@Wharton: Can we take it, then, that the stock market generally is going to mirror this tentative comeback that we expect in the economy in the latter part of the year? Not a giant leap, but a gradual gain, of the sort that we’ve been seeing overall since January?
Siegel: Well, of course, we had a tremendous downturn from January to March, a plunge. And we’ve had recovery back to those January levels, basically. So year-to-date, we’re sort of even on the market. Actually, in Asia, we’re well above it. Markets are about 20% higher than the year-end. For the emerging markets and the Asian markets, there’s been a much better recovery, because there’s been a better economic recovery.
It’s always very hard to predict the stock market. It’s certainly taking a breather now. I maintain that if we can keep oil at the $70 level, and if interest rates on long-term bonds, 10-year bonds, don’t go much above 4%, the market will stage another recovery that could bring it up another 15% to 20% — really, by year-end. It’s hard to know exactly when that will take place. But I think people really see [that] the recovery is coming. Again, just like they were relieved that, “Oh, it’s not a depression, it looks like it’s ending,” [they see] we are getting some recovery. I think if the [price of oil] and interest rates … remain stable and low, we will put more money in stocks. There’s still over $4 trillion in money funds that are earning about 1% or less, which is not as attractive as rates that I believe could be moved into the market, once prospects of the recovery seem more certain.
Knowledge@Wharton: So, we’ve finally seen some details of the Obama Administration’s plan to overhaul financial regulation. What’s been your initial reaction to that?
Siegel: My … considered reaction is, what’s the hurry here? We don’t have any danger of another bubble coming up. Financial institutions are not going to be taking too much risk in the next year or two. Probably in the next decade, given how destroyed they were from overleveraging now. The government, on one hand, says to the banks, “Lend. Take on some more risk.” And then all of a sudden, they say, “We’re going to have to rush financial regulation to make sure you don’t take [too much] risk.” I think that the financial regulation could be put on the back burner. There’s not going to be another risk splurge [by] banks while we tackle other problems and the recession, and then … all the other issues on the Obama agenda. So my opinion is, what is the hurry here?
Knowledge@Wharton: Well, given the political process, I would imagine that this will take a long time anyway, although it is effort that could be spent on other things, correct?
Siegel: Yes. The health care [issue], with all the costs, and long-term Medicare … are really more important to start tackling right now. [It has been] 75 years [since we] fixed the Great Depression …. We had [a bubble] 75 years later. I’m not going to say it’s going to take another 75 years to have another bubble, but it’s certainly not going to take 75 days. And so, again, I think that this is adding too much to the plate of Congress, with all the other issues that it has to consider over the next several months.