Why Witches Burn

In Today's Wall Street Journal, Wharton professor, Jeremy Siegel and Wisdom Tree director of research, Jeremy Schwartz express concerns that there may be a bubble in treasury prices. They make the argument that the economy is stronger than many, including the Fed, believe and that rates cannot stay down today's level forever. They advocate dividend paying stocks over bonds and de-emphasize the importance of the consumer in terms of economic growth. I find myself agreeing with them on some points, but disagreeing on others. Let's do a little dissecting of their thesis.'


Mr. Schwartz and Mr. Siegel do not see headwinds stemming from consumer deleveraging. They state:




"Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar."



I know it may seem out of place for me to challenge a Wharton professor, but I don't know where they are getting their evidence? The banks themselves report a lack of demand for credit because consumers are overleveraged and are in the process of deleveraging. There is also evidence that banks HAVE NOT marked down loans to pennies on the dollar because loans were never subject to mark-to-market accounting, mortgage bonds were subject, but not actual mortgages held on balance sheets.Another article in today's Journal mentions that many banks are reluctant to alter the terms of mortgages by forgiving principal because it would force them to realize losses on loans that have not yet been marked down. There is one hole in their theory


Another hole comes as the result of their belief that it is productivity and not the consumer which drives economic growth. They state:



"Furthermore, economists generally agree that the most important determinant for long-term economic growth is productivity, not consumer demand. Despite the subpar productivity growth reported for the last quarter, the latest year-over-year productivity growth of 3.9% is almost twice the long-term average. For the first two quarters of this year productivity growth, at over 6%, was the highest since the 1960s."


Viewing productivity as the determinant rather than a means to a consumer spending end is, in my opinion, incorrect. Productivity has indeed helped drive growth, but it has done so by freeing up capital which was used to fund production of a product to be used for expansion, research and development of new products, etc. It also worked to make products more affordable thereby increasing consumer spending. Approximately two-thirds of U.S. economic activity is generated by consumers. Discount them at your own risk. Again, I am not an economist, nor did I attend Wharton, but the productivity gains we have seen have not translated into robust economic growth. It has translated into stronger balance sheets as margins have widened even as retail sales have been lackluster. Also too much productivity leads to poor job creation or even job destruction. That cannot not good for growth. Saying that productivity is independently responsible for growth and not a contributing factor to overall consumption is something out of Monty Python. It has the same logic as trying to determine if someone is a witch.

If productivity increases and growth increases, then productivity must increases growth. However, such logic ignores the real driver of growth, that is consumption. Productivity can make consumption more affordable, by lowering the cost of goods and services, but it can also reduce wages and eliminate jobs. This is what we are currently experiencing. Where is Sir Bedevere when you need him?


This brings me to where I do agree with Mr. Siegel and Mr, Schwartz:

Low rates, increased productivity the propensity for U.S. consumers to spend, albeit at a slower pace, should keep corporate balance sheets relatively health unless consumers become so spooked that they stop spending as they had in 2008 and early 2009. If that happens a self-fulfilling double-dip prophecy could occur, but we are probably not their. Large-cap firms, utilities, etc. should be able to pay healthy dividends and will be less volatile during the next several years as the economy adapts to structural changes.

Another area in which I agree is interest rates. Unless the U.S. becomes Japan, rates should trend modestly higher during the next several years. Since U.S. consumers are unlikely to adopt Japanese consumer customs, a truly lost decade is not all that likely. Rates should back up at some point. Although rates on the long end of the curve could (probably should) move up 100 or more basis points during the next few years, their absolute levels should not be historically high. Even Mr. Schwartz and Mr. Siegel use a move to a 4.00% 10-year as an example. Not exactly runaway rates. However, 4.00% is 140 basis points higher than today's level. That translates to approximate price declines of about 10 to 12 points on bonds with a 10-year maturity. However, bonds 10-year bonds issued by BAC, MER (not explicitly backed by BAC), C, MS and even GE have room to experience credit spread tightening which could offset rising rates. Most other sectors are relatively rich. If long-term rates and inflation are modest, the Fed will not have to do much in the way of tightening. Sure, it may eventually raise the Fed Funds rate to 2.00% to 3.00%, but that is not enough to get %25-par LIBOR floaters off of their floors and would result in coupons of fixed-to-float bonds in falling even as their long-term treasury trading benchmarks rise. The result is lower bond prices.

However, there is another respected professional whose opinion is nearly diametrically opposed to those expressed by Mr. Siegel and Mr. Schwartz. Noted financial analyst, Gary Shilling is more doubtful of a robust U.S. economic recovery than even I. He believes that we could be entering a deflationary environment and that the yield of the 30-year government bond could fall to 3.50%. Dr. Shilling became famous in the 1980s for predicting a long-term rally in bonds. His prediction came to fruition in spades. Dr. Shilling believes that consumers are grossly overleveraged and will need decades to right their financial circumstances. I agree with him. We have been on a 25-year spending spree. It is now time to pay the piper and the tune is not a happy one.