Why The Nasdaq Just Hit Correction Territory

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1:35Torsten Slok:Money market's bad. If money is evil, then that building is hell. Show goes on! The folks are never watched. Show, show! Welcome to Prof G Markets. I'm Ed Elson. It is July 29th. Let's check in on yesterday's Market Vitals. The S &P 500 and the Dow rose. Meanwhile, the Nasdaq declined as chip stocks got crushed. More on that in a moment. Brent crude declined to about$84 per barrel. The yield on 10-year treasuries fell ahead of the Federal Reserve's interest rate decision due later today. And And finally, SpaceX shares fell to a new low of$107 per share, down 52 % from their all-time high. Okay, what else is happening?

2:23Torsten Slok:The most important sector in the stock market is starting to fall apart. The tech-heavy Nasdaq 100 fell for a fifth straight day, briefly entering correction territory, meaning it fell 10 % from its highs. Chip companies led the decline. the PHLX Semiconductor Index sank as much as 6 % and Micron fell 9%. But the sell-off started overnight in Asia, where SK Hynix dropped nearly 15 % and the Kospi Index fell 11%. This drawdown raises a major red flag. In the first half of this year, nine of the 12 biggest contributors to the S &P 500's return were semiconductor stocks. So investors are left wondering, where can this market go without chip stocks?

3:11Torsten Slok:Here to discuss this, we're speaking with Torsten Slock, chief economist at Apollo Global Management. Torsten, great to see you again. Thank you for joining us. You said a striking quote recently on our friend Steve Eisen's podcast. You said, quote, this AI thing better work out because if it doesn't work out, your portfolio will be in trouble. Is this a sign that AI might not be working out? The challenge at the moment is that the hyperscalers and those who are building the infrastructure, they are changing their financing, which used to be mainly from the equity side of the balance sheet to now being on the debt side of the balance sheet.

3:53And the amount of debt that has come to the market from the hyperscalers, meaning the companies that are building out the infrastructure, has just been enormous. So as a result, we've seen very, very significant increase in supply of investment-grade credit that is in the hyperscaler space. And the consequence of that is that we have started to see spreads in credit widened out on that hyperscaler debt. And this has resulted, of course, in a number of questions being asked, namely, are spreads widening out on hyperscaler debt because of worries about the underlying credit of these companies, meaning their ability to pay back their debt?

4:27Or is it simply just because of demand and supply that there's just more supply at the moment and now there's just not so much demand? And as a result, spreads have been widening out. The other development more recently to your question, Ed, is also the CDS spreads, meaning the cost of insuring yourself against these companies going under in the next five years. Those CDS spreads have also widened out quite significantly. So one way of answering your question is that there's simply so much debt that has come to the market and the market has now begun to ask some questions around, well, if these companies need all this financing, what is the right interest rate?

5:02What is the only level of yield that is required to finance the build-out the way that we're seeing at the moment? And that is really the starting point for how the domino bricks are toppling here, namely that spreads have widened out. And as a result, the equity in these companies, the stock price of these companies have also started to underperform. And that is where we are today, namely this discussion around what is the speed of the AI build-out? What is the payoff from the AR build-out? And all those questions, of course, are very important when we think about the stock price, especially for the hyperscalers and more broadly, the magnificent seven.

5:34Torsten Slok:Yeah, just looking at the price of those credit default swaps that you mentioned there, some companies whose credit default swap prices have hit record highs in recent weeks. Oracle, SpaceX, Google, Amazon recently, NVIDIA. I mean, from your perspective, how dangerous is the debt situation in AI right now? How likely is it that some of these enormous names that have become so structural and so important to the market could actually go under in the next five years? Remember that all these companies, as you of course know all too well, they are investment grade credits. That means that they are very, very profitable.

6:18They have very, very strong earnings growth. They have very high profit margins. They generally have very, very solid credit fundamentals. That's, of course, very important when we begin to think about the question, will they go under over the next five years? Because companies that are among the most profitable companies in the world and have done exceptionally well in the last three, four years, of course, they are very, very unlikely to go under. But that is exactly the mirror image of this discussion. Given everything that, if we just agreed on how solid they are from a credit perspective, why is it that these credit spreads are widening out?

6:52Especially to your point, why is the CDS widening out? Meaning, why are people buying protection against these companies going under the next five years? What are people really worried about? And that's, of course, why the discussion in the market at the moment is about how can these companies that have been market leading, meaning that they've been driving returns for this and P500 so strongly for the last several years, how can it be? that suddenly people are beginning to ask questions about what will be the situation for these companies over the next five years. And it's that divergence between, hey, fundamentals are really great, but at the same time, market pricing is telling you that there's more and more worries.

7:29That is the conversation. And is it the market pricing that's wrong and the fundamentals are good? Or vice versa, is the market pricing telling you that there is some more danger coming down the road? And of course, that danger is all about the payoff from AI. How long time will it take before we see the payoff from AI? Remember, as we all know, stock prices today is the net present value of future discounted cash flows. So that means that at the moment, the market has a certain expectation, the consensus has a certain expectation, that returns will look, say, like this. But if the payoff in AI is going to come only like this, that means that the net present value of these companies today should be lower.

8:06And that is the risk, of course, at the moment, that maybe the market pricing is actually correct in the sense that there's more questions being asked about what is the payoff profile. Because if it is involving a slower stream of payments in the future, then it does imply that the equity should be lower today and credit spread should be wider today. So this is this discussion around AI implementation, where are we seeing it paying off? Are we seeing it in the form of higher productivity? Are we seeing it in the form of a stronger economy? That is the very abstract discussion that is behind most of these price movements that we have seen.

8:40Torsten Slok:Why do you think this is all happening right now? And when I say this, I refer to the negative sentiment surrounding these companies and surrounding the AI buildup. Because these are topics that you and I have discussed for many months at this point, that other people and other investors have discussed for a long time. But it seems as though, I mean, to Jeremy Irons' quote in Margin Call, it seems as if the music is beginning to get quieter only now. And I can't quite tell why that is. Why is it happening at this moment? There's a series of developments that have brought us to this point. First was Amazon issuing debt.

9:21And that resulted in some concessions and some changes in the debt that was issued. and it's been trading wider, meaning the market's saying that spreads on this particular credit should be a bit wider. We've also seen last week, and you talked about this last week, of course, Google going for the first time in its history to now having negative free cash flow, which is also a development where people are beginning to ask, is there too much investment? Is there too little investment? If there's negative free cash flow, what does that mean? How long time is that going to take? How many years will it take before we see a payoff on those investments.

9:55So I think it's a reaction to some of the individual events we've seen around individual names that are moving towards the narrative, exactly to your point, or in your language, as you just mentioned, the music being a little bit more quiet because people are beginning to ask, okay, yes, this has been going on for a while, in effect for several years, this has been the main driver of returns in the S &P 500 and NASDAQ. But now the questions are being asked, well, okay, but what is the profile of this payoff in earnings. So there's two races going on. Namely, there's a race to deliver ROI, meaning return on investment for AI.

10:31And there's a second race, namely that the data center build-up requires a lot of financing. And if that financing now is becoming more and more expensive, then people are asking essentially two questions about, on the one hand, how quickly will the AI investments pay off? In other words, in the form of higher profit margins, in the form of higher earnings growth, not so much in the Magnificent Seven, but higher profit margins for the S &P 493 and higher earnings growth for the S &P 493. And similarly, the other race is on the other side, namely, can we still continue to see issuance of hyperscaler debt of debt for the build-out to grow at this very, very rapid pace if the spreads are now widening and if the CDS spreads are also widening?

11:10So those two things are the two areas to watch, namely, what's the evidence of AI paying off? And the other area is to watch what is the returns and what is there for the spreads that investors require, especially, of course, on hyperscaler debt.

11:23Torsten Slok:It seems like whenever these questions are put to the CEOs of these companies, these big tech companies, they often avoid the question or they don't answer it fully. Or in the case of like Jensen Huang, for example, where it was asked of his company, what's going on with all these circular deals? And his response was, I don't think there's anything circular about what we're doing, which to me is kind of insane. We have big tech earnings coming up. I'm curious if you think that we will get some clarity on a lot of these questions from the leaders of these big tech companies and these hyperscalers.

12:00Torsten Slok:Do you think the fears will be addressed? This is extremely important because I actually think the most important event tomorrow and also on Thursday are the hyperscaler earnings. It's actually become more important than the FOMC meeting. And despite that, I'm an economist who spent all my time on the Fed, and you and I have talked about this for a long time, namely that, of course, Fed action is very important. Are they raising interest rates? Are they not raising interest rates? That's a very important debate at the moment. But currently, because we are approaching, and it looks like, at least some inflection point, and the risks are rising that the market might interpret this as an inflection point, it becomes very, very important what we get from the three hyperscalers that are reporting tomorrow and Thursday.

12:39because to your point, it almost feels like that there's a whole different conversation going on. The labs and the hyperscalers are talking like this is existential. We have to do this. There can be no discussion about it because this is the only thing that's required. So of course, we need to create as much compute as we can. Whereas on Wall Street, the conversation is saying, well, hold on, what is the price for that compute? How much revenue can you generate for that compute? So I think that discussion really is really the technologist talking in the direction of saying, of course, we need a lot more tech, we need a lot more compute.

13:11And the market and the Wall Street language saying, well, no, that price of building that compute is now coming at a wider spread, because there's simply not enough capital available to build that compute. And that is coming together tomorrow and the day after in the hyperscaler earnings, because then we will figure out, is it still the message from them, like it was with Google last week, that we're still growing the capex more and more and more? Or are there signs that the capex is being in a row lower? and how is that then going to be interpreted by market? So there's a lot of different small signals, not so much only about the headline earnings, but also about what is the action from the hyperscalers.

13:43How do they think about the spread and widening we've seen during this quarter in terms of their plans for the CapEx continued build-out?

13:50Torsten Slok:Final question. One of your big themes has been, you pointed out how dependent on AI the market has become. And so your advice is try to find areas and investments that are not AI. Can you figure out how to diversify away from AI? And that might be the right investment strategy. First question, I mean, Apple has been the best performer of the year. They're the ones who sat out of the AI race. Number one, is that a non-AI investment? And number two, what areas and what sectors are you looking at? What are some ways that people and investors can diversify out of AI if they're worried that the AI trade is starting to slow down.

14:34If we think about the 60-40 portfolio, this is the simplest way of thinking about investing. I have some bonds, I have some equity, and the equity is 60%, the bonds is 40%. Historically, this has been very diversified. When stock prices went up, bond prices would go down and vice versa. When stock prices went down, bond prices would go up. So I would be naturally hedged that if one side didn't do well, then the other side would do well. This worked out for a long, long time where interest rates were falling. and that resulted, of course, in rising stock markets. And at the same time, whenever there was a bump, it was always a good idea to be in bonds.

15:07Today, we have a very different situation because in the equity side of my portfolio, the 60, that has to a very significant degree the return's been driven by AI. The 10 biggest stocks now make up 40 % of the index. It's very clear that AI has been dominating returns when it comes to investing in public equities. On the bond side, it's also turning into more and more AI. Hyperscaler issuance is, of course, AI. In software, we also have a lot of issuance now in AI. And venture capital, it used to be the venture capital was inventing prescription drugs, pharma, biotechs. But now venture capital, 87 % is also AI.

15:45So the challenge to this discussion is that investors, AI is really everywhere. It's in equities, it's in credit, meaning public credit, and it's also, of course, in venture capital. So the answer to your question is exactly that a good recommendation at the moment is to invest in non-AI. And what really is fundamentally non-AI is really value. Value investing has not been popular for a long time, but if you look at the factor models at the moment, growth is absolutely crashing completely and value is skyrocketing because people are going away from growth towards value, to actually invest in companies that have earnings, to actually invest in companies that are able to pay the debt servicing cost.

16:23so that they're not vulnerable where interest rates are higher for longer. So non-AI, in this case, in the public space, means the S &P 400. In the private space, it means private equity that is value investing, the private credit that is value investing. And more broadly, non-AI, of course, also means sectors globally, of course, also commodities that are not directly associated with the AI trade. Those are places to hide and to invest, to benefit from not being in the AI trade because the AI trade, of course, is wobbling at the moment. All right.

16:56Torsten Slok:Torsten Slock is chief economist at Apollo Global Management. Torsten, always appreciate your time. Thank you. Anytime, Ed. Thank you. After the break, Justin Wolfers joins the show to break down Trump's latest tariff strategy. And for even more markets insights, you can subscribe to my weekly newsletter, simply put at simplyput.profgmedia.com.

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19:52Torsten Slok:We're back with Prof G Markets. Trump's latest trade strategy just took effect. Early on Friday, a new set of tariffs kicked in on 80 countries, covering more than 99 % of U.S. imports. These tariffs replaced the temporary levies Trump put in place back in February, the same day the Supreme Court struck down his original Liberation Day tariffs. And this time, the Trump administration is reaching for a new legal tool, Section 301 of the Trade Act of 1974, the stated rationale countering the loss of U.S. business from the use of forced labor. Countries that have taken steps to ban forced labor will face a 10 % tariff, while those without a ban face a 12.5 % tariff.

20:37Torsten Slok:The average tariff rate is now 11.1%, and it is expected to rise to 11.8 % by the end of 2026. That is according to the Yale Budget Lab. Joining us to discuss these tariffs, we're speaking with Justin Wolfer's Professor of Public Policy and Economics at the University of Michigan and the founder of Platypus Economics. Justin, it is great to see you. It feels like it's been a long time. I'm sure it has, but it feels that way. We wanted to get your views on this new tariff regime. Specifically, is it different from the previous one? Is it worse, better, the same? What do you make of it? I'm going to give folks at home just a little bit of rewind.

21:22You know, it's three episodes. Episode one was Liberation Day, the Emergency Powers Act, a set of tariffs that they've had to pay back because they were never constitutional. Then they moved to a so-called balance of payments crisis, despite the fact that America's balance of payments is and has been for decades precisely zero dollars, but that was regarded as a crisis. Those tariffs are still unclear if they were legal and whether we might have to pay them back. But by the same token, even if they were legal, they ended last week, six months later. That was the nature of the legislation. So now we need to look around behind the couch and see if we can find a leftover tariff authority that the United States government might be able to use.

22:03Remember, actually, it's very easy to get tariffs done if you're the U.S. government. What you do is you read in the Constitution where it says the right to tax and the right to tariff belongs with Congress. The president refuses to go to Congress because the president doesn't like Congress and Congress doesn't like tariffs. So he fiddles around down the back of the couch and discovers this Section 301 thing that you're talking about. What it does, if you're a White House lawyer, you get to say, you beauty, the boss wanted tariffs. I found a way to give them to him. If there was an economic team at the White House, they would have said, no, no, no, no, no.

22:36That one doesn't work because it doesn't actually achieve any of the things we want. Let me explain why. This is a global across-the-board tariff, basically 10 % or 12.5 % on essentially every country we trade with. If what the president wants is bargaining power when he sits down with President Xi in China, this doesn't give it to him. He can't say, do what I want, or this form of tariff goes down, or it goes up. And he can't say, thank you for paying homage. I'm going to reduce this form of tariff. So the very thing the president wants tariffs for, this doesn't deliver. So episode three of the tariff saga is the worst and surprisingly enough, the dumbest one yet.

23:14Torsten Slok:I think this brings up an important question, which is like, why are we doing it again? It seems like the consensus from 2025 is it was not paid for by other nations. We have a pretty clear understanding of that. It was paid for mostly by American companies or by American consumers. We gave the money back. Right. When they were illegal and unconstitutional, we didn't even raise money. And that was another piece of it, too. So we tried it, didn't work. Then we were told by the Supreme Court, not legal. Now we also have launched a war in Iran, which is adding more fuel to the fire than is inflation.