The inaugural ESG Day is becoming more common. Enterprise Products Partners (EPD) held theirs in early March. Pipeline companies are quite rightly asserting their role in combating climate change. EPD noted the beneficial effects of natural gas in limiting coal consumption.  SVP Tony Chovanek also discussed the growing interest in clean-burning hydrogen. Every energy company that can is talking up hydrogen on their earnings calls, although EPD’s plain spoken CEO Jim Teague noted on their 3Q call in October that, until it’s cheaper to produce, …” this one is going to take a while to develop.”

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As a fuel, hydrogen’s most appealing quality is that when combusted, it generates heat and water. The technology to produce it is well understood, although the cost makes it higher than conventional fuels. Hydrogen is well suited to be moved and stored through existing pipeline infrastructure, which is why today’s energy infrastructure companies are increasingly talking about it if not yet making large scale investments.

The vast majority of hydrogen is produced from natural gas or coal, in an energy-intensive process that produces around 830 million tonnes of CO2 annually. In the color-coded world of hydrogen production, this is known as “grey”. “Blue” hydrogen relies on the same inputs but captures the CO2 emitted in its production. “Green” hydrogen is produced using renewables and offers the potential for emission-free energy if costs can be brought down substantially.

Green hydrogen is produced using electrolysis powered with solar or wind – hence no emissions. It separates the hydrogen molecules from water. It’s currently less than 1% of produced hydrogen, becayuse it’s expensive. The EU’s 2030 Hydrogen Strategy seeks to create a new “green hydrogen” industry producing 40 Gigawatts (GW) of hydrogen by 2030 (versus 0.1 GW now), and 500 GW by 2050. Electrolysis is an energy hog. Goldman Sachs, in a report called Green Hydrogen, noted that at least 2GW of power is required for each 1GW of hydrogen produced. This only makes sense if power is free, or nearly so.

The EU’s hydrogen initiative envisages enormous scale. Goldman Sachs estimates that green hydrogen production could eventually double Europe’s electricity consumption, becoming the region’s largest electricity customer.

Solar and wind are both weather-dependent and unresponsive to demand shifts. Using solar for example during the middle of the day, when the sun’s high and electricity demand dips between the peaks of breakfast and dinner time, could be a good way to store energy that would otherwise be wasted. In the EU, Spain and Portugal would be attractive candidates for using solar to produce hydrogen, as would the SW U.S.

An Italian utility, Snam, has estimated that a hydrogen pipeline from sunny North Africa to Italy could deliver energy at just 13% of the transportation cost of an ultra-high voltage power line.

A U.S. pipeline investor who bears the scars of the increased investment caused by the Shale Revolution might pause at this point. Although the U.S. has no equivalent to the EU’s 2030 Hydrogen Strategy, the Biden administration is surely working on one. In some regions such as southern California, hydrogen is being blended into the natural gas supply.

The last thing U.S. midstream energy infrastructure investors want is another period of increased growth capex. In the EU, a group of gas transport operators estimated that modifying natural gas pipelines to move hydrogen would require €40BN of investment over 20 years, or $2.4BN p.a. In 2018 the U.S. industry spent $45BN on growth capex, so this seems manageable.

Pipeline investors will be relieved to know that hydrogen is well suited to move through natural gas pipelines, though some modifications would be needed.  Hydrogen has nearly twice the energy density of methane, but less than half the energy content by volume, because it’s so light. So more cubic feet of hydrogen are needed to deliver the same energy as natural gas.

Hydrogen burns with an almost invisible flame, by contrast with the familiar blue flame of natural gas. Prolonged exposure to hydrogen can make the steel used in pipelines brittle, although companies like EPD already supply hydrogen to industrial customers so are familiar with that problem. America’s has 1,600 miles of hydrogen pipelines already, with the biggest network located in Texas. Perhaps most interesting is that hydrogen molecules (H2) are small enough to leak through metal if stored for an extensive time. This creates challenges with long term storage, although salt caverns can be repurposed from holding natural gas to hold hydrogen.

In Utah, Intermountain Power Project (IPP) burns coal to generate electricity for southern California. It plans to convert to a 70/30 blend of natural gas (methane) and hydrogen by 2025 and expects to be 100% hydrogen by 2045, aided by hoped for improved technology. The plant is conveniently located atop a vast salt cavern which will be used to store hydrogen. Natural gas power plants can be modified to run on a methane/hydrogen blend, adding further to their clean energy credentials.

The EU’s 2030 Hydrogen Strategy is going to jumpstart a new industry. The existing European pipeline network will be key to European plans for reduced emissions. North American pipeline companies should be well situated for a similar initiative here.

There was some additional clean energy news last week — NextDecade (NEXT), which plans to deliver Liquified Natural Gas (LNG) while capturing the CO2 produced during liquifaction (see Making LNG Cleaner) announced an agreement with Oxy Low Carbon Ventures (a unit of Occidental) to transport and permanently store CO2. Solar panels and windmills are far from the only story in the energy transition.

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

A series of recent client meetings in south east Florida was good news in two respects – both as evidence that in-person meetings are slowly returning, and because people want an update on the new momentum sector, pipelines. Although in truth all these clients would have extended friendship at any and all times in the past.

Focused as we are on the cheapest sector in the market, one financial advisor revealed that many of his clients are nervous. Stocks look expensive, and bonds more so. Very little seems to offer an attractive long-term return versus risk, although plenty of quick trades are there for the opportunistic.

The message of rising free cash flow and increasing global energy demand resonated (see Pipeline Cashflows Continue Higher). Democrat policies impede pipeline construction and promote higher energy prices, creating a happy alignment of interests between the country’s leaders and energy investors (see Is Biden Bullish For Pipelines?). Dividend yields of 7% suggest stress, although dividends are stable and, in some cases, rising. Buybacks equal to around 2% the sector’s market cap provide further support.

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It’s a year since the American Energy Independence Index (AEITR) and other MLP indices made their low. At least closed end funds, one of the causes, destroyed enough capital to lose any future potency (see MLP Closed End Funds – Masters Of Value Destruction). The rebound since then has been breathtaking, with the AEITR returning 182% since March 18, 2020.

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Even the perennially lagging Alerian MLP Infrastructure Index (AMZIX), tracked by the much-maligned Alerian MLP ETF, has rebounded 153% from its low. The superior return from c-corps versus MLPs is increasingly apparent, since the AEITR (80% c-corps/20% MLPs) is ahead of AMZIX (100% MLPs) over the past one, three and five years. Investors have spoken.

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It’s increasingly clear that the March 2020 collapse was an aberration. Most of the biggest pipeline corporations reported 2020 full year EBITDA close to guidance they provided before the pandemic. These businesses are more stable than last year’s sellers.

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Some clients are feeling concerned about inflation, although not yet making wholesale portfolio changes. Investments that offer protection are few – on this score, pipelines that are tracking the ten-year year yield higher are one of the better ones. For now it’s the reflation trade, but it may transpose into the inflation trade later this year.

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Fed chair Jay Powell is increasingly alone with his equanimity about the inflation outlook. On Monday the National Association for Business Economics (NABE) released their Economic Policy Survey which revealed that almost half the NABE panelists expect the Fed to hike rates next year. A majority sees elevated inflation risk.

Eurodollar futures are more reflective of the NABE outlook than the Fed’s, demonstrating investors’ scant regard for the Fed’s forecasting ability. Jay Powell’s repeated assertions that higher inflation will be temporary and not of concern reflect growing frustration with the market’s dismissive response.

The Fed is simply one more forecaster, and not a good one. But their power over monetary policy is absolute. They can determine whether December 2022 eurodollar futures incorrectly suggest a hike late next next year by holding short term rates steady indefinitely. However, a graceful exit from $120BN of monthly bond purchases becomes harder to envisage as yields move steadily higher.

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The ECB has responded to rising yields by increasing its bond purchases. The Fed may yet do the same if they feel financial conditions are becoming too restrictive. This starts to look like a central bank defending a currency peg – usually doomed to failure, except that in this case the analogous effort is to prevent the currency going too high.

A central bank trying to cap its currency should always win – after all, they can provide an unlimited supply of it. Similarly, there’s no theoretical cap on the Fed’s capacity to buy bonds. As Modern Monetary Theory (MMT) teaches, a central bank’s balance sheet to finance its own sovereign’s debt is unlimited (see Modern Monetary Theory Goes Mainstream).

It therefore seems unwise to expect interest rates to move higher than the Fed wants (although they may). It’s more sensible to bet on inflation staying higher than they would like. The Fed can’t control inflation, and their efforts to buy the bond market’s silence mean inflation will go higher than it otherwise would.

Right on cue, news leaked of the White House plan to launch a $4 trillion infrastructure/climate change/jobs initiative. This should dispel any lingering doubts that MMT is government policy. If you need further convincing, check out Stephanie Kelton’s The Deficit Myth, the playbook on current fiscal policy. We reviewed it here.

With fiscal and monetary policy synchronized to produce inflation, this is the path of least resistance. Inflation-sensitive assets, of which energy pipelines are a good example, are becoming indispensable to everyone’s portfolio.

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

In November, Engie, a French utility, pulled out of discussions with NextDecade Corp (NEXT) to import up to $7BN of Liquified Natural Gas (LNG). It was a big blow to NEXT, which is seeking partners to underwrite its construction of an LNG export facility in Brownsville, TX. Engie concluded that the natural gas sourced by NEXT would be tainted by its involvement in fracking, methane leaks and flaring. It wasn’t consistent with their energy transition goals.

Last week, NEXT launched a new business, NEXT Carbon Solutions (NCS). Their intention is to use Carbon Capture and Sequestration (CCS) to keep 90% of the CO2 generated by their proposed LNG plant as it chills methane in preparation for transfer onto an LNG tanker.

It’s a natural response to the market. Engie’s decision was a wake-up call. Natural gas has a clear edge over coal when it’s burned to generate electricity. But the flaring and methane leaks that are part of natural gas production worldwide are a consideration for some buyers.

Liquifaction of natural gas uses a lot of energy. NEXT plans to use natural gas to power this process, and then capture and store the resulting CO2 emissions in former gas wells. The geology of south Texas is well suited to this. By installing the CCS equipment when the LNG liquifaction facility is built, there are substantial savings compared with adding CCS to an existing facility. NEXT intends to make the clean credentials of its product a competitive advantage.

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Interestingly, the added cost is modest, maybe 2% of the price of natural gas based on its U.S. benchmark once tax credits are added. It’s less than 1% of its ultimate delivery cost to European buyers

NEXT is going further, by planning to use Responsibly Sourced Gas (RSG). This will be natural gas whose production has been independently certified as not associated with routine flaring and reliant only on electricity from renewables.

Their goal is to deliver natural gas to customers in Europe and Asia that has generated almost no Global Greenhouse Gases (GHG) on its way to the LNG tanker. Will it make a difference? NEXT is convinced it will.

It’s a logical development. The world has a huge opportunity to substantially reduce emissions by phasing out coal in favor of natural gas. Reducing the emissions involved in producing natural gas makes it even more compelling. NEXT is betting that gas produced with lower GHGs will attract environmentally motivated buyers, presumably an increasing portion of the market.

Over the next couple of years, U.S. GHG emissions will be moving in the wrong direction (see Emissions To Rise Under Democrats). This is partly an unavoidable result of comparisons with last year’s Covid slump in economic activity. But we’ll also be increasing coal consumption relative to natural gas, reversing a very positive trend that has lowered emissions for the past decade. Higher natural gas prices are the reason, since prior coal-to-gas switching by U.S. power plants has been driven by favorable economics.

This will be an uncomfortable result for a Democrat administration that campaigned on reducing emissions. Promoting coal to natural gas switching should become a more visible part of their strategy, both here and overseas.

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NEXT includes an interesting slide comparing CO2 emissions that result from the RSG they plan to ship with competing sources. Nord Stream 2, the natural gas pipeline from Russia to Germany, is already controversial. Trump asked why the U.S. maintains troops in Germany to protect against Russia when Germany plans to increase its energy dependence on this potential adversary. There’s no good response to this question, and the Biden administration is similarly opposed to the pipeline’s completion.

Although geopolitics is a strong enough reason for Germany to buy its natural gas elsewhere (such as from the U.S.), the chart above from NEXT’s presentation suggests that different sources of gas come with a different climate impact. Maybe Climate Czar John Kerry can use such data in his discussions with other countries about lowering emissions.

NEXT is a tiny company with big plans. Their latest move may be a last, desperate attempt to sign up enough customers to finance the construction of their LNG facility. Or it may be an important step in the energy transition. If other established companies, such as Cheniere, make similar plans it’ll confirm that NEXT is on to something.

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

The Trump presidency was unequivocally good for investors. The S&P500 returned 14.9% p.a. during his four-year term. There will be strong opinions on either side, and we’ll leave that debate for others. But it’s fair to say that this beat the expectations held by many when he was elected.

Energy executives cheered the loudest when Trump won in 2016. This is an industry where Republican views dominate. Few energy investors were expecting such a miserable subsequent four years. Even before Covid decimated crude oil demand, the American Energy Independence Index (AEITR) had returned 3% p.a., versus 16% for the S&P50 through 2019. On the day voters elected Biden, the numbers for Trump’s term were –4.9% and +14.9% respectively.

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Trump’s policies were energy-friendly – he eased regulations, pulled out of the Paris climate agreement and promoted American “energy dominance”. The problem was energy executives. They over-invested, over-produced and, in the case of some pipeline companies, overbuilt. The lesson for energy investors is that when management teams get what they want, look out!

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It’s still early to assess the Biden impact on pipelines, but the signs are encouraging. Democrats are naturally anti-fossil fuels, but the ones in power recognize that keeping the lights on is important to staying in office. The energy transition is a long one. We’re not yet fully reliant on intermittent solar and windmills and should hope we never are. Democrat policies are oriented towards constraining the supply of what they dislike, not demand.

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This is turning out to be investor-friendly. Every energy company has a few ESG slides in their presentation. They all discuss the energy transition. Some are even investing in solar and wind, although wouldn’t unless the IRR on such investments was supplemented by the benefits of a greener image. On their recent earnings call, Energy Transfer (ET) co-CEO Mackie McCrea revealed that, “… we’re struggling with wind quite honestly, it’s hard for us to figure out how to make that work. And we’re not going to do anything that doesn’t make good economic sense for unitholders.” He then added, “I don’t know if we’ll ever get involved as far as investing in a solar project because the returns are …so much less than what we can achieve with other opportunities we have.”

Financial discipline is acting as a constraint against boldly leaping into renewables. At the same time, traditional pipeline projects on a large scale are becoming too risky to contemplate. When Biden canceled the Keystone XL, he reversed a prior executive order approving it and gave scant attention to our ally Canada’s need to find export routes for its crude. TC Energy (TRP) had already brought in the province of Alberta as a partner in case a Democrat president canceled the project. Alberta’s CS1.5BN investment is likely to be lost.

Kinder Morgan (KMI) similarly offloaded the Trans Mountain Pipeline project to the Canadian federal government in 2018 when they tired of navigating Alberta and British Columbia’s conflicting views on its completion (see Canada’s Failing Energy Strategy). Enbridge’s Line 3 Replacement is also at risk from U.S. government opposition, although most expect it to be completed.

Pipeline construction risk has become almost unquantifiable, because Democrat leaders are willing to over-turn previous approvals. Court challenges from environmental extremists can add substantial delays. Renewables projects advance PR objectives, but low IRRs limit their scope. The result is pipeline companies’ assessment of new investments reflect economic and political realites. Democrats have achieved something that long eluded investors, which is to limit growth capex. Smaller projects are still being done. The Energy Information Administration (EIA) yesterday noted new gas pipelines with 4.4 billion cubic feet per day of capacity entered service between November and January.

Reduced capex among upstream companies is constraining oil and gas supply, which is contributing to rising prices. Although pipeline companies have limited direct economic exposure to commodity prices, they reflect sentiment and overall economic activity. High energy prices are good for energy investors.

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Gasoline prices are well above the $2.57 per gallon average of the Trump presidency and are on the verge of exceeding the range of his four-year term. Since the Administration felt compelled to provide a $1.9TN fiscal boost to the economy, it’s likely that gasoline prices are headed higher. The EIA expects domestic oil production to recover slowly, and for the U.S. to revert to being a net importer of crude next year.

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The pandemic dominated energy prices last year and has permanently impacted production. Maybe U.S. output would be on the same modest growth path if Trump had won re-election.

Nonetheless, Democrat policies are oriented towards less spending and higher energy prices, both very pro-investor policies. With the emphasis on impacting supply not demand (i.e. no carbon tax), these trends are likely to continue. They’re consistent with efforts to combat climate change. They’re also good for the energy sector. The Biden administration has become an unwitting friend of pipeline investors.

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

Covid accelerated a trend already in place in the U.S. energy sector, which is to grow Free Cash Flow (FCF) rather than production. Chevron’s Investor Day last week promised 10% annual increase in FCF through 2025. This return to shareholder-friendly metrics is attracting investors – including recently Berkshire Hathaway.

Midstream energy infrastructure has grasped this as readily as their upstream E&P customers. Full year 2020 earnings have been reported. The companies in the American Energy Independence Index, the best representation of the North American pipeline industry, grew FCF to $25BN last year. This is almost three times their 2019 performance, a result that seemed implausible a year ago when Covid drove panic selling.

Continued reductions in growth capex are the reason – Distributable Cash Flow (DCF), equivalent to cash from operations minus maintenance capex, was flat last year. Pre-Covid, DCF was expected to increase from $54BN to $60BN, but Enbridge (ENB), Enterprise Products Partners (EPD), Kinder Morgan (KMI) and TC Energy (TRP) each came in $1BN or more below target. However, capex reductions were widespread during the year, and these largely offset the drop in DCF which is why FCF came in around target.

The result is the bridge chart shown below, which continues to track a path towards higher FCF for the industry. On current trends we should exit 2021 with a FCF yield of over 10%, more than twice the S&P500. Having rallied so far, one might conclude that the sector’s mis-valuation prevailing last year has been eliminated. The FCF yield shows this isn’t the case.

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The biggest single variable in the industry’s capex figures is Enbridge’s planned replacement of Line 3. This is a 1,000 mile crude oil pipeline oroginally built in the 1960s that runs from Edmonton, Alberta to Superior, Wisconsin. Canada has long struggled to find economic ways to get its crude oil to market. The proposed new pipeline will more than double capacity, from the current 370 thousand barrels a day (MB/D) to 760 MB/D. ENB recently raised the estimated total cost of this project by almost $1BN, to $7.3BN.

Predictably, environmental extremists are opposing the pipeline, although it’s a safe bet that they drive regularly, including to their protests. With Biden having canceled the Keystone XL project shortly after his inauguration, the Line 3 Replacement (L3R) has become a new target. So far, ENB and most analysts expect the project to proceed. Our estimate of 2021 growth capex for the industry is $4.5BN higher than we forecast in December; $3.5BN of this relates to L3R.

For 2022 and beyond, the pipeline sector is on track to further reduce growth capex.

Energy executives provided quarterly updates over the past few weeks, which included updating their capex guidance. On the energy transition, typically they acknowledge it and have plans to reduce their company’s carbon footprint. The prevailing view is that global energy consumption will increase for all forms of energy, including oil and gas.

Consider the following: China’s oil consumption is about two thirds the U.S. But China’s per capita consumption is only 15% of the U.S. Its population is growing at around 0.4% p.a., versus about 0.6% for the U.S. China’s per capita consumption of crude is growing at 4.3%, and total consumption at 4.7%.

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If China’s per capita oil consumption grows over the next decade at the same rate as it has for the past five years, China would be consuming more than the U.S. if we kept consumption flat. If the U.S. wanted to lower consumption to offset China’s growth, our per capita consumption would need to fall by almost 10% p.a. Currently it’s growing at 0.9%.

Even in this implausible scenario, crude oil consumption is unchanged – it’s simply shifted from the U.S. to China.

This is the daunting math that confronts efforts to reduce emissions. Electric vehicle penetration is higher in China, and they drive around a quarter as many miles as Americans. But 1.4 billion Chinese striving for western living standards is going to require a big adjustment from 330 million Americans, if crude oil consumption and emissions are to fall.

There are many more variables to consider, but this simple example illustrates why Exxon Mobil and Chevron think oil still has a future.

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

Last month saw U.S. Electric Vehicle (EV) sales up 40% year-over-year. Every Tesla owner I know loves their car – although the February jump was helped by the launch of Ford’s Mustang Mach-E. EV market share (which includes hybrids as well as all-electric vehicles) rose from 1.8% to 2.6% in February. Nonetheless, EV sales fell last year due to Covid, from 331K to 296K.

Forecasts of booming EV sales are so common as to scarcely be news anymore. It’s possible to go back and find old forecasts that were way off. This one from 2011 looking ahead to 2020 includes a few the authors would like us to forget. Deutsche Bank’s forecast of U.S. sales was off by 2X. However, McKinsey’s global estimate was only slightly high.

David Victor recently published Energy Transformations in association with Engine No. 1, the activist investor pushing for Exxon Mobil to respond more quickly to the energy transition. The chart below is from his report – the small chart in the inset is a 1992 forecast from Shell on EV sales which has turned out to be wildly inaccurate. But the point of the main chart is that sales really are going to take off over the next decade.

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It’s possible to find other old forecasts that were wildly inaccurate. Futurist Tony Seba predicted in 2017 that by 2030 100% of auto sales would be autonomous (self-driving) EVs (see A Futurist’s Vision of Energy). It’s still nine years away, but for autonomous EVs in the U.S. to reach that level would require their market share to double approximately every 20 months.

Growth in renewables and EVs have been about to break out for years. The world will need more energy – the U.S. Energy Information Administration (EIA) expects global energy consumption to increase by 50% over the next three decades. They expect every source to increase, including coal.

High among Elon Musk’s many talents is marketing, because he’s successfully linked EVs with clean energy in the minds of consumers. America generates around 60% of its power from coal and natural gas, with renewables (including hydro) and nuclear each providing around a fifth.

There are substantial variations – California is required to reach 100% emission-free power by 2050, and is about two thirds of the way there, even if their grid sometimes fails (see California Dreamin’ of Reliable Power). The state leads in EV sales. But Wyoming residents who buy a Tesla thinking they’re contributing to a cleaner planet overlook that over 80% of the state’s power comes from coal.

America’s coal consumption is heading in the wrong direction – the EIA expects coal’s market share of power generation to rise from 20% last year to 23% this year and next, matching the growth in renewables. Some of the growth in coal is due to higher natural gas prices – Democrat policies are intended to raise energy prices, although using more coal is an unintended result. And nuclear continues to drop, which is a big missed opportunity.

EV sales globally reached a 6.9% market share last year. President Biden is planning for the U.S. government to only buy EVs in the future. As my partner Henry pointed out, today’s internal combustion engine automobiles are built around a small power generator, which does seem less efficient than simply a battery.

Although insufficient charging stations and the time required to recharge remain impediments for many buyers, these challenges can be surmounted. A battery that lasted an entire day’s drive would certainly help. There are also fewer moving parts, which keeps maintenance costs down. And every EV owner loves the acceleration.

EVs are selling because they’re providing consumers what they want, and are growing market share as a result. By contrast, growth in renewable energy is more reliant on utilities increasing the portion of the power they supply from solar and wind. The absence of a carbon tax from the Democrats’ planned clean energy legislation reveals that, although many voters express concern about climate change, they’re unwilling to spend much to solve the problem.

Meanwhile, pipeline operators such as Williams Companies (WMB) have found that increased use of renewables is boosting natural gas demand – weather-dependent power needs something reliable when it’s not sunny and windy.

Increased EV penetration is part of the electrification of the transportation sector. Since natural gas remains America’s biggest source of power generation, this trend will tend to constrain growth in crude oil demand in favor of natural gas, although the impact remains years in the future. In emerging countries, EV growth adds to the urgency to lower their dependence on coal for power generation. The energy transition continues to rely on natural gas.

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

Fed chair Jay Powell wasn’t to blame for Thursday’s equity market sell-off, no matter what journalists thought. His comments were dovish, reaffirming the Fed’s desire to see meaningful improvement in employment before moderating their bond buying. Tightening is nowhere in sight. Had he said the opposite, markets would have probably fallen further, which simply means bonds are in a bear market.

Powell’s comment that he would only be concerned about bond weakness if it led to tighter financial conditions suggested that the Fed would be inclined to counter such a development, perhaps by increasing their own bond purchases. He expects any increase in inflation to be temporary. Fixed income investors aren’t so sanguine and are demanding fair compensation for increased risk. To own bonds at current yields requires a faith in the Fed’s forecasting ability not supported by their track record. They have no insight that isn’t found in many private sector forecasts; but they do have the power to act.

The Fed’s beige book provided a mildly encouraging outlook, but mentioned the word “shortage” 31 times, the most in a decade. It applied to difficulties in filling many different job types, petrochemicals and chips used in automobiles. CNBC reported that raw materials costs for a new car had risen $1,152 in the past year. Today’s Fed cares more about unemployment than adequate returns to bond buyers. It’s correct and democratic, but translates into inadequate interest rates.

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We were also surprised to see evidence of very strong new business formation. Thanks to Barry Knapp of Ironsides Macroeconomics for pointing out the surge in IRS issuance of Employer Identification Numbers (EINs), one of the first steps in launching a new business.

Stocks are attractive but, in some sectors, vulnerable to higher rates. This is most apparent among growth sectors such as technology, which has been supported by low rates for years. Ten year treasuries at 2%, 0.5% higher than now, still wouldn’t make bonds a buy. But because the net present value of a growth stock is more reliant on distant cashflows than is the case for the overall market, rising rates hurt more. If you think of a growth stock as analogous to a zero-coupon bond (returns backloaded) and compare it with a similar maturity coupon-bearing security, you’ll appreciate that growth stocks have greater interest rate sensitivity (duration), just like a zero-coupon bond.

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OPEC’s decision not to increase supply for now gave a further boost to the energy sector. Pipelines are providing useful protection against rising rates, since both are going up with the reflation trade. After several years of negativity, it’s a long way from a crowded trade. We expect Free Cash Flow (FCF) to continue growing this year, such that pipelines will offer a FCF yield of 10% by year’s end; double the S&P500. The American Energy Independence Index (AEITR) is now back above its pre-Covid 2019 year-end level, and is narrowing the performance gap with the S&P500.

Exxon Mobil (XOM) has doubled in price since October. Its dividend, increasingly secure as crude rallies, still yields over 6%. It’s hard to see a strong bearish case even following such a strong rally.

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The strength in energy has coincided with weakness in solar stocks. The Invesco Solar ETF (TAN) is –7% YTD, versus the AEITR which is +20%. Over the past year, solar stocks have outperformed significantly, but as growth stocks they’re vulnerable to rising rates.

Maybe solar investors have considered the two maps showing the global disposition of coal-burning power plants, which vividly portrays where the world’s increased CO2 emissions will be coming from. Developing countries, many of them in Asia, will be adding significant power capacity reliant on coal. Increasing global trade in natural gas is preventing this damaging development from being even worse.

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The hype around renewables makes it seem as if America can singlehandedly save the planet if we’d just shift to 100% solar and wind. New York’s mayor Bill de Blasio wants to ban natural gas hookups for new buildings by the end of the decade. If you’ve visited New York recently you may conclude that de Blasio’s chronic mismanagement is curbing the need for much new construction anyway. But he epitomizes the simplistic view that is oblivious to what’s actually happening.

The world’s going to use more of all kinds of energy in the next several decades, as economic growth in emerging economies drives up demand. We’ll use more renewables, natural gas and, unfortunately, more coal. Unless we can flip those dots, each of which represents a new source of coal-based emissions, to something cleaner (natural gas is the obvious choice), we’d better plan on living with more CO2.

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

U.S. bond investors would do well to remind themselves that the Fed’s objective of stable prices is linked to maximizing employment. They have a twin mandate. In theory these goals are aligned, but not all the time. From 1980-82 the U.S. endured two sharp recessions as interest rates were hiked to vanquish inflation. Today, maximizing employment is the more important of the Fed’s linked goals. They’re willing to take a little risk with inflation, as Fed chair Jay Powell noted last week (see Bond Investors Are Right To Worry).

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Boosting employment is why the Fed launched Quantitative Easing (QE) during the 2008 financial crisis, to good effect. It turned out that monetizing debt, via the Treasury selling directly to the Fed, wasn’t inflationary. It’s become a permanent fixture. Sluggish improvements in employment meant that the Fed’s balance sheet continued growing until 2014 when it reached $4.5TN. It only began to shrink in 2018. Then Covid hit, and it quickly jumped to $7TN. It’s been growing at $28BN a week for the past three months.

Inflation expectations have been rising at the fastest pace since 2009 as the economy emerged from the last recession. Forward estimates of the five-year inflation rate five years from now (i.e. 2026-31) are around 2%, not yet especially worrying since that’s the Fed’s target.

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Such estimates are derived from the yields on treasury securities. The Fed’s increasingly large holdings of debt instruments distorts their message. For example, their position in inflation-linked bonds has risen sharply over the past year, such that they now hold 20% of the outstandings.

To the extent that these purchases depress real yields, the nominal minus real yield spread would widen, indicating markets expect higher inflation. However, their purchases of regular bonds have also been increasing, creating the opposite effect.

The bottom line is that the Fed’s large holdings make the bond market’s precise forecast of future inflation less reliable. Nonetheless, rising bond yields suggest investors are recalibrating their own expectations.

Increasing labor force participation by drawing discouraged workers back into the jobs market has gained more attention in recent years, both at the Fed and within Congress. This is no bad thing – it shows the twin mandate with Congressional oversight working.

But in a subtle way, the Fed has been shifting its focus. Inflation isn’t a problem; unemployment is. The returns to bond investors have been a low priority for years, as central banks around the world drove long term rates lower. Now there’s a risk that rising inflation will further erode returns.

Bond yields have been rising globally, reflecting the recovery from the pandemic but also, in the U.S., plans for fiscal profligacy. Central banks don’t like the market message they’re receiving. Australian ten year bond yields have doubled this year, from under 1% in December to almost 2% last week. The Reserve Bank of Australia has acted to counter this trend, recently announcing they’d buy A$3BN of longer-dated debt.

U.S. fixed income markets are communicating an important signal, that a robust recovery is coming. The Fed’s bond buying serves to moderate that message. Yields would clearly be higher, perhaps even affecting the political debate around whether we need $1.9TN in additional covid relief spending. America’s fiscal response to Covid will reach 25% of GDP as a result, regarded by many as more than sufficient. The Fed is muting the bond market’s response.

QE was originally conceived to extend easy monetary policy out along the yield curve. Yields were falling, but not as far as the Fed desired.

Today’s global yields reveal no shortage of return-insensitive buyers of bonds. In his annual letter published on Saturday, Warren Buffett warned that, “Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.” QE is evolving to counter the prevailing trend in bond yields – the Fed is rejecting the collective analysis of bond buyers who are demanding higher returns for what they perceive as increased risk. The Fed’s QE isn’t helping these investors. Withdrawing the support will be hard. Watch out if they do.

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Protecting portfolios against rising interest rates is hard for most investors. The ETFs that are designed to profit from falling bond prices are very inefficient and costly. Some shelter in bank debt, where their focus on short maturities linked to Libor insulates against rising bond yields. But the underlying issuers are non-investment grade, so this means swapping interest rate risk for credit risk. Interest rate futures are the best choice, but many are put off by the leverage. America’s bifurcated regulatory structure means financial advisors shorting eurodollar futures for clients would then come under CFTC oversight as well as FINRA.

Since the market bottomed almost a year ago, the recovery trade has transitioned into the reflation trade, spurred on by the first vaccine announcement in early November.

Pipeline stocks have tracked the ten year treasury yield higher over the past year, a connection that makes sense since renewed economic activity is driving both higher. Midstream energy infrastructure offers a source of return as rates move higher. It also comes with an attractive yield, something long absent from the bond market.

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

“At this point, the Federal Open Market Committee is seeking inflation running moderately above 2% for some time.” Fed chair Jay Powell, Senate testimony February 23.

The Fed is walking a fine line, and it’s easy to take this comment out of context. Inflation can be too low, and in order to ensure they adhere to their dual mandate of maximum employment consistent with stable prices, the Fed is willing to take a little risk with price stability. Nonetheless, if the marble hallways of the Federal Reserve building in Washington DC display carved quotes from Powell’s predecessors, this one is unlikely to be added.

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The Democrats have embraced Modern Monetary Theory (MMT) in all but name (see Democrats Will Test The Limits On Spending). The only theoretical limit on government spending is when it’s inflationary, and until it is one must conclude spending plans weren’t bold enough. Today’s low bond yields are a piggybank to be raided for Covid relief, infrastructure spending and the energy transition.

Fixed income investors have been abused by paltry yields for years. The biggest question in finance today is why long-term rates have remained so persistently low for so long. Real yields have been falling for at least a generation. Inflexible investment mandates for institutional investors such as pension funds, which mandate a fixed income allocation regardless of return prospects, are part of the reason.

Bond investors’ passive acceptance of diminished returns has made Democrat spending plans possible. $2.8TN in the Fed’s expansion of its balance sheet, $3.4TN in deficit-financed spending, plus the latest $1.9TN Covid relief plan add up to over $8TN in stimulus.  As Barry Knapp of Ironsides Macroeconomics notes, this is to offset the estimated $1.1TN nominal GDP output gap caused by the recession. In other words, we’re plugging the economy’s hole by a factor of over 7X. There’s little risk that the government’s financial response to Covid could be criticized as inadequate.

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Against such a backdrop, even though Powell was simply repeating past comments on desiring higher inflation, it did betray a lack of sensitivity to bond investors still contemplating the 7X noted above. Under these circumstances, when the Fed wants inflation above 2% “for some time,” why would a return-oriented investor hold ten year U.S. treasuries yielding only 1.5%?

Inflation expectations have been drifting higher, recently breaching 2% for the first time in two years. Powell noted that, “… forecasters need to be humble and have a great deal to be humble about frankly.” Such humility must be abundant at the Fed, whose forecasts of short-term interest rates published in their projection materials were too high for most of the past decade (see Bond Market Looks Past Fed).

The bond market’s forecast of the “neutral”, or longer run Fed funds rate was consistently lower than in FOMC projections for years. The Fed steadily followed the market’s forecast lower. Predicting interest rates is hard. The Fed’s not very good at it. But their persistent failure to correctly forecast a rate that they set is amusing, for those who follow such things.

Now the situation is reversed; fixed income markets are beginning to price in higher short term rates by late next year, whereas the FOMC expects to keep rates low at least through 2023.

It’s unwise to bet against the Fed. But with $8TN of stimulus going up against the FOMC’s forecasting record, it’s likely that the Fed’s reputation will remain intact.

Inflation may not rise at all, in which case the bond market’s hissy fit will have been just that. However, Powell expects it to rise later this year before falling, which will be far more interesting.  The period of time during which inflation is above target may seem interminably long for investors positioned for it to be temporary. Bond yields will reflect how closely investors share the Fed chair’s breezy confidence.

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The eurodollar futures market reflected this change in expectations over the past week. Risks are more correctly priced in than before. However, there is no limit to the amount of stimulus that Washington will provide. If a Covid mutation creates a setback, the response will be predictable (see The Biden Put). Ten year treasury yields at 1.5% still don’t reflect that reality.

Rising rates aren’t necessarily bad for stocks, unless they move sharply.

For example, pipelines have performed well so far this year. The sector is more insulated than many to bond market risk – if rates do move substantially higher, it will be because demand for most things including energy is booming. Investors are beginning to recognize this, since the sector (as defined by the American Energy Independence Index, AEITR) has become a reflation trade, tracking bond yields higher.

Pipeline company dividend yields remain very attractive. Consider natural gas pipeline behemoth Williams Companies (WMB), whose equity yields almost 7%, a level still suggesting still some risk to the security of the payout.

Last week they announced they’ll be increasing it by 2.5% this year. Pipeline stocks still offer attractive upside.

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

Inflation fears are percolating. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) had its biggest ever stretch of outflows over the past six weeks. There are plenty of warnings signs. Commodity prices are booming. This is happily driving up midstream energy infrastructure, with the American Energy Independence Index up 15% YTD, well ahead of the S&P500 at up 4%. Cyclical and value sectors are drawing renewed interest. Energy has been outperforming technology since November’s vaccine announcement.

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M2 money supply is growing at 26% year-on-year, the fastest since records began. The link between inflation and money supply broke years ago. Money velocity is down sharply, which is why inflation isn’t surging. The Fed isn’t worried. They would be happy with inflation running above their 2% target for a while. For those of us whose careers include the 1980s, when inflation and interest rates peaked, this is quite an an adjustment.

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Covid figures are collapsing, which will likely unleash pent-up spending that interminable lockdowns have stifled for a year. The CDC counts 474K deaths involving Covid, less than the 500K figure seen elsewhere because the CDC waits for official death records to be uploaded by the states. This is without doubt a tragedy.

Over the same period, 3.3 million Americans died without Covid. They spent their last months or year alive constrained by all the restrictions we know so well. To pick one cohort, 99K people aged 65-74 died with Covid, but 631K of the same group died without it. 21K aged 45-54 died with Covid, reflecting their low risk profile, but 183K in this group died from other causes, while enduring pandemic restrictions like the rest of us. Even for those 85 and older, who are almost a third of all Covid fatalities, 87% of deaths in this group were non-Covid.

A friend of mine I’ve known since elementary school died on Saturday from a heart attack, which probably caused me to consider the figures in this way. The lost final year of life for the non-Covid fatalities denied the normalcy of dinners out, companionship with friends, travel and so on is another tragic element of the pandemic, but doesn’t get much attention. Do you know anyone who isn’t ready to get out there and live once more?

Money market funds hold around $5TN, a figure that’s slowly declining but still nonetheless $1TN higher than a year ago. This has low velocity while it’s sitting there but could easily be deployed in a recovery of consumer spending. Examples of rising prices include crude oil, copper and resins used to manufacture plastics. Pipelines, which move with commodity prices and reflect ownership in physical assets, offer more protection than most sectors in this environment.

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Meanwhile, the Administration wants to spend $1.9TN on Covid relief – even if that figure is negotiated down, the vaccine rollout and falling hospitalizations suggest that the worst is behind us. A weekend article in the WSJ even suggested that the U.S. was nearing herd immunity. It’s predicated on an estimate that 0.23% of people who get infected die. Assuming that’s a reliable statistic and the 500K Covid fatalities is also accurate, it suggests 217 million Americans have been infected (500K divided by 0.23%). That’s approximately two thirds of the country. Add the growing vaccinations and you can see the country could be at 70-80%.

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It’s a controversial assessment, and friends/readers who know more than us on the topic will be moved to respond. Fauci isn’t so optimistic. Virus mutations may cause a setback. But it’s not possible to definitively reject the optimistic conclusion, only to say it’s unclear.

Once the Covid relief plan is approved and money being sent out, Biden will turn to infrastructure – another $1TN. Climate change will justify at least that in addition. There are no longer any fiscal hawks (see Modern Monetary Theory Goes Mainstream).

Although there are plenty of warning signs that inflation will rise, we’ve had almost three decades where it hasn’t. Many worried about the inflationary effects of Quantitative Easing when it was first deployed following the 2008 financial crisis. To Ben Bernanke’s credit, he knew it wouldn’t and he was right. The economists at the Fed are similarly confident today. They’re expected to keep short term rates low for at least the next couple of years.

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Betting against the Fed is usually wrong. But today, betting with them doesn’t offer much upside. The eurodollar futures curve remains extremely flat, so an investor in two year securities will do scarcely better than holding overnight deposits for the same period of time. Fed chair Powell reiterated his cautiously optimistic outlook yesterday with no need to raise rates anytime soon.

The Federal government is pouring fiscal and monetary stimulus into the economy simultaneously. And if a virulent Covid mutation sets back the current path to re-opening, more $TNs will be forthcoming.

People used to refer to the Bernanke “put”, recognizing that the Fed would respond to sharp economic weakness by easing, giving equity investors effectively a put option on their holdings. Nowadays we have both the Powell Put and the Biden Put. Bond yields are too low to properly reflect the new reality.

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