If you weren’t able to join Thursday’s webinar, SL Advisors Midstream Energy and Inflation Outlook, you can watch a recording here.

The media referred to the Fed’s “hawkish pivot” following Wednesday’s revised dot plot and faster taper. More accurate is that chair Jay Powell confirmed that the FOMC was following the market’s earlier revisions to the rate outlook. Eurodollar futures traders and the Fed are once more synchronized over the next couple of years in looking for the Fed Funds rate to reach around 1.5%. Forecasts diverge beyond that, with fixed income traders comfortable that rates will peak, whereas FOMC members expect continued increases. When it comes to forecasting even their own actions, history shows the Fed has much to be humble about.

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The great penalty of inflation is suffered by fixed income investors, who conventionally demand a return at least as high to preserve purchasing power. Negative real yields on G7 sovereign debt are muting the market’s concern about value erosion. Persistently low bond yields that result are supporting risk assets such as equities. Buoyant bond and stock markets mean that there has been very little pressure on the Fed to act. The pleas for tighter policy have not come from financial markets, but from well-qualified observers such as former Treasury secretary Larry Summers and former NY Fed leader Bill Dudley. A handful of politicians have expressed concern about inflation, but Congressional enthusiasm for tighter policy will expire before the first rate hike.

The result is that financial markets regard today’s high inflation as relatively costless. Return-oriented investors in US government debt should demand high real rates as compensation for the dire fiscal outlook. But return-insensitive buyers (central banks; pension funds) dominate, and their acceptance of guaranteed value erosion is a subsidy that makes inflation more tolerable.

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Five year inflation expectations derived from TIPs yields began the year at 2%, and reached 3.1% a month ago although have moderated recently. The Fed targets Personal Consumption Expenditures (PCE) Inflation whereas TIPs settle against CPI. Technical differences mean PCE inflation runs lower than CPI – about 0.5% since 2000 but 0.3% since 2008. The bond market’s long term inflation outlook is a little higher than the FOMC’s long term 2% forecast even adjusting for PCE/CPI differences.

The consensus interpretation of the yield curve is that raising short term rates to 1.5% will be sufficient to bring inflation back to the Fed’s 2% target. An alternative explanation is that financial markets, and therefore the Fed, will tolerate higher inflation.

The Fed and most analysts expect declining inflation next year. Criticism flows easily when inflation is rising, but if it moderates as expected next year the FOMC will draw a collective sigh of relief. They’ll still taper and normalize rates, but the pressure from opinion leaders will be off. If Owners’ Equivalent Rent (OER), the quixotic survey-based measure of the cost of shelter, increases expect the Fed to look past it as a non-cash expense.

The absence of financial market stress during the current inflationary spurt will lessen the urgency to follow the rate path they’ve laid out. A hint of economic weakness will embolden those wishing to pause normalization. The flat yield curve would steepen.

Spiraling Federal debt and fortuitously low (negative) real rates make moderately higher inflation in America’s interests. The resilience of financial markets affords the Fed flexibility in normalizing rates and tolerance for a slower return to 2% inflation – or indeed inflation settling at a somewhat higher level.

The “hawkish pivot” shouldn’t be confused with a hawkish Fed. They simply followed the market. Their tolerance for temporarily higher inflation in support of full employment, the revised interpretation of their mandate announced last year, represents a more dovish approach to monetary policy. It’s one they’ve been following faithfully ever since.

Midstream energy infrastructure, as we noted in Thursday’s webinar, still offers attractive yields with decent upside through real assets that should provide protection against inflation.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Sign up here for this Thursday’s webinar at 12 eastern. SL Advisors’ Midstream Energy and Inflation Update.

Allianz SE’s Mohamed El-Erian recently said the, “Transitory Inflation Call Likely Fed’s Worst Ever.” There is some competition for that title. Just in my career (1980-) you’d have to include Alan Greenspan’s summer 1987 tightening which was soon followed by the October 1987 Crash; Greenspan’s assessment that the internet had boosted productivity, which underpinned easy late 90s policy; and Greenspan’s laissez-faire approach to regulatory oversight which helped cause the 2008-9 Great Financial Crisis (GFC). Greenspan made a few mistakes, but he was Fed chair from 1987-2006, so he had plenty of time. And he got much more right than wrong.

But the Fed’s imminent concession that they misread inflation earlier this year exceeds those three, and probably any that came before. Today’s FOMC announcement will likely see them start to correct, but unless the Fed immediately stops buying bonds they’ll still be moving too slowly – maintaining bond market support for an economy that long ago ceased needing it.

“Worst Call Ever” is justified because Fed chair Powell’s equanimity over inflation was so obviously misplaced. Like many observers, we saw reasons to be concerned a year ago (see Deficit Spending May Yet Cause Inflation). Earlier this year, Congress passed the American Rescue Plan, $1.9TN of further stimulus not needed since vaccine distribution was already underway. Through this, the FOMC maintained its pro-cyclical monetary policy and continued to finance most of America’s mortgage origination.

Even Democrat lawmakers have begun pushing the Fed to tighten policy (see US Democrats push Fed for tougher action against inflation). Representative Jay Auchincloss (D-MA) is an example of Congressional muddled thinking – he supported the abovementioned $1.9TN profligacy but now says, “The Fed needs to start tapering immediately and then they need to raise interest rates.”

This is exactly why Modern Monetary Theory (MMT) is flawed – the notion that Congress should increase deficit spending until it’s inflationary assumes they’ll curb largesse in time, which they obviously haven’t (see Reviewing The Deficit Myth, Stephanie Kelton’s support of MMT which unwittingly reveals its flaws). When members of the party in power want the Fed to tighten to offset their fiscal mistakes, you know there isn’t much hard thinking going on. Somehow Auchincloss is a member of the House of Representatives financial services committee, which oversees monetary policy.

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The sad truth is that the Federal government’s 2021 fiscal and monetary approach to Covid was dead wrong. By contrast, the government’s response to the GFC was broadly correct, and impactful. Then Fed-chair Bernanke introduced Quantitative Easing (QE), using the Fed’s balance sheet to buy $TNs of bonds. This was a bold and controversial move, but Bernanke was right in arguing it wouldn’t be inflationary. That might be the best call ever by a Fed chair. Jay Powell has simply incorporated QE into the Fed’s toolkit, but with the opposite result.

It’s likely the FOMC’s “dot plot” will move up towards eurodollar futures. The market is priced for the Fed Funds rate to reach 1.5% and by 2023 and remain there. The implication is this will be sufficient to reduce inflation back to the Fed’s desired 2%-ish level. Tightening and tapering are both reflected in ten year treasury yields, which remain below 1.5%.

The assumption is that it will not take much for the Fed to tame inflation, and ten year inflation derived from TIPs has moderated from 2.75% to 2.45% in the past month.

Another possibility is that the inflation figures are losing relevance. The deep flaw in the CPI’s measure of housing costs is receiving more attention (see U.S. Home-Price Surge Looks Much Tamer in Government CPI Report). We regularly point out the flaws in Owners Equivalent Rent (see The Subtle Inflation Pressure From Housing).

When the survey-based method of cost of shelter finally rises, expect the Fed to dismiss it as a non-cash item. If other measures of inflation are moderating then, they’ll be unlikely to act on it.

We could be entering a period of permanently higher inflation – a function of the Fed’s revised policy of greater tolerance but also an increasing gap between reported inflation and what consumers experience. Stocks and other real assets are the only investment solution.

It’s many months since we wrote about Covid – it’s often tempting, and statistics are plentiful. But it can appear self-indulgent, since there’s no shortage of literature available from better qualified writers.

However, a recent New York Times article was so egregious as to demand attention. Always in need of depressing news, they reported that 1% of older Americans have died of Covid. To further demonstrate journalistic innumeracy, they noted that 590K, or 75% of Covid deaths were the over 65s. Forget “with Covid” versus “from Covid”. The media often conflates the two, although the CDC defines “All Deaths involving Covid-19 (italics added).

Putting aside with versus from, CDC data also shows that 4.7 million over 65s died from all causes since Covid began, 73% of the 6.4 million total. In other words, older people die at roughly the same rate regardless of Covid. 1% of older Americans have died with Covid since early last year, but 8% of older Americans have died from all causes.

A New York Times non-story shouldn’t matter, except when such a widely read news outlet makes news out of something that plainly isn’t, it gets people like Representative Jay Auchincloss to mistakenly vote for unneeded fiscal stimulus.

The current inflationary environment is a result of poor analysis and policy errors. With the same cast of characters in charge, Investors should be prepared for more.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Sign up here for this Thursday’s webinar at 12 eastern. SL Advisors’ Midstream Energy and Inflation Update

Last week an investor asked us what he should do with his bond portfolio. We began publishing a monthly newsletter in January 2010 and over the years it evolved to the now twice-weekly blog. The poor outlook for bonds has been a regular topic almost from the beginning. Through descriptions such as “returnless risk” and “pigmy yields” we have sought to convince investors what a losing proposition they face in fixed income. The partners of SL Advisors have not personally held any bonds since the firm was founded in 2009.

In a blog post in October 2011 (see The Sorry Math of Bonds) we made the case for replacing a bond portfolio with a 20/80 barbell of stocks and cash. Back then the 2% dividend yield on the S&P500 was close to the yield on ten year treasuries. The logic of preferring stocks is that their dividends grow over time, and their tax treatment is better. These two features mean that the investment return on $100 in a ten year bond yielding 2% can be achieved with a lot less in stocks – we suggested $20 back then, with the rest sitting in treasury bills. It’s not complicated to build a model comparing the two – the most sensitive assumption is that dividend yields are unchanged at the end of the ten year investment horizon.

Other blog posts on the topic include A New Approach to Bonds, Stocks Are the Cheapest Since 2012 (see 3^rd and 4th charts) and Stocks Are Still A Better Bet Than Bonds (see 4^th chart).

Naturally, our response to this investor’s question was to dump bonds and create a bond-like portfolio of stocks and cash. We’ve been recommending this for over a decade.

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The charts show how this approach has worked. Since November 2011, bonds (defined as the iShares Core U.S. Aggregate Bond ETF, AGG, which tracks the Bloomberg US Agg Total Return Index) have returned 3.0% p.a. This is considerably better than we would have predicted a decade ago and not something investors should expect over the next ten years. The S&P500 returned 16.2% p.a. over the same period. The 20/80 portfolio delivered 3.7% p.a., assuming the cash portion was invested at the Fed Funds effective rate. Cash didn’t always earn close to 0% over the past decade. Next year cash balances should once again start to receive a modest return.

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The two portfolios tracked each other quite closely as well, although the stocks/cash mix was marginally less volatile. Its monthly returns had a standard deviation of 0.8%, versus 0.9% for bonds. The maximum drawdowns were also similar. Bonds suffered a 4.0% loss of value in 2013 during the “taper tantrum,” an experience that is behind the current FOMC’s measured (we would say very overdue) withdrawal of their bond buying program. The stocks/cash portfolio fell 3.9% from its previous high in March 2020 because of Covid. Bonds suffered two other drawdowns in excess of 3%, while the stocks/cash portfolio did not.

The 20/80 stocks/cash portfolio beat bonds with less risk over the past decade. Remember, past performance is no guarantee of future returns.

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Although monthly returns had similar volatility, rolling two year returns varied more for bonds than their synthetic substitute. The point of a fixed income allocation lies not just in its lower risk profile but also its diversification. Clearly, a 20/80 stocks/cash portfolio will be correlated with stocks and provide no diversification, albeit with 80% less volatility.

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Over the past three years the correlation between stocks and bonds (calculated using trailing two years’ monthly returns) has trended up, although it remains low. Diminutive bond yields have underpinned equities for years. A sharp drop in bond prices remains a major risk for stocks, even if it’s hard to predict what might cause that. In such circumstances, a conventional stock and bond portfolio would likely not enjoy much diversification.

In my 2013 book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors I looked at the stocks/cash substitute for bonds in more detail (Pp 195-8).

The case for replacing fixed income with the stocks/cash barbell is stronger today than it was in 2011 when we first suggested it. US government bond yields are held down by $TNs of demand from return-insensitive buyers such as foreign central banks, and others with inflexible mandates such as pension funds. With real yields of -1% dragging down returns throughout fixed income, the only prospect buyers have of a decent return is if these trends continue. It’s a bit like owning gold — you’re hoping someone else takes you out at a sillier price than you paid.

The conventional belief that investors should retain a fixed income allocation is being undercut by negative real yields. The government’s response to Covid shows that massive fiscal stimulus will be deployed against a recession, and the Fed’s balance sheet will be used to monetize debt. This new paradigm makes inflation more likely than deflation following an economic downturn. It’s time to leave the bond market to those not in need of a return on their investment.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

In March we wrote about start-up Liquified Natural Gas (LNG) exporter, NextDecade (NEXT) (see Making LNG Cleaner). As with Tellurian (TELL) and Cheniere (LNG) before them, NEXT needs to sign up buyers of its LNG before obtaining the financing to complete the liquefaction infrastructure. The rolling global energy crisis which has seen European and Asian buyers paying over $35 per Million BTUs (MMBTUs) for shipments has improved the outlook for US LNG exports. The $25 per MMBTU regional difference with US domestic prices is testament to the constraints posed by limited LNG export capacity. NEXT aims to partially solve that – foreign buyers are eager, although US customers will wind up paying marginally more as increased exports push up prices.

French utility Engie pulled out of discussions with NEXT late last year because they were unhappy at buying Texan natural gas given the prevalence of flaring. Regulators in Texas have interpreted their oversight of methane flaring very broadly, with the result that flaring permits are routinely granted. In 2019 a dispute arose between Exco, a natural gas driller, and Williams Companies over Exco’s application to flare natural gas rather than pay the tariff Williams demanded for pipeline transportation (see Texas Reconsiders Flaring). It showed how Texas’ ready approval of flaring had abandoned the original intent, which was to allow the flaring of associated gas where no infrastructure existed in order to allow crude oil production. Williams argued that the natural gas infrastructure was available, but that Exco didn’t like the price. In September, a judge ruled in Williams favor but that may not be the conclusion.

European LNG buyers are likely to share Engie’s sensitivity to how their product is produced, so NEXT created a “carbon solutions” unit to capture the CO2 associated with their LNG activities. Last week SL Advisors partner Henry Hoffman chatted with management during Cowen’s 2021 Energy Summit.

We think NEXT is under the radar for most investors. They do have some sell-side coverage though. Credit Suisse raised them from Neutral to Outperform in March, which gave the stock a boost. The company has a firm offtake deal with Shell to deliver 2 million tons per annum (MPTA) of natural gas for 20 years. NEXT needs agreements on 9 MPTA more in order to fully sell out capacity for Phase 1 of their proposed Rio Grande facility in south Texas. They are optimistic that they’ll reach this goal next quarter, reporting discussions on volumes well in excess of what’s needed.

The Administration’s Build Back Better legislation, which is currently with the Senate, may boost revenues at Next Carbon Solutions if the CO2 tax credits are sufficient to stimulate additional demand for the new unit’s services.

NEXT is aiming to provide “green” methane, whose production is certified to have resulted in minimum methane leaks along with the capture and sequestration of the CO2 generated in its processing and eventual liquefaction for transfer to LNG tankers.

Henry Hoffman also held discussions with Tellurian’s (TELL) management. TELL’s founder and CEO is Charif Souki, whose weekly Youtube videos have developed a following among retail investors. We like TELL too, but Souki has an unpredictable, risk-seeking streak. He was forced out of Cheniere by Carl Icahn who opposed Souki’s plans to expand into natural gas trading. Why complicate a business with years of cashflow visibility not exposed to natural gas prices?

Last year Souki suffered a margin call on his personal holdings of TELL when the stock collapsed during the Covid rout. He has a healthy risk appetite. We also didn’t like the August secondary offering which was done at a substantial discount to the prevailing price. TELL has a business model that incorporates exposure to LNG prices, which is probably making it harder to finance but allows greater upside if LNG prices remain firm, as Souki believes they will.

TELL told us they were in discussions with private equity investors, which we think could be good as it will improve corporate governance, and get the company closer to having enough financing to begin construction of their LNG facility.

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Natural gas remains the most impactful way for the world to lower emissions, by reducing reliance on  coal. Recently an overly hasty effort to transition to renewables in Europe has exposed weaknesses in their energy strategy and created further demand for natural gas. Although $35 per MMBTU is likely unsustainable, the long term demand for LNG is clear.

NEXT and TELL both offer the opportunity to invest in continued global demand growth for natural gas. We are invested in them.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Please sign up here for our webinar, Making Sense of Rising Inflation and the Global Energy Crisis, on Thursday, December 16 at 12 noon Eastern.

Last week Fed chair Jay Powell pivoted away from “transitory”, and adopted a tone more in keeping with the market’s newly revised interest rate forecast. As a result, today’s yield curve is far away from the September FOMC projections, even though they’ll be revised at this month’s meeting.

The most important question for bond investors must be the persistence of negative real rates – currently around –1.0% on the ten year. Moreover, the market has lowered expected short term rates five years out compared with their level at the September FOMC (the last time they issued projections materials). The biggest change in the meantime has been the Fed’s assessment of the inflation outlook.

Real rates have been declining for years, and so has the economy’s resilience to high rates. The eurodollar curve is currently priced for the Fed Funds rate to peak in two years at around 1.5% and for policy to remain on hold from then on. Ten year treasury yields are inexplicably at 1.4%, with inflation running over 6% year-on-year, tapering set to begin and the Fed likely to raise rates as soon as next spring if they decide to accelerate tapering later this month.

It doesn’t seem likely that the Fed will be able to restrain economic growth much without seeing long term yields rise. A 1.5% peak Fed Funds rate probably isn’t enough.

Former NY Fed president Bill Dudley recently commented that the market was extremely sanguine about how little increase in rate will be necessary to curb inflation. Five year inflation expectations derived from the treasury yield curve are 2.7%, and ten years 2.5%.

Add it all up, and the market is priced for Fed Funds to peak at 1% or so below inflation, which is nonetheless expected to moderate without monetary policy becoming restrictive. If someone articulated such an outlook, they’d be regarded as impossibly optimistic, yet it’s the market forecast.

One of the great pleasures of writing this blog is receiving comments on it. I remain in touch with many former colleagues and business associates as a result. Last week our post on the Owners’ Equivalent Rent, or OER (see The Subtle Inflation Pressure From Housing) drew an emailed response from Donald H. Layton, former CEO of Freddie Mac from May 2012 until June 2019. Now that he is enjoying a well-earned, though still typically industrious, retirement Don is writing papers on public policy with respect to housing. He has much to offer on the subject.

For 14 years of my 23 year JPMorgan career (1986-2000) I worked under Don Layton. As vice chair, Don led global capital markets and investment banking, which included my business of US interest rate derivatives trading.

Don is one of those rare executives able to combine strategic vision with an intense focus on detail. He often kept managers on their toes by revealing more knowledge about their business unit than might be expected from one of the bank’s top three executives. He was a superb leader who inspired loyalty and respect in equal measure. To my great pleasure we have remained in touch, and our annual reunions on the golf course followed by lunch inevitably include thought-provoking discussions about finance.

A couple of months ago Don wrote an excellent blog post about OER (see What Do Runaway House Prices Mean For The US?). He noted three disadvantages of the current housing boom: increasing inequality (if you don’t own a home and/or stocks, you’re slipping farther behind the asset-owning classes); decreased home ownership (it’s harder than ever for first time homebuyers) and artificially lowering inflation (because OER fails to adequately reflect the costs of home ownership, especially for current buyers).

Don noted, as we often have on this blog, the problems with estimating the cost of shelter by surveying homeowners on the possible rental income they might earn on their home. He notes that, “while the FHFA (Federal Housing Finance Agency) is saying that house prices went up 19.2 percent over the past year, the OER says that the cost of shelter for owner-occupied homes went up by only 2.43 percent! That’s a lower percentage increase than even for the median rent of an actual rental unit.”

Don goes on to argue that, “This result fails the common sense “smell test. The OER approach may work adequately well in normal times, but it does not seem to be working properly under the stress of today’s unprecedented increases in house prices.

“Unfortunately, given the high percentage of the typical household budget that is taken up by shelter, claims of today’s inflation being transitory may therefore not be well-founded. This suggests that policymakers are flying more than a bit blind, not seeing the inflation that the citizenry feels (especially those looking to buy their first home). That does not bode well for those policymakers, especially at the Federal Reserve, making the best decisions.”

US monetary policy would be better served if such clear thinking was more prevalent among policymakers.

CPI inflation is likely to remain stubbornly higher than the FOMC might like as home price appreciation filters through to rent, and their theoretical analog OER. Market forecasts of a peak in the Fed Funds rate of 1.5% seem very optimistic.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

Please sign up here for our webinar, Making Sense of Rising Inflation and the Global Energy Crisis, on Thursday, December 16 at 12 noon Eastern.

The Administration’s explanation for the less than transitory inflation relies on supply bottlenecks and a faster than expected rebound in energy demand. Both are wrong. The Wall Street Journal recently made an interesting argument that inflation will persist (see Another Reason Inflation May Be Here to Stay).

Personal Consumption Expenditures (PCE) on all goods (i.e. both durable and non-durable) is running well ahead of the long-term trend. March’s $1.9TN covid relief plan marked the end of Joe Biden’s presidential honeymoon. Critics of this and other elements of excessive fiscal stimulus point to the reason goods purchases are so strong with consequent higher inflation. Apparently, government planners expected prior spending patterns to be repeated, but services expenditures don’t show the same above trend trajectory.

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In short, more of this $1.9TN was channeled into goods purchased online, and less than expected on services, reflecting that a portion of the population remains wary about going out to dinner, movies and other entertainment.

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Services represents two thirds of PCE and goods only one third. So it might seem plausible to assume goods inflation will moderate, reinforcing the discredited transitory narrative.

However, as the Wall Street Journal points out, housing and healthcare make up over half of services PCE. With the government largely picking up the cost of Covid-related healthcare on top of Medicare and other Federally-financed programs, this sector is distorted.

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But the Housing and Utilities component is dominated by rents – both actual and imputed. The WSJ notes that leases come up for renewal infrequently, and that eventually the buoyant real estate market will translate into higher rents.

This may be true – but the WSJ overlooks the fact that two thirds of American households own their homes. For them, the cost of shelter is based on Owners’ Equivalent Rent (OER), the often criticized estimate of the value of the shelter (a service) their home provides. This shows up in the services PCE.

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For those unfamiliar with the distortions caused by OER, inflation is all about the cost of goods and services, not assets. A home is an asset that provides shelter, a service. Inflation statistics try and separate the two, by surveying home owners on what they think they could rent their house for. This is the estimated value of shelter. Because home ownership is so common in the US, a large chunk of estimated housing costs are based on OER. (for a more detailed explanation, see Why You Can’t Trust Reported Inflation Numbers). The Bureau of Economic Analysis published a revised explanation of housing costs earlier this year.

OER is a creation only a Bureau of Labor Statistics economist could love. It’s not supported by any cash transactions, but it’s used to estimate around $2TN of PCE. As the chart shows, it bears little relationship to the Case-Shiller index which tracks actual house prices – probably because most homeowners are puzzled when confronted with the survey question about rent. A defense of OER is that, over very long periods of time (i.e. a decade or more) it tends to track home prices – and sure enough since the last peak in home prices prior to the 2008 Great Financial Crisis the two series’ have similar returns.

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Where next for OER? It’s hard to forecast since it’s drawn from survey responses and not actual transactions. But it’s unlikely to decrease its growth rate, and at least some homeowners might be expected to raise their imputed rent estimate in response to the strong housing market.

A rising OER will drive the services PCE higher, causing its trajectory to return to its prior trend or even exceed it. Although there won’t be any increase in cash receipts as a result, calculated spending on services will be higher and so will inflation, since CPI also derives its housing methodology from PCE.

Easing supply constraints may allow goods inflation to moderate, although there are no signs of that yet. Whether it does or not, services inflation seems likely to move higher. This will maintain the pressure on the FOMC to respond to inflation, even though OER doesn’t impact household budgets in the same way that, say, rising gasoline prices do.

It may even cause some at the Fed to comment about the weaknesses of OER, although strength in this metric would simply be a delayed reflection of the actual appreciation in home prices we’ve all seen.  Either way, inflation is likely to remain persistent not transitory, a term Fed chair Powell retired at his Congressional testimony yesterday.

Join us on Thursday, December 16^th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

For the past few months the eurodollar futures market has steadily priced in the FOMC’s abandonment of “transitory” in its assessment of inflation. More often than not the Fed follows the market. The typical absence of public comments that precedes FOMC meetings was extended while Biden contemplated renewing Powell’s term. In short order, Powell’s reappointment was announced, several Fed governors publicly contemplated faster tapering and the release of minutes revealed a lively debate. “Transitory” has become a derogatory adjective in finance betraying cognitive dissonance. As in, “The hedge fund manager described his losses from shorting meme stocks as transitory.” Something is transitory, until its permanence becomes painfully obvious.

President Biden and Fed chair Powell had their discussion during which no doubt Biden hoped for a lethargic policy response to inflation while Powell demurred. With Powell’s reappointment secure, all that was left was for the next FOMC meeting to make the taper briefer, in preparation for three to four rate hikes beginning next spring.

B.1.1.529, the new Covid mutation identified in South Africa, has scrambled everything. The World Health Organization has assigned it the Greek letter “Omicron” since that’s the next one in the alphabet. The $8 drop in crude oil will be welcomed by the Administration which will likely claim partial credit since it so closely followed the release from the Strategic Petroleum Reserve. Eurodollar futures removed one projected tightening from next year.

The energy sector modestly outpaced the S&P 500’s 2.2% fall, dropping 2.6% (defined as the American Energy Independence Index).

Last year when investors asked for our outlook on midstream energy infrastructure, we’d often note that the path of Covid would be an important factor. We all became amateur virologists in attempting to project investment returns. The vaccine ushered in economic growth powered by an excessive fiscal response, with the removal of monetary accommodation (albeit very late).

How much has changed?

As before, the near-term direction depends on the virus. If existing vaccines prove ineffective, economic activity will slow until a new one is created and distributed. Some fear the new mutation may require a new vaccine. It’s a science question not an economic one.

The pipeline sector has just reported solid 3Q21 earnings. Cash flows continue to grow, buoyed by recovering volumes and continued financial discipline. Progressive energy policies have been more constructive than expected – impeding sufficient supply of oil and natural gas has improved prices and sentiment. COP26 revealed the gulf that exists between the climate goals of OECD countries and the growth objectives of emerging countries. Unilateral policies to accelerate the energy transition increase prices for consumers and mostly serve to accommodate increased emissions from China, India and others.

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Given the uncertain near-term direction, it can be helpful to remember the long-term growth outlook for US energy consumption. Although renewables command excessive media attention, the chart shows that the big energy story of the past decade was the huge drop in coal consumption which was mostly offset by increased natural gas.

The Energy Information Administration expects the US to increase consumption of renewables, natural gas and even petroleum products over the next three decades. “Other renewables”, which is mostly solar and wind, is forecast to grow from 7.5 quadrillion BTUs to 17.5 by 2050. Even then it’ll still provide less than half the energy of natural gas.

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Energy transitions are slow, and forecasters have a long history of overestimating the speed of change. Just over four years ago we noted Tony Seba’s forecast (see A Futurist’s Vision of Energy) that by 2030 US consumers would only be buying Electric Vehicles (EVs). Their share is currently around 4%, with Tesla dominating. Although we expect EVs to grow like most forecasters, reaching one third market share (defined to include hybrids) as expected by LMC Automotive seems more realistic. Electricity produced from natural gas will still be the dominant source of power generation. Incidentally, Exxon Mobil’s 2030 EV market share forecast back in 2017 was 10% — likely to be low. Forecasting adoption rates for new technology is hard.

Near term market direction will depend on the Omicron variant. Over a year or more, we still expect the constructive fundamentals of the US energy sector, especially natural gas, to drive cash flows and stock prices higher.

Join us on Thursday, December 16^th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

On Monday the Energy Information Administration (EIA) announced that 27.3 Gigawatts (GW) of natural gas power plants will be added to the US fleet over the next three years, representing a 6% increase from current capacity. The US is blessed with abundant supplies of natural gas, sufficient to power the country for many decades.

Many US states are pursuing sensible energy policies designed to maintain reliability and affordability, as well as diminish our reliance on coal. The map below shows where these power plants are being added – generally close to existing natural gas supplies. New York state is conspicuously not taking advantage of this opportunity, since its energy agenda has been hijacked by progressives.

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The COP26 in Glasglow revealed the divide we’ve often chronicled between OECD countries who want lower CO2 emissions and emerging economies that are focused on raising living standards, which requires more energy. The inability of COP26 to produce anything meaningful exposed the ambivalence of countries like the US to an overly rapid energy transition. Higher crude oil has brought solicitations to OPEC to increase supply and now sales from the Strategic Petroleum Reserve (SPR).

The first failure of climate extremists is their inability to convince consumers that they should give up reliable fossil fuels and opt for higher-priced intermittency.

The most important development this year in US power generation is the resurgence of coal demand at the expense of natural gas. After several years of losing market share, domestic demand for coal has rebounded because of improved relative pricing.

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US natural gas for January ‘22 delivery touched $6.50 per Million BTUs (MMBTU) a month ago, before retreating to its current level of around $5. US consumers are not immune to the policy errors in other countries (see Why The Energy Crisis Will Force More Realism) but are thankfully being spared from the type of Greta-inspired outcomes endured in the UK (see U.K. Power Prices Soar Above £2,000 on Low Winds). The new natural gas power plants noted by the EIA are an example.

By contrast, nothing newsworthy is happening with US solar and wind. They continue to grow — since January 2018 solar’s market share of US power generation has increased from 1.2% to 2.2%, and windmills have gone from 6.0% to 7.5%.

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It’s possible to create some impressive numbers from this – solar output has a Compound Annual Growth Rate (CAGR) of 20% since January 2018, and wind has 9%. But as the charts show, if both disappeared tomorrow, we mostly wouldn’t notice. Coal use is up 12% in the past year, and currently generates almost twice the power of solar and wind combined. Vaclav Smil has shown that energy transitions play out over decades. Renewables will be small with a high CAGR for many years to come.

US energy-related CO2 emissions are forecast to be +7% this year – not just because energy consumption is rebounding from covid-depressed levels, but also because of this adverse fuel mix. Next year is forecast to be +1%, in part due to a shift back towards natural gas by utilities.

This leads to the second failure of climate extremists – their refusal to differentiate among fossil fuels has impeded their effectiveness. Had they pushed public policies that encouraged utilities to switch from coal to natural gas, perhaps with a carbon tax, the trend towards natgas would have continued this year and CO2 emissions wouldn’t have jumped as much. Instead, their purist approach has left market forces through cheap natural gas to drive most of the reduction in CO2 emissions the US has achieved.

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The US even declined to join 40 other countries in pledging to phase out coal within two decades. This puts us alongside China, the world’s biggest emitter and consumer of half the world’s coal.

American voters want to reduce emissions as long as it doesn’t lead to higher energy prices. Administration efforts to jawbone crude oil prices lower reflect that reality. High gasoline prices should incentivize switching to electric vehicles (which are more likely to rely on natural gas power plants than any other fuel). Instead, the White House is trying to diminish this incentive with sales from the SPR. Foregoing the coal pledge is another example of pragmatism over-ruling progressives.

Pragmatic policies in many states and the White House’s incoherent energy strategy are helping us avoid the poor planning of the UK, Germany and California. Many states such as Florida are adding natural gas capacity in order to preserve reliability. It’s one more reason why migrants from New York state with its poorly conceived energy policies will continue to move to the sunshine state.

Join us on Thursday, December 16^th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

It’s easy to criticize the Fed. They’ve maintained their uber-accommodative monetary policy for probably a year longer than needed. Once the vaccine breakthrough was announced last November, prudence dictated that they anticipate an economic rebound and begin normalizing rates.

Instead their bond buying has had the effect of partially monetizing Federal debt issued to fund the huge fiscal response to the pandemic. The March stimulus package was clearly an additional $1.9TN in buying power that consumers collectively didn’t need, which is why personal consumption expenditures on goods are running well above the long term trend.

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The relevant quote from former Fed chair William McChesney Martin, Jr., as lifted from his written speech is, “The Federal Reserve…is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.” Instead, current chair Jay Powell and his colleagues have been pouring in the Absolut.

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Housing is another example. The FOMC must be the only group of Americans unaware that suburban residential real estate is red hot, making it more expensive for the two thirds of American households who choose to own their home to find shelter. Owners’ Equivalent Rent (OER) allows them to pretend that nothing untoward is happening, in willful defiance of the S&P/Case-Shiller U.S. National Home Price Index (C-S).

By coincidence, since the last housing peak in July 2006 both indices have increased by approximately the same amount. The real estate market has felt a lot different to consumers versus the number crunchers at the Bureau of Labor Statistics who produce OER. They might even argue that this shows OER is a decent proxy for housing. However, the C-S is +20% over the past year.

The Fed is still buying $40BN of mortgage-backed securities every month. Even though they’re winding down, at their current tapering pace they won’t be completely out of the market until June.

It’s easy to criticize the Fed. Markets have priced in a significantly more rapid tightening than the most recent FOMC projection materials, with almost no public comments from officials that such was likely. With inflation running at 6.2% it’s easy to see why.

So it’s interesting to consider the defense of the Fed, one that the Fed chair may offer once Biden has announced his choice.

Reports that the White House is considering replacing Powell with Lael Brainard are likely all optics, and although some commentators perceive Brainard as more dovish, the FOMC has maintained the monetary gusher without much public dissent. They’re all doves.

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It starts with financial markets – one of the more interesting recent charts is the one showing an unprecedented drop in the correlation between short term and long term rates. The bond market used to be a real-time measure of Fed policy, but inflation expectations and monetary policy seem to play less of a role than in the past. This may be why the correlation has dropped.

Anchored by central bank buying and other return-oblivious investors, bonds seem impervious to rising consumer prices.

Ten year treasuries at 1.6% are hardly onerous unless you think you’re entitled to a return on your money, a requirement bond investors have abandoned. TIPs yield –1.1%, so the ten year inflation expectation is 2.7%. This is somewhat higher than the Fed’s 2% target but not out of control, and not inconsistent with the Fed’s optimistically transitive narrative.

The recent shift in tightening expectations has been almost exclusively reflected in the short end of the curve. The precise market forecasts offered by eurodollar futures show that traders expect any tightening to be completed within two years or less, with stability thereafter. Ten year treasuries yield the same 1.6% as they did in May.

The Fed’s $8.5TN balance sheet has helped depress bond yields, but now the buying will slowly stop and the market knows that. There’s no shortage of other return-insensitive buyers for debt of a profligate government, starting with Japan ($1.3TN) and China ($1TN).

Interest rates are the transmission mechanism by which lenders receive compensation for inflation. In a world of negative real yields, perhaps the economy can tolerate some inflation.

The buoyant stock market is another financial market indicator that current and expected inflation aren’t creating any big problems. Quarterly earnings show that many companies seem able to pass through higher costs to their customers.

There are numerous signs that the jobs market is strong, with September job openings of 10.4 million just below August’s record of 10.6 million. Workers are increasingly willing to quit for a better job, and companies routinely complain of difficulties hiring enough qualified workers.

Unusually, inflation has become a political problem before becoming a markets problem. More common, for those of us old enough to remember tightening cycles, is for bond yields to rise, compensating investors for the risk of higher inflation and pressuring stocks. The administration, usually subtly, pushes back.

Today talk of inflation is everywhere, but anyone invested in stocks is still ahead of the game. For my part, stopping at a gas station has become a cause for unseemly celebration as I happily fork over an extra $40 while smiling at the bull market in pipeline stocks.

Borrowers are also benefiting from continued low rates.

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The point is, today’s inflation is not an economic problem but a political one. Raising rates so as to drive up the unemployment rate won’t produce more truck drivers and will only appease the talking heads who are the visible pressure for action. An FOMC that has willingly monetized debt, synchronized easy policy with enormous fiscal stimulus and promoted a housing bubble doesn’t look like a group to willingly cause economic damage by hiking rates precipitously.

The FOMC will likely move slowly, because there’s plenty of justification for doing so. However, vice-chair Richard Clarida suggested on Friday a speedier tapering, which would allow faster tightening in line with current market prices. We think the FOMC’s dovish tendencies will incline them to move slowly – the market is priced for a more aggressive response.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

We often get questions on the correlation between pipeline stocks and crude oil. Most investors intuitively believe they are linked – and inconveniently they seem especially so when prices are falling. March of last year is a recent example.

Pipelines are a volume business — the “toll model” has often been used to describe the fact that it’s volumes passing through the pipelines, not the value of the commodity, that drive midstream economics. To the extent that high prices imply increased production it can appear that they should be related.

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This year pipelines and crude oil have both marched higher, propelled by the strong economic recovery from covid and restrained investment in new output by energy companies. US oil production remains 1.5 Million Barrels per Day (MMB/D) below its pre-covid peak. The volume-driven pipeline industry ought to be suffering with less crude oil passing through its infrastructure – except that the industry’s new financial discipline has driven free cash flow higher.

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Lower volumes are a result of constrained growth capex, both among the upstream customers of pipelines as well as the midstream sector itself.

Although visually crude oil and pipelines (defined here as the American Energy Independence Index, AEITR) move together, the correlation isn’t that high. Over the past decade the average 90 day rolling correlation of daily returns is 0.41. As the table shows, year by year it doesn’t stray too far from that.

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In 2015 when crude oil and pipeline stocks were falling, some clients asked us if we’d considered hedging by shorting crude oil futures. It was a reasonable question, since the sector seemed to follow oil prices relentlessly lower. But the correlation shows that it’s really a weak relationship. And the devil is in the details – any hedge would require a hedge ratio. How much crude oil should a portfolio short in order to hedge its equity exposure? The unstable relationship means that the choice of hedge ratio would depend on the past time period examined, revealing it to be a somewhat arbitrary choice.

Unable to identify a reliable hedging strategy we rejected the suggestion. In mid-2017 such a fund was launched (see Oil-Hedged MLP ETF Launches at Propitious Time) but it’s since closed, confirming how hard it is to get the hedge ratio right.

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Natural gas is a more important source of cashflows for pipeline stocks than crude oil, but here the correlation is non-existent. The US is fortunate to possess decades worth of reserves of natural gas. Moreover, because exports of Liquified Natural Gas (LNG) are limited by the availability of specialized infrastructure to chill it down to 1/600^th of its volume so it can be pumped onto an LNG tanker, US consumers have been mostly insulated from the energy crisis sweeping through Europe and Asia. EU governments and the UK have committed a series of policy errors in recent years. These include: becoming too reliant of intermittent solar and wind; cutting back local production and storage of natural gas; and relying too heavily on Russia’s capricious supply schedule.

Unexpectedly quiet weather in the normally blustery North Sea has once again cut electricity generation from windmills (see U.K. Power Prices Soar Above £2,000 on Low Winds). The £2,000 price per MWh cited should be compared with the $75-$140 range that US customers pay. Converted to US$, UK electricity is being sold for as much as $2,700, 20-36X times as much as American wholesale prices. Even the policymakers in California haven’t been able to screw up as badly. The UK government is subsidizing prices to avoid the political outcry that would quickly follow, so in effect the entire country is paying for past energy policy blunders.

Lowering CO2 emissions is a worthy goal, but examples of the folly of pursuing the agenda of climate extremists keep piling up.

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One of the most positive developments of the year for the pipeline sector has been the steady recovery in natural gas volumes. High crude prices have buoyed investor sentiment, but the return of domestic natural gas output to its pre-covid high represents a tangible benefit that has boosted earnings at companies such as Williams and Cheniere.

COP26 showed that emerging economies such as China and India continue to value raising living standards over reducing CO2 emissions. India’s per capita GDP is $1,900, compared with the US at $63K. Hundreds of millions of Indians live in poverty. Fighting global warming isn’t resonating with them or their government. The US can help by encouraging India and other countries to buy more natural gas and use less coal. That’s the pragmatic solution, and America is well positioned for it.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.