MLPs have been weak recently. On Monday the Alerian MLP Index (AMZX) sank almost 2%, on a day when equities were broadly unchanged. For the month, MLPs are down 4.7%, although still up almost 6% on the year. Much of the damage has taken place since the election. As the chart shows, MLPs have lost 3.6% since President Obama won re-election to a second term. However, most other income generating sectors and the overall market are all down more than 3% (REITs have held in slightly better).

Clearly the Fiscal Cliff and its resolution have weighed on the market. A failure to prevent automatic sequestration and tax hikes would probably tip the U.S. into another recession and concerns over that outcome have anecdotally been a headwind to capital spending and hiring for several months. But investors are also starting to contemplate the impact of tax hikes on various sectors, and are adjusting prices accordingly. Higher taxes on dividends and capital gains have seemed likely all year. Congressional inaction would result in dividends being taxed at over 40% (including the Affordable Care Act surcharge) for high income taxpayers, a substantial leap from the current 15%. While the proposals being floated don’t go that far, higher taxes on investment income at least for some taxpayers seem likely.

Which is why the retreat in MLPs may be the start of an opportunity. Most MLP income is treated as a return of capital with a consequent adjusted cost basis for the holder. Taxes on this component of income are ultimately paid when the MLP is sold and are assessed at the taxpayer’s ordinary income tax rate. Wholesale tax reform could of course change this treatment, although that’s not currently on the cards and in my opinion is highly unlikely. Supporting capital formation in support of energy infrastructure seems like a sensible strategy for the U.S. at all times, but especially as the U.S. is just a few years away from being the world’s largest oil producer and increasingly energy independent. And private equity managers continue to pay just 15% on their carried interest from running funds (Mitt Romney is an example) and while ultimately that obvious loophole will surely be closed, its continued existence reveals the power of lobbyists. Holders of MLP units are passive investors, so not in the same category as PE managers whose income is effectively taxed at 15%. And Congress has estimated the tax treatment of MLPs as being worth just $300 million, not an obvious target.

So if taxes on conventional investment income rise, MLPs might in fact be relatively more attractive. In the near term fund flows out of all income generating sectors may continue to pressure the sector. The Alerian MLP ETF (AMLP) has drawn in many smaller investors who don’t mind (or don’t realize) that the 1099 they receive rather than a K-1 costs them 35% of the return they might otherwise earn. Short term flows from these investors may continue to put pressure on MLPs in general. But nothing fundamental has changed for the underlying businesses so there’s little reason to take realized, taxable gains.

It turns out that a state of increasing anger at the demonstrated fragility of our energy infrastructure may not be the best place from which to write objectively about the subject; nonetheless that is what I’m going to attempt.* Dark evenings huddled around a gas fireplace hoping the laptop’s battery lasts the length of the movie before 9:30 bedtime (well what else is there to do?) can become boring pretty quickly – indeed, I can report that it has done so already for many people.

Such discomforts of course are trivial by comparison. We are fortunate in that everybody we know is safe.  The stories of tragic deaths are heartbreaking and far too numerous. The flooding and destruction are way beyond our expectations.

We were mercifully spared water damage since we’re not close to the ocean and rainfall was less than expected. We suffered only minor property damage from this 100 year storm even though the extended loss of power is testing in its own way. There may be a bulge in births nine months from now, but don’t expect many babies to be named Sandra.

Energy infrastructure has long been recognized as in need of greater investment. For our part we have focused on its impact on MLPs and in particular the need for new pipelines, storage facilities and so on to move shale natural gas and oil from where it’s found to where it’ll ultimately be consumed. Several months ago for example we added Oneok Partners (OKS) to our MLP portfolio based on the strong growth prospects from their exposure to the Bakken in North Dakota. We’re also invested in the domestic natural gas theme through E&P names such as Range Resources (RRC) because of its abundance and low cost. While reliable delivery wasn’t a consideration, it’s ironic that 19^th century-style gaslight never ceased for those quirky enough to use it. Gas lines are underground.

In August 2003, wide areas of the northeast U.S. and Canada suffered a loss of electricity as a result of cascading failures caused by an evident weak point in the grid. Cross-border interconnectedness and minimal redundancies are no doubt efficient most of the time, but like just-in-time inventory there’s little room for error or Mother Nature. Much hand-wringing ensued about the aging U.S. power grid and need to upgrade its infrastructure. No doubt some work was done although the issue slipped from public attention soon after.

Nine years later the devastation wrought by Sandy has exposed a form of tail risk, though not the one familiar to investment professionals. Although the U.S. is in many ways the most advanced country on the planet, many Europeans express surprise at the 19^th century technology that relies on aboveground delivery of power using wires strung between utility poles. It increasingly looks like an overly optimistic way to deliver a service that needs to be available 100% of the time. Many other rich countries have buried the wires underground, whereas one of the less attractive features of suburban life in America includes the regular risk of power loss when a modestly vigorous wind blows down trees and cuts supply lines. It’s so predictable that one wonders why such vulnerability persists.

Industry estimates are that putting power lines and transformers below ground and therefore out of harm’s way (assuming they’re also protected from flooding) can cost up to ten times the cost of aboveground infrastructure and presumably utility customers or taxpayers are unwilling to meet the cost. This type of analysis relies both on accurate estimates of the probability of unlikely events as well as both the cost of those events and of mitigating against them. In many cases there’s more guessing than estimating involved. European population areas tend to be more dense, but not all of America is the wide open prairie and large metropolitan areas such as New York aren’t much different from London in that regard.

As people move to population centers, the per capita expense falls and studies have found the cost to be closer to five times such as this one prepared in the UK last year by the Institution of Engineering and Technology (an organization that promotes the exchange of ideas on science, engineering and technology). Besides, we will be spending more to compensate for the current delivery system in at least two ways: insurance coverage for anything related to a disruption of power such as business interruption and property damage will assuredly become more expensive as the revised loss history and increased demand drive up rates. In addition, many more businesses and an increasing number of private homes will invest in back-up generators to assure the reliability they need that the public system currently cannot provide. Installing a generator in one’s home is not a trivial undertaking, and yet the sound of their engines providing power to those neighbors whose risk assessment was accurate proves that reliable electricity is highly valued by many. I’ve never visited Baghdad, but apparently the noise of generators is a familiar evening chorus there. Enough said.

Mike Cembalest of JPMorgan’s Private Bank recently noted a London School of Economics study (evidently they think harder about this stuff in the UK) which revealed the relatively low threshold of New York City’s flooding preparedness compared with other major cities, an issue picked up by New York State Governor Andrew Cuomo in the days immediately following Sandy. New York’s standard of preparation is to withstand a 1 in 100 years flood. Contrast this with Osaka (1:300), London and Tokyo (1:1,000) or Amsterdam (1:10,000). New York’s relatively low standard appears even less acceptable when compared with the value of assets exposed and higher per capita GDP (i.e. financial capacity) to improve protection. Inevitably when the rare event happens the ex-ante forecast appears flawed and yet statistically the sighting of one black swan doesn’t imply another, unless the future won’t reflect the history on which such forecasts are necessarily based. The black swan may have a family. Our weather appears to be changing in ways that make it less predictable and more volatile (yes, let’s buy weather volatility). As a power refugee living in what seems like 19^th century discomfort, it’s hard not to embrace the idea that a more robust energy infrastructure will draw greater political attention and support than it has in the past, and correspondingly more investment.

One positive outcome at least for financial markets is that the hit to 4Q12 GDP (estimated as high as 0.5%) is likely to make at least a short term resolution of the fiscal cliff far more probable than it appeared pre-Sandy. The legislated tax hikes and spending cuts that are set to occur automatically on January 1^st, 2013 without new legislation to avert them have been looming as an unresolved issue in recent months. There was little reason to be optimistic about a negotiated compromise to delay the sharp fiscal contraction that would result until Sandy showed up. Now, facing a regional economic catastrophe big enough to produce a stumble even at the nationwide level of economic output, a lame-duck, post-election Congress is likely to put partisan wrangling aside for once. One weather-related tail event is likely to head off another, following the pattern of 2012 for financial markets in avoiding each of the shocks that lurked in the wings while confronting a natural disaster none of us contemplated. Predictability is a virtue in many things; as it relates to power deliverability it’s probably now valued a little more highly.

*We regained power after six days, and as cold and miserable an experience as that was you quickly realize how much worse it has been for many others.

The FT today has a dynamite article with the abovementioned title by Gavyn Davies, Chairman of Fulcrum Asset Management. As the title suggests, Mr. Davies speculates that the vast holdings of government debt create the possibility that central banks may forgive some of it so as to further stimulate growth. It’s a quite electrifying thought. In the U.S. and EU governments at all levels are grappling with the conflicting objectives of stimulating growth and reducing indebtedness. So far one can question their success on both fronts, especially in southern Europe where continued austerity is exposing its one-dimensional weakness in impeding exactly the type of real GDP growth necessary to reduce debt.

As a thought experiment it could appear quite alluring. After all, in the U.S. the central bank is part of the Federal government, so on a consolidated basis debt issued by the U.S. Treasury and held by the Federal Reserve simply nets out. The Wallace Neutrality Theory holds that because the public recognizes that this debt will ultimately find its way back into the private sector, its temporary residence at the Federal Reserve doesn’t alter behavior, similar to the way tax cuts funded by deficits don’t promote growth because households save more in anticipation of higher taxes later (Ricardian equivalence). Gavyn Davies is not a believer in the Wallace Theory, but rather than get into the theoretical difficulties instead consider the consequences of debt forgiveness.

The most compelling feature is that there is no obvious injured party. Putting aside for a moment the likely adverse market reaction of such a move, if the Federal Reserve did agree to a modification of terms on the debt it holds, there would be no direct private sector losses as a result. It could be done in many ways more subtle than a complete write-off, which might include taxing interest income to the Fed, extending maturities or even rolling over maturing debt at favorable rates. Carried out in small, incremental steps that sought to minimize any negative market reaction such an approach could be politically very appealing. At a time when Congress will be wrestling with a set of highly unpalatable choices involving spending cuts and tax increases, a modification in debt terms that was part of a wholesale improved fiscal outlook could gather populist support at a minimum. After all, if we owe the money to ourselves, which in effect we do for that component of the debt held by the Federal Reserve, why shouldn’t we be free to alter its terms.

All this of course creates the risk of increased inflation expectations and perhaps higher actual inflation down the road. The point of the thought experiment though is to highlight how politically such a course of action, in conjunction with other fiscally prudent moves, could happen. There’s no directly injured third party. If such a subject was broached without triggering a spike in bond yields (an important IF no doubt) it might gain support. Gavyn Davies notes in his article that one possible future Bank of England governor privately considers such a step worthy of serious consideration.

The fact that the steps outlined above are plausible albeit clearly not imminent supports the case for an investor to own assets that provide some type of inflation protection and to shun fixed income risk entirely. Companies with strong franchises and a history of earnings growth should represent an important part of any investor’s portfolio. For example, we like Microsoft (MSFT) which currently trades at less than 7 times 2013 earnings ex-cash on balance sheet and possesses two powerfully cash generative businesses in Windows and Office. We like owning the Gold Miners ETF (GDX) –although we don’t think gold is a good long term investment, the balance of risks and potential return as described above argue in favor of exposure to bullion. And Japan, with its lost two decades and periodic bouts of deflation, may be a candidate for the debt modification described above. We are long $/Yen through owning the ProShares Ultra Short Yen ETF (YCS).