Goldman Sachs Chief Credit Strategist: Path Toward Soft Landing Narrows, But It's Not All Bad News

There is a major shift happening in the U.S. economy. Interest rates are on the rise and the Federal Reserve is expected to continue increasing them throughout the year. The goal is a “soft landing,” a term that refers to curbing inflation by raising interest rates, but not so much that it will push the country into a recession. 

These moves pose a lot of questions for the future of the economy, and one person well-equipped to answer them is Lotfi Karoui. As chief credit strategist for Goldman Sachs, Karoui is responsible for research and analysis of global credit markets. On this week’s Walker Webcast, he spoke with Walker & Dunlop CEO Willy Walker about the state of the economy and what lies ahead.

Walker asked Karoui what he made of Tudor Investment founder Paul Tudor Jones’ recent comment on CNBC that “you don't want to be in bonds or stocks right now.” Karoui said he agreed that the return of cash as a scalable and investable asset class has been a key shift in the economy the last couple of months.

“Think about it this way: You can park your cash by buying two-year Treasurys for a total yield of 2.5%, which is a very valuable degree of freedom that you sort of lost for the last two years,” Karoui said. “Basically, the urgency to be invested all the time, whether it's in bonds and stocks and commodities, has dramatically declined.”

Walker pointed out that the economy is up 150 basis points and DoubleLine CEO Jeffrey Gundlach recently said that the last four months have been the worst for Treasury and investment-grade bonds since 1978. He asked Karoui if he sees a reprieve ahead in terms of bond markets. 

Karoui said most likely yes, the worst is over, adding that anything that has a little bit of duration risk is off to its worst start ever, from investment-grade bonds to Treasury bonds, but that the symmetry has clearly improved.

“The curve has flattened a fair amount, notwithstanding maybe a week or two, ​​but yeah we're close to the end of it,” Karoui said. 

Karoui said he believes the path toward a soft landing has narrowed because the equation that the Fed is trying to solve is a difficult one. It is trying to slow down the rate at which companies are hiring without cutting the workforce. But it isn’t all bad news. 

“Even if we get a slowdown in the economy, keep in mind that we're going into this in a position of strength,” he said. “When you look at the state of fundamentals of the private sector, such as nonfinancial corporations, which is a sector I watch very closely, you will see that 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.” 

He said this cash can help companies withstand any adverse shock that could be caused by something like a recession. Households also went into the pandemic in a position of strength, with a decade of nonstop deleveraging after the global financial crisis, and things have kept getting better. 

“One of the side effects of a hot housing market is it gives households a lot of untapped equity they can use if things go wrong,” Karoui said. “Even if you get a slowdown it’s important to think about the depths of that slowdown, but as I see it today you have enough lines of defense to prevent you from experiencing a large shock.” 

Compared to the runoff to the global financial crisis in 2008, he said, the private sector is not seeing the same types of imbalances it did years ago. 

Though household balance sheets are strong thanks to the amount of liquidity the Fed pumped into the system, Walker said if people don’t have free cash flow they could end up going paycheck to paycheck if the Fed continues to try and push wage growth down. 

Karoui said the high-frequency indicators he looks at suggest that wage inflation is abating a little. He didn’t disagree widespread wage struggles are a risk, but he does not believe it will happen. He said there could also be a de-anchoring of long-term inflation expectations, where if people are constantly waiting for prices to go up, they will buy more, creating a spiral. 

“The good news is we have yet to see any evidence of that, and the five-year forward inflation metric has been very well behaved,” he said. 

In terms of making predictions for the rest of the year, Walker asked Karoui what the one data point would tell him things are going to be OK. Karoui said that when it comes to assessing that sort of outlook, he looks at risk and the price of risk. 

The good news, he said, is that over the past two months the price of risk has gone up and the market is paying out better than it has in the last few months. He added that a de-escalation of the war in Ukraine would be positive — from both a human and an economic standpoint — and that inflation remains key. 

“If three, four months from now we're in a situation where everyone becomes confident that actually there is mean reversion in inflation, and if its speed gives enough confidence to the Fed that they can push a soft landing without breaking too much into a system, that would be a very welcome development,” Karoui said. 

On May 18, Walker will interview Sen. Michael Bennet. Register here.

This article was produced in collaboration between Studio B and Walker & Dunlop. Bisnow news staff was not involved in the production of this content.

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