Hey, this is Steve Eisman. This is another episode of The Real Eisman Playbook. There are just so many issues going on these days: tariffs, politics, war. But from an economic perspective, I think the biggest issues are the impact of AI, re-industrialization, short-term, the so-called big beautiful bill, unemployment, the deficit, and the overall investing environment. And these are major issues, and we've actually never had an economist on to sort of plow through all of them. So today I've invited Torsten Slok, who is the chief economist of Apollo, an excellent economist, and we're going to go through a ton of issues. And afterwards, I'm going to come back and talk about lessons learned. See you soon.
Hi, this is Steve Eisman, and welcome to another episode of The Real Eisman Playbook. So there's so much going on these days: AI, K-shaped economy, oil prices, the deficit. I mean, it's just hard to keep up. So today we have as our guest chief economist at Apollo, Torsten Slok, who's going to help us, I hope. I certainly hope my best to go through what must be like every day. You can't believe how much information is coming. So, Torsten, welcome first of all.
Thank you, Steve. Thanks for having me.
So let's start with a simple topic. Give us your very broad overview about the health of the US economy. A simple question. And then we'll dig deep.
Well, thanks again first for having me. But it's really quite simple initially. What are the headwinds and tailwinds to the economy at the moment? Because there are three very important tailwinds that are driving growth. First of all, we have an AI spending boom because of the data centers and the energy associated with the data centers. We calculate that that contributes at the moment about 1% point to GDP growth. Normally GDP growth at two, and now 1% is coming from the AI spending boom alone.
So in other words, GDP growth this year, you estimate up about two, and 50% of it is purely from AI spending.
Absolutely. So that's both the boom coming from the data center and energy buildout, but also the associated wealth effects from the stock market being high and the increase in consumption, especially for high-end consumers. So this is a very important source of growth. That's very unusual. We have not seen this source of growth for literally decades before, where we've seen one sector in such a significant way contributing. Even with housing, we didn't see a contribution that was as high as 1 percentage point because this sector is just really, really significant. The second source of growth is the industrial renaissance. Industrial renaissance means politicians that want to do home shoring or production of semiconductors. This was the CHIPS Act under Biden, home shoring of pharmaceuticals, prescription drugs, and of course importantly also home shoring and production of defense.
You know, I've had industrial economists on, and when I would ask them, is there evidence of this? In other words, people building factories in the United States, their response generally would be that it was literally... So you're saying it's stronger than... eh.
It is a bit stronger than that. It only adds 0.3% GDP, so not a full percentage point like the AI spending boom. But we are seeing, especially after the CHIPS Act, we saw significant increase in manufacturing capacity for semiconductors, and we've also seen significant increase in capacity for manufacturing generally. So that means the ISM in the last five, six months has started to go up. So the manufacturing sector is doing a little bit better than that, but it's not as big a source of growth compared to the AI spending boom.
So 1% from AI, 0.3 from re-industrialization. That's out of two.
Exactly. From the globalization reversing. That's out of two. And then the last thing we have is 0.9 coming from the one big beautiful bill. Remember the one big beautiful bill which was signed last year. It lowered taxes retroactively for consumers so that taxes were lowered starting January 1, 2025. The consequence of that is when people are filing their taxes this year, both those who did in April and those who had extension, last year the average tax refund was around $3,000, and this year the average tax refund for households is about $4,000. That means over the next six months we will continue to see consumption do really well. That's a very strong tailwind coming to consumers because of the one big beautiful bill that was implemented last year.
So let me pause you on that one. Okay, I'll grant you that. But that's one time. So 2027, 90 basis points of growth. If what you're saying is 90 basis points of growth this year is from the one big beautiful bill, next year it's not going to be there.
That's absolutely correct. So it will be smaller, and that's why if you add those things up — AI about 1%, the industrial renaissance about 0.3, and 0.9 from the one big bill — you get to a little bit more than 2% this year, right? But what's most important about these three different sources of growth is that they are not sensitive to interest rates. Right? In other words, this is not your traditional economic situation where interest rates go up and the economy slows down. We are seeing the sectors that are sensitive to interest rates, namely housing and autos, are not doing well because they are very sensitive to interest rates that have gone up in the front end and in the long end of the yield curve. But at the moment, because these sources are not sensitive to interest rates, that's why Kevin Warsh is dealing with a strong economy, high inflation. That's why long rates continue to be high because the economy is just not slowing down. So that's why you're right when we come to 2027, that's a different discussion. But for the next six to nine months, we still have strong tailwinds coming from the AI boom, strong tailwinds from the industrial renaissance, and strong tailwinds coming from the one big beautiful bill.
Okay, so since you brought up Warsh, let me press Warsh a little bit. Given all what you've just said, would you agree that the probability of the Fed cutting rates this year is zero?
Yes. Zero. It's not going to happen. Economy is too strong, inflation is high for a number of different reasons, partly because the economy is, also because of tariffs, also because of, of course, oil prices that have gone up. And we're also seeing now a contribution to inflation of 0.3 coming from the AI and data center buildout because semiconductors are more expensive, labor to build data centers is more expensive, and you also have equipment is also more expensive, and energy also being more expensive is also adding to inflation. So there is literally zero chance that he will cut interest rates this year.
Well, the market as we speak today are pricing that the Fed will be hiking rates in September and in December. So that's two hikes.
Wow. So that's pretty a shift.
It is a very dramatic shift. As you and I know very well, in the beginning of the year, the dot plot was clearly saying that the Fed is going to cut, cut, cut, and rates are going down. And now suddenly we have a situation where the market is pricing that, well, maybe especially after his latest press conference where he said, 'I'm not going to give any forward guidance.' And when you don't give forward guidance, the market has to start guessing. And that's why you and I are now guessing. And the best guess that the market has at the moment is that we will see hikes coming because the economy is really strong and we have some upward lift. Inflation at the moment is 3.5%. That means we have some strong tailwinds not only to GDP growth, also to inflation, and that just makes it impossible for Warsh to cut rates over the next six months.
Sounds like that's pretty bad for housing.
Well, because housing is... not that housing is so good right now either. You are the world expert in this, of course, but it is absolutely the case that housing lives and dies on what's going on with mortgage rates. And housing is already experiencing very little supply. The home builders have been very reluctant to produce and create more housing. And if you're on top of that, on the demand side, also have that rates are very high for a very long period because we now have a strong economy and upward pressure on inflation. It is indeed the case that the most sensitive parts of the economy, housing and autos, are just not doing very well at the moment. And we expect that to continue because the growth is not coming from traditional sources of growth that are sensitive to interest rates. It's coming from these really unique three areas: the AI boom, the one big beautiful bill, and the industrial renaissance.
All right, so let's dig down into AI a little bit. So tell me if you agree with this or disagree with this. It seems to me, I mean, not a day goes by that something dramatic doesn't happen with AI. It's kind of... it's pretty hard to keep up. I get the impression that at least part of the AI story has really dramatically changed in the last, I would say, not even more than a month. And I would say it's along two vectors. One, and this is what I'm curious what you think about. Number one, this is now a very capital-intensive business. You know, last year, for example, Google spent 80 billion on AI and basically funded it from its own cash flow. And this year, they're spending 190 billion and they just raised 85 billion in equity. And so you're starting to see more and more companies raise capital because the demands on their balance sheets are just so huge. So that's new. And the second thing, which maybe is even more important, is I get the impression that there are no moats in this business, that people flip from Gemini to Claude to ChatGPT. So you're talking about massive companies spending trillions of dollars for something that may have no moats, and that's not a recipe for longevity. So I'd be curious what you think about that.
Yeah. So absolutely on the first point, if you look at the free cash flow for the hyperscalers, it has absolutely gone from being very, very high and literally is dropping down over the next six, twelve months towards zero, and it might even begin to go negative because the capex requirements, which is so massive, it's very, very, very substantial. And these are and continue to be very profitable businesses, especially the Magnificent Seven, of course, which we have most information about, have had significant cash flows, have continued to do so well, and they have now decided to spend an enormous amount into the trillions, as you're saying, in terms of spending on data centers and the energy buildout because they really view this clearly as existential, that they got to have the capacity, the computing power that is needed in this case, of course, to deliver all the demand for compute that's going to come along. And to your second point, I think actually my second point is more important because if there were moats, let's assume that there were very high moats, as an investor I would say, okay, so you're going to spend a lot of money, but you're going to spend a lot of money, and I'll give you... because at the end of the day, you're going to have a business that's a duopoly or very well protected. But if you're asking me to give you money for a business that has no moats, I don't want to give it to you. I'd rather buy Cisco that's going to supply you. Is the analogy that I've drawn is it's kind of like comparing airlines to TransDigm. Airlines is a terrible business because it's very capital-intensive and you have no pricing power, and TransDigm, which supplies parts to airlines, is a great business. So I'm just curious as an economist, if I'm right, what does that mean?
What's exactly most important about this discussion is exactly: are there no moats for everyone, or is it just moats for someone for the hyperscalers? There could be some of the hyperscalers that will end up being the winners and others who will end up not being the winners. In other words, there are clearly moats in the sense that there are some, including of the private hyperscalers, that have clear pricing power and clear products that they are rolling out in a very substantial way. But the question becomes: of all the capacity that's being rolled out, is that all going to have moats? Or in other words, are they going to have pricing power? Are they going to have special products? Or is there a scenario, as you're saying, where you can begin to worry about that some of them may not be able to survive in this situation, even though compute demand continues to go up, which is absolutely indisputable that there will be almost unlimited compute demand. The question is what is the price that they're going to generate? In other words, what's the revenue they're going to generate on that compute demand? Because if the price of compute, the price of tokens, keeps going down towards zero, then it may absolutely be the case that there are some moats that might be a lot more shallow or be much smaller.
I mean, let's imagine that one of the companies that has no moats is ChatGPT, OpenAI, just hypothetically. I've got no skin in that game, but that one day OpenAI is in huge trouble. The ramifications of that, because so much of what's being spent is related one way or another to OpenAI and Anthropic, are massive. I mean, Oracle, for example, has a 600 billion backlog, but half of the backlog is OpenAI. I mean, it's a little scary what's going on.
But the added issue here is also because from a pure competitive perspective, the competitive landscape is also dominated not only by the names we're talking about here in the hyperscalers. But remember also that a lot of this also happens to then turn into more open-source models, including Chinese models, right? So that means that if you are a business and you say, 'I need some compute to do some things for AI,' well, are you willing to instead say it may be that the price of tokens, say, from a Chinese model is only 1% of what is the price of a token from a US model? It still raises some important questions. Are you still willing to go after the cheap model because it runs the risk that you have to upload your data into, say, Chinese models and therefore into something that could become a much bigger issue rather than just thinking about the cost? So the moat is also and should also be, in my view, thought of as there is also this proprietary discussion about you're right, the data is transferable, the models are replaceable, and they can replace each other very easily. But it still ends up being a discussion that those that have the cheapest tokens at the moment, at least, they are certainly the Chinese models, and that becomes important because a lot of businesses might be able to say and willing to say, you know what, I'm willing to pay for the moat over here and for the fact that this is a good service because this is a US service rather than running the risk of doing this as an open-source model or in a Chinese model. So from that perspective, there is some unique characteristics by the US hyperscalers relative to the hyperscalers, especially again from China.
Okay, let's switch gears. Let's talk about the K-shaped economy, the K-shaped consumer. Why don't you first define it? I mean, people throw this term out all the time, and half the time I think that when they throw the term out, they don't even know what they're talking about. So I say to you, person, K-shaped economy, K-shaped consumer, define this for me. Like, what is this all about?
This is all about three things. Number one is about a K-shaped situation in wealth, that high-income households today relative to 2019 have literally savings that are trillions of dollars higher than where they were in 2019. Low-income households, trillions, about one and a half trillion dollars higher than where it was in 2019. That's why the airlines have been saying quite simply, basically, that they have no problem selling business class tickets to high-income households, but they're having some challenges selling business class tickets, sorry, economy class tickets to low-income households. Okay? Because low-income households, the bottom 20% of the population, people who make less than $25,000 a year, their savings cumulatively as a group today is literally in dollar terms exactly the same as where it was in 2019.
So what you're saying is people 25,000 below have no more savings they had in 2019, in nominal terms. And people at the upper end have a trillion and a half more savings. That's an enormous disparity.
And that's because people at the upper end have been benefiting from three things: benefiting from stock prices going up, home prices going up, and people at the other end also own fixed income. So when the Fed still has interest rates high and still talk about raising interest rates, that means that the cash flow you get as a high-income household is at the highest level in fixed income that has been in decades. That means that high-income households are not only making money on their stocks and on their home prices, but they're actually also making money on the cash flow that they get because some Apollo funds pay like 8 and 10%. And those returns you can get in private credit, public credit, and fixed income is basically at the highest level we have seen literally in 20, 25 years. So for that reason, high-income households continue to benefit both from asset price inflation and also from cash flows being very, very strong. So this is the first answer to your question, namely, when it comes to wealth, there is a K-shaped situation, and that continues to... the legs are just getting longer in the K, if you will, because the stock market obviously continues to do well and the cash flows continues to also do well. There is now also a K-shaped situation secondly in wage growth. The Atlanta Fed has wage growth measures across income distribution, and people at the bottom are seeing lower wage growth relative to people that are in the middle and higher income distribution. So that means that the K-shaped situation is not only in wealth, it's also in income growth. And finally, there's also a K-shaped situation when it comes to inflation. The New York Fed has measures for inflation across income distribution, and people at the bottom of income distribution then spend a bigger share of their consumption on food, energy, and housing, and these have seen a much bigger increase in inflation. So people at the bottom are also facing a higher inflation rate related to people at the top and in the middle. So from that perspective, the answer is there's a K-shaped situation for wealth, there's a K-shaped situation for income growth, and there's a K-shaped situation for inflation. And lastly, if you look at stock prices for baskets of luxury names in consumer spending have outperformed over the last several years a basket of retailers that of course cater to discount or value names. So that's why this discrepancy you can look up on your screen every single day. What is the difference? And it just continues to be the case that high-income names and those who cater to high-income names continue to outperform discount retailers. So that's why the K-shaped situation continues to be a major theme in the outlook at the moment.
Okay. So grant that. What are the implications for the economy? So the long term for this, because this is not a trend that's going to flip in one day. This is long term.
Absolutely. The net effect of the K is that in aggregate, the top 20% of consumers, they account for 40% of consumer spending. The bottom 20% only account for 8% of consumer spending. So in aggregate, total consumption is actually still okay. If you look at the weekly data from Redbook for same-store retail sales. So that means Redbook goes out once a week and asks retailers, what were your sales this week relative to the same week a year ago, and that's still holding up very nicely. So that means that in aggregate, despite the K getting wider and wider, you're still seeing in aggregate because the bigger part of the K still has such a big weight that in aggregate the consumer is actually still doing well. So that's why the answer to your question is if the K continues, it almost instead becomes a political discussion. What does it mean when you have a bigger and bigger share of the lower leg of the K that continue to face headwinds not only because of the three dimensions I mentioned with wealth and income and inflation, but there's also the added issue that when you look at the delinquency rates on auto loans have been going up, the delinquency rates on credit cards have been going up, and the delinquency rates on student loans have also been going up because there are a lot of households in the bottom and the middle of income distribution that also are facing higher interest rates because they have this problem that they have now also not only a K-shaped situation for wealth and income and inflation, but also because of this issue that delinquency rates are going up, especially for people in the middle and the bottom of the K.
So that means to your question before that, it means that the share of households that are getting impacted on the lower leg of the K is unfortunately just growing and getting bigger and bigger, and that's of course why this becomes a political discussion. Well, what do they do? Well, the worse it gets, the bigger the political discussion, because then they become a bigger part of the population, and you can then ask who do they vote for and what are they doing. And this becomes ultimately the risk, namely meaning risk from an upside, downside. But what is exactly the outcome when you have that K-shaped situation is unfortunately continuing.
Let's switch to private credit.
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Talk to me about, from an economist perspective, what does the growth in private credit mean or not mean? And what do you think of the over-indexing of private credit to software?
So let's back up and think about exactly why private credit and why the financial system has changed so much since 2008, because Dodd-Frank, as you know better than anyone, was implemented, and that meant that the banks were essentially asked to do less and the market was asked to do more. So let's just agree that this was the rules changes that came after the... This is what happened. This is where we are today, right? What are the consequences of this? Well, where we sit right now, if I just back up and you ask me as a macroeconomist, what's the situation in credit? Well, if you look at default rates in loans and in high yield, they have actually been going down for the last 12 months. If you look at distressed exchanges, meaning that I borrow $100 from you, I come back two years later and say, 'Sorry, I can't pay you back.' You can then decide to say, 'It looks like you're in distress. Why don't you instead give me some equity in your business? Why don't we instead extend the maturity of the loan? Why don't we lower the interest rate of the loan? Let's make a deal and we will change your capital structure because you were not able to survive higher interest rates. Let's try to find a solution out of this.' But distressed exchanges have also been going down. So not only are default rates going down, distressed exchanges are going down, and finally liability management exercises are also going down. So let's agree at the highest level, credit is actually getting better because default rates are going down, distressed exchanges are going down, LME are going down. So what is the problem in credit? And this gets exactly to your question. The problem is in credit that there are some sectors in credit that have much higher leverage and much lower coverage ratio. And one sector that absolutely stands out is...
Just for viewers, because not everybody knows, what does coverage ratio mean?
The leverage means, of course, how much debt you have in your business. And coverage ratio means what are my earnings divided by my debt servicing cost. In other words, what is my coverage ratio?
What's my ability to pay my interest?
Exactly. Bottom line, am I able to pay my debt? Am I not able to pay my debt? And if you do a simple scatter diagram of all the sectors in credit, or really all sectors in the economy, and ask which sectors have a lot of debt, which sectors have little debt. So that's a very important exercise in equities and in credit to understand are these sectors highly levered, are they able to pay their debts, where is their ability to pay their debts relative to other sectors. And software stands out in a very significant way by having significant amounts of debt and at the same time having actually very little ability to service that debt. So even before... and it has very little ability to service that debt because... because interest rates are now higher for longer because Kevin Warsh is about to raise interest rates later. So the coverage ratio is deteriorating because these companies are unfortunately not being helped by the Fed hiking rates. Got it. So that's why if you now, even before you and I begin to talk about AI disruption, we can talk about AI disruption. Some software companies in cybersecurity may be better. Some software companies in education may be worse. So from that perspective, there are some nuances. But the big picture is all software companies across the spectrum, they have very high levels of debt and very little ability to service that debt, especially now that Kevin Warsh is about to raise interest rates. So therefore it becomes important to look at the maturity wall. A lot of these vintages in software were originated in 2021 and 22, and a lot of these vintages have a seven-year maturity on their debt. That means that exactly in 2028 and 29 we are running into the maturity wall for software. That means that... a little bit, but most of it is 2028 and 29. So that means if Kevin Warsh is not lowering interest rates before we get to 2028, these companies will have significant problems rolling over their debt. So even before we debate whether AI disruption is going to create a terminal value of software companies that's very low, we already have the macroeconomic problem that when interest rates are higher for longer because inflation is higher for longer, the sectors that have a lot of debt and the sectors that have little ability to service that debt will continue to struggle, and software unfortunately stands out as the number one sector that's vulnerable in that environment. So that's why yields on loans in software continue to trade higher and higher. At the moment, you and I can take $100 and put into software loans and get 12%.
I mean, if we buy it in the open market, we're selling it less than par.
Absolutely. So if we buy in the open market, you and I could basically say we get 12% return in software loans. I mean, 12%, that's pretty juicy in any investment. But the reason why the market still trades that wider and wider is moving up towards 12.5% is that if these companies have a terminal value that's zero and at the same time they also are not able to roll over their debt, then they will be facing significant headwinds. It's a double whammy to software coming from the terminal value being questioned and at the same time rates higher for longer meaning that they're not able to service their debt. So the bottom line is there is one sector, and in particular that sector alone, there's also some parts of healthcare, small parts of consumer services, but the software sector really stands out as the number one problem in credit. And this gets back to what you asked about, namely that in direct lending or in private credit, which is a $2 trillion market, $500 billion of private credit is software that was originated in the last six, seven years. So for that reason, software is a significant part of private credit and is a significant part of public credit, and it is those parts of the credit market that are wrestling with these problems of rates higher for longer and the terminal value, whereas the rest of the credit market, very broadly speaking, is actually in good shape, exactly exemplified by the fact that default rates are going down, distressed exchanges are going down, and LME are going down.
You know, $500 billion sounds like a big number, but would you agree that in the context of the US economy, which is a $31 trillion economy, eh, it's not. In other words, for the people who made these loans, God help you. But would you agree that for the implications for the US economy overall are not so bad?
Yeah. Because what's also important back to this upper crisis, and again, you know, much better than anyone, is of course that it all becomes a question of where are these loans located, right? Are they on very levered balance sheets? And generally speaking, the banking sector, of course, as you know better than anyone, was like levered 20, 30 times at the time in the GFC. 40 in some cases, 40. And of course now you have the BDCs by law are only levered twice, two to one. Yeah. So that means that of course if it is even in BDCs and if this is in pension funds around the world, if this is insurance companies around the world, then of course this is indeed a smaller...
number and therefore not a magnifier the way that we saw during the GFC when subprime was located in balance sheets that had to deleverage very, very quickly. So in other words, and this might be the way that the Fed is thinking about it, some people make investments and lose money. Some people make investments and make money. And to your point,
Exactly. You have some losses, you have some gains. And 500 billion, yes, it's not, of course, it's a huge number in some dimensions, but from a macroeconomic perspective, the US economy is like 33 trillion GDP. Yes, it makes some importance, but it's not anywhere near those systemic levels that we had with subprime in 2006 and 2007.
So I actually think the software story is even worse than what you're saying. Not from a macro perspective, but just from a micro perspective in the sense that if you look at all the public software companies, you know, like Salesforce, ServiceNow, they're down 50, 60% from their peaks. So if you're the lender and it's 2028 and the loan is now due, the discussion is not just, well, you're a riskier company, I want to charge you more interest. You're going to the private equity owner of the company and you're saying, dude, the value of your equity is basically gone. You got to pony up more money. Otherwise, we ain't going to make, we're not even going to have a discussion about lending you, you know, rolling over your loan until you pony up more equity. And then the question is if the private equity has to decide whether they want to do that or not.
Absolutely. And we've seen some examples of this more recently, of course, but you're right. It's absolutely the case. This is page one in your finance textbook, right?
This is private credit. You are senior to, of course, private equity. And if you are the equity in these businesses and if private credit in software is in trouble, then of course private equity in software is almost in even more trouble.
Let's move on to just general employment. What's the employment situation like in the United States?
What's remarkable about the discussion we had earlier about AI? There's so many stories being told about mass unemployment going up 10, 20%. People freaking all losing our jobs. But there are two important dimensions of this in the data at the moment. Number one is non-farm payrolls continues to be incredible. Why is that incredible? Because we have the tailwinds from the AI spending, the one big beautiful bill, and the industrial renaissance. But it's also the case that it's incredible because clearly AI is not resulting in mass unemployment. So the first conclusion is we are still creating a lot of jobs in this economy and this is despite that immigration has been slowing down. Remember it was the case in 2022, 23 and 24 that net immigration, legal and illegal, into the US was 3 million people came in every single year to the US. Now
3 million people every single year. Today basically net immigration is zero.
That has resulted in our friends at the Federal Reserve putting out working papers, blog posts saying, well, hold on. If we're not having 3 million coming in every year, non-farm payrolls has dropped from when it was 3 million, it was 200,000 every month. Now they break even for non-farm payrolls according to the Dallas Fed is 30,000. In other words, a dramatic drop in the number of jobs because we simply have much fewer people coming into the country. So from that perspective, 172,000 in job growth, 100,000 job growth is a phenomenal number, way, way higher than the numbers that you would be getting if you just looked at the demographics alone. So that's why the labor market is actually in really, really good shape which is likely also again back to the reason why Kevin Warsh and the FOMC is worried about maybe they have to hike rates is because it's not only inflation is three, three and a half but it's also the fact that we have a labor market that are actually quite strong. Even if you look finally at another indicator of the labor market, let's look at the unemployment rate for people that are between 20 and 24. It's been getting a lot of attention that young people can't find a job. Young people
