The continued ascent in natural gas prices has transfixed the energy sector but hadn’t much impacted broad market commentary, until recently. Europe has an energy crisis to be sure – a combination of over-reliance on windpower, years of policy discouraging natural gas production and strong global demand for natural gas. If sentiment in the pipeline sector was as sensitive to natural gas prices as it is for crude oil, its performance would likely have been even stronger in recent days. The recent jump in crude prices has grabbed more mainstream attention, propelling energy sector stocks up with it.

The Federal Reserve and other central banks will have to grapple with the feedthrough impact on inflation. Policymakers already exclude food and energy from the inflation statistics they target, on the basis that these are volatile and mean-reverting. However, higher utility bills and increased cost of transportation will have a secondary effect on most areas of the economy.

Wage inflation has historically been the trigger for shifts in monetary policy – wage increases beyond what improved productivity justifies. The same test could be applied to commodities though. A thousand cubic feet (MCF) of natural gas delivers the same one million BTUs whether the price is $3 per MMCF as it was a year ago or $6.25 as it is currently. Even at that level it’s a quarter of the price European and Asian buyers are paying for imports of Liquified Natural Gas (LNG).

The only constraint on US prices is the availability of more LNG export terminals capable of chilling methane so it’s 1/600^th of its normal volume. As more LNG export capacity becomes operational, domestic natural gas prices will move higher. Interestingly, European prices for carbon credits have been following natural gas prices higher. Even at €70 per metric tonne, they’re no constraint. Natural gas generates 121lbs of CO2 per MCF, so a power plant has to pay around €3.30 per MCF for CO2 credits. The fact that these credits are rising with natural gas prices reveals the strength in demand.

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The FOMC continues to believe inflation is transitory, which is why they’re comfortable with a very gradual reduction of bond market support. It looks as if monthly buying of mortgage-backed securities will continue into next spring, a year after it was abundantly clear that the US housing market was hot (see Federal Reserve Housing Support Has Run Its Course).

Because the FOMC relies on the quirky Owners’ Equivalent Rent (OER) survey of homeowners to gauge the cost of shelter, they don’t see housing inflation (see Why You Can’t Trust Reported Inflation Numbers). The followers of OER are probably limited to a few hundred people, consisting of statisticians at the Bureau of Labor statistics, Wall Street economists and the FOMC. The rest of America looks at house prices. So the Fed is once again feeding a housing bubble by not looking at it.

An unusually calm North Sea was the proximate cause of Europe’s energy crisis (see Europe Follows California Into Renewables Oblivion), but the loss of windpower has exposed years of underinvestment in conventional energy such as natural gas. Higher prices are an obvious consequence and are part of the climate extremists’ playbook. Shifting towards renewables was always going to lead to higher prices (see Is The Energy Transition Inflationary?). This provokes two big questions for markets: (1) will the Fed feel compelled to respond to energy-driven inflation as it becomes clear that it’s not transitory, and (2) does the jump in natural gas prices suggest that we need more supply, or will unreliable solar and wind benefit from improved relative pricing?

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On the first question, we’d bet on the FOMC exploring every alternative explanation before concluding that inflation requires changes in monetary policy. They’ll be relieved to see that the sell-off in bonds is mostly driven by rising real yields. The market is adjusting to approaching cessation of Fed buying. Ten year implied inflation has remained in the 2.3-2.4% range.

The second question is more complicated. Investment in new oil and gas production has been declining for years. Rich world policies that discourage fossil fuels and climate extremists’ efforts have constrained energy sector capex. Today’s high prices are the result. Solar and wind power are incapable of filling the void. As Britain has discovered, intermittency remains a huge problem. Back-up battery storage still isn’t available on economic terms. Power grids require substantial upgrades. So, do policymakers correctly accept the inevitability of continued natural gas use for decades to come while seeking technological solutions to emissions, such as carbon capture? Or do they conclude we need even more renewables? Climeworks is a start-up company that sucks CO2 out of the air. It was profiled in a WSJ story describing OPEC’s expectation to gain market share through 2045, helped by global demand growth led by emerging economies and falling rich world production.

New Jersey is one state heading for poor choices. Earlier this week PennEast dropped plans to build a natural gas pipeline from Pennsylvania to New Jersey because of continued regulatory challenges. As a result, New Jersey customers will in years to come face less reliable power.

Public support for the energy transition is about to be tested by higher prices. Polls show voter support until it hits their wallets. Political leaders sure of their footing will embrace today’s energy prices as an important element of the transition.

Meanwhile, higher energy prices will feed into the broader inflation statistics in the months ahead.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Last week’s FOMC meeting for once gave the market something to ponder. The $120BN of monthly bond buying looks set to taper before the end of the year, and to be down to zero by next summer. Fed buying of mortgage-backed securities has been especially superfluous, as shown by the red-hot housing market.

The market interpreted a more hawkish message, and eurodollar futures yields rose to price in a slightly more aggressive pace of tightening. It’s true that median rate expectations of FOMC members edged up compared with June. But the range of forecasts remains very wide. This may be one of the reasons Fed chair Jay Powell continues to advise against too close a reading of the projection materials, even though we all pore over them with great care as soon as they’re released.

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To use one example – the median FOMC member’s forecast for the Fed Funds rate at the end of 2023 rose, from 0.625% to 0.875%. A 0.25% increase, even over two years out, seems significant. But as the chart shows, views within the FOMC vary widely. One member doesn’t think they’ll have raised rates at all by then (down from five who held that view three months ago). There’s still a gaping 1.5% gap between the high and low forecast. Committee discussions about the outlook must be lively, at least within the constraints of what’s plausible when discussing monetary policy.

Most FOMC members continue to expect to raise rates faster than implied by eurodollar futures, which offers an opportunity for those able to participate. The spread between Dec ‘23 and Dec ‘25 futures remains too flat – it came in briefly on Wednesday along with the twos/fives yield curve following the release of the FOMC statement but widened again the next day.

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Another interesting evolution concerned FOMC members’ “longer run” outlook for short term rates, the so called equilibrium rate. For years this has been declining, along with real rate or the premium markets demand over inflation. Chair Powell has discussed “R-star” in the past. R-star is the Fed’s assumed equilibrium real rate, or the margin over inflation they should target for neutral policy. R-star of 0.5% added to 2% inflation is how they’ve arrived at a 2.5% neutral rate, and it’s the reason today’s FOMC appears so dovish. A lower equilibrium rate means there’s less room to cut rates when needed, which makes it harder to achieve their inflation target. Hence the new policy adopted just over a year ago of allowing inflation to exceed their 2% target rather than acting pre-emptively to prevent it.

So it’s notable that FOMC members’ “longer run” forecast of short-term rates came down somewhat. Only 15 of them offered such a forecast, down from 17 in June and short of the 18 who provide annual rate forecasts through 2024. It’s unclear why an FOMC member would provide less than a complete set of forecasts, but the missing ones were probably more hawkish because all the three forecasts in June above 2.5% were gone last week.

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At the same time, inflation forecasts have edged up slightly, with core Personal Consumption Expenditures inflation (the Fed’s preferred measure) expected to run at 2.2% in 2023, up 0.1% from June. Most notably, although 2.5% is their median long run neutral policy rate, only one FOMC member expects rates to be above that level even by 2024.

What conclusions should one draw from all this numerical insight into the Fed’s thinking? Their opinions vary widely, but they expect to raise rates faster than implied by the market. But they are optimistic — even though they’ve had to constantly revise their inflation forecasts higher, they overwhelmingly expect inflation to return to their 2% target without having to raise rates above the 2.5% neutral level.

Moreover, the tone of the FOMC is very dovish, at least to this observer of 40+ years. There are no hawks in the traditional sense. The notion that monetary policy can be used to moderate income inequality, as Jay Powell has suggested in the past, has not been suggested by his predecessors. It’s easy to imagine the dilemma such a view will pose when it comes time to tighten rates. There will be a healthy debate about whether lower income Americans are hurt more by inflation or higher rates, and the consideration of income inequality along with the level of employment will cloud the right course of action.

It’s also likely that Democrat administrations will apply a monetary policy litmus test when selecting future FOMC members, in the same way that Supreme Court candidates’ past rulings are examined for signs of reliable political bias. For example, Boston Fed president Eric Rosengren, who just announced his early retirement, is an outspoken critic of the Fed’s bond buying (see The Fed’s Balance Sheet Has One Way To Go). His replacement is likely to be more dovish.

The bottom line is that, while short term rates will inevitably rise, the Fed has shifted to care more about maximizing employment than protecting savers. Investors should position accordingly.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

A feature of renewables not widely acknowledged is their relatively low capacity utilization. Solar is limited to daytime, with peak generation around midday. Output is typically 20-25% of capacity, meaning a 10 MW solar farm would generate 48-60MWh every 24 hours. The UK’s windpower capacity utilization was 37% last year, higher than is typical. As the chart shows, it bounces around unpredictably.

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Offshore wind tends to produce more often than onshore, which is why the UK has been adding installations in the windy North Sea. The recent tranquility has cut wind to 7% of UK power generation, from 24% last year, likely bringing capacity utilization down to 10-11%. The sheep in the photo have evidently learned that windmills can offer relief from the sun at least as often as they produce electricity. It’s true the tower is stationary, but careful examination of the photo also reveals sheep standing in the shadow of the (presumably motionless) blades.

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Three years ago efforts to develop fracking of natural gas in Britain were abandoned following relentless pressure from environmental extremists (see British Shale Revolution Crushed: America’s Unique Ownership of Oil and Gas). The UK’s Lord Ridley, a member of the House of Lords, warned that Russia was funding the opposition to these efforts to reduce Britain’s reliance on imported energy. NATO’s secretary general had voiced similar concerns as far back as 2014.

Ridley recently referred to Friends of the Earth, a vocal opponent of fracking in the UK, as “useful idiots” during a radio interview. They shared Russia’s objective of crushing domestic gas production, albeit for different reasons. Now the IEA is calling for Russia to increase such exports to Europe. Russian funding of western environmental opposition to natural gas production has delivered Russia an astronomical IRR, about to be paid for by European governments forced to subsidize household energy bills.

The energy squeeze confronting western Europe is coming at a time when energy demand is usually low. Cooler weather as summer ends is when natural gas supplies are typically built up in preparation for winter. For reasons that include mysteriously low Gazprom exports and a Brazilian drought that has lowered hydropower, global natural gas prices are soaring.

Analysts are warning that Europe faces a real possibility of power cuts if unusually cold weather exposes low gas inventories. Compounding matters, Gazprom CEO Alexey Miller recently said that, “… the Asian market is more attractive for producers and investors despite the record-breaking prices in Europe.”

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Asian and European natural gas prices have risen together, with Asian buyers especially keen to avoid a repeat of last January’s winter squeeze. As a result, they are often outbidding European buyers for shipments of liquified natural gas.

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European governments are being forced to respond to sharply higher household electricity bills and bankruptcy risk among electricity providers. An Italian government source said, “a plausible amount to tackle the issue [of soaring energy costs] could reach up to €4.5bn.” U.K. Business Secretary Kwasi Kwarteng warned that the country faces a “long, difficult” winter with high energy prices tipping power suppliers into bankruptcy.

So far the UK is not planning to bail out power suppliers that fail, and PM Johnson has refused to scrap “green levies” on power bills even though they’ve helped cause the problem by subsidizing windpower investments.

Since the energy transition is all about new technologies, policymakers need to look beyond intermittent sources of energy. Direct Air Capture of CO2 is another example of what might be possible while allowing reliable electricity generation to continue.

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On a different topic, my wife and I were disappointed to find downtown Minneapolis almost deserted on a recent Sunday lunchtime, still reeling from the twin blows of Covid lockdowns and violent protests following George Floyd’s murder. Nicollet is described as “downtown’s core shopping and entertainment artery” on the city’s hopelessly out of date website.

I posed next to the Mary Tyler Moore statue watched by two bored cops and no one else.  A 20 minute drive north, a local strip mall had lost all its tenants except for a Dollar Tree. Afterwards we headed to Duluth, on Lake Superior, which was more vibrant.

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We went to Minnesota to visit my wife’s penpal of 45 years, a relationship that began when they were both in middle school. Their friendship through writing predates our own. They had shared life’s events via air-mail letters and birthday cards, retaining this medium even when email because ubiquitous, but had never met until now. Over several very agreeable hours we became friends with a warm and friendly family, typical of the midwest. Our next meeting won’t take as long.

For years environmental extremists have campaigned with increasing success for less investment in fossil fuels. The logic has been that as CO2-emitting sources of energy become harder to access and more expensive, the world would increasingly turn to renewables. Confronting demand for energy has generally been eschewed in favor of targeting suppliers. It’s far easier to demonize a few hundred companies providing the reliable energy that billions of consumers want.

EU governments have been especially keen to increase their reliance on intermittent solar and wind. The combination of reduced supply of fossil fuels and increased use of renewables is the precise result energy policies have been seeking.

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The success of this strategy is now delivering to European customers what should have been expected – sky high electricity prices combined with increased risk of supply interruption.

Unusually calm weather in the normally windy North Sea slashed windpower from the UK’s 11,000 turbines by 80%. Deprived of a source that generates more than 20% of its electricity, Britain turned to natural gas and coal (see The Cool North Sea Breeze Lifting US Coal). Europe’s production of natural gas has been in decline for years, even while consumption has been rising. Imports now account for 90% of the EU’s total.

With unfortunate timing, a key undersea electricity cable from France went down because of a fire at a converter station in SE England, giving UK wholesale electricity prices a further boost. Ireland, also coping with uncommonly calm winds, cut power it normally supplies to Scotland.

The result has been European natural gas prices four times the US benchmark, and wholesale electricity prices up by 8-10X from a year ago (see The Bull Market in Natural Gas). Europe-bound Liquified Natural Gas (LNG) shipments from the US have in some cases been diverted to Asia where prices are even higher.

Britain has even seen two fertilizer production facilities cease operations indefinitely, because of the high cost of natural gas, a key input. Although grain shortages as a result seem improbable, higher prices are likely.

Achieving the desired mix of increased renewables and reduced availability of natural gas has not generated the popular enthusiasm environmental extremists might have hoped. Consequent double digit increases in household electricity bills have commanded more attention from governments than celebrating progress in the energy transition.

Instead, the focus has been on protecting consumers from the high electricity prices climate change policies have wrought. Italian households have been warned to expect 40% higher electricity bills in the next quarter, following a 10% hike which would have been twice as big but for a €1.2BN subsidy from the Italian government. In Spain the government plans a €2.4BN windfall profits tax on utilities that benefitted from selling electricity pegged to natural gas prices that came from other sources, such as nuclear.

What we’re seeing is a glimpse of the dystopian future climate extremists are trying to foist on us. Their single-minded focus on solar and wind, rejecting every other power source including emission-free nuclear, is behind Europe’s soaring power prices.

Governments are scrambling to limit the damage from policies they believed enjoyed solid support. It’s increasingly clear that polls reflecting voter concern about climate change fail to measure how shallow such support is. Erftstadt in Germany experienced severe flooding earlier this summer, which politicians quickly blamed on climate change. 180 Germans died from the heavy rains. But polls show the Green party, most clearly identified with aggressive policies to combat climate change, garnering only 15-17% of the vote. Improved infrastructure to prevent flooding must seem more sensible than adding windmills.

Cranford, NJ suffered flooding from Hurricane Ida recently (see Climate Change: Prevention or Mitigation?). It’s unclear whether global warming is to blame; Cranford seems to flood every decade or so. I spoke to someone recently whose weekend was spent in the heartbreakingly familiar task of cleaning out a recently flooded basement. But he drew some solace from an expected $200K FEMA disaster relief payment. His family has received FEMA payments in the past, and while I don’t begrudge them the help, such policies hardly encourage moving to higher ground.

President Biden, having failed to persuade OPEC to increase crude oil output (listen to Joe Biden Wants More Oil), is now looking into why gasoline prices at the pump are so high. You’d think he’d use this as justification for the government’s plan to build 500,000 electric vehicle charging stations. Progressive Democrat policies are designed to drive gasoline higher.

European energy policy is turning into a disaster. Well intentioned efforts to lower CO2 emissions are colliding with the physics of relying too heavily on unreliable, weather-dependent energy. Governments and corporations are responding to the shrill protesters who want conventional energy use stopped dead in its tracks. Climate extremists can celebrate Europe’s heavy reliance on a combination of imported and intermittent energy for which they’ve advocated. They should probably celebrate quietly, because the average European household isn’t that enthused about current energy prices.

It’s hard to believe that the solution must be more renewables. Instead, what’s needed are pragmatic policies that value reliable power as much as finding ways to lower emissions. Europe, like California, is showing the rest of us where climate extremists are trying to take us. The US has more diversified sources of energy and hasn’t experienced the kind of price turmoil and unreliability we’re seeing across the Atlantic, except where poor policies such as those in Sacramento are followed.

Chevron CEO Mike Wirth sensibly said the company would rather pay dividends than invest in low-returning solar and wind. His message was that investors should reap the benefits of Chevron producing reliable energy, and if they choose then reinvest those profits in renewables themselves.

Let’s not follow Europe’s lead on energy. More natural gas availability is the obvious solution.

Anyone who’s visited Felixstowe on England’s windy east coast knows that umbrellas enjoy a brief existence in offering protection from the rain. Farther north off the coast of Scotland, the North Sea is one of earth’s most hostile places to drill for oil. Gales are common. Working an oil rig isn’t for the nervous.

Consequently, the North Sea is an obvious location for windfarms. Last year Britain obtained almost a quarter of its electricity from wind, a key element in the country’s drive to reduce CO2 emissions. But even the North Sea isn’t always windy, and a recent period of relative tranquility has caused havoc to European markets for electricity.

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Renewables clearly have their place, but the problem of their intermittency increases with their share of power generation. They’re also non-diversified – ten gas-burning power plants operate independently with downtime at one unlikely to affect the others. But if it’s not sunny or windy, a region’s entire renewables supply can be rendered inoperative. One indicator of a grid overly reliant on unreliable power is sharp spikes in electricity prices.

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Wholesale electricity prices one day ahead (in effect, the spot market) soared to €331 per Megawatt Hour (MWh) in the UK recently. It’s priced in Euros not Sterling because the UK grid sometimes imports electricity from France or the Netherlands. Britain had to restart gas and coal burning power plants, including one in Nottinghamshire that will be permanently closed by 2024 when the government has committed to phase out coal completely.

There was a ripple effect into European markets. But there are reasons to think this recent price spike is not just a temporary result of unusually calm North Sea weather. In Germany, one year ahead baseload power prices continued their ascent and reached a new thirteen-year high.

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German household electricity prices are already the world’s highest, more than double the US and four times China. There are a couple of lessons here – the first is that western societies will clearly tolerate much higher energy prices than we have in the US. Environmental extremists continue to disingenuously promote renewables as cheaper than conventional power. But the biggest users, such as Germany or California, have the highest prices.

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The second lesson is that it’s implausible for China to wish to emulate OECD countries’ electricity cost structure. Their commitments on emissions reductions aren’t credible. Progressive Democrats seem to think that with solar and wind the US can alter the climate alone and lower prices. Instead, they should be honestly promoting much higher energy prices as easily affordable and worth paying for. They should also be advocating to confront China on its hollow CO2 commitments.

Less wind in Europe has boosted demand for natural gas, including imports of Liquified Natural Gas (LNG) from the US (see The Bull Market in Natural Gas). This has pushed up domestic natural gas prices to such an extent that the US Energy Information Administration expects gas to provide 35% of power generation this year and 34% in 2022, down from 39% last year.

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Coal-to-gas switching has been the biggest source of reduced US emissions over the past fifteen years. Although solar panels and windmills get all the attention, actual progress has come about through increased use of natural gas. The Shale Revolution may not have delivered promised investment returns, but the abundant and cheap natural gas that resulted have driven our CO2 emissions down.

This positive development came about through relative pricing — cheap natural gas caused utilities to use more of it versus relatively higher-priced coal. Today’s increased natural gas prices are causing this positive development to reverse. The good news is that the US has enormous supplies of natural gas that can be profitable below $3 per MMBTU, compared with current prices of over $5.

US coal production has been in steady decline for over a decade. Connected global energy markets have created a link between a windless North Sea and increased US coal demand.

OPEC also revised up their forecast for 2022 global crude oil demand, which they now expect to eclipse the 2019 pre-Covid level of 100.3 Million Barrels per Day. It’s more proof that the world will use more of all energy sources in the years to come.

Pipeline company earnings for 2Q21 were satisfyingly unremarkable, and were followed up recently with news of further givebacks to investors. Cheniere Energy implemented a dividend as part of a comprehensive long term capital allocation plan. They also plan to repay $1BN of debt annually as they target an investment grade rating. The company expects to generate $15-17 per share in Distributable Cash Flow DCF over the long run (stock closed on Friday at $88). The dividend had been long expected – Cheniere exemplifies the industry’s improving balance between growth projects and free cash flow as well as any company.

Williams Companies announced a $1.5BN share repurchase program, having previously announced full year results were trending towards the higher end of earlier guidance.

Overall there were no notable 2Q21 earnings misses versus consensus expectations.

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Free Cash Flow (FCF) continues to grow. The pipeline sector has undergone a significant change to its cash generation since 2018, when virtually all its DCF was plowed back into new projects. Investors demanded improved financial discipline, but the Covid shock caused further cuts in growth plans. The Democrat administration has also helped, by continuing to make new fossil fuel production unappealing. However, this hasn’t stopped the White House from appealing to OPEC to offset such policies by increasing crude oil supply (see Is Biden Vulnerable At The Gas Pump?).

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Against this backdrop, natural gas prices have been rising steadily. Last winter saw sharp price spikes for all three benchmarks as the northern hemisphere winter delivered periods of severe cold. Traders are preparing for a repeat. Global supply shortages have been exacerbated in recent months by a drought in Brazil which reduced their output of hydropower. Congestion in the Panama Canal has slowed deliveries of Liquified Natural Gas (LNG) to Asia. This has forced some tankers to sail round the tip of South America, adding to transport costs and limiting supply.

European imports of natural gas from Russia have also been lighter than expected, with official explanations from Gazprom being vague and unconvincing. It’s a safe bet that Europe’s increased reliance on Russian imports via Nordstream 2 will at times in the future look ill-advised. On Friday Russia announced the completion of the controversial pipeline.

If crude oil had more than doubled over the past six months, as natural gas has, financial markets would be intently focused on every daily move. Pipeline stocks would be enjoying a similar bull market, even though oil prices affect sentiment more than cashflows. By contrast, rising natural gas prices really are benefitting the US – enabling Cheniere’s LNG export facilities and Williams’ pipeline network to increase cash returns to shareholders.

The spread between US natural gas versus the Asian and European benchmarks is easily wide enough to cover LNG transportation costs. Deliveries to US LNG export terminals are running at 10.9 Billion Cubic Feet per Day (BCF/D), up from 3.7 BCF/D in the same period last year. Last week 20 LNG tankers left US ports carrying 74 BCF of LNG to foreign customers.

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Demand is recovering faster than supply. Associated gas output remains flat YTD since oil production from places such as the Permian remains below pre-Covid levels. Dedicated dry gas regions such as the Marcellus and Haynesville are increasing output, but the net result is that domestic prices are being forced up modestly too.

Financial discipline remains strong. Natural gas E&P names covered by Morgan Stanley reached $10BN in FCF for 2Q21, a welcome development after years of negative or flat FCF. These are some of the customers of pipeline companies – upstream as well as midstream is responding to investor demand.

Growing LNG exports are the main driver of increased domestic demand. Production is lagging behind. This led Morgan Stanley to recently ask “Is The Era Of Low Prices Over?” Production is currently running around 93 BCF/D, still below December 2019’s 97 BCF/D just before Covid. Near term risks appear skewed to the upside, especially if the northern hemisphere has a colder than normal winter.

Looking farther ahead, supply is likely to increase, which will bring lower US prices. This is because there still exists ample US supply that can be produced profitably at below $3 per MMBTU. 2-3 BCF/D of increased output looks likely over the next couple of years, much of which will feed our increasing LNG export capacity.

The budget plan making its way through the House of Representatives currently excludes natural gas from its list of “clean” energies eligible for subsidies from the Department of Energy. This is a mistake, since technologies already exist allowing natural gas to be burned cleanly. Carbon capture and sequestration (see Carbon Capture Gains Momentum) and the Allam-Fetvedt Cycle (see Clean Energy Isn’t Just About Renewables) are two examples. Nonetheless, global demand for US natural gas is growing, and puts the domestic pipeline industry in a good position for continued growth.

On a different and more somber topic, it would be remiss of me not to acknowledge the twentieth anniversary of 9/11. Like tens of thousands of people who worked on Wall Street at that time, I am remembering friends killed in that attack. In the first half of my career during the 80s and 90s I traded derivatives with Euro Brokers and government bonds with Cantor Fitzgerald, two firms that suffered substantial loss of life amongst their employees. Everybody remembers their location and what they were doing at that time. Our thoughts are with the families and loved ones of the people who lost their lives on that day.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Last week the northeast US suffered 52 deaths as Hurricane Ida (by then a tropical storm) dumped up to ten inches of rain in just a few hours. Cranford, NJ on the Rahway River is prone to flooding. It’s a couple of miles from Westfield, GHQ for SL Advisors, and it seems like every decade or so hundreds of basements are flooded in those homes close to the river. Garwood is another small neighboring town and source of the striking photos below.  

Seemingly unrelated to the heartbreaking losses caused by Ida, journalist John Kemp noted China’s continued reliance on coal for power generation, which has experienced a Compound Annual Growth Rate (CAGR) of 5% over the past two years. Since Covid caused a drop last year, this highlights the strong underlying trend. Coal futures on the Zhengzhou Commodity Exchange recently traded at $150 per tonne, compared with $85 a year ago. The market is signaling more demand for coal.

Apologists for China herald the 25% CAGR for wind power over this time, and 24% for solar. Hydro output dropped slightly. Don’t be fooled. Thermal power, which is mostly coal since China burns half the world’s output, still provides 72% of China’s electricity as was the case two years ago. Thermal power also met 72% of the increase in demand, hence its static share of the total.

This is why China generates 28% of global CO2 emissions. It plans to continue increasing at least through 2030 before reversing course on an improbable path to zero by 2060 (see Is China Worried About Global Warming?).

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Here’s why China’s power output is linked to flooded towns in New Jersey. Ads for solar panels are everywhere, because of generous state and Federal subsidies. As a result, New Jersey electricity customers have so far paid $3BN in higher fees to help pay for solar installations. Future tax breaks for solar are expected to add $800 million annually to utility customers’ bills, rising to $1.4BN by 2030.

Hurricane Ida may or may not be a consequence of climate change. The media interprets every weather fluctuation as caused by global warming. The UN’s report earlier this summer warned of more extreme weather events but attributing any single event to the one degree Celsius increase since the 1850s is impossible.

Nonetheless, if you’re pumping water from your Cranford basement, as you do every decade or so, proliferating subsidized solar panels aren’t much use. Living in a solidly blue state, you’re probably convinced that global warming will cause even more frequent flooding. Having long ago rejected the wholly sensible idea of moving to higher ground, you might like those solar panel subsidies redirected towards improved infrastructure to stop the Rahway River from bursting its banks. Users of the New York City subway would favor mitigation of the sudden indoor waterfalls we saw on news reports and social media.

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The widely reported efforts by rich countries to blanket the landscape with solar panels and windmills aren’t having any noticeable impact on global CO2 emissions. Implementation carries local costs while any benefits are shared globally. Californians can feel good about their efforts to shut down natural gas plants, even though it results in more expensive and less reliable electricity. They still get forest fires. New Yorkers may support constraints on new natural gas connections. The subway still had to shut down because of flooding.

We may already be experiencing the climate changing effects of a warmer planet. If so, at some point there’s a valid choice between prevention and adaptation. None of us can control the planet’s CO2 levels. But every community can fortify itself again extreme weather events. The quest to lower emissions is a global social undertaking that relies on widespread participation. It requires community spirit on a worldwide scale. The free-rider problem is likely fatal to success. China is only the most visible emerging economy exploiting this – the world’s biggest producer of solar panels, which it sells to dozens of countries, is also the #1 consumer of coal and generates over a quarter of global CO2 emissions.

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The energy transition has lots of momentum. Shifting from coal to natural gas remains the world’s most assured path to reduced emissions. Nonetheless, China’s increase in wind and solar only met 25% of the additional demand for power since 2019. The desire of rich countries to lower emissions remains in conflict with emerging economies’ intention to raise living standards by using more energy.

This misalignment of interests means that eventually a sea wall will be more useful than a windmill. That time is coming.

Democrat Senator Joe Manchin from West Virginia holds more sway than most over White House legislative strategy, because he’s one of the few willing to break ranks with Democrat orthodoxy. In his WSJ Op-Ed last week, he argued for a “strategic pause” on Congressional spending. This means his support for the White House’s proposed $3.5TN budget isn’t assured. Manchin sensibly notes that we’re leaving ourselves little fiscal room to deal with future crises, such as a more virulent Covid mutation, terrorist attack or major international conflict. Manchin doesn’t mention Modern Monetary Theory, but it’s safe to assume he’s a skeptic.

Friday’s weak jobs report revealed how investors are regarding the balance of risks. Although it may add a modest delay to the onset of Fed tapering, ten-year yields rose as the yield curve steepened. The payroll data provided some support to FOMC doves, but also strengthens the argument in favor of further fiscal stimulus. Since spiraling indebtedness provokes no discernible economic costs, the threshold for more of the same is falling.

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This is what provoked Bill Gross to refer to bonds as “investment garbage” in an interview last week. He’s right, but his warning that ten-year treasury yields could reach 2% in a year is unlikely to cause much concern. Yields have been too low for over a decade, and at 2% treasuries would still represent return-free risk. Japan ($1.3TN), China ($1TN) and our own US Federal Reserve ($5.7TN) are the three biggest in a long list of non-commercial buyers.

No return-seeking investor should own bonds, but avoiding fixed income with stocks and cash retains a link to interest rates, because low yields continue to show the Equity Risk Premium (ERP) still favors stocks. Factset earnings estimates continue to improve. Forecasts for FY 2021 profits have risen 25% since January. Year-over-year EPS growth for 2022 is 9%.

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The ERP average over the past two decades is higher than over the past half century. Using more recent history, stocks are still cheap but not outrageously so. As long as earnings continue growing, the main risk will be interest rates. Even Bill Gross is looking for a <1% increase in yields, an acknowledgment that demand is permanently skewed by central banks and other buyers with inflexible mandates. A 2% ten year treasury yield might be a minor shock if reached quickly but would not move stocks into expensive territory.

The risk of foreign selling has gone, since it’s now clear the Fed would step in to offset a sharp rise in yields. In fact, it’s not a huge leap to consider the circumstances under which the Fed might feel additional bond support was necessary. If ten-year yields rose to, say, 3% the FOMC might assess a potential threat to economic growth and employment. Joe Manchin worries about excessive spending driving inflation, but he doesn’t warn of indebtedness driving interest rates punitively high. Perhaps he’s also concluded that the Fed stands ready, just as MMT advocates.

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In spite of weaker than expected economic data over the past month, long term yields have drifted higher.  The yield curve is too flat, pricing in just over one tightening per year from 2023-25 versus the FOMC “blue dot” forecast of almost twice that rate. Eurodollar futures moved back towards the FOMC’s rate path but remain more sanguine about future rate hikes than even the FOMC doves.

Coincident with the steeper curve, inflation sensitive sectors such as gold and silver outperformed on Friday. Weak economic data make additional fiscal stimulus more likely.

Russia’s central bank warned that if global inflation isn’t constrained the global economy could, “deteriorate drastically and rapidly.” While not a thought leader, it illustrates that inflation is already a global concern.

Bond yields remain constrained between the threat of more spending and the promise of ongoing central bank support if needed. Earnings remain the key driver of returns, and the picture there is positive. Stocks remain the place to be.

To learn why you should worry about inflation, watch this brief video.

In Fed chair Jay Powell’s closing speech from the virtual Jackson Hole symposium he went to great pains to illustrate that currently elevated inflation is transitory. He compared the strong rebound in spending on durable goods to above its pre-Covid trend with services spending, which remains 7% below its pre-Covid trend. He noted the unevenness of the recovery from the shortest, sharpest recession in history.

Jay Powell remains convinced that inflation will moderate, and surveys of inflation expectations can be interpreted as supporting this view. Market forecasts of inflation derived from treasury securities have moderated recently. With the Fed is buying over half of new treasury supply, market rates are far from being set freely (see Behind The Fed’s Benign Inflation Outlook).

Since the FOMC believes the bond market is still in need of their support, they must also believe that yields would otherwise be higher. If so, they should draw scant comfort from such inflation expectations, but the Fed nonetheless relies on this circular argument for comfort. The University of Michigan Consumer Survey has not yet shown signs of moderating.

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Towards the end of his speech. Chair Powell briefly reviewed the experience from 1950 to the early 1980s, a period that, “taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation.”

It’s hard to be sure that anything is permanent until it’s continued for a long time, including higher inflation. This stance is provoking criticism. “The Fed has tied its hands to be quite late to remove monetary-policy accommodation,” says William Dudley, former president of the New York Fed in a recent Economist article.

This is an unfortunate moment for the Fed to be implementing its new doctrine, revised following last year’s Jackson Hole symposium, of being more tolerant of higher inflation and therefore more reactive. History offers policymakers scant insight into how economies emerge from a pandemic.

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Inflation may conform to the Fed’s benign outlook. If it doesn’t, the cause will be partly traced to Congress. Budget deficits of above $1TN will soon become the norm. While this year we’re on track to hit $3TN before falling sharply, the CBO forecasts deficits will begin increasing again by 2025. The President’s current budget proposal will add $12TN to the deficit over the next decade. This is why the Fed is likely to remain a significant buyer of US treasuries.

A Fed with a more acute sense of risk would use this relentless fiscal stimulus to support a hastier return to more normal monetary conditions. Congress has adopted Modern Monetary Theory (MMT, aka the  Magic Money Tree) philosophy of guilt-free largesse (see Democrats Will Test The Limits On Spending). Continued monetary stimulus leaves little room for error if the Fed’s inflation outlook turns out wrong.

Financial markets are embracing a more dovish Fed by pushing down the yields on eurodollar futures two years out and longer. Oddly, the market still expects one tightening of monetary policy by the end of next year, even while rate forecasts farther out have sunk below even the most Dovish FOMC members’ blue dots.

A reduction of bond buying, even if it begins in September, will likely mean the Fed’s balance sheet will continue to grow at least into 1Q22. In his speech last week, Powell said that, “…we will continue to hold the target range for the federal funds rate at its current level until the economy reaches conditions consistent with maximum employment…” He also noted that, “In the United States, unemployment ran below 4 percent for about two years before the pandemic, while inflation ran at or below 2 percent. Wages did move up across the income spectrum.”

From these statements it’s clear the Fed won’t raise rates until the unemployment rate is solidly below 4%. It’s likely they will await evidence of wage inflation before concluding full employment has been reached.

Everything about this FOMC argues for sloth-like policy normalization combined with a high roller’s embrace of substantial risk of a policy error. This is all to ensure that everyone who wants a job has one. Among the papers distributed to Jackson Hole attendees was Monetary Policy in Times of Structural Reallocation. Powell has argued that inflation has been caused by disruption of supply chains induced by Covid. The inference is that some corporations will need to restructure their logistics to accommodate a new world where lockdowns can occur with little notice. Once done, price hikes due to supply disruptions should dissipate.

The paper posits that higher inflation allows greater variation in real wages, which can hasten such restructuring. Since wages rarely shrink in nominal terms, higher inflation can accelerate the movement of workers to more logistically-efficient jobs. Inflation and wage hikes of 5% in growing sectors combined with low or zero nominal wage growth in shrinking ones would quickly widen real wage differentials, motivating workers to switch jobs accordingly. Higher inflation allows for a bigger drop in real incomes – getting a 1% raise with 5% inflation is a 4% cut in real wages, something not easily achieved with, say, 2% inflation.

Jay Powell didn’t broach the topic, but a dovish, risk-tolerant Fed focused on its employment mandate might find elements to like in such an approach.

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There seems little reason for interest rate futures to plot a different course than the FOMC’s own dot plot – the odds of monetary tightening next year are receding. Circumstances may evolve to compel the Fed to “… respond and use our tools to assure that inflation runs at levels that are consistent with our goal.” If so, rates will eventually need to move higher than is currently priced in. That remains some way off.

To learn why you should worry about inflation, watch this brief video.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

This week the Fed is holding their annual Jackson Hole symposium – although it will be virtual again because of the Delta variant. Media coverage has built expectations of a sharp internal debate around tapering. The recent minutes show some in favor of reducing the Fed’s bond buying program this year. Boston Fed president Eric Rosengren noted the futility of using low rates to stimulate interest rate sensitive sectors such as housing when demand is already strong (listen to our recent podcast Episode 80: Tapering Draws Closer).

Since former Fed chair Ben Bernanke showed the world in 2008 that Quantitative Easing (QE) could be done safely, the Fed has been a buyer of US treasuries almost all the time. Their balance sheet only shrunk for a year beginning in May 2018 and began growing sharply again early last year in response to Covid.

Bernanke’s original initiation of QE was criticized at the time as likely to cause inflation. He was correct that it wouldn’t, recognizing that Wall Street’s frozen plumbing needed extraordinary help. Once the crisis passed the FOMC struggled to extricate itself from the bond buying program. The 2013 “taper tantrum” when bonds slumped on fears of QE ending continues to hover over today’s FOMC deliberations.

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It should be clear that the need for QE is long gone – not least because this time around inflation has surged. Most obviously the $40BN per month of mortgage-backed securities purchases should cease since the housing market is hardly short of demand.

Even when tapering begins it will only slow the Fed’s balance sheet growth, since they’ll still be buying bonds albeit at a slower rate. QE is now part of the Fed’s toolkit, to be used whenever accommodative policy is needed. A decade passed since the 2008-09 Great Financial Crisis before any meaningful reduction in the Fed’s balance sheet occurred.

The Fed’s original exit strategy was to let holdings mature and not replace them. This time around their holdings will likely flatten out around $9TN, 2X the peak from the earlier crisis. It’s hard to imagine the Fed moving to actually sell bonds, so allowing the portfolio to run off remains the most likely outcome, as before.

It’s a good bet that the next crisis will hit before any meaningful reduction in this $9TN balance sheet. The bar has been lowered. QE is being justified in part to promote job creation, part of the Fed’s twin mandate of achieving full employment with stable prices. If a bear market in bonds threatened the economy, it’s likely the Fed would see fit to step in and assure an orderly market. If our foreign creditors sold US treasuries, either for geopolitical reasons or out of frustration with our profligate fiscal policy, the Fed would scoop those up too.

The Fed is now and probably always will be the biggest buyer of US government debt. Their $8.3TN balance sheet includes $5.3TN of US treasuries, almost a quarter of all publicly held US debt. The Fed’s now permanent holding of US treasuries is debt monetization. Only three quarters of the government’s borrowing is being met by a combination of domestic and foreign savings. QE was originally intended as a temporary measure in extraordinary times, but it’s become business as usual. The Fed is enabling The Magic Money Tree (see Modern Monetary Theory Goes Mainstream).

Rep. Alexandria Ocasio-Cortez, a fan of government solutions for everything, said in 2019 that MMT needed to be, “a larger part of our conversation.” AOC and her progressive wing of the Democrats are not on the side of investors.

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Our fiscal path virtually guarantees continued growth in the Fed’s balance sheet. Publicly held debt:GDP crossed 100% because of Covid and is on track to double over the next thirty years. This is based on figures from the non-partisan Congressional Budget Office, which doesn’t assume recent uber-profligacy will become endemic. It’s hard to see how The Fed will reduce its holdings when the CBO expects debt to increase annually at $1TN or more for the next thirty years.

This is why inflation is inevitable. QE has morphed into debt monetization, enabling ever larger deficits even while our fiscal outlook is poised to soar beyond past extremes. Bonds have been emasculated of their ability to warn of such excess, because the Fed stands ready to provide support whenever needed.

It’s never been more important to invest with regard to maintaining purchasing power – which means staying well ahead of inflation (see Why It’s No Longer Enough To Beat Inflation).

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund