Fiscal policy impact on rates to reach maximum in Q1'21: Torsten Slok

Yahoo Finance's Julie Hyman, Myles Udland, and Brian Sozzi break down economic outlook with Apollo Global Management Chief Economist, Torsten Slok.

Video Transcript

JULIE HYMAN: But let's start with that outlook on inflation, bring Torsten into the conversation. Torsten Slok is Apollo Global Management Chief Economist and his charts that he sends out hotly watched by many on Wall Street. Torsten, good to see you. You, like many folks, are looking at the prospects for inflation right now. This is a debate that we are very frequently on this show about whether it is coming or not. And it sounds like you think it is coming, but it might not last long. What is-- walk me through your thinking around this.

TORSTEN SLOK: Absolutely, Julie. This is very important. So remember what happened in the second quarter of last year? When the pandemic hit, the prices of many things, and particular in the service sector, started falling. So the prices of airline tickets started falling; the prices of hotel stays started falling; the prices in all of rents, meaning housing, also started falling. And that's literally, now, 12 months ago going into the second quarter of this year.

So that means that if we had lower levels of prices in the second quarter of 2020, we should expect, at base effect, whereby we will see some move high in inflation going into the second quarter of this year. So we should expect to see inflation going up over the coming two or three months.

But this is not something that the Fed will be worried about. And we see the same phenomenon in Europe, we see it in Japan, in emerging markets. This is not something that I think emerging markets or developing countries or [INAUDIBLE] countries will worry about. But we think on the contrary, that when we get to the second half of this year, we will begin to see inflation then moderate again.

So the bottom line to your question, Julie, is that, yes, we will see some base effects simply because the level of prices declined artificially in the second quarter of last year. And then 12 months later, bring us forward to the second quarter of this year, we should expect to see inflation go up but then start to, again, come down a bit in the second half of this year.

So inflation is a problem in the near term, and that might have some implications for rates markets. But I feel quite strongly that the Fed will not be talking about this as a problem, but will look through this and say, let's just wait and see until the second half of this year where inflation is.

MYLES UDLAND: Now, Torsten, certainly, you know, as you outlined, the Fed is probably not likely to move. But we have seen quite a large back up on the long end of the Treasury yield curve and that has some knock-on effects as you get into markets, certainly that the private credit markets that Paul is going to be playing, as well. I'm curious if there's a level on, let's say, the 10 year that you're watching as, OK, now market dynamics are going to be quite different because, again, I think we agree that 2% or 3% inflation even doesn't matter. But it does matter if we're talking about a 1 and 3/4 10 year all of the sudden.

TORSTEN SLOK: Absolutely, and this is very important. So 10 year rates can go up for different reasons. The most important reason, of course, is that the Fed turns more hawkish. If the Fed begins to say, we're very worried about inflation, we're worried about overheating-- then you would expect long rates to go up. But that's not what we expect. Clarida said two weeks ago that he thinks that the Fed will do QE, meaning continue to buy $80 billion in treasuries every single month throughout the rest of this year.

So that tells you that the Fed is probably going to stay on hold and be very dovish. So that's probably not going to be a reason why rates would be going up. The other reason why rates could be going up is, now, if you do have a normalization in financial markets, if you do have a normalization in the economy, you would also expect the term premium. And they expect a longer level of rates to also begin to go up.

Let's not forget that the beginning of 2020, 10 year rates started at $190. So in that sense, to your question, Myles, which is very important for markets, at what levels should we be worried? I would not be worried if rates go up into the range of 1.5% to 2%. What I would be watching mostly is whether it's beginning to have a negative impact on the housing market, whether it's beginning to have a negative impact on consumers, and whether it's going to have a negative impact on Capex spending.

But given the boost in growth that we all now in the consensus expecting to see in the second half of this year as the vaccine starts to work, then there is a very, very limited chance that we will see negative effects on rates going up at this point. So the short answer to your question is, that I still think at this stage, the consensus expects 10 year rates to be $134 by the end of this year. I think it could be higher than that, more in the range of 1.5% to 2%. But I still think that the economy should get a big burst, not only from the vaccine, but also from the fiscal stimulus that we all spend so much time on at the moment.

BRIAN SOZZI: Torsten, what also could impact Capex plans is higher taxes. And there are some chatter on the street today that when this admin-- when the Biden administration unveils its infrastructure plan maybe in a month, month and a half, that might include higher taxes on corporations. As an economist, what would a tax hike on corporations, what would that mean to companies trying to come back from the depths of the crisis?

TORSTEN SLOK: Absolutely. I mean, as seen in isolation-- you're absolutely right, Brian-- higher taxes would not be a good either on consumers or corporates. That being said, let's not forget the corporate tax rates just went down from 35% to 21%. And what Biden and several other people around him have been saying, of course, publicly is that they expect that the corporate tax rates will go up somewhere in the middle-- this is what Janet Yellen said in the confirmation hearings the other day-- it's in the middle between 21% and 35%.

So to your question, would that create a big negative shock on the economy? I would still think that if we get the rebound because of the vaccine, that should still be creating more growth burst to the upside, particularly if it comes at the same time. Both with the infrastructure spending that potentially is coming, as you mentioned. Also, with the potentially $1,400 checks adding on to the $600 checks to the household sector. And on top of that, the general thrust of the fiscal expansion talks that we've seen at the moment, it probably will dominate and overwhelm to the upside any of the negative consequences that might come, at least in the near term, of corporate tax rate being a little bit higher relative to the lower level that there are at the moment.

JULIE HYMAN: Torsten, I want to talk about the implications of both of these things that you're talking about for tech companies, in particular. Both the higher tax rate, which could hit some of the largest tech companies that tend to pay very little taxes. Because there's also talk about a new alternative minimum tax of 15%. And then also, the higher rates question and the effect it's going to have. Because we've talked a lot about the concentration of tech companies in the major averages, in the S&P 500. Are these things going to be problematic for those companies and the index by extension?

TORSTEN SLOK: Absolutely. This is very important, Julie. Because think about it, today the 10 biggest stocks in the S&P 500, they make up in round numbers, roughly, a third of the index. So in that sense, if you're just a passive investor and you just buy the S&P 500, it's really not very diversified. At least it's not as diversified as it was just a few years ago. So what is the implication of this? Is, of course, that you are much more-- if you just buy the index overall-- you're much more concentrated in one sector, namely the tech sector.

The second thing to your point is exactly that, the tech sector-- because the tech sector, generally speaking, is a longer duration asset that you're buying more on an idea that some of these companies will potentially deliver a lot of growth, a lot of revenue in the future. Which is very different from, say, the retail sector, which is very short duration, you have some assets that are here and now, very easy to measure and to look at.

So that's why historically you have seen a much higher correlation between rates and longer duration sectors in the S&P 500, specifically the tech sector. So the implication is that if you have a situation this year-- let's say that we all agree that rates are going to go up this year-- we don't know exactly how much, but long rates will be going up-- the difficult thing from an asset allocation perspective is that if you're just a passive investor, that means that you're even more vulnerable than normal to higher rates simply because the concentration in the S&P 500 is now in a sector, mainly tech, that is more vulnerable and sensitive to higher rates.

So yes, for passive investors, there's a lot of homework that needs to be done at the moment, which of course argues to start thinking about, well, what are the opportunities where I'm not as exposed to higher rates compared to this situation? Where the concentration of the S&P 500 is in a sector that historically has been very highly correlated with rates going up from a negative perspective.

MYLES UDLAND: Well, and, Torsten, guess it gets to another question that I think investors will be asking themselves this year, which is, did I miss the entire cycle in 2020 because the crash and the rebound came so quickly? And I wonder if that puts folks back where they were in 2019 where we started to see huge valuations being paid for takeovers in private markets, certainly the SPACs have just been on fire recently. It does seem like we are back to some of that late cycle financialization, at least, that prevailed, let's call it, '17 through '19 right before the pandemic.

TORSTEN SLOK: Absolutely, Myles. That's why in some sense, as you also talk so great about always on your show, a lot of things are really expensive. And in plain English, you could say that almost everything is expensive. And what do I do as an investor if everything is expensive? I try to find things that are uncorrelated with this trait that everyone has on where everything is expensive both in bonds and in equities and in credit and has spread product more broadly.

And what are those things? Well, those things are more thematic investments. So those are, of course, themes such as ESG, themes impact funds, everything that is uncorrelated with the general idea that everything is expensive. Something that might be both recession proof but also something that might be inflation proof, and those things could, again, be themes, again, as ESG, environmental, areas both from a credit and equity perspective. I realize that some of these things are also expensive, but you would expect that if there is a shock hitting the general market, it would be those themes that would be most important.

Other themes, of course, everything from artificial intelligence, fintech, clean tech, it could also be the middle income consumer in emerging markets. There's a broad range of different areas where you can look for thematic issues to invest in instead of simply just being so invested in the passive trade that is so highly correlated just with race. And the passive, if you will, not very diversified index buying, say, of the S&P 500.

BRIAN SOZZI: Torsten, I'm scanning the markets the past couple of days. And what I've noticed is that tech stocks, big cap tech stocks are starting to work again. Now, that wasn't the case in the early going of this month. Do you think-- and these stocks did well throughout the pandemic. They were viewed as the safe haven tree. I mean, the fact that these stocks are now working, do you think-- you think investors understand the economic reality of what is about to happen over the next few weeks? Infrastructure plans, cool. That might be a next year thing. Stimulus might be later this year. But right now, what is the downside risk to the economy from the pandemic?

TORSTEN SLOK: Yeah, and you're right, Bryan. But I think one very important reason why tech stocks work so well during the pandemic is that it just happens to be that a lot of the tech stocks are really stay at home stocks. So in that sense, it wasn't necessarily something to do with that it was, if you will, take as such, it was really just that these were stocks that generally traded very well when everyone was staying at home in the midst of the pandemic. And then it happened to be the case that when rates went down, that just gave additional boost to tech stocks.

Now, looking ahead to your question, valuations do look quite stretched on tech stocks. And on top of that, if you begin to worry about more tech regulation coming, that's certainly also something that would speak to more to the downside. So maybe the reason why tech stocks have done OK here more recently is that rates went up quite quickly. And then they went, sort of, more sideways and a little bit down here in the last week or so. So maybe we're taking a little bit of a break in the race trade.

But I still think that a lot of this discussion with the tech stocks really starts and ends with a discussion about, what do you think will happen to long rates? And adding on top of that, what do you think will happen to tech regulation? And all that does argue still for more caution on the tech front, and in particular on top of the very high valuations that we're looking at.

JULIE HYMAN: Yeah, it argues, again, sort of seeing a repeat of 2020 in terms of the tech stock action that we've seen. Not just 2020, but the years prior to that as well when we've seen strength in tech shares. Torsten, it's great to see you. Thank you so much for joining us and hope to talk to you again soon. Torsten Slok is the chief economist at Apollo Global Management. Thanks again, Torsten.