Finance & Economy

Lotfi Karoui, Chief Credit Strategist at Goldman Sachs on rates, spreads, inflation, and more

May 11, 2022

Lotfi Karoui, Chief Credit Strategist at Goldman Sachs on rates, spreads, inflation, and more

Lofti Karoui

Chief Credit Strategist at Goldman Sachs

In the midst of a global pandemic and conflict overseas, Lofti Karoui joined us to discuss how the credit market is faring.

In the midst of a global pandemic and conflict overseas, how is the credit market faring? On another episode of the Walker Webcast, we were joined by one of the most insightful minds on Wall Street, Goldman Sach’s Chief Credit Strategist, Lotfi Karoui. He and Willy discussed economic trends, inflation, interest rates, labor markets, the housing market, his predictions for the future, and so much more.

To begin, Willy asks Lotfi to share his view on the markets we’re in today. He agrees that one of the key shifts we’ve seen in the last few months is the return of cash as a scalable and investable asset class. The urgency of investing has dramatically declined. When it comes to bond markets, he thinks it is most likely that the worst is behind us now. The Fed is trying to slow down the economy below trend in an effort to slow down the pace of hiring without causing companies to cut the workforce. Even if the economy does slow down, we must keep in mind that we are now in a position of strength when it comes to the state of fundamentals of the private sector.

Right now, we’re in a situation where the tradeoff between growth and inflation has changed. Lotfi’s idea of a soft landing would look like slowing down the economy below trend while avoiding a recession, thus preventing companies from cutting their workforce. On the other hand, another round of supply chain disruptions could further exacerbate goods inflation. However, in good confidence, Lotfi predicts we will see two back-to-back 50 basis point hikes. The current cycle is unique in so many aspects, and there is no playbook to refer to. The credit cycle, Lofti explains, is still relatively young, two years post-pandemic.

Looking at the 12-month trailing default rate in the high yield bond market, it peaked lower than what is typically seen in a recession. The most important driver of this was the strength of the policy response. Looking toward the future of defaults, Lotfi doesn’t expect them to increase. Compared to just a few years ago, the normalization of the process of monetary policy today is much more simplified. Thus, yields globally are rising at a similar pace.

Shifting gears, Lotfi speaks of his views regarding the future of the single-family housing market. The overall story is a tug of war between deteriorating affordability in the form of high mortgage payments and tight inventories. In the US, average monthly mortgage payments have increased by 41% this year due to both higher housing prices and mortgage rates. Over time, he predicts house price appreciation to mellow out back to trend.

Then, Willy shares statistics on the relationship between wage increases and inflation. There is a risk of a wage spike spiral similar to the 70s, in which wages increase, but prices increase even more. Lotfi’s view, however, is that this will be avoided. Another risk is what he calls de-anchoring long-term inflationary expectations. Lotfi and his team recently published a research piece called The Postmodern Cycle. The report perfectly summarizes the fact that today’s cycle is different in many aspects from any previous time. There is more aggressive fiscal spending pressure, inflation uncertainty, and the variables of risk assets. He believes that fiscal policy will play a bigger role, which is ultimately a good thing. Lotfi closely monitors the fixed income ESG market in which he observes that demand continues to make its own supply. From a capital standpoint, there is an enormous appetite from investors to fund ESG initiatives.

As the episode wraps up, Lotfi highlights one data point which may reassure that everything will be okay.

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