Current Macro and Credit Market Outlook with Goldman Sachs' Lotfi Karoui

Colbert Cannon: Hello and welcome back to season 11 of the HPScast. I’m your host, Colbert Cannon. If you’re new to the pod, HPS is a global investment firm that manages approximately $150 billion dollars in assets. That capital is invested across private credit and public credit strategies.

This week, we have a special episode featuring Lotfi Karoui, Chief Credit Strategist and Head of Credit and Mortgage Strategy Research at Goldman Sachs. Lotfi is responsible for research and views on global credit markets, and his research spans fixed income markets, interest rate models and macro-finance. Recently, he joined us at an HPS event to discuss his macro and credit market outlook, and we’ve edited a portion of it for you.

So now, I’ll turn it over to Lotfi.

Lotfi Karoui: Obviously, we’re entering a new phase in the cycle. The Fed has started, officially, the cutting cycle. And then, more importantly, in my view, actually, what we discovered about a month ago or a couple weeks ago is that the Fed’s reaction function has shifted, right?

There’s a lot more sensitivity to downside surprises and growth, much less sensitivity to upside surprises and inflation. And that’s really what the market loved. And so what I’m going to try to do is really walk you through the implications of that shift, across markets, fundamentals, defaults, and then really talk a little bit about what could go wrong.

So, what are the questions that I’m looking to address here? Number one. The market impact, how much is in the price, not just in the rates market, but also in credit, and how to really position for this positive interaction between easier monetary policy on the one hand, and then a cycle that we think will, you know, continue to survive over the next couple of years.

And so soft landing versus Fed cuts, how much is in the price, and how much upside can be captured within corporate credit. The second question is the fundamental impact. There’s a lot of talk about lower rates and, and what that could do to the low end of the quality spectrum, but how much should we expect in terms of a reprieve, particularly, you know, for the CCC bucket?

The third question is the impact on defaults and LMEs. I’ll walk you through what the historical evidence says about these repeat, sort of, LMEs or distressed exchanges, flows and technicals.

A question I get all the time is we have almost $7 trillion of AUM in money market funds. The Fed is cutting. Are we supposed to see a rotation away from that front end of the curve into duration, investment grade, high yield, bank loans, etcetera? And again, I’m going to try to focus on the historical precedent and what we can learn from that.

And then lastly, I will conclude with the risks. What could go wrong? It feels like, you know, a lot is in the price already, but what are the areas that we’re focused on from a macro standpoint?

So let me start with the Fed. The Fed’s job is to try to go back to a level of Fed funds rates that is consistent with an economy that’s growing either at trend or below trend. If you go back to the history of the last 40 years, that’s never been done.

I mean, the only precedent that I can think of is actually 1995, and even then, the Fed cut by 75 basis points. And so, the magnitude of the cuts that were delivered were actually very small relative to what will probably be delivered over the next couple quarters. But what we think will happen is the Fed will probably take rates to the vicinity of maybe 3-3.25%.

The market is pricing in something a little lower than that, but we’re not going back all the way to zero, in my opinion. And so, that is a very important nuance to keep in mind. What that also tells you is that relative to the post global financial crisis period, the level of policy rates will settle at a higher equilibrium.

But if you go back further, to the 90s or the 2000s, actually, Fed Funds rates will likely be lower. And so, I know that there’s a sentence that’s been used ad nauseum, which is higher for longer. And I really like that phrasing, actually, to begin with, because it’s higher for longer if you were born in 2010. But if you’re a student of history, or if you were born prior to that, actually what’s happening now is that rates are no longer low. That is really the adjustment. And so, we’ve been there many times before in my opinion.

Now, what does that mean for credit? A lot is in the price, unfortunately. So, I’ll take the BB high yield index as an example. If you looked at the history from 2000 to today, you’re basically at the third percentile range. So, in other words, you traded tighter than today’s levels 3% of the time over the past 24 years. And so, there is negative convexity if you look at spreads. And I think what that tells you is that the market has already embraced the view that we are in some kind of a no landing or soft landing.

And that everything the Fed will do is sort of validating what’s in the price already. And so, at the index level, I don’t see an obvious pocket of convexity here, maybe with the exception of CMBS, and by the way, spreads are there wide for a variety of reasons. And so there’s premium, but you have to be very careful with that.

And so, what won’t change in my view, is the fact that carry will continue to be the dominant component of excess returns. It hasn’t really felt like that year to date, but if you take your standard IG or high yield indices and you kind of decompose your year to date excess return into a carry component and a spread compression component, actually what’s been happening the last couple months is that carry component is gradually gaining the upper hand, and if everything goes according to plan, I think we’ll eventually converge to a state of the world where carry becomes the dominant component of your excess return. So, that’s my baseline view, which is we stay in the no landing or soft landing, and that makes coupon payments the dominant component of returns at the index level.

Now, it gets more interesting underneath the surface. You know, people complain all the time about tight spreads, tight spreads, tight spreads. That is all true, but I think we should look at the left tail of the distribution in the high yield bond market.

Up until recently, high yield dispersion was basically at recession levels, while in IG it was very compressed. And so, through this period of, sort of, tighter monetary conditions, what the high yield market did, it completely isolated the left tail and treated it as if it was basically in financial distress. And so, the high yield market for the last two years has been the story of the haves and the have nots. If you’re BB or B rated, you did fine. The minute you dip below that threshold, it felt a little ugly, and that’s what drove dispersion basically through the roof.

Now, interestingly, over the last month and a half, things have started to change, basically. Dispersion is coming down. A lot of that is driven by your TMT (Technology, Media and Communications) sector. Obviously, there’s a lot of excitement vis a vis the role that some of the wired lines can play in the AI supply chain. But in my view, it’s also a cost of capital story. I think if you zoom in on that, sort of, low end of the quality spectrum in the high yield bond market, what you see immediately is that there’s a lot of sensitivity to the level of finite rates.

There’s a big chunk of those capital structures that have actually had a lot of leverage loans in them. So, if you push basically the floating rate component down, they benefit mechanically.

And then more importantly, the market never really bought the idea that, you know, the economy can withstand the massive amount of tightening that we’ve seen. Now, that risk premium should compress a little bit. So, my expectation is nothing changes at the index level. When you scratch the surface, that dispersion has room to come down quite a lot.

Now, that’s not a macro trade, just to be clear. That is a name picking game, basically. That’s a bottom-up trade out there because there’s no index that you can buy that would allow you to capture that decline in dispersion. It’s really your ability to pick winners and losers in a world where the cycle survives, and the Fed, sort of, continued to gradually bring back the level of Fed funds rates to that long run equilibrium level.

Next question: what does that mean from a fundamental standpoint? I’m going to talk about the BSL and the high yield bond market.

So, one thing I would say is that going into the hiking cycle, the BSL market was in a weak position, at least relative to the high yield bond market. So, what you see is time series of the weighted average rating factor in the high yield bond market and the BSL market – when it goes up, that means quality is lower. When it goes down, that means quality is higher. And in 2020, for the first time in a long time, the average rating of the high yield bond market was actually higher than the BSL market, which is very counterintuitive. You’d think the BSL market is senior secured, the bulk of the high yield bond market is unsecured – it should be the other way around. A lot of that, I think, reflected the fact that we had a big wave of fallen angels in 2020 that added a lot of quality to the high yield bond market. The BSL market didn’t really benefit from that wave of fallen angels.

But what I found really interesting now is that a big chunk of that gap has closed. And so, very surprisingly, the BSL market has done a really nice job digesting, basically, what has been one of the most aggressive and front-loaded hiking cycles that we’ve seen pretty much since the onset of the great moderation in the mid-eighties. And so, good job for the BSL market.

What do I think will happen next? Well, one point I would make is that a lot of easing has been delivered already.

If you look at 2024, we’ve repriced 30% of the BSL market year to date, basically. Every single one of those repricing transactions, on average, translated into 50 basis points of a coupon reduction for the issuers. And so, in other words, investors gave borrowers the equivalent of two cuts even before the Fed started to deliver those cuts. And so, to me, this is good news. That’s how monetary policy is supposed to work, but there’s quite a lot of easing that’s, sort of, found its way into the system.

You know, the other interesting fact here is that 2024 is on track for the second busiest year ever for repricing volumes after 2017. 2017 was also interesting. It was a year where the market capitulated to a soft landing after a very difficult 2015 and 2016. The other piece of evidence that the financing environment has been very healthy in the BSL market is actually the composition of supply, but look at the share of refinancing – highest ever share of LBOs, M&As are the lowest ever. And so, this is a market that’s still very much focused on extending maturities, minimizing interest expenses, fixing the balance sheet as opposed to adding leverage. That’s a good story if you’re an investor. Basically, it tells you that the mindset among the majority of management is still actually on the conservative side, at least from the perspective of a creditor.

You know, same thing in the CLO market. I would argue that the fact that we’ve seen a record high share of resets and refis in the CLO market is somewhat evidence that easing has also found its way on the structured side too. CLO managers have been able to add a lot of quality to their portfolios by doing these resets and refi transactions, and that’s a positive and healthy development in my view.

Now, what lies ahead? About 70% of the BSL market is loan only capital structures. That was very problematic about a year ago when the Fed was adding, basically, jumbo hikes every FOMC meeting. But now that headwind is actually turning into a tailwind because those loan-only capital structures, you know, if you think about their cost of capital and cost of debt more specifically, there’s a mechanical relationship between that cost and the level of Fed funds raised.

And so, what was a pretty strong headwind for two years is about to turn into a tailwind now. And I think, from a fundamental standpoint at least, the fact that a big chunk of the loan market is loan-only capital structures is, in some ways, good news.

What about the bond market? Well, I would say the bond market has been even more forward looking than the loan market. So, the easing is done basically. And the reason I think most of the easing is now behind us in the bond market – and I’m really talking about the performing bond market, so your B or BB capital structures – because the path of least resistance for the cuts is for a steeper yield curve, right? If you think the terminal value of Fed Fund rates is going to be around 3, 3.25%, and you add 75 to 100 basis points of risk premium to hold duration, then the long-run equilibrium level of your 10-year yield is probably around 4%, maybe 3.25%, which is exactly where we are today. And so, I don’t think it’s reasonable to expect intermediate, long-dated yields to further decline as the Fed delivers the cuts.

The job of the Fed is just to validate what the market is pricing in today. The market has already incorporated that information. Refinancing penalty is basically zero today for BB and B issuers. And so, to me, that settles the maturity wall debate, at least for 90 or 85% of the high yield bond market. Where it’s still complicated is for the CCC part of the market, where that refinancing penalty is still very elevated.

And so, what does that mean? It probably means that these LMEs will remain the path of least resistance for many of these over-leveraged capital structures to find, sort of, a sustainable solution in the long run. But for 80% or 85% of the market, I think we’re, kind of, done, basically.

Now, how much of a relief should we expect basically for CCCs? Again, one way to, sort of, assess that is to break down that CCC bond universe by type of capital structure. And the idea is that hybrid capital structures have more potential to benefit from Fed cuts. Good news, actually. You know, there’s probably 40 or 45% of the CCC universe that has, you know, floating rate component into their liabilities, and hence, is very well positioned to benefit from Fed cuts. And so, you know, I said earlier that dispersion has started to come down, and that CCCs have started to outperform. Well, part of the reason is because their cost of capital has started to decline. And so, people ask me, what’s the trade in high yield? You can be very bearish on fundamentals on the low end, but that’s the trade in my opinion. The trade is really to identify winners and losers in that low-end of the quality spectrum. And it’s pretty much the analog to the rotation in the equity market away from large caps into mid-caps or small caps. It’s exactly the same thing. You’re buying low quality, and you’re buying it because you think the cycle is going to survive, and you think the cost of capital will see a little bit of a relief.

It’s complicated. It’s a bottom-up, basically, story, and so, you, kind of, have to pick the winners and losers. But I think we complained for a very long time that active management, you know, wasn’t in a very good position to outperform because volatility was low, dispersion was actually very low and depressed for a long time. We’re not in that environment today, and so, to me, that’s really the biggest implication of the upcoming cuts, that it allows, basically, active management to showcase its capabilities in terms of alpha generation.

What does this mean for defaults? I will start by saying that this was the default cycle that never was. So, we never had really a default cycle to begin with. In my view, it’s been incredibly gentle, depending on your definition of a default event. Defaults have been very bifurcated. If you include distrust exchanges, defaults went up a little bit. If you don’t include distrust exchanges, it’s as if nothing happened, basically. Defaults stayed at rock bottom levels.

You know, we didn’t really see the wave of, like, pre-packaged restructurings or Chapter 11 or, you know, in-court restructurings. Most of it has been dealt with out of court, and it was largely concentrated among small firms as opposed to larger firms. There’s a reason for that. The bigger you are, the more operational flexibility you have, the more financial agility you have. And so, the hiking cycle, kind of, weighed more heavily on smaller firms. But, in aggregate, it’s not a big deal.

Flows. This is a big question I get all the time. The Fed is cutting. Is that good or bad for credit? Let’s start with the supply side of that equation before we get into, sort of demand.

Credit and leveraged finance, in particular, has been incredibly well supported on the supply side the last two years. If you look at the high yield bond market, it shrunk by 20% from its peak basically in mid-2022. The BSL loan market has been on a flat trajectory since, also, mid-2022. I mean, net supply has been slightly negative.

And so, when the market shrinks, when the bond basically dies naturally, there’s no ownership transfer, and that’s been an incredible technical tailwind to the market. Is that going to change? Probably not, in my view, unless you think the Fed is taking rates back to where they were pre-COVID, post GFC. But if the cost of capital is going to settle at a level that is somewhere between what we had pre-GFC and post-GFC, then I would argue that creates some pretty strong incentives on the borrower side to continue to manage debt capital, conservatively. And so, I don’t think it’s reasonable to expect debt markets to grow at the type of levels that we had from 2010- 2019 for one simple reason: capital was quasi free back then. It’s not anymore.

And so, the biggest shift I think that’s happening now is really on the supply side, where you’re creating much stronger incentives to manage capital conservatively. And I think, you know, naively, if I think about it, if you look at percentage growth of all of credit – public, private, IG and high yield – and compare that to nominal GDP growth, I think the annual percentage growth in debt markets will probably never exceed, basically, nominal GDP growth again, which is a mirror image of what we had from 2010 to 2019 where corporate America went on this crazy, basically, re-leveraging path. That is unlikely to happen, you know, in my view, in this cycle, unless we’re all wrong, basically, and the Fed has taken rates back to where they were post-GFC. And so, that is really key because you will live in a world where net supply is very much constrained. Demand is always a more difficult beast to, kind of, forecast.

I will tell you, most clients do ask me, when are we going to see the start of a rotation away from money market funds into other things? Money market funds are sitting on almost $7 trillion of assets, which is completely unprecedented. My view is don’t hold your breath, really, because the Fed is not killing, basically, the value proposition of the front end. You’re still being paid. Like, if we’re having this conversation a year from now, the odds are very high that you’re still getting paid 3%, maybe 3.25%, to take absolutely no risk. And so, to me, if you flip that argument and think about it in terms of a portfolio construction standpoint, the risk-free asset is back in the game, basically. You know, that degree of freedom that you, sort of, lost for over a decade is now back into the game. And so, I don’t think it’s reasonable to expect a big decline in the AUM in money market funds.

With the caveat that we’re really in uncharted territory, and there’s no precedent to what the Fed is trying to do this time around, but for what it’s worth, if you go back to the mid-1980s and try to look at the relationship between flows into money market funds and the level of Fed Funds rates – leaving aside basically cases where the Fed cut rates in response to recessions and so it literally basically took rates back to zero – if you look at the mid-1990s, which I think is the closest you can get to the current environment, you didn’t really see a big rotation out of money market funds. You saw a little bit of a softening but no big rotation. So, to me, I think it’s reasonable to expect a deceleration in the base of flows into money market funds, but a big rotation remains unlikely in my opinion.

What does it mean for the demand for bank loans relative to bonds? Common wisdom would tell you own fixed rate structures, but I think you have to be a little bit more careful and more thoughtful about it. It’s not just about the carry duration trade off. I would probably note that we had a period of pretty significant outflows from bank loan funds, mostly ETFs. That seems to have stabilized, and so, my guess is that a lot of people probably did the work and looked at where the front end is, and how much excess carry you are getting versus bonds, and they figured out that, you know what, this may not be that bad after all. And so, I think, you know, it’s unlikely that you’ll see a surge in inflows into anything that floats, but again, just like I’m skeptical vis a vis, sort of, the prospect of a big rotation out of money market funds, I’m also skeptical that the cuts will kind of, completely reduce the value proposition of bank loans.

Risks. We didn’t talk about the election. Look, I would say the bid ask between, sort of, the various outcomes is a lot narrower this time around than it was in 2016, but I do worry about the deficit. I mean, it’s kind of striking to me that when you compare all the various combinations – blue wave, red wave, or some kind of a divided government – they all lead you to the same path, which is a wider deficit. At some point, the market will start pushing back if we don’t fix it. And so this may not feel like October 2022 in the UK, where you really don’t have an analog to, sort of, the LDI channel in the US, but this is unsustainable, basically. And at some point, we need to, sort of, take care of it.

I will tell you, I’ve been covering fixed income markets for almost two decades. I don’t remember the last time we were paying attention to treasury auctions. We’re treating them basically like an IG syndicated deal a little bit. And now we’re saying, okay, this auction went well, this didn’t go that well, but that already tells you that the market has, sort of, incorporated a little bit of a fiscal premium in the back end, and we need to get out of this, basically. But the deficit situation is a little bit concerning in my view.

The biggest risk is that we get a duration shock come November. That’s problematic on many accounts because it would flip the correlation between spreads and rates into positive territory again. So, double whammy – higher rates, wider spreads. And then it would put the Fed in an incredibly difficult position. They’re trying to ease, but if you stimulate an economy that’s already at full employment, you force them to lean against that a little bit. And so, I think it would get us to a much more complicated environment.

Somewhat related to that, I think this is the second risk that I would highlight is just plain vanilla garden variety growth risks. But it could well be that we’ve underestimated how much hidden weakness there is in the economy, particularly in the labor market. We’re not immune from another growth scare in my view.

One thing that caught my attention is the fact that, again, if you go back the last couple of years, this environment took a far heavier toll on high yield firms relative to their IG counterparts. And I think it’s a size, sort of, issue a little bit. High yield firms have depleted their excess or liquidity positions a lot faster than their IG counterparts. And so, one way they dealt with rising input costs – wage inflation, et cetera – is by spending more and using more aggressively their excess savings.

Margins have been contracting in the high yield market at a much faster pace than in IG. In fact, in IG, they’ve been expanding, I mean, which is the same message that you see when you look at the S& P 500, which is amazing, by the way, because a lot of people were very concerned about margins about a year ago, two years ago. S& P 500 companies have done really an amazing job expanding those margins. You don’t see that when you look at high yield, or Russell, or mid-caps. It looks a lot more fragile than that. That needs to correct in my opinion, and if it doesn’t, the obvious way to protect your margins is to cut the the workforce, basically.

That’s the path of least resistance. Keep in mind that three-quarters of the labor force in the U. S. is not in the S& P 500. It’s basically small businesses – small caps and mid-caps. And so, this sort of margin erosion, I think, needs to end at some point.

Colbert Cannon: There you go – a macro and credit outlook from Lotfi Karoui, Chief Credit Strategist and Head of Credit and Mortgage Strategy Research at Goldman Sachs. We thank him for joining us and allowing us to share his thoughts on the HPScast. And thanks to all of you for listening.

This podcast was brought to you by At Will Medi with HPS Investment Partners. Please be sure to rate, review and subscribe on Apple podcasts or wherever you like to listen.