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After a terrible August, when the U.S. stock market appeared to be headed for the pits, October 1 saw a massive rally that sent the Dow Jones Industrial Average soaring above 14,000. Markets seemed to be celebrating the effects of the Fed’s interest rate cut, and media reports said money was pouring back into equities. The following day, however, stocks began to fall again — because the National Association of Realtors reported a sharp drop in home sales. In short, Wall Street still seems to be sending out mixed signals.
What will be the long-term effects of the Fed’s decision to cut interest rates? Will the U.S. economy move past the sub-prime mortgage mess, or will it sink deeper into a morass and perhaps into a recession? What will be the effect of these developments on the European market? Knowledge@Wharton spoke with Wharton finance professor Jeremy Siegel and Jacob Wallenberg, chairman of the board of Investor AB, which is listed on the Stockholm Stock Exchange and is the largest industrial holding company in the Nordic region. In addition, he is vice chairman of Sweden-based SEB. An edited version of the transcript follows.
Knowledge@Wharton: Jeremy Siegel, you have been a consistent bull during this credit upheaval. Does the recent record price of the Dow vindicate your position?
Siegel: I’ll tell you, I was taking a lot of heat from Knowledge@Wharton readers. They were emailing me and saying, “Jeremy, you don’t look like you’re very right here.” My position was that yes, housing is in a mess. But still the credit structure outside of housing was strong and the economy wouldn’t go into a recession. What we saw was that contagion and uncertainty just spread like wild fire and the Fed stepped in appropriately, in my opinion. With the Fed’s backing, we are getting a lot of confidence back. The lower interest rates are a good reason the market is rising again.
Knowledge@Wharton: Jacob Wallenberg, we just heard about all of the problems in the U.S. market. Has the U.S. subprime crisis and the credit crunch had an impact in Europe as well?
Wallenberg: It has. Anyone who follows European news would see [mortgage lender] Northern Rock as a glaring example of this entire situation because there we had the run on the bank, which is about the last thing that any of us would [have predicted]. It just shows how fragile the system is when we have a situation of this nature. So, of course Europe is very much aware of what’s going on and Europe is paying a price.
We have seen a few banks in Europe take significant hits. It’s been in the news the last few days. It’s not only Citibank that has problems. UBS took a significant write-down; so did Credit Suisse and I think that you are going to see a few other players. We have seen at least one German bank being protected by the system. I think that we are going to see more fall-outs as the third quarter results are being announced.
But what is interesting is that Europeans are less aware of the nervous situation in this country that has prevailed over the last two months. The reporting in the European media, with the glaring exception of The Financial Times, has been more moderate. If I call and speak to my American colleagues in France, those haven’t been very happy calls over the last few months.
Siegel: What is also quite interesting about Northern Rock is that Great Britain does not have the type of deposit insurance that we have in the United States. It is much more skeletal, with just a few thousand pounds insured and then a fraction of anything above that. They are now debating whether they should have the FDIC [Federal Deposit Insurance Corporation] insurance that has actually been present in the United States for 70 years.
But what happened in the UK was that the Bank of England had to come around. It was one of the few banks that didn’t do much and now it had to say, basically, “We’re backing the deposits.” That has put a lot of heat on Mervyn King, the head of the Bank of England. There are certainly a lot of ramifications in Europe and the United States. I don’t see Asia involved yet, but there are probably some touches there.
Wallenberg: There will be investors that have [commercial] paper that will be affected one way or another, but maybe less so than the others.
Knowledge@Wharton: Jeremy, how can you explain yesterday’s stock market?
Citibank and UBS reported huge write-downs and yet their stocks rose.
Siegel: That was sort of puzzling. I think there are a number of things and it actually didn’t surprise me. First of all, they said, “These are our losses and this is our extent.” They also said — and this was important — that “we expect a much more normal environment in the fourth quarter.” That was very encouraging for the market.
Third, and this is something that I’ve been saying in some of my commentary in the last few weeks, is that we see loan demand coming back to the banks….. So many borrowers went directly to the market. The market now is way too expensive and what [these borrowers] are doing is coming back to the banks. The banks eventually can get fees on those loans because they have direct access to the Fedand the discount window.
Really, in the long run, this might be good for the banking system. I think that maybe several others are thinking, “Boy, they’re cheap now.” You pick up banks at 10 times earnings, 11 times earnings — people are thinking that this might be an opportunity for the future.
Knowledge@Wharton: Does that mean that the worst of the subprime mess and the credit crunch is behind us? Or, do you think that there is still some risk?
Siegel: I think that the worst is over. Everyone is going to say that “There is going to be a big bomb and there is going to be a hedge fund that is going to go under” [and so forth]. Well, we haven’t heard anything recently and that’s another thing that is moving up the market. No news is good news. That’s actually been the mantra of the market the last two months. No news is good news. We haven’t heard any real big bombs and they are taking their losses with the write-downs…. We are slowly returning to normal here.
Wallenberg: I tend to agree with that — especially the part, “No news is good news.” That is hugely important because at the end of the day, this is all a matter of psychology. The consumer sits on his hands because he or she is concerned — and that seems to slowly be going away. So, let’s just hope and keep our fingers crossed.
But one question that goes through my mind, as a banker, is of course the underlying economic consequences of this — and a lot of other things. Are we in the beginning of a real downturn in this market or aren’t we? And on that particular point, I don’t think we have seen the answer yet.
Siegel: I have been saying that there is a 25% probability of a recession. Most others have gone up to around 30%, 35%, 40% and some to 50%. I’m on the low side; I’m on the optimistic side. But I think that we’re going to see 1% to 2% real growth, which is above the zero mark.
Housing is still bad and will remain bad. But we’ve gone through a year of bad housing and still managed to stay above water. I think that we can continue to do that in 2008 — and then look better towards mid-year and further beyond.
Knowledge@Wharton: How do you think the Fed under Ben Bernanke is handling monetary policy? If the troubles in the real estate and mortgage markets continue, do you think there will be more interest rate cuts?
Siegel: I think that he has done extraordinarily well. The first move he made on August 17th was lowering the discount rate for borrowing. The reason he didn’t move the Fed funds rate then was because he didn’t have all of the votes he needed on the Federal Open Market Committee. It was due to that. But the governors themselves decided the discount rate, so it was sort of unprecedented.
And then, to get a unanimous vote for a 50 basis point cut — I thought this showed that his powers of persuasion are excellent. He’s a consensus builder par excellence. And, let me tell you, that going into that meeting on September 18th, he did not have unanimity among the bank presidents. There were probably three or four and he was able to convince them to go for the 50 basis point cut. I think that it’s right.
There are risks and I’d like to ask Jacob about that. We’ve seen what’s happened to the dollar. I think that it’s a little overdone in the markets. A plunging dollar is not good. It does bring about inflation. That’s the only downside that one sees so far on that. But, it’s too short term to see how this really plays out. I don’t know what your opinion is on that.
Wallenberg: Well, in all fairness, I am not an economist. I’m just trying to practice these things in day-to-day life. Of course inflation has to be the outstanding question at the end of the equation. But you know that is the reality; you don’t have the answers to everything, every day. You just have to wait and see how this pans out.
Siegel: The news coming in on inflation is good. And we don’t like to see oil over $80, although it’s interesting because the actual wholesale price of gasoline has stayed low and natural gas has also stayed very low. So, those big items that feed into the CPI directly have not been up as much as oil and we’re getting very moderate readings.
Knowledge@Wharton: Jacob, as a European banker, is inflation your biggest concern, or are there other issues that keep you up at night?
Wallenberg: Lately, over the last six months, inflation has been an issue. We have seen increasing interest rates but then we saw the whole subprime question coming in and a reversal on the interest rate side. If you ask anyone right now, it’s the underlying risk — a consequence of the subprime situation — that is the core issue. I think that bankers are less comfortable with the situation.
We’re very happy that UBS and the others came through and put numbers on what the expected losses were. Certainly, we can start to box the situation. So yes, we’re slightly less concerned but it’s not over yet. We’re going to wait and watch it for a little while.
But, generally speaking, the European economy is not stuck in a housing price situation, with the exception of parts of England. So the underlying economic development is on a slightly more positive note. And we have seen that Europe has done quite well for some time, with the exception of Germany.
Overall, Europe is doing slightly better than the United States right now, which I think no one expected. It is nice when we can beat the almighty United States at their own game — economic growth.
Siegel: Germany has not had that much housing inflation. But I hear that there have been some problems in Spain among home builders.
Wallenberg: You will find some pockets of that, of course.
Siegel: There was a lot of speculation that really started earlier in the summer. There are some pockets and it seems cities like London and New York City keep on defying gravity by moving higher. They are fueled by those people who have a lot of money and are still bidding freely for real estate.
Wallenberg: We have more Russians in London than you have in New York.
Siegel: It used to be the Arabs coming to London. Now are the Russians coming to London?
Wallenberg: Absolutely. It’s an important part of the equation.
Knowledge@Wharton: Jeremy has said that he believes there is a 25% chance of a recession. I wonder if you also share that view, Jacob. And if not, what do you think would be the consequences for both the U.S. and for Europe in the world economy?
Wallenberg: I’m not going to put a probability on it, but I have a concern. Despite all the nice warm words, I think that there is a significant risk. And I think that, at the end of the day, if nothing else, for every day that we are not in a recession — we are at least one day closer to a recession.
We have had a prolonged period of high economic growth and I look at the way that U.S. consumers have been behaving. I look at what Wal-Mart communicates and so on. It is obvious that the U.S. consumer is cautious — more cautious than before. That might very well spill over into a recession or a recession-like economic environment. The question then is: Will that spill over into the rest of the world or not? And what do China and India mean in this overall equation?
Reasonably, there are more cushions today than what we would have had 20 years ago. Reasonably, Europe is stronger today, more on its own than ever before. So, maybe it’s not going to spill over entirely. But on the other hand, this might be a locomotive of the United States economy. Despite the fact that I am not an economist, I cannot see the United States going into a recession without that having some significant consequences in the rest of the world. I really can’t see that happening.
Now, when I say significant, I mean that other parts of the world could go into a recession as well. On the other hand, that’s part of the game. It’s even in the bible –seven good years and seven bad years. There is nothing peculiar about it. It’s human psychology.
Siegel: We’ve had 10 good years actually, between 1990 and 2000.
Wallenberg: I’m sure we could find other exceptions. But it’s more the principle. You have to learn to live with these things — and that’s the voice from reality.
Siegel: I think that we are more in a mid-cycle slow down, very much like 1995. After the Fed raised rates dramatically in 1994, we had a big slow down, but no recession in 1995. And, here we are also suffering with the fall-out from a rise in rates and excesses that come when the rates are low for a long time.
I think that it is going to be the same — that there’s going to be a slow down and then a pick up. At least, that is what I hope because you know we had some very good years in 1996, 1997, 1998 and 1999 and another four years of expansion, before it got also overblown by technology and all sorts of other things that happened later on.
Knowledge@Wharton: What would be the appropriate strategy for investors these days?
Siegel: I always say, “Keep your eyes towards the long run. Don’t panic.” This was so evident in what we saw this summer — all the gloom and doom, [people saying] “this is the end” and all that. A lot of people became safer and are now sitting on the sidelines and the market is back where it was. They are sort of regretting it. If you stay in there for the long run and allocate properly, you will see the dips as times to buy. I’m sure that you’re not going to hit the bottom.
Right now, for instance, I’m very optimistic going forward. People are talking about this as just a very short-term rally over here. I think that if there are no big surprises [and that's what I believe will be the case] and risk normalizes going forward, that earnings are very good. Actually, there was a very interesting statistic that I read today. It is that we have only had half as many warnings for third quarter earnings — which are going to start being reported in earnest, beginning next week — at this point this year, as opposed to last year.
That’s a good sign. If the economy was really tanking, you would get a lot of warnings. This is because if you want to know the truth, CEOs now know pretty much what it is. If it’s way off, then they usually have to let that information out. So far, that has not been a particularly high number and I think that this is also encouraging buyers. In fact, expectations may have been set a little too low.
Knowledge@Wharton: Jacob, do you agree?
Wallenberg: Let’s put it this way, slightly different. I very much echo the view that if you have capital you can deploy long-term — this is one of the great challenges that we have today — that most fund investors, fund managers and so on, have to move very swiftly. They are rarely willing to sit it out for a longer time. This is for the simple reason that they are evaluated on a monthly, or even more frequent, basis. So you don’t have the stamina because you are going to lose out vis-a-vis the competition. I think that that is one of the great weaknesses of the system as we know it today.
It is that people are so caught up in the short term — and I’m now talking about the way we invest capital, not the way we run our companies. That will, in itself, be a challenge for any fund manager today. This is because it is going to be a bumpy road at the minimum. You have to have the staying power so that you can hang in there for a longer while. Then you can do fine.