Jeremy Siegel: The Impact of the Brexit Vote on Markets

Wharton finance professor Jeremy Siegel sees U.S. stocks rising 10% to 12% by year-end, despite any blowback to the world economy resulting from the Brexit – the U.K.’s looming withdrawal from the European Union. Siegel also says, in this Knowledge@Wharton interview, that the swoon in European stocks that followed the vote offers a buying opportunity. “If you were a longer-term investor, you are able to get European stocks … at around 12 [times] price-earnings ratio … an extremely good valuation in low-interest-rate environments.” He does not expect any other countries to leave the EU, and says a Fed rate increase this year remains possible, though not likely until after September.

An edited transcript of the conversation appears below.

Knowledge@Wharton: We’re here with Wharton finance professor Jeremy Siegel to talk about Brexit, with the U.K. voting to leave the European Union, and what it means for markets. Thank you for joining us today, Jeremy.

Jeremy Siegel: I’m happy to be here.

Knowledge@Wharton: The vote was taken Thursday, but the announcement was made Friday last week. There was the biggest one-day loss in global equities in history — over $2 trillion.

Siegel: And then another trillion [dollars] yesterday. So that was the biggest two-day dollar loss in history — $3 trillion.

Knowledge@Wharton: Not the biggest percentage loss.

Siegel: Oh, by no means. No.

Knowledge@Wharton: Today [Tuesday, June 28], the markets are recovering a little bit. The Dow Jones, at least in the U.S. now, and the S&P 500 are both up about 1%.

Siegel: And Europe is up, actually, quite nicely.

Knowledge@Wharton: It looks like perhaps the dust has settled a little bit, at least for the moment. What are the main takeaways from all of this, and what should people be thinking about as we go forward? It looks like it didn’t turn into a rout or a panic, at least so far.

Siegel: No. There was no disruptive trading, and the [European] Central Bank stood ready in case there was. But foreign exchange trading … was pretty orderly. No real gaps. Liquidity was good. We’ve had a big price adjustment. The markets react in the short run to uncertainty, and that’s what this bred — a tremendous amount of uncertainty. So we have to stand back and [ask], “Are the fears justified?” We should talk about that.

Knowledge@Wharton: It looks, for the moment, like things have stabilized. But anything could change at any moment. So, let’s talk about that. What are the key [factors]?

Siegel: Having studied these for many, many years, one of the big fears — not the only one, but one of the big fears — is that this will spread to other countries. We’re hearing about Frexit and Grexit, and all sorts of things like that. There will be no other major country that will leave [the European Union], and absolutely there will be no country in the eurozone that will leave. (The eurozone has 19 of the 28 European Union member-countries, including the U.K.)

“I do not believe at all that there’ll be any other country of any significance [that will want to leave the euro zone].”

Getting out of the eurozone is a whole order of magnitude more difficult than just leaving the EU once you have your own currency. We can look at the Greek situation, [in] which the voters were trying to give the thumbs to Germany. They wanted out of every agreement, but they did not want [to be] out of the euro. As a result, the Germans and the Europeans had a stranglehold over them, and there was nothing they could do.

So my feeling is that this is not going to spread. There was a lot of talk about the anti-EU forces. We already had an election over the weekend, in Spain, where the ruling party did better than expected. After seeing what had happened, there may be some pause on the part of many Europeans. “Is this the direction we want to go?” [they may ask]. But nonetheless, even if those parties do gain strength, I do not believe at all that there’ll be any other country of any significance [that will want to leave the euro zone]. I’m not talking about tiny, tiny countries here or there. This is something that is extremely unique to the U.K.

Knowledge@Wharton: One of the main reasons for [other countries not wanting to leave the euro zone] is the difficulty that they would have in introducing their own currency?

Siegel: [Yes], their own currency. The public does not want the risk of going to [their country’s own] currency. Because the euro, even though it certainly has been hit as a result of this, is one of the world’s strongest currencies. Any country that goes on its own is going to have to deal with [the fact that they are] going to be discounted. They’re going to be given their own currency at a discount to the euro, and no one wants their banking [institutions]. That was basically why the Greeks couldn’t do anything with the banks. They would have been better off going back to the drachma, honestly. But no one wanted to give up the euro.

Knowledge@Wharton: The first level of fallout, you’re suggesting, seems to be that people are seeing what’s happening in the U.K. as a bit chaotic, because there doesn’t seem to have been much planning. The Economist had a headline, “Britain is sailing into a storm with no one at the wheel.”

Siegel: Well, [British Prime Minister David] Cameron resigned. We don’t know who’s going to take over. There seems to be a lot of regret. People now say if the vote was taken today, the ‘Remain’ [supporters] would win. I don’t think there will be another vote. They will start negotiating an exit.

[What is] interesting is Scotland. With an exit, Scotland will have another referendum. That’s a live possibility. We really could see the breakup of the U.K., more than the breakup of the EU, as a result of this vote.

Knowledge@Wharton: Let’s talk about the economies. What is likely to happen in the U.K., and in Europe, over the coming months? Is this likely to lead to a recession for one or both of them?

Siegel: I don’t think [a recession is likely] for Europe. For the U.K., they’re saying the probabilities are certainly higher. There’s been a big hit on equity values [with the] uncertainty. The question is: will a lot of people put off investment as a result? You don’t want to invest in the future, when the future is uncertain. That would be the major source. With the pound going down so much, [the U.K. will] probably have a tourism boom. They’re going to do probably better for their exports, because their costs have been lowered. From that point of view, it’s very good.

“I think [European Central Bank President Mario Draghi] would prefer [the euro to be] between $1 and $1.10 — closer to a dollar.”

The big uncertainty is how much will investment go down? [This is about] people putting off decisions to put real capital expenditures into the U.K. until the situation gets clarified very much. Believe it or not, I think they will avoid a recession. But certainly they’re going to take a growth hit as a result.

Knowledge@Wharton: I guess there’s the short term and then the more medium-term [and] long-term effects.

Siegel: The euro did go down, too, relative to the dollar. [European Central Bank president Mario] Draghi was a little bit concerned. You know, one of the purposes of the quantitative easing that Draghi introduced nearly two years ago was to bring the euro down. It has been my position for many years, and I’ve voiced it in columns, that the euro at $1.35 and [$1.40] was inconsistent with an economic recovery in Europe, and [that] they would have to bring it down. Draghi then decided, “Yeah, we’re going to have to bring it down.” Remember, they brought it all the way down.

I think [Draghi] would prefer [the euro to be] between $1 and $1.10 — closer to a dollar. As you know, before the Brexit vote, it had gone up to $1.15-$1.16, which is a little higher than [what] he wanted, because they need that export-led recovery. There were some signs of a recovery. Europe was looking better before this Brexit vote.

The Brexit vote, of course, depressed the pound the most. But secondarily, it depressed the euro down to about $1.10. That must please Draghi. But he wouldn’t mind bringing it down a little bit more. Certainly that would be part of a policy separate from Brexit, if Draghi wants to bring that down more. I don’t think the fall in the euro by just 2% or 3%, [or] 4%, is going to [provide] a significant lift to their exports from Brexit alone.

Knowledge@Wharton: Let’s talk about the effects of all of this on the U.S. One of the first things people started talking about was that the [U.S.] Fed is highly unlikely to have any interest rate increase this year. Before Brexit, there was talk that maybe one to two increases were possible, maybe even likely. Do you agree that [a rate increase] is unlikely this year?

Siegel: Well, it’s not a slam dunk that there will be none. Now certainly, if we look at the Fed Fund’s futures market, it has priced out any increases this year. Certainly there won’t be any increase in July. And probably not in September. But I would not rule out December. If things normalize again and people say, “Wow, this did not cause a domino effect that’s going to really threaten world economic growth,” you have to look back at what kind of growth we’re going to have in the United States. Unemployment continues to move down. It was 4.7% [in May 2016]. The Fed basically said 4.8% or 4.9% was the lowest they’re going to go [to].

I would not rule it out [an interest rate increase in the U.S.] Clearly, if things get worse in Europe and everything else [looks bad], then obviously it’s less likely. We have a couple [of] more labor reports [expected this year]. But December — and that will be after the presidential election, so they won’t be accused of trying to manipulate the election — I think is on the table.

Knowledge@Wharton: Is, in general, the low-interest-rate environment in the U.S. the new normal?

Siegel: Yes.

Knowledge@Wharton: Is this where we’re going to be in the foreseeable future — two, three or five years out?

Siegel: Yes. I’ve been stressing this for a while. It was [U.S. bond investor] Bill Gross, who two or three years ago introduced the concept of the “new neutral,” where he [said] the Fed Fund rate [will not increase] to 4%, [but increase] to 2% at most. He thinks interest rates [will be] permanently lower for the next five to 10 years. And I agree. You see the Fed’s long-run dot-plot — it keeps on moving down, down, down.

“If this does lead to a permanently higher dollar, that is going to be hard for our exporters but great for our consumers and importers, in keeping inflation down.”

Following up on your previous question about what the effect could be in the U.S., certainly a stronger dollar is going to hurt our exporters. We already know it has hurt our exporters over the past year. We’ve generally let Japan and Europe devalue, to help their economies, and have been absorbing those shocks. If this does lead to a permanently higher dollar, that is going to be hard for our exporters but great for our consumers and importers, in keeping inflation down. That, of course, will mean the Fed could be on hold for a long, long time [with interest rates].

But again, it depends [on other factors as well]. [Take] Japan, particularly, right after the [Brexit] vote. I saw the yen going to $0.0099, and settle around $0.0102, $0.0103. But that’s still much lower than [what] either [Japan’s Prime Minister] Shinzo Abe or [Haruhiko] Kuroda, the head of the Japanese central bank (Bank of Japan), can tolerate the yen [at]. None of [Abe’s] economic plans really can be realized at $0.0100 or $0.0102.

In fact, Shinzo Abe [had] instructed Kuroda to offset any increased flows. There’s just kneejerk reaction. Whenever there’s an increase [in economic stress] around the world, people go to the Japanese yen. That comes more from history — the fact that many international investors and speculators would finance through the yen, because it’s the world’s cheapest currency. And whenever there would be a risk-off position, they would repay their loans. Therefore, they would buy yens to do that, and cause the yen to rise. So you saw that big spike in the yen right after the Brexit vote.

Knowledge@Wharton: Some people are feeling better today, because the drop seems to have halted, right?

Siegel: Correct.

Knowledge@Wharton: There’s [also] a little bit of a buy-back. But obviously things are still fragile. They’re still dangerous out there. One crack in the facade might be in Italy, where banks in Europe in general have been seen as being on the weak side. New rules are forcing them to increase their holdings and their reserves. But in Italy in particular, banks are seen as very fragile. This seems to have pushed at least some of them over the edge. Now there is talk of a $40 billion bailout there. Is this the kind of thing that has some danger of sliding out of control and becoming more systemic?

Siegel: Draghi has faced the bank problem. The big ones were two or three years ago. It was the Spanish banks, too. It was not just the Italian banks. Many of them have been [getting capital infusions, but] they haven’t recapitalized the way the U.S. has. The U.S. has a much safer, better cushion. [The Italian banks] never really recapitalized. [The Brexit aftermath] is exposing it. Obviously, Britain leaving, in and of itself, doesn’t have that much of an effect, unless the Italian banks made big loans to the U.K. I don’t know enough about their balance sheet to say that.

But one thing that Draghi is completely committed to [is] not letting a European banking situation turn into a major crisis. He has already prevented two of them, in the first Greek crisis and then [in] the Spanish crisis after that. He is willing to go all out on whatever is needed to do that. So whatever we find, if a few banks have overextended in an area which is now very weak, certainly it’s not a good situation. But Draghi and the ECB [are] committed to make sure that that doesn’t snowball into a general crisis.

Knowledge@Wharton: The ECB changed rules a couple years back, to make it officially the lender of last resort.

“[The U.K.] will avoid a recession. But certainly they’re going to take a growth hit as a result.”

Siegel: Yes. Basically, they have become the lender. Draghi has been educated into the same sort of central banking motif that [former U.S. Federal Reserve chairman Ben] Bernanke was — and certainly Mervyn King was, as former Governor, and Mark Carney, current Governor of the Bank of England — is that [the] lender of last resort is critical. It was critical, obviously, during [the U.S.] financial crisis, to prevent the recession [in 2007-2008] from ballooning into a Great Depression again. [Draghi] is fully committed to that.

Knowledge@Wharton: Throughout the EU, there’s a new rule that talks about bail-ins for banks. Could you talk about that?

Siegel: Bail-in means, “We’re not going to protect you 100%.” Equity holders don’t get bailed out very much. But who does get bailed out often are bondholders or depositors. So saying “bail-in” means you’re not going to get 100% bailed out. “We’re going to put you into the mix, also.” We saw that with Cyprus. When the Cyprus banks went under, the EU forced the depositors and bondholders to take some of the losses.

Knowledge@Wharton: If you have money in an Italian bank and it starts to look shaky, and suddenly you realize you’re subject to bail-in provisions, you’re going to be a little bit quicker about taking it out, don’t you think?

Siegel: Certainly. And that could cause [bank] runs. As I said, the only case was Cyprus, and that’s because there were a huge amount of illegal loans, often financed from Russia, that were placed in the bank. And the EU [said] “no way” on that. But that was a very unique and particular situation. I don’t think it’s going to apply to the major EU members.

Knowledge@Wharton: What else should we be thinking about or talking about when it comes to the whole Brexit issue, and where are things likely to head — for the global economy, for the U.S., [and] for Europe?

Siegel: I don’t believe this is going to spread in any meaningful way. I’ll certainly admit the uncertainty that’s there. Honestly, if you were a longer-term investor, you are able to get European stocks now selling at around 12 [times] price-earnings ratio, which is an extremely good valuation in low-interest-rate environments. Obviously, you’re going to be taking on some risk. But we all know through history it is when the risk is the highest that the rewards have been the greatest. If you have some room in your portfolio and you’re thinking of it, European stocks have been beaten down a lot. They will be rewarding in the three-to-five-year-hence portfolio.

Knowledge@Wharton: Where do you think U.S. stocks will be at the end of this year?

Siegel: Well, earnings need to increase. That’s been the major problem. We had a stall-out in earnings last year, [and in this year’s] first-half. We’re not going to get much of a rise in the stock market unless we get the second-half earnings doing better. It may take several months for us to see clear. If they do improve, as many expect, we can see the market 10% or 12% higher by year-end.

Jeremy Siegel: Despite Volatility, Stocks Could Rise 10% in 2016

[Editor’s note: In view of the most recent market volatility and devaluation in China, Knowledge@Wharton has updated this interview, which was initially conducted earlier this week.]

Despite the global upheaval as the Chinese stock market plunged this week, Wharton finance professor Jeremy Siegel is sticking with his forecast for a 10% rise in the Dow for 2016 (or around 19,000 by year-end). But he cautions that the first half of the year will suffer an economic drag caused by lower oil prices, which touched a 12-year low on January 7.

He also notes the following, regarding the most recent events in China:  

“The devaluation of the yuan is the most important issue driving markets in recent weeks. China knows the circuit breaker [a mechanism allowing the forced shut-down of selling in Chinese stock markets when prices fall too far, too fast] is not a good idea as it is set up, and they are going to substantially widen the band.

“The market is oversold at this point, but there is still worry about the Chinese currency,” Siegel continues. “The Chinese want the yuan lower but, unfortunately the government’s slow adjustment causes more people to want to get out of the yuan because they feel it will go lower. That is one of the things spurring the stock sell-off and some of the destabilization.

“The result is the lower yuan is going to export more deflation into the developed world, which is going to make it even harder for the central banks to hit their inflation goals, and that will lead to a much slower rise in U.S. interest rates by the Federal Reserve.”

The other big issue is oil prices, Siegel adds: “If they break below $30, it will make the transition for energy investors more difficult. Even though net lower energy prices are good for the U.S., there is capital in that industry that must move out to find other profitable projects. That is very disrupting – it’s not enough to spark a recession, but it does slow down growth in the first half until that capital gets redirected.

“In the second half [of the year], once people see that the Fed is not going to be as aggressive as before – and outside of the oil sector — earnings are going to be fairly good. So I think my positive projection has a very good possibility of working out. The negative sentiment we see now is getting way too bearish. Don’t forget, we are not anywhere near the panic lows we were at in August. We’ll see if [today’s levels] will hold – I think they will.”

In this Knowledge@Wharton interview, Siegel also discusses U.S. labor markets, productivity and absent wage increases, problems in the junk bond market, and the risks of worldwide deflation and recession.

An edited transcript of the conversation follows.

Knowledge@Wharton: We’re speaking today with Jeremy Siegel, a Wharton finance professor, about the outlook for markets in 2016. Welcome, Jeremy. Thank you for joining us.

Jeremy Siegel: Happy to be here, and happy New Year.

Knowledge@Wharton: Happy New Year to you as well.

Siegel: Although not so happy in the stock market today [Monday, January 4, 2016].

Knowledge@Wharton: Let’s talk about a couple of things. One is that 2015 was the worst for stock markets since 2008. The Dow Jones and S&P 500 indexes … lost a little bit, but basically they were flat. That is the lowest performance in quite a while. Where [do] you see them going in 2016? We have these issues in China, [with] suspension of trading, [and] and a drop of 7% in the stock market there. These are all connected. Let’s talk about the short term, and then we can talk about the long term.

Siegel: One thing is interesting: The worst in what — six or seven years, and that’s a flat market? That’s not bad, right? It shows how many up-markets we have had over the last seven years, and the worst is a slight negative on the index. If you add the dividend return, it’s actually a very slight positive. The major reason for that is we had a tremendous drop in earnings. Unexpected, both the rise of the Dow [at the time] and the collapse of the energy prices. The earnings were way, way below estimates. It is not a bad stock market performance given the decline in earnings that we had.

Knowledge@Wharton: The projections are that earnings in the upcoming reports aren’t going to be great either, and that we have this wrinkle, large or small, with China at the moment. What do you see? It’s a tough call for 2016.

Siegel: Let’s get to the real short run. The China [aspect] — a circuit breaker at 5% for a volatile market is way too small. There [are] also fears that there is a big lockup — they prevented insiders from selling stocks for six months. That’s going to end on Friday. Whenever something bad happens [people feel], ‘Oh my God, there’s going to be millions of shares sold on Friday,’ and ‘Get out now before the circuit breakers come in.’ It’s a mess. We all know that they’ve handled the market really badly. It’s an important market of the world, and that certainly contributed to the declines we saw today.

Knowledge@Wharton: Do you think the situation in China is not quite as bad as the market suggests today, and that technical things are making it overshoot on the downside?

Siegel: The market always overreacts. How much will GDP go up? I heard on CNBC some forecaster saying it will be as low as 2-3% for this year, which would be a shock. But most of the people that I talk to … say maybe it’s 5%. That’s a comedown, but still not a disaster. We wish we could get anywhere near that figure.

Knowledge@Wharton: Let’s look in to the first quarter [and] first half.

Siegel: The whole year.

Knowledge@Wharton: The whole year. What are you seeing?

Siegel: There’s a lot of pessimism now. If you take a look at bulls and bears, there’s a lot of downbeat on the market. I don’t think it’s going to be as downbeat. First of all, I don’t think the Fed is going to tighten as much as many observers fear right now. A lot of people [are] calling for four “tightenings,” and some even think more. I don’t think so. I think it’s going to be two “tightenings” — around that level. That is going to be a positive in the market, once they realize, ‘Oh my goodness, the Fed is not going to tighten that much.’ Hey, at that particular point, you look at the valuations of stocks. Even though they’re high from a historical basis, they are not high relative to current and prospective interest rates, and that realization will bring some money back into equities this year.

“With the earnings increase, and fears being allayed on how aggressive the Fed is, we would be at the same price-earnings ratio for a 10% move in the market this year.”

Knowledge@Wharton: Where would you see the indexes at the end of the year?

Siegel: We can do 10% this year. Twitter  Again, we were flat last year. I think our earnings are going to rise about 10%, [and] bounce back from about the 7% drop that we had this year. With the earnings increase, and fears being allayed on how aggressive the Fed is, we would be at the same price-earnings ratio for a 10% move in the market this year.

Knowledge@Wharton: What do you see as the major positives and the major threats to the U.S. economy for 2016?

Siegel: The positives are: I don’t think interest rates are going to be a threat. In fact, they are going to be less of a threat than many people think. That is going to turn out on the positive side. Earnings are going to recover. We had a tremendous decline in particularly energy-earning sectors, and they’re going to recover. The threats are, my goodness, there are still people calling for $20 [a barrel] oil.

A drop in oil prices is good, net for the U.S. economy, although not as good as it used to be, because we are almost balanced in terms of imports and exports, with our tremendous increase in shale oil production over the last five years. But nonetheless, the S&P 500 is not just a U.S. index. It is way more heavily weighted towards energy — the manufacturing companies that supply the energy. Companies like Caterpillar and others with all of the drilling equipment and all of that, are definitely hurt and marking down.

Also the fact that the strong dollar, although it helps us in terms of imports, it is very challenging for those companies that sell abroad and bring back euros and yen that are worth less in dollars. That is another reason for the hit in earnings. So again, oil prices [going] down is not going to be good for the earnings of the S&P 500 even though it is not going to have a big negative effect on U.S. consumers.

Knowledge@Wharton: How about places like in Europe and China? They would benefit, of course, from these lower oil prices.

Siegel: China is a net importer and India is a net importer. By the way, India is growing 7%-8% now —faster than China. It’s the oil producers in the emerging markets that have been hit the most. China is a big story about what happens on oil — unquestionably. If we get a big slowdown in China, oil will continue to be under pressure in 2016.

Knowledge@Wharton: What are the chances that the relatively positive picture for job growth in the U.S. in 2015 will finally lead to some real wage growth in the U.S., which has been lagging — some would say for decades — when you account for inflation? And connected to that [is] real investment by corporations in increasing production or in expanding in some way.

“… The S&P 500 is not just a U.S. index. It is way more heavily weighted towards energy.”

Siegel: One of the biggest disappointments over the past four or five years is that while we have had a really good increase in the number of jobs, productivity growth and GDP growth have been very poor. People say, ‘Well, it’s 2%, and 2.5%,’ but that’s the trend rate. That’s if you had no increase in jobs. We, of course, have had a net increase in number of workers — over two million a year over the last three years. We should be producing 4.5% or 5% growth rates in real GDP.

We don’t completely understand the reasons for the productivity collapse. Part of it is more regulations, part of it is maybe a mis-measurement of prices. So many things are now free because of our cell phones and our apps and everything [else]. If they’re free, they’re not in GDP, because GDP is price times quantity.

There are some people, and I am one of them, who think there is actually more deflation going on than people think when you actually take into account all of the things that have gotten free over time. [This] means we are understating real GDP, and understating the growth of real wages. So there is some measurement problem, there may be some compliance problem, and a regulation problem. It’s not completely understood. If we get a bounce-back in productivity, you will see a bounce-back in the real wages.

Knowledge@Wharton: Is this connected in any way to the labor participation rate? It’s great when you see jobs increasing and so forth. But when you compare it historically to the percentage of the workers in the U.S. who are employed, which is in a way a more long-term measure, we are still struggling back to where we were before the financial crash.

Siegel: Actually, we’re at record lows. The participation rate has continued to fall — and you’re absolutely right — fallen much more than we would have expected. We do know the participation rate will be falling because the baby boomers are going into the retirement period now. But it is falling about twice as fast as most economists say it should be falling. Why people are quitting the labor force? There is a lot of speculation. But that is one of the things that has put pressure on the unemployment rate.

We’re going to have a jobs report Friday, and of course every month we have that jobs report. If we could get the participation rate to stabilize or even move up in 2016, that would take a lot of pressure off the Fed, moderate any sort of increases they would have, and that would be a very positive development for the U.S. economy.

Knowledge@Wharton: What do you think the odds are of that happening?

Siegel: I’m not sure. It keeps on surprising us on how poor it is. With a good labor market, [an] unemployment rate of 5% — one of the lowest in the developed world — we should see more people saying, ‘Hey, you know what? There are job openings out there.’ Why aren’t they coming back in to the job market? It’s not just low-wage jobs and so on. We don’t understand all of the reasons people change in attitude about workers, and double-income families. There’s a very complicated dynamic that is going on.

Knowledge@Wharton: This unemployment rate of 5% doesn’t really capture the number of people that are outside [the formal labor force].

Siegel: The U6, which includes those, [is] good. [According to the U.S. Department of Labor, the broader U6 measure of unemployment includes those who are unemployed as defined by the International Labor Organization; “discouraged workers” or those who have stopped looking for work; “marginally attached workers” or “loosely attached workers,” or those who “would like” and are able to work but have not looked for work recently; and part-time workers who want work full time but cannot due to economic reasons.] But that’s gone down a lot, too. That fell below 10% again. So we have reduced even the discouraged workers, the marginally attached workers, the workers that are working part-time instead of full time. All of those have also seen a dramatic decline. We have done a great job there, [but] still have not been able to coax people back in to the labor force.

Knowledge@Wharton: As bad as you say things are with that number in the U.S., it is even worse in Europe.

Siegel: Many of them have a much earlier retirement age, and much more generous pension. Unemployment insurance is automatic for them, whereas for us it isn’t automatic. There are a lot of differences that make ours a much more flexible labor market than in Europe.

Knowledge@Wharton: What signals should we take from the big dip in high yield – or junk — bonds?

Siegel: Almost all of that is in the energy sector. If you take high yield off the energy sector, it is only a very modest weakening. [It has to do with] the collapse of oil prices, and there was a lot of debt associated with that. [Also, the] master limited partnerships and the disaster that occurred last year. [Master limited partnerships are essentially limited partnerships that are publicly traded. Most of them are in the business of energy transportation, and saw a one-third drop in returns last year.] People thought they had a safe income vehicle, and those prices have been crushed 70% or more. That has hurt it. I do not think that we are going to see a weakening of the high yield market this year. In fact, there are probably some good values right now in that market.

“One of the biggest disappointments over the past four or five years is that while we have had a really good increase in the number of jobs, productivity growth and GDP growth have been very poor.”

Knowledge@Wharton: You would disagree with those who say this could be the canary in the coal mine that is suggesting there is some underlying weakness in financial markets and that’s why this is showing up?

Siegel: Yes…. You can always take a look at the 2007-2008 financial crisis, but that was much more endemic. This [crash last year had to do with] just the energy credits, which by the way the banks are not in at all. This is very, very important in contrast to 2007 and 2008. The banks basically [said], ‘We’re not going to do any of this financing of this oil [business].’ There was so much money on the sidelines that went in directly [that] they didn’t have to go to the banks. The banks are very, very sound at this juncture.

Knowledge@Wharton: How big of a threat is deflation? With China’s slowdown, commodity prices have plummeted. It’s not just oil, it’s copper, [and so on].

Siegel: Everything. It’s almost everything.

Knowledge@Wharton: Almost everything. We are at the end of a major pricing cycle, but now with China doing this pull-back, it is causing a tremendous effect. So where are we with deflation? Europe seems very vulnerable, China seems vulnerable, and if they were to devalue [their currency] again, for example….

Siegel: Which they are. We saw a tremendous weakening today in the value [of the renminbi], and it looks like it wants to be weaker. And yes, that does export deflation, and yes, I think (Fed chair) Janet Yellen is going to have difficulty meeting her 2% [inflation] target. That is one of the reasons why we are going to have very moderate increases in the rate this year.

Knowledge@Wharton: But not something that is going to spin out of control?

Siegel: I don’t see [that occurring]. If oil goes down to $20, that’s another leg down. But [things could change] if we get stability in oil. If you look at the core rates of inflation, they are not quite at 2%, but they are much closer to 2%, and they don’t show a sign of substantial weakening. I still don’t think [we need to worry about] deflation per se, but hitting the 2% target might still be a challenge.

Knowledge@Wharton: If the economy in the U.S. performs — the stock market performs — the way you are suggesting it will, that is going to help the world economy in general. But there are people out there that say the world economy could already be in a recession, or certainly that one is ahead. What is your feeling on that?

Siegel: The emerging markets are the most challenged, and of course those that are producers of these commodities are the most challenged. Europe is looking better than it did a year ago, and the U.S. is not really looking weaker. Looking in to this year, I still see 2-2.5% [U.S. GDP growth]. We’ll see what happens to the labor force and the productivity. [It is] not great for good labor market growth because of that productivity feature.

In Japan, Shinzo Abe’s plan for revival has been very slow in coming off, but I don’t see a recession there. The emerging markets are the most challenged of the group, and since their internal growth rate is so much higher. A recession [in] China is 3%-4% GDP growth. India still looks very, very strong. So I don’t see [a] world recession in 2016.

Jeremy Siegel: Despite Volatility, Stocks Could Rise 10% in 2016

Despite the global upheaval as the Chinese stock market plunged this week, Wharton finance professor Jeremy Siegel is sticking with his forecast for a 10% rise in the Dow for 2016 (or around 19,000 by year-end). But he cautions that the first half of the year will suffer an economic drag caused by lower oil prices, which touched a 12-year low on January 7.

He also notes the following, regarding the most recent events in China:  

“The devaluation of the yuan is the most important issue driving markets in recent weeks. China knows the circuit breaker [a mechanism allowing the forced shut-down of selling in Chinese stock markets when prices fall too far, too fast] is not a good idea as it is set up, and they are going to substantially widen the band.

“The market is oversold at this point, but there is still worry about the Chinese currency,” Siegel continues. “The Chinese want the yuan lower but, unfortunately the government’s slow adjustment causes more people to want to get out of the yuan because they feel it will go lower. That is one of the things spurring the stock sell-off and some of the destabilization.

“The result is the lower yuan is going to export more deflation into the developed world, which is going to make it even harder for the central banks to hit their inflation goals, and that will lead to a much slower rise in U.S. interest rates by the Federal Reserve.”

The other big issue is oil prices, Siegel adds: “If they break below $30, it will make the transition for energy investors more difficult. Even though net lower energy prices are good for the U.S., there is capital in that industry that must move out to find other profitable projects. That is very disrupting – it’s not enough to spark a recession, but it does slow down growth in the first half until that capital gets redirected.

“In the second half [of the year], once people see that the Fed is not going to be as aggressive as before – and outside of the oil sector — earnings are going to be fairly good. So I think my positive projection has a very good possibility of working out. The negative sentiment we see now is getting way too bearish. Don’t forget, we are not anywhere near the panic lows we were at in August. We’ll see if [today’s levels] will hold – I think they will.”

In this Knowledge@Wharton interview, Siegel also discusses U.S. labor markets, productivity and absent wage increases, problems in the junk bond market, and the risks of worldwide deflation and recession.

An edited transcript of the conversation follows.

Knowledge@Wharton: We’re speaking today with Jeremy Siegel, a Wharton finance professor, about the outlook for markets in 2016. Welcome, Jeremy. Thank you for joining us.

Jeremy Siegel: Happy to be here, and happy New Year.

Knowledge@Wharton: Happy New Year to you as well.

Siegel: Although not so happy in the stock market today [Monday, January 4, 2016].

Knowledge@Wharton: Let’s talk about a couple of things. One is that 2015 was the worst for stock markets since 2008. The Dow Jones and S&P 500 indexes … lost a little bit, but basically they were flat. That is the lowest performance in quite a while. Where [do] you see them going in 2016? We have these issues in China, [with] suspension of trading, [and] and a drop of 7% in the stock market there. These are all connected. Let’s talk about the short term, and then we can talk about the long term.

Siegel: One thing is interesting: The worst in what — six or seven years, and that’s a flat market? That’s not bad, right? It shows how many up-markets we have had over the last seven years, and the worst is a slight negative on the index. If you add the dividend return, it’s actually a very slight positive. The major reason for that is we had a tremendous drop in earnings. Unexpected, both the rise of the Dow [at the time] and the collapse of the energy prices. The earnings were way, way below estimates. It is not a bad stock market performance given the decline in earnings that we had.

Knowledge@Wharton: The projections are that earnings in the upcoming reports aren’t going to be great either, and that we have this wrinkle, large or small, with China at the moment. What do you see? It’s a tough call for 2016.

Siegel: Let’s get to the real short run. The China [aspect] — a circuit breaker at 5% for a volatile market is way too small. There [are] also fears that there is a big lockup — they prevented insiders from selling stocks for six months. That’s going to end on Friday. Whenever something bad happens [people feel], ‘Oh my God, there’s going to be millions of shares sold on Friday,’ and ‘Get out now before the circuit breakers come in.’ It’s a mess. We all know that they’ve handled the market really badly. It’s an important market of the world, and that certainly contributed to the declines we saw today.

Knowledge@Wharton: Do you think the situation in China is not quite as bad as the market suggests today, and that technical things are making it overshoot on the downside?

Siegel: The market always overreacts. How much will GDP go up? I heard on CNBC some forecaster saying it will be as low as 2-3% for this year, which would be a shock. But most of the people that I talk to … say maybe it’s 5%. That’s a comedown, but still not a disaster. We wish we could get anywhere near that figure.

Knowledge@Wharton: Let’s look in to the first quarter [and] first half.

Siegel: The whole year.

Knowledge@Wharton: The whole year. What are you seeing?

Siegel: There’s a lot of pessimism now. If you take a look at bulls and bears, there’s a lot of downbeat on the market. I don’t think it’s going to be as downbeat. First of all, I don’t think the Fed is going to tighten as much as many observers fear right now. A lot of people [are] calling for four “tightenings,” and some even think more. I don’t think so. I think it’s going to be two “tightenings” — around that level. That is going to be a positive in the market, once they realize, ‘Oh my goodness, the Fed is not going to tighten that much.’ Hey, at that particular point, you look at the valuations of stocks. Even though they’re high from a historical basis, they are not high relative to current and prospective interest rates, and that realization will bring some money back into equities this year.

“With the earnings increase, and fears being allayed on how aggressive the Fed is, we would be at the same price-earnings ratio for a 10% move in the market this year.”

Knowledge@Wharton: Where would you see the indexes at the end of the year?

Siegel: We can do 10% this year. Twitter  Again, we were flat last year. I think our earnings are going to rise about 10%, [and] bounce back from about the 7% drop that we had this year. With the earnings increase, and fears being allayed on how aggressive the Fed is, we would be at the same price-earnings ratio for a 10% move in the market this year.

Knowledge@Wharton: What do you see as the major positives and the major threats to the U.S. economy for 2016?

Siegel: The positives are: I don’t think interest rates are going to be a threat. In fact, they are going to be less of a threat than many people think. That is going to turn out on the positive side. Earnings are going to recover. We had a tremendous decline in particularly energy-earning sectors, and they’re going to recover. The threats are, my goodness, there are still people calling for $20 [a barrel] oil.

A drop in oil prices is good, net for the U.S. economy, although not as good as it used to be, because we are almost balanced in terms of imports and exports, with our tremendous increase in shale oil production over the last five years. But nonetheless, the S&P 500 is not just a U.S. index. It is way more heavily weighted towards energy — the manufacturing companies that supply the energy. Companies like Caterpillar and others with all of the drilling equipment and all of that, are definitely hurt and marking down.

Also the fact that the strong dollar, although it helps us in terms of imports, it is very challenging for those companies that sell abroad and bring back euros and yen that are worth less in dollars. That is another reason for the hit in earnings. So again, oil prices [going] down is not going to be good for the earnings of the S&P 500 even though it is not going to have a big negative effect on U.S. consumers.

Knowledge@Wharton: How about places like in Europe and China? They would benefit, of course, from these lower oil prices.

Siegel: China is a net importer and India is a net importer. By the way, India is growing 7%-8% now —faster than China. It’s the oil producers in the emerging markets that have been hit the most. China is a big story about what happens on oil — unquestionably. If we get a big slowdown in China, oil will continue to be under pressure in 2016.

Knowledge@Wharton: What are the chances that the relatively positive picture for job growth in the U.S. in 2015 will finally lead to some real wage growth in the U.S., which has been lagging — some would say for decades — when you account for inflation? And connected to that [is] real investment by corporations in increasing production or in expanding in some way.

“… The S&P 500 is not just a U.S. index. It is way more heavily weighted towards energy.”

Siegel: One of the biggest disappointments over the past four or five years is that while we have had a really good increase in the number of jobs, productivity growth and GDP growth have been very poor. People say, ‘Well, it’s 2%, and 2.5%,’ but that’s the trend rate. That’s if you had no increase in jobs. We, of course, have had a net increase in number of workers — over two million a year over the last three years. We should be producing 4.5% or 5% growth rates in real GDP.

We don’t completely understand the reasons for the productivity collapse. Part of it is more regulations, part of it is maybe a mis-measurement of prices. So many things are now free because of our cell phones and our apps and everything [else]. If they’re free, they’re not in GDP, because GDP is price times quantity.

There are some people, and I am one of them, who think there is actually more deflation going on than people think when you actually take into account all of the things that have gotten free over time. [This] means we are understating real GDP, and understating the growth of real wages. So there is some measurement problem, there may be some compliance problem, and a regulation problem. It’s not completely understood. If we get a bounce-back in productivity, you will see a bounce-back in the real wages.

Knowledge@Wharton: Is this connected in any way to the labor participation rate? It’s great when you see jobs increasing and so forth. But when you compare it historically to the percentage of the workers in the U.S. who are employed, which is in a way a more long-term measure, we are still struggling back to where we were before the financial crash.

Siegel: Actually, we’re at record lows. The participation rate has continued to fall — and you’re absolutely right — fallen much more than we would have expected. We do know the participation rate will be falling because the baby boomers are going into the retirement period now. But it is falling about twice as fast as most economists say it should be falling. Why people are quitting the labor force? There is a lot of speculation. But that is one of the things that has put pressure on the unemployment rate.

We’re going to have a jobs report Friday, and of course every month we have that jobs report. If we could get the participation rate to stabilize or even move up in 2016, that would take a lot of pressure off the Fed, moderate any sort of increases they would have, and that would be a very positive development for the U.S. economy.

Knowledge@Wharton: What do you think the odds are of that happening?

Siegel: I’m not sure. It keeps on surprising us on how poor it is. With a good labor market, [an] unemployment rate of 5% — one of the lowest in the developed world — we should see more people saying, ‘Hey, you know what? There are job openings out there.’ Why aren’t they coming back in to the job market? It’s not just low-wage jobs and so on. We don’t understand all of the reasons people change in attitude about workers, and double-income families. There’s a very complicated dynamic that is going on.

Knowledge@Wharton: This unemployment rate of 5% doesn’t really capture the number of people that are outside [the formal labor force].

Siegel: The U6, which includes those, [is] good. [According to the U.S. Department of Labor, the broader U6 measure of unemployment includes those who are unemployed as defined by the International Labor Organization; “discouraged workers” or those who have stopped looking for work; “marginally attached workers” or “loosely attached workers,” or those who “would like” and are able to work but have not looked for work recently; and part-time workers who want work full time but cannot due to economic reasons.] But that’s gone down a lot, too. That fell below 10% again. So we have reduced even the discouraged workers, the marginally attached workers, the workers that are working part-time instead of full time. All of those have also seen a dramatic decline. We have done a great job there, [but] still have not been able to coax people back in to the labor force.

Knowledge@Wharton: As bad as you say things are with that number in the U.S., it is even worse in Europe.

Siegel: Many of them have a much earlier retirement age, and much more generous pension. Unemployment insurance is automatic for them, whereas for us it isn’t automatic. There are a lot of differences that make ours a much more flexible labor market than in Europe.

Knowledge@Wharton: What signals should we take from the big dip in high yield – or junk — bonds?

Siegel: Almost all of that is in the energy sector. If you take high yield off the energy sector, it is only a very modest weakening. [It has to do with] the collapse of oil prices, and there was a lot of debt associated with that. [Also, the] master limited partnerships and the disaster that occurred last year. [Master limited partnerships are essentially limited partnerships that are publicly traded. Most of them are in the business of energy transportation, and saw a one-third drop in returns last year.] People thought they had a safe income vehicle, and those prices have been crushed 70% or more. That has hurt it. I do not think that we are going to see a weakening of the high yield market this year. In fact, there are probably some good values right now in that market.

“One of the biggest disappointments over the past four or five years is that while we have had a really good increase in the number of jobs, productivity growth and GDP growth have been very poor.”

Knowledge@Wharton: You would disagree with those who say this could be the canary in the coal mine that is suggesting there is some underlying weakness in financial markets and that’s why this is showing up?

Siegel: Yes…. You can always take a look at the 2007-2008 financial crisis, but that was much more endemic. This [crash last year had to do with] just the energy credits, which by the way the banks are not in at all. This is very, very important in contrast to 2007 and 2008. The banks basically [said], ‘We’re not going to do any of this financing of this oil [business].’ There was so much money on the sidelines that went in directly [that] they didn’t have to go to the banks. The banks are very, very sound at this juncture.

Knowledge@Wharton: How big of a threat is deflation? With China’s slowdown, commodity prices have plummeted. It’s not just oil, it’s copper, [and so on].

Siegel: Everything. It’s almost everything.

Knowledge@Wharton: Almost everything. We are at the end of a major pricing cycle, but now with China doing this pull-back, it is causing a tremendous effect. So where are we with deflation? Europe seems very vulnerable, China seems vulnerable, and if they were to devalue [their currency] again, for example….

Siegel: Which they are. We saw a tremendous weakening today in the value [of the renminbi], and it looks like it wants to be weaker. And yes, that does export deflation, and yes, I think (Fed chair) Janet Yellen is going to have difficulty meeting her 2% [inflation] target. That is one of the reasons why we are going to have very moderate increases in the rate this year.

Knowledge@Wharton: But not something that is going to spin out of control?

Siegel: I don’t see [that occurring]. If oil goes down to $20, that’s another leg down. But [things could change] if we get stability in oil. If you look at the core rates of inflation, they are not quite at 2%, but they are much closer to 2%, and they don’t show a sign of substantial weakening. I still don’t think [we need to worry about] deflation per se, but hitting the 2% target might still be a challenge.

Knowledge@Wharton: If the economy in the U.S. performs — the stock market performs — the way you are suggesting it will, that is going to help the world economy in general. But there are people out there that say the world economy could already be in a recession, or certainly that one is ahead. What is your feeling on that?

Siegel: The emerging markets are the most challenged, and of course those that are producers of these commodities are the most challenged. Europe is looking better than it did a year ago, and the U.S. is not really looking weaker. Looking in to this year, I still see 2-2.5% [U.S. GDP growth]. We’ll see what happens to the labor force and the productivity. [It is] not great for good labor market growth because of that productivity feature.

In Japan, Shinzo Abe’s plan for revival has been very slow in coming off, but I don’t see a recession there. The emerging markets are the most challenged of the group, and since their internal growth rate is so much higher. A recession [in] China is 3%-4% GDP growth. India still looks very, very strong. So I don’t see [a] world recession in 2016.