Wharton finance professor Jeremy Siegel is sticking with his forecast from the beginning of the year for equity prices: Markets will be flat, or up by as much as 10%, for 2018. Major concerns in the news – from the risk of extra Fed interest rate increases, a major trade war or a fizzling out of the share buybacks that have been propping up prices to some degree — are unlikely to become major stumbling blocks, he said in an interview with Knowledge at Wharton.
And while key interest rates may seem to be heading quickly towards an inverted yield curve – a reliable indicator of a looming recession since World War II – the particular rates that the Fed currently watches in this regard are painting a different picture than what many other observers are seeing. Siegel still expects a total of four interest rate hikes by the Fed this year. He notes that share buybacks are not nearly as important to equity prices as most observers think. In addition, strong employment reports contribute to a positive outlook.
An edited transcript of the conversation appears below.
Knowledge at Wharton: A looming trade war has not shaken market confidence nearly as much as many analysts expected – at least so far. I assuming that has to do with the good economic data on GDP, employment and so forth.
Siegel: The Friday employment report was a blockbuster. It was really about as good as it gets. You had strong payroll growth but you also had people moving into the labor market. The [labor] participation rate jumped up. That’s a rate that I look at very closely. If we’re not going to have the Fed hiking aggressively, we need more people entering the labor force because the demand for labor is 200,000 plus a month. Natural supply from population growth and other factors is only 100,000, so unless we have more people entering the labor force, it’s just going to become a tighter and tighter labor market, which is going to prompt the Fed to tighten.
The good markets that we’ve had since that report are definitely tied to that report and not really to any new trade developments, because there haven’t been too much just very recently.
Knowledge at Wharton: In your view that will take some pressure off the Fed as they look towards the number of rate increases?
Siegel: Absolutely. Again, this is only one month.
The participation rate and the unemployment rate – those measures are from what’s called the “household survey,” which is more volatile. We could see a reversal next month but it’s a definite move in the right direction. If we get more participation, the Fed will not tighten – probably not even tighten four times. I still think the Fed will tighten four times this year, but certainly Friday’s news dialed back that probability.
“I still think the Fed will tighten four times this year, but certainly Friday’s news (the June employment report) dialed back that probability.”
Knowledge at Wharton: Oddly, there was an increase in the unemployment rate.
Siegel: Which is actually – believe it or not – good news at this point because unemployment is so low that we need more breathing space, where there are people that firms can employ without bidding up their wages. That’s what the Fed is really looking at. Higher unemployment is no good when the unemployment rate is 8%, 9% or 10%, but when it’s down below 4%, you don’t want that unemployment rate to keep on going down, because that inevitably has sparked inflation.
Knowledge at Wharton: You’re referring to the worries in some circles that the strong employment numbers can lead to wage-led inflation, which then gets a reaction from the Fed. But the middle class workforce hasn’t had a raise in 30 years or 40 years after you account for inflation. The typical way for people to get raises is when the labor pool tightens, because if there’s a lot of demand for labor, that bids up wages. But if every time that starts to happen, the Fed takes away the punch bowl – to use an old expression – and raises interest rates to tone down the economy, people are never going to get a raise. Is that right?
Siegel: What we want is wages to go up because of productivity. Productivity is by far the most important influence on wages after inflation – the correlation is over 90% over longer-term periods. Unfortunately, although the economic recovery that started nine years ago has been very good in terms of jobs created, it has been very poor in terms of productivity growth. It has in fact been the poorest productivity growth that we’ve had in any economic recovery in the post-World War II period.
Now you asked why. Economists don’t really know all the reasons why productivity growth has been so poor. Is it the younger workforce that isn’t as experienced as baby boomers that are retiring? Is it that we are on the verge of new technologies but not yet in them? Basically we’ve pumped the internet and PCs for what improvement it can get. A everything else, like AI, robotics, self-driving cars and nanotechnology – these things are on the horizon but not quite here. We’re in a lull. We’re in a terrible lull, and that’s one of the reasons why wages after inflation have not risen as they should have during this economic recovery.
Knowledge at Wharton: We live in a sea of media that talks about innovation and this new app and that new app. What you’re saying is at the heart of all that, what’s going on today are really just refinements of what’s already been going on, and not real breakthroughs.
Siegel: Exactly. Our games are getting better on our iPhones, and we’re [spending] more time on that. But in terms of massive shifts of productivity, really there haven’t been any. And in factory techniques and manufacturing, I’ve seen some shocking statistics that actually have shown a slight decrease in productivity.
“Don’t overstate the importance of buybacks….. Corporate earnings, interest rates and other things really weigh up and down on stocks, far more than the amount of buybacks.”
Agriculture and manufacturing used to be the cornerstones of productivity increases. We just don’t have techniques now that are producing better and faster. Again, a lull. Some people say this is a lull between major technologies, and other people are not sure. There are productivity pessimists, such as Robert Gordon, a professor at Northwestern University, who really thinks those best years are basically past, and we’re going to have slow productivity growth for the next 20 years. There’s a big debate among economists about it.
Knowledge at Wharton: Another aspect that flows from that is the labor participation rate, which is right now just under 63%.
Siegel: Correct. Stationary, basically. Flat over the last [four years, at below 63%]. Let’s talk a little bit about the broad trends on that.
Knowledge at Wharton: It’s still below where it was before the financial crisis. (The labor participation rate was between 66% and 69% from May 2005 to June 2008.)
Siegel: Absolutely. let’s take a big review on the labor participation so that people can see what the big trends are. Labor participation rate in the U.S. rose dramatically from 1950 to 2000 – 50 years. This is the percent of the population available for work — between ages 16 and 65 — that are working.
It rose dramatically, and it was all because of women. The women participation rate in the 1950s was very poor. Then women moved into the labor force over the next 50 years. Their participation rate peaked out in 2000, but the male participation rate has continued to go down.
Part of that is because the baby boomers that are definitely retiring, but even participation rates among prime males has gone down. Lack of opportunities or of preparing for the type of jobs that are available now, discouragement, and a lot of increase in disability, right after the financial crisis are factors that have drawn people out of the workforce.
But economists say that because of baby boomers retiring, we’re now going to be in a long-term down trend that started in 2000. Right after the financial crisis, the labor participation rate dropped much faster. We’ve leveled out over the last three or four years, and now we’re at the where economists predicted it to be in back in 2000. But we need that to not only level off but actually increase the rate if we’re going to continue to handle the job growth, which during this nine-year recovery has averaged over 200,000 new jobs a month.
So unless the Fed tightens up to get it down to 100,000, we’re going to get tighter and tighter labor markets unless we motivate people that are old enough to be working but are not actively looking for jobs, to say, “I want to get a job now.”
Knowledge at Wharton: How do you expect markets to behave, specifically over the next few weeks, with summer typically a sleepy time. At the beginning of the year, you had talked about where the market was going to be for the year.
Siegel: I had said it was going to be a much rougher year than it was in 2017, and I think I predicted 0 to 10% growth for the whole year. And I’m still there. We’ve just been about there, right? I said it was going to be a tougher year. Now again, it’s so hard to predict the stock market in the short run. People say, “Oh, Jeremy, that’s a wide range.” I say, that’s not even one standard deviation of what the stock market can do in a year. There can be a lot of volatility.
“Unemployment is so low that we need more breathing space, where there are people that firms can employ without bidding up their wages.”
The main challenges to the stock market as I still believe are higher interest rates from the Fed. The second was political challenges that I thought Trump would face as time goes on. I still think the Democrats are favored, although not overwhelmingly, to take the House of Representatives in November. What will that do? Also, the trade war has come up as a threat, and we can talk about that later.
[The driving factors are] rising interest rates, those political uncertainties, and also the projections for 2019. We had a good jump in earnings in 2018, and a lot of that is of course because of the corporate tax cut. For 2019 I think the projected jumps are too big. I think analysts are going to be scaling back some of their 2019 projections in the second half of the year, and that’s going to also add pressure to the stock market. That’s why I don’t think this is going to be a great year. It’s not going to be a terrible year, though, for stocks overall.
Knowledge at Wharton: Much has been written about stock buybacks and the effects they may be having on stock prices. There’s been a lot of money going into it. You’ve had many years of low interest rates. Companies have been able to borrow cheaply to pay for them. So there’s a thought out there that that’s what is, unrealistically, holding stock prices up right now.
Siegel: No — stock buybacks are about 2-1/2% of market value, so at most that would mean a 2-1/2% of gain. And we’ve had gains in 2017 of almost 20%. The gains and losses year-to-year overwhelm the buybacks. Also, I do definitely believe that strong corporate profits are a motivation for buybacks. On interest rates, a lot of firms don’t have to borrow. Some of them do anyway. Apple has often said it has borrowed because of the way it arranges its corporate assets. It had to borrow and not use the money it had abroad, otherwise it was going to be taxed. But actually, firms have not had to borrow too much for their buybacks. Their earnings have more than covered the buybacks.
Buybacks became very popular in the 1980s for a number of reasons. One is the SEC (the Securities and Exchange Commission) finally made them easier to do. There was some question of the legality of buying back stocks, and they said, “You can buy back.” Secondly, the tax on dividends is a factor. If you buy back, it’s a capital gain and you don’t pay a capital gains tax until you sell.
Now why do you think Warren Buffett, for instance, never pays a dividend on Berkshire Hathaway? He says, “I don’t want my people to be subject to tax. I want it to keep on going up in price, and if and when they sell, they’ll have to pay a capital gains tax. Many of them are going to give it to charity, and it will never be taxed.” So the taxes on dividends is another factor.
And the third factor is the predominance of management and employee stock options. You want the stock to go up rather than to pay a dividend. If you pay a dividend, it’s good if you own shares. But if you have options, it’s good to do a buyback.
So the big increase in stock options over the last 30 years has been another force motivating the buybacks. But don’t overstate the importance of buybacks. They are only one component of the return on stocks. Corporate earnings, interest rates and other things really weigh up and down on stocks, far more than the amount of buybacks.
Knowledge at Wharton: I also wanted to ask you about the inverted yield curve, because statistically over many decades, it has been shown to be a precursor of a recession. It doesn’t tell us exactly when a recession will occur – it could be six months it could be two years – but that has been a fairly accurate indicator, is that right?
Siegel: It has been. In fact, I teach my students, that if you’re going to take one variable, by far the single best indicator of an upcoming recession is the inversion of the yield curve.
Knowledge at Wharton: We’ve been heading there pretty rapidly recently.
Siegel: Yes.
Knowledge at Wharton: It looks like we’re almost there. Could you tell us briefly what that inversion is? And if we cross the Rubicon, so to speak, does that mean we’re going to have a recession sometime soon?
“We’re in a terrible lull, and that’s one of the reasons why wages after inflation have not risen as they should have during this economic recovery.”
Siegel: The yield curve refers to the difference between long-term rates and short-term rates. Normally long-term rates are higher. If you want to borrow long-term there’s more risk and as a result you have to pay higher than short-term rates.
But occasionally through history, particularly if the central bank is trying to slow the economy, they push short-term rates up to and exceeding the long-term rates. If long-term investors see trouble ahead in the economy, they’re going to be buying bonds. They’re going to say economic demand will be down, inflation will be down and they start buying bonds. The rate on long going below short is called an inversion of the term structure. And yes, I think in the 13 recessions we’ve had in the post-World War II period, we have had an inversion that has been anywhere from 6 months to 18 months beforehand.
Now the people say “long” and “short-term” rates. I hear a lot about the difference between the 10-year bond and the two-year bond. Honestly, I think the best [indicator] is the difference between the 10-year bond and the 90-day treasury bill, because two years is not really “short-term.” When people buy short-term assets, the maturities are usually less than a year. That spread right now is just a little less than one percentage point – about 90 basis points. A hundred basis points is one percentage point. Now that spread of 90 basis points is lower than the average from 1950 to the present. But interestingly enough, it is not lower than the average in a low-interest rate and low-inflation environment, such as we had in the 1950s and 1960s.
People are jumping the gun a little bit too fast on this and worrying about it. They’re comparing it to the average spread that we saw in the 1970s, 1980s and 1990s, which was a much higher-inflation period and a much higher-interest rate period.
In a low-inflation, low-interest rate period, actually, the average spread between the 90-day bill and the 10-year bond has been around 70 basis points, [going up] to 80 basis points. And we’re still a little bit above that. So yes, we are moving that down, but we are not flat, by any means. I would not put out the warning signal.
Most importantly, the Fed knows about this signal. It’s not going to continue to raise short-term rates if the long-term rate does not rise with it. Because that will tell the Fed that there are people worrying about the economy, [and that] they don’t think it’s as strong as the Fed does. They’re keeping that long-term rate stable, and that’s a signal to the people at the Fed. So, fortunately, everyone at the Fed knows this signal, too. So I don’t think they’re going to push it as far as some people fear that they will.
I think, actually that the long-term rate is going up. I said I thought it would end the year at 3-1/4%. So as a result, the Fed will push above 2%, but there’ll still be a good percentage point between that short-term rate and that long-term rate.
“People are jumping the gun a little bit too fast on this and worrying about [a recession ahead].”
Knowledge at Wharton: I want to expand on that a little bit and take a broader view. Many experts in finance and economics have said over the years that somewhere in the world, on average, every seven, eight, nine, or 10 years or so, there is a major financial crisis of some sort. It could be a currency crisis. It could be an interest rate crisis. And so we’ve had this almost Goldilocks period, where we had this horrible crisis, but there has been pretty steady growth almost worldwide since then. And so that raises the question: Will that average that people talk about apply one day soon and lead to a financial crisis?
Siegel: Well, some people say it has to do with the average of the economic expansions, which is only about six years. And we’re already nine years into this expansion. The longest expansion in the U.S. post-World War II history has been 10 years, from 1990 to 2000. We are one year away from the longest expansion in U.S. history. Could it go longer? Yes. There are countries that have gone longer. Britain went 18 years between 1990 and 2008. Australia went over 20 years. They didn’t actually have a recession during the financial crisis.
So as a result, it is possible to have it longer. Our economic cycles are getting longer. Actually, a lot of it has to do with the fact that we’re a more service-oriented economy than an production economy, which has shorter cycles.
Is there going to be a crisis around the world once every so often? Of course we had the mother of all crises nine years ago, so in a way, we need a rest. People thought bitcoin is a bubble. I did think it was a bubble, but it was nowhere near big enough – even in any conception – that its breaking could cause economic recession. There are a few other stocks that you could argue are too high, but generally, there are no bubbles now around the world.
Can there be bubbles that would affect the U.S.? Yes. The 1997 emerging market crisis – when the attack on the Thai baht, the Indonesian rupee and many other currencies in Southeast Asia, including Hong Kong’s – caused the U.S. stock market to take a dive. However, we did not have a recession in 1997. The Fed moved quickly. We insulated ourselves from that recession.
So sometimes even if there is a crisis outside the U.S., it doesn’t necessarily mean there will be a crisis or a recession in the U.S.
Knowledge at Wharton: So this time, it’s a little bit different?
Siegel: It’s always a little bit different (laughs). Nothing is exactly a carbon copy of what we had before. The biggest dangers I see [for markets] are, again, the pool of labor is getting too tight. The Fed will tighten because it sees labor markets getting tight, and that means that wages are going to be bid up. And again, wages would be getting bid up not because of productivity growth is good, but being bid up just because we need your productivity – it’s just that there’s not enough workers – that’s not good. That’s what causes inflation, because those higher costs are then pushed onto the consumer in terms of higher inflation.
Knowledge at Wharton: If you had to choose the things that were most worrisome for the macro economy in the U.S. primarily, but in the world, too – what would they be? The trade war would be an obvious one right now.
“Analysts are going to be scaling back some of their 2019 projections in the second half of the year, and that’s going to also add pressure to the stock market.”
Siegel: Yes, the trade war is a threat. The stock market still thinks it’s a low-probability threat. I think they are right. But low-probability is not zero probability of a threat. So that’s a wildcard. No one knows exactly how that’s going to turn out, although my feeling is that Trump is not going to push it so far that it does become a major issue, mainly because we know from his past tweets that he loves the stock market. And if he loves the stock market, one way to keep it going up is not by engaging in a trade war. So we’ll see.
He wants to push it to a brink, which is short of something that would really cause a downturn in stocks. Now, who knows? That’s just one of my ways of looking at it and saying it’s a low-probability event. But again, as I say, a low-probability event is not a zero-probability event.
Outside of that, the biggest threat is that the labor market gets tight much faster than the Fed even anticipates, generating inflationary wage gains. The Fed then tightens faster – considerably faster than the market expects – driving up interest rates. And that would certainly put pressure on stocks.
Knowledge at Wharton: One of the central obstacles you’re talking about is productivity. What could be done to increase productivity numbers?
Siegel: Well, we as economists don’t know all the reasons why productivity has been so poor the last eight or nine years. Actually, even extending to before the [2007-2008] financial crisis, there was a dip in productivity. So if you’re not absolutely certain, it’s hard to say what you can do to correct it.
In one sense, I do agree with Trump that there were too many regulations. I think that they did slow down some productivity growth, because people had to be hired to manage all sorts of rules and regulations. That doesn’t creatre more output. So to the sense that some of those regulations can be eased, that would also improve productivity.
Also it would improve productivity if we did a better job at educating the workforce towards the types of jobs that are around in the 2010s. I’m not too sure whether we are doing a good job on that. In fact, by international standards, our graduates of high schools and primary schools are doing very poorly. Our graduates of college are doing well, and graduate school particularly well, but we’re not doing a good job at educating in the middle and lower end of our spectrum. We need to improve that.
The other factor is just to wait until some new technology comes in and really begins to allow us to produce a lot more output with fewer workers. And then that’s what will raise wages and increase productivity growth.
We’ve talked about most of the important things. We should talk about that earning season, of course. You’re right about in being a long summer that is in the doldrums, but we are going to be getting this week and next week earnings estimates in the second quarter, and guidance for the four quarters and into 2019.
I mentioned at the beginning of our program that for most companies it’s too early to give guidance on 2019. Some CEOs will give 2019 guidance — not many — until October. I think that you’re going to see that move individually. And then, of course again, the movements of trade are very important, and so point, counterpoint — how that works out is going to move stocks this summer.
