I Think the Dominant Economic Narrative for 2024 is Wrong and an Interesting Perspective from the Philippines - Monthly Depth Report February 2024

Hi?Gary, ?

Sorry for the delay in getting our monthly newsletter out. Exciting things are happening at DKI as cause for the delay. Let's just imagine it is February 29th, Leap Day!

In the introduction to last month’s letter, I wrote that “it’s worthwhile to look at how the current narrative is manufactured and not representative of reality”. As we get past 4Q earnings announcements, there’s a lot of focus in the financial world about the condition of the economy, the probability of a shallow or deep recession, and the expected reaction of the Federal Reserve.

For months, the market has been pricing in 6 rate cuts this year for a total of 1.5% of reductions. I’ve been saying that we should see fewer reductions which will come later in the year than people have been expecting. In the past two months alone, market expectations for the first fed funds rate cut have been pushed back from January to June. ?

Past fewer rate cuts, my prior expectations for the year hadn’t been so different from consensus. I’m now finding that’s no longer the case. I currently?believe the macro narrative is highly unlikely to play out in the way people expect. More details below. ?

DKI also made a new idea public. Shockwave Medical ($SWAV) is an innovator in cardiac healthcare. Premium subscribers started buying the stock around $190 in December. We made the idea public a few weeks ago with the stock around $235. As I write this, $SWAV is trading in the mid-$260s. So far, everyone has done well. We’ll go through some of the details here. ?

Finally, I have an interesting story or two related to my December/January trip to the Philippines. Let’s dive in: ?

I Think the 2024 Macro Narrative is Wrong

There’s a lot of discussion in the financial community about the 2024 macro situation. Many people are claiming the Federal Reserve raised interest rates too much and too fast and has put the US in recession, or at least on the path to one. The debate centers around how bad the expected recession will be, and how quickly the Fed should pivot to a lower fed funds rate to save the economy.

I think the Fed’s error was keeping interest rates at or around zero for almost a decade and a half. In contrast to conventional wisdom, I don’t think the current 5.3% fed funds rate and a real interest rate (fed funds rate less the CPI) around 2% is extreme, restrictive, or a problem. Despite that difference of opinion, I can understand why some think higher rates are about to crash the economy and that the logical hoped-for response from the Fed would be lower interest rates. ?

I also think this narrative is incorrect. The cause of our inflation the past couple of years was near-zero rates for too long combined with massive Congressional overspending.

Former Federal Reserve Chairman Ben Bernanke was famous for saying he could solve a slow economy by dropping cash from a helicopter. During the Covid-related lockdowns, Congress tried just that and sent thousands of dollars of “free” checks to every household in the country and then sent trillions more to businesses. Much of that money was diverted and stolen. What we got was a real-world test of “helicopter Ben’s” theory. It turns out that spraying trillions of dollars of debt-fueled cash into the economy didn’t save us; but rather, led to the highest inflation we’ve seen in 40 years. We’re all paying for our “stimmies” through higher prices, and will do so for the rest of our lives. Prices are not coming down to pre-Covid levels. ?

Rather than get spending under control, Congress has done exactly what they’ve done for decades; took the higher “emergency” spending as the new baseline and continued to spend as if every year was an emergency. They regularly tell us that any reduction in spending levels would be “mean” and that people need unlimited spending funded by dollar-printing. Thus, every “emergency” rachets the budget deficit higher. The government share of the economy only grows. ?

This is an election year, and the White House doesn’t want to head into November with the country in a recession. Despite lots of talk about other issues, the American people tend to vote reliably based on the economy. As a result, we can expect continued massive overspending for the remainder of the year. This was part of the plan last year when we avoided a government shutdown due to a plan to kick the next debt ceiling discussion until after the 2024 election. That timing wasn’t an accident. ?

Government spending adds to gross domestic product (GDP) even if it produces no value. Much of today’s government spending doesn’t represent any kind of investment; but rather, simply pulls forward future demand in exchange for higher debt. This is the governmental version of living an extravagant lifestyle funded by your credit cards and pretending the card companies won’t bother to ask you to pay your debt in the future. ?

The current budget calls for $2 trillion of excess on-balance sheet spending funded by debt plus another $4T - $6T of off-balance sheet spending. The latter category is for things like Medicare, Medicaid, social security, and other social spending. They don’t count against the current and ever-rising $34T of official debt, but it’s still unfunded spending that will stimulate the economy this year. ?

I think this massive spending combined with the Treasury Department monetizing the debt means we’re unlikely to have an official recession this year. If you want to argue that economic growth due primarily to unproductive government spending isn’t a healthy economy, I’ll agree with you. However, I think it keeps us from recording negative economic growth and leads to more inflation. This is the “kick the can” strategy where government officials delay dealing with our financial problems and hope that they’ll become too large to manage only after they’ve decided to leave office. ?

In this scenario, we will have neither a recession, nor much of a reason for the Federal Reserve to lower the fed funds rate. The Fed might reduce rates later in the year, but without a recession and with inflationary spending, it’s unlikely they lower 6 times for a total of 1.5% of cuts. ?

Typically, when you have an alternate view of the world, that’s an opportunity to make money, but this is one of those unusual situations where there’s not much to do. Thinking we won’t have a recession would be bullish for the economy, but a Federal Reserve that keeps rates higher for longer is bearish. Further, there’s something interesting going on with company earnings. In mid-2022, DKI wrote that 2023 earnings estimates for the S&P 500 were too high and needed to come down. At the time, expectations were for about $260 of earnings. A year and a half later, it looks like 2023 earnings will be closer to $220. ?

With such a large reduction in estimates, you’d normally expect the market to be down, but the market rose through the second half of 2022 and for all of 2023 on hopes of Fed rate cuts that never arrived. Consensus estimates are for 2025 earnings to be in the mid-$260s. So, we’re getting the 2023 numbers two years late and with years of lost earnings growth. Despite that, the market is at all-time highs due to the performance of a few mega-cap tech stocks.

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For those who agree with my conclusions on the macro environment, that leaves you with the option of buying stocks during an earnings recession and without the Fed rate cuts many are hoping will happen, or shorting the market when strong guidance from Nvidia ($NVDA) or Microsoft ($MSFT) could cause the entire S&P 500 to rise. Neither of these is an attractive option so I’ve stuck with owning stocks I like and hedging out much of the equity risk.

Shockwave Medical ($SWAV)

In last month’s letter, I told you I was shifting my attention back towards individual stock picking instead of focusing on the macro situation. DKI subscribers started buying new pick, Shockwave Medical , in December around $190. The stock is currently in the mid-$260s. Revenue growth last quarter was 41%, and I think the company gets bought by a larger competitor for more than $300. ?

Shockwave makes an innovative catheter that uses electrical impulses to break up calcification from inside an artery. This enables an interventional cardiologist to safely place a stent in a cardiac artery that was previously inaccessible due to a hard blockage. The old standard of care was something called a Rotablator which carries a risk of perforating the artery and can’t get to plaque that’s close to the artery wall. The Shockwave solution is better and safer. ?

Because $SWAV is staffing up for future growth, the company is growing infrastructure at a rate that exceeds even the huge rate of revenue growth. This is leading to margin reductions. Normally falling operating margins despite excellent revenue growth would be cause for concern, but in the case of Shockwave, it’s an opportunity. The company is growing due to its superior and safer solution. The expense problem becomes more apparent with each quarter of declining margins and is the main reason Shockwave should be bought by a larger medical device company with existing infrastructure. There were acquisition talks last year that fell apart due to a disagreement about price. Based on multiples paid in prior deals, it’s easy to get to takeover valuations in excess of $300 per share. ?

A Different Perspective from the Philippines ?

I spent six weeks in the Philippines from the end of 2023 through the first week of January. As always, when I travel, I have interesting conversations with the locals. Last year, I told you about the Philippine citizen I met in Thailand who described his country as a US colony. When I asked him why he thought that was the case, he noted that the US saved his country from a terrible foreign occupation…and then didn’t leave. His feelings were a bit of a mix of gratitude for the rescue, but less enthusiastic about the continued military presence. I suspect that as the Philippines has increasing maritime conflict with China, it’s possible that his feelings may turn back to gratitude for the US naval presence there. ?

On my recent trip, I met a resident of Manila who also made the claim that the Philippines is a colony of the US. When I asked her why she felt that way, she acknowledged that her country wasn’t actually a colony, but then said that she wished it was. This surprised me so I asked her why she wanted her country to be a colony. She responded that had the US colonized the Philippines, they could have potentially been the 51st State; a much larger version of Hawaii, but much further west (east?). That’s a fascinating perspective. She sees the dysfunction in her country, and imagines it paired with US economic strength and marginally better governmental practices. While surprising, it does make sense. The general standard of living in Hawaii is much better than in the Philippines. ?

I have conversations like these all over the world, and have found that people will tell you incredibly intimate details of their lives as long as you convey that you’re interested in understanding their point of view, and not interested in judging them. This is an important attitude to take as an investor when making every effort to understand the view of people who disagree with you can save you from making a money-losing mistake. ?

This approach is also valuable when conducting interviews with company management or industry experts. Keeping a neutral tone is often the best way to get honest answers as opposed to leading someone. There’s a difference between “what will make margins improve” and “what impact do you think this will have on margins”. The second one is more neutral and, in most situations, is more likely to get you an honest answer. ?

Being open to another point of view can also save you from embarrassment. When I was a first-year analyst in the Mergers & Acquisitions Department at Morgan Stanley & Co., I was working on an automotive parts deal that led the team to make a trip to Detroit. I was working out the details of the trip with the Vice President on the deal who was a bit snooty even by investment banking standards. He informed me that even though we’d have to get up early to make our flight, we’d pick up an hour on the way due to Detroit being in the Central time zone. ?

I mentioned to him that I grew up in Michigan, and that it’s in the Eastern time zone. The VP, who had been born and raised in another country, insisted that I was wrong and that we were going to gain an hour on the way. After several rounds of this, I told him that I had lived all but the last year of my life in Michigan, and regularly flew between New York and Detroit. When doing so, I never adjusted my watch and still was on time for everything. In other words, I had extensive personal experience in this matter, and that Detroit is in the Eastern time zone. In a moment of hubris I remember more than 3 decades later, the VP told me he still thought Detroit was in the Central time zone. My conclusion is that you don’t need to agree with everyone, but if you choose not to listen to people who know a particular part of the world (or a particular part of the investing landscape), you’re going to end up looking foolish. This is true both in traveling and investing.

Time to Wrap It Up for This Month

DKI has started to partner with sponsors to reach our growing audience of investors and financial professionals in the weekly 5 Things and these monthly letters. If you’re interested in connecting with hundreds of family offices and thousands of individual investors, please reach out at [email protected] . The open rate for our emails is around 2x – 3x the industry norms. ?

Our January subscribers’ meeting was with cardiologists, Dr. Paul Thompson and Dr Daniel Fram. They outlined the medical case for Shockwave, and explained the different treatment options for artery blockages with excess calcification. At the end of the call, each of us understood exactly why the Shockwave solution was both innovative and superior. As usual, subscriber questions were insightful. We are indeed fortunate to have a community of such knowledgeable thoughtful investors in addition to our fantastic Board of Advisors. ?

For February, we already had an excellent webinar with energy expert, Tracy Shuchart . Following that was one with Dr. David Glancy on geopolitics and economics . Dr. Glancy works with DKI Board Member, Dr. John Lenczowski . His insight at the intersection of economics and policy is outstanding. ?

DKI has a partnership with Tidal (@leadlagreport on Twitter).? If you’re a financial advisor with more than $50MM under management, please reach out to us so we can arrange for you to get a premium subscription to Deep Knowledge Investing at no cost to you through Tidal. Michael Gayed runs the program, has been a great partner and friend, and is an expert on conditions-based investing. A chat with him and a subscription to DKI both provide great value.

If any of you have questions, concerns, or thoughts regarding issues we should address in a future depth report, please feel free to reach out to me at [email protected] . ?

If you think a friend, RIA, family office, or portfolio manager would be interested in this monthly commentary, please feel free to pass it on to them. Also, if you send this letter to more than 5 people, please get in touch and let me know. ?

Thanks for being part of Deep Knowledge Investing, ?

Gary Brode ?

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