HYH Interview: Deflation & Recessions With RTB

Hey everyone,

Welcome back and thanks for tuning in.

I’m excited to announce a new segment that should significantly differentiate this newsletter from other FinMeme newsletters:

On a go-forward basis, I plan to interview an anon FinTwit/FinMeme account once every 1-2 months to get their sharp takes on actionable market topics. I’ve realized from being on FinTwit that’s there a ton of super smart people behind anonymous accounts. You truly never know whether an Anon account with a cartoon profile and 35 followers is a Wall Street legend/multi-millionaire. I want to start picking their brains and give them a channel to provide value.

I personally HATE podcasts – they’re too long and it becomes a bunch of bros just shooting the shit vs. getting to the point. That may be a controversial take, but time is a valuable commodity and I’d rather digest something just as informative in 10-20 minutes instead of in an hour. So these interviews are going to serve as an antithesis to a podcast – direct, to the point, tackling something important in every question, and providing clear, concise takeaways rather than jumping all over the place. With that said, I like Odd Lots, and enjoy listening to Joe and Tracy. Secondly, I like Vital Dawn, run by Adam Crisafulli (who led market intelligence commentary at JPM for 10+ years), who gives equity market previews every morning before the bell in less than 5 minutes. These are really the only podcasts I will listen to at least once every few weeks. Beyond that, I recommend utilizing the sell-side research reports you may get and see which ones help you the most.

Among the many smart people on FinTwit is RTB, aka RaisingTheBar47, who I obviously recommend following. RTB tweets out Macro views, opinions on Energy (Oil/Nat Gas/Refiners), classic NYC finance bro culture tweets, and mocks “Tech Stock Ponzis”. Of course, RTB notes that his tweets are “not investment advice” and “I’m an idiot”.

So today, RTB and I are going to dive into whether deflation is coming in 2023, the Fed, and the energy markets. Disclaimer – RTB notes he changes his views frequently, and more importantly this is not legal or financial advice of any kind, these are opinions from two anonymous idiots shooting the shit. Nothing contained within the newsletter should be understood as investment or financial advice.

RTB Interview:

1) Let’s start with the million-dollar question – in 2023 will inflation finally prove to be transitory??

My view here is that inflation may be structurally higher on a trending basis (e.g. 3% annual vs 2% annual pre-covid) as we do have structurally tight S/D in many commodity products and the labor force saw some declines from covid retirees. That said, I think we likely see trending lower or possibly negative headline CPI at some point mid-23 due to deflationary recession impulses (higher discounting, elevated good inventory), difficult compares for food and energy (e.g. $140 oil, $300 TTF, $400 Newcastle, >$50 crack spreads) and the lagged housing price flow to OER (6-9 months).

Remember how we got here - there was a large macro growth shock (covid) that led to companies expecting a downturn and right sizing inventory / capacity (as is typical in a recession). Through policy tools (stimulus checks and monetary policy induced wealth effects e.g. yolo options up 10x = an upside demand impulse for goods) we had the greatest cyclical recovery of the modern era, which had the nasty effect of causing a global reverse bullwhip effect as it created a massive inventory restocking impulse for goods as businesses chased this artificially induced demand.

This massive demand impulse to try to normalize global goods inventories led to effectively supply chains breaking (shipping rates and lead times stratospheric), non-commodity goods saw a large upside swing in pricing (semis, retail goods etc) and commodities had an S/D dislocation due underinvestment and the knock-on effects of commodity demand due to global growth and stimulus.

Thankfully corporate America and most people are inherently linear thinkers so they over extrapolated this overearning and thus overordered inventory, and we're now set up for a deflationary destocking impulse in many sectors (retail and semis inventory corrections the most prominent examples of this). This happened as mgmt teams and investors focused on t+1 growth rate forecast at x% y/y where x = trend growth instead of focusing on the '19-23 4y CAGR returning to where it was pre-covid (which strips out the overearning and truly returns you to trend).

Further, decomposing various portions of CPI, it's difficult to be constructive on headline prints into mid-2023. Looking at CPI basket items here:

1. Rent + OER = 6-9m lagged change in home prices @ 32% CPI. Summer RE price correction will hit in 1Q-2Q23 which is going to create negative y/y #s.

2. Non-food & energy commodities @ 21% CPI weight = new cars, apparel, used cars, medical commodities etc. These are mostly seeing pullbacks which is going to create negative y/y #s.

3. Energy = gasoline & electricity @ 8% CPI weight. These face nasty comps (e.g. $140 oil and ATH cracks) which is going to create negative y/y #s.

4. Food at home = groceries @ 9% CPI weight. I view these as tracking energy through fertilizer stream (e.g. a nat gas deriv) so likely see negative y/y #s.

I'd also highlight the "shadow energy" impact of 2nd and 3rd order derivative products that have energy input costs that feed into CPI (e.g. things like steel and shipping costs embedded in goods prices are effectively just energy exposures) - CPI as an index tracks crude oil outright fairly closely despite the smaller weighting as a result.

If I'm wrong on this one I'd think it would because OER and rent never came down in CPI #s or oil went to $200 in '23.

2) You tweeted out the belief that when inflation comes down, people may take this as a signal to buy stocks – do you view this moment as a defining shift from testing market lows or “would the dip keep dipping”?

Investors for the past decade have played a riveting game of "don't fight the fed" which has made everyone have performance anxiety on not being positioned for a policy pivot and subsequent meltup. Given this type of muscle memory in most investors (noting people in senior roles probably "bought the f'ing dip" on every pullback 2010 onward) combined with inflation actually slowing it seems like a very powerful narrative to get people back into the market, especially during a lull in fundamental news cycle (e.g. earnings) ahead of 4Q22 earnings and FY23 guidance.

When you dig into a bit more however and assume the age-old "stonks follow numbers" the outlook outside of narrative chasing isn't too compelling. If we assume a typical cyclical recession of ~20% EPS declines in the SPX in '23, estimates still seem broadly elevated. Further, many of the posterchild investment for the 2010s (e.g. software) have never had a true cyclical correction in their current form which could present some left tail risks if we find out many of these business models are much less resilient in a downturn than they guided investors to believe.

So in summary, I think there's a tradeable rally here but still further downside to '23 estimates @ index level which I think needs to rerate before you can call the fundamental bottom.

3) Is the market underappreciating how badly a string of cold weather could impact energy supply? What’s your take on what happens this winter?

I don't view global energy supply as an issue this winter frankly sans a globally synchronized cold winter (possible given La Nina). Even in a high-demand environment however inventories are elevated globally (Europe natty inventory near 5y highs, US @ 5y avg and continuing to accelerate y/y). That said, as the zeitgeist is "Energy Crisis" and Russia headlines have a nasty way of shaking out weak hands.

I'd also call out a number of European-specific issues that are destroying fuel demand here (and thus help offset Russia supply loss) such as shuttering industrial capacity, behavioral changes in consumers due to inflation and concerns about winter fuel.

On the oil side of things, products generally see a strange dynamic where every incremental barrel is basically used to price gouge Europe due to the geopolitical risk premium embedded because of Russia. This has led to huge crack strength up until recently and higher than typical US exports. This is further exacerbated by Euro refiners being overly exposed to EU natty and power costs which takes them way higher on the cost curve than historically (e.g. US takes that volume). Area of point to watch remains China volumes which have recently spiked and coincided with a massive collapse in US crack spreads (indicating a rapidly deteriorating demand market for US products, with distillate the one holding everything together).

4) And structurally beyond winter 2023, how is the world now shaped for energy independence going forward?

There is a huge amount of global LNG capacity coming online in the mid to late 2020s which should help alleviate a large portion of global energy market friction in my view. A majority of that will come from the US which has a structurally advantaged cost basis due to cheap gas, but other nations such as Qatar and Russia similarly are building out this capacity. Generally, natural gas prices the marginal cost of energy through the power and petchem stacks so should continue to converge globally (ex friction costs like liquefication, shipping, etc).

5) Everyone’s been caught offsides occasionally through the back and forth between a bear market and a bear market rally, but are there any particular ways you can infer whether a rally/downturn is about to reverse?

I think picking up knowledge around options expiries, how hedging flows work from market makers in those is very helpful. It allows you to understand periods where the stock could be most unhinged or able to actually move.

Similarly, post opex moves tend to keep going for a while, especially this year there is a very heavy amount of autocorrelation (e.g. down day implied down the next day) in stock prices.

Generally think a lot of it comes down to don't bet against trends unless you have a strong fundamental reason.

6) IMO, it seems like the Fed usually overdoes it both ways (not hiking soon enough/now hiking too much) – do you think there’s any hope the Fed navigates a soft landing?

Generally agree, the fed overshoots both ways, but it's somewhat inherent in the fed's dual mandate of focusing on inflation and unemployment (e.g lagging indicators). If global energy prices collapse that is the one scenario I see a possible soft landing given it would have an immediate and material stimulatory impact. it would be to some extent reflexive as well as lower energy costs reduce inflation which gives GCBs more room to ease or at least not tighten

7) How bad could things get if a Fed driven hard landing plays out? Could we get a prolonged recession vs. something we’re able to get out of quickly? Additionally, is it possible the typical Fed QE toolbox may not be available to navigate a hard landing?

I've never liked this "hard vs soft landing" debate and view it as more so a "is this a mid-cycle slowdown or recession" type macro impact. A mid-cycle slowdown like in '16 and '19 seems unlikely this time given the Fed's seeming intent to crush the labor market (in addition to seemingly more layoffs announced every week). This generally seems like it's shaping up to be a classical recession with the bulk of the true pain to be felt in '23 vs '22 being more so the preview. That said I think talks of a 2H23 and 2024 recovery and for growth to reaccelerate is fair and somewhat how I'm viewing things at this juncture.

Think it's a bit difficult to try to make the call that this is an '08 or historic recession unless we see some sort of systemic risk get unwound.

With respect to the QE toolbox, I think Covid was pretty strong defense of GCBs to really do whatever it takes - expanding asset purchases to atypical asset classes is a strong tool any way you look at it.

8) Thanks a ton for the rundown RTB, to sum it all up, what's your closing message for the HYH newsletter readers?

Never forget you're supposed to own things that go up and short things that go down - public equity market prices are set by the least informed investors. If your VaRiAnT pErCePtIoN is some absurdly nuanced thesis you're probably going to get murdered on some random thing people actually care about.

End of the day you're just picking some funny strings of letters betting that the flashy price light on your terminal will go up or down.

That’s all for this interview – thank you RTB for agreeing to my ask to hop on the newsletter, make sure to check him out on Twitter.

Closing Comments: I have a few follow-up items.

I posted a bunch of compensation data for US Investment Bankers and Private Equity professionals recently that I want to make sure everyone saw. I have highlighted these updates as a story highlight on Instagram, with elaboration posted on the HY Newsletter page.

Coming soon – we will have the 3rd annual best finance movie tournament over on Instagram. This is one of my favorite ways to end the year, so I’m really excited. My finance movie and tv show rankings were posted last month.

The next newsletter (and last one of 2022) will focus on reflecting on the turbulent 2022, ending the year on a high note, and thinking about what’s to come in 2023.

The first newsletter of 2023 should be a good one – I’m planning an interview with an anon industry analyst who nailed a short call many didn’t see coming in 2022. It will be a good one.

That’s all for now. Talk soon!