The U.S. Presidential race has reached a critical juncture. The Republicans have a confirmed nominee in John McCain; as for the Democrats, Hillary Clinton has bounced back, while Barack Obama retains a marginal lead in terms of delegates. How the presidential race evolves will be shaped in part by the increasingly worrisome state of the U.S. economy. Though it has not yet gone through two consecutive quarters of negative growth — the common definition of a recession — signs of a slowdown are evident everywhere. Meanwhile, consumer prices are rising, oil has crossed $103 a barrel and gold is nudging $1,000 an ounce — suggesting that the economy could be entering a phase of 1970s-style stagflation. Fed chairman Ben Bernanke, however, told Congress last week that he doesn’t anticipate stagflation, and he continues to indicate his willingness to keep cutting interest rates. What lies ahead for the U.S. and world economies? What is the right strategy for investors in this environment? Knowledge at Wharton discussed these questions and more with finance professor Jeremy Siegel, author of The Future for Investors.
Knowledge at Wharton: Given all that is going on in the primary elections, what do you think a President Clinton, or Obama, or McCain would mean for the U.S. economy?
Siegel: We certainly had some exciting primaries last night. Hillary came back and could be a factor. If the Democrats beat themselves up, that might improve the chances of Republicans a bit. A lot of people talk about what kind of policies [will be made], and I think that whoever is president, or whatever party wins, that the question of taxes is going to necessarily come up first. The reason is that under current law, all of the Bush tax cuts will expire in 2011. That means that if nothing is done, we go back to taxation under the Clinton administration.
And of course, what is also very important is the fact that no matter whether McCain or a Democrat wins, as long as Congress remains Democratic — and that is considered over 90% now — they will draft the tax legislation. Even if McCain vetoes it and says, “I don’t want these rates to increase” — taxes will automatically go up anyway. So, they are going to be wrestling about taxes.
Health care, which everyone talks about, will probably have to play second fiddle to taxes. The home mortgage situation — I think that is going to be done during this year, the last year of the Bush administration. Although all of the presidential candidates are really talking about that issue now, I think that any legislation that might come out of it will come out this year. But, I think that the first priority really is going to be taxes, and the battle will be fought on that front.
Knowledge at Wharton: Many have been saying that we are entering a period of 1970s-style stagflation. Do you agree with that assessment?
Siegel: No, not at all. In the 1970s, inflation went up to 14%; interest rates up to almost 20%. We are certainly moving to slightly higher inflation rates, but nothing like the 1970s. So, if you want to call it a tiny, little touch of stagflation, I would tend to agree with that, because we have a soft economy with some rising prices. But, we have to realize that we’re not going to be in the 1970s situation. I look for inflation topping out, at most, at maybe 5% or 5.5%, and that’s with oil prices. On the core rate of inflation, I think we won’t go above 3%.
Knowledge at Wharton: Fed chairman Ben Bernanke has indicated that he is willing to keep cutting interest rates. Do you agree with that approach?
Siegel: I’ve been a big fan of Bernanke through his two years. I’m a little bit disturbed recently, because I don’t think that he is acknowledging the inflationary threats. Now, I just said that I don’t think that inflation is going to get as bad as the 1970s. But we have had a tremendous rise in commodity prices, we’ve had a large fall in the dollar, imported costs are going up — there’s even a possibility of revaluation of the Chinese currency, and that will raise import prices.
I worry about the international community losing faith in Bernanke’s anti-inflation credentials, and that is not good. I think we’re going to get a 50 basis-point reduction in rates on March 18th, the next FOMC meeting. But I would like for him to say at that point that we’re signaling an end to the cuts, to see how much they are going to work. Otherwise, open-ended cuts could revive inflationary expectations and just make it harder for Bernanke, down the road, to stabilize the economy.
Knowledge at Wharton: You mentioned the rising of commodity prices. What impact will those have on the U.S. and world markets?
Siegel: If the dollar continues to sink downward — and that, of course, is partly the confidence in Bernanke’s policy — that will raise import prices, particularly for energy and all imported materials. I am particularly concerned that China may revalue the yuan, because their inflation (they’ve pegged their currency, or are sliding their currency slowly against the dollar) has reached a nine-year high.
There’s pressure in China to revalue, to lower their prices, and that would just raise the prices of everything that we import from China. The falling dollar does have inflationary consequences here in the U.S. Although it will improve our trade balance, when we take all of the positives and negatives, we don’t want the dollar to keep on going down; that will not be good.
Knowledge at Wharton: How does the falling dollar affect the European business market?
Siegel: That makes it a little bit harder for the Europeans to compete, because the U.S. manufacturers have now become more competitive. And they are complaining a little bit now that the euro has gone over $1.50.
The interesting thing is that Europe has been able to compete. Even with a strong euro, on average, their trade balance is pretty near balanced, while ours is very much still in deficit, although improving. The world out there is very, very competitive. A falling dollar does help our competitiveness. But I think that the downside of higher import prices is something to be considered very seriously.
Knowledge at Wharton: Meanwhile, the manufacturing sector seems to be contracting. What does this mean for the economy in general?
Siegel: The manufacturing sector has been contracting for thirty years now. We’ve lost 50% to 55% of manufacturing jobs over the last three decades. So, this is something that is continuing. It is happening in all of the developed countries of the world, as well as in the United States — and it’s irreversible. It has to do with the patterns of global trade and wages.
And, if it isn’t China, it’s going to be India; if it isn’t India, it’s going to be Indonesia, it’s going to be Vietnam and then maybe even Africa. We have to learn how to be a service economy. We have to learn about using intellectual capital and using our strengths. Except for some specialty items which we will manufacture and require a higher technical expertise, in general manufacturing jobs will continue to be lost.
Knowledge at Wharton: The Employment Report should be out this Friday…
Siegel: That’s a very important report. We just got this morning data called the ADP [Automatic Data Processing] Report which gives you a little preview, and that showed a loss of jobs. The expectation of Wall Street is for a gain of maybe 20,000 — that’s very low, but positive. Yet, we did have a surprise loss last month, and there could very well be a loss. This is an important announcement. If we’re going to have a recession, you’ve got to have a loss of payroll jobs. And, by the way, [a loss of] 20,000, 30,000 is usually not enough bring about a recession; you need 100,000 to 200,000 jobs lost, and you need that for several months. We haven’t experienced that yet.
We are still skirting the recession, just barely, at this juncture. I also look at jobless claims, which come out every Thursday. They have been ratcheting upward — again, not quite into recession levels, but close to recession levels.
Are we going to have a recession? I think that we’re going to skirt it, but just barely. We are certainly having a slow down; whether it’s technically a recession or not is perhaps secondary.
Knowledge at Wharton: What about the threat of prolonged inflation?
Siegel: Well, there is an inflationary threat if we have a continually falling dollar and if commodity prices continue to rise. I have been concerned that despite the tremendous slow down in the U.S. economy, which is usually coupled with a slowdown of commodity prices, we have not seen prices go down. Now, it is true that the emerging markets have still been strong. Europe has slowed down, but not a lot. Nonetheless, the fact that oil and all of these commodity prices are so strong in face of a declining economy is even more evidence that the Fed and Bernanke must take inflation into account.
We’re going to have fiscal stimulus with the rebates, starting at the end of the second quarter and into the third quarter. This is going to boost spending, and that may cause another boost to commodity prices. If we don’t get some sign that the Fed is going to stop lowering rates, I’m afraid that inflationary expectations may worsen. Even the Fed claims that we don’t want inflationary expectations to get out of hand. That’s one of the hardest things to eradicate in the economy. I think we’re not going back to the stagflation of the 1970s — those were mistakes that made inflation much worse than anything that we face today. But the fact is that we have to nip inflation in the bud. We can not let those inflationary expectations get anchored — and I think that that’s a top priority of the Bernanke Fed.
Knowledge at Wharton: Bernanke also spoke yesterday about providing relief to homeowners who are facing foreclosure. Do you agree with his approach of having banks write down loans?
Siegel: We’re already seeing all sorts of accommodations. I would rather that the private market do it. If the government or the Fed wants to provide a few blueprints, that’s fine. But, we’re getting the mortgage service industry moving and making deals … some [involve] interest rates, some might be forgiveness of a certain amount of principal.
Remember, a lot of these mortgages are selling in the open market at 50 cents on the dollar. If a bank could actually say “we’ll forgive 10% or 20% of the loan” and actually then get the interest they are due, they’re going to be making a huge profit on this. So, in a way, the incentive is there for them to do it. I don’t think that we need legislation. I don’t think that we need governmental action. I think that the private sector can handle this and is beginning to handle this now.
Knowledge at Wharton: You have written in the past that when the U.S. and Europe are in trouble, emerging economies such as China and India could come to the rescue. Do you think that that’s the case?
Siegel: The U.S. is an important engine of the world economy, but it’s not the only engine. We’re about 20% of the world GDP at the present time. That’s going to be shrinking, and it’s much less than it was 30 years ago, when we were one-third of the world GDP.
In essence, it used to be said that “the U.S. sneezes and the rest of the world catches a cold.” I don’t think that happens anymore. That being said, if there is a significant slowdown in the U.S. and a recession, it’s almost impossible that India and China will not be affected by that. There are just too many goods that they are exporting here. But will our slowdown necessarily trigger a worldwide recession? No, not necessarily.
There’s a huge middle class, certainly, in India and even in China. And the truth of the matter is — because China is providing us a lot of goods — that if consumers feel pinched, those cheaper Chinese goods are going to be in demand. So, my feeling is that China might go from an 8% to 10% growth down to 4% to 5% growth, but no recession as we define it here in the United States.
Knowledge at Wharton: Given all that’s going on, what do you think investors should be doing?
Siegel: Right now, I’ve turned cautious on the stock market. I think that there could be some more downward adjustment, until Bernanke makes a stand and the international community begins to say, “The U.S. is going to be fighting inflation.” We could see, short run, another 5% or even 10% decline in the market. I see a maximum 10% downside risk. If we should see that decline, I think that it could be the buying opportunity of the decade for investors — because long term, I’m bullish, and long term, I think that valuations still are very attractive.
Short term, still, it’s going to be a little bit rocky until the inflation situation gets clarified. Anyone that has their stock position long term, they’re going to be fine. If you have a little cash, you might decide to put some of that to work in the next couple of weeks. As stock prices decline, you might be getting some very good bargains.
