Hopes for a Trade Deal Slipping

Article I of the U.S. Constitution gives Congress the “…Power to lay and collect Taxes, Duties, Imposts and Excises…” Congressional control over tariffs has never been so strong since.

The Reciprocal Trade Agreement Act of 1934 granted President Roosevelt the authority to adjust tariffs and to negotiate bilateral trade agreements without prior congressional approval. Other legislation increased the Administration’s control over trade, including the Trade Act of 1974 which allowed the President to impose a 15% tariff if imports threatened national security. There’s much to recommend a single decision maker heading up such negotiations. It should lead to more predictable, less capricious discourse than one requiring congressional approval. For decades, it’s how the U.S. has conducted trade negotiations, and it’s broadly worked.

In recent months, President Trump has demonstrated the full range of options afforded a president to manage trade. Updates on the progress of negotiations with China have been responsible for much of the recent market volatility.

An interesting chart from Goldman Sachs divides the three year performance of the S&P500 into two periods – a steady uptrend that prevailed from Trump’s surprise election until the first imposition of steel tariffs early last year, followed by a modest rise punctuated by higher volatility.

Trade War Increases Market Volatility Lowers Returns

A second Goldman chart infers the market’s estimate of a trade deal by comparing baskets of stocks with sharply different exposure to China. Based on this, market expectations of a trade deal are low, and Goldman duly do not expect one before next year’s election.

Market Places Low Odds on Trade Deal

Stocks are cheap relative to bonds (see Stocks Offer Bond Investors an Opening). It seems self-evident that Trump’s re-election prospects are better without trade disputes slowing growth, and therefore rational for him to seize a deal. The trade deficit with China is already falling (see Trade Wars: End in Sight), so the opportunity to declare victory and reach agreement is a real one.

Low expectations of an agreement coupled with relatively cheap stocks mean a big rally would follow.

But this analysis isn’t unique, and market participants are looking beyond it. Current pricing of no deal before the election either means Trump won’t seize one, or China will decline to offer a graceful exit from a negotiating strategy that hasn’t yet worked.

This brings us back to the issue of which arm of government should control trade negotiations. There’s much to be said for the current structure. Congress is an unwieldy negotiating partner, and myriad parochial interests could easily derail an almost perfect agreement.

If the low expectations of an agreement turn out to be accurate, calls to restore some of the power originally vested in Congress are likely to grow. Senators from both parties have begun advocating for such a change. If protracted trade uncertainty continues into next year, the odds of legislative action will rise.

Paradoxically, such an outcome could well be bullish if it removed much of the trade uncertainty we’re learning to live with. It’s just hard to assess how much intervening market volatility will be required to provoke lawmakers into action.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Trade Wars: End in Sight

Last week’s fears of global recession herald the late stages of Trump’s trade war. It’s already possible to see the outlines of a triumphant victory speech. The U.S. trade deficit with China is on track to fall for the first time in at least 30 years. After it reached a new record last year, critics were quick to point out the Administration’s failure to resolve an issue that figured prominently in the 2016 campaign. But as the chart shows, unless trade flows for the second half of 2019 follow a dramatically different pattern than in the past, this year will provide the White House with plenty of ammunition heading into the 2020 election.

U.S. China Average Monthly Trade

The U.S. always had a stronger hand; America’s vast domestic market means trade penetration is the joint-lowest among the world’s ten biggest economies (tied with Brazil). America has hundreds of world class companies selling goods and services globally. But many thousands more achieve years of growth without having to venture abroad. Compare that with Germany’s vaunted “mittelstand”, of small and mid-size industrial companies that export successfully around the world. Overseas customers are vital to German GDP growth, which is why ongoing trade friction tipped the German economy into contraction during the second quarter.

Trade as a Percentage of GDP

Soybean exports to China represent 10% of all U.S. farm output, so there are regions and industries that have suffered. Consequently, the Administration recently announced $16BN in aid to farmers hurt by Chinese reciprocal tariffs. But the overall result is that U.S. GDP has been less harmed than in other countries. High-tech goods such as aircraft and integrated circuits are among the biggest export categories to China, but since intellectual property is one source of conflict, these industries shouldn’t be surprised if they get caught in the crossfire.

Trump draws widespread condemnation for the manner in which he governs, but in taking on the trade deficit with China he is reflecting the views of many Americans. Since World War II, the U.S. navy has protected vital shipping lanes around the world, facilitating trade and thus promoting global prosperity. Questioning this policy doesn’t resonate with most politicians; but the emergence of other big economies, such as China, to compete with the U.S.suggests that American security policy can be less selfless than in the past.

A more transactional U.S. approach, less drawn to underwriting the greater good prompts simple questions: one is, why does the U.S. maintain troops in Germany as protection from Russia, while Germany increases its imports of Russian natural gas? America has bankrolled military support for many countries rebuilding their economies since World War II. Times are changing.

Bilateral trade deals suit the U.S. Although the White House was widely criticized for withdrawing from the Trans Pacific Partnership (TPP), negotiating within large groups blunts the leverage of the world’s biggest economy. The U.S. benefits from a series of bilateral agreements creating a hub and spoke framework, although most nations do better by coordinating with others.

Last year’s free trade deal with South Korea is an example. More recently, NAFTA was replaced with the US-Mexico-Canada Agreement (USMCA) in a pair of bilateral negotiations with Canada and Mexico that tweaked the old deal to suit the U.S.

It’s why the EU is more popular with smaller countries. Once Britain leaves the EU and opens bilateral trade negotiations with the U.S., it’ll experience the reduced leverage that comes from being outside the group.

The shrinking deficit with China is creating an opening for Trump to reach an agreement, removing the growing headwind slowing global GDP. He can boast of being the first president to interrupt the steadily increasing trade deficit with China. If he doesn’t dwell for too long, he may even head off the recession that investors increasingly fear.

What’s unclear is whether it’s been worth the fight. The U.S. Federal budget deficit relies on financing by foreign investors. Because America doesn’t save enough to meet its borrowing needs domestically, the surplus dollars held by trade partners, including China, get reinvested into U.S. financial assets, such as treasury bonds. A lower trade deficit suggests fewer excess dollars owned by foreigners to be invested. This in turn means more U.S. debt will need to be financed by domestic savers, which will require higher interest rates as an inducement. And even though the U.S. has a strong hand in trade negotiations, slowing GDP growth doesn’t help anyone.

Provoking trade friction may not always be smart policy, but it does reflect popular opinion. It is democratic. Trump’s critics are many, but he is a reflection of American views on trade.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Art of the Tariff

Yesterday’s White House announcement that newly imposed tariffs on Chinese goods would be delayed three months sent stocks higher. The trade dispute hasn’t hurt the U.S. that much, although there’s widespread evidence of financial distress among farmers. Agriculture Secretary Sonny Perdue showed his sledgehammer wit in a joke aimed at farmers complaining about tariffs. China recently stopped buying U.S. agricultural products entirely in response to the latest U.S. tariffs. Farmers vote, and the White House has modestly recalibrated its approach. Trump clearly enjoys the relatively unfettered freedom of action afforded the president on trade.

Trade friction threatens global growth. The IMF recently called for a quick resolution between the U.S. and China. It’s blamed for the continuing drop in bond yields, with some investors openly contemplating whether the U.S. could soon join other developed country sovereign debt with negative interest rates. U.S. ten year yields of 1.7% are the highest in the G7, and among those who shop for value in government bond markets they probably look enticing.

America’s higher yields reflect our relative immunity to trade war fallout. The S&P500 recently broached 3,000 for the first time before retreating on new tariffs. But yesterday’s bounce took it back to within 3% of recent al-time highs. We noted last week how the Equity Risk Premium provided a compelling case for investors to allocate towards risk assets (see Stocks Offer Bond Investors an Opening).

America Shielded from Trade War

Although Trump’s protracted dispute with China has broad domestic support, we continue to believe that a resolution will be found within the next few months, so as to avoid any economic fallout in an election year. Expect to see agricultural exports and natural gas heralded as big winners.

The U.S. energy sector could certainly use a confidence boost. Pipeline earnings have generally been at or ahead of expectations. The bull story relies on the growth in free cash flow (see The Coming Pipeline Cash Gusher). 2Q19 earnings reports provided further confirmation that growth projects peaked last year, leaving more cash available for dividend hikes.

Traders betting on a global slowdown are quick to short crude oil, and recent weakness in energy prices has hurt the sector’s stocks too. No matter that pipeline company earnings are generally not sensitive to commodity prices. The most asked question by clients recently centers around the incongruity of good operating performance with falling stock prices. The short answer is that several years of dividend cuts left income-seeking investors betrayed. So far this year, this traditional buyer hasn’t rushed back, as shown by flows into retail-oriented funds.

Improving fundamentals and compelling valuations are attracting private equity buyers. Public market buyers will surely follow.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Brexit Meets the Shale Revolution

Britain’s new prime minister, Boris Johnson, sports a mop of blond hair, shuns conventionality and routinely spins facts to suit his purpose. The photo is from a 2006 charity soccer game in London against Germany, when he head-speared an opponent in a maneuver better suited to wrestling. It’s an appropriate metaphor for the upcoming Brexit negotiations with the EU.

Boris Johnson Rugby Tackle

Even to a Brit, the unfolding constitutional drama has been hard to comprehend. Boris was chosen by 96,000 hard-core Conservative party members, and will be PM because they (barely) have a Parliamentary majority. The country voted for Brexit (by 52%-48%), and yet Parliament has rejected both a negotiated EU exit and a hard Brexit. It’s possible the next deadline of October 31 may pass with the UK still a reluctant EU member.

Poor leadership is all Britain has. If Theresa May wasn’t all but gone, she would have faced more withering criticism over the entanglement with Iran. Having seized an Iranian tanker, the careless loss of a British-flagged ship might charitably be ascribed to domestic leadership distractions. The inability of the Royal Navy to offer protection, along with Britain’s intimidating vow to resolve using all diplomatic means, reveals a country wrestling with diminished status and no plausible military option.

PM Johnson enters office with an unwanted foreign policy crisis. But as a vocal cheerleader for Brexit, it is appropriate that he should be the one leading the country as it plows ahead into unknown status.

Meanwhile, the main protagonists are both avoiding direct conflict — Iran because military defeat would be swift, and Trump because it would jeopardize his re-election. So the situation percolates without boiling over, with little end in sight.

Crude traders have remained sanguine over the potential for supply disruption through the Straits of Hormuz. A defining feature of the Shale Revolution is that it has ameliorated the price spikes that used to threaten global growth. Higher prices increase profitably accessible reserves, and shale’s short production cycle always promises more availability within a matter of months, if needed.

Fewer Monthly Spikes in Crude Oil

Britain’s economy is slowing due to Brexit uncertainty. Shaky consumer confidence doesn’t need a debilitating spike in crude. Fortunately, such moves are becoming rarer. Volatility in crude oil isn’t much different than a decade ago, because prices still fall quickly. But world growth is more susceptible to sharp increases. Encouragingly, price spikes are becoming less frequent and milder, another tangible demonstration of the Shale Revolution’s impact in addition to generally lower prices.

President Trump could justifiably note how American energy independence is protecting oil importing nations like Britain from price shocks. PM Johnson needs a narrowing Atlantic to offset the politically widening English Channel.

U.S. LNG exports, another Shale Revolution benefit, are likely to be on the table as Brexit Britain seeks deeper ties with the U.S., allowing Trump to show he can close a trade deal. A Donald-Boris honeymoon beckons.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Our Fossil Fuel Future (With a Bit More Solar and Wind)

Climate change is driving tremendous upheaval in the energy sector. One consequence is that making long term investments is exceptionally difficult. A large, conventional oil or gas project is exposed to uncertainties around GDP growth, production costs and commodity prices over a payback period that can extend 10 to 20 years or more. Public policy changes add further uncertainty, which is why big projects are shrinking, and investments with a faster payback are gaining favor. The short-cycle projects offered by U.S. shale are one answer to energy production at a time of uncertainty.

There are at least seven entities publishing projections on long term global energy use, and because of multiple scenarios they produce 13 forecasts. Resources for the Future, a non-profit research institution, has helpfully combined these in Global Energy Outlook 2019: The Next Generation of Energy (“GEO”) so as to allow easy comparison. These fall into three categories of energy consumption to 2040 based on different public policy regimes: (1) unchanged policies, (2) likely new policies, and (3) policies designed to lower CO2 emissions.

The World Will Use More Energy

Surprisingly given the diverse set of forecasts and long horizon, there is reasonable consensus in some key areas. Energy consumption will continue to grow, driven by rising living standards in developing countries and increased population. Lowering CO2 emissions pits wealthy countries (“West” in GEO terminology, meaning Europe, Eurasia, North America, South and Central America) willing and able to constrain energy use against the aspiration to western living standards in non-Japan Asia (“East” in GEO which is Asia-Pacific but includes Africa and the Middle East). An estimated 1.1 billion people don’t have access to electricity today.

Asia Will Drive more Growth in Energy Consumption

Consumption of oil and related liquids reflects greater auto ownership, aviation and plastics use in the East, more than offsetting improved efficiencies which will curb demand in the West. But the bigger challenge remains global coal consumption, where East and West are moving in opposite directions. China alone burns 6X as much coal as the U.S.  In fact, China consumed more coal last year than the rest of the world combined.  Any path to reduced climate change with today’s technologies includes sharply reduced coal consumption.

Asia Burns More Coal

Substitution of natural gas for coal underpins our constructive outlook for U.S. exports of Liquified Natural Gas (LNG). Even on current policies most GEO forecasts see steady growth in natural gas. If the countries of the East decide to use less coal than most forecasts expect,LNG should see additional demand growth.

Renewables Outlook For Power Varies

By contrast with natural gas, views on renewables vary widely. The International Energy Agency’s “Sustainable Development Scenario”, which incorporates policies to lower CO2 emissions, sees 4X as much renewable power generation as the U.S. Energy Administration’s “Reference Case”.

EV Forecasts Vary

Electric vehicles (EVs) are marketed as a reduced CO2 solution, although when you properly account for emissions in their manufacture and battery disposal, the benefits are murky. It also depends on how the electricity used is generated. Wyoming relies exclusively on coal, making a Tesla purchase in the Cowboy State an environmentally unfriendly choice. Estimates of global EV penetration in two decades vary widely.

Still a Fossil Fuel World

Most of the promise of renewables lies in their generation of clean power, and electrification of the world’s energy consumption is part of any attempt to tackle climate change. But the production of steel, cement, fertilizer and plastics rely on the high heat generation and other chemical properties of fossil fuels. Aviation is unlikely to use batteries in the foreseeable future. The result is that renewables penetration of total primary energy is expected by most forecasts to increase modestly,  to around 20%.

The conflict between energy use and emissions is shown in the three forecasts that incorporate reduced CO2. Two of them assume falling energy consumption, which seems politically implausible for countries of the East barring transformational improvements in the technology around energy use and storage.

Every energy investor needs to stay current on trends and developments in energy use. The GEO report is a useful reference guide.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

America Questions Role As World’s Super-Cop

On Monday, President Trump asked, “Why are we protecting the shipping lanes for other countries (many years) for zero compensation?”

America Polices the Middle East

Few American voters give much thought to the U.S. Navy’s role in ensuring safe passage for seaborne trade around the world. This interactive map, although seven years old, provides a fascinating picture of the volume and location of merchant ships. Choke points such as the Straits of Hormuz look like commuters at the Times Square subway station.

The U.S. has protected shipping lanes for decades, picking up from the British Navy’s historical role. The world benefits from free trade, but America bears more of the cost of security than any other country, and perhaps most of it. American taxpayers who considered the issue would likely seek some burden-sharing. Trump’s supporters and critics alike can agree that when he asks simple questions like this, he understands the prevailing mood of the electorate.

It reminded me of Paul Kennedy’s 1987 book, The Rise and Fall of the Great Powers; Economic Change and Military Conflict from 1500 to 2000. Kennedy chronicled the challenges faced by the Spanish, French and British empires as they successively succumbed to “imperial overstretch.” This is the inability of any great nation to support sufficient military power to retain control of its conquered territory. Kennedy’s central premise that Japan was about to surpass the U.S. was spectacularly wrong, but his concept of imperial lifecycles is provocative.

The U.S. does not occupy foreign countries. There is no American empire analogous to the historical versions. But the U.S. leads an empire of culture, values and economic liberalism. Soft power, along with hard.

Military power flows from GDP, and in 1945 America’s share of the global economy was at its peak. Today, China and India enjoy faster economic growth which inexorably diminishes America’s share of world GDP. In time, relative military strength must reflect this, and the U.S. will once again contend with a multi-power world. Today, the U.S. defense budget is more than 2X China and as much as the next seven countries combined. Military dominance is not in doubt.

But Trump’s comments reflect an isolationism that questions the need to be the world’s police force. It’s a rational adaptation to a world in which many U.S. allies have prospered under security provided and funded by the U.S. Enough already.

The seductive simplicity of problem-solving by tweet glosses over complexity. Trump’s comments were likely prompted as he cancelled a planned military strike on Iran and wondered why the U.S. was in the Persian Gulf in the first place. The two stricken tankers were from Japan and Norway. The lost U.S. drone was patrolling the area. Is it really our job? Chinese warships aren’t about to start patrols there, but Trump’s sentiments were valid.

Here’s where the Shale Revolution provides geopolitical flexibility. The U.S. is on the verge of becoming a net exporter of crude and petroleum products.  For decades, we’ve maintained a significant military presence in the Middle East and fought two wars there in part to assure the world’s continued access to crude oil. Without this resource, the region would be governed like Somalia and we wouldn’t care.

U.S. energy independence affords geopolitical flexibility. This includes the freedom to be more selective about our military commitments. It reduces our vulnerability to supply disruptions. It lowers our exposure to Paul Kennedy’s imperial overstretch. America’s energy renaissance has many benefits. Add to that list increasing burden sharing among other countries in providing global security.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Why You Should Only Buy China Through the S&P500

Last week’s article by Jason Zweig (see Think Before You Fish for Bargains in Chinese Stocks) caught my eye, because it warns against investing in Chinese stocks with the expectation of high GDP growth driving high equity returns. A major reason investors allocate to emerging economies is because they expect that relationship to reward them, although there’s plenty of evidence that it doesn’t work.

Zweig references a 2004 academic paper (Economic growth and equity returns) which highlighted one important reason: GDP growth can be driven by technological innovation among new, private companies. This does nothing for current investors in public equities. Technological improvements are usually good for consumers but less often for public companies, unless they can exploit their advantage without meaningful competition. The true driver of returns comes from earnings paid out as dividends, and the return on retained earnings that are reinvested back in the business. Chinese public companies have been poor at the latter.

Moreover, the market cap of the MSCI China stock index has grown largely through new equity issuance. So global investors who allocate passively based on market size are induced to increase their China exposure, even though returns on invested capital have been poor.

A 2010 paper from MSCI Barra (Is There a Link Between GDP Growth and Equity Returns?) similarly found no meaningful connection between the two.

Jason Zweig generously concludes that Emerging Markets (EM) investing can still make sense if a country’s market looks cheap. But if GDP growth doesn’t correlate with equity returns, the justification for an EM investment becomes weak. What’s left is a tactical move based on what looks like temporarily weak pricing. That’s not a long term strategy for most people.

American investors are accustomed to a market with the world’s toughest rules all designed to promote fairness. Protecting investors from bad actors lowers the overall cost of equity, which does boost GDP growth. But it’s easy to assume that America’s standards are global, which they are not. I remember some years ago chatting with a senior regulator from the Reserve Bank of India. I asked him how many insider trading cases are typically prosecuted in a year, to which he replied, “None. There is no insider trading in India.”

Or the hedge fund friend who described how two or three Mumbai-based hedge funds would trade a small local stock amongst themselves, generating volume and a higher price. This would attract, “the New York hedge funds” in search of a rising stock with good liquidity. Having hooked one, the local hedge funds would dump the stock on the naive foreigner (see The Hedge Fund Mirage, pg 42).

An emerging market doesn’t mean the participants are unsophisticated – in fact, the comparative absence of rules mandates more highly attuned street smarts than is required in developed markets.

Almost every company in the S&P500 does business in China and other emerging economies. They are infinitely better suited to allocate their capital where returns are highest. They’re far better equipped to protect their property and future cashflows from nefarious activity. This means that an investment in a broad portfolio of U.S. stocks includes exposure to the growth of emerging economies. And the portion of that portfolio’s overall EM exposure is the aggregate of hundreds of capital allocation decisions by the senior executives of those companies.

China's Global Market Cap

Blackrock published a paper last year suggesting that China’s 8% global weighting should drive an investor’s China allocation. But this seems too simplistic. The S&P500 derives 2% of its revenues from China. 500 management teams from America’s biggest companies have collectively arrived at 2% as the optimal exposure. An investor who deviates from this 2% figure needs a good reason. Size of market is not one of them, because Jason Zweig’s article shows that most of the growth in China’s equity market cap has come from new issuance, not appreciation. Blackrock’s suggestion ignores the conclusion of hundreds of companies doing business there that have settled on 2%. And when they collectively decide to go to 3%, your exposure will change without you having to think too hard about it.

SP500 China Exposure

Relying on the S&P500 to determine your EM exposure must surely be better than simplistically relying on market cap or trying to figure it out yourself. Simple can be better, and in investing it usually is. Invest in America’s global companies. Let them allocate to EM for you. Stay away from EM funds. You’ll sleep better, and the research shows you’ll get better results too.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Fanatics Protest From a Steel Cell

You might think that using a crane to place steel boxes so as to block all the entrances to a global energy corporation might attract some attention before completed. Nonetheless, Greenpeace successfully demonstrated a gap in business continuity planning, just hours before BP’s annual general meeting. Even at 3am, BP’s global headquarters should have had some security staff on site. They might be expected to notice the unplanned delivery of five steel boxes so as to block access to the building. Perhaps they were taking a nap. It must have led to a lively exchange between the head of security and senior executives.

Greenpeace BP Protest

People sealing themselves inside a chamber with several days of food and water should perhaps be allowed to languish for somewhat longer. One imagines that, had this imaginative protest occurred in Houston not London, the authorities’ response would have been different.

The steel boxes and the fuel for the cranes were enabled by the type of petroleum products BP produces, but this well-worn criticism of environmental activists (do protesters ever cycle to their protests?) is not our point. The energy industry is under attack by a small but vocal group who deny science to try and impose their own quirky vision of 18th century living standards on the rest of us.

Enbridge (ENB) told us last week they would not attempt a new, “greenfield” crude oil pipeline in Canada given the unpredictable approval process. New York recently denied Williams Companies (WMB) permission to build a natural gas pipeline connecting the Marcellus Shale in Pennsylvania with consumers in New York City. Boston relies on Russian imports of liquefied natural gas in winter, because new pipelines to bring domestic natural gas have been successfully opposed.

80% of the energy that supports modern life comes from fossil fuels and it’s never been cheaper. Living standards and longevity in developing countries are improving due to greater energy use. In spite of this undoubted success, the energy sector has lost the PR battle. Providing the world with what it clearly wants draws the smug opprobrium of those whose fixation on solar and wind power includes opposition to nuclear energy. Bill Gates, who writes thoughtfully on big subjects, has questioned the focus on R&D for renewables instead of more on cleaner use of fossil fuels: “Should you really be funding the intermittent stuff with all the money and putting no money in the stuff that works all the time?”

The tobacco industry has no claim to improving well-being, but does share with the energy sector a constant need to apologize for its existence. 25 years ago, big tobacco was being sued by U.S. states and individuals for the terrible health outcomes caused by its products. In 1998 they entered into a Master Settlement Agreement with almost all U.S. states, agreeing to pay billions of dollars over many years.

We are no fans of tobacco companies and the morality of energy companies is wholly different. But it’s worth noting that much-reviled tobacco stocks have provided strong returns since, as shown in the chart. The Wall Street Journal has included Altria (MO) in its “30 best-performing stocks of the past 30 years”. It’s just behind Apple (AAPL). MO also made the top 25 S&P500 stocks of the past 50 years.

Midstream energy infrastructure offers predictable cashflows that are growing, and will always be out of favor with those who like to inhabit steel boxes. It’s a recipe for attractive future returns.

We are invested in ENB and WMB.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Why Keeping Up With Inflation Isn’t Enough

Cher wanted to turn back time to regain love lost. But economists are always turning back time to adjust prices for inflation, to calculate a measure in today’s dollars. This is to provide a relative price, comparable to current purchases.

Although mathematically correct, applied over decades or more it produces a misleading picture of what consumers were spending.

For example, in 1931 Schick launched the electric razor, going on to sell over a million over the next two years. Priced then at $25, there’s no need to convert to 2019 dollars — it was obviously a luxury good. Based on Consumer Price Inflation since 1931, Schick’s new product would now cost sixteen times as much, $412. Today, you can still buy an electric shaver for $25. It probably offers a better shave too.

Buying a shaver was clearly an expense requiring some thought. But by considering only inflation, this analysis assumes disposable incomes have risen by the same rate since then. GDP per capita was $623 in 1931. A razor therefore cost 4% of this measure of annual income per person. Today’s GDP per capita is $62,590, 73 times as big. Incomes have risen roughly four times as much as inflation since 1931, which reflects rising living standards.

If you really want to appreciate the comparative sacrifice required to be quickly clean-shaven during the Depression, Schick’s shaver today would have to be $2,500. That’s 4% of 2018 GDP per capita, the same proportion required in 1931. This more accurately translates the choice consumers made back in 1931.

In 1955 gasoline cost 29 cents a gallon. That’s $2.61 in today’s dollars as conventionally calculated, or $6.96 if we hold it constant as a proportion of GDP per capita. Transport takes up a smaller percentage of household budgets than in 1955. To the anguish of peak oil devotees, driving is cheap.

Incidentally, this is why home prices generally outpace inflation. Incomes, which heavily determine prices, grow faster than inflation. Unfortunately New Jersey, where I live, has denied homeowners this benefit by raising property taxes faster than inflation. But not every state is so poorly run.

The purpose of this thought experiment isn’t merely to demonstrate that stuff used to cost more than you thought; there’s an important investment lesson here. Earning a return equal to inflation on a portfolio, enough to preserve its purchasing power, is every saver’s minimum goal. The point is to be able to maintain today’s standard of living in the future. The problem is that living standards themselves improve.

CPI vs GDP per Capita

A family who earns the median income, which supports an average standard of living, presumably wants that happy state to persist into retirement. In 2000, this average earner brought in $40,597 (median income per family). Correctly forecasting 2% inflation, she would anticipate that $50,000 would be adequate by 2018 to maintain that 2000 lifestyle. Meanwhile, median family income rose to $60,000, because of rising living standards on top of inflation. Following conventional advice, our average family has fallen from the middle of the pack to only 83% of the median income.

Economists retort that our saver can still purchase a basket of goods and services in 2018 with the same utility as she could in 2000. But she’ll feel poorer, because her friends who have maintained their incomes relative to the average will have moved ahead.

There are two points here. First, when it comes to inflation, economics measures what it wants to, not necessarily what non-economists think is being measured or what we want. Most of us care about maintaining our income relative to our peer group today, rather than constant utility.  John Rockefeller’s fabulous wealth couldn’t buy plane travel, internet access or TV during his lifetime. Many of us today enjoy a higher standard of living than the richest people did several decades ago.

The second point is that although investors can’t determine what set of investment returns are available, they should recognize that merely keeping up with inflation is going to leave them feeling poorer than they expected.  Over the past couple of decades, per capita GDP has grown at almost twice inflation. Savers looking to the long term should keep this in mind, and build a bigger nest egg.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

A Slogan Not Science

JPMorgan’s recent Eye on the Market: Energy Outlook 2019 is the best analysis we’ve seen of the Green New Deal (GND). Author Mike Cembalest, whom I know from when I worked there, as always takes a balanced approach supported by insightful research.

Cembalest breaks down the challenge aided by figures and charts to pick the GND apart. Suppose for example, by 2030 the U.S. achieved:

  • Primary energy use back to 1988 levels
  • 11X more solar generation
  • 5X more wind
  • 90% decline in coal use
  • 40-50% of passenger cars being electric (today 1-2%)

These and related objectives would represent a “Herculean effort” that is unfathomable over the next decade. Even with the necessary political and public support, this would be a path to a 40% drop in CO2 emissions by 2040, versus the GND’s goal of 100% by 2030. If anything, the GND’s unattainability should drive support for significant spending on flood remediation projects, as Cembalest suggests.

Aspirational Goals of the Green New Deal

The conversion of electricity generation to solar and wind receives lots of attention. But electricity represents only 17% of primary energy use. A sobering related statistic is that 2/3rds of the primary energy used to generate electricity (coal, natural gas, renewables etc.) gets lost through thermal conversion, power plant consumption and transmission.

Greener Electricity Helps Modestly

The three big end user sectors of energy are industry, transport and residential/commercial buildings. Industry is more than half – production of cement, steel, ammonia and plastics are the “four pillars of modern society.” Many industrial processes require high heat and temperature, and while electricity can theoretically replace natural gas, it’s 3-5X more expensive. Moreover, that’s based on today’s electricity, which is itself 2/3rds derived from fossil fuels. A 100% renewable electricity supply would be even less competitive.

Fossil Fuels Are Industry's Main Energy Source

Lowering greenhouse gases globally can’t happen without China’s active participation. They produced more than half of the world’s cement in 2017, half the steel, and a third of the ammonia, all substantially used domestically. 85% of ammonia is used in fertilizer, without which the world could only feed half its current population. 40-70% of ammonia used in fertilizer is lost due to leaching or erosion. Its production causes 1% of global Greenhouse Gases (GHGs).

The world currently generates around 34 gigatonnes of CO2 annually (a gigatonne is a billion tonnes). The International Energy Agency (IEA) expects global GHGs to increase by a third over the next two decades with unchanged policies. Rising living standards in emerging economies, led by China and India, will swamp greater energy efficiencies in the developed world. Use of plastics (produced with methane, naphtha and ethane) is forecast to rise by 150% over the next thirty years.

The GND promotes planting more trees. U.S. forestland of 750 million acres captures 10% of emissions. A 2017 study found that replanting trees on 20 million acres of cleared land could offset almost 1% of U.S. GHGs. This would be challenging; current U.S. Forest Service efforts are 120 thousand acres, around 0.5%.

Natural Carbon Capture_U.S. Forests

Germany’s “Energiewende” has impressively lifted their renewable share of electricity generation to 38%. However, emission reductions are disappointing. Phasing out of nuclear power, and renewables intermittency (it’s not always sunny and windy) have increased use of coal. Further use of wind requires substantial investment in transmission infrastructure to link the windy north with population centers in the south.

The report is full of fascinating facts like these. Vaclav Smil is JPMorgan’s technical advisor. Smil is the author of 40 books, such as Energy and Civilization: A History. He’s a highly regarded thinker and his writings on energy development and use are absorbing. Smil, who is Bill Gates’ favorite author, describes the GND as “…not a useful foundation for a serious policy discussion.”

Energy Outlook 2019 ranks among Mike Cembalest’s best pieces of work. It’s highly readable.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund, please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com)

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