HYH Interview: 2024 and Holiday Season Outlook with RTB

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Before we get into it, in case you missed it, My Merch Site is back!

The Merch store is only live during the holiday season since that’s the busiest shopping season of the year. This is the first year where I’ve really built out the collection. There’s a lot of different Mugs and this is the first year where there’s Hats and Fitted Shirts.

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Today, we’ve got an interview with the anonymous FinTwit Equity Investor known as Raising the Bar (RTB). RTB loves talking markets and was down to come back for round 2 after our discussion last year. Our conversations are always entertaining and cover a lot of ground, so I was pumped to set up another interview.

We covered a lot of different topics within the newsletter - from the economy in general, to the holiday season, the energy market, and the “strong” consumer. You can follow RTB on Twitter here.

Here’s our conversation below:

1) Let's start with the Consumer - How strong is the Consumer?

My view is the bifurcation between the European consumer, Asia consumer, and US consumer continues to be wide given biased international economies to the goods > services market. This is largely because GDP is less driven by the sale of products so there's less direct impact on the US consumer if the goods market mean reverts to the backend of covid. That said I think we see incremental US consumer weakness into the winter and 2024 but not an outright collapse unless the labor market truly turns. Which is to say there's a high relative preference for US facing consumer companies going forward but are maybe not necessarily a good absolute long because of likely relative weakness and they've been pretty resilient so far. Not really sure if there's a trading opportunity on this as any incremental weakness will likely come from the US consumer on just a very difficult services compare into mid-2024, but I think any notable rollover would be related to the employment cycle turning.

2) What's the outlook look like for the Consumer this holiday season? A lot of big ticket or discretionary retail is in the dumps - but a bunch of other pockets of retail seem to be holding up. Q4 aka the Holiday Season is a massive cash flow generation period for retailers - are retailers going to get a lump of coal?

My view is holiday season sales are probably not terrible but likely subseasonal with incremental weakness as we get later into 4Q. This is against a backdrop of elevated inventory across the chain. Which is to say my holiday season view is actually a SUPPLY view and not a DEMAND view. Lead times collapsed in 2024 leading to elevated inventory and it's likely co's will be left with too much inventory too soon and demand, while not necessarily outright weak, will be weaker than expected. Some consumer co's are pointing to declining inventory but I question how much of that is a result of high cost freight and input costs (there is a lagged flow of inventory from procurement till ultimate sale) versus true declines in product units held on retail and goods companies' balance sheets. My thought is this leads to an acceleration of promotional activity through the holiday season as inventory units track above expectations. Why hasn't this happened yet? Well, the holiday is seasonally strong and that's a chance to clear inventory and "true up" your inventory so to speak with a lot of potential real time price elasticity to help normalize inventory as we see the levels of black friday and holiday season demand. Thus no one has yet had an "oh shit" moment and felt the need to try to aggressively flush excess inventory due to the impression there would be a large spike in demand exiting the year.

The more important question I think for the retail space is what does inventory look like after the holiday season as any subsequent designer t-shirt and blue-tooth enabled toaster glut could easily spiral into the greatest promotional activity we've seen in our lifetimes (!!!). And thus leads to the final mean reversion in 1H24 to pre-covid margins for the entire goods space as names that picked up massive margin gains relative to precovid on aggressive pricing vs fixed operating leverage mean revert. Thus we finally complete the stupidity circle that was the covid impulse (thank god).

3) Thoughts so far on an interesting earnings season? Any trends or interesting statements made by my companies stand out to you?

Expectations are low for anything cyclically exposed and cuts get bought in anything that doesn't grossly underperform low expectations or you can argue is at or near "trough" EPS. Anything viewed as defensive, able to grow, or is expected to see topline accelerate in a weak macro backdrop aka software and many of these rates proxies, is immediately eviscerated as valuation derates to a more intuitive multiple given the rates backdrop. The key focus this earnings season is "reversion to the mean" which is to say a miss or beat on results is a reason for an illogically priced company to derate or rerate to closer to its intrinsic multiple violently. You've seen this in perceived compounders or growth stocks that trade a very elevated multiples despite their implicit multiple based on long-term growth trends being much lower. This is to say you now need to essentially backsolve to a multiple that gets you to a 12 to 15% unlevered return on enterprise value (aka unlevered free cash flow divided by enterprise value plus revenue or EBITDA growth) versus a 7 to 10% unlevered return on enterprise value in a ZIRP world.

4) Views on the Magnificent 7 carrying the market and the sustainability?

Large cap GARP beta in secular growth industries at justifiable valuations should outperform materially in a down or sideways market. This is further helped by duration beta if rates do worse in a recession. These stocks are relatively cheap all else equal, although they are closer to the higher end of multiples versus precovid so some caution is warranted. That said if we're entering a new bull flattening market regime, aka growth expectations down with still relatively elevated inflation, and growth expectations normalize from high levels it creates lower discount rates on long-duration cash flows, or those things we call compoundoooooors, and should lead to relative outperformance.

I caveat that NVDA and TSLA are two that stand out as at risk within the group, but in reality the future of everyone's retirement and the state of the world financial system as we know it only really cares about FAAMG at the end of the day. So any other name that gets grouped in with them is probably going to die a horrific death at some point as has been the case for the last 2 decades. 'member FAAMNG wen Netflix was a compounder? Lol. Lmao. Hahahaha. Not but ironically Netflix is so back so who am I to poke fun at them

5) We've hiked quite significantly over the past 20 months - how do you think the Fed has done? I'm still ticked at them for frankly moving too slowly early on. I don't think they're necessarily reaching their desired impact because 1) large corporate borrowers figured out their debt maturity profile quite well when rates in '21 were miniscule and 2) we created crazy housing illiquidity in some markets due to a bunch of people sitting on insanely low mortgage rates that they won't sell/move out of unless things look really bad.

I have a somewhat unique take on that because the fed either doesn't have or hasn't acted on any of its true short term transmission mechanisms for rates to flow to the economy, nothing the fed has done has affected really anything so far on such a macro level that it resulted in notable slowing. And by that I mean that the last 2 year narrative has just been the fed pandering to the inflation zeitgeist to some extent. In reality, what happened was we had a supply side shock through a covid destocking event as we shut down the global economy, then a massive reverse bullwhip effect into late 2020 when stimulus caused massive outsized demand and above trend growth on the backend resulting in unconstrained pricing power for every goods company globally due to long lead times and supply chain snarls which caused a large inflation in input costs and end goods pricing. Lead times, excess savings and stimulus are now normalizing which means we're mean reverting. You layer on a global energy crisis when Russia invaded Ukraine and that caused the "inflation supercycle" zeitgeist off 2022 and 2023.

Which leads back to the irony of the Fed. Consumer financing rates ex home and auto lending are already hilariously expensive on credit spreads that moving 400bp higher has a relatively inelastic shift in consumption on things like credit cards etc. Mortgages in the US meanwhile are fixed so there's no cash drag on households in the same way there was during the financial crisis or in other more floating rate markets. The only way for the fed to actually hurt the economy in reality is to raise rates to either blowup housing, blowup the stock market and cause a massive wealth effect impulse on the consumer, or blowup the banking system and materially slow lending activity and access to capital. Ironically we got the last one but the fed blinked with the BTFP program and solved the entire duration issue overnight for the potential bank-flow fed transmission mechanism

Also another fun fact: Fed tightening raised a lot of S&P EPS because of the amount of net cash and higher short end rates these co's hold on their balance sheet.... whoopsie!

NOW if we think about the medium term... tightening cycle probably blew up the economy as we slowed investment, and blew up a bunch of sectors with material financing needs (real estate, cable, utilities, parts of healthcare, companies that finance at prime rates, banks paying cash on deposits versus fixed lending with now negative NIMs) and materially impeded the consumers' access to affordable lending for asset-backed loans aka housing. Looking forward corporates rolling debt at 2% debt to 7% over the next 3 years with every PE portfolio company having issues because of too much floating debt use on the backend is also going to be a spectacle to watch unfold over the next few years barring a massive cutting cycle.

6) How are we with Inflation - are we getting below 3% soon and are we done hiking? I agree with the Hatzius thinking that the Fed will be okay with 2.8% inflation vs. getting all the way down to 2%.

Trend is now 3% ex-cyclicality until we have a massive recession and unemployment cycle. Inflation isn't inflation until everyone knows its inflation which means inflation so you need more wages to inflate away the inflation and help fight the inflation (!!!).

This is precisely why there was no inflation after the financial crisis. Massive deflationary bust - everyone knew that everyone knew there is no inflation. No one is asking to take price nor are consumers worried about inflation. The name of the game is deflation. Inflation? Ha!

These both are to say once something's in the zeitgeist you cannot get it out of the zeitgeist without a visceral and violent catalyst to shift perception around an inherently reflexive way of thinking about inflation and deflation. What did that post covid? Russia invading Ukraine. Literally every single company then used that as an overt excuse to push price and it caused a pseudo-wage price spiral that's now culminating with a likely loss of pricing power, aka margins down, after deflation padded margins through the first 3 quarters of 2023 and excess demand allowed taking price in 2022. Now prices are coming down with weaker demand as they track input costs with a lag and we're seeing goods prices normalize.

BUT that doesn't mean services normalize. You can't cut wages. And everyone knows there's inflation! You try to tell someone who KNOWS that there is inflation that there is, in fact, actually deflation and they don't deserve a massive wage hike to fight the inflation? Good luck... hence ye olde adage that inflation is sticky as the cool economists in the ivory towers say.

Hiking question we're probably done but you need to see an unemployment cycle crack and Powell remains "data dependent" so it truly does depend on the data which everyone for some reason doesn't seem to understand after he's said that ***checks notes*** 50,000 times since 2022.

7) Layoffs haven't been super widespread - it's just been Tech and then Banking resuming ~5% headcount reductions - but Layoffs in the Finance industry and Fortune 500s typically seem to be all over headlines from November-February in conjunction with year budgeting/bonuses - where do you think unemployment is heading?

The next 6 months are very key as corporates will be conservative with their budgeting processes into 2024 given the uncertain backdrop and recent bout of macro weakness. If 4Q and the start of 2024 show continued issues in the economy and businesses lose the pricing power they've seen and been able to leverage on a relatively fixed operating cost basis, that's the environment where you likely see layoffs start more massively in early 2024. We've already theoretically started to see some weakness in the SMB and single-employee economy that hasn't necessarily flowed through the data yet but if these cracks widen with weakness expanding to larger businesses and showing up in higher frequency data like jobless claims and NFP we can very quickly see the employment cycle deterioration quickly accelerate.

8) Do you buy into AI as an immediate game changer? I buy into AI as a tool for the most talented workers to use but think we're a while off from making it a useful, trustworthy, and secure tool.

Real answer: who knows. RTB answer: cool narrative bro, now show me the AI software MONEY

There will be use cases where it makes sense but I don't understand the current arms race for capacity nor the profitable use case, nor am I a software galaxy brain guy so this really is not my place to comment.

9) How about energy? How's your outlook on oil looking given geopolitical volatility? How's your outlook on nat gas going into winter?

Oil fundamentally is tricky as you're seeing early-stage signs of demand weakness as gasoline cracks collapsed during the end of seasonal driving in the US in September, and there's been some recent rumblings of falling disty demand given weakening macro backdrop. That said there is now a very large geopolitical premium priced into oil given the tragic events in Israel. Inventories also remain in a bad spot in the US albeit less terrible globally. I think oil is generally very difficult to call right now given a very wingy type return distribution to the upside and downside, so I think fundamentals are mixed to slightly negative but there's big upside risk on a supply shock. Playing the space through downside to crack spreads in a macro or oil supply shock type situation is probably the easiest directional fundamental view you can put on here if you have to take a view.

S/D dynamics in the US on gas are relatively fine though we still see slightly elevated inventory into winter. The real issue is that European gas inventories are >99.5% entering winter which is the highest ever, there's continued demand weakness on industrial utilization lost during 2021 and 2022 that likely never comes back and it remains the dumping group for LNG. That said prices have hung in very well which you wouldn't expect.

The big overhang in my mind is that given it's an El Nino year which historically averages above seasonal warmth in the northern hemisphere the setup into post-winter and summer 2024 is very poor for the global LNG market and realistically if the global LNG market implodes US exports are cutoff and you see Henry Hub inventory backfill so it's truly a global market at this point. You need a global cold snap to avoid this outcome in my mind which is statistically less likely given El Nino but it's the weather so anything can happen and that's what makes the natty market fun fun fun!

There is one caveat in terms of there have been rumblings of sanctions on Russia's LNG exports but I think that's a very difficult argument to make given the zeitgeist is that Europe's entire citizen base is still going to die this winter because they don't have heating fuel so the political will to do this is probably not there so it's simply a risk to watch going forward

10) Ozempic discourse has gotten wild, apparently, it's going to reduce broad-based demand among sweets and treats. What's your take? Was the sell-side just pre-earnings szn bored?

Real answer: Who knows. RTB Answer: I'ts a convenient narrative to justify weakness in consumer-facing companies coming at precisely the correct time in the cycle. Much of the price action you've seen in many of these GLP1 losers coincided with a backdrop of mispriced valuation or slowing fundamentals so I think outside of some one-offs where there's a true and measurable near-term business disruption this was just a catalyst for a derate in many of these names.

11) Curious in general your thoughts on EVs - whether you think OEMs and new entrants are screwed playing catchup to Tesla, whether we have and will have the infrastructure needed to support increased EV adoption, whether you think EVs are going to upend the aftermarket repair or oil change market, and whether in general, you find EV adoption estimates to overstated, understated, or just right.

Real answer: Who knows. RTB Answer: Auto market is slowing and EVs specifically have outsized exposure to China, with Tesla price cuts coming back to the retail theme of covid pricing power being vaporized before our eyes. There's such a massive base of ICE autos out there that will be driving for many more years that even if 25% plus of new vehicle sales are EVs there's marginal impact on demand in the near term. Realistically better MPG in ICE vehicles is a bigger driver of declines in gasoline demand near-term more so than anything so even energy markets are a big question.

I think the EV theme with suppliers and input producers like lithium is a very good idiosyncratic trade going forward but it's not going to change the fact that the auto market is very cyclical, there will be massive corrections and its a GDP driven market at the end of the day regardless of how the OEMs are jockeying for share. Then any business catering to an electric grid buildout probably gets murdered on rates and slowing investment at utes and the lagged ability to get rate cases done due to it just being a lengthy process, so against this backdrop so not really sure there's anything exciting to do in this space right now.

12) How are you thinking about credit? Ik you're more equity focused, but know you've spent some time looking at HY paper/special sits. Curious on any thoughts from the HY/Loan ecosystem, to T-Bills/Treasuries, and/or the Golden Age of Private Credit.

Credit is a strange place because it's primarily commodity producers, banks, consumer cyclicals like retail, secular decliners with lots of debt that trade at elevated multiples like media or companies that just get murdered by higher rates and the need to invest a lot of debt-funded capex like cable & telco. The fundamental backdrop for most of these types of companies is no bueno and I don't find the equities compelling with credit risk also difficult to stomach given balance sheet debt on many of these is just outright high with massive macro uncertainty.

That said commodity producers seem like the most exciting part of the credit world as they've generated such massive profit windfalls over the last 4 years that their balance sheets are essentially fixed and investors still give them a massive credit risk premium because everyone got their faces ripped off on commodity producer exposure from 2010 until 2020. If we're talking about 8% plus type yield in their debt with clean balance sheets, that's a very exciting prospect, especially with low leverage and mature assets that will have solid free cash flow even if you assume the world economy blows up and we're back to a $50 oil, $2 gas, $2.50 copper, $60 iron, $500 HRC type pricing environment.

Outside of that most of the credit space seems difficult outside of non-cyclical IG or high-yield type names.

I'd caveat that inflows will likely really pickup at a point given real money like insurance and pensions have definitive hurdle rates. So if you can get your previous 6% or 7% "equity return" in a fixed income asset that has 20% of equity vol and cash flows it makes owning equities as an asset class much more unappealing in a post ZIRP world barring a rapid return to 0% rates. Even then your explicit duration risk taken through fixed income means if we DO see us fall back to ZIRP... well you're getting 20 or 30% mark to market return on your 10y duration risk plus coupons so high quality fixed income has to be competing for bigger allocations right now.

13) The noise post-regional bank failures has largely cooled down after a chaotic Spring - do you think we may see trouble again with the regional banks in '24?

Fed waved their magic wand with the BTFP facility and solved all the issues related to liquidity more or less. Aka unless we see a massive recession where defaults skyrocket I think most of the existential issues are resolved. I'm not a bank guy so I'll leave it at that and am probably wrong.

14) Is DJ D-Sol giving up DJ-ing the bottom for M&A activity?

He's planning his next venture because it's a conflict of interest... Wen boutique DJ investment bank DJ-Sol Cap?

15) What's your most middle of the fairway call?

Large-cap healthcare and likely medtech will be the best performing sector in 2024 given implicit duration beta but no fundamental duration exposure aka capex financing needs like utilities, REITs, cable or customer financing needs like auto, home lending. A supportive slowing macro backdrop with potentially lower or least stabilizing rates also creates room for sector to rerate after trading terribly for the last 2 years.

16) What's your craziest call?

The renewables sector just had its 2014 shale moment and is in for a decade of pain, sadness and downside just like energy a decade ago.

17) Thanks for answering my all-over-the-place questions - what's your closing thoughts for the HYH newsletter readers?

Never forget the entire equity game is just really betting a number on a screen will go up or down because reasons that may or may not make sense. If you always remember this you'll really save yourself a lot of brain damage (I sometimes forget this as well!)

Thanks RTB!

On that note, I wanted to call out that I’m interested in connecting with any Private Equity Associates/Senior Associates or Direct Lending Professionals (Associate and up) who want to talk about their recruiting processes and what they’ve learned along the way. Please DM me if interested.

That’s all for this newsletter!

Until next time!

Best,

HYH