Jamie Dimon thinks the Fed may tighten rates six or seven times this year. Bill Ackman believes the Fed should punctuate the start of the tightening cycle with a 50bp hike in order to regain some credibility. Whatever their self-image, this is a dovish FOMC. Central bank bond buying is set to continue until March, and raising short term rates can only start then. So monetary stimulus continues, in the interests of avoiding any surprises. An unemployment rate of 3.9% combined with hourly earnings increasing at a 7.5% annualized rate (December was up 19 cents to $31.31) reflects full employment. They’re already late.

Cyclical peaks in short term rates have declined over the past couple of decades. It seems the economy succumbs to monetary tightening more readily each time. This is why the market doesn’t expect rates to move much above 2%, and is probably why the Fed is so lethargic in normalizing policy. They don’t expect to tighten much.

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Over the next year, the risks seem skewed to the upside for rates. Fed chair Jay Powell continues to blame goods shortages for inflation, even though labor is most clearly under-supplied. FOMC forecasts of inflation have been steadily increasing. A 2% rate cycle peak with the economy booming and the Fed still stimulating seems optimistic. Eurodollar futures have been pricing in less optimism recently, but surely need to at least match FOMC projections in order to stop offering an asymmetric bet.

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Looking farther out, ten year inflation expectations at 2.5% invite one to wager on higher. Although Jamie Dimon’s warning of more aggressive tightening looks prescient, we only reached this point because of the FOMC’s dovish posture. Reducing inflation from 7% draws little debate; bringing it down from 4% to 3%, and eventually to their long run 2% target, is likely to provoke concern about unnecessarily costing jobs. The Fed has taken excessive inflation risk to achieve today’s full employment – they clearly interpret their dual mandate as weighted towards people over bonds.

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This is not necessarily bad. Monetary orthodoxy has long held that 2% inflation maximizes employment, but that could change. America’s indebtedness is relentlessly up. Expect more thoughtful pieces arguing that a little higher inflation eases the burden of debt service by providing more room for negative real rates. It is the endless gift from investors who must own bonds to those who service them — US taxpayers. We should take advantage of it.

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There are in any case ways for the Fed to overlook certain elements of inflation. Owners’ Equivalent Rent (OER) is one. This flawed survey of what homeowners believe their home would rent for continues to show the cost of shelter to be only inconsequentially rising, in complete defiance of the buoyant real estate market the rest of us see. Since the July 2006 peak in housing OER and the Case Shiller index, which actually measures home prices, have recorded similar increases albeit along very different paths.

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OER is lagging housing prices by over 15% year-on-year but has belatedly begun to reflect the housing market since its annual rate of increase has risen from 2% in April to 3.8% now. This suggests OER is set to inconveniently accelerate just when the FOMC strategy of hope is supposed to be working. But since OER is the only non-cash item in the inflation statistics, it wouldn’t take much for the Fed to dismiss its message since nobody writes a monthly rent check linked to OER.

The energy transition is another example. Shifting to a lower carbon energy system is going to raise prices – obviously, or we’d already be there. The inflation that counts usually excludes food and energy, because they’re volatile. But Europe’s energy crisis shows what excessive reliance on windmills and policy aligned with Greta soundbites can deliver.

ECB member Isabel Schnabel recently warned that Europe’s transition to cleaner energy presented upside risks to their inflation target. US states have generally avoided the worst of Europe’s policy errors but won’t be immune to rising global demand for coal, natural gas and oil. Investments in new production remain well behind what most analysts believe is necessary to meet emerging economies’ increasing living standards, and energy sector growth capex will remain constrained by caution around public policy.

If inflation is elevated due to the energy transition, tighter monetary policy need not follow. Although the energy value of a British Thermal Unit (BTU) is fixed, officials could conclude that greener BTUs are more desirable. It’s similar to the numerous quality adjustments statisticians at the Bureau of Labor Statistics make, which lower stated inflation. Successive iPhones are more expensive, but their added features represent improved quality. Since inflation measures the cost of a basket of goods and services of constant utility, this approach records falling prices for most consumer electronics even if the consumer winds up paying more. The same approach could be used for energy, in that the BLS could assess a quality improvement to energy delivered with reduced emissions, muting its actual increased cost.

The bottom line is that investors over the next year or so should consider the risks of a more hawkish Fed. But over a longer timeframe, the impact of sustained 3-4% inflation on portfolios warrants more attention. It’s likely to be the path of least resistance.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Investing based on Environmental, Social and Governance criteria (ESG) continues to gain following. Committing capital to companies that strive to do good appeals. Naturally, every company claims ESG credentials – because the criteria are so flexible it’s an inclusive definition. My favorite is Lockheed Martin’s regular membership of the Dow Jones Sustainability Index. If a company that builds machines to blow up people and things can have an ESG portal, it demonstrates the infinite flexibility of ESG.

Blackrock offers 30 socially responsible funds and leads AUM in the space with $60BN.  Investors are often surprised to learn that energy stocks are included, but for example, the $25BN iShares ESG Aware MSCI USA ETF (ESGU) has a 3% weighting to energy. Conventional ESG thinking is that companies that handle fossil fuels, which provide over 80% of the world’s energy, are not deserving of the ESG imprimatur. But Blackrock invests in pipeline corporations such as Williams Companies. Natural gas offers the greatest opportunity to lower CO2 emissions, by displacing coal. The EU looks as if they’re finally reaching the same conclusion, via changes to their taxonomy that would classify it (along with nuclear) as clean energy based on meeting certain criteria.

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Although ESGU’s energy weighting is a pragmatic choice, the energy transition will create challenges for those who seek a moral purpose from their investments along with outperformance. Evy Hambro, Blackrock’s global head of thematic investing, sees the energy transition boosting infrastructure spending. Hambro recently said, “What we’re likely to see is strong demand that will keep prices at very very good levels for the producers for many years into the future, and that could be decades.”

Hambro expects prices for copper, cobalt and other minerals vital to electrification to enjoy a long bull market. But spending on infrastructure will also boost traditional energy demand, because concrete, steel and other inputs won’t suddenly be produced using windmills.

This creates a conundrum for ESG funds. Positioning for a world that’s decarbonizing implies a much bigger allocation to Basic Materials, which along with Energy is only 5% of ESGU’s holdings. Apple, Microsoft, Google and Amazon are almost 20% of their portfolio. Many observers question the move to carbon neutrality these companies and others claim. Apple manufactures consumer electronics; Amazon delivery trucks are ubiquitous, and all have cloud-based offerings that require server farms consuming vast amounts of electricity.

Given the infinite flexibility of ESG funds, their most important attribute has been relative outperformance. This has been driven by fund flows, and there are signs this tailwind may be easing. As we noted last year (see Pipelines Are ESG) ESGU was beating the S&P500 for a couple of years. Its portfolio only deviated modestly from the index, demonstrating how many ESG-eligible companies there are. But over the past few months ESGU has started to lag.

The energy transition is fundamentally inflationary. This is axiomatic – reducing emissions will cost money, raising the price of energy. Otherwise we’d already live in a world full of solar panels and windmills. The energy crisis roiling Europe, a result of poor planning and too much dependence on windpower, is a case in point. ECB member Isabel Schnabel recently gave a speech warning about the inflationary effects of decarbonization.

ESGU is very highly correlated with the S&P500, because their holdings are so similar. Although it had modestly outperformed the market in the past, 2021 relative performance was negative. The past three months have been especially poor, leaving it 2.5% worse off over the past twelve months. This period of underperformance corresponds to heightened inflation fears with sectors like Basic Materials and Energy doing well.

ESG has long enjoyed a very flexible set of criteria. Relatively strong performance led some to believe that companies with high ESG standards were generating better performance metrics, such as ROE or profit margins. However, the evidence was never compelling, and more likely is that investor bias towards ESG funds has been self-fulfilling.

That may have started to reverse. It’s likely a portfolio designed to profit from a long bull market in commodities, as forecast by Blackrock’s Hambro and others such as Goldman’s Jeff Currie would look quite different from today’s ESG funds. The irony is that concern about climate change is high on the ESG checklist, and yet decarbonization may leave ESG funds underinvested in the sectors most likely to profit from this.

It’s fortunate that ESG is so flexibly interpreted, because if recent trends continue we’ll likely see new offerings that combine ESG with heavy commodity exposure.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

In Fed chair Jay Powell’s testimony yesterday during his renomination hearing before the Senate Banking Committee, he stuck to his familiar narrative of blaming inflation primarily on supply bottlenecks. We think excessive fiscal and monetary stimulus are more important reasons. One of the more persuasive charts is of Personal Consumption Expenditures (PCE). The Fed likes to use the PCE deflator to measure inflation, because unlike CPI its weights adjust to incorporate substitution (i.e., apples for pears if relative prices move).

Consumer spending is running well ahead of its ten year trendline – currently 7% above, equal to an extra $1TN. It’s 10% above it’s pre-Covid level. This would seem to be a more plausible explanation for inflation than supply bottlenecks. Fiscal and monetary policy are the cause. It still beggars belief that the Fed continues to buy bonds and maintain near-zero interest rates, providing ongoing stimulus that the economy no longer needs.

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Senator Pat Toomey (R-PA), the ranking Republican on the Committee, asked if it was realistic to expect the Fed to succeed in curbing inflation without bringing short term rates at least up to the level of inflation itself. Prior to entering politics, Toomey traded derivatives at Merrill Lynch and in the 1980s he and I once ate dinner together in New York with several other markets people. He understands finance better than most politicians, and this was a good question.

Powell responded that they expect supply bottlenecks to ease, but that the Fed was ready to do more if required. Their slothful normalization of policy reflects a degree of hope that supply constraints will recede, and inflation fall, without them having to do much.

Toomey’s question was salient, because the FOMC’s projections are for the Fed Funds rate to reach 2.5% in about five years’ time, presumably long after inflation has been vanquished. The eurodollar futures market is even more optimistic, priced for short term rates to stall out at around 2% within three years. Both are consistent with the supply constraints explanation for inflation. If it turns out that the $1TN in extra spending power available to consumers is more important, a change in expectations will be warranted.

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Bond yields have provided support for stocks for many years. Low long term yields continue to defy logic. Former Fed vice chair Alan Blinder was on CNBC yesterday morning, and like many observers he remains puzzled by this. Return-insensitive investors with substantial assets indiscriminately buying sovereign debt is our best guess. While it’s foolhardy to assume bond yields will rise significantly, it’s a risk worth pondering as the Fed finally starts normalizing policy.

Attention recently has focused on the Fed’s $8.8TN balance sheet. In response to a question, Powell said, “We will reduce the balance sheet sooner and faster than last time.” FOMC minutes from December fueled concern about how this might take place. The minutes noted that the balance sheet, “… was much larger, both in dollar terms and relative to nominal gross domestic product (GDP), than it was at the end of the third largescale asset purchase program in late 2014.”

If the Fed sits on its hands, $1.1TN in US treasuries will mature within the next year. More intriguing is whether the Fed concludes long term yields need to rise in order to slow inflation. They have $3.9TN with maturities longer than ten years, $2.6TN of which is Mortgage-Backed Securities (MBS). Total 2021 MBS issuance was $4.2TN, so the Fed is a big player here. Their balance sheet was growing at a $1.4TN annual rate until the recent taper announcement. If they ever decide to shrink it at the same pace, the Fed would have to start auctioning off some of its holdings.

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For equity investors it’s worth considering what a 3% yield on the ten year treasury might mean. The Equity Risk Premium (ERP) would no longer show stocks to be cheap, at least compared with valuations over the past decade.

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Energy continues to perform well, and yet pipeline stocks remain mispriced relative to their bonds. Several investment grade issuers offer dividend and free cash flow yields substantially higher than their long term bonds. A buyer of debt maturing in three decades by definition holds a constructive view on the equity.

Midstream infrastructure bond yields reflect equanimity if not optimism over the long term prospects for the issuers. By contrast, equity valuations continue to suggest concern about the security of payouts, overlooking the increasing prevalence of dividend hikes and stock buybacks. The apparent disconnect between equity and debt pricing remains a puzzle.

Stocks are vulnerable to a sharp jump in bond yields.  However, pipeline stocks offer much better valuations as well as protection against inflation if it persists at a higher level than many expect.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Last Thursday Jim Cramer described the performance of the ARK Innovation ETF (ARKK) run by Cathie Wood as “attrocious”. This caught my attention – Cramer, whether you love him or not, doesn’t often criticize other asset managers.

It turns out that the demise of ARKK highlights what happens too frequently in finance. To wit, because inflows to ARKK followed strong performance, as is usually the case, it turns out that the cumulative P&L on ARKK is negative. It peaked last February at just under $12BN and has been in steep decline ever since. At the beginning of this year it crossed into negative territory. The average dollar invested in ARKK has lost money.

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I employed this type of analysis when I wrote The Hedge Fund Mirage a decade ago. The high returns hedge funds generated in the 1990s weren’t enjoyed by many, because Assets Under Management (AUM) was small. There just weren’t that many clients.

Flows followed performance, and by the 2008 financial crisis the hedge fund industry was big enough that in one year it lost all the earlier profits ever generated for investors. This inspired the book’s opening sentence: “If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.”

This indictment of the hedge fund industry was justified because in its early days “absolute returns” were promised – a positive return over a market cycle. Investors were also led to believe funds would close to new capital once the manager determined deploying it would dilute returns. More common was for the most successful wealthy hedge fund managers to return ALL the capital so they could focus on their own money.

Marketing has moved on since then because absolute returns were unachievable. Good relative returns was tried but also dropped as empirical evidence found this wanting. They later settled on uncorrelated returns, and have succeeded with undiscerning investors ever since.

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Even though ARKK has now joined hedge funds in generating net losses for investors, it would seem unfair to be quite as critical of PM Cathie Wood. ARKK clearly doesn’t hedge, and every manager believes their fund will generate positive returns. It’s easy to forgive circumstances beyond the manager’s control – your blogger has run an energy mutual fund and ETF for many years. It hasn’t always seemed the place to be, which is partly why performance has been so strong lately.

It is nonetheless sobering to compare the cumulative P&L of ARKK with the management fees earned, which we estimate at around $230 million since its 2014 launch and still piling up at around $300K per day. Clearly an investment in Ark Investment Management, LLC, the advisor to ARKK, was a much better choice than ARKK itself, just as being a hedge fund manager has been far better than being a client.

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Fund managers can resolve this misalignment of interests between them and their investors by investing alongside their clients. Fluctuations in the value of my personal holdings of pipeline stocks exceed by a wide margin the returns from asset management, which is how it should be.

Even though the contrast between the fortunes of Ark Investment Management, LLC and ARKK is due in large part to inflows chasing performance, it’s still visually striking. A large segment of the investing public needs confirmation from others before committing their own capital.

While copying others is  usually a sound approach in the purchase of most things (cars, consumer goods etc.) financial markets don’t work that way. History regularly provides examples of the folly in following the crowd. But it repeats. The timing of ARKK’s biggest inflows coincided with its peak – the moment of maximum misplaced confidence.

Morningstar doesn’t help. Even now, with a lifetime negative P&L, ARKK has four stars and is the #1 ranked fund over five years. Morningstar’s rankings are all based on quantitative data, presumably to eliminate any analyst judgment. But you might think that the trajectory of ARKK’s cumulative profits would be worth considering. It’s hard to identify much useful for investors here, although Morningstar rankings do drive fund flows which generally benefits managers.

ARKK has still handily outperformed the energy sector over the past five years. Pipelines have not drawn innovation-seeking buyers, instead appealing to more pedestrian tastes. The opposite trajectories of ARKK and energy have persisted during the boom in commodity proces and global energy crisis.

Although there’s no pleasure in seeing ARKK’s fall from grace, the shift from growth to value has benefited midstream energy infrastructure. Pipelines are also a long way from experiencing the type of manic buying that punctuated the peak in ARKK’s share price, which seems like another good reason to consider the sector.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Although markets were quiet over the Christmas break, treasury yields drifted steadily upward. On the first trading day of the new year the ten year yield burst higher by 0.12%. Although the Fed seemed to bring inflation expectations under control at their most recent FOMC meeting in December, this is now starting to reverse.

The yield curve has been steepening, reversing the sharp flattening that hurt several hedge funds late last year. It still seems impossibly flat – we’re about to enter a tightening cycle and expectations are that it will be mostly complete by the end of 2023 – less than a full 0.25% tightening is priced in over the following two years.

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Eurodollar futures are still priced for Fed Funds to remain below 2% — implausibly optimistic, because it implies that the Fed will contain inflation without raising short term rates even to their long term inflation target. The FOMC’s guidance is 0.50% higher, and although they are awful at forecasting their own actions, this time perhaps the market will adjust to the Fed rather than the other way around as usually happens. Put another way, history suggests that inflation won’t get back to 2% unless the Fed raises rates above this level.

Part of the justification for equanimity over how high short term rates need to go has come from the bond market. In mid-December, ten year treasury yields were below 1.5%. Pushing short term rates above long term yields, creating an inverted curve, would provoke warnings that the Fed was about to cause a recession. An inverted yield has a mixed track record as a predictor of a slower economy, but it might be expected to give decision makers pause.

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However, following the recent slump in the bond market, ten year treasury yields are within reach of last year’s 1.73% high. Maybe it’s a delayed reaction, but confidence about the Fed’s ability to bring inflation back down has been seeping away for a month. The continued fall in real yields has muffled the message somewhat, but ten year inflation expectations have risen 0.30% since the announcement of a speedier taper.

Employers are budgeting for wage increases of 3.9% this year, according to a survey by the Conference Board. Most analysts expect inflation to moderate, but bringing it back to 2% is looking less likely. The modest tightening projected by the market is unlikely to convince businesses to expect it, which would make ~4% annual wage hikes more likely to persist.

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The Fed over-estimated the amount of slack in the labor market, a point chair Jay Powell began to concede during his press conference last month. They maintained a highly accommodative policy stance for too long in the hope that labor force participation would improve. They targeted a return to employment level of 152 million last seen in January 2020, before Covid hit. It’s still more than four million below that level, and since the Fed now emphasizes the “full employment” element of their twin mandate, they were willing to risk inflation to help those remaining unemployed people back to work.

The Fed has not given up, because their policy remains highly accommodative. A slower pace of buying bonds and near-zero rates do not represent hawkish policy. But they’ve belatedly recognized all the other signs of a tight labor market, such as 3.9% wage increases or the record 4.5 million Americans who quit their jobs in November.

“The important metric that has been disappointing really has been labor force participation,” noted Powell during his press conference. He cited, “factors related to the pandemic, including caregiving needs and ongoing concerns about the virus…”   Others were, “aging of the population and retirements” Three years of a strong market has probably helped many people retire ahead of time.

The rise in treasury yields is bearish. It reflects rising inflation expectations and implies a higher peak in the Fed Funds rate during this tightening cycle. At a certain point it is negative for stocks, since low rates have driven investors into equities for years. However, ten year yields would need to be approaching 3% not 2% for that to be a factor. And the pool of return-insensitive capital willing to own sovereign debt at negative real yields seems limitless, which is facilitating a degree fiscal profligacy that would otherwise be much more costly.

But it does mean that eurodollar futures 2+ years out below 2% remain too low. The Fed’s sloth-like return to neutral policy relies on the hope that inflation will moderate of its own accord, not that the Fed’s actions will cause it to. Much can go wrong with that.

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Unrelated to inflation but notable nonetheless was news that last month the US became the world’s biggest exporter of liquified natural gas.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

As we noted last week, the world doesn’t need another anodyne “2022 Outlook”. So we’ve put together a set of upside scenarios that are plausible but not consensus.

Last week we published The Upside Case For Pipelines – Part 1. This examined factors unrelated to commodity prices that could provide the sector a boost. This blog post considers what might boost oil and gas prices, which would likely provide a lift to the sector.

They fall into four categories – cyclical, geopolitical, Covid and the energy transition.

1) Cyclical factors that are bullish

Reduced growth capex has become a positive habit for the energy industry. Depletion of oil and gas wells is 2-4% of production – meaning that the industry needs to invest in that much new supply just to stay even. Crude oil demand has obviously been volatile over the past couple of years, but looks likely to reach new record levels over the next couple of years, driven by growth in emerging economies. The industry seems poorly positioned to meet this extra demand.

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Capex is down 2/3rds from its 2014 peak, and the industry shows little inclination to boost it in spite of high prices and entreaties from the Administration. RBN Energy expanded on this theme in September (see Where Has All The Capex Gone? E&P Investment Down Despite Rising Prices And Cash Flows).

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Global oil inventories have been drawing down since early last year, leaving little excess available. Moreover, OPEC countries are producing well within their stated capacity, which leads some to suspect that their actual maximum production capability is less.

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The story is similar with natural gas, except that global demand is more clearly rising. Because transportation costs are relatively high, regional prices vary substantially. TTF futures, the European natural gas futures benchmark, are priced at the equivalent of $26 per Thousand Cubic Feet (MCF) for January 2023, lower than the $29 equivalent price of the front month January 2022. US prices are one seventh of this, so the prospects for continued growth in shipments of US Liquified Natural Gas (LNG) to Europe and Asia look good.

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Against this positive backdrop for prices, it’s worth remembering that oil services companies shrank payrolls in response to the drop in capex, so even if spending did ramp up it would take time for the industry to rehire and retrain.

Lastly, economies around the world have been improving their energy efficiency. The US is no exception. Adjusted for inflation, it takes 60% less energy per $ of GDP output than was the case in the 1970s. Therefore, energy prices have a smaller impact on the economy today, making it better able to withstand higher energy prices than in the past.

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2) Geopolitical factors that might surprise

The middle east remains one of the less stable regions of the world. A fifth of the world’s crude and an increasing amount of natural gas pass through the Strait of Hormuz. Although it’s unlikely Iran could ever cause more than a temporary disruption to supplies, the threat remains, along with the possibility of conflict breaking out elsewhere. The world has very little spare capacity, so is vulnerable to surprises here. A failure in the Iran negotiations over nuclear weapons would keep Iranian oil mostly off the world market.

Russia’s growing military threat to Ukraine is another flashpoint where armed conflict could disrupt supplies of Russian natural gas to western Europe. Nordstream 2, the controversial natural gas pipeline from Russia to Germany, is completed but not yet operational pending German and EU regulatory approval. Conflict in Ukraine might delay its start indefinitely – likely a factor behind the elevated price of January ‘23 TTF natural gas futures noted above.

3) Covid loses its ability to disrupt

The Omicron variant is highly infectious and milder than preceding variants. It is causing far fewer hospitalizations and research shows why it’s causing less severe illness (see Studies Suggest Why Omicron Is Less Severe: It Spares the Lungs).

Economic disruption from Covid has come mostly from the mitigation steps countries have taken to curb its spread. In the near term, Omicron’s fast rate of spread is likely to drive global supply disruptions in a more synchronized matter. Former FDA Commissioner Dr Scott Gottlieb has become a widely followed resource on covid, and he expects in 2022 we will “…go from a pandemic into a more endemic phase,” as countries learn to live with Covid without noticeable disruption.

As the world opens up, energy demand will increase especially in Asia where many borders have remained partially or fully closed. International air travel remains the one weak point in liquids consumption, and a rebound could push crude prices higher. We’ve already seen prices reach $80 recently without these sources of extra demand.

4) Energy transition

So far there’s little sign that renewables are reducing the world’s demand for oil, gas and coal. Higher prices for fossil fuels remain inevitable if consumers are to switch to other forms of energy. The failure of COP26 in Glasgow may lead to renewed unilateral efforts by policymakers to reduce emissions. Curbing coal remains the obvious target – consumption limits or wider use of carbon taxes would drive demand for natural gas as the closest substitute, and to a lesser extent crude oil.

New Year’s Day brought an encouraging report that the EU will classify nuclear power and, in certain cases, natural gas as “green” energy. The requirements for natural gas include that it’s being used to replace coal, and that its emissions are no higher than 270g per Kilowatt Hour (KWh). Natural gas emits 180g per KWh, so even allowing for conversion losses this ought to be an achievable benchmark.

Assuming the news report is comfirmed, EU endorsement of natural gas as part of the energy transition solution is a long term very postive development for the natural gas industry. It will likely add momentum to emerging economies and perhaps even the US to adopt a similar approach. It should be supportive of natural gas demand and correspondingly negative for coal.

The energy crisis of 2021, which exposed some countries’ overly hasty embrace of renewables, showed that traditional sources of energy are vulnerable to sudden price jumps.

Any of the factors above or some in combination could drive oil and gas prices higher, potentially much higher, which would support already improving sentiment in the energy sector.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

The world doesn’t need another “what to expect in 2022” outlook piece. Inboxes are full of them this time of year. Therefore, what follows is part 1 of a two-part look at what could create upside surprises for midstream energy infrastructure. The downside is well understood and was experienced in full force quite recently. On March 18, 2020 the Alerian MLP Index (AMZIX) closed down 67% for the year. The broad-based American Energy Independence Index (AEITR) was marginally better at down 63%. There’s no plausible downside scenario that can beat that for a live ammunition drill. Within 19 months the two indices had rebounded 220% and 264% respectively.

What follows is inspired by Byron Wien’s Ten Surprises. These are upside developments that are plausible but not consensus. This blog post will focus on non-commodity price items – Sunday’s will look at scenarios for higher oil and gas.

1) Investors become convinced financial discipline will continue

Although growth capex peaked in 2018, the sector continues to be priced as if such prudence will prove temporary. We project that for the companies in our index 2021 spending will be down by more than half from the 2018 peak, and continue lower in 2022. A couple of companies are expected to buck this trend somewhat (Kinder Morgan and Pembina), but generally the direction is down. Lower spending has been the most important factor driving Free Cash Flow (FCF) higher, although rising Distributable Cash Flow (DCF) has also helped.

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Although four years of discipline is presumably reflected in the market, we continue to believe that dividend yields above 7% and FCF yields above 11% reflect persistent skepticism, perhaps because of the prior history. This is an industry that long attracted income seeking investors with stable payouts that grew, and modest growth capex. The damage that abandonment of this model and the associated investor base caused still tarnishes its reputation. If the market starts to become convinced this is the new normal, the sector could reprice to the upside.

2) Pragmatism guides the energy transition 

There’s little doubt that solar and wind will grow. But there aren’t many examples of intermittent power delivering the cheap energy and attractive jobs that progressives  keep promising (listen to our podcast Incoherent Energy Policy). Failures are becoming more visible and costly – sky-high prices for Liquified Natural Gas (LNG) in Europe and Asia are the latest example of the recklessness of turning public policy against existing energy supplies while new ones remain inadequate.

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Practical solutions may gain traction, including acknowledging a slower energy transition, increased use of nuclear, favoring natural gas over coal and boosting incentives for hydrogen, and for carbon capture and storage from the use of existing, reliable energy. Looking at the figures instead of the media’s breathless coverage, renewables are insignificant yet disruptive.

3) Real yields continue to fall

Ten year TIPs yields of –1.0% already seem impossibly low, but there is no theoretical limit to how far they can fall. This may temper an otherwise inevitable increase in bond yields, by projecting higher inflation expectations without a rise in nominal yields. The fall in real yields traces back decades and there’s no reason to think it stops here. It represents an enormous wealth transfer from those who must own sovereign debt — foreign central banks, pension funds and others with inflexible investment mandates. The beneficiaries are borrowers, chiefly the US government and by extension, taxpayers. It’s why our dire fiscal outlook continues – there is little discernible cost.

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If these current trends continue the appeal of stable income with inflation protection, which real assets (including pipelines) offer, could become irresistible. Fixed income remains a completely losing proposition.

4) Inflation surprises to the upside

Most forecasters expect inflation to fall substantially in 2022. However, there are plenty of indications that Americans expect it to remain elevated. Low bond yields mean the yield curve could invert with as little as 1.5% of tightening by the Fed. This traditional precursor of a recession is likely to create offsetting concern about employment.

Having helped cause inflation, the Fed’s tools will as usual be blunt and they’ll face the unenviable choice between throwing people out of work or tolerating inflation closer to 3%. The return to 2% inflation over the long run is by no means assured. Real assets such as pipelines would benefit.

5) Republican mid-term gains squash any anti-energy sector legislation

Build Back Better remains alive and could pass in a further reduced form with climate change policies. Whether Joe Manchin and the White House reach agreement or not, this is probably the progressives’ last opportunity to implement the less extreme elements of their wish list.

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A shift of the House back to Republican control, or the loss of one Democrat senator would leave executive actions as the only remaining tool. Perhaps this would even lead to a more substantive dialogue about the energy transition – one that acknowledges the cost and seeks to justify it, doesn’t falsely claim thousands of new jobs and explains why it’s in our interests to continue reducing emissions while most emerging economies are growing theirs. A thoughtful debate about how to manage the possible risks of increased emissions is overdue.

6) Sector fund flows turn positive 

Sentiment is no longer negative and is showing signs of cautious optimism, at least based on the dozens of calls we’ve had in recent weeks. Fund flows turned negative in February 2020, and just turned positive two months ago. The sector has enjoyed a strong rally without significant retail participation. If the trend on inflows persists that could provide a significant boost. 

Any one of these factors could push pipeline stocks higher. There remains plenty of opportunity for upside surprises.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Today is Boxing Day. The US is rare among English-speaking countries in not celebrating the day following Christmas. Perhaps the habit was dropped following the War of Independence in a further shedding of the colonial yoke.

Our family continues to enjoy Boxing Day even after nearly 40 years in the US. It is in truth another day to over-indulge, including of Christmas pudding. This is a dark, heavy type of fruit cake liberally fortified with brandy and best served hot, with heavy cream. Americans know it as plum pudding, although it contains no plums.

English Christmas dinner of turkey and all the trimmings is only complete following dessert. Because a Christmas pudding is never as big as it looks, what appears to be a generous quarter slice presents as Scrooge-like by the time it reaches your plate. My opportunities to enjoy it are limited by my wife, who proclaims the ingredients (notably suet, which is fat derived from beef or mutton) deeply unhealthy which is of course why it tastes so good. Because the alcohol greatly extends its shelf-life Christmas pudding can, and often is, made months ahead of time. My grandmother used to make it in September, and once as a special treat served me one in May left over from Christmas.

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This history, along with what the uninitiated hold is an unappetizing appearance, has convinced my children to steadfastly reject even a small portion. This is fine with me, not least because my wife’s reported desire to have me around for a good many more years limits the amount available. One consequence is that I offer it to our guests sotto voce with easily constrained enthusiasm while noting how good the chocolate cake looks. At such times my mother’s hearing becomes temporarily acute, and she claims my anticipated second slice. I’m told Christmas pudding is very hard to get, but I suspect if I did the holiday food shopping I’d find it in abundance.

Last week my wife, whose care for my general well-being is only exceeded by her love of a bargain, let me know she just bought two Christmas puddings on sale. She’ll keep them for next year.

Friends often ask me about the history of Boxing Day. Since servants had to work to make Christmas Day memorable for the household, Boxing Day was when they received a Christmas “box” (gift of money) and enjoyed their Christmas feast downstairs. Watch the Downton Abbey Christmas special sometime. For generations the English have coped without household staff, so Boxing Day has served to extend Christmas into a second day.

Boxing Day isn’t just about leftovers. The Premier League (English football) kicks off an intense schedule requiring each team to play three times through January 3^rd. It is a holiday season football festival. Coaches complain about insufficient recovery time but the world’s biggest soccer league supplies what its global TV audience demands.

Omicron is thankfully little more than a minor inconvenience and has not been allowed to interupt proceedings, although some games will inevitably be postponed while infected players self-isolate.  Nonetheless, for just over a week the choice of games to watch seems limitless.

For energy investors this has been a good year, by some measures the best in a decade. Because of this I reached Christmas, already one of my favorite times, in a thoroughly agreeable disposition.

Which is why on this Boxing Day, if your blogger can procure an extra slice of Christmas pudding while watching Arsenal win their first game of the hectic nine-day schedule, it will cap a Christmas as perfect as can be. Encouragingly, their opponents Norwich City languish at the very bottom of the table.

Boxing Day aside, I expect happiness from investing in 2022 will easily exceed the ephemeral pleasures offered by Arsenal and the Christmas repast. If so, few will complain.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

Build Back Better (BBB) includes many provisions beyond the scope of energy and interest rates, the two topics this blog covers. But to the extent that Senator Joe Manchin (D-WVa) has torpedoed progressive goals on climate and $3TN in additional debt, he’s demonstrated better judgment than the rest of his party.

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Start with the debt. The American Recovery Act passed in March was $1.9TN of deficit spending that wasn’t needed given the positive vaccine news five months earlier. It has contributed to the inflation that Manchin cited as one of his concerns. Had Congress and the White House been less impulsive, the dire fiscal outlook wouldn’t have made it quite so easy to criticize BBB. Modern Monetary Theory is already showing its limits.

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Now to the energy transition. America’s success in reducing emissions over the past decade has come from coal to natural gas switching for power generation. Solar and wind grab most of the headlines, but the data is clear. Renewables create most of the media noise but not the substance.

One piece of good news is China’s growing natural gas imports from America, which will help reduce their voracious coal appetite and help curb their emissions. Senator Elizabeth Warren, often short of policy insight, recently asked if big natural gas producers had, “considered cutting, suspending, or ending exports of natural gas to help ease spiking domestic prices.” Supplying China with natural gas helps reduce global CO2. Higher domestic prices, which still remain substantially below those in Europe and Asia, are a cost of the energy transition that she ought to be championing.

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Cynics will point to Manchin’s fealty to West Virginia’s coal sector – and if he’s responding to his voters that seems more democratic than the opposite. But if BBB embraced more practical solutions such as sharply increasing nuclear power and supporting continued coal to natural gas switching, it would at least be more practical than the relentless focus on intermittent, weather-dependent energy.

Manchin added, “…if technology is not there, we got to make sure that we’re able still to rely on United States of America. We have been energy basically independent for the first time in many, many years, 67 years or more.”

The Shale Revolution may have been an investment bust, but it has created a degree of energy security in America that was previously unknown. It’s hard to see why we’d give that up. White House pleading with OPEC to lower gasoline prices represents a low point.

On Sunday’s talk show, Manchin correctly said, “The main thing that we need is dependability and reliability. If not, you’ll have what happened in Texas and what happens in California.” He might have added most of Europe as another example of energy policy gone awry. Trying to rely on windmills and solar panels before the technology is robust enough is not a viable strategy.

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European wholesale electricity prices are at multiples of the US, because of poor planning, naivete about Russia’s intent to be a reliable natural gas supplier, and cold weather. Month ahead German power prices reached €350 per Megawatt Hour, and French prices almost €600.

German households were already paying about 3X US households for electricity a year ago, before the price spike. The German wholesale cost of power has jumped from €30 per MWh since then, an increase of 10X. Even though three quarters of the average German household’s monthly bill is distribution, fees and taxes, allowing the full increase to pass through to households would result in a tripling of bills. EU governments (i.e. taxpayers) are likely to absorb much of the increase.

US energy policy in many states remains far better than the European model. Manchin added, “…we should not have to depend on other parts of the world to give us the energy.” The energy transition will be expensive, and it may be worth it. The problem is politicans keep pretending it’s costless, while examples of its expense keep piling up. Intermittent power that’s 10X the cost in America isn’t how we’ll get there. And it makes more sense to start when the biggest emitters are signed up.

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Until China, 28% of the world’s CO2 emissions and growing, is prepared to make actual cuts, it’s hard to see why OECD countries should. Until a solid majority of the world is aligned why should Americans pay more while Chinese and Indians just burn more coal?

Concern about climate change is broad, but its shallowness is betrayed by politicians’ reluctance to answer these questions. The failure of Build Back Better in its current form offers the chance of a more pragmatic energy transition that is less disruptive to growth and therefore better for the economy, including the energy sector.

The energy sector received a boost from Joe Manchin. Reducing emissions to deal with climate change will remain a focus of the sector, but rejecting the solutions of climate extremists will allow for a more pragmatic, durable approach.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Please see important Legal Disclosures.

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

Real Assets Fund

Please see important Legal Disclosures.