The Bond Market Sends A Warning

Although markets were quiet over the Christmas break, treasury yields drifted steadily upward. On the first trading day of the new year the ten year yield burst higher by 0.12%. Although the Fed seemed to bring inflation expectations under control at their most recent FOMC meeting in December, this is now starting to reverse.

The yield curve has been steepening, reversing the sharp flattening that hurt several hedge funds late last year. It still seems impossibly flat – we’re about to enter a tightening cycle and expectations are that it will be mostly complete by the end of 2023 – less than a full 0.25% tightening is priced in over the following two years.

Eurodollar futures are still priced for Fed Funds to remain below 2% — implausibly optimistic, because it implies that the Fed will contain inflation without raising short term rates even to their long term inflation target. The FOMC’s guidance is 0.50% higher, and although they are awful at forecasting their own actions, this time perhaps the market will adjust to the Fed rather than the other way around as usually happens. Put another way, history suggests that inflation won’t get back to 2% unless the Fed raises rates above this level.

Part of the justification for equanimity over how high short term rates need to go has come from the bond market. In mid-December, ten year treasury yields were below 1.5%. Pushing short term rates above long term yields, creating an inverted curve, would provoke warnings that the Fed was about to cause a recession. An inverted yield has a mixed track record as a predictor of a slower economy, but it might be expected to give decision makers pause.

However, following the recent slump in the bond market, ten year treasury yields are within reach of last year’s 1.73% high. Maybe it’s a delayed reaction, but confidence about the Fed’s ability to bring inflation back down has been seeping away for a month. The continued fall in real yields has muffled the message somewhat, but ten year inflation expectations have risen 0.30% since the announcement of a speedier taper.

Employers are budgeting for wage increases of 3.9% this year, according to a survey by the Conference Board. Most analysts expect inflation to moderate, but bringing it back to 2% is looking less likely. The modest tightening projected by the market is unlikely to convince businesses to expect it, which would make ~4% annual wage hikes more likely to persist.

The Fed over-estimated the amount of slack in the labor market, a point chair Jay Powell began to concede during his press conference last month. They maintained a highly accommodative policy stance for too long in the hope that labor force participation would improve. They targeted a return to employment level of 152 million last seen in January 2020, before Covid hit. It’s still more than four million below that level, and since the Fed now emphasizes the “full employment” element of their twin mandate, they were willing to risk inflation to help those remaining unemployed people back to work.

The Fed has not given up, because their policy remains highly accommodative. A slower pace of buying bonds and near-zero rates do not represent hawkish policy. But they’ve belatedly recognized all the other signs of a tight labor market, such as 3.9% wage increases or the record 4.5 million Americans who quit their jobs in November.

“The important metric that has been disappointing really has been labor force participation,” noted Powell during his press conference. He cited, “factors related to the pandemic, including caregiving needs and ongoing concerns about the virus…”   Others were, “aging of the population and retirements” Three years of a strong market has probably helped many people retire ahead of time.

The rise in treasury yields is bearish. It reflects rising inflation expectations and implies a higher peak in the Fed Funds rate during this tightening cycle. At a certain point it is negative for stocks, since low rates have driven investors into equities for years. However, ten year yields would need to be approaching 3% not 2% for that to be a factor. And the pool of return-insensitive capital willing to own sovereign debt at negative real yields seems limitless, which is facilitating a degree fiscal profligacy that would otherwise be much more costly.

But it does mean that eurodollar futures 2+ years out below 2% remain too low. The Fed’s sloth-like return to neutral policy relies on the hope that inflation will moderate of its own accord, not that the Fed’s actions will cause it to. Much can go wrong with that.

Unrelated to inflation but notable nonetheless was news that last month the US became the world’s biggest exporter of liquified natural gas.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

The Upside Case For Pipelines – Part 2

As we noted last week, the world doesn’t need another anodyne “2022 Outlook”. So we’ve put together a set of upside scenarios that are plausible but not consensus.

Last week we published The Upside Case For Pipelines – Part 1. This examined factors unrelated to commodity prices that could provide the sector a boost. This blog post considers what might boost oil and gas prices, which would likely provide a lift to the sector.

They fall into four categories – cyclical, geopolitical, Covid and the energy transition.

1) Cyclical factors that are bullish

Reduced growth capex has become a positive habit for the energy industry. Depletion of oil and gas wells is 2-4% of production – meaning that the industry needs to invest in that much new supply just to stay even. Crude oil demand has obviously been volatile over the past couple of years, but looks likely to reach new record levels over the next couple of years, driven by growth in emerging economies. The industry seems poorly positioned to meet this extra demand.

Capex is down 2/3rds from its 2014 peak, and the industry shows little inclination to boost it in spite of high prices and entreaties from the Administration. RBN Energy expanded on this theme in September (see Where Has All The Capex Gone? E&P Investment Down Despite Rising Prices And Cash Flows).

Global oil inventories have been drawing down since early last year, leaving little excess available. Moreover, OPEC countries are producing well within their stated capacity, which leads some to suspect that their actual maximum production capability is less.

The story is similar with natural gas, except that global demand is more clearly rising. Because transportation costs are relatively high, regional prices vary substantially. TTF futures, the European natural gas futures benchmark, are priced at the equivalent of $26 per Thousand Cubic Feet (MCF) for January 2023, lower than the $29 equivalent price of the front month January 2022. US prices are one seventh of this, so the prospects for continued growth in shipments of US Liquified Natural Gas (LNG) to Europe and Asia look good.

Against this positive backdrop for prices, it’s worth remembering that oil services companies shrank payrolls in response to the drop in capex, so even if spending did ramp up it would take time for the industry to rehire and retrain.

Lastly, economies around the world have been improving their energy efficiency. The US is no exception. Adjusted for inflation, it takes 60% less energy per $ of GDP output than was the case in the 1970s. Therefore, energy prices have a smaller impact on the economy today, making it better able to withstand higher energy prices than in the past.

2) Geopolitical factors that might surprise

The middle east remains one of the less stable regions of the world. A fifth of the world’s crude and an increasing amount of natural gas pass through the Strait of Hormuz. Although it’s unlikely Iran could ever cause more than a temporary disruption to supplies, the threat remains, along with the possibility of conflict breaking out elsewhere. The world has very little spare capacity, so is vulnerable to surprises here. A failure in the Iran negotiations over nuclear weapons would keep Iranian oil mostly off the world market.

Russia’s growing military threat to Ukraine is another flashpoint where armed conflict could disrupt supplies of Russian natural gas to western Europe. Nordstream 2, the controversial natural gas pipeline from Russia to Germany, is completed but not yet operational pending German and EU regulatory approval. Conflict in Ukraine might delay its start indefinitely – likely a factor behind the elevated price of January ‘23 TTF natural gas futures noted above.

3) Covid loses its ability to disrupt

The Omicron variant is highly infectious and milder than preceding variants. It is causing far fewer hospitalizations and research shows why it’s causing less severe illness (see Studies Suggest Why Omicron Is Less Severe: It Spares the Lungs).

Economic disruption from Covid has come mostly from the mitigation steps countries have taken to curb its spread. In the near term, Omicron’s fast rate of spread is likely to drive global supply disruptions in a more synchronized matter. Former FDA Commissioner Dr Scott Gottlieb has become a widely followed resource on covid, and he expects in 2022 we will “…go from a pandemic into a more endemic phase,” as countries learn to live with Covid without noticeable disruption.

As the world opens up, energy demand will increase especially in Asia where many borders have remained partially or fully closed. International air travel remains the one weak point in liquids consumption, and a rebound could push crude prices higher. We’ve already seen prices reach $80 recently without these sources of extra demand.

4) Energy transition

So far there’s little sign that renewables are reducing the world’s demand for oil, gas and coal. Higher prices for fossil fuels remain inevitable if consumers are to switch to other forms of energy. The failure of COP26 in Glasgow may lead to renewed unilateral efforts by policymakers to reduce emissions. Curbing coal remains the obvious target – consumption limits or wider use of carbon taxes would drive demand for natural gas as the closest substitute, and to a lesser extent crude oil.

New Year’s Day brought an encouraging report that the EU will classify nuclear power and, in certain cases, natural gas as “green” energy. The requirements for natural gas include that it’s being used to replace coal, and that its emissions are no higher than 270g per Kilowatt Hour (KWh). Natural gas emits 180g per KWh, so even allowing for conversion losses this ought to be an achievable benchmark.

Assuming the news report is comfirmed, EU endorsement of natural gas as part of the energy transition solution is a long term very postive development for the natural gas industry. It will likely add momentum to emerging economies and perhaps even the US to adopt a similar approach. It should be supportive of natural gas demand and correspondingly negative for coal.

The energy crisis of 2021, which exposed some countries’ overly hasty embrace of renewables, showed that traditional sources of energy are vulnerable to sudden price jumps.

Any of the factors above or some in combination could drive oil and gas prices higher, potentially much higher, which would support already improving sentiment in the energy sector.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

The Upside Case For Pipelines – Part 1

The world doesn’t need another “what to expect in 2022” outlook piece. Inboxes are full of them this time of year. Therefore, what follows is part 1 of a two-part look at what could create upside surprises for midstream energy infrastructure. The downside is well understood and was experienced in full force quite recently. On March 18, 2020 the Alerian MLP Index (AMZIX) closed down 67% for the year. The broad-based American Energy Independence Index (AEITR) was marginally better at down 63%. There’s no plausible downside scenario that can beat that for a live ammunition drill. Within 19 months the two indices had rebounded 220% and 264% respectively.

What follows is inspired by Byron Wien’s Ten Surprises. These are upside developments that are plausible but not consensus. This blog post will focus on non-commodity price items – Sunday’s will look at scenarios for higher oil and gas.

1) Investors become convinced financial discipline will continue

Although growth capex peaked in 2018, the sector continues to be priced as if such prudence will prove temporary. We project that for the companies in our index 2021 spending will be down by more than half from the 2018 peak, and continue lower in 2022. A couple of companies are expected to buck this trend somewhat (Kinder Morgan and Pembina), but generally the direction is down. Lower spending has been the most important factor driving Free Cash Flow (FCF) higher, although rising Distributable Cash Flow (DCF) has also helped.

Although four years of discipline is presumably reflected in the market, we continue to believe that dividend yields above 7% and FCF yields above 11% reflect persistent skepticism, perhaps because of the prior history. This is an industry that long attracted income seeking investors with stable payouts that grew, and modest growth capex. The damage that abandonment of this model and the associated investor base caused still tarnishes its reputation. If the market starts to become convinced this is the new normal, the sector could reprice to the upside.

2) Pragmatism guides the energy transition 

There’s little doubt that solar and wind will grow. But there aren’t many examples of intermittent power delivering the cheap energy and attractive jobs that progressives  keep promising (listen to our podcast Incoherent Energy Policy). Failures are becoming more visible and costly – sky-high prices for Liquified Natural Gas (LNG) in Europe and Asia are the latest example of the recklessness of turning public policy against existing energy supplies while new ones remain inadequate.

Practical solutions may gain traction, including acknowledging a slower energy transition, increased use of nuclear, favoring natural gas over coal and boosting incentives for hydrogen, and for carbon capture and storage from the use of existing, reliable energy. Looking at the figures instead of the media’s breathless coverage, renewables are insignificant yet disruptive.

3) Real yields continue to fall

Ten year TIPs yields of –1.0% already seem impossibly low, but there is no theoretical limit to how far they can fall. This may temper an otherwise inevitable increase in bond yields, by projecting higher inflation expectations without a rise in nominal yields. The fall in real yields traces back decades and there’s no reason to think it stops here. It represents an enormous wealth transfer from those who must own sovereign debt — foreign central banks, pension funds and others with inflexible investment mandates. The beneficiaries are borrowers, chiefly the US government and by extension, taxpayers. It’s why our dire fiscal outlook continues – there is little discernible cost.

If these current trends continue the appeal of stable income with inflation protection, which real assets (including pipelines) offer, could become irresistible. Fixed income remains a completely losing proposition.

4) Inflation surprises to the upside

Most forecasters expect inflation to fall substantially in 2022. However, there are plenty of indications that Americans expect it to remain elevated. Low bond yields mean the yield curve could invert with as little as 1.5% of tightening by the Fed. This traditional precursor of a recession is likely to create offsetting concern about employment.

Having helped cause inflation, the Fed’s tools will as usual be blunt and they’ll face the unenviable choice between throwing people out of work or tolerating inflation closer to 3%. The return to 2% inflation over the long run is by no means assured. Real assets such as pipelines would benefit.

5) Republican mid-term gains squash any anti-energy sector legislation

Build Back Better remains alive and could pass in a further reduced form with climate change policies. Whether Joe Manchin and the White House reach agreement or not, this is probably the progressives’ last opportunity to implement the less extreme elements of their wish list.

A shift of the House back to Republican control, or the loss of one Democrat senator would leave executive actions as the only remaining tool. Perhaps this would even lead to a more substantive dialogue about the energy transition – one that acknowledges the cost and seeks to justify it, doesn’t falsely claim thousands of new jobs and explains why it’s in our interests to continue reducing emissions while most emerging economies are growing theirs. A thoughtful debate about how to manage the possible risks of increased emissions is overdue.

6) Sector fund flows turn positive 

Sentiment is no longer negative and is showing signs of cautious optimism, at least based on the dozens of calls we’ve had in recent weeks. Fund flows turned negative in February 2020, and just turned positive two months ago. The sector has enjoyed a strong rally without significant retail participation. If the trend on inflows persists that could provide a significant boost. 

Any one of these factors could push pipeline stocks higher. There remains plenty of opportunity for upside surprises.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

Boxing Day

Today is Boxing Day. The US is rare among English-speaking countries in not celebrating the day following Christmas. Perhaps the habit was dropped following the War of Independence in a further shedding of the colonial yoke.

Our family continues to enjoy Boxing Day even after nearly 40 years in the US. It is in truth another day to over-indulge, including of Christmas pudding. This is a dark, heavy type of fruit cake liberally fortified with brandy and best served hot, with heavy cream. Americans know it as plum pudding, although it contains no plums.

English Christmas dinner of turkey and all the trimmings is only complete following dessert. Because a Christmas pudding is never as big as it looks, what appears to be a generous quarter slice presents as Scrooge-like by the time it reaches your plate. My opportunities to enjoy it are limited by my wife, who proclaims the ingredients (notably suet, which is fat derived from beef or mutton) deeply unhealthy which is of course why it tastes so good. Because the alcohol greatly extends its shelf-life Christmas pudding can, and often is, made months ahead of time. My grandmother used to make it in September, and once as a special treat served me one in May left over from Christmas.

English Christmas Pudding

This history, along with what the uninitiated hold is an unappetizing appearance, has convinced my children to steadfastly reject even a small portion. This is fine with me, not least because my wife’s reported desire to have me around for a good many more years limits the amount available. One consequence is that I offer it to our guests sotto voce with easily constrained enthusiasm while noting how good the chocolate cake looks. At such times my mother’s hearing becomes temporarily acute, and she claims my anticipated second slice. I’m told Christmas pudding is very hard to get, but I suspect if I did the holiday food shopping I’d find it in abundance.

Last week my wife, whose care for my general well-being is only exceeded by her love of a bargain, let me know she just bought two Christmas puddings on sale. She’ll keep them for next year.

Friends often ask me about the history of Boxing Day. Since servants had to work to make Christmas Day memorable for the household, Boxing Day was when they received a Christmas “box” (gift of money) and enjoyed their Christmas feast downstairs. Watch the Downton Abbey Christmas special sometime. For generations the English have coped without household staff, so Boxing Day has served to extend Christmas into a second day.

Boxing Day isn’t just about leftovers. The Premier League (English football) kicks off an intense schedule requiring each team to play three times through January 3rd. It is a holiday season football festival. Coaches complain about insufficient recovery time but the world’s biggest soccer league supplies what its global TV audience demands.

Omicron is thankfully little more than a minor inconvenience and has not been allowed to interupt proceedings, although some games will inevitably be postponed while infected players self-isolate.  Nonetheless, for just over a week the choice of games to watch seems limitless.

For energy investors this has been a good year, by some measures the best in a decade. Because of this I reached Christmas, already one of my favorite times, in a thoroughly agreeable disposition.

Which is why on this Boxing Day, if your blogger can procure an extra slice of Christmas pudding while watching Arsenal win their first game of the hectic nine-day schedule, it will cap a Christmas as perfect as can be. Encouragingly, their opponents Norwich City languish at the very bottom of the table.

Boxing Day aside, I expect happiness from investing in 2022 will easily exceed the ephemeral pleasures offered by Arsenal and the Christmas repast. If so, few will complain.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Joe Manchin Puts America First

Build Back Better (BBB) includes many provisions beyond the scope of energy and interest rates, the two topics this blog covers. But to the extent that Senator Joe Manchin (D-WVa) has torpedoed progressive goals on climate and $3TN in additional debt, he’s demonstrated better judgment than the rest of his party.

Start with the debt. The American Recovery Act passed in March was $1.9TN of deficit spending that wasn’t needed given the positive vaccine news five months earlier. It has contributed to the inflation that Manchin cited as one of his concerns. Had Congress and the White House been less impulsive, the dire fiscal outlook wouldn’t have made it quite so easy to criticize BBB. Modern Monetary Theory is already showing its limits.

Now to the energy transition. America’s success in reducing emissions over the past decade has come from coal to natural gas switching for power generation. Solar and wind grab most of the headlines, but the data is clear. Renewables create most of the media noise but not the substance.

One piece of good news is China’s growing natural gas imports from America, which will help reduce their voracious coal appetite and help curb their emissions. Senator Elizabeth Warren, often short of policy insight, recently asked if big natural gas producers had, “considered cutting, suspending, or ending exports of natural gas to help ease spiking domestic prices.” Supplying China with natural gas helps reduce global CO2. Higher domestic prices, which still remain substantially below those in Europe and Asia, are a cost of the energy transition that she ought to be championing.

Cynics will point to Manchin’s fealty to West Virginia’s coal sector – and if he’s responding to his voters that seems more democratic than the opposite. But if BBB embraced more practical solutions such as sharply increasing nuclear power and supporting continued coal to natural gas switching, it would at least be more practical than the relentless focus on intermittent, weather-dependent energy.

Manchin added, “…if technology is not there, we got to make sure that we’re able still to rely on United States of America. We have been energy basically independent for the first time in many, many years, 67 years or more.”

The Shale Revolution may have been an investment bust, but it has created a degree of energy security in America that was previously unknown. It’s hard to see why we’d give that up. White House pleading with OPEC to lower gasoline prices represents a low point.

On Sunday’s talk show, Manchin correctly said, “The main thing that we need is dependability and reliability. If not, you’ll have what happened in Texas and what happens in California.” He might have added most of Europe as another example of energy policy gone awry. Trying to rely on windmills and solar panels before the technology is robust enough is not a viable strategy.

European wholesale electricity prices are at multiples of the US, because of poor planning, naivete about Russia’s intent to be a reliable natural gas supplier, and cold weather. Month ahead German power prices reached €350 per Megawatt Hour, and French prices almost €600.

German households were already paying about 3X US households for electricity a year ago, before the price spike. The German wholesale cost of power has jumped from €30 per MWh since then, an increase of 10X. Even though three quarters of the average German household’s monthly bill is distribution, fees and taxes, allowing the full increase to pass through to households would result in a tripling of bills. EU governments (i.e. taxpayers) are likely to absorb much of the increase.

US energy policy in many states remains far better than the European model. Manchin added, “…we should not have to depend on other parts of the world to give us the energy.” The energy transition will be expensive, and it may be worth it. The problem is politicans keep pretending it’s costless, while examples of its expense keep piling up. Intermittent power that’s 10X the cost in America isn’t how we’ll get there. And it makes more sense to start when the biggest emitters are signed up.

Until China, 28% of the world’s CO2 emissions and growing, is prepared to make actual cuts, it’s hard to see why OECD countries should. Until a solid majority of the world is aligned why should Americans pay more while Chinese and Indians just burn more coal?

Concern about climate change is broad, but its shallowness is betrayed by politicians’ reluctance to answer these questions. The failure of Build Back Better in its current form offers the chance of a more pragmatic energy transition that is less disruptive to growth and therefore better for the economy, including the energy sector.

The energy sector received a boost from Joe Manchin. Reducing emissions to deal with climate change will remain a focus of the sector, but rejecting the solutions of climate extremists will allow for a more pragmatic, durable approach.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

Inflation’s Upside Risk

If you weren’t able to join Thursday’s webinar, SL Advisors Midstream Energy and Inflation Outlook, you can watch a recording here.

The media referred to the Fed’s “hawkish pivot” following Wednesday’s revised dot plot and faster taper. More accurate is that chair Jay Powell confirmed that the FOMC was following the market’s earlier revisions to the rate outlook. Eurodollar futures traders and the Fed are once more synchronized over the next couple of years in looking for the Fed Funds rate to reach around 1.5%. Forecasts diverge beyond that, with fixed income traders comfortable that rates will peak, whereas FOMC members expect continued increases. When it comes to forecasting even their own actions, history shows the Fed has much to be humble about.

The great penalty of inflation is suffered by fixed income investors, who conventionally demand a return at least as high to preserve purchasing power. Negative real yields on G7 sovereign debt are muting the market’s concern about value erosion. Persistently low bond yields that result are supporting risk assets such as equities. Buoyant bond and stock markets mean that there has been very little pressure on the Fed to act. The pleas for tighter policy have not come from financial markets, but from well-qualified observers such as former Treasury secretary Larry Summers and former NY Fed leader Bill Dudley. A handful of politicians have expressed concern about inflation, but Congressional enthusiasm for tighter policy will expire before the first rate hike.

The result is that financial markets regard today’s high inflation as relatively costless. Return-oriented investors in US government debt should demand high real rates as compensation for the dire fiscal outlook. But return-insensitive buyers (central banks; pension funds) dominate, and their acceptance of guaranteed value erosion is a subsidy that makes inflation more tolerable.

Five year inflation expectations derived from TIPs yields began the year at 2%, and reached 3.1% a month ago although have moderated recently. The Fed targets Personal Consumption Expenditures (PCE) Inflation whereas TIPs settle against CPI. Technical differences mean PCE inflation runs lower than CPI – about 0.5% since 2000 but 0.3% since 2008. The bond market’s long term inflation outlook is a little higher than the FOMC’s long term 2% forecast even adjusting for PCE/CPI differences.

The consensus interpretation of the yield curve is that raising short term rates to 1.5% will be sufficient to bring inflation back to the Fed’s 2% target. An alternative explanation is that financial markets, and therefore the Fed, will tolerate higher inflation.

The Fed and most analysts expect declining inflation next year. Criticism flows easily when inflation is rising, but if it moderates as expected next year the FOMC will draw a collective sigh of relief. They’ll still taper and normalize rates, but the pressure from opinion leaders will be off. If Owners’ Equivalent Rent (OER), the quixotic survey-based measure of the cost of shelter, increases expect the Fed to look past it as a non-cash expense.

The absence of financial market stress during the current inflationary spurt will lessen the urgency to follow the rate path they’ve laid out. A hint of economic weakness will embolden those wishing to pause normalization. The flat yield curve would steepen.

Spiraling Federal debt and fortuitously low (negative) real rates make moderately higher inflation in America’s interests. The resilience of financial markets affords the Fed flexibility in normalizing rates and tolerance for a slower return to 2% inflation – or indeed inflation settling at a somewhat higher level.

The “hawkish pivot” shouldn’t be confused with a hawkish Fed. They simply followed the market. Their tolerance for temporarily higher inflation in support of full employment, the revised interpretation of their mandate announced last year, represents a more dovish approach to monetary policy. It’s one they’ve been following faithfully ever since.

Midstream energy infrastructure, as we noted in Thursday’s webinar, still offers attractive yields with decent upside through real assets that should provide protection against inflation.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

 

The Fed’s Biggest Mistake In History

Sign up here for this Thursday’s webinar at 12 eastern. SL Advisors’ Midstream Energy and Inflation Update.

Allianz SE’s Mohamed El-Erian recently said the, “Transitory Inflation Call Likely Fed’s Worst Ever.” There is some competition for that title. Just in my career (1980-) you’d have to include Alan Greenspan’s summer 1987 tightening which was soon followed by the October 1987 Crash; Greenspan’s assessment that the internet had boosted productivity, which underpinned easy late 90s policy; and Greenspan’s laissez-faire approach to regulatory oversight which helped cause the 2008-9 Great Financial Crisis (GFC). Greenspan made a few mistakes, but he was Fed chair from 1987-2006, so he had plenty of time. And he got much more right than wrong.

But the Fed’s imminent concession that they misread inflation earlier this year exceeds those three, and probably any that came before. Today’s FOMC announcement will likely see them start to correct, but unless the Fed immediately stops buying bonds they’ll still be moving too slowly – maintaining bond market support for an economy that long ago ceased needing it.

“Worst Call Ever” is justified because Fed chair Powell’s equanimity over inflation was so obviously misplaced. Like many observers, we saw reasons to be concerned a year ago (see Deficit Spending May Yet Cause Inflation). Earlier this year, Congress passed the American Rescue Plan, $1.9TN of further stimulus not needed since vaccine distribution was already underway. Through this, the FOMC maintained its pro-cyclical monetary policy and continued to finance most of America’s mortgage origination.

Even Democrat lawmakers have begun pushing the Fed to tighten policy (see US Democrats push Fed for tougher action against inflation). Representative Jay Auchincloss (D-MA) is an example of Congressional muddled thinking – he supported the abovementioned $1.9TN profligacy but now says, “The Fed needs to start tapering immediately and then they need to raise interest rates.”

This is exactly why Modern Monetary Theory (MMT) is flawed – the notion that Congress should increase deficit spending until it’s inflationary assumes they’ll curb largesse in time, which they obviously haven’t (see Reviewing The Deficit Myth, Stephanie Kelton’s support of MMT which unwittingly reveals its flaws). When members of the party in power want the Fed to tighten to offset their fiscal mistakes, you know there isn’t much hard thinking going on. Somehow Auchincloss is a member of the House of Representatives financial services committee, which oversees monetary policy.

The sad truth is that the Federal government’s 2021 fiscal and monetary approach to Covid was dead wrong. By contrast, the government’s response to the GFC was broadly correct, and impactful. Then Fed-chair Bernanke introduced Quantitative Easing (QE), using the Fed’s balance sheet to buy $TNs of bonds. This was a bold and controversial move, but Bernanke was right in arguing it wouldn’t be inflationary. That might be the best call ever by a Fed chair. Jay Powell has simply incorporated QE into the Fed’s toolkit, but with the opposite result.

It’s likely the FOMC’s “dot plot” will move up towards eurodollar futures. The market is priced for the Fed Funds rate to reach 1.5% and by 2023 and remain there. The implication is this will be sufficient to reduce inflation back to the Fed’s desired 2%-ish level. Tightening and tapering are both reflected in ten year treasury yields, which remain below 1.5%.

The assumption is that it will not take much for the Fed to tame inflation, and ten year inflation derived from TIPs has moderated from 2.75% to 2.45% in the past month.

Another possibility is that the inflation figures are losing relevance. The deep flaw in the CPI’s measure of housing costs is receiving more attention (see U.S. Home-Price Surge Looks Much Tamer in Government CPI Report). We regularly point out the flaws in Owners Equivalent Rent (see The Subtle Inflation Pressure From Housing).

When the survey-based method of cost of shelter finally rises, expect the Fed to dismiss it as a non-cash item. If other measures of inflation are moderating then, they’ll be unlikely to act on it.

We could be entering a period of permanently higher inflation – a function of the Fed’s revised policy of greater tolerance but also an increasing gap between reported inflation and what consumers experience. Stocks and other real assets are the only investment solution.

It’s many months since we wrote about Covid – it’s often tempting, and statistics are plentiful. But it can appear self-indulgent, since there’s no shortage of literature available from better qualified writers.

However, a recent New York Times article was so egregious as to demand attention. Always in need of depressing news, they reported that 1% of older Americans have died of Covid. To further demonstrate journalistic innumeracy, they noted that 590K, or 75% of Covid deaths were the over 65s. Forget “with Covid” versus “from Covid”. The media often conflates the two, although the CDC defines “All Deaths involving Covid-19 (italics added).

Putting aside with versus from, CDC data also shows that 4.7 million over 65s died from all causes since Covid began, 73% of the 6.4 million total. In other words, older people die at roughly the same rate regardless of Covid. 1% of older Americans have died with Covid since early last year, but 8% of older Americans have died from all causes.

A New York Times non-story shouldn’t matter, except when such a widely read news outlet makes news out of something that plainly isn’t, it gets people like Representative Jay Auchincloss to mistakenly vote for unneeded fiscal stimulus.

The current inflationary environment is a result of poor analysis and policy errors. With the same cast of characters in charge, Investors should be prepared for more.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

Betting On Gas With LNG

In March we wrote about start-up Liquified Natural Gas (LNG) exporter, NextDecade (NEXT) (see Making LNG Cleaner). As with Tellurian (TELL) and Cheniere (LNG) before them, NEXT needs to sign up buyers of its LNG before obtaining the financing to complete the liquefaction infrastructure. The rolling global energy crisis which has seen European and Asian buyers paying over $35 per Million BTUs (MMBTUs) for shipments has improved the outlook for US LNG exports. The $25 per MMBTU regional difference with US domestic prices is testament to the constraints posed by limited LNG export capacity. NEXT aims to partially solve that – foreign buyers are eager, although US customers will wind up paying marginally more as increased exports push up prices.

French utility Engie pulled out of discussions with NEXT late last year because they were unhappy at buying Texan natural gas given the prevalence of flaring. Regulators in Texas have interpreted their oversight of methane flaring very broadly, with the result that flaring permits are routinely granted. In 2019 a dispute arose between Exco, a natural gas driller, and Williams Companies over Exco’s application to flare natural gas rather than pay the tariff Williams demanded for pipeline transportation (see Texas Reconsiders Flaring). It showed how Texas’ ready approval of flaring had abandoned the original intent, which was to allow the flaring of associated gas where no infrastructure existed in order to allow crude oil production. Williams argued that the natural gas infrastructure was available, but that Exco didn’t like the price. In September, a judge ruled in Williams favor but that may not be the conclusion.

European LNG buyers are likely to share Engie’s sensitivity to how their product is produced, so NEXT created a “carbon solutions” unit to capture the CO2 associated with their LNG activities. Last week SL Advisors partner Henry Hoffman chatted with management during Cowen’s 2021 Energy Summit.

We think NEXT is under the radar for most investors. They do have some sell-side coverage though. Credit Suisse raised them from Neutral to Outperform in March, which gave the stock a boost. The company has a firm offtake deal with Shell to deliver 2 million tons per annum (MPTA) of natural gas for 20 years. NEXT needs agreements on 9 MPTA more in order to fully sell out capacity for Phase 1 of their proposed Rio Grande facility in south Texas. They are optimistic that they’ll reach this goal next quarter, reporting discussions on volumes well in excess of what’s needed.

The Administration’s Build Back Better legislation, which is currently with the Senate, may boost revenues at Next Carbon Solutions if the CO2 tax credits are sufficient to stimulate additional demand for the new unit’s services.

NEXT is aiming to provide “green” methane, whose production is certified to have resulted in minimum methane leaks along with the capture and sequestration of the CO2 generated in its processing and eventual liquefaction for transfer to LNG tankers.

Henry Hoffman also held discussions with Tellurian’s (TELL) management. TELL’s founder and CEO is Charif Souki, whose weekly Youtube videos have developed a following among retail investors. We like TELL too, but Souki has an unpredictable, risk-seeking streak. He was forced out of Cheniere by Carl Icahn who opposed Souki’s plans to expand into natural gas trading. Why complicate a business with years of cashflow visibility not exposed to natural gas prices?

Last year Souki suffered a margin call on his personal holdings of TELL when the stock collapsed during the Covid rout. He has a healthy risk appetite. We also didn’t like the August secondary offering which was done at a substantial discount to the prevailing price. TELL has a business model that incorporates exposure to LNG prices, which is probably making it harder to finance but allows greater upside if LNG prices remain firm, as Souki believes they will.

TELL told us they were in discussions with private equity investors, which we think could be good as it will improve corporate governance, and get the company closer to having enough financing to begin construction of their LNG facility.

Natural gas remains the most impactful way for the world to lower emissions, by reducing reliance on  coal. Recently an overly hasty effort to transition to renewables in Europe has exposed weaknesses in their energy strategy and created further demand for natural gas. Although $35 per MMBTU is likely unsustainable, the long term demand for LNG is clear.

NEXT and TELL both offer the opportunity to invest in continued global demand growth for natural gas. We are invested in them.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Please sign up here for our webinar, Making Sense of Rising Inflation and the Global Energy Crisis, on Thursday, December 16 at 12 noon Eastern.

The Market’s Sanguine Inflation Outlook

Last week Fed chair Jay Powell pivoted away from “transitory”, and adopted a tone more in keeping with the market’s newly revised interest rate forecast. As a result, today’s yield curve is far away from the September FOMC projections, even though they’ll be revised at this month’s meeting.

The most important question for bond investors must be the persistence of negative real rates – currently around –1.0% on the ten year. Moreover, the market has lowered expected short term rates five years out compared with their level at the September FOMC (the last time they issued projections materials). The biggest change in the meantime has been the Fed’s assessment of the inflation outlook.

Real rates have been declining for years, and so has the economy’s resilience to high rates. The eurodollar curve is currently priced for the Fed Funds rate to peak in two years at around 1.5% and for policy to remain on hold from then on. Ten year treasury yields are inexplicably at 1.4%, with inflation running over 6% year-on-year, tapering set to begin and the Fed likely to raise rates as soon as next spring if they decide to accelerate tapering later this month.

It doesn’t seem likely that the Fed will be able to restrain economic growth much without seeing long term yields rise. A 1.5% peak Fed Funds rate probably isn’t enough.

Former NY Fed president Bill Dudley recently commented that the market was extremely sanguine about how little increase in rate will be necessary to curb inflation. Five year inflation expectations derived from the treasury yield curve are 2.7%, and ten years 2.5%.

Add it all up, and the market is priced for Fed Funds to peak at 1% or so below inflation, which is nonetheless expected to moderate without monetary policy becoming restrictive. If someone articulated such an outlook, they’d be regarded as impossibly optimistic, yet it’s the market forecast.

One of the great pleasures of writing this blog is receiving comments on it. I remain in touch with many former colleagues and business associates as a result. Last week our post on the Owners’ Equivalent Rent, or OER (see The Subtle Inflation Pressure From Housing) drew an emailed response from Donald H. Layton, former CEO of Freddie Mac from May 2012 until June 2019. Now that he is enjoying a well-earned, though still typically industrious, retirement Don is writing papers on public policy with respect to housing. He has much to offer on the subject.

For 14 years of my 23 year JPMorgan career (1986-2000) I worked under Don Layton. As vice chair, Don led global capital markets and investment banking, which included my business of US interest rate derivatives trading.

Don is one of those rare executives able to combine strategic vision with an intense focus on detail. He often kept managers on their toes by revealing more knowledge about their business unit than might be expected from one of the bank’s top three executives. He was a superb leader who inspired loyalty and respect in equal measure. To my great pleasure we have remained in touch, and our annual reunions on the golf course followed by lunch inevitably include thought-provoking discussions about finance.

A couple of months ago Don wrote an excellent blog post about OER (see What Do Runaway House Prices Mean For The US?). He noted three disadvantages of the current housing boom: increasing inequality (if you don’t own a home and/or stocks, you’re slipping farther behind the asset-owning classes); decreased home ownership (it’s harder than ever for first time homebuyers) and artificially lowering inflation (because OER fails to adequately reflect the costs of home ownership, especially for current buyers).

Don noted, as we often have on this blog, the problems with estimating the cost of shelter by surveying homeowners on the possible rental income they might earn on their home. He notes that, “while the FHFA (Federal Housing Finance Agency) is saying that house prices went up 19.2 percent over the past year, the OER says that the cost of shelter for owner-occupied homes went up by only 2.43 percent! That’s a lower percentage increase than even for the median rent of an actual rental unit.”

Don goes on to argue that, “This result fails the common sense “smell test. The OER approach may work adequately well in normal times, but it does not seem to be working properly under the stress of today’s unprecedented increases in house prices.

“Unfortunately, given the high percentage of the typical household budget that is taken up by shelter, claims of today’s inflation being transitory may therefore not be well-founded. This suggests that policymakers are flying more than a bit blind, not seeing the inflation that the citizenry feels (especially those looking to buy their first home). That does not bode well for those policymakers, especially at the Federal Reserve, making the best decisions.”

US monetary policy would be better served if such clear thinking was more prevalent among policymakers.

CPI inflation is likely to remain stubbornly higher than the FOMC might like as home price appreciation filters through to rent, and their theoretical analog OER. Market forecasts of a peak in the Fed Funds rate of 1.5% seem very optimistic.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

Please sign up here for our webinar, Making Sense of Rising Inflation and the Global Energy Crisis, on Thursday, December 16 at 12 noon Eastern.

The Subtle Inflation Pressure From Housing

The Administration’s explanation for the less than transitory inflation relies on supply bottlenecks and a faster than expected rebound in energy demand. Both are wrong. The Wall Street Journal recently made an interesting argument that inflation will persist (see Another Reason Inflation May Be Here to Stay).

Personal Consumption Expenditures (PCE) on all goods (i.e. both durable and non-durable) is running well ahead of the long-term trend. March’s $1.9TN covid relief plan marked the end of Joe Biden’s presidential honeymoon. Critics of this and other elements of excessive fiscal stimulus point to the reason goods purchases are so strong with consequent higher inflation. Apparently, government planners expected prior spending patterns to be repeated, but services expenditures don’t show the same above trend trajectory.

In short, more of this $1.9TN was channeled into goods purchased online, and less than expected on services, reflecting that a portion of the population remains wary about going out to dinner, movies and other entertainment.

Services represents two thirds of PCE and goods only one third. So it might seem plausible to assume goods inflation will moderate, reinforcing the discredited transitory narrative.

However, as the Wall Street Journal points out, housing and healthcare make up over half of services PCE. With the government largely picking up the cost of Covid-related healthcare on top of Medicare and other Federally-financed programs, this sector is distorted.

But the Housing and Utilities component is dominated by rents – both actual and imputed. The WSJ notes that leases come up for renewal infrequently, and that eventually the buoyant real estate market will translate into higher rents.

This may be true – but the WSJ overlooks the fact that two thirds of American households own their homes. For them, the cost of shelter is based on Owners’ Equivalent Rent (OER), the often criticized estimate of the value of the shelter (a service) their home provides. This shows up in the services PCE.

For those unfamiliar with the distortions caused by OER, inflation is all about the cost of goods and services, not assets. A home is an asset that provides shelter, a service. Inflation statistics try and separate the two, by surveying home owners on what they think they could rent their house for. This is the estimated value of shelter. Because home ownership is so common in the US, a large chunk of estimated housing costs are based on OER. (for a more detailed explanation, see Why You Can’t Trust Reported Inflation Numbers). The Bureau of Economic Analysis published a revised explanation of housing costs earlier this year.

OER is a creation only a Bureau of Labor Statistics economist could love. It’s not supported by any cash transactions, but it’s used to estimate around $2TN of PCE. As the chart shows, it bears little relationship to the Case-Shiller index which tracks actual house prices – probably because most homeowners are puzzled when confronted with the survey question about rent. A defense of OER is that, over very long periods of time (i.e. a decade or more) it tends to track home prices – and sure enough since the last peak in home prices prior to the 2008 Great Financial Crisis the two series’ have similar returns.

Where next for OER? It’s hard to forecast since it’s drawn from survey responses and not actual transactions. But it’s unlikely to decrease its growth rate, and at least some homeowners might be expected to raise their imputed rent estimate in response to the strong housing market.

A rising OER will drive the services PCE higher, causing its trajectory to return to its prior trend or even exceed it. Although there won’t be any increase in cash receipts as a result, calculated spending on services will be higher and so will inflation, since CPI also derives its housing methodology from PCE.

Easing supply constraints may allow goods inflation to moderate, although there are no signs of that yet. Whether it does or not, services inflation seems likely to move higher. This will maintain the pressure on the FOMC to respond to inflation, even though OER doesn’t impact household budgets in the same way that, say, rising gasoline prices do.

It may even cause some at the Fed to comment about the weaknesses of OER, although strength in this metric would simply be a delayed reflection of the actual appreciation in home prices we’ve all seen.  Either way, inflation is likely to remain persistent not transitory, a term Fed chair Powell retired at his Congressional testimony yesterday.

Join us on Thursday, December 16th at 12 noon Eastern for a webinar where we’ll provide an update on the midstream sector during rising inflation.

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

Energy Mutual Fund Energy ETF Inflation Fund

Please see important Legal Disclosures.

 

 

 

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