At some point Congressional oversight of the Federal Reserve should result in a careful examination of the central bank’s error-strewn record under Chair Jay Powell. Below is a roadmap for discriminating legislators willing to conduct a critical review of the Fed’s serial mistakes. 

Above the Fed’s twin mandate of seeking maximum employment with stable prices sits their overarching responsibility for financial stability. The collapse of Silicon Valley Bank (SVB) was an isolated event, the result of a largely non-FDIC insured deposit base that quickly ran when excessive interest rate risk forced the bank to dump bonds at a loss. But the banking system’s challenges are bigger than one bad interest rate bet in Santa Clara.  

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SVB might be the worst run bank since the 2008 Great Financial Crisis (GFC), but similar imprudence is reflected across much of the industry. Loans and securities that are classified as Held To Maturity (HTM) don’t fluctuate in value on bank balance sheets, but they can still cause losses. Tier One equity capital of the US banking system fell by 2.2% last year (from 15.6% to 13.4%) partly due to lower valuations on Mortgage Backed Securities (MBS) and treasury securities. This is a bigger loss than at the outset of the pandemic, when provisions for bad loans soared. Unrealized losses are estimated at $620BN, against capital of around $2.2TN. US government debt carries favorable capital treatment because it has no credit risk. But that doesn’t mean it’s riskless.  

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Including unrealized losses on loans would show bank capital is almost wiped out. Loans are rarely marked to market and are treated like HTM securities. But two recent academic papers show that, if they were valued like securities available for sale and assuming a duration of 3.9 years, banks would show losses of $1.7– $2.0TN.  

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Interest rates have been unrealistically low since the GFC. Banks have responded by loading up on risk – the portion of loans and securities held with longer than three years’ duration has increased from 28% to 40% over the past fifteen years. Quantitative Easing (QE) saw the Fed’s balance sheet expand to $9TN as they acquired almost a fifth of all US government debt and depressed yields. SVB and many peers concluded that lower returns justified greater exposure. 

As a regulator the Federal Reserve has watched over this increase in duration with little public comment. FOMC minutes reveal no concern. Their Summary of Economic Projections (SEP) released quarterly provided little reason until recently for banks to worry that their low-yielding portfolios of assets would continue to be funded with even lower-yielding deposits. In March of last year the SEP still only forecast mildly restrictive policy of 2.8% vs a long run neutral rate of 2.4%. It wasn’t until June that the SEP warned of higher short term rates that would increase banks’ cost of funding and create competition for deposits from money market funds and treasury bills.  

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Banks benefit from lethargy among depositors when rates rise by only slowly increasing the rates they pay. The average savings account pays 0.40%, compared with three month treasury bills at 4.5%. It’s as well most depositors don’t leave banks for higher returns because resorting to the Fed Funds market would create a negative spread against their low-yielding portfolios. SVB’s rejection of this choice led to their sale of bonds, aborted equity raise and FDIC takeover. 

You might think that years of low rates and a steady increase in duration would lead regulators to include the impact of an abrupt reversal among the many stress tests they run on banks. But in an absence of macroprudential foresight, there is no meaningful inflation stress test. They assume a benign 1.25% increase. Regulators model a sharp drop in real estate, jump in unemployment and emerging market crises but monetary accommodation is assumed to ameliorate the impact of any such shocks on the real economy. The only interest rate stress test contemplates a steepening yield curve with a 0.49% increase in ten year treasury yields and three month treasury bill rates up 0.14%. 

The Fed has overseen stress tests since they were introduced in 2013 under Dodd-Frank. The biggest stress banks have undergone since then has been caused by the Fed and wasn’t one of the scenarios they tested.  

Today’s economic and financial environment is the result of a series of errors and poor judgment by the Fed. They have implemented one of the fastest increases in monetary policy in modern times, which if banks marked their assets to market would wipe out virtually all their capital based on reasonable assumptions. FOMC minutes reveal very little awareness of exposure in the banking system the Fed oversees to sharply higher rates.  

Bank portfolios are full of low yielding assets because the Fed incorrectly maintained QE for too long. QE was a singularly useful tool during the GFC with little to justify its subsequent use. The pandemic’s economic hit was severe but brief. The Federal government’s initial fiscal and monetary policy moves were exemplary, but the largesse and accommodation were ultimately excessive, synchronized and damaging.  

Low mortgage rates and a behavioral shift to hybrid work boosted housing. This was evident to all except the FOMC with their slavish devotion to Owners’ Equivalent Rent (OER) and its theoretical notion of the cost of shelter (see The Fed Is Misreading Housing Inflation). Two thirds of American households are homeowners. Home prices matter to almost everyone. OER lags real estate by around eighteen months. The FOMC was similarly late in seeing inflation.  

In summary, the Fed has raised interest rates sharply because they were late, ravaging the capital base of the banking industry they oversee. On their watch banks have increased duration in low-yielding assets because the Fed maintained low yields with QE. The Fed has in effect led ruinous competition with banks for yield-bearing assets, and is now leading competition for cheap deposits with which to fund them, all with little apparent understanding of the industry’s overall exposure. 

SVB failed because of a depositor run, but that was preceded by a steady loss of deposits to higher-yielding money market funds and treasury bills. Banks now depend to a substantial degree on continued acceptance by customers of pygmy yields on cash, so they can continue to fund assets that yield too little. If money keeps leaving the banking system more banks will face SVB’s unenviable choice between funding assets at a loss or dumping them at a loss.  

First Republic National Bank is reported to have a tangible book value of negative $73 per share once their assets are marked to market. Who would buy a bank today? 

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The FOMC released their latest SEP last week, forecasting another rate hike before the end of the year. Based on Fed funds futures, this is wrong by at least 1%. Such a gap between the FOMC and market expectations is testimony to the Fed’s loss of credibility. The inflation fight will be paused or declared won so that reduced short term rates can ease the banking system’s pain.  

The Fed can at least claim success in maximizing employment. Unfortunately, consumers and households report being as pessimistic as ever, reflecting today’s uncertain outlook. This is in spite of what remains, for now, a reasonably strong economy with a job available to anyone that wants one. Perhaps consumers and households have an intuitive understanding of how poorly monetary and regulatory policy have been administered.  

Fed chair Jay Powell should go. 

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

An Op-Ed in the Washington Post last week suggested that unrealized losses on fixed income investments are likely much higher than the $640BN on held to maturity MBS. It was written by Sebastian Mallaby, who wrote about hedge funds in More Money Than God and has published several other finance books.

Mallaby relies on two recent academic papers which add interest rate exposure on loans to the MBS unrealized losses. Not much data is publicly available on duration risk in bank loan portfolios. Based on the reasonable assumption that loans have an average duration of 3.9 years, the academic papers Mallaby cites estimate US banking system mark-to-market losses of $1.7TN-$2TN, against a capital base of $2.2TN.

These staggeringly big numbers are theoretical and unrealized. Banks are not going to recognize losses anything like that. That’s not to say this isn’t going to be a problem.

It’s worth remembering how we got here. Since Quantitative Easing (QE) was first unleashed in the 2008 Great Financial Crisis (GFC), the Fed has generally found it easier to grow its balance sheet than shrink it. Their huge bond portfolio has depressed government bond yields, which are the benchmark from which all other fixed income securities are priced. The MBS and loans on bank balance sheets mostly originated within the last few years. From mid 2019 until early last year, the ten year yield was below 2%.

Bankrate.com calculates the average rate paid on savings accounts is 0.23%. The Federal Reserve Bank of St Louis calculates 0.35%. Depositors are normally a lethargic bunch but have been galvanized into action by Silicon Valley. Flight from shaky institutions is the current fear, most vividly represented in First Republic’s collapsing stock price. But this problem will likely be solved with a system-wide guarantee on all deposits, not just those under the FDIC $250K threshold. That is de facto government policy today having found Silicon Valley Bank to be systemically important. As the “too big to fail” tent gets bigger, the moniker no bank will want is “small enough to fail”. This is why Treasury Secretary Janet Yellen announced more support for small regional banks.

QE didn’t just help cause a housing bubble, it’s also weakened the banking system. Applied on a sustained basis, QE left them with little choice but to buy bonds and make loans at rates that only prevailed because of the Fed’s enormous portfolio.

Today’s inverted yield curve shows that the problem still exists. Ten year treasury yields are 1% below the Fed Funds rate.

That makes this week’s Fed announcement more important than most, because it’ll reveal how well they understand the banking system’s sensitivity to the funding costs of their vast portfolios of bonds and fixed rate loans that are theoretically underwater. If they regard the depositor run as localized and temporary it’ll mean higher rates to quell inflation remains their primary objective. This will put further pressure on net interest margins.

Held To Maturity (HTM) accounting has once again come in for criticism. The CFA Institute (I sit on the board of the Naples, FL chapter) thinks “hide to maturity” accounting should be abolished because it obscures information investors need. This was considered after the GFC but rejected in 2010 as adding unnecessary volatility to bank financial statements. The information is there if investors choose to look. The problem is that depositors rarely feel the need to consider creditworthiness.

Depositor inertia is what’s under threat. Last year Charles Schwab changed their sweep feature on brokerage accounts to make Charles Schwab Bank the default choice for cash rather than money market funds. Banks routinely pay paltry deposit rates, and this quiet change boosted Schwab’s profitability.  We duly adjusted client accounts to hold treasury securities.

This is the real threat facing the banking business model, not depositor runs which are solved relatively easily with a blanket guarantee.

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Three academics recently asked Why do banks invest in MBS? in a paper published earlier this month. They include a chart showing how inadequately deposit rates rise during tightening cycles. This captures the banking system’s vulnerability. Deposit rates lag because of inertia among savers. There’s nothing like a banking crisis to make you pay attention to where your money is. Depositors are likely to become more sensitive to savings rates.

Notwithstanding turbulent markets, the case for higher commodity prices remains intact. Goldman’s Jeff Currie believes the commodities supercycle will take oil prices higher by June. Hedge fund manager Pierre Andurand expects oil to reach $140 by year’s end. Citadel’s head of commodities Sebastian Barrack doesn’t expect any long-lasting pressure on commodities.

Inflation risks haven’t meaningfully fallen, but the Fed’s flexibility to confront them has to be balanced with the poor interest rate decisions made across much of the US banking system.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Investors have reacted to the aftermath of Silicon Valley Bank’s (SVB) failure by assuming tighter credit conditions. This makes sense over the near term. The US banking system has been increasing duration risk, and while SVB was more reckless than most they were not alone.

Piling into long term government bonds and mortgage-backed securities required minimal amounts of capital because interest and principal are guaranteed. In perusing the Fed’s most recent stress tests, it’s clear a sharp jump in interest rates wasn’t given much consideration. Guided by the 2008 financial crisis, regulators focused on a sharp drop in equity markets, real estate and employment along with widening credit spreads.

In the interest rate stress test scenario, US interest rates are modeled to increase from 0.12% to 0.52% out along the yield curve. Regulators clearly focused on a slump in economic activity. The worst they could conceive of the bond market was a steepening of the curve led by falling prices on longer maturities. Stress scenarios largely assume an event is followed by accommodative policy.

There is no stress test remotely like the past year. An upside inflation surprise doesn’t appear anywhere.

Consistent with fighting the last war, an inflation stress test scenario will be added, designed along the lines of what we’ve just experienced. When implemented, it will force banks to reduce their tolerance for funding long term bonds with short term liabilities. It doesn’t matter whether those deposits are guaranteed by the FDIC or not – the rates banks pay will have to be more competitive than in the past.

The Fed is still in crisis mode, but a post-mortem is bound to expose the absence of co-ordination between the Fed’s setting of monetary policy and its impact on the banking system it regulates. The most recent FOMC minutes note that, “Vulnerabilities associated with funding risks were characterized as moderate.”

Elsewhere the minutes say, “Several participants discussed the value of the Federal Reserve taking additional steps to understand the potential risks associated with climate change.” It looks as if this was more important to them than the drop in Tier 1 capital ratios across the US banking system from 15.6% to 13.4% during 2022.

Silicon Valley Bank still has no buyer, and its parent Silicon Valley Bank Group filed for Chapter 11 bankruptcy protection on Friday. We’re unlikely to see a repeat of the Great Financial Crisis (GFC) of 2008-09 when the strong bought the weak – such as JPMorgan buying Bear Stearns and Washington Mutual, and Bank of America buying Countrywide.

By 2018 the banking industry had paid $243BN in fines related to the GFC. Bank of America paid $76BN, and JPMorgan $44BN, largely related to actions by the companies they had acquired in the lead up to the GFC.

For these two and other “too big to fail” banks, placing several $BN on deposit with Republic National Bank is much less risky than buying them. It’s doubtful any bank in distress could find a commercial banking buyer because the Fed isn’t empowered to issue immunity from subsequent lawsuits.

I was working at JPMorgan in 2008 at the time of the Bear Stearns acquisition. CEO Jamie Dimon described it as doing the right thing for America, because JPMorgan was in a position to help. His sentiments were not reflected in subsequent regulatory actions or litigation. He’s been very clear that he would not do the same thing again.

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Testifying on recent events before Congress will be uncomfortable for Fed chair Powell. If there isn’t a pause in the cycle of rate hikes it’ll just confirm how out of touch they are. Banks need some time to rebuild their capital. Further tightening of monetary policy won’t help. With the focus shifted from inflation and the Fed forced to adopt more cautious changes in monetary policy, medium term inflation risk has gone up. Blackstone’s Larry Fink wrote in his recent annual letter that inflation is, “more likely to stay closer to 3.5% or 4% in the next few years.”

Infrastructure, especially in the energy sector, offers the potential to protect investors since around half the sector’s EBITDA is derived from inflation-linked contracts, according to research last year from Wells Fargo.

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The sector has dropped too far in response to recent events. At a time when bond yields are declining the dividend stability of pipeline companies looks more appealing to us.

Over the past year pipelines have easily beat the S&P500 and other infrastructure such as real estate and utilities. The past week has seen a minor reversal. And yet, the case for inflation protection has never been stronger in the past 40 years.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Commercial banks have long benefited from depositor lethargy regarding rates. Although we now have a de facto guarantee of all commercial banking deposits, not just those up to the $250K threshold, customers are likely to pay a little more attention to return and risk, which will force banks to be more competitive.

On the asset side, capital rules that favor riskless US treasuries have encouraged banks to load up on longer maturities. Although a return of interest and principal is guaranteed, a profit is not when funded with floating rate debt. Regulatory scrutiny of banks’ duration risk will follow given the hit to capital ratios since the Fed started their belated, and therefore hurried, tightening a year ago. Bond purchases will be less eager, although the drop in rates caused by Silicon Valley Bank’s collapse has boosted bank portfolios.

The combination of having to pay more for deposits while being more cautious in taking risk represents the tightening of financial conditions long sought by the Fed. The consequences won’t be clear for months – under the circumstances a hike next week must seem imprudent. The path of monetary policy has correctly repriced to peak lower, and perhaps immediately.

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The unwitting creation of tighter financial conditions the Fed’s rapid hikes caused now needs time to percolate. Monetary policy is best implemented slowly with few surprises. We’re seeing why. Tier 1 capital ratios for the US banking system fell by an unprecedented 2.6% last year.

The Fed interprets its twin mandate of achieving maximum employment consistent with stable prices as addressing whichever of the two metrics is farthest from target. The 2019 Jackson Hole symposium sought greater employment at the tolerance of higher near-term inflation because this was stubbornly low.

Last year’s pivot was late because of their disbelief that elevated inflation was entrenched.

But sitting atop the Fed’s twin mandate is an overarching responsibility for financial stability. Assuring that now takes priority.

What’s unfolding is a significant regulatory failure – the Fed leads banking oversight and failed to make the connection between countering inflation and the financial system it oversees. As a result, they’re relying for now on suddenly lost confidence in regional banks to slow inflation since the previously communicated rate path is untenable. Not for the first time, the blue dots on the FOMC’s Summary of Economic Projections (SEP) will need to be revised towards market forecasts.

All it would have taken was a speech by Jay Powell eighteen months ago warning that banks’ increased duration risk was going to receive greater scrutiny from regulators. Under Powell’s leadership the Fed can claim credit for low unemployment but little else. It’s often said that tightening cycles continue until the Fed breaks something. They have.

What this means for investors is that inflation risk has risen because it’s no longer the Fed’s primary concern. The rising share of Federal expenditures taken up by interest on our debt (see How Tightening Impacts Our Fiscal Outlook) will, over time, impact the conduct of monetary policy.

But the banking system’s exposure to interest rate risk presents a more immediate consideration. Industry Tier 1 Capital as a percentage of risk-weighted assets fell from 15.6% to 13.4% last year, arresting a steady trend towards a better capitalized industry begun after the 2008 Great Financial Crisis (GFC). Not every bank has JPMorgan’s fortress balance sheet, and markets have quickly identified the weak ones.

Capital ratios are now a consideration for monetary policy. The rate path indicated by the blue dots in the last SEP would likely hurt capital ratios further, so that’s no longer an option. The months ahead will determine whether the Fed’s done enough. FOMC members routinely make speeches about awaiting actual evidence of moderating inflation before slowing tightening. Circumstances now dictate that they must pause and await developments.

Yesterday’s CPI report exposed the Fed’s dilemma. Even though it showed that inflation remains elevated, tightening next week is hard to justify given recent events. Shelter was also a significant factor and this element provides a flawed reading of the housing market that lags behind actual developments by at least a year (see The Fed Is Misreading Housing Inflation). The FOMC might be relieved to explain this away as not indicative of underlying trends.

For now inflation expectations remain sanguine. Ten year TIPs imply 2.3% CPI over the next decade, not much changed since last summer. For those unconvinced that price stability will return so easily, energy infrastructure offers 5-6% yields from companies whose cashflows are linked to inflation via tariff price escalators.

The case for infrastructure, particularly in the energy sector, remains as strong as ever.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Silicon Valley Bank (SIVB) succumbed to poor risk management in holding long term bonds funded with demand deposits. If that’s all there was to banking we wouldn’t need many banks. But at a strategic level, Quantitative Easing (QE) as pursued for too long during the pandemic created the conditions for poor decisions.

Central bank strategy for many years has been to slowly squeeze the commercial return out of the government bond market. The banking system has responded by steadily lengthening the duration of its assets, moving out along the curve in search of increased yield. This sloppy thinking is now being exposed.

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Since the 2008 Great Financial Crisis (GFC), the portion of all bank portfolios invested in loans and securities more than three years in maturity has grown from 28% to 40%. QE logically ought to have had the opposite effect on discerning chief investment officers, but the data suggests it caused the banking sector to compete with the Federal Reserve for yield.

Having been squeezed by the Fed on the asset side, sharply tighter monetary policy has created competition for deposits. Two year treasuries recently touched 5%, a level which beats savings accounts and even offers a plausible, safe alternative to stocks. Our big economic imbalances trace their roots to the $1.9TN Covid Recovery Plan shortly after Biden’s inauguration, and the Fed’s lethargic withdrawal of QE with ultra-low short-term rates. Both stoked inflation.

Nonetheless, SIVB made poor choices.

The result is a stunning leap in unrealized losses on banks’ holdings of securities. Not all of this is flowing through income statements. When bonds are classified as “Held To Maturity” (HTM), their mark-to-market losses show up in other comprehensive income under shareholders’ equity. In effect the losses are spread over the life of the bonds through a negative spread between the yield earned and cost of funding.

Ten year treasury yields dipped below 2% a few months before the pandemic in August 2019 and only moved back above 2% early last year. A sizeable portion of banks’ securities would have been purchased during that environment and now their deposit retention is competing with treasury bills at close to 5%.

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The $620BN in unrealized losses represents around 28% of the banking system’s total equity capital of $2.2TN. Losing a quarter of the industry’s capital in a year, even if the losses are unrealized, does look like a regulatory failure. If not the beginning of another financial crisis it is at best likely to put a crimp on loan growth at banks that have found they took too much duration risk. And it may cause corporate clients and anyone with accounts over the $250K FDIC insurance threshold to shift large deposits to the biggest banks rather than analyze the credit risk they are enduring as depositors. For hundreds of smaller banks, that would start to look like a crisis.

YE2022 unrealized losses on HTM bonds at JPMorgan were 14% of common equity, but they’re 26% at Wells Fargo and 44% at Bank of America. 1Q23 results are unlikely to look any better.

Like a three card monte professional, the Fed convinced too many bank investment departments that low rates were here to stay and then sprung the trap with rapid hikes.

Skill in risk management is unevenly distributed. For every Jamie Dimon who avoided excessive duration risk, there are plenty of other CEOs who didn’t think that hard. We don’t have any clients with bond losses because, as one client kindly noted to me on Friday, we’ve shunned the asset class since the GFC. Only now are yields beginning to justify modest exposure.

It’s hard to imagine the Fed moderating policy because of bond losses at banks, but at the margin it means tighter credit conditions and that is the Fed’s objective. It also means that substantially higher short term rates of say 6-7%, especially if implemented over a brief period of time, would exacerbate the problem. The returnless risk that bonds represented for so many years has consequences.

At the CERAWeek energy conference last week, NextEra CEO John Ketchum surprised attendees by criticizing the expense of offshore wind projects. NextEra regards itself as a leader in renewables and is adding 45 gigawatts of power output from onshore wind and solar over the next few years. Such facilities typically operate 20-30% of the time. Offshore wind utilization tends to be 30-40%, since the wind blows more reliably at sea.

But Ketchum reported challenges with salt water corrosion, hurricanes, availability of ships and the installation of subsea cables. A renewables champion offered a dose of realism

Lastly, author and energy realist Alex Epstein testified before Congress last week on the Administration’s mis-use of the Strategic Petroleum Reserve last year to try and lower gasoline prices before the mid-term elections. Epstein showed more poise and energy understanding than his Democrat interlocuters in explaining why Biden’s expressed desire to end fossil fuel use has reduced investment and led to higher prices.

As we often tell clients, extreme greenies have helped impose capital discipline by discouraging growth capex. We have an alignment of interests. If you meet a climate extremist, give them a hug and offer a drive to their next protest.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Real estate investors are keenly attuned to the Fed’s efforts to curb inflation. The Vanguard Real Estate Index Fund (VNQ) is down 18% over the past year, lagging the S&P500 which is –6% and the American Energy Independence Index (AEITR) which is –1%.

Rising rates have cooled the hot property market that the Fed’s bond purchases caused following the pandemic. The Economist believes real estate is signaling an imminent recession. An economic slump has been forecast for months even though hiring remains strong. Last month’s unemployment showed the startling resiliency in the job market. In my experience recessions rarely arrive when expected, and don’t start with 3.4% unemployment. Acknowledging the fortunate failure so far of doomsayers, the WSJ explained “Why the Recession Is Always Six Months Away.”

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But real estate companies are getting more cautious. Forward guidance for 1Q23 was negative for all 26 members of the S&P500, and 20 of them revised down their full year outlook. Property may be a good long term inflation hedge, but rising mortgage rates and a realization that hybrid work is becoming permanent are substantial headwinds.

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The Wall Street Journal recently reported that US office occupancy is around 40-60% of pre-pandemic levels compared with 70-90% in Europe and the Middle East. Asia is even higher, at 80-100%. This is partly due to American homes being bigger, averaging 2.4 rooms per person compared with other rich countries that are generally below 2.0 and average 1.7 across the OECD. If you live in Hong Kong which must be close to 100% apartments, going to the office and grabbing dinner afterwards is understandably more appealing.

Two years ago we converted the formal living room of our house, rarely used and little more than a furniture showroom, into my office. My wife didn’t share my enthusiasm for more efficient use of our home, but it’s the best office I’ve ever had. You can see it in our company video.

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For 25 years I endured a daily commute of 75 minutes each way (or more) from New Jersey to New York City. Transit infrastructure in many US cities is often inadequate, and inferior to other big cities around the world. Like tens of millions, I have first hand experience.

Now I walk downstairs.

It helps that America is a big country. Covid caused us to spread out. There is a lot of available space. But bigger homes mean longer commutes which is another reason Americans are happier working remotely.

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Real estate may be performing poorly, but it’s not yet attractively valued. The FTSE Nareit Index which covers the US commercial real estate industry yields 4.3%, less than two year treasuries and midstream energy infrastructure. It’s close to its ten year average EV/EBITDA multiple, whereas energy infrastructure is 28% cheap. One measure of the real estate sector’s rich valuations is that its current multiple is almost 2X the pipeline sector.

Wells Fargo has estimated that around half midstream’s EBITDA is derived from pipeline contracts that have explicit inflation linkage, usually via the PPI or CPI (see Pipelines Still Linked With Inflation). For energy infrastructure investors, inflation raises the value of the real assets they own as well driving commensurate increases in tariffs. Few investments offer the potential to so readily maintain their value with inflation.

Many innumerate climate extremists assert that solar and wind are the cheapest way to generate electricity. Nonetheless, running a profitable renewables business is surprisingly difficult. Last month wind turbine manufacturer Siemens Gamesa, which calls itself “the global leader in offshore power generation,” announced a quarterly loss of $967million.

BP has moderated an earlier pledge to reduce emissions and its production of oil and gas, because that’s where the returns are highest. Along with Shell, because they’re based in Europe both companies are more vulnerable to pressure from activists. Recently the market has perceived flexibility in their energy transition goals, because traditional energy is so profitable. Their stocks have performed well as a result.

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Renewable infrastructure has been an especially poor investment. The Kayne Anderson Renewable Infrastructure Index is flat since 2018 (earliest available data) compared with midstream energy infrastructure which has returned 6.9% pa over the same period. We’re biased towards natural gas infrastructure because that’s where we believe the returns are most attractive. When windmills can offer similar cash flow visibility, we’ll take a closer look.

For now, it’s increasingly clear that when it comes to hard assets, or infrastructure, traditional energy is the place to be.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

From time to time we come across new companies and technologies that offer the potential to reduce emissions, thereby contributing to the energy transition. One recent example is Sea Forest, an Australian company developing a seaweed-based food additive for cattle that will reduce methane emissions (see How Seaweed Can Fight Global Warming). A few weeks ago Bill Gates invested in Rumin8, another Australian company with similar objectives to Sea Forest.

Recently I chatted with Mitch Swergold, whom I first met around two decades ago when he was running a long/short technology hedge fund. Mitch heads investor relations for Zentek, a Nasdaq-listed company developing new products using graphene, a one-atom-thick layer of carbon atoms arranged in a hexagonal lattice. Graphene is a carbon-based nanomaterial that Zentek believes will be a key building block for a sustainable future. Carbon may offer solutions to the world’s carbon problem.

Mitch connected me with Zentek’s CEO Greg Fenton. Thousands of businesses are finding ways to link their activities to the energy transition. At SL Advisors we believe fossil fuels will be needed for many more decades, and we focus on natural gas because it offers the world’s best opportunity to reduce emissions by replacing coal.

We have no investment or other relationship with Zentek, but thought it would be interesting to share their story. Nothing here should be interpreted as an endorsement by us of Zentek or their products.

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Zentek has two technologies designed to reduce energy consumption. One is a coating for HVAC (Heating, Ventilation, and Air Conditioning) and PPE (Personal Protective Equipment) which improves its filtering of particulate matter. This higher efficiency promises to reduce the need for higher-rated HVAC that require more energy to run in schools and buildings.

Another Zentek technology reduces rust and corrosion on steel used in all kinds of construction, which can make it last longer.

They are presented below in the words of CEO Greg Fenton:

Zentek develops and commercializes Intellectual Property (IP) based on graphene, which makes it possible to develop new, sustainability-oriented solutions for some of the world’s biggest challenges.

Because of graphene’s nanomaterial properties, our proprietary IP innovations are expected to give our commercial partners a competitive advantage by making our clients’ high-volume products better, safer, and greener, at a low incremental cost per unit, which means they will help create real impact in the real world and should be good for the transition and for the more efficient use of energy well beyond that transition. If we reduce the amount of energy required to accomplish the same outcome/task, that is as good in our book as using energy generated or stored in a different way, and if we can improve the efficiency of those, as well, better yet.

ZenGUARD™ is our first success story. It is a patented antimicrobial technology platform from which we have already launched two applications, with more to come. HVAC filtration systems were designed to filter particulate matter, not viruses and bacteria. A new generation of effective filtration is needed, without requiring capital upgrades or greater energy consumption. ZenGUARD™-coated filters meet that need, providing nearly 5x the viral filtration of same-rated uncoated MERV (Minimum Efficiency Reporting Value) 8 filters, according to testing by the National Research Council of Canada and further confirmed by LMS Technologies in the United States.

This should give many buildings, schools, and transportation systems a viable option vs. upgrading to more expensive higher rated filters and, importantly, not only save on capital upgrade costs, but also provide substantial savings vs the increase in energy usage required for higher rated filters, which we estimate can be as high 15%. With no additional capital costs and a significant pricing umbrella vs. a higher rated filter, which can cost more than twice as much as a lower rated filter, ZenGUARD™ provides a simple, elegant solution with a compelling ROI for building and transportation system owners, operators, and tenants, etc.

We recently announced our second patent-pending technology platform, ZenARMOR™, for corrosion protection applications. Testing by Quantum Chemicals, a leader in corrosion protection, showed that ZenARMOR™ significantly improved their best product in a side-by-side comparison. We think it should be useful for preventing rust and corrosion in applications such as bridges/infrastructure, naval/marine, oil and gas pipelines and valves, and rebar and steel in construction, etc. Less corrosion means less demand for metals, which means less energy consumption to extract and transport those metals, which is good for the environment and good for investors.

The possibilities for graphene to have a positive impact on numerous industries are nearly limitless – and we believe Zentek is uniquely positioned to generate long-term growth as these possibilities unfold.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

Casually following news of the energy transition can create the impression that the world is a few years away from running on solar power and windmills. The reality is that climate extremists have propagated two impractical beliefs that are impeding policies based on pragmatism. One is that solar and wind are the complete solution. The other is that emerging economies are similarly committed to reducing emissions.

Starting with electrification – the NYTimes recently acknowledged the growing delay in connecting solar and wind projects to the grid. The US has three grids — Eastern, Western and ERCOT which is approximately Texas, along with 66 balancing authorities. New sources of power supply have to negotiate access to this system, which often requires adding power infrastructure.

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PJM Interconnection, a regional grid running from Illinois to New Jersey, has frozen new applications to add power until 2026 while they process the backlog. Developers often have to pay for grid upgrades. A wind farm in North Dakota was asked to pay millions of dollars to upgrade transmission lines hundreds of miles away in Nebraska and Missouri.

Across the US approvals now take on average four years. It’s estimated that less than a fifth of new solar and wind projects get connected. Climate extremists have become adept at using court challenges to vacate environmental permits issued to pipeline projects. But the same approach can also delay infrastructure to support renewables, because NIMBYs are not a coordinated political force. Permitting reform is sorely needed.

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The Energy Information Administration reports that renewables were almost two thirds of investment in new power output in 2021, with natural gas 22%. There were no new coal plants. Natural gas often enables renewables by compensating for their intermittency.

Owners of Electric Vehicles (EVs) often struggle with charging. In my experience everyone loves their Tesla, but I recently took an Uber ride in Pennsylvania where the driver reported a daily one hour wait to recharge her (Uber-owned) EV. She wasn’t willing to spend the $6K required to install an EV charging outlet in her home. Most EV owners I know have a second car for long trips.

EVs will continue to gain market share, and the US is a relative laggard. Cheap gasoline, a preference for big cars and high annual mileage have slowed EV penetration outside California. Like many people, I’m going to wait until improved charging speed and availability makes buying an EV an upgrade to quality of life.

It’s also easy to think that our efforts on climate change here in America are critical to solving the global challenge of reducing CO2 emissions. We have had a lot of success over almost two decades. US CO2 energy-related emissions peaked in 2007 at 6 Billion Metric Tonnes (Gigatonnes, or GTns), and are now 18% lower. This has come about in part because coal dropped from 48% to 22% of power generation. Natural gas rose from 22% to 38%, compared with zero-carbon (which includes reliable nuclear and hydro as well as intermittent solar and wind) which rose from 28% to 39%.

This is why a sensible strategy to reduce emissions would eliminate what remaining coal we use and replace it with natural gas and nuclear. Climate extremists are purists if not practical.

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Emerging countries are defining the world’s CO2 emissions, and they continue to invest in coal burning power plants. At the COP21 in Glasgow India promised to “phase down” coal, which practically speaking means its use will grow more slowly than other sources of energy. Old coal mines are being reopened, and coal executives expect their output to be required for at least another quarter century. Its fastest growing coal mine is scheduled to triple in size.

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China’s coal use dwarfs the rest of the world. The Centre for Research on Energy and Clean Air (CREA) calculates that 85% of the planet’s planned new coal projects are in China.  Living standards can’t improve without increased energy use, but China’s policies render other countries’ efforts irrelevant. Or our efforts allow China to do less, depending on your perspective.

No review of climate policies would be complete without reference to that obnoxious little girl Greta Thunberg, who once preached to the rest of us from the UN (“How dare you”). Betraying her discombobulated understanding of the world’s energy needs, she recently accused Norway of “green colonialism” because of plans to build an onshore wind farm in the middle of an area where reindeer graze.

Natural gas remains the world’s best hope for serious emissions reduction, as it has been in the US in spite of sometimes incoherent opposition from climate extremists.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

The “energy” in midstream energy infrastructure is often the primary consideration of potential investors. It probably began with the increased investment during the shale revolution, and the energy transition generated questions about energy mix and stranded assets. But nowadays capital discipline beats growth capex while without energy security there is no transition.

It’s time to emphasize the “infrastructure” in midstream energy infrastructure.

Longtime MLP investors recall the “toll-model” by which pipeline businesses were described. During times of extreme turmoil such as the Covid collapse of March 2020, the implied promise of stability was conspicuously absent to say the least. But the price recovery since then has been accompanied by improved risk metrics that are making the comparison with other long-lived infrastructure more relevant.

Cheniere provided an example of longevity on Thursday when they announced plans to sharply increase capacity at their Sabine Pass LNG plant. This expansion will increase export capacity by 74% and is planned to be in service by the end of the decade.

On the company’s 4Q22 earnings call, CEO Jack Fusco added, “Over the next few decades, both the supply and demand side are supportive of new liquefaction infrastructure.” (emphasis added).

This sounds more like the outlook of a company that owns and runs hard assets with visible long-term cashflows.

What’s true for LNG exports must also be true for the pipelines and related infrastructure that moves the natural gas from America’s interior to its coast. Enbridge, Energy Transfer, Enterprise Products, Kinder Morgan, Williams Companies and others are also in the long-lived infrastructure business with cash flow stability, earnings visibility and multi-year contracts.

Balance sheet risk has been declining (see Pipelines Grow Into Lower Risk). Debt:EBITDA below 4.0X is the norm for investment grade companies. 3.5X is common, and Enterprise Products finished the year at 2.9X, below their recently revised 3.0X target.

Capital is being returned to shareholders in the form of dividend growth and buybacks, further cementing the lower capex trajectory.

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A reduced risk profile means less commodity sensitivity (see Energy’s Asynchronous Marriage). Last year crude oil rallied following Russia’s invasion of Ukraine but was weak in the second half of the year, finishing roughly where it started. Unburdened by much correlation with oil, the American Energy Independence Index was up 21.3%.

Natural gas prices are near record lows, but infrastructure stocks are immune to that too. This uncoupling from the products they move is allowing investors to consider the sector’s long-lived assets and contracts.

Compared with other infrastructure sectors such as real estate or utilities, energy is attractively priced. Free cash flow yields are half as much again as REITs and 5X utilities. The 5.4% dividend yield is amply covered by cash flow and the P/E ratio also lower than other sectors. Compared to the S&P500, energy infrastructure metrics are substantially better.

The recent upside surprise on inflation and economic growth also adds to the appeal of energy infrastructure where inflation escalators are a common feature of pipeline contracts (see Confronting Asymmetric Risks). Expectations for Fed policy have undergone a rapid change since the employment report.

Cheniere and others recognize that cheap US natural gas will be in demand for years, both as a cleaner substitute for coal and to compensate for the intermittency of renewables. Thanks to the Inflation Reduction Act, energy infrastructure will play a vital role in carbon capture and in the development of hydrogen.

For example, Exxon Mobil announced plans to build the world’s biggest “blue” hydrogen facility near Houston. It will extract hydrogen from natural gas, capture the emitted CO2 for sequestration, and convert the resulting hydrogen into ammonia for easier transport in chemical tankers. The new plant is expected to be operational by 2027.

Rather than confronting existential challenges from the energy transition, the sector’s biggest companies are embracing opportunities. Solar and wind garner disproportionate attention. The reliable manufacture of steel, cement, fertilizer and plastic, what author Vaclav Smil calls “the four pillars of civilization”, will continue to rely on fossil fuels. It’s becoming clear that reliable, clean energy needs existing infrastructure companies.

Buyers and sellers of LNG are signing long-term contracts. China Gas Holdings just signed two 20-year agreements with Venture Global.

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European LNG purchases are set to increase sharply. Germany was the large country most exposed to the loss of Russian pipeline imports last year. Their government now expects to reach 70 million tonnes per year of LNG import capacity by 2030, putting them fourth in the world behind South Korea, China and Japan. Germany has been slower in making long term commitments than Asian buyers, but they’re adding significant capability.

On Thursday BASF provided a reminder of the costs Germany’s past misguided energy policies have imposed by cutting 2,600 jobs due to, “high costs in Europe, uncertainty due to the war in Ukraine and rising interest rates.”

American Energy Infrastructure is well placed to profit.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund

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For anyone in finance, the US budget deficit has always been a looming disaster but rarely a current problem. It hasn’t been a political issue since Clinton ran for office and Jim Carville quipped that the bond market intimidated everybody. For a few brief years we had a budget surplus (1998-2001), but fiscal prudence long ago lost its appeal with voters because the current costs of profligacy are inadequate to impact elections.

But tomorrow is approaching, and according to the Congressional Budget Office (CBO) sooner than we thought a year ago.

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Last week the CBO updated their 10-year budget projections, with disappointing revisions compared with the prior release last May. Our Debt:GDP is at levels last seen towards the end of World War II. Back then following the end of hostilities spending fell, and artificially depressed government bond yields helped lower the country’s debt burden.

This time around, ballooning Medicare and social security spending will take us into uncharted territory.

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Rising debt has increased our interest rate sensitivity. The CBO’s outlook for inflation and bond yields hasn’t shifted apart from reflecting today’s higher inflation. Compared with last year’s forecast, inflation is expected to return to the Fed’s 2% target a year later.

The impact on our finances has been dramatic. Debt will now exceed GDP next year, four years earlier than before. Interest expense over the next decade will be $159BN higher annually, bringing forward by approximately two years milestones such as $500BN, $1TN or $1.25TN in annual debt servicing cost.

The White House is unlikely to dwell on this, but the change in circumstances between the two CBO publications might represent the most rapid deterioration in America’s finances in history. The bigger the problem gets the harder it is to solve.

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It would be worse without Quantitative Easing (QE). The Fed still holds $5.4TN in government bonds and another $2.6TN in MBS. Without return-insensitive buyers such as central banks (see More Than A Fiscal Agent) and others with inflexible investment mandates financing our debt would be even more costly.

The Fed follows its dual mandate by focusing on whichever of the two variables (employment or inflation) is farthest from its desired level. In the summer of 2019 at Jackson Hole, they concluded that we could tolerate a little more inflation over short periods to boost employment (see The Fed’s Balance Sheet Has One Way To Go). The timing was unfortunate, and within a couple of years a modest overshoot demanded their attention.

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The Fed’s Congressional mandate doesn’t include concern about the fiscal impact of their actions, but they are becoming more impactful. QE has emasculated debt hawks by hiding the apparent cost of fiscal excess. QE’s slothful removal has impeded the Fed’s efforts to slow the economy, as seen in recent strong data such as employment and retail sales.

The current tightening cycle hasn’t been enough to raise unemployment, but it’s had a meaningful impact on our debt outlook. The Fed’s interpretation of its dual mandate now has a fiscal dimension.

The logical response is to tolerate higher inflation. There’s nothing magic about 2% – stability is more important than its level (see El-Erian, Rogoff Say It’s Too Late to Fix Too-Low Inflation Target). The numbers suggest that tolerance of 3% inflation leaves us better able to service our debt than 2%. There are few tangible benefits from the current effort to stick to the old inflation target.

Last year interest expense alone was 1.90% of GDP. Within a decade it is expected to reach 3.52%, up from a 3.254% projection in May.

The Fed’s Summary of Economic Projections has the Fed Funds rate ending this year at 5.1% and next year at 4.1%. The CBO expects Fed Funds to average 3.6% in 2024 (last year they were projecting 2.6% for 2024). If the Fed is right, the CBO’s 2024 interest rate forecast will be around 1% too low, which will result in further adverse updates to our fiscal outlook.

The CBO aligns with where interest rate futures were when they prepared their budget outlook. Since then, strong data has caused the market to shift towards the Fed’s projections.

Fed chair Powell has been clear that bringing inflation back to 2% is in everyone’s interests. While this is consistent with their Congressional mandate, it’s no longer the most desirable public policy. Our vast debt, poor fiscal outlook and heightened interest rate sensitivity make increased inflation tolerance preferable.

For now, investors should take the Fed at its word that they’ll do what it takes. But the impact on our finances of returning inflation to its 2% target is eventually going to make this a consideration. It means defining price stability as 2% inflation is becoming more costly. Maintaining the purchasing power of your assets means assuming inflation settles in higher than this target.

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

Energy Mutual Fund

Energy ETF

Real Assets Fund