Jeremy Siegel: The Impact of the Brexit Vote on Markets
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.)
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.
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.
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?
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.
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
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.
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.