Webcast transcript:
Willy Walker: Good afternoon and welcome to another Walker Webcast. It is my great pleasure and honor to have Lotfi Karoui join me today.
Lotfi Karoui is the Chief Credit Strategist at Goldman Sachs. He is responsible for research and views on global credit markets. He joined Goldman Sachs in 2007 and was named managing director in 2015. He publishes regularly on the state of fixed income markets and asset allocation. Prior to joining the firm, Lotfi taught undergraduate and graduate level courses in finance and operations research at McGill University and HEC Montreal.
Lotfi's academic research spans fixed income markets, interest rate models and macro-finance. It has been recognized with awards from the Financial Mathematics Institute of Montréal and published in a number of leading academic journals such as the Journal of Economic Dynamics and Control, the Journal of Financial Economics, the Journal of Derivatives.
Born and raised in Tunisia, Lotfi graduated from the Institut des Hautes Études Commerciales in Carthage, Tunisia, with a bachelor’s degree in finance in 2000. He earned a master’s degree in Financial Engineering from HEC Montréal in 2002 and a PhD in Financial Economics from McGill University in 2007. He is fluent in Arabic, French and English.
So, Lotfi, thank you so much for joining me today. Let me start here. I watched an interview that Paul Tudor Jones gave last week on CNBC. And in it he said, “You don't want to be in bonds or stocks. Can't think of a worse macro environment than we are in right now.” Do you agree with Paul Tudor Jones' view on the markets we're in today?
Lotfi Karoui: First of all, it’s a pleasure to be here. I certainly agree with the notion that one of the key shifts that we've seen in the last couple of months is really the return of cash as a scalable and investable asset class. So, think about it this way. You can park your cash by buying two-year Treasuries, for example, have a total yield of two and a half percent. That is a very valuable degree of freedom that you sort of lost for the last two years. And so basically the urgency to be invested all the time, whether it's in bonds, in stocks, in commodities, real assets — that urgency has dramatically declined. Same things for the need to buy the dip on a constant basis. I think that need has dramatically gone. The biggest driver of that is that now you have the ability to park your cash, earn a decent amount of money and sleep very well at night. And so that's nothing short of a paradigm shift in my view.
Now, with respect to the view on risk assets themselves, whether it's credit or equities, look, I do think that you need to recognize that we've built a fair amount of risk premium. So corporate bond spreads, for example, have widened quite dramatically in just the past two weeks. You've also dramatically improved the value proposition of fixed income from an all-in yield standpoint. I'll give you one concrete example. You look at public investment grade bonds. They yield on average around four and a half percent. The last time we saw that was in 2010-2011. And so, the math looks slightly different. And our message has been that you should probably re-engage, but you should pick your spot, so to speak, focusing on pockets of the market where the rebuild of risk premium has gone far enough, either in absolute terms or in relative terms. But I don't disagree with this idea that the game has changed a little bit and that the risk-free asset that you lost for two years is now back into the system. And that gives you an option that you didn't have only six or nine months ago.
Willy Walker: And so, we're up 150 basis points year to date on the ten year and about 200 basis points on the two year. I was watching Jeffrey Gundlach of DoubleLine in an interview earlier this week, and he was basically saying that the last four months have been the worst four months for Treasury and investment grade bonds ever. His calculation was back to 1978. Do you see a reprieve ahead? And is this the worst behind us as it relates to the bond markets?
Lotfi Karoui: Most likely, yes. I mean, you're right. You know, anything that has a little bit of duration risk, and it has probably off to its worst start ever. That is true for investment grade bonds. It's true for Treasury bonds and CMBS, high yield bonds, you name it. Literally anything that has a rates component in it has suffered pretty big declines and worse returns. Now, I think relative to the last four months, I do think that the symmetry has clearly improved. Tenure is close to 3%. The curve has a flat and a fair amount notwithstanding maybe a week or two where we saw a little bit of steepening. But yeah, we're close to the end of it. And in fact, typically if you look at the history of rates, bear markets, what you see is that actually full returns start recovering way before you get to the peak. And in ten-year yields of five-year yields, I don't think things will play out in any different ways. And so, I do think that if you have a six, nine month or even a 12-month type of horizon, I do think that you have to recognize that the asymmetry has improved here.
Now, that is all predicated on one key view here, which is that the terminal value of Fed funds rate, which is where that Fed funds rate is going to peak in the cycle, should be around three- and three-quarter percent. If you disagreed with that view or if you thought that we can overshoot that to say 4%, then some people have been floating numbers like 5%, then it's probably a little bit premature to dip your toes and add risk into bonds. But that is not the Goldman Sachs view we’re of the view that three out a quarter is probably a sensible target to think about. Of course, there are risks to the upside, there are risks to the downside. But three and a quarter percent is the most likely outcome in our view, as far as the terminal value of Fed funds rates go. Ten year is close to 3%, five years not far. So, we're almost there, there could be some volatility, but certainly from a distribution of risk standpoint, the worst is definitely behind us at this point.
Willy Walker: When you're talking about the Fed funds rate and some people thinking that it gets up into the low threes, it makes me think about an inverted yield curve being a predictor of a recession. And one of the things I'm curious about is as you look at an inverted yield curve to determine a recession, do you look at the ten years to the two year or do you look at the 10-year to the three month?
Lotfi Karoui: I mean, they both sort of give you the same answer. It's been sort of documented in the academic literature that the spread of ten year to three months does a slightly better job. But there's no question that if you went back to the last four or five recessions, the shape of the slope of the yield curve has done a fantastic job in predicting recessions. However, there's a couple of caveats behind that. Number one, correlation is not causation. So, it is a very powerful predictor of where the economy will head eventually but there's not much of a story behind it other than the fact that there's sort of one that leads the other. Two, there's a lot to be said about this cycle and how different it is from anything we've seen since the onset of the Great Moderation in the early 80s. But one key difference I think in the cycle is that you do have a very flat nominal curve, but a very steep real curve. Right. And so, what matters eventually for the economy is how much tightening you have in real terms, not in nominal terms. And to me, you know, I look at the shape of the curve in real terms and it's still very steep by historical norms. And so that's a counterargument number one.
Counterargument number two, fundamentally, yes, the path to it towards a soft landing has clearly narrowed because the equation that the Fed is trying to solve is a very difficult one. Basically, the Fed is trying to slow down the economy, we think, to half a point, to a point below trend. And in doing so, it's basically trying to discourage companies from hiring or trying to slow down the pace of hiring without causing companies to actually cut the workforce. And that's a narrow path almost by design. It's a very difficult equation to solve. But even if we get a slowdown in the economy, keep in mind that we're going into this in a position of strength. When you look at the state of fundamentals of the private sector, i.e., the sum of households and non-financial corporation. I’ll take non-financial corporations, which is one sector that I watch very closely. The bulk of the proceeds from the debt that was raised in 2020 and 2021 hasn't been spent. It is basically still sitting comfortably on balance sheets in the form of excess cash that is there to allow companies to withstand any adverse shock could potentially be a recession. Same thing for households. In fact, households went into the pandemic already in a position of strength. We had a decade basically of nonstop deleveraging after the global financial crisis. Things have kept getting better actually since, but the amount of excess savings on household balance sheets is still very elevated. What are the side effects of a hot housing market is that it gives households a lot of untapped equity that they can use if basically things go wrong? So even if you get a slowdown, I do think it's important to think about the depth of that slowdown. But as I see it today, you have enough lines of defense, I think, to isolate you or prevent you from experiencing a large shock. But to me, you're not seeing the type of imbalances in the private sector that you saw in the run up to the global financial crisis or even prior to that, in the run up to the 2001- 2002 recession where you had excessive CapEx, basically in the telecom sector that eventually led to a recession. None of that is just true today. I think what you have today is a pretty unique set of circumstances. There's an imbalance in the labor market. The Fed is trying to correct it. If it succeeds, great. Well, basically realize that we're sort of in mid-cycle and that this cycle can live for a little longer. If it doesn't, then I think there's something to be said about the depth of the recession. And I don't think that depth is going to be remotely close to what we saw in certainly in ‘08-‘09 or even prior to that in 2001-2002.
Willy Walker: So, a lot in there. Let me let me go at a couple of them. The first one is that you talked about a soft landing. What in your mind defines a soft landing? Everyone talks about a soft-landing role like, oh, well, what does that specifically mean either as it relates to where inflation is, where rates are, where the markets are, where employment is? How do you define soft landing?
Lotfi Karoui: So right now, we're in a situation where the tradeoff between growth and inflation has changed basically. And it looks very different from anything we've experienced since the onset of the Great Moderation in the early 80s. What I mean by that is that you have a Federal Reserve whose reaction function is a lot more sensitive to upside risk and inflation as opposed to downside risk and growth. And that totally makes sense. I mean, the second mandate of the Fed is price stability. And so, it is totally logical that they would defend that side of the mandate. A soft landing would basically look like this. You slow down the economy below trend. So, we think one and a half percent on an annualized basis for GDP growth, you discourage companies from continuing to fill up new positions you are hiring more people. And so, you correct the imbalance that we're seeing in the labor market. By doing that, you also avoid the risk of a wage price spiral, which is similar to what you saw in a lot of places in the emerging world.
For example, we saw that in the U.S. in the 70s. And so, the soft landing basically looks like slowing down the economy back below potential while avoiding a recession i.e., an area in which you cause companies to overreact a little bit and cut the workforce as opposed to just slowing down the pace of hiring. And so, it is an incredibly difficult equation to solve. And in fact, if you go back to the last cycles in the U.S., it has never been achieved. Now what gives us confidence that the Fed has a good shot in achieving that this time around is number one, I think the evidence outside of the U.S. is quite encouraging, at least if you look at the G10 universes of advanced economies that are similar to ours. And then like I said earlier, you're going into this with a few interesting lines of defense, namely, particularly the fact that the private sector is in pretty good shape today. And so, you don't have to worry about imbalances like you did back in 2008-2009 or prior to that. But that's what a soft landing looks like.
Now, just to be clear, that path is narrow. It does look narrower than it was only a couple of months ago. And that's one of the reasons why we put the odds of a recession over the next two years at around 35%. So that's more elevated than the sort of long run average, but it's still there. I think it's doable.
The other thing that I would add, I would pay attention to the high frequency indicators, but we had two back-to-back readings in the core PCE that were quite encouraging in my view. But on an annualized basis you had the core PCE at three and a half percent, which is fantastic news. I mean, I wouldn't overreact to it. I think that the April presence will be very important to watch, but there's some evidence to suggest that the peak is likely behind us at this point. The key question is what type of speed of meter reversion you're going to have and how much confidence will that give the Fed to sort of moderate a little bit at the pace of a finding in monetary policy.
Willy Walker: On that Lotfi, I think that tomorrow we have the print for April coming out. And there's a lot of talk that that is going to be down in the basis points and not at sort of a north of 100 basis points. If we were to get a print of 20 basis points of inflation during the month rather than I think it was 120 basis points a year ago. Do you think that that then plays into the Fed's thinking that the inflationary pressures are going to recede from here and that rather than looking at potentially 350 basis point rate hikes, they could put that final rate hike out there and potentially come in on that one in three meetings from now?
Lotfi Karoui: I mean, look, monetary policy is rarely, in fact, never on autopilot mode. Everything is data dependent. Right. And so, yes, I think as it stands right now, will most likely have two back-to-back 50 basis point hikes, one in June and one in July, where the Fed goes back to 25 basis point increments will depend on what you just described. We need to see evidence that actually things are getting better on the inflation side, if things go according to plan, so to speak, and if we see a deceleration or some kind of a return towards the longer run average, then I think that will give the Fed greater confidence that they have sort of engineered the soft landing and you'll likely see 25 basis point increments in September onwards as opposed to 50.
If on the other hand, for whatever reason, one potential channel could be, you know, another round of supply chain disruptions, for example, that further exacerbates the pressure in goods inflation. If that's the case, then I think that could force the Fed to lean more towards a 50-basis point hike in September. So, to answer your question, things are data dependent. I think now we have pretty good confidence that we'll get to back-to-back 50 basis point hikes in June and July. After that, you'll need a couple of data points to get the Fed comfortable that actually things are heading in the wrong direction. And if that's the case, then you're back to 25 basis point type of scenario.
Willy Walker: I know you watch the oil markets quite closely, and I want to dive into some of the inputs here on the inflationary pressure and get your insights into where you think we might see some, if you will, moderation and where you think kind of inflation is baked for the foreseeable future. Like you just talked about labor markets. On oil, I was getting ready for this Lotfi. I read an article that was talking about the 3-2-1 crack spread, which was something that I'd never heard about before. And I'm assuming you know about it. And let me for our listeners, just explain it really quickly, which is just that the markets are very focused on the spot price for WTI crude. And right now, that's trading at 108 or $110 a barrel. But actually, that isn’t what's driving the inflationary pressure in the oil markets. It's actually the refined oil that is coming out, and that's the 3-2-1 crack spread where you need three barrels of crude to turn it into two barrels of refined gasoline for our cars and one barrel of refined diesel fuel or jet fuel. And those prices per barrel are 165 for refined gasoline and 275 for refined diesel and jet fuel. And so, I think one of the interesting things there is, while the U.S. and other governments have sort of flooded the markets with their reserves of crude oil, our real problem and bottleneck today is actually on refining capacity and that refineries aren't investing to make up for some of the capacity lost during the pandemic, is what I've read on this correct? Do you see any way for us to get out of that other than just shrinking the demand side of the equation?
Lotfi Karoui: Yes, I think that's definitely the view of my colleagues on the commodity side, which is that demand destruction is probably the only way to rebalance the market here. And precisely for the reasons that you mentioned, which is we've had more than a decade of chronicle lender investment in the oil and gas industry. And so, the ability to bring supply very quickly in order to rebalance the market is actually quite diminished. And so that leaves you with the demand side of the equation. That's pretty much the only mechanism through which you can rebalance things.
The two other things I would add, and this is where it gets interesting, is that if we went through a shock like this 30 years ago, 40 years ago, the US economy would have immediately slipped into recession. Now that's not the case anymore, and a lot of that is because, yes, you do take a hit on the consumer side because it costs more, to fill up your tank and gasoline prices are higher, etc.. But there's a meaningful offset through the energy sector or the energy industry and so on net. It sort of isolates and protects the US economy from the negative effect of these oil shocks because in terms of magnitude, the shock that we went through is actually on par with the 70s except that its impact on the real economy hasn't been that big.
Europe, on the other hand, is in a dramatically different position, in my view, because it's a net importer of commodities, particularly on the energy and the metals side and the natural gas side. That matters not just for consumption, but it also matters for industrial production. And so that's one of the reasons why on the credit side at least, we have been more positive on the U.S. relative to Europe is because we see more downside risk to growth there. And a lot of that downside risk is coming from a stronger reliance on Russia in terms of commodity imports. But as far as the U.S. goes, I think what a really interesting lessons of the last couple of months is that we're able now to withstand shocks of this magnitude in the old market, which is absolutely fascinating in my view, because if we went through the same thing only 20 years ago, the odds would have been very high that the economy would have slipped into recession. Now, that wasn't the case this time around.
Willy Walker: I heard you say a year ago, about the fact that the investors see great confidence in the durability of the recovery. And here we are a year later, I think from exactly when you made that interview, do you think we're still in a recovery?
Lotfi Karoui: I think the jury is out as to what exactly is the age of the cycle. Certainly, you passed basically full employment and that typically indicates that you sort of transitioning into the last inning or the final inning of this business cycle. So, to answer your question, yes, I think, it's pretty unique in many aspects. And there's definitely a debate as to how old exactly the cycle is based on the labor market. It seems like it's actually pretty old based on market pricing. There's a little bit of a debate like if you look at the rates market, we started the conversation with the shape of the yield curve. That seems to suggest that we're sort of close to an inflection point and that the cycle is sort of old. If you look at corporate credit spreads, actually spreads are at levels that are consistent with an economy that's still at mid-cycle. If you look at S&P multiples, yeah, same thing. Multiples have contracted a little bit on the back of the April selloff, but in the grand scheme of things, you're not remotely close to levels that are sort of implying an economy that's heading to a recession. And so, I think that dispersion in views definitely highlights the uniqueness of the cycle. There is no playbook basically for the current cycle. It's unique in so many aspects that I'd be careful to not extrapolate too much.
The other thing that I would add is that, if you're a fixed income investor, I think it's obviously very important to think about the stage of the business cycle and where you are, but it's even more important to think about the credit cycle, right? Typically, those are kind of the same thing. They could move together. If you actually take 30 years of default data, what you see is basically four data points are four big humps and those corresponded with the last four recessions. However, this time around, I think, you could argue quite confidently that the credit cycle is still very young. And the reason for that is we're starting a year or two post-pandemic. And so, you haven't had enough time to sort of misallocate capital and make bad decisions that eventually cause credit fundamentals to deteriorate and then the cycle to inflect. And so, there's a bit of a disconnect, I think, between the credit cycle and then the broader business cycle.
I wouldn't be surprised that even if we're wrong and even if you get a recession, say, in 2023, it would not surprise me to see defaults and all sorts of metrics of financial distress sort of decoupled from the general state of the economy in outperformance, so to speak, mainly because the credit cycle is young that I can confidently say. The business cycle, I don't know. I think it's a big question mark as to how old exactly is this business cycle? Yeah.
Willy Walker: Last year, you were talking a lot about investors in the bond market seeking yield and going and investing in even C rated bonds to try and get that additional yield. Now that we're a year later and the economy isn't running quite as hot as it was a year ago, do you think that there's any issue there as it relates to people being stuck in junk debt that might default? I think the number you used last year was that your prediction was that there would be 13% defaults in the high yield market. How do we end up at the end of 2021 as it relates to because that's like a from my take on what you said that sort of a recessionary level as it relates to defaults on high yield debt? And so how do we end up in 2021? And what do you think about high yields in 2022?
Lotfi Karoui: Very benign from a default standpoint and in fact, one of the many remarkable aspects of this recession is actually how benign the default cycle turned out to be on the back of the pandemic. And so, if you look at the 12-month trailing default rate in the high yield bond market, for example, that peaked around 6.5%-7%, which is lower than what you typically see in a recession. Now, of course, that speaks to a lot of things, but the most important driver of that lower default rate or lower peak in default rate was the strength of the policy response that you had, both on the monetary but especially on the fiscal side. We had basically perfect income substitution for households and small businesses and then for larger corporations, the big game changer in the cycle was the decision of the Fed to announce the corporate credit facilities, which was literally the turning point in markets on March 23, 2020.
And so that's one aspect, in terms of the forward trajectory of defaults, I don't expect defaults to increase a lot. That's certainly a debate that we're starting to have with investors. There are some people who are raising the alarm bell on defaults and the narrative that you typically hear is that while funding costs have increased dramatically, you have to have a little bit of a payment shock among nonfinancial corporations. We disagree with that narrative for really one simple reason, which is that the debt servicing capacity of non-financial corporations, including lower rated ones, including triple C rated companies, is the best we've seen ever. And so, you can factor in a shock of 100 basis points or 200 basis points of the cost of funding. I think it won't do much. You need something a lot bigger than that. The second argument that I would make is that it's assets and liabilities. You can make the cost of your liabilities higher. Great. Keep in mind that we're also in a high nominal GDP sort of growth type of environment. And so, your assets are also growing at the same time. The ratio, I think, shouldn't change that much in my view, but we've always been quite skeptical of this idea that going into a hiking cycle you should expect something that looks like a payment shock for non-financial corporations. And so, I don't expect defaults to increase. That being said, we do think that the case to be down in the quality spectrum, so be overweight, those triple C rated bonds has dramatically weakened because the other really major shift that happened in fixed income markets recently, particularly in high quality segments of fixed income, investment grade agency, MBS, is that the level of yields has reset to much higher levels and the level of crisis has gone down quite dramatically. And so, before this call, I was actually looking at the 2020 vintage of issuance and a lot of these bonds were issued at par and 130, 140, and now they're back to par. Right. So, you've created a lot of upside convexity in high quality markets and all of the sequel that should incentivize investors to actually start moving up in quality just because you're being paid better today to all low data assets.
So again, back to where we started the conversation, I do think that search for yield motives have declined, partly because you brought back better yield support into fixed income. And so, the incentives have weakened quite a lot. Third thing I would add, this is also a unique aspect of this cycle. But if we had this conversation in 2017, we would have been talking about the Fed sort of normalizing policy and then the rest of the world being on hold. That is absolutely not the situation we're in today. The normalization process of monetary policy is a lot more synchronized. Everyone is heading in the same direction, maybe with the exception of the Bank of Japan. But everyone is actually normalizing monetary policy and so yields globally are rising pretty much at a similar pace. And that is good news for high quality fixed income assets.
Willy Walker: Looping back for a moment on the inflationary pressures in housing. I saw it was published this morning that the average rent across the country for a one-bedroom apartment is up 12% between March of 2021 and March 2022. A year ago, you thought the housing market would go from white hot to warm by the end of 2021. It stayed hot pretty much throughout the year. So, in your mind, what's 2022 look like? I think I heard you on CNBC say that your estimation was that you'd see price appreciation in the single-family housing space of about 8% in 2022 and then normalizing to something closer to 2 to 3% in 2023. Have you changed that view or is that pretty much where you are on the single-family front?
Lotfi Karoui: We're still of the same view and so high single digit levels this year. A lot of it, by the way, was realized already in the first two or three months of the year, but you should expect some normalization for the remainder of the year and then back to normal in 2023. But this story has been exactly what you just described, which is a tug of war a little bit between deteriorating affordability in the form of higher mortgage payments. I'll give you one interesting stat, but on our estimate, the average monthly mortgage payment in the U.S. has actually increased by 41% this year. That's a combination of higher home prices, but also higher mortgage rates above 5% for the first time since 2010. But on the other hand, you're still operating in a market where supply is very, very tight. And up until now, tight inventories or tight supply has sort of kept the upper hand on deteriorating affordability. I think over time, you should expect the balance to kind of drift a little bit more towards deteriorating affordability, ultimately pushing basically house price appreciation of the pace of house price appreciation back to trend, which is anywhere between two and a half and 3% now.
One question that we get all the time from market participants is, is this a problem from a financial stability standpoint? Like the trauma of the global financial crisis is actually still there. A lot of people have in mind some of the memories of strong house price appreciation, eventually leading to a bubble and a full-blown financial crisis. We're absolutely not in that situation today. In fact, if you look at lending standards, they're actually quite tight and certainly a lot tighter relative to what we saw back in 2007-2008. So, I don't think this is a problem from a financial stability standpoint. This is just, again, a unique situation in which we've sort of under built for many years, in fact, since the aftermath of the global financial crisis. And now you're in a situation where there's no supply, very little supply. And so, demand has come down, but it's still far off basically from where supply is. And so, it will take another leg basically of deterioration and affordability to sort of rebalance the market here.
Willy Walker: It's really interesting on all of that. Last week, Art Laffer wrote in the Wall Street Journal an article as it relates to kind of what the Fed ought to be doing and the need to tamp down on inflation. And one of the stats that he put into his op ed piece was that between 1972 and 1981, hourly earnings in the United States went from $4 an hour to $7 an hour or relative or roughly 70% appreciation in wages. But purchasing power due to inflation fell by 12%. And he noted that because I think he wanted to capture the attention of the Biden administration, both Gerald Ford and Jimmy Carter were voted out of office after being elected to one term. And he goes on to say that workers' purchasing power over the last 12 months has decreased by 3%. Even with wages going up and you just talked about that kind of stunning number as it relates to mortgage costs being up over 40% year over year. What's happening with wages in the sense of, I mean, so much you talked about household balance sheets being better than they've almost ever been, both going into the pandemic and clearly coming out of the pandemic, given the amount of liquidity that the Fed pumped into the system. But unless people have, if you will, free cash flow. They're not sitting on some balance sheet, sitting there, managing it like you or I would be managing a corporation. They're going paycheck to paycheck. What's the view on wages and wage growth? Because the Fed's trying to push that down at the same time as we have all this inflationary pressure. Isn't there a mismatch coming up here?
Lotfi Karoui: I mean, that's certainly the biggest risk, which is the risk of a wage price spiral similar to what you had in the 70s and up until the early 80s. And so, wages go up, but prices go up even more. And so, you sort of constantly catch up a little bit and get caught in a spiral. We think that risk is actually quite low. If anything, a lot of the high frequency indicators that we look at do seem to suggest that there are signs that wage inflation is sort of abating a little bit and the risk of that vicious circle is declining a little bit. But I don't disagree that that would be the biggest risk, I think, to the outlook, not least because it would force an even more aggressive pivot of monetary policy. That was certainly the playbook that we had in the 80s, which eventually it led to a double dip recession. Two back-to-back recessions in order to sort of rebalance things and get us back to two to where we should be in terms of inflation. The other, I think, risk, in addition to some kind of a wage price spiral, which again is not our baseline view we think we'll avoid, is what I would call the risk of de-anchoring long term inflation expectations. And so, this idea that you're constantly anticipating prices to go up and as a result of that, you buy more today. And so, again, it sort of generates a little bit of a spiral.
The good news is that we're not seeing any evidence of that. Of course, those of us who look at fixed income markets know the five year forward inflation. That's the one metric that everyone looks at. If you look at it, it's been very well behaved. Same thing. If you look at some of the survey-based measures of long-term inflation expectations, they do look okay to me. But of course, if there's any evidence that long term inflation expectations are becoming de-anchored a little bit, then that would force again an even more aggressive posture from the Fed in terms of monetary policy. But back to your question with respect to the risk of a wage price spiral, that is not our baseline view. We think that would actually be avoided.
Willy Walker: So, your team worked on a research piece that came out I think last week called The Postmodern Cycle. And I just want to talk about it for a moment. I think that and in it, it calls for a bigger risk in inflation than deflation, greater regionalization, more expensive labor in commodities, and larger and more active governance. Those are sort of the main tenants, at least that I took out of it.
The first thing that I just wanted to ask you, is the way the paper is set up and the fact that it basically looks at three eras pre-1980, 1980-2022 and then post 2022. I sat there, I read it and I sort of said to myself, that's a pretty dramatic statement as it relates to the new fundamentals. In other words, I listened to Alan Patricof this morning on CNBC and he's sitting there saying, oh, most people investing today never lived through a bad market. And I sort of say, hang on a second. Most people investing today were around for the great financial crisis. They were around for the pandemic. We've all seen lots of shocks come into the market at various times. So, let's not go back to just you gotta be 75 years old and a lot of gray hair to have lived through markets. But I found it to be striking that the Goldman piece was segmenting, sort of, if you will, the history of economic theory in the economy into three big chunks, one of being a 42-year period. And now all of a sudden you think that things have materially changed going forward. Can you dive into that a little bit on why you see right now such a dramatic shift?
Lotfi Karoui: First of all, why cut it that way? Why basically the pre-80s, post 80s and onwards? I mean, the answer is the pre 80s is the pre great moderation period, a period where you had elevated macro volatility in the form of high inflation, high growth, big swings in the business cycle. And then came the post Volcker period, which featured a steady decline in inflation expectations, a stronger predictability in monetary policy. That's also a big change. And then more generally, lower macro volatility, maybe notwithstanding some violent episodes like the global financial crisis. But aside from that, it was a period where macro vol was trending lower, inflation was under control, maybe in an excessive way, maybe. But that was sort of the great moderation. Now we're in a different regime, whether we like it or not. And I think Peter Oppenheimer, my colleague who wrote the report, perfectly summarized that the cycle is different in many aspects, but those that you mentioned, which is, more aggressive fiscal policy, you got to see more fiscal spending. I mean, Europe in particular is the one place where you will see more fiscal spending because you need to decouple from Russia. And how do you do that? We need to spend more. What we've seen in the last 2 to 3 months is stronger commitments in terms of defense budgets in Germany. I think that will probably be mimicked in other countries in Europe. You've seen stronger commitments to invest in renewable energy and decouple from Russia. All of that essentially will have to be financed and the result is sort of that you're going to see more bonds basically issued on the sovereign side, and that will justify higher levels of risk premium because investors will have to absorb all of that.
Second shift, I think, is this idea that at least if you look at the trajectory of markets in the economy post the global financial crisis. Sort of fair to say that you had a lot of inflation in financial markets, very little inflation in the real economy. If you think about what's lying next, it's almost like the flip side of that, you know, a little bit where, of course, we'll normalize on the inflation side. The question is, where are we going to settle eventually? And I think we'll probably settle at levels that are higher structurally relative to some of the equilibrium that prevailed pre-pandemic.
On the other hand, for risk assets there are quite a lot of headwinds that you need to take into account. One of them is that the real cost of capital is going to go up because one of the reasons why April, just to take that as a data point, was so painful for risk assets, particularly in the equity market is because you had a selloff in nominal yields that was entirely driven by the real yield component. And so, when you make the cost of capital in real terms more expensive, everything has to be readjusted accordingly. Your equity risk premium, your credit risk premium, any premium that you demand to hold, a risky asset has to go up and adjust accordingly. And I think that's sort of the path going forward. If, again, you think that real cost of capital should adjust higher in response to a new regime that features a structurally higher equilibrium level of inflation.
Willy Walker: And one of the other pieces to it, which I found to be fascinating, was this move from globalization to regionalization. And in it, there's a very interesting explanation that for the past 42 years, whenever we needed additional labor, we typically went offshore. Whenever we needed new manufacturing capacity, it went offshore. And now all of a sudden, you're going to find companies that have to invest in labor in their local markets for basically the first time in four decades. You're going to have corporations that rather than just going in offshoring a manufacturing facility where we've all sat around and seen these numbers as far as manufacturing, both in the U.S. and more dramatically in Europe. You have in there a graph on German manufacturing. I mean, it makes Donald Trump's graphs on U.S. manufacturing look like a walk in the park as it relates to the number of jobs lost in Germany to manufacturing offshore. And it's an interesting paradigm shift as it relates to not only investing in human capital, investing in property, plant, and equipment, but also how you're going to finance all that. To exactly what you just pointed out as it relates to more CapEx expenditures, more issuance of bonds at a higher cost, and how that's going to change corporate balance sheets in the United States.
Lotfi Karoui: Yeah. I mean, look, we would characterize that as a slowdown in the pace of globalization as opposed to a complete rollback of possibly three decades of globalization. But you're absolutely right. I mean, if you're bringing back the supply chain to local markets as opposed to constantly seeking the optimal way to build things, well, then you're introducing inefficiencies, basically, and all else equal that is also inflationary. And so that is probably one additional reason to expect whatever equilibrium level will prevail in terms of inflation to possibly be higher than what we had in the past two to three decades.
But I guess, the big debate we're having is are we on the verge of a complete rollback of three or four decades of globalization, or is it just a slowdown in the pace of globalization? We're probably in a lot of camp here, which I think it's a little excessive to expect a complete rollback. I think what is happening is clearly a slowdown in the pace of globalization, and that goes a bit too far that you sort of introducing inefficiencies in the supply chain, and that's also by design inflationary. You know, you have to pass on that extra cost to the end user, i.e., the consumer.
Willy Walker: Whether it's a deceleration of globalization or a true move to regionalization, is that due to the pandemic? Is that due to Russia invading Ukraine? Is that due to the global cost of capital? I sit here and think about everything that's come together. It's all the above, It's so interesting.
Lotfi Karoui: And all of the above! I think all those events exposed some fragilities that companies had in terms of their supply chain. But you're right. I mean, I think the shipping industry is a great example where I pre-pandemic, by and large, without generalizing, but that was an industry that was in quasi distress. I mean, certainly in the high yield bond market, it was a sector that was trading at a pretty meaningful discount. Now it's the complete opposite of that where the shipping industry is sort of viewed as a high-quality sector. But I do agree with you. I think we've had a number of geopolitical events. We've had the pandemic. And that exposed several weaknesses in the way companies manage their supply chains. And I think it increased the urgency to reduce the reliance on those sources of fragility. The other thing that we've seen, which is somewhat related to that, but last year as a great example, we had a big boom in M&A. Right. Why did we have that big boom in M&A is because every company realized that it's very important to have as much as a diversified business model as you can, because you can’t afford basically depending on one market or one product or one consumer segment. And so, it's the same driver at the end of the day, you go through these large shocks, companies draw the lessons. And one of the lessons I think that we've drawn from the past episodes of geopolitical tensions and the pandemic is really the need to reduce reliance on those sources of fragility and have a business model that is as diversified as you can.
Willy Walker: The final point in the paper is that we ought to expect governments to play a bigger and bigger role, which, as my friend Peter Linneman from Wharton said last time he was on the Walker Webcast, he said the only thing we have to fear is the government stepping in and putting price controls in place and trying to play too big a role in the economy. Does Goldman feel the same way in the sense that there is likely going to be more government intervention here, whether it's from a price control standpoint or trying to prop up special industries? And I want to lead this into ESG. So that's where I'm headed with this. But is there a real concern there or do you think that governments will play a marginally higher role? But we can get into this more regional world without having governments take the punchbowl away.
Lotfi Karoui: I think there's no concern, really, other than an acknowledgment that, yes, fiscal policy will play a much bigger role, again, certainly relative to the aftermath of the global financial crisis, where with the benefit of hindsight, actually fiscal policy should have played a bigger role because we had a contractionary fiscal policy that sort of resulted in a weak recovery after the global financial crisis. Now, you may have the opposite of that, and you have it for different reasons. I think one of them is the need to sort of invest in renewable energy, cut the reliance on some commodity exporters a little bit. So, you know, it's not what I would describe as a concern, but that is a reality that needs to be acknowledged. And it certainly has some implications on the market side for sure.
Willy Walker: And so, on the ESG side, we talked a little bit about oil in this sort of imbalance that exists today. We're trying to get to a less carbon centric economy. And at the same time, we don't have the renewables already in place. We've got corporate governance that's driving corporations to invest here, but we can't kind of catch up fast enough. Anything that you see might be sort of a release valve for this supply demand imbalance as we transition from a carbon economy to a less carbon economy?
Lotfi Karoui: So, one market that I watch actually very closely is sort of the ESG fixed income market. And I can tell you one thing, demand continues to create its own supply. Basically, that is pretty much the story. But one fascinating development in the last four months, obviously, we started the conversation commenting on the performance of fixed income year to date and how it's been the worst ever. Now, as a result of that, you've had massive outflows basically in fixed income funds except for ESG funds. Right now, there's a fascinating picture, actually. If you look at ESG versus non ESG funds, it's like a mirror image basically where capital continues to flow into ESG fixed income funds. I'm not even talking about equity funds. And then at the same time, capital is sort of avoiding non-ESG bond funds. And so that's the story. I think, you know, there is still a remarkably strong level of appetite from investors to actually fund anything that has sort of that looks like an ESG initiative, which is a good thing now.
The flip side of that, and this is also an interesting development this year, it used to be two or three or four years ago that if you're a company and you decide to issue a green bond, for example, that the market would actually reward you for that green bond by giving you a little bit of a borrowing discount. And so, there's a variety of estimates of how large that discount is. We think it was around ten, five basis points depending on the sector and the issuer. That discount has actually completely shrunk this year and it's just not there anymore. And the reason for that is that ESG basically in fixed income is gradually becoming mainstream a little bit. I'll give you one staggering stat. 25% of investment rate new issue volumes in the euro market are ESG today. So, for every euro that gets issued in the primary market, you get $0.25 that have an ESG label on them. And so, there's no question in my mind that from a capital standpoint, there's an enormous appetite, I think, from investors to fund those initiatives. At the end of the day that’s what matters. As long as capital is there, I think you can operate that transition. And if I had to make a guess, I do think that that transition will happen a lot quicker than most people think.
Willy Walker: So, as you look out for the rest of the year, what's the one data point that sort of says, things are going to be okay? Is it Russia who decides that they're done invading Ukraine? Is it that we get an inflationary print that makes it so that maybe the Fed doesn't have to do another 50-basis point rise? Is it the ten-year settling in somewhere between 275 and three for an extended period of time? Or is it something that I'm not even thinking about?
Lotfi Karoui: So, when it comes to assessing that forward outlook, you always have to look at both sides of the equation: risk and price of risk. What's the risk and how much would be paid for that risk? The good news is that over the past two months, the price of risk has gone up. The market is actually paying you a little bit better than it did only a couple of months ago. Now that means that you have to assess how big the risks are. I think on the positive side, obviously any de-escalation of the conflict would be a very welcome development, not just on the human side, but also on the economic side. And then inflation is really key. I mean, if three-four months from now, we're in a situation where everyone becomes confident that actually there is mean reversion in inflation and that the speed of mean reversion is given enough confidence to the fact that they can actually engineer a soft landing without pushing too much, without anything sort of breaking in the system yet that would be a very welcome development. And I can tell you that if I look at higher bonds, yields are around seven and a half, 8% now, that's a pretty good value proposition if we get that type of scenario where inflation actually comes back, comes down fairly quickly. And then the Fed doesn't deliver anything beyond what's currently already in the price.
Willy Walker: It's great. Lotfi, thank you so much for your time. It's been a really interesting conversation. I greatly appreciate you taking the time to share your insights with us.
And to everyone who joined us today, thank you so much for tuning in to the Walker Webcast. I will be back next week with Colorado Senator Michael Bennet to talk about what's going on in Washington. And he is on the Senate Banking Committee. So, it'll be interesting to hear Senator Bennett's insights into the markets and what's going on. Again. Lotfi, thanks very much and I hope you have a great day.
Lotfi Karoui: Thank you for having me.
Willy Walker: Take care.
