It was an unexpectedly stellar year for U.S. stock markets in 2017 – up about 24% thanks to a stronger economy, falling unemployment and expected tax breaks for companies that finally materialized at the last hour. According to Wharton finance professor Jeremy Siegel, since most of the good news has been baked into indexes now, markets will likely take a breather in 2018. The Dow Jones Industrial Average, he projects, will be either flat or will rise by up to 10% by year end, with a correction of 10% or so possible at some point in the year. In this Knowledge@Wharton interview, Siegel also offers his views about the Fed, GDP growth, inflation, wage growth, a Bitcoin bubble and why future Republican economic legislation will face a tough road.
An edited transcript of the conversation follows.
Knowledge@Wharton: After the Dow went up about 24% in 2017, a lot of people would say there’s just not a lot more room for it to grow. At the same time, we’ve had some last-minute changes, most notably on taxes — corporate taxes will be much lower, and some companies will see a big pile of cash overseas freed up. There are also more liberal expensing rules, which it’s hoped will promote investment. What’s your view on how all that plays out?
Jeremy Siegel: Well, it was a great market in 2017. I think the stock market’s going to be much more challenged and the bond market is going to be much more challenged in 2018. The good news about the corporate tax reform — and I think most of that is good news — was a reason for the run-up of stock prices in the latter half of last year.
Knowledge@Wharton: So that benefit has been of baked in already.
Siegel: Yes, I think it’s baked in. A lot of the good news is already in there, and I think that there are two things that are going to challenge the equity markets: One is going to be the Fed raising interest rates. And two, I think Trump is going to have many more political challenges this year. Really, there are no more 51-49 votes, because reconciliation could only be done once a year. That can only be done at budget time. [A bill moving through Congress under the reconciliation process cannot be blocked via a filibuster.] We have to wait until October.
For anything else to get passed, the Democrats really have to approve of it. I don’t know what else is going to be there. I’m, for instance, quite pessimistic on whether there’s going to be any infrastructure spending, which is a big topic now that everyone seems to be turning to after the tax changes. I think there will be a deal on DACA [the Deferred Action for Childhood Arrivals immigration policy] — the Democrats will throw some money at security, which Trump will demand on the borders, in return for DACA approval.
But outside of some of those very narrow things, I really don’t think anything is going to get done legislatively next year. The Democrats think they’re in the driver’s seat. Polls are very favorable for them. Stonewalling the President — they may look at that as being the very best choice.
Now, all that said, things that come out of Washington are not always good. So deadlock is not always a bad thing, as far as that’s concerned. But very clearly, with both the House and the Senate at threat to turn Democratic, for the Trump agenda, basically, we’ve got for now what we see and I think very little else.
Knowledge@Wharton: When you boil that down, where do you see the Dow ending up for the year?
Siegel: I think it’s zero to 10%. I wouldn’t be surprised if some time during the year we get a correction. Now, a correction is defined as a 10% decline. It doesn’t mean we’re going to end 10% lower. And we may go up 10% before we go down 10%. But we haven’t had a correction for quite a while. As you know, it’s been a very stable upward market. I think there’s going to be more volatility in 2018 than we saw last year.
Knowledge@Wharton: What about GDP growth?
Siegel: That could be good. We had 3% plus in the second and third quarter. The experts I follow are looking for a little over 2.5 % for the fourth, which will probably disappoint Trump. He wants to see three in a row that are 3% or above. But it is very possible that we could shift into a 3% to 3.5% growth economy next year. That would certainly give risk to higher interest rates from the Fed. That’s one of the things that’s going to be worrying the stock market. Remember, strong economic growth is a double-edged sword for the stock market. They like higher earnings, but higher interest rates that capitalize those earnings are negative for stock prices.
Knowledge@Wharton: Because higher interests rates siphon away some stock purchases.
Siegel: Yes. It means the bonds become much better competitors. Even now, where we’re basically over 2%, people can get that on CDs coming due this year, maybe close to 3% at the end of the year. That is, for the first time in 10 years, higher than the interest rate, than the dividend yield you can earn in the stock market. Now, I still think the stock market’s a much better bet, because you’ve got growth in the long run, et cetera. But there isn’t that urgency — “My goodness, I’m getting zero,” as we all got for so many years following the financial crisis. People might say, “Hey. I sit in the bank at 2.5%; I’m not all that motivated at this point to move into any more stocks.”
Knowledge@Wharton: We have a new Fed Chair coming [Jerome Powell], and that’s going to have some influence. And the Fed is projecting three rate increases — now, their rate increases have been pretty modest.
Siegel: Twenty-five basis points each. In fact, it was in December 2016 that they forecast three for last year. And believe it or not, they hit it on the head — the first time that they actually did what they said they were going to do. And that’s because the economy was fairly strong. Goldman Sachs, I think, is projecting four increases next year.
Again, it’s all going to depend on the economy. But when we have payrolls rising as fast as they are, these monthly payrolls — the number of jobs expected to be created are more than twice the growth of population. So that’s what eats into that unemployment rate, which is down to 4.1% — much lower than the Fed had thought it was going to be at the end of last year. Many economists now, even the optimists, are saying: “Well, you know, we haven’t seen much wage growth, and that’s good in the way of inflation.” They’re now looking at 3.5% as triggering labor shortages. And if we go through history, that has triggered shortages. But at the rate we’re going, we will reach 3.5% by the end of the summer. So, unless we slow down that payroll growth – and there are no signs at this point that that’s going to happen — that will really tighten the labor market.
Knowledge@Wharton: Is there any real reason to want to slow down that labor growth?
Siegel: Well, only in the sense that, where are you going to get the workers? In other words, normal immigration and just the population growth is supplying around 75,000 a month — so, when you get 190,000 [new jobs a month], you’re eating into that ever-diminishing pool of unemployed. That means there’s going to be a shortage of workers, which means there’s going to be bidding for labor. And the wage rates will, to the extent that they exceed productivity, add to inflation. And that is exactly what motivates the Fed to tighten its interest rates. And that is definitely a threat to the stock market this year.
Now, we’ve been lucky so far. Economists have been very pleasantly surprised that 4.1% unemployment has not yet tightened labor markets to the point of producing any real inflation at all. But if you go through history — it may not be 4.5% [that kicks inflation up]; it may not be 4.0%. When you get down to 3.5% — there are very few times we’ve ever gotten below a 3.5%, except in war times, when we’ve had price and wage controls, and not had some inflation on the wage front.
Knowledge@Wharton: When you get to 3.5% or 4%, how long does that take to actually push up inflation? Is that immediately or an 18-month lag?
Siegel: Not that long a lag, because labor costs are still 70% of the costs for firms to produce their products. Some are more and some are less. So if they have to bid up for labor, and if it’s not matched by productivity growth — and we’ve had very poor productivity growth, although there are some signs of some favorable developments on that recently — then that just adds to their costs. And they pass on those costs right away in the markets. Bond markets are protective … they look forward. The sensitive commodity markets look forward. They provide that pressure that puts the Fed on alert.
Now we also have the uncertainty of a new Fed chair, with not as strong a profile of what we know about him compared with what we knew about Janet Yellen, and certainly Ben Bernanke or Alan Greenspan, who preceded him.
And we’re awaiting the choice of a vice chair, which I think is going to be much more important. Don’t forget, this is the first Fed chair I think, going all the way back to William Miller in the 1970s, that has neither a graduate nor an undergraduate degree in economics. That doesn’t necessarily disqualify him. But from what I hear from the Trump Administration, they’re trying to find someone that does have those degrees, as vice chair– he or she will be more influential than previous vice chairs. And, you know, these will be ongoing important developments for the markets.
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Knowledge@Wharton: Isn’t it also possible that the pressure on wages that could come from inflation would also help to increase productivity? In other words, you have to find more efficient ways to do things if your labor costs are going up.
Siegel: Certainly. And that’s been commented a bit on these minimum wage increases. A lot of states have jumped past the federal government [and raised the minimum wage], which under a Republican administration doesn’t want to raise the minimum wage … so you search for cost-effective ways around it.
But the most disappointing aspect of the economy since the Great Recession, and that bottomed in June of 2009, has not been job growth. Job growth has been spectacular. The unemployment rate has gone down faster than even the Fed or almost all private economists had thought possible. Don’t forget, we peaked at 10% and now we’re down to 4%. That’s a huge, six percentage point drop. What has been so disappointing is very poor productivity growth during this period. And that is the major reason why wages have been stagnant. Because in the long run, wages can only increase if the productivity of workers increases.
Knowledge@Wharton: So there could be a possible positive benefit from increased wages, which could be higher productivity. Is that right?
Siegel: There might be. Let’s put it this way. There are two forces on wages. One is productivity, which is the real positive force. In other words, if workers are better-qualified, they have better machines, they have better productive capabilities, then their wage will go up. And that’s exactly what we want, no inflation.
But the second source of wage increases is a shortage of workers, just because there’s so much demand out there. That’s the one the Fed fears. And as that unemployment rate went down from, as I said, 10% to 4%, we’re getting close to the point where that shortage of workers, that second source of wage increase, which is not a good one — because that’s not due to productivity growth — would impel the Fed to raise interest rates faster.
Knowledge@Wharton: Is another potential wrinkle that when wages go up, since consumer spending is 70% of GDP, they’re going to have more money to spend? And so that’s going to boost the economy.
Siegel: But we haven’t had problems with boosting the economy. Spending has been good during this period. And then that’s another thing that somewhat worries me, and another reason I’m very pessimistic about infrastructure spending: Where are we going to get these workers? Infrastructure spending is great when you have 10% unemployment. When you have 4% unemployment, well, where are the workers? Right now, job openings are a near record high. Anyone who really wants a job can get the job. So that’s another push of demand — where is the supply going to come from? And that’s another danger of inflation. The political wrangling is going to actually do in most of the infrastructure spending — more than the fact of “where are the workers.” But “where are the workers” certainly has to be a consideration.
Knowledge@Wharton: We’re at a moment right now when most of the world’s regions and major economies — Europe, Japan, many other regions of the world, a lot of developing countries in Eastern Europe and so forth, and emerging Asia — are all growing relatively strongly. So you’ve got this sort of Goldilocks moment, when many countries and regions are growing strongly. You’ve said that in the past, that hasn’t been unusual, but it has been unusual in the recent past. What does it mean?
Siegel: Well, you’re right. The three major so-called sectors, the American economy, the developed non-American economy — which is mostly Europe, although there are other developed areas of the world — and then the emerging-market economy all bottomed out in 2009. They all took a hit. We in the U.S. recovered first. And Europe was beginning to recover, and then bang. It got hit by the debt crisis. The Greek crisis, the Spanish crisis, the Italian crisis. And it did a double dip there.
Emerging markets started out well, and then bang, oil crashed from $100 a barrel, finally down to below $30 at one point, along with other commodities. And emerging markets — although they’re trying to get away from being commodity-based — do have an awful lot of commodities and they crashed in 2016. Now, with commodity prices back up — and we see, of course, oil now above $60 a barrel — we have a strong recovery in the emerging markets. Europe is recovering from its debt crisis. Finally, countries like Spain and Italy are moving up. And the U.S., of course, is still very strong.
So yes, all the major engines are working together here. And that does mean something perhaps for inflation, because it isn’t like we have a soft area of the world that can provide us with goods at cheap prices if we run out of workers here. We really do have, now, strength in virtually all the major regions in the economy.
Knowledge@Wharton: So that could start to affect commodity prices.
Knowledge@Wharton: And then that works its way through everything.
Siegel: It absolutely does.
Knowledge@Wharton: To get back to Fed a little bit: It seems they have another reason for wanting to raise interest rates, not just concerns about inflation. But interest rates have been so low for so long that many worry that if we hit another recession, the Fed will be out of bullets when it comes to monetary policy. And we see that with fiscal policy, it’s very difficult to get things done. So we’ve been relying on the Fed — over-relying on the Fed, some would say.
Knowledge@Wharton: So they do have an incentive [to raise interest rates], don’t they, other than just the pure economic reasons – looking at inflation and the things they usually look at?
Siegel: Yes. And this is a big concern. The Fed has talked about it. So, we are in a world of lower interest rates than we’re used to. You know, we are used to the interest rates 4% or 5%, 6% on the longer end. We’re in the area of 2%, 3%. And that does mean, since zero is an effective bottom — now, I know that Europe has gone a little bit below zero but basically, not much below zero, as an effective lower rate – that you have fewer bullets in your holster if things do turn bad. And of course, this is one reason why in a financial crisis, Bernanke — but then all the other major central banks followed suit — took extraordinary monetary measures, such as quantitative easing, which I personally always supported and do think it helped us get out of the situation we were in.
They’d prefer not to use that. They want to use the more traditional interest rate targets. And there’s been a lot of talk about, in a low interest rate world, not having as much of that [leeway]. So in a way, it is good that we’re getting back to normal. If something bad happens, we would have some room to lower rates.
Remember, those extraordinary measures are still there. Some of us theorists have been [suggesting that] they should target a higher inflation than 2% to try to get interest rates higher, so they’ll have more bullets in case something bad happens. But there not a tremendous movement, at least at this point, in that direction.
Knowledge@Wharton: Do you see any financial bubbles that could pop in 2018? And maybe wrapping into that your view of cryptocurrencies like Bitcoin — because there’s been talk about a bubble there.
Siegel: Oh, yes.
Knowledge@Wharton: Will that get big enough to affect the so-called real economy, or regular financial markets?
Siegel: Well, you know, it is my opinion that the cryptocurrencies are a bubble. I do not see them as effective replacements for the national currencies. Actually, I think a break in Bitcoin prices would actually be good for the stock market. I think it’s drawn some money away.
Some people think, “Stocks are not as exciting — they’re not as volatile. Let’s move toward Bitcoin….” So I think it’s a bubble, but I don’t think it’s a threatening bubble. I see very few other, really, bubbles at this point, overextensions that I think are dangerous at all in 2018.
It doesn’t mean that all is free sailing ahead. Because as I said, if the Fed does continue to raise interest rates, that is going to be a challenge for stock prices. After the big gains we’ve had in 2017, [having] a year of digesting these gains without being too bad of a market — I don’t think that is the worst thing in the world.
Knowledge@Wharton: If those interest rate increases are on the aggressive side, you’re saying it would affect the market. Would it affect the economy that much? Because in the end, these increases aren’t all that much, are they?
Siegel: No, they’re not. In the big picture, they’re small and still very, very low. So, the Fed moves to 2% to 3%. We used to think that 3% was the bottom of the interest rate cycle rather than the top. But one of the reasons why stocks are selling for 20 times earnings has been because interest rates are low. And even at 3%, I think that still justifies close to 20.
So I’m not talking about a big crash, or terrible markets going forward. But I’m just talking about a little bit of a pause to make sure that the earnings are going to come out the way [they are forecast] — there are some very positive earnings forecasts, especially with this tax cut. I’m not sure all of them are going to be met in 2018. And with a threat of higher interest rates, that’s what makes me more cautious on stocks this year than I was last year.
Knowledge@Wharton: Any summing up comments?
Siegel: Well, always short-term forecasting is difficult. So I’m just trying to give people a framework in which to think of the major issues. I think the political issue, for the Republicans, is going to get much more difficult, plus the Fed being on alert as the labor market tightens is going to be probably front and center. [Those will be] the major concerns for investors.