Irene:
Hi everyone. Thank you for joining WisdomTree's post-Fed reaction Office Hours, titled Fed Watch: Can I See the Finish Line?, where you'll hear from Professor Jeremy Siegel, WisdomTree Senior Economist, Jeremy Schwartz, WisdomTree's Global Chief Investment Officer, and Kevin Flanagan, Head of Fixed Income Strategy at WisdomTree.

Jeremy Schwartz:
Well, it's always great to get the professor's reaction to the Fed. He's been one of the harsh critics of the Fed, but also one of the real insightful forecasters. If you haven't been listening to our weekly show Behind the Markets, you would've heard a very good prediction of what was going to happen today. I think he hit it spot on. But professor, let's get your current read from the Fed, what you heard, what you saw in the markets…

Professor Siegel:
Right. Well, we are near the top of the hill. The hill didn't get any higher. The thing is the hill kind of turned into a plateau rather than a downside on the other side. So taking away two rate in decreases next year, that's what upset the market. I think most people were thinking of one, a few were thinking two, but two rate decrease instead of a hundred basis points at the end of 2024, 50. Now again, I maintain they don't really know. It depends absolutely on the evolution in the economy, on what is actually happening. Also, the fact is that a majority of them still think one more increase either in November or December, but I think what really woke up the market was we're going to stay higher for longer. There's just no question. He talked about the neutral rate of interest, that's the rate of interest consistent with 2% inflation, and neither expansionary or contractionary.
And he talked about that becoming higher and we talked about that on our show for two months, that the 0.5% real rate, which is 2.5% Fed funds, given the strength of the economy that I've seen, that neutral rate may have to go up to 1.5%. When you look at the dot plot, they're still looking at that neutral rate at a half 0.6%. But you see the skewness, there's three or four participants that have raised it a hundred basis points, so that's not the consensus yet. So we have shifted into an economy where higher rates are going to be the norm. We talked about some of the reasons, faster growth. By the way, one thing which I think is kind of shocking in a way, in the June, they forecasted growth through 2023 at 1.0%. Now we're only three months later and they raised it to 2.1%.
That shows you how far off they can be in even seeing the growth. So by over a hundred percent, they've raised the GDP growth rate for this year in three months, and that's a source of, my goodness, if it can grow this fast, GDP can grow this fast with these real rates, then I think real rates are going to have to stay higher longer. Now again, they are data dependent. We see big deteriorations coming in, it will show. We have now begun that home builders index, which had soared up about 30% from the big plunge it took, has lost half of its increase in the last two months. We saw housing starts well below expectations. We see the commitment on a zero point, 30 year fixed mortgage is actually going to 7.6%. It's hard to believe that's not going to affect the housing.
Big wild card as we know is the oil increases, because if you're a bond holder, you don't just care about core inflation, you care about all inflation, and the fact that oil remains firm. Now, if I take a look right now, I'm trying to spot it on what we got in terms of WTI at 90. Well, it's down 1% and WTR down about 1% today. But we know that has been a soaring feature in the market. It's going to cut down on purchasing power. It is definitely going to cause a rise in inflation, and that's why the inflation, overall inflation rate for this year, actual projection, went up from last year. So yeah, it hurts higher duration assets more as this real rate rises. I'm taking a look right now at the 10-year tips. Jeremy, I see the 10-year tips at 2.03% on my screen, and I have not seen it above 2% before.
It may have tipped there a little bit, but that is definitely a challenge. Faster GDP growth, a poor hedge on bonds for the inflation fight, stocks are really outpacing bonds this year. And I think stocks can still do well this year, even though if you worry about inflation, you want to hedge. And if you want to hedge, the long-term hedge that you want is definitely going to be the stock market. So I think actually, the ramifications of staying in this 5% range much longer is going to kind of wake up a lot of people. What should you do with your funds? Are banks going to wake up? Can they afford to pay 5%? Because everyone's going to do a year end review of a financial advisor and every financial advisor is saying, "Why do you have $200,000 stuck in your 1% savings account at this bank?"
And there's going to be a lot of shifting out. Another reason why I think Russell 2000 has been relatively weak, the lending costs of small firms because of the pinch on deposits is really hurting those small companies more than large. This is something I pointed out right away after SVB failed, that it would be the small firms hurt more. And we do like the small stocks and we do like their valuation, but they're facing an even more challenging rate environment than the big stocks who yeah, they cost more, but at least they can get it at this more costly rate.

Kevin Flanagan:
Professor, I want to get the ball rolling here. We've gotten a ton of questions. I'm going to try to consolidate. And the first one of course is the R word, which we haven't seen yet this year. That's recession. So there's questions about our outlook for recession, what should we be looking for? And I thought what would be interesting as well, if you could sort of go into the GDP and gross domestic income discussion that we heard a lot about last year when we had negative GDP and everyone was saying, "No, look at this gross domestic income figure." And that's kind of been topsy-turvy this year.
Professor Siegel:
Yeah, it's been topsy-turvy and we actually talked about that a week ago on our Behind the Markets. A recent study has shown that... Well, first of all, let's get the facts. A GDI, gross national income is supposed to theoretically...gross natural products. It's two sides of the balance sheet. One is the income side, the other is the sales side. Gross domestic income has fallen way behind by a record amount of GDP this year. A new study has shown that one of... There's been a big revision in GNI, and that is due to all the interest that has been paid by the Fed to the banks, which was not recorded as transfers of income.
And with interest rates at 5% to 6%, 5%, 5.5%, well, 5.33% on reserves, you have trillions of dollars of reserves that was not included. When you do that, you close half the gap between GNI and GDP. And I understand other revisions close another 20%. So GDI is still lagging behind it, but not nearly as much as it did before this interest rate revision was made. So it looks like right now, I would follow GDP as being the closer one to the truth in 2023, than GNI.
Kevin Flanagan:
So what should we be looking for? That was the other question. Are we going to achieve the soft landing? And if not, I mean Powell likes to talk about the new term is the totality of the data, but are there any economic reports that go to the front of the line in that totality argument?

Professor Siegel:
Well, you know my favorite high frequency economic report is initial jobless claims. It is noisy, but that's one of my favorite ones. Another one if you want market ones instead of economic announcements is just take a look at commodity prices, what is basically happening on the commodity side, because if there's a threat of recession, you're going to get commodity prices down, even oil, no matter what OPEC does. So certainly, like oil down today, is partly, "Oh my goodness, is the Fed going to overtighten?" I mean, oil has a big beta to the economy, so that's another signal that you have. But other commodities have big betas to the economy also. I don't see anything right now that looks like a recession.
So as a result, as long as the Fed doesn't overreact and reacts quickly if they see the data really deteriorate, jobless claims, commodity prices, copper prices, those that are linked to the economic activity, early indicators there, some of the high frequency credit card reports are something else that you would like to look at in terms of interpreting the data, knowing the higher the frequency the more volatile, so you have that trade-off.
But at this particular time, and I made the turn early in July when I basically said, I'm looking at this data, I'm not seeing this recession at all, and I'm revising upward my whole path of interest rates of what we're going to have. Now, whether the Fed achieves what is referred to as immaculate disinflation or not, is yet to be determined. Did they hit the higher points just right is still yet to be determined, but before I give the Federal Reserve a Nobel Prize, everyone should remember that they got us into this mess to begin with. So the fact that they might get us out less painfully than we had feared is only partly compensating the overly stimulus policy that they pursued for so many years.

Jeremy Schwartz:
Jonathan wrote in a question about the outlook for regional banks. I'm going to tie that into a comment and get the professor to comment on something a bit. The professor alluded to one of our concerns when we've been managing the Siegel models and our own model portfolios, we've been a little bit concerned about the banks still. I mean people say, "Hey, their prices are so low, they've gone down so much after the Silicon Valley crisis. Do they now represent great value?" And what the professor said of they're not really paying you the appropriate depositories and they can't afford to pay appropriate interest rates because of their cost of funding and their interest margin, they can't really pay 5% that you can get in treasuries. And so there is this exodus. And so maybe the deposits are safe, the government said they're not going to let these banks fail depositors.
But the profit outlook for a lot of the banks still looks challenges. We can still see flights to treasuries, things like our floating rate treasury, USFR that Kevin talks about a lot, and there was a question that Kevin, I'll come back to you on. But professor, just on the comment on value growth with the banks are part of value, today you saw tech sell off with these higher rates. What do you think generally about the economic cycle, the inflationary outlook for value and growth over the next, call it 18-24 months?

Professor Siegel:
Yeah, that's hard because we've had such a run. We had such a big value surge in 2022 and such a tremendous growth comeback, still not to the high certainly that we reached in January of last year in stretching, but certainly growth, they retained at least half of that. Yeah, the financials are going to be continued to be challenged. There's not going to be failures, there's going to be a lot of consolidations for any of those firms that can keep their dividend in these challenging times. They might be long-term buys, because this will pass and interest rates will go down. And at valuations, I don't know what those funds... Small banks, what are they? 8, 10 times earnings, Jeremy? You know better than I on some of these. I mean, that's a 10%, 12% earnings yield if they can be maintained at that level. It's not whether a company's good or bad, it's whether the price is too high relative to whether it's good or bad.
So it's discounting a lot of bad things, but higher for longer is more challenging for the smaller banks that are financing, that really can't afford to pay the 5%. Now, again, it depends on what their loan portfolio is, and if there's escalators on the loan portfolio, et cetera and so on, and they don't have too much commercial real estate, where they have to take the keys back, then they could really be buys. I mean, one of the big things we know about the stock market is the good guys go down with the bad once a sector gets tainted. So you got to be sometimes, okay, which one really holds that real estate where they're going to have to take it back? How much deposits do they have that are paying way below? What rate is it going out and not? This really may be a time to make some discrimination there, but in general what's happened is that everyone gets painted as in trouble and sent down as a result of these structural problems.

Kevin Flanagan:
I was looking at another question I thought was interesting, professor. It doesn't get much discussion, I don't think, at least outside of the political realm and the economic one. Government spending. Is that complicating the Fed's mission here?

Professor Siegel:
No. I mean, we have a deficit, but a trillion and a half is not... $30 trillion worth of debt, adding another $1.5 trillion. Now the Fed by a quantitative tightening is adding some more on that score, probably around $800 billion. You got about $2 billion, about 6%. Well, GDP is growing about 6%. You got 3% inflation, 2%, 3% GDP growth, 6%. We're not really increasing the debt to GDP ratio that much now. And of course you all know that with this rapid inflation, we reduce the debt to GDP ratio, because of the inflation that we have. So actually, since all those stimulus packages were passed at the end of the Trump term and beginning of the Biden term, I think we're actually at a lower debt to GDP ratio now, than we were two years ago because of the inflation data. Don't forget, debt is nominal, GDP is nominal. Real GDP hasn't grown all that much, but nominal GDP has grown dramatically and the debt to GDP ratio is nominal, debt to nominal GDP.

Jeremy Schwartz:
Kevin, there was a few questions on where to position in the bond market. Somebody asked about what maturity on corporate bonds. And another question on Securitize, specifically MBS. Our committee's been talking a lot about that MBS market and a little bit on the corporates and high yield market. You want to give any quick comments on those two markets?

Professor Siegel:
Well, high yield of course, it's just a premium for recession that goes up and down. If you really feel you see a recession, the market doesn't, you want to get out of those. Vice versa, long run they do pretty well because they get that discount and business eventually improves. The volatility has really hurt the mortgage market because it's really a combination of short and long rates with that option. Since you give out a mortgage and the freights go up, no one refinances, rates go down, they refinance, and you lose your big rate. And with volatility of rates, it makes the spread between that mortgage rate and the 10-year much higher than it would be otherwise. And that's one reason why you do have a 7.6% 30 year mortgage, which has about a 10-year average duration of the 10-year treasury, and that spread is so high. It has to do with the volatility, because mortgages really are an option to the borrower to pay it off early. And that option goes way up the more volatile those rates are.

Kevin Flanagan:
Well, I mean just to add to that, we've been major proponents of being late than early to the duration party. And if anything, I think the, let's call it a hawkish pause today, I think that's pretty fair to say. Doesn't change our outlook at all. Matter of fact, as we were talking, that's why I put my glasses on, we're almost 440 now on the 10-year treasury. And it just seems as if every time everyone was ready to get back into that duration pool, something bad happened. So Jeremy, you asked a question before and alluded to treasury floating rate notes where you're looking at something with one week duration essentially, yielding over five and a half percent, and you're looking at the volatility we've seen in the back end of the curve. There really is no urgency or incentive-

Professor Siegel:
No.

Kevin Flanagan:
 To get into duration at this point in time.

Professor Siegel:
No, there's no incentive in duration to take the volatility. And I really can see that tenure go to 4.5 or higher given these oil prices. Don't forget, oil prices don't... Excuse me. Bond buyers don't react to core, they react to headline, because they've got to watch out purchasing power, and it doesn't matter whether it's a core or oil. And so when they see inflation, they got to protect themselves on this front. So right now you got nothing going for you in the treasury market. I see a lot of weakness there, and I see a lot of then challenges to the higher duration portfolios. And again, as you mentioned Kevin, you love the liquidity of an ETF that reflects these extremely high short-term rates and they're going to remain there, even though again, we might see that the top of the hill is in higher, but the top of the hill kind of turned into a plateau rather than a hill that we're going down by the middle of next year.

Kevin Flanagan:
It's kind of like crusted butt, right, in the great western part of our country. Another question that I wanted to ask. China, throw China into the mix here real quickly. Any thoughts about deflation being exported from China to the U.S., or the developed world?

Professor Siegel:
Well, you got to understand that any change of monetary policy in different countries, it gets reflected in the exchange rate and therefore nullifies its direct effect by the time it comes to U.S. It can affect the US's trade policy, how much are we going to get from China, because they are still lower cost producers. There's going to be a trade war and not going to be a trade war. I mean, these are the questions, labor costs and all the rest, and restrictions on imports and exports. Those I think are going to be the dominant questions about whether we can benefit from lower prices in China or not. And more than basically what is happening to the yuan, which also reflects a lot of domestic monetary policy in China.

Jeremy Schwartz:
Professor, there is a question on earnings and worries about earnings coming disappointing, maybe we don't have a recession but maybe have an earnings recession. What's your sense of how earnings cycles have gone recently?

Professor Siegel:
Well so far of course they have not on balance. So far, the 2024 S&P, and I just checked it a little while ago, instead of usually deteriorating by approximately a dollar a month, a dollar and a half a month, it's been holding in there, because that recession calls keeps them and pushed back and back and back. So right at this particular... And I don't even have a lot of warnings on firms. Obviously if weakness happens... Weakness happens, that becomes obviously a different story at any time. But at this particular time, all the official estimates are holding in extremely well. And that's one reason the stock market is firm. The stock market caress much more about the economy than whether the Fed is going another 25 basis points or not. What the stock market does want is for the Fed to be receptive to a slowdown and stop the rate hikes and start lowering them if they see that to be the case. That's what they really want.
But as long as the economy chugs along, you want to know the truth? I don't really think the stock market worries about whether in November or December we're going to have another quarter point or not, as long as they don't see any working weakness in the real economy.

Kevin Flanagan:
So professor, we're getting ready to turn the calendar to the fourth quarter. I haven't seen one yet, but you know one's coming. Christmas holiday shopping commercials will be hitting the TV screens any day now. So one of the questions that came in. The consumer, you have higher energy prices, higher interest rates, student loan payments perhaps coming back. How's your viewpoint? Can the consumer hold up with this barrage?

Professor Siegel:
And we have the UAW strike and we have the shutdown of the government. I mean, yeah, there are a lot of risks going forward. And that's why right now, I mean the stock market, I think right now with this decline today, S&P is selling for under 19 times next year's projected operating earnings on the S&P 500, a blend of the last quarter and the first three quarters of next year. That's a pretty reasonable price. So yeah, I think you're getting paid to take on some of those worries, and as long as they don't snowball into recession, it still definitely wants me to be in stocks. And at this point, again, I don't expect any of those to snowball into recession. However, we all know consumer sentiment was down, there could be some sort of developments. There's a tipping point. Could it be the tipping point be oil if it keeps on going up from this level?
Could the tipping point be everyone rushing to get out of banks when they need those extra dollars to pay those gasoline prices? That would certainly complicate the mix and the lending certainly to small firms that rely on that banking sector. Any of those could start to accelerate. The Fed has to be very, very vigilant on those and ready to react. It seems like there is flexibility on the part of Powell, and a number of the members on the FOMC, if not quite the majority right now. So again, we all know we're heading into election year. I guess we're 13 months away. You know that the political pressure on Powell to be very sensitive to any shortfall on the unemployment side and economic growth side is going to be extremely high and growing through the coming months.

Jeremy Schwartz:
Just before we came on, I heard Gundlach on CNBC saying June 2nd half, he sees them cutting rates. Are you taking the overt or you think about that in terms of if they...

Professor Siegel:
Ah, when that might come? Yeah, I think he's got the line pretty close. I think he's got the line pretty close there. Actually, in some ways, if the economy remains strong and you can stay at this level, it might actually be better for stocks. At the beginning of the year at the rate that the Fed was raising that it would have to start cutting at the end of this year. And of course now that the economy can tolerate these higher rates, at least at this point... Yeah, Gundlach has thought that the rates have been too high like I had been. I pivoted more quickly to saying it can stand these rates. He's still not as sure as I am. But yeah, I think we might get a cut in June and July.

Kevin Flanagan:
So professor, I know we only have a couple of minutes left here, but just wanted to add onto that. So obviously the timetable for market expectations just continues to get pushed out further and further for the timing of the rate cut. Do you think there is any reasonable expectation the Fed doesn't do anything, doesn't cut rates at all next year, and we are where we are come January 2025?

Professor Siegel:
The only way that would happen, and my thing is that the economy remains very strong. I mean, if the economy remains this strong, even with inflation, we'll be going down, but maybe not as fast, than anyone lower rates. But he knows it's restrictive right now and inflation will be going down. It'll become more restrictive. So in that particular juncture, the only thing that I think could keep the rates up is economic growth. That could be 2% to 3% next year with the productivity rebound extending into 2024.

Kevin Flanagan:
Jeremy, we have about 30 seconds I think. Final comments, thoughts?

Jeremy Schwartz:
There's a few questions from people on where they want to be positioned for 2024. And generally, I'll just say you can follow Professor Siegel's asset allocation guidance through our model portfolios. We have Siegel oriented model portfolios on a number of platforms, but also on our website. You could follow our WisdomTree models and Siegel's models, and you should follow up with our team if you want any sort more custom advice on that. We do a lot of consultation with people looking at portfolios and making some recommendations, but I think some of the value high dividend parts are certainly interesting where valuations are, and we certainly sell it today as an example. But there's some longer term value we see, but we're happy to help with model portfolios to give you guys some good suggestions there. I think with that, we could wrap it up. Professor, always a pleasure to get your live comments on the Fed. Thanks so much for joining us right after the report today.

Professor Siegel:
Thank you very much, and we'll see all you guys again soon, I'm sure.