Professor Siegel's Weekly Commentary Archive
When the Facts Change
July 24, 2023
John Maynard Keynes was asked in the 1930s about his view on the British economy and he gave a forecast that differed from his past comments. One follower said to Lord Keynes, “you've changed your opinion on this, why?” And Keynes responded, “Well, Sir, when the facts change, I may change my opinion. What do you do, Sir?”
I’ve held the opinion the Fed has tightened too much and have believed the risks that this tightening will push us into a recession are higher than necessary. But as I look at the cumulative weight of evidence and recent data, I now believe the Fed is not as tight as I feared. This will not give the Fed a full reprieve from my criticism: the Fed still kept interest rates far too low in 2020 and 2021 and I do not believe it needs to hike any more at this point. But let’s look at what facts are changing my mind on forward economic risks.
Forward-looking indicators are the key: the money supply, housing and commodity prices. The dramatic increase in the money supply during 2020-2021 spurred my warnings of rapid inflation from the pandemic. The Fed should have identified inflation pressures earlier and removed their accommodation much earlier.
But the Fed then played catch up and slammed on the brakes with 500 basis points in tightening in a very abbreviated period. The money supply started declining at levels we have not seen since the Great Depression. Even during the Volcker rate hikes to arrest high inflation, the money supply never shrank like we saw recently.
But that decline looks to be over. We are now starting to see the money supply recovering. Last month, it ticked higher; I watch weekly deposits and it looks like when the data comes out this week, it will again grow. This is one big factor causing me less angst.
Secondly, housing prices, which soared during the money supply explosion in 2020-2021 and started falling when the money supply first contracted, have turned the corner the last three months. I'm not going to say housing price increases are a permanent trend change with 7% mortgage rates, but we've had a consecutive string in housing price gains in both Case-Shiller and other national housing price indexes. We will get more data on both the M2 money supply and housing this week, but forecasts are for increases in both.
Thirdly, commodity prices, which are extremely important because they are very sensitive to economic growth pressures, look like they’ve bottomed and ticked up again. The Bloomberg Commodity Index, which plummeted 20-25% in May from the highs, has firmed recently.
Those three indicators imply the current real rates, and the Fed rate path projection is not excessively high.
We did not receive much new data last week but the one sensitive economic indicator—jobless claims—still are showing a robust and resilient labor market with jobless claims reverting to lower levels. These jobless claims are not signaling a super-hot economy but one that is growing modestly. Most economists’ estimates for second quarter GDP are in the range of 2-2.5%—far from a recessionary decline in output.
I am thus revising my estimate of where I believe real rates will settle. I previously thought the 10-year TIPS would go from current levels of 1.5% back towards zero. My new estimate is the 10-year TIPS yields may only revert down to 1% and the neutral Fed Funds rate to 2.5%-3%, also a point higher than my previous estimate.
This week the Fed will hike rates another 25 basis points. I would still say the downside risks to the economy of this action outweigh the upside growth risks, but not by as much as before.
My view on TIPS yields settling higher are because bonds are not quite as attractive portfolio diversifiers. The real rate on bonds staying more elevated is good for coupon clippers of yield, but fears of sticky inflation risk are making bonds a less attractive hedge assets for portfolios. With bonds losing this extra diversification appeal, the required compensation to own bonds (and the starting yield) is going up.
Supporting my view is better economic growth and productivity looks to be coming from the new AI technology spillovers. There is a lot of hype at the moment and that many of these stocks have been driven too high, but I do think an upgrade in the economic growth potential is warranted from the latest technology advances.
All this is generally good news for equities because the probability of recession risk is now down in my view. I think value stocks are pricing in a recession—with the non-tech sector in the S&P 500 selling at 17x forward earnings, right at the median multiple over the last 30-years. Dividend weighted indexes are priced even lower (the WisdomTree LargeCap Dividend Index is selling at 16x forward earnings and WisdomTree SmallCap Dividend Index only 13x forward earnings). There are value baskets even lower at 11-12x earnings.
If you agree with this upgraded assessment of the economic growth picture, value tilts are likely to be rewarded. AI hype turbocharged growth stocks after initial fears of a recession hurt more cyclically prone value stocks. But the break in growth stocks last week showcased well the old saying ‘staircase up, elevator down.’ When you have trending markets, you can ride the wave for a while but have to know when to exit. With such dramatic and large trends in place as we have now, an initial reversal as we saw last week is unlikely to be the permanent one. It can take 2-3 tests of the trend before a valuation rotation is fully confirmed, but I believe that will be coming.
My shift in view is not set in stone. If the forward indicators reverse and deteriorate, I am willing to revert to my previous forecast that the Fed will have to reduce rates rapidly. However, at this moment the indicators show a firm economy.
Past performance is not indicative of future results. You cannot invest in an index. Professor Jeremy Siegel is a Senior Economist to WisdomTree, Inc. and WisdomTree Asset Management, Inc. This material contains the current research and opinions of Professor Siegel, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy, or deemed to be an offer or sale of any investment product and it should not be relied on as such. The user of this information assumes the entire risk of any use made of the information provided herein. Unless expressly stated otherwise the opinions, interpretations or findings expressed herein do not necessarily represent the views of WisdomTree or any of its affiliates.