In a recent newsletter, Wharton finance professor Jeremy Siegel noted that “everything is coming up roses for the equity markets — except for the latest developments in the commodities markets.” What does that imply for the economy and stock markets? Siegel, who is also the author of the book, The Future for Investors, notes that the economy is heading for a soft landing, which means it is slowing down. “But we’re not going to a recession, by any means,” he told Knowledge at Wharton in a recent discussion. He does worry about high commodities prices, though. 

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Podcast Transcript: Jeremy Siegel on the “Soft Landing” economy

Knowledge at Wharton: Well, here we are just ahead of the second quarter earning season and who better to have with us again then Wharton finance professor Dr. Jeremy Siegel, also author of The Future for Investors.  Thank you for joining us, professor. It’s great to have you on today. 

Each week you publish a highly successful commentary on the economy in finance in general.  Last week your analysis stated that “everything is coming up roses for the equity markets – except for the latest developments in the commodities markets”.  Can you elaborate on that observation for us?

Siegel: Yes, most certainly.  What we have looking at the economy is a soft landing, in the sense that we are slowing down.  But, we’re not going to a recession, by any means.   In fact, it doesn’t even look like we’re going into what sometimes is called a growth recession which is 0 to 1% economic growth.  And, in addition earnings are doing very well. This is the beginning of the earnings season.  It looks like another double digit quarter increase, which means over a year ago or now estimating something between 11 and 13% increase. 

This is very, very good news but I say I worry about those commodities. I worry about rising prices.  If there’s anything that’s going to force the Federal Reserve higher, and that is the main worry of Wall Street, it is higher commodity prices.  So what I’m saying is if we could get those commodity prices down and by the way today, [Monday, July 10] we did have some welcome softening on the oil front.  My feeling is that everything else has it going for the stock market and should cause an increase.

Knowledge at Wharton: Last week, the West Texas crude oil prices [you said in your newsletter] had hit an all time high of $75.55.  So, how come the prices are coming down?  And, do you expect that trend to continue?

Siegel: There were some reports today; actually [I think] there was a lead report in the Wall Street Journal about new techniques that Saudi Arabia may use to extract heavy oil that might increase the supply.  That’s been a major issue in the oil industry.  You know up in Alberta [Canada] they have what’s called very heavy oil, with the tar sands, which contains actually millions of barrels of oil, if it can be extracted.  So that sort of said, well there might be some supply on the line.  But this is one day.

There is no question that the world economy is strong.  The emerging markets are strong.  China is really not showing any sign of a slowdown with the Yuan. Their currency is also strong against the dollar. They’re bidding up the price of oil and imports and those are the reasons why commodities are so strong in price.

Knowledge at Wharton: You had mentioned that the commodities could somehow affect the Fed to perhaps raise rates.  Are there certain commodities that they look at, that are more impactful as to their status than others?  And what would they be? 

Siegel: Well, oil is most important.

Knowledge at Wharton: Because of its world impact?

Siegel: Yes, and its direct impact on the Consumer Price Index.  We also had gasoline futures prices, not quite hitting right after Katrina.  We know about that very bad spike.  But the highest since Katrina and what we are seeing, in terms of the higher oil prices is that it’s beginning to spread a bit to what’s called the core rate of inflation.  And that’s inflation directly outside the energy and food complex.  The reason is that it takes some energy to produce almost everything.  So as a result eventually these factors are going to move into the market.

Now what we have on the other side is increases in productivity.  We have cheap products coming from abroad, China in particular.  This helps keep that inflation down.  But we are beginning to see a little bit of a seep into that from the energy complex.  This is what’s concerning the market, concerning the Fed and what is producing year over year increases in inflation that are not looking good.  But let me emphasize that year over year data, although it’s very widely quoted, contains eleven months of old data, and only one month of new data.  People say “oh yeah, year over year is now reached whatever else”.  But over 90% of that is old data. 

The Fed has that forward look and one of the favorable things on the inflation front and I think this is a very important point to make clear is, there was some anxiety caused by the ½% increase in average hourly earnings that was reported on Friday.  Every other piece of data that we have on labor costs is not accelerating.  The more comprehensive indexes of labor costs, particularly the Employment Cost Index is actually showing a slowdown.  So I dismiss a lot of the anxiety and the concern that we saw, when we saw that increase in average hourly earnings. 

Knowledge at Wharton: ADP didn’t do a very good job last week of predicting the employment numbers.   Since the employment numbers were so much lower that what the market was anticipating, do you think that means that the Fed isn’t going to raise interest rates in August?  What do you think?

Siegel: Actually in a way, I think the lower payroll numbers eased some anxiety.  You know we didn’t have a good stock market to say the least, last Friday [down over 100 points].  My feeling is that if we had a very strong payroll with that 5/10th increase in average hourly earning, everyone would have said “Oh my God this economy is just running away.  The Fed is just going to have to keep on increasing the rates”.   That would have produced a lot of anxiety.  The fact that we had the payroll increase far below expectations and way below that sort of scare number that ADP previewed for us on that Wednesday, before that final announcement is actually I think some welcome news. 

There are head winds against the economy.  The slowdown in housing is absolutely confirmed – virtually everywhere.  The only place you could say real estate is strong is in the commercial area.  Vacancy rates are down, rentals are strong.

Knowledge at Wharton: So it’s not just new construction?

Siegel: Yes and that’s one reason why real estate investment rates are actually doing fairly well despite the slowdown in housing.  However, in the residential sector there is an absolutely confirmed slowdown.  That is spreading.  We’re actually seeing furniture sales that are down.  Retail sales that were announced for the month of June were on the disappointing side.  We also have the increase in gasoline prices.  It’s now $3 and higher a gallon. 

And we have another notch up of interest rates at 5¼%; which makes the prime rate 8¼%.  Many people who borrow on their home equity loans go higher than that.  They go anywhere from sometimes up to two points higher than that. So we are getting 8, 9 and sometimes 10% on home equity loans which just two years ago were 4% and 5%.  That is a huge difference.

That’s one reason why when we look at the second half of this year, we’re looking at GDP increases that are going to be around 3%, which is okay but certainly less than 3½ to 4 and plus that we’ve had over the last three years.  This last quarter, we don’t have the announcement yet and we won’t get it until the end of July. But most experts say that it’s going to come in the second quarter 2½ to 3; the third quarter they are looking at about 3 and nothing much more for the fourth. 

We have downshifted.  Now, why I said that it’s coming up roses is – that’s sustainable growth.  If the Fed can see those commodity prices going down, given that the housing sector has already slowed, they can say “hey we have now increased enough; we do not have to increase…”

Knowledge at Wharton: It’s all in balance at that point.

Siegel: Yes, they would come much closer in balance. 

Knowledge at Wharton: What’s the time frame between the commodities not softening to where the Fed would increase rates? 

Siegel: Well, my feeling is that if we see oil up at $80 and gasoline moving even higher, we will see again a spark in those [called] industrial metals such as aluminum, zinc, nickel, copper, scrap steel, etc., if we see a continuing falling dollar and continuing rising gold price.  Now gold has snapped back from a real bad loss that it took the previous month, but still well below its high.  But if the Fed sees all those real markets signals that say that’s there’s still pressure there, just to keep credibility and the fact that we have a new Chairman, you must establish credibility up there, he will have to raise rates.

Knowledge at Wharton: And do you feel raising basis points that would establish credibility for him?

Siegel: Oh yes.  I even actually said that if that commodity goes really up, he might even say 50 basis points.  Actually there are many in the market that would prefer 50 basis points and done, rather than these 25, 25 [incremental], what I call the Chinese water torture — a continuing and never ending type of thing.  We’ve had seventeen consecutive quarter point increases, that’s unprecedented.  I mean we’ve had higher increases because they’ve jumped at 50 or 75 but we’ve never had seventeen consecutive quarter increases. And the whole question on the market is when is this going to end? 

And then we get some…. you know Bill Gross of PIMCO [Pacific Investment Management Company] now he hasn’t always been right but I respect him a lot.  He now says that he sees signs that the U.S. government market may be turning those sensitive government rates.  He thinks that there is going to be some widening of risk premiums on the other rates.  But he thinks that the Bear Market in government bonds is over.  Now if he proves to be right that means that the government bond market does not see overheating, that will be a signal to the Fed.  If that market doesn’t see it then you can pretty well relax. 

Knowledge at Wharton: What’s the timetable for that to reveal itself?

Siegel: Well, right now we have come down.  We were over 5¼% since Friday’s labor market news and even today without much news, the rallying has continued.  If we could get that ten year rate below 5, it would be very difficult for the Fed to really justify a 5½% rate.  This is because they would really be inverting the term structure, which all economists have learned is something that you don’t do unless you find it’s absolutely necessary [any excuse not to do it] and that would be one of the excuses.  If the long rate went below 5, I would say that Bernanke would have good reason to pause on August 8th, the next meeting of the FOMC.

Knowledge at Wharton: What does the interest rate outlook over the summer mean for the stock market?

Siegel: Well again, if Bernanke is done and if the commodity market does not surge above its level and begins to soften off as it sees economic activity softening off, then I think we’ve seen the highs.  And I think that I actually might agree with, I don’t always agree with Bill Gross on a number of issues, but I see his reasoning here.  I think there’s a good chance we may see that ten year rate below 5% and therefore we may have seen the peak in rates.  But that again to me depends on the commodity market.

Knowledge at Wharton: What are the next indicators that you are looking at in the next week and a half? You’ve got quarterly earnings coming out soon, but what’s before that?

Siegel: We had a really negative one from 3M Corporation, but not many warnings.  That’s going to affect the market and quite selectively depending on the companies.  But nowadays if a company is going to miss it by a big amount, it’s going to generally warn of that and we have not gotten very many warnings. 

Knowledge at Wharton: It’s a good sign.

Siegel:  Yes. That was actually a good sign. It’s very interesting the market always seems the week before, to react to these warnings “oh my goodness, they’re coming in below expectations” realizing that firms are sort of obligated to do that.  And, they’re not obligated to do it as much on the other side.  I mean if they’re going to really blow it out, sometimes they do choose to do it, but there’s not the obligation in a way to do that.  So you got an asymmetry there. You always get the warnings coming through, and the market seems “Oh my God, they’re coming through”, and it’s often a good time to buy actually…

Knowledge at Wharton: Leak the bad news and create fanfare for the good news.

Siegel: Right – at that particular juncture as far as that’s concerned.  Again, I’ll be watching commodities.  I will also be watching consumer price indices, producer price indices, and the personal consumption deflators, which come out after that.  We’re going to get another employment cost index, I think coming up either late this month or early next month, which will give us another quarterly read on employment costs. 

And of course ongoing is the labor market, the tightening.  Is it tightening?  Because remember labor costs are still 70% of the costs for firms.  If the labor market is not tightening significantly it’s hard to get a lot of those inflationary pressures really moving in any momentum/way.  You really need the labor markets to be moving up on wages.  So you know, you’re watching all of that and as I said I’m getting good readings on the wage side of the inflation picture.  I’m nervous about that commodity side; I’m feeling good about the wage side.  If commodities don’t continue to peak up the Fed will pause.