Investors should start to prepare for turbulence ahead: Slok
Apollo Global Management's chief economist, Torsten Slok, discusses the inflation debate, the Fed and the risks for stocks.
JULIE HYMAN: Let's talk about inflation while we talk about returns. And let's include Torsten Slok from Apollo Global Management. He's the chief economist there, a friend of the program.
Torsten, nice to see you. You know, this inflation debate is of course raging with a view to the Fed and whether they'll be behind the ball on inflation. They also watch inflation and how we might see the transition from temporary inflation to more sustainable inflation. Why not take us first through how this could possibly happen?
TORSTEN SLOK: Yes, this is very important and a very important debate, Julie. If you think about what the Fed is saying, they are saying that we will see a temporary rise in inflation and then it will fall. But when we look at what's going on with commodity prices, energy prices, and lumber prices, it's definitely only going one way, and that's because the economy is opening up again.
They have had very strong production and all of this speaks in favor of a sustained rise in raw material prices. And that doesn't just feel temporary. It feels like commodity prices will continue to rise as the economy opens up further.
The other anecdote that is very pronounced right now and is getting deeper and deeper is that there are a significant number of stories about companies that simply cannot find the right people for the vacancies they have. We saw in the job data here earlier this week that the number of vacancies has increased significantly. So, these anecdotes also suggest that wages and the labor market are rising and, if you will, mismatching in the labor market, which may also suggest higher wages.
And when you combine those two factors, where commodity prices go up and labor costs go up too - just like an anecdote like you saw last Friday, leisure and hospitality wages are now 5% yoy. It jumped pretty hard in March. You shouldn't expect higher wages in leisure and hospitality as there are so many people who are still unemployed in leisure and hospitality.
So if you combine these things, Julie, on your question, I would say that input costs for companies are pushed up significantly. And that begs the question of what that means. Does that mean margins are under pressure, which is a likely scenario?
Does this also mean that companies will start raising the prices of the manufactured goods they sell, ie consumer prices? And all of this creates problems for the markets about whether margins are under pressure because input prices and input costs are rising, and whether there is also a risk that consumer prices will cause higher inflation. Then the question arises as to whether investors should not start to watch out for inflation, not only in consumer prices, but also in input prices.
MYLES UDLAND: We saw the opening bell there this Wednesday morning. Torsten, let's talk a little about the Fed's response function and how it might fit into this inflationary environment. Because if we go back three years in time, inflation is running, which is 2%, 2.1%, 2.2% maybe, and the Fed hiked rates four times in 2018.
Now we can argue about whether they resisted this specific inflation, they continued their cycle. But, as far as I can see, Jay Powell wants investors to forget that time in Fed history and say that we are completely different now. But the way I hear you speak, the risks are too great for investors to take Powell at his word. You have to consider the possibility that he is actually reacting similarly to what the Fed did a few years ago.
TORSTEN SLOK: I think the tension - exactly. I think the tension in the market is that maybe the Fed is saying, ah, we just don't want to look at this surge in inflation. Let's just ignore that. Let's just ignore that. But when you're a company and you're faced with higher raw material prices and higher energy prices, when you're a company and suddenly you have to pay more workers, you can't just take the luxury of saying, Oh, I'm going to just ignore those higher costs .
Need to make a decision what to do with the higher input costs you have? So the tension is in a sense that the Fed is saying, oh, just ignore that. If you are a company planning for the next few quarters, you need to consider whether I want to just ignore this surge in input prices. Or do I actually have to take that into account?
And that's the challenge for markets here that if, as Julie said, they could see this transition from a temporary spike in inflation to a more permanent one, the risk, of course, is that it won't be just a temporary boost. And as Larry Summers and Olivier Blanchard said that this is not just, as Blanchard said recently, not just overheating, but like a fire, then there is a risk that we will have this transition from a temporary surge to inflation to a more permanent one Inflation problem. And then, to your point, Myles, you will have the Fed come over and say, OK, then we need to realize that inflation numbers are higher on a more consistent basis.
BRIAN SOZZI: Torsten, Jamie Dimon, who stated in his annual letter this morning that stock valuations are "pretty high", might be justified, however, as the economy is likely to be booming in the months and years to come after the pandemic. Two questions. First, do you see the economy booming this year? Second, do the valuations, where they are now, reflect that boom right now?
TORSTEN SLOK: And that's ... that's fair Brian, to say completely that the ratings are high. But what is also fair to say is absolutely that if the economy reopens, expect the E in the PE ratio to go up and other earnings to improve if you get into a situation where you get more jobs in the service sector and more service sectors have parts of the economy coming back. The horse race in this situation is that we are reopening the economy, so expect to see profits rise as a result.
But at the same time, if the cost of making things, if the cost of a business also goes up because raw material prices go up and labor costs go up, then it becomes a question of what goes up the most. Is it the increase in sales growth, if you will, due to the reopening of the economy that is growing the most? Or will the production of input costs increase even more? And this is where investors need to be more cautious, especially with loans and stocks.
In my view, there is a significant risk of turbulence due to this uncertainty about rising input costs and their impact on markets and ultimately profits. Because if profits are putting some downward pressure on margins due to high input costs, which are not temporary, you should expect this in the next few quarters when the economy opens again, then I think stocks and credit will see it too relatively rich at this point, in other words, relatively expensive compared to the underlying risk that inflation is now falling not only in output prices, ie consumer prices, but also in input prices and input costs above rises.
JULIE HYMAN: So let's get back to the level of inflation and the effects on the economy and income. What is the magic number, Torsten, where it really is - the turning point where it becomes problematic? Because the Fed wants inflation, right? That's part of that equation.
She wants inflation as a reflection of a consolidating economy. Where is that tipping point from which it reflects that strength until it dampens growth because inflation is too high? Where are you doing - what do you think is this number?
TORSTEN SLOK: I would say the magic number is 2.2 because the Fed has always said - as Myles just pointed out, the Fed has always said that we just want inflation to be 2. Now they say we want inflation to rise to be 2 over a period of time, which certainly opens up the possibility that we can exceed 2 for a while. And then, to your very good question, what that means, there are many different interpretations of what the Fed is actually saying and trying to tell us in the market right now.
My interpretation, however, would be that if we go above 2.2 on the core PCE, which is the Fed's preferred measure of inflation, we will [inaudible] because, say, over a six month period inflation is above that level lies. We'll see investors say they have to wait a minute. If you want to allow inflation to be above this magical number of 2.2, or at least significantly above 2, then as a fixed income investor I need to be compensated not only in government bonds but also in loans for the risk that inflation could too 2 and 1/2 or maybe even 3 because keep in mind that inflation that rises above 2.2 or to 2 and 1/2 or 3 is an erosion of my portfolio if I'm a bond investor. And, of course, that could ultimately become a risk for stocks too.
So it's really a very, very cautious game that the Fed is playing here where they say we want inflation to be a little above 2 for an extended period of time, or we just don't want to specify exactly what that means. And so the market itself will begin to guess when this becomes a concern. And if there's one thing you don't like as a bond investor, it is surely inflation that is undermining the value of your returns.
From this perspective, your question of what level to worry about becomes very important as all of these things will ultimately mean something to the level of the 10 year installments. Ultimately, if there is another premium to inflation uncertainty that needs to be priced in, it means that long-term interest rates will continue to rise.
JULIE HYMAN: Yeah. And we're going to start that conversation all over again on the market that may be forcing the Fed's hand. Torsten, always great to chat with you. Torsten Slok, Chief Economist at Apollo Global Management, thank you very much for your time.
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