The cover photograph in the latest copy of The Economist says it all. The May 25 edition has a picture of a bear peeping out of the woods, with a headline that asks, “Which Way is Wall Street?” The magazine notes in an editorial that after nearly three years of gains, international stock markets tumbled by more than 10% during the past couple of weeks. Emerging markets have been volatile, as have markets in Europe. Is this likely to lead to the kind of bearish slump that followed the dot-com bust in the spring of 2001? Or will the volatility pass? Jeremy Siegel, a finance professor at Wharton and author of the book, The Future for Investors, spoke with Knowledge at Wharton’s Mukul Pandya and Robbie Shell about the commodities market, the appointment of Henry Paulson as the new Treasury Secretary and the challenges faced by Fed chairman Ben Bernanke, among other topics.  

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Podcast Transcript: Jeremy Siegel on Dangers of the Commodities Bubble

The cover photograph in the latest copy of The Economist says it all: The May 25th edition has a picture of a bear peeping out of the woods, with the headline that asks, “Which Way is Wall Street?” The magazine notes in an editorial that after nearly three years of gains, international stock markets tumbled by more than 10% during the past couple of weeks. Emerging markets got clobbered, as did equity markets in Europe. Is this likely to lead to the kind of bearish slump that followed the dot-com bust in the spring of 2001, or will the volatility pass? Jeremy Siegel, a finance professor at Wharton and author of the book, The Future for Investors, spoke about these issues and others with Knowledge@/Wharton’s Mukul Pandya and Robbie Shell.

Knowledge at Wharton: Before we talk about the markets, let me ask you about something that has just happened. John Snow has stepped down as the Treasury Secretary and Henry Paulson, the chairman of Goldman Sachs, has been named as his successor. What do you think of that? What do you think will be the impact on the U.S. and on the international stock markets?

Siegel: I think Paulson is an excellent choice, more suited for the job than John Snow was. He has more of a background in economics, he has an MBA, yes it’s from Harvard, but [laughs]. He was an outstanding undergraduate also, understands the markets very well, which I think is critical to be a Secretary of the Treasury today. One also has to remember that the Secretary of Treasury’s function has moved more in the area of supporting the administration’s economic policy and pointing out what’s good about the economy, while the American public seems to be focusing on what’s wrong with the economy.

The actual power of the Secretary of Treasury to implement policy is limited. We’re in a world of floating exchange rates and foreign exchange traders look to the Fed and the Central Bank. Bernanke is many times more powerful than the Secretary of Treasury, and even though Bernanke and the Fed say the realm of exchange rates goes to the Treasury Department, the truth of the matter is it falls to the Federal Reserve and their policy. It’s not anywhere near as important a position as Bernanke’s by any stretch, but it’s welcome. And  I believe we do have a very well-qualified person in that position.

Knowledge at Wharton: The past couple of weeks have been very stressful for international stock markets. What caused the volatility and is the worst over now?

Siegel: I actually think the worst is over. Let me tell you foursquare where I think the drop came from. It came from a disappointment with a May 10th FMOC, announcement. The market was expecting the Fed to say that conditions were such that the Federal Reserve could pause in the upward movement of interest rates.

As you know, we’ve had 16 consecutive increases over the last two years. The market was looking for a 5% anchor. Bernanke hinted in testimony before that May 10th hearing that this very well could be the case. But once the statement came out, there was no hint of an ease. Right on the next day, we had a 100 point fall. We had another 100 point fall on Friday. Then the next week, we had some more even more serious declines. The stock market wants an anchor. It wants to know where we are going. An open-ended upward movement in interest rates is very frightening to the stock market because bonds compete with stocks and I think this is, without question, what set the reaction off.

Knowledge at Wharton: Speaking of Mr. Bernanke, you wrote in your market commentary recently that you think that the markets are testing him. How do you think he’s doing so far in these tests?

Siegel: So far, his main problem has been in communication. There was that miscommunication in his testimony hinting at something and then telling a reporter that the market misinterpreted him. These are mistakes that a rookie sometimes makes, but as I stated, he’s a very intelligent individual and a very quick study, and I think that we won’t see these mistakes in the future.

When I said the markets are testing him right now, as I look ahead, there are two bubbles that the Federal Reserve needed to puncture. One was the real estate bubble, which has been punctured. There is just no question now when we look at the data that real estate has slowed significantly, that price increases in fact have turned into price decreases in the hot coastal areas of our country. This is basically what the Fed wanted to do.

What has not yet been convincingly popped is the commodity bubble –typically oil, the metals, copper, zinc, aluminum, etc. Yes, in the last week or two we’ve had a reaction downward, but we’ve had such reactions in the past and they’ve been followed by upward surges.

The test will come if these commodity prices and oil prices surge to new highs. They’re going to say to Bernanke, what are you going to do about this, are you really committed to a very strong dollar and a firm monetary policy, or are you going to be weak and not raise rates? So far, we haven’t had that confrontation, but it might happen. It might happen relatively soon.

Knowledge at Wharton: The Conference Board has just reported that consumer confidence in May has fallen to the lowest point in the past three months. As you might expect, this reflects the high gasoline prices and to some extent the volatile stock market movements. Should investors be concerned about this?

Siegel: What is interesting is actually of the two surveys, the Conference Board has shown a surprising strength. Even though it did decline last month, it’s nowhere near as low as the University of Michigan survey which is consumer sentiment. That is showing multi-year lows. When we look at a graph of the Conference Board, we see that it had dropped but it’s still not that low. We’ve never really seen quite as big a divergence. It’s sort of hard to understand why that’s been. But you’re right, this last one was down. There’s no question that high gasoline prices and high interest rates are the two factors that have an immediate impact.

A longer-term factor is unemployment and the economy. That’s looking much better. You know, everyone talks about gas prices. It’s almost like the weather nowadays, what you chat about. I think that if you start realizing we just came back from Memorial Day, people had to fill up their tank several times, and you do feel that pinch. The consumer’s going to slow down, there’s no question, in the second half of this year. We’re going to have to rely on corporate capital expenditures to keep the economy moving at least at a moderate pace.

Knowledge at Wharton: Speaking about corporate, what’s going to happen on the corporate side? Walmart stock prices have come down because the retail giant has just reported disappointing sales. Again, the company has blamed the high gasoline and utility prices for its performance. Should investors be concerned that in addition to consumer confidence, corporate profits will be tepid or depressed because of the commodity bubble that you talked about earlier?

Siegel: The energy costs, those firms that have high energy costs, certainly are impacted. The consumer will shift downward. Actually, the interesting thing about the Walmart phenomenon is, even though it is the low end that really gets hurt by the interest rates and the oil, Walmart starts gaining some customers from the middle end that now have to go to Walmart. [laughs] Also Walmart’s having some difficulties on the international side. There were articles in the Wall Street Journal about not making it into Korea and having trouble in Japan. The international component is also a very big component, knowing your market and understanding your market.

All this is indicative of the fact that we’re going to have a slowdown. Something else, by the way, is the fact that in past years, tax declines have boosted income. No tax decline this year, just barely an extension of the previous tax, so we are not getting that tax boost and we are getting [hit] both by the energy costs and the interest rates. The only bright side of the energy costs is how low natural gas is. You say, well, how important is that, since yes, we don’t run automobiles on natural gas.

Natural gas is a very important source of electricity production. Electricity, a couple of months ago, was up at a five percent rate when gas was way up. Don’t forget, there’s quite a few heating systems which are dual; they can use either oil or gas. That’s a moderating factor for the heating season. However, that’s about the only bright spot that we see.

Today, again, the day after Memorial Day, we see another surge of commodity prices. I’m watching them very, very closely because I think that that’s where the test will be if they surge into new high ground.

Knowledge at Wharton: Some people point out that the impact of high energy prices is being offset by the fact that China and India have opened up their economies and their cheap labor is helping to push down the costs of goods and services. Do you agree, and if so how long can that effect continue?

Siegel: Yes, I’ve made that very point.


Knowledge at Wharton: You’re one of the observers I’m mentioning.

Siegel: One of the reasons why overall inflation outside the energy complex is so moderate is the fact that a lot of it is coming because of imported goods — [that’s] one of the big differences [compared to] the 1970’s when you also had a surge of oil and energy prices, we didn’t have those imports, and everything was produced here or in Europe. As a result everyone suffered through the energy situation.

That has been one reason why it hasn’t impacted the economy more. In virtually every economist’s model, you told them $75 oil and they would tell you you’re going to be near a recession. We’re not. Slight slowdown, yes. a moderate slowdown on the consumer, but not a recession. All that said, you can’t run your automobile on those Chinese products. Disposable income is still [going to be cut].

Knowledge at Wharton: Just like the impact of China and India have stimulated supply, cheap money has stimulated demand. Now the days of cheap money seem to be coming to an end. All around the world the major central banks are in fact, as you said, tightening monetary policy. How long can the demand side of the picture remain good? Should there be any concerns?

Siegel: This is the one-two here. One from the energy costs, two from the interest rates. We have a fancy term called MEW, mortgage equity withdrawal, MEWs, which is how much people take out on second mortgages, on home equity loans, which has been huge. Two years ago they were giving home loan rates as low as 4%, sometimes 3.5%. These were not teaser rates, these were home equity rates, but they were variable rates. Now those same rates are 8% or higher. That’s a huge change. So those people have been using, as we say, their homes as an ATM machine to cash out.

Obviously we are going to be crimped dramatically. That’s the second source of the slowdown, and that’s why I think in the second half of this year, consumer spending could slow down to only a 2% rate. The only way that we would get to 3% GDP which is minimal growth — most economists think 3.5% is what we’re capable of — would be capital expenditures rising and maybe exports rising. If we just had to rely on the consumer in the second half of the year, I think we would have a significant slowdown.

Knowledge at Wharton: Someone said recently, and I believe it was you, Jeremy, that a low dollar is favorable for the equity markets but the anticipation of a falling dollar is unfavorable to both stocks and bonds. Do you think the Bush administration is amenable to a decline in the dollar, and what could be the impact of that?

Siegel: We’re going to obviously get statements here from Mr. Paulson, designated Secretary of Treasury, that the official position is still a strong dollar, although interestingly enough, today the dollar has actually weakened. This is another form of the test that I think that Bernanke might be put to. A falling dollar and rising commodity prices. If the dollar can hold around this level and commodity prices don’t move, I think I’m very favorable. If they surge and the dollar falls, Bernanke may have to hike again and maybe even by more than just a mere 25 basis points and say, listen, I’m really serious about this. I’m not soft on inflation, I’m not going to let the dollar just slide anywhere … It would be a cold bath for stocks and bonds and commodities particularly.

We did talk a little bit about the foreign markets. I do want to get that in. Those were almost straight-up markets, particularly the emerging markets. I’ve long lectured that whenever you have markets that go up almost every day as they have for the last three or four months, when they go down they’re going to go down fast and big. That’s always been the case. People say, oh my god, there’s a 20% drop in the emerging markets. They’re still 30% ahead of where they were a year ago. The increase had been extremely strong and actually, that’s another bubble.

I think the emerging markets were in a bubble, the foreign markets somewhat but not as much. That is actually healthy if they break, because no market can be up every day … Eventually when there’s a wobble it’s going to be a big one. Is it the start of something major? No. I don’t think so. This is a question of how high we have to go in order to control the second bubble, the commodity bubble in the economy.

Knowledge at Wharton: We’ve talked several times about the commodity bubble. What is the appropriate response, and how can that bubble be burst without causing damage?

Siegel: The balancing act that Bernanke has today is, we know that housing has slowed. Commodities, we’re not convinced that we’ve seen the lows. The worry is, if he really puts a strong move on the commodities by raising interest rates, would he tip housing into such a decline that it could tip us into a recession? That is the major balancing act that he has to do at the present time. But my feeling is that, if commodities rise, if they test them and the dollar falls and he comes in very strong, it’ll be, as I say, a real cold bath right at the beginning, but I actually think that interest rates, long-term interest rates, could start downward, because they could say, wow, he’s serious about inflation control and he’s not worried about how much he has to slow the economy to do that.

Right then, I would maybe want to be a buyer of long-term bonds … In other words, even though he’ll jack up the short rate, it’s basically to show he’s serious. It might cause a decline in the long rate. By the way, that’s the first sign, which is usually all you have to do. Back in 1994, 12 years ago, when Greenspan sent that rate up half a point at the very end to 6%, that was all that was needed. The bond market started rallying, and from that point on there were no further increases.

Knowledge at Wharton: Let’s end with the one question we always ask you. What do you think investors should do now?

Siegel: I think actually, I say sit tight, certainly don’t bail out. Right now, I think for those of you who didn’t get in this year and maybe you’ve regretted it, you are now back to January levels. My feeling is that positioning in stocks at the present time is appropriate. The international stocks are down. Position yourself there. I think that long run, investors are getting better returns now than they were just a month ago.

Knowledge at Wharton: Professor Siegel, thank you very much for speaking with us.

Siegel: Thank you for having me here.