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Climate Change: Prevention or Mitigation?

Last week the northeast US suffered 52 deaths as Hurricane Ida (by then a tropical storm) dumped up to ten inches of rain in just a few hours. Cranford, NJ on the Rahway River is prone to flooding. It’s a couple of miles from Westfield, GHQ for SL Advisors, and it seems like every decade or so hundreds of basements are flooded in those homes close to the river. Garwood is another small neighboring town and source of the striking photos below 

Seemingly unrelated to the heartbreaking losses caused by Ida, journalist John Kemp noted China’s continued reliance on coal for power generation, which has experienced a Compound Annual Growth Rate (CAGR) of 5% over the past two years. Since Covid caused a drop last year, this highlights the strong underlying trend. Coal futures on the Zhengzhou Commodity Exchange recently traded at $150 per tonne, compared with $85 a year ago. The market is signaling more demand for coal.

Apologists for China herald the 25% CAGR for wind power over this time, and 24% for solar. Hydro output dropped slightly. Don’t be fooled. Thermal power, which is mostly coal since China burns half the world’s output, still provides 72% of China’s electricity as was the case two years ago. Thermal power also met 72% of the increase in demand, hence its static share of the total.

This is why China generates 28% of global CO2 emissions. It plans to continue increasing at least through 2030 before reversing course on an improbable path to zero by 2060 (see Is China Worried About Global Warming?).

Here’s why China’s power output is linked to flooded towns in New Jersey. Ads for solar panels are everywhere, because of generous state and Federal subsidies. As a result, New Jersey electricity customers have so far paid $3BN in higher fees to help pay for solar installations. Future tax breaks for solar are expected to add $800 million annually to utility customers’ bills, rising to $1.4BN by 2030.

Hurricane Ida may or may not be a consequence of climate change. The media interprets every weather fluctuation as caused by global warming. The UN’s report earlier this summer warned of more extreme weather events but attributing any single event to the one degree Celsius increase since the 1850s is impossible.

Nonetheless, if you’re pumping water from your Cranford basement, as you do every decade or so, proliferating subsidized solar panels aren’t much use. Living in a solidly blue state, you’re probably convinced that global warming will cause even more frequent flooding. Having long ago rejected the wholly sensible idea of moving to higher ground, you might like those solar panel subsidies redirected towards improved infrastructure to stop the Rahway River from bursting its banks. Users of the New York City subway would favor mitigation of the sudden indoor waterfalls we saw on news reports and social media.

The widely reported efforts by rich countries to blanket the landscape with solar panels and windmills aren’t having any noticeable impact on global CO2 emissions. Implementation carries local costs while any benefits are shared globally. Californians can feel good about their efforts to shut down natural gas plants, even though it results in more expensive and less reliable electricity. They still get forest fires. New Yorkers may support constraints on new natural gas connections. The subway still had to shut down because of flooding.

We may already be experiencing the climate changing effects of a warmer planet. If so, at some point there’s a valid choice between prevention and adaptation. None of us can control the planet’s CO2 levels. But every community can fortify itself again extreme weather events. The quest to lower emissions is a global social undertaking that relies on widespread participation. It requires community spirit on a worldwide scale. The free-rider problem is likely fatal to success. China is only the most visible emerging economy exploiting this – the world’s biggest producer of solar panels, which it sells to dozens of countries, is also the #1 consumer of coal and generates over a quarter of global CO2 emissions.

The energy transition has lots of momentum. Shifting from coal to natural gas remains the world’s most assured path to reduced emissions. Nonetheless, China’s increase in wind and solar only met 25% of the additional demand for power since 2019. The desire of rich countries to lower emissions remains in conflict with emerging economies’ intention to raise living standards by using more energy.

This misalignment of interests means that eventually a sea wall will be more useful than a windmill. That time is coming.




The Fed’s In No Hurry

In Fed chair Jay Powell’s closing speech from the virtual Jackson Hole symposium he went to great pains to illustrate that currently elevated inflation is transitory. He compared the strong rebound in spending on durable goods to above its pre-Covid trend with services spending, which remains 7% below its pre-Covid trend. He noted the unevenness of the recovery from the shortest, sharpest recession in history.

Jay Powell remains convinced that inflation will moderate, and surveys of inflation expectations can be interpreted as supporting this view. Market forecasts of inflation derived from treasury securities have moderated recently. With the Fed is buying over half of new treasury supply, market rates are far from being set freely (see Behind The Fed’s Benign Inflation Outlook).

Since the FOMC believes the bond market is still in need of their support, they must also believe that yields would otherwise be higher. If so, they should draw scant comfort from such inflation expectations, but the Fed nonetheless relies on this circular argument for comfort. The University of Michigan Consumer Survey has not yet shown signs of moderating.

Towards the end of his speech. Chair Powell briefly reviewed the experience from 1950 to the early 1980s, a period that, “taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation.”

It’s hard to be sure that anything is permanent until it’s continued for a long time, including higher inflation. This stance is provoking criticism. “The Fed has tied its hands to be quite late to remove monetary-policy accommodation,” says William Dudley, former president of the New York Fed in a recent Economist article.

This is an unfortunate moment for the Fed to be implementing its new doctrine, revised following last year’s Jackson Hole symposium, of being more tolerant of higher inflation and therefore more reactive. History offers policymakers scant insight into how economies emerge from a pandemic.

Inflation may conform to the Fed’s benign outlook. If it doesn’t, the cause will be partly traced to Congress. Budget deficits of above $1TN will soon become the norm. While this year we’re on track to hit $3TN before falling sharply, the CBO forecasts deficits will begin increasing again by 2025. The President’s current budget proposal will add $12TN to the deficit over the next decade. This is why the Fed is likely to remain a significant buyer of US treasuries.

A Fed with a more acute sense of risk would use this relentless fiscal stimulus to support a hastier return to more normal monetary conditions. Congress has adopted Modern Monetary Theory (MMT, aka the  Magic Money Tree) philosophy of guilt-free largesse (see Democrats Will Test The Limits On Spending). Continued monetary stimulus leaves little room for error if the Fed’s inflation outlook turns out wrong.

Financial markets are embracing a more dovish Fed by pushing down the yields on eurodollar futures two years out and longer. Oddly, the market still expects one tightening of monetary policy by the end of next year, even while rate forecasts farther out have sunk below even the most Dovish FOMC members’ blue dots.

A reduction of bond buying, even if it begins in September, will likely mean the Fed’s balance sheet will continue to grow at least into 1Q22. In his speech last week, Powell said that, “…we will continue to hold the target range for the federal funds rate at its current level until the economy reaches conditions consistent with maximum employment…” He also noted that, “In the United States, unemployment ran below 4 percent for about two years before the pandemic, while inflation ran at or below 2 percent. Wages did move up across the income spectrum.”

From these statements it’s clear the Fed won’t raise rates until the unemployment rate is solidly below 4%. It’s likely they will await evidence of wage inflation before concluding full employment has been reached.

Everything about this FOMC argues for sloth-like policy normalization combined with a high roller’s embrace of substantial risk of a policy error. This is all to ensure that everyone who wants a job has one. Among the papers distributed to Jackson Hole attendees was Monetary Policy in Times of Structural Reallocation. Powell has argued that inflation has been caused by disruption of supply chains induced by Covid. The inference is that some corporations will need to restructure their logistics to accommodate a new world where lockdowns can occur with little notice. Once done, price hikes due to supply disruptions should dissipate.

The paper posits that higher inflation allows greater variation in real wages, which can hasten such restructuring. Since wages rarely shrink in nominal terms, higher inflation can accelerate the movement of workers to more logistically-efficient jobs. Inflation and wage hikes of 5% in growing sectors combined with low or zero nominal wage growth in shrinking ones would quickly widen real wage differentials, motivating workers to switch jobs accordingly. Higher inflation allows for a bigger drop in real incomes – getting a 1% raise with 5% inflation is a 4% cut in real wages, something not easily achieved with, say, 2% inflation.

Jay Powell didn’t broach the topic, but a dovish, risk-tolerant Fed focused on its employment mandate might find elements to like in such an approach.

There seems little reason for interest rate futures to plot a different course than the FOMC’s own dot plot – the odds of monetary tightening next year are receding. Circumstances may evolve to compel the Fed to “… respond and use our tools to assure that inflation runs at levels that are consistent with our goal.” If so, rates will eventually need to move higher than is currently priced in. That remains some way off.

To learn why you should worry about inflation, watch this brief video.

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 




The Fed’s Balance Sheet Has One Way To Go

This week the Fed is holding their annual Jackson Hole symposium – although it will be virtual again because of the Delta variant. Media coverage has built expectations of a sharp internal debate around tapering. The recent minutes show some in favor of reducing the Fed’s bond buying program this year. Boston Fed president Eric Rosengren noted the futility of using low rates to stimulate interest rate sensitive sectors such as housing when demand is already strong (listen to our recent podcast Episode 80: Tapering Draws Closer).

Since former Fed chair Ben Bernanke showed the world in 2008 that Quantitative Easing (QE) could be done safely, the Fed has been a buyer of US treasuries almost all the time. Their balance sheet only shrunk for a year beginning in May 2018 and began growing sharply again early last year in response to Covid.

Bernanke’s original initiation of QE was criticized at the time as likely to cause inflation. He was correct that it wouldn’t, recognizing that Wall Street’s frozen plumbing needed extraordinary help. Once the crisis passed the FOMC struggled to extricate itself from the bond buying program. The 2013 “taper tantrum” when bonds slumped on fears of QE ending continues to hover over today’s FOMC deliberations.

It should be clear that the need for QE is long gone – not least because this time around inflation has surged. Most obviously the $40BN per month of mortgage-backed securities purchases should cease since the housing market is hardly short of demand.

Even when tapering begins it will only slow the Fed’s balance sheet growth, since they’ll still be buying bonds albeit at a slower rate. QE is now part of the Fed’s toolkit, to be used whenever accommodative policy is needed. A decade passed since the 2008-09 Great Financial Crisis before any meaningful reduction in the Fed’s balance sheet occurred.

The Fed’s original exit strategy was to let holdings mature and not replace them. This time around their holdings will likely flatten out around $9TN, 2X the peak from the earlier crisis. It’s hard to imagine the Fed moving to actually sell bonds, so allowing the portfolio to run off remains the most likely outcome, as before.

It’s a good bet that the next crisis will hit before any meaningful reduction in this $9TN balance sheet. The bar has been lowered. QE is being justified in part to promote job creation, part of the Fed’s twin mandate of achieving full employment with stable prices. If a bear market in bonds threatened the economy, it’s likely the Fed would see fit to step in and assure an orderly market. If our foreign creditors sold US treasuries, either for geopolitical reasons or out of frustration with our profligate fiscal policy, the Fed would scoop those up too.

The Fed is now and probably always will be the biggest buyer of US government debt. Their $8.3TN balance sheet includes $5.3TN of US treasuries, almost a quarter of all publicly held US debt. The Fed’s now permanent holding of US treasuries is debt monetization. Only three quarters of the government’s borrowing is being met by a combination of domestic and foreign savings. QE was originally intended as a temporary measure in extraordinary times, but it’s become business as usual. The Fed is enabling The Magic Money Tree (see Modern Monetary Theory Goes Mainstream).

Rep. Alexandria Ocasio-Cortez, a fan of government solutions for everything, said in 2019 that MMT needed to be, “a larger part of our conversation.” AOC and her progressive wing of the Democrats are not on the side of investors.

Our fiscal path virtually guarantees continued growth in the Fed’s balance sheet. Publicly held debt:GDP crossed 100% because of Covid and is on track to double over the next thirty years. This is based on figures from the non-partisan Congressional Budget Office, which doesn’t assume recent uber-profligacy will become endemic. It’s hard to see how The Fed will reduce its holdings when the CBO expects debt to increase annually at $1TN or more for the next thirty years.

This is why inflation is inevitable. QE has morphed into debt monetization, enabling ever larger deficits even while our fiscal outlook is poised to soar beyond past extremes. Bonds have been emasculated of their ability to warn of such excess, because the Fed stands ready to provide support whenever needed.

It’s never been more important to invest with regard to maintaining purchasing power – which means staying well ahead of inflation (see Why It’s No Longer Enough To Beat Inflation).

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

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

Energy Mutual Fund

Energy ETF

Inflation Fund

 

 

 

 




Futures Still Disbelieving The Fed

Memories of the 2013 “Taper Tantrum” loom over today’s FOMC as they engineer an exit that will hopefully be more elegant than our current one from Afghanistan. Both were well overdue, although there is no doubt the military withdrawal was handled disastrously. Can the Fed do better?

Unlike the Afghan army, the bond market has reacted well to the approaching loss of US government support. Treasury yields even dropped modestly on the week, with the ten-year still around 1.25%, 0.50% below its high in late March.

Real yields have stayed below –1.0%, with implied ten-year inflation (nominal yields less TIPs) of 2.3%. Since the Fed’s bond buying will be over within 6-9 months, today’s yields must reflect close to an equilibrium level for a bond market operating without the crutch of partial debt monetization.

Persistently low long-term interest rates remains one of the most important drivers of valuations. Japan holds $1.3TN in US treasury securities, and China over $1TN. These and other holders are clearly not seeking generous returns. Moreover, the specter of foreign investors dumping bonds and causing a recession has gone. Our second stint of Quantitative Easing (QE) shows that the Fed is a fully capable buyer of last resort. China’s position would sit comfortable alongside the other $8TN on the Fed’s balance sheet. Whatever risk premium bond yields once offered against such a possibility has evaporated.

The bond market’s positive response to tapering is more accurately a reflection of concern over the Delta virus. Cyclical stocks have been under pressure since mid-June, and on Thursday the S&P Energy ETF (XLE) dipped below the 200-day moving average. There are signs that Covid is flattering the bond market’s apparent equanimity over tapering. Nonetheless, the Fed stepping back when there’s clearly ample demand for bonds represents a more elegant exit than waiting until yields had risen to, say, 2%.

The eurodollar yield curve has flattened over the past couple of months as bond yields have drifted lower. Market interest rate forecasts are now solidly below those of the FOMC. Five years out, even the most dovish of the “blue dots” that indicate individual FOMC members’ rate forecasts is almost 0.40% above the market. Although bond investors have pushed yields lower in response to rising hospitalizations from the Delta virus, it’s unlikely FOMC members’ rate forecasts have altered much two to five years out. And the market is still forecasting around one tightening per year from 2023, about half the pace of FOMC members.

Given their explicitly reactive posture, it’s quite likely that the FOMC will be slow to normalize rates. Chair Powell never misses an opportunity to remind us that achieving full employment, which means an unemployment rate at least as low as the January 2020 pre-Covid level of 3.8%, is their objective. It’s likely that the FOMC will rely on emerging wage inflation as confirmation we’ve reached full employment. So they’ll be playing catch-up, which is why the current flatness of the eurodollar curve seems incorrect. Put another way, with the market priced for two tightenings during 2024-25, we think three is more likely than one, and four a decent possibility.

Interest rate futures reflect a slow pace of easing at odds with FOMC forecasts and past history. Given that a philosophy of unlimited spending now drives fiscal policy (see Modern Monetary Theory Goes Mainstream), if the lethargic pace of tightenings turns out to be accurate, there wil be ever greater calls for additional fiscal stimulus to boost economic growth.

It began with the Greenspan put, and successive Fed chairs have been awarded the same moniker. Add to that the Biden put. At the first sign of economic weakness the call will go out for more spending, which remains virtually costless. With debt funded at negative real rates, it almost seems irresponsible to not take advantage of the opportunity.

In 2008 Ben Bernanke revealed the limitless balance sheet capacity of the Federal Reserve, which has moved from $2TN to $8TN since then with no discernible disadvantage to the US economy. Covid-induced fiscal stimulus ushered in Modern Monetary Theory (MMT) as mainstream policy, exploiting a country’s unlimited ability to borrow in its own currency.

Now that Congress has discovered the Magic Money Tree (i.e. MMT), the conditions that justify super-stimulus will become steadily relaxed, just as the use of QE will transition from an extraordinary measure to business as usual.

It’s against that context that the forecasts embedded in the interest rate futures market must be judged.

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




US Explores The Limits On Spending

Paul Kennedy’s The Rise and Fall of the Great Powers coined the term “imperial overstretch”. Throughout history, the decline of every great power has coincided with military commitments beyond its means. Such cycles last many decades, and Kennedy’s 1987 book speculated that Japan was the new rising power about to overtake America. That call was spectacularly wrong, but the underlying principles remain valid. After twenty years, almost a $1TN and over 2,300 US military lives lost in Afghanistan, we have little to show for it. America’s humiliating exit from Kabul is not how superpowers conclude military expeditions.

Simple math shows that US military dominance will slowly give way to a multi-power world. War is expensive, and economic size drives success. US share of global GDP has declined from 40% in 1960 to 24% today, as emerging economies such as China have made strides.

Historically, great powers have begun to decline when they continued to assume obligations inconsistent with their capacity to meet them. Such decisions aren’t inevitable, and the arc of history is long. America remains a great country. But it’s useful to consider episodes such as our recent withdrawal from Afghanistan against our growing debt, set to test all notions of sustainability.

America’s debt:GDP is projected to double in the next three decades, according to the non-partisan Congressional Budget Office (CBO). This assumes no new pandemic and no wars, both significant sources of past unplanned spending.

It’s likely we will not acknowledge whatever constraints on our spending this projection should imply. Long term interest rates remain low, helped by the Fed’s monetization of around half of all newly issued Federal debt (see Behind The Fed’s Benign Inflation Outlook).

Modern Monetary Theory (MMT) is the great enabler (see Reviewing The Deficit Myth, Stephanie Kelton’s book on the subject). It teaches that the only constraint on a government’s ability to borrow and spend in its own currency is inflation. Since the Federal government can always issue bonds to the Federal Reserve with its unlimited ability to create the funds to buy them, we always have a buyer of last resort. If government spending goes beyond the economy’s ability to deliver the goods and services offered, thereby driving up prices, inflation results. This is the only practical constraint on the budget deficit.

Forget about our foreign creditors’ willingness to finance our borrowing. The threat of Japan, or in recent years China, dumping US bonds and causing a recession through sharply higher rates has been periodically raised. It hasn’t happened, and likely won’t. They couldn’t sell $1TN in bonds, and if they tried the Fed would undoubtedly step in to manage the process. Ben Bernanke opened the Pandora’s Box of a greatly expanded Fed balance sheet during the 2008 Great Financial Crisis. Having discovered its power, we will steadily increase the set of circumstances that justify such largesse. The bar will be lowered, because it’s apparently costless to do so.

This is why inflation is likely, because there is no other force limiting our ability to borrow. Today’s deficit hawks have lost influence because their message doesn’t resonate. That’s because it doesn’t fit the facts. Their predictions of fiscal disaster make climate change forecasts look astute. The world is 1°C warmer than pre-industrial times if not obviously much worse for it. By contrast, record low bond yields suggest record indebtedness is harmless.

This serves to further increase the government’s perceived ability to borrow, because both the Administration and the Fed assess the current uptick in inflation to be temporary. It may be so, which will show that borrowing hasn’t yet become ruinous. Therefore, more will follow.

Inflation isn’t correctly measured anyway. Statisticians insist on ignoring the rising cost of home ownership even though two thirds of American families choose to obtain shelter that way (see Why It’s No Longer Enough To Beat Inflation). $40BN a month in MBS purchases during a very hot housing market is finally making some FOMC members uncomfortable. Boston Fed president Eric Rosengren recently said, “If you can’t get housing materials and you can’t get construction workers to come back on site, but we do increase demand for housing, then it doesn’t do much for our employment mandate—but it does increase housing prices more than it otherwise would.”

MMT has quietly become mainstream fiscal orthodoxy. Even proponent and author Stephanie Kelton advocated for a CBO-type scoring of the inflationary impact of spending plans. Instead, we are looking at a $3.5TN budget to be passed via reconciliation with no formal consideration of the possible inflationary consequences. If it doesn’t cause the economy to overheat, such budgetary largesse will become business as usual. Inflation is eventually assured.

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




Why It’s No Longer Enough To Beat Inflation

The most recent CPI report was a little better than expected – all-items less food and energy was up 4.3% year-on-year. Used car prices had boosted prior inflation figures but were up just 0.2% in July. Owners’ Equivalent Rent (OER), the statistician’s’ quixotic means of measuring what it costs to attain shelter through home ownership, rose just 0.29% in July. It’s up 2.1% over the past year, compared with the Case Shiller National Home Price index which is +16.6% through May (most recent available).

CPI is important because it’s used to make cost of living adjustments to social security and other government transfer payments. It’s part of the return on inflation—linked bonds and is often used in long-term commercial contracts to make price adjustments. But it’s becoming less relevant as target against which to grow your income. Investing is all about retaining purchasing power for the future. Most interpret this as being able to afford in ten years what you could buy today. It turns out that’s CPI is inadequate for this.

Because incomes grow faster than inflation, if your income fails to keep up with the median, you’ll be relatively poorer. Savers don’t just want to maintain today’s absolute purchasing power – they want to keep the same relative consumption as their peers. If you enjoy the median income today, growing it at CPI means falling below the median, and won’t feel like much fun. Average income has been dragged above the median by “the 1%”, or the increasing income inequality we often read about. So using the median provides a more representative figure for the typical family.

Whenever a writer quotes a price for something decades ago and converts it into “today’s dollars”, he’s using the CPI inflation rate. This understates the effective cost, because it fails to account for the fact that incomes have been rising after inflation. It doesn’t fully capture the chunk of income it cost the median household. For example, a new car in 1953 cost $1,850, which is $17,531 today after adjusting for CPI inflation.

You won’t get much new car for that today – Kelley’s Blue Book reports the average new car costs just over $40K. This is not much different than $37,511, the 1953 price adjusted by income growth. In other words, the average new car cost 44% of the median household’s income in 1953, and it’s 47% today. In relative terms, cars have kept track with incomes, not inflation. Milk and most groceries are much cheaper. Food commands less of a household budget than in the past. Color TVs are dramatically cheaper because they were only just being produced in the early 1950s.

Electronic goods such as TVs have long experienced deflation, because as their quality has improved the Bureau of Labor Statistics (BLS) converts this into a price drop. The CPI measures a basket of goods and services of constant utility, and a better TV at the same price is like a price cut. They try to adjust for the countless quality improvements that market economies deliver. The problem is that this kind of price cut doesn’t free up any cash to buy anything else. The BLS regards TVs as having fallen in price, even if the actual cost hasn’t.

Most products become better over time, and government statisticians expend much effort converting those improvements into imputed price cuts that don’t make you richer even if they add utility. It’s another example of the inflation statistics being theoretically correct and increasingly out of touch with people’s lives.

The average new home costs a little over 4X median household income, not much different than in 1953 although this is twice as much as if houses had simply risen with CPI inflation.

The Financial Times ran an article last week (see Why central bankers keep their cool over rising house prices) which found that separating out the value of shelter that home ownership provides is widely accepted by economists. The US isn’t alone in using a non-cash theoretical input for housing in its inflation statistics.

The article goes on to note that central bankers don’t worry about housing inflation because it rarely shows up in OER and its foreign equivalents. It’s a circular argument – OER is low because it’s not measuring the cash cost of home ownership, and therefore appears well behaved.

Median family incomes have always grown faster than inflation, but that gap has widened in recent years. Over the past decade, incomes grew twice as fast as inflation. This is mostly good news, because higher real incomes mean higher living standards. It’s bad news only for those whose incomes are tied to inflation since they’re slipping behind their peers at a faster rate than before.

The inflation statistics remain important for financial markets and those whose incomes are linked to it, but are steadily losing relevance for anyone who’s saving for the future.

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




Is China Worried About Global Warming?

The UN’s Intergovernmental Panel on Climate Change (IPCC) released their latest report on Monday, in preparation for COP26, the November meeting of heads of government in Glasgow to discuss how we should respond.

The report says humans have warmed the planet by 1° C since pre-industrial times, the agreed-upon benchmark. A further 0.5°C is likely on current trends within the next two decades. The New York Times, rarely short of hyperbole, misleadingly wrote, “Even if nations started sharply cutting emissions today, total global warming is likely to rise around 1.5 degrees Celsius within the next two decades, a hotter future that is now essentially locked in.” This sounds like an additional 1.5° over the next 20 years, unless you’ve read the IPCC Summary for Policymakers.

Putting aside biased news coverage, the most important question is what does China think? The IPCC’s summary presents a sober case that the world needs to begin dramatically cutting CO2 emissions from fossil fuel use with a view to reaching carbon neutrality by 2050. Only then can we be assured that the remaining capacity of the atmosphere to absorb additional CO2 will not be exhausted, with irreversible consequences.

As with most things, actions count for more than words. Even though we’re supposed to cut emissions now, China plans to keep increasing them until 2030. At that point, an improbable pledge to be carbon neutral within three decades is supposed to usher in a sharp decline. While China could perhaps do this, there’s good reason to doubt they will.

How must Chinese policymakers regard their choices? Real per capita GDP has grown at 5% pa since 1980, three times the US rate. It wouldn’t have happened without higher energy use. Yet even now, China is at less than 24% of the US level. The looming energy transition is hugely expensive and negative for growth.

Improving living standards beats climate in China. They likely deem the increased incidence of heatwaves and extreme weather as inconsequential. Although much of the western media appears almost suicidal over the planet’s future, everyday life for the typical Chinese citizen (or US for that matter) isn’t visibly impacted by the 1°C warming we have engineered so far.

While the science of human-caused warming is generally beyond question, predicting the consequences is far harder. The UN has an unfortunate track record of offering dire predictions that miss, although the science is presumably now better than ever. Chinese citizens, if they think about it, may even conclude that the current climate isn’t necessarily the best we could have.

Like many people, I spend far more time and money coping with excessive cold rather than heat. I head to Florida as soon as the daytime high in New Jersey drops below a golf-impeding 50°F. Cold weather is miserable. If human-induced Global Cooling threatened, I’d find that far more distressing — it might get me to join the Sierra Club. But a slightly warmer planet, like a slightly warmer day, doesn’t sound so bad. The Chinese probably feel the same way.

Despite the absence of any meaningful weather impact, as a matter of risk management, it seems sensible to take the science seriously. As an investor, it’s important to assess the likely outcomes.

Emerging economies are where energy use, emissions and living standards are growing fastest. Regardless of its pronouncements, China shows every sign of valuing continued growth of living standards over reduced energy use to lower CO2 emissions. Non-OECD countries emit around two thirds of global CO2, and this is growing at eight times the pace of rich countries. China and India count for 35% of the total. Although both countries regularly highlight renewable energy, they’re using more of everything, including coal. Their energy needs continue to rise.

Moreover, emerging economies want money from rich countries to finance green energy investments. $100BN per year was pledged but not delivered last year. Some are asking for far more (listen to our recent podcast, Episode 79: The Bill For The Energy Transition to hear South Africa’s Environment Minister telling citizens substantial foreign aid is needed). This receives no attention in the US media but certainly does in supplicant countries. The Biden Adminstration recognizes that US political support for the energy transition doesn’t mean voters are willing to pay for it.

High crude oil prices are a necessary step in inducing drivers to switch to electrric vehicles, but the White House continues to urge increased production from OPEC. National Security Advisor Jake Sullivan called for, “Americans to have access to affordable and reliable energy, including at the pump.” It remains the case that there are votes in appearing to push for the energy transition but fewer in executing, which is why Democrats continue to be good for the sector.

The inevitable conclusion is that climate change is occurring too slowly and with too limited impact to cause the dramatic behavioral changes called for by the IPCC. Western countries are moving aggressively to confront it, but the most likely outcome is that we’ll be stuck with the negative consequences of ever more solar panels and windmills without seeing any discernible impact on global CO2 emissions. Even though the IPCC report warns that populations in poorer countries are most vulnerable to heatwaves and rising sea levels, their energy consumption shows they deem increasing living standards to be more important.

We’re going to adapt to a modestly warmer planet, while at the same time pursuing policies that reduce CO2 emissions. Coal to natural gas switching remains a big global opportunity, and US LNG export growth remains a bright spot for the domestic energy business. But the conflicting goals of raising living standards versus lowering emissions will continue to dominate the outcome.

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




Inflation Concerns Remain

The fall in treasury yields can be misinterpreted as implying that inflation expectations are moderating. Although ten-year treasury yields have dropped 0.40% over the past three months, almost all of that has been through lower TIPs yields. Inflation expectations (nominal yields minus TIPs) have hardly budged.

Given the Fed’s outsized role in the bond market, it’s hard to discern market expectations absent their activity. They’re buying 54% of all net supply this year, and as we noted a couple of weeks ago (see Behind The Fed’s Benign Inflation Outlook) they bought 85% of net new supply in July. Over the next couple of months, reduced maturities and increased issuance combined with the Fed’s regular $80BN in monthly purchases will draw on increased purchases by others to balance the market.

Friday’s payroll report kept us on the interminable path towards tapering and an eventual cessation of Fed debt monetization. Former NY Fed president Bill Dudley was interviewed on Bloomberg and noted that restoring the Fed’s $8TN balance sheet to more normal levels will take many years.

Prior to 2008, quantitative easing via Fed buying of bonds was an unknown tool. Former Fed chair Ben Bernanke unlocked it to good effect, but the Fed’s balance sheet continued to grow for several years after the 2008-09 financial crisis. It took almost a decade for assets to start rolling off meaningfully. Covid hit within a year, and the Fed’s assets soon doubled.

It is a partial monetization of our debt, no matter how Fed chair Powell may describe it otherwise. Society’s tolerance for this is one more proof that inflation has few opponents nowadays. Monetary policy aims, “to achieve inflation moderately above 2 percent for some time” according to the FOMC’s most recent statement, and the bond buying will continue until, “substantial further progress has been made toward its maximum employment and price stability goals.”

While the Fed aims to boost inflation, fiscal policy is striving for the same. The $1TN infrastructure plan working its way through Congress will add $256BN to the deficit according to the non-partisan Congressional Budget Office, even though negotiators claimed that it would be revenue neutral.

Expect very little outcry over this, since low bond yields reflect the inconsequential cost. With fiscal hawks long gone, excessive deficit spending will continue until it causes inflation. The stock market’s brief pullback in mid-July was arrested in part because of the “Biden put” — a severe drop in economic activity would draw another multi-$TN fiscal stimulus.

Although bond yields have remained near their recent lows, eurodollar futures yields rose during the week as the odds of a tightening in short term rates by the end of next year increased.

The yield curve nonetheless remains too flat. Median FOMC projections of short-term rates as well as the most dovish forecasts both suggest a sharper rate of increase from 2023 on. The FOMC’s forecasting record is abjectly poor. But this Fed is unashamedly dovish, so FOMC forecasts that are more aggressive than the market continue to look like an opportunity to bet with the FOMC by positioning for a steeper yield curve in eurodollars 2023-25, or that the 0.55% spread between two and five year treasuries is too narrow.

In other news, the Economist magazine recently ran a piece called A 3°C world has no safe place. It presented a sober contrast between the (mostly unmet) pledges of countries to reduce CO2 emissions and the scientific modeling that predicts the consequences. Rich countries committed $100BN per year to help developing countries adapt, although even this sum has not been delivered. Even though such promised transfer payments get virtually no coverage in US media, political leaders in countries like South Africa can be found on TV telling viewers that much larger sums are needed to pay for the energy transition.

As we noted in a recent podcast (Episode 79: The Bill For The Energy Transition), South Africa believes $750BN per year is needed from OECD to emerging economies, which would work out to $250BN from the US if apportioned among rich countries based on relative GDP. This is almost 4X what we spend on Medicare and Health, or over 40% of our defense budget. It’s as well that such discussion doesn’t make it to the US, because it would at a minimum cast a pall over the Adminstration’s excited talk about green growth opportunities.

One of the most striking features of the Economist article was how slowly the climate changes. Models, which have a checkered past of making climate predictions although presumably are better today than ever, forecast dire consequences by 2100. None of the people likely to be impacted by this can read the article, while the people who must make sacrifices in the meantime to reduce emissions will have mostly died by then.

It’s why developing countries like China and India are more concerned about increased energy use to raise living standards now, and don’t share the concern of OECD countries about global warming.

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




Absurdity Abounds In The Energy Sector

Williams Companies (WMB) announced 2Q21 earnings on Monday. Results were largely in-line with expectations; Adjusted EBITDA came in at $1,317MM, $11MM ahead of forecasts reflecting the stability of their business. Their dividend is +2.5% YoY and is now expected to be 1.9X covered by Available Funds From Operations (analogous to the Distributable Cash Flow metric often used in the past by MLPs). The $1.64 dividend yields 6.6%. Under the old ~90% payout regime MLPs used to follow, WMB would yield over 11%.

6.6% is an attractive yield by any measure. Transco, WMB’s extensive pipeline network running along the eastern US, has investment grade bonds outstanding to 2050 that yield 3.06%. The equanimity with which bond investors accept equity-type risk for comparatively little is not unique to the pipeline sector. Rigid investment mandates partly explain the bifurcated market for WMB’s securities, and emphasize the continuing opportunity for equity buyers. Leverage (Net Debt:EBITDA) is expected to reach 4.2X by year-end, down from 4.35X the prior year.

The energy transition notwithstanding, natural gas volumes passing through WMB’s pipeline network showed continued healthy growth. Of particular note was the 30% jump in natural gas for export, either as Liquified Natural Gas (LNG) or via pipeline to Mexico.

WMB is planning to invest $2BN to bring an additional 1.8 Billion Cubic Feet per Day (BCF/D) of natural gas to customers, mainly in the northeast. Careful examination of the map shows that the expansion only reaches as far as NJ and Pennsylvania. Massachusetts, which could surely use more natural gas, is currently debating whether to require that new construction omit natural gas connections (see Towns Trying to Ban Natural Gas Face Resistance in Their Push for All-Electric Homes). All-electric homes don’t sell as quickly as regular ones, reflecting a market push-back against the imposition of new regulations.

Residential power supplies are already prone to outages during bad weather, so it’s understandable that the prospect of becoming fully reliant on electricity even while utilities add intermittent renewables is not appealing. Natural gas never goes down.

Meanwhile, South Africa is sensibly looking to natural gas as a way to reduce its CO2 emissions (see Coal-Reliant South Africa Is Turning to Gas Power). They estimate electricity produced using natural gas will cost 3X as much as from the coal plants that are nearing the end of their useful lives. Renewables may even be cheaper, but tellingly South Africa is willing to spend more for reliability.

In preparation for the COP26 UN meeting in Glasgow in November, environment ministers have been discussing the level of financial support OECD countries should be willing to provide to emerging economies to help them pay for the energy transition. It’s a valid debate, but not one that has yet caught the public’s imagination. South Africa’s Environment Minister recently suggested that $750BN per year would be needed in financial support from rich world countries. Assuming this burden was shared according to each OECD country’s share of OECD GDP, the US would be on the hook for about a third.

The prospect of the US paying $250BN per year to poor countries to speed their energy transition is sharply at odds with Joe Biden’s message that it was all about well-paid union jobs. There’s zero prospect that Congress would approve anything like this – but the fact that such figures are floated exposes the gulf between practical solutions and underlying political support. OECD countries have already failed to meet a $100BN pledge for 2020.

Returning to WMB, like most pipeline companies they self-funds their growth plans. Cash generated now goes to dividends and capex. Rising EBITDA reduces leverage and investors do not expect any dilutive secondaries.

This is in marked contrast to many utilities, which are spending $BNs on renewables and delivering negative Free Cash Flow (FCF) in the process. Today’s market forgives them because they’re investing in green projects. But battle-scarred US energy investors will recall the same willingness of Wall Street to overlook negative FCF during the early years of the Shale Revolution.

Germany has demonstrated that too much reliance on renewables leads to much more expensive electricity. California has managed to combine high prices with unreliability. Many of the utilities currently outspending their cash flow may find that expensive intermittency isn’t highly valued if they go too far, at which point the years of negative FCF will not look so smart.

Banning new natural gas hookups, outspending cash flow to build renewables and poor countries demanding GDP-sized payments to help reduce emissions; the energy sector is witnessing much that is absurd. Fortunately, natural gas pipeline transmission continues to grow reliably.

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




Pipelines Still Linked With Inflation

The link with crude oil is a familiar topic for investors in pipelines, who have often been told that the two are uncorrelated only to experience both inconveniently plunging together.

Since the Covid bottom in March, crude oil and midstream energy infrastructure have conveniently tracked each other higher – until the last several weeks during which the sector has slid while crude oil has held its gains. Visually, the last 16 months looks as if the two are closely linked. But the correlation of daily returns over that period is surprisingly low at only 0.28.

Episodes such as April 2020, when the two diverged sharply as crude went briefly negative, have an outsized impact on this statistic. As we’ve also noted, 2020 operating performance for most big pipeline companies came in within a few % of pre-Covid operating performance. It remains the case that stock prices move far more with oil than cash flows.

One reason for the relative weakness in midstream recently has been the drop in bond yields. The rise in inflation expectations increased interest in businesses with pricing power, and many pipelines have agreements that link price hikes to PPI. The ability to increase prices with inflation used to be an attractive feature years ago when MLPs were bought for their stable yields.

The volatility ushered in by the Shale Revolution took focus elsewhere, but this feature of contracts has remained and will likely become more important in the years ahead. In research last month (see Market Underprices Rate Hike Risks), Wells Fargo calculated that 60% of midstream EBITDA was exposed to inflation escalators, and with a 5.5% 2021 PPI estimate they calculated a 3% lift to sector EBITDA.

The recent moderation in inflation fears reflected in lower bond yields has similarly depressed the pipeline sector. This is likely to be temporary. As we noted last week, Fed bond buying took up almost all available net new supply in July (see Behind The Fed’s Benign Inflation Outlook). Inflation concerns are everywhere, with both fiscal and monetary policy being managed without regard to rising prices. The government will get what it wants, and the coincident drop in bond yields and pipelines serves to confirm the latter’s use as protection against inflation.

On a different topic, the International Energy Agency (IEA) recently issued a report on global electricity demand growth. It’s easy to conclude that renewables will soon be providing the majority of our power based on today’s popular press. The IEA noted that global electricity demand is increasing faster than renewables-supplied power. Since the power sector is renewables’ most important target, inability to even match demand growth reveals how unrealistic it is to think windmills and solar panels are going to fully solve the problem of climate change.

Moreover, because the growth in global electricity demand is centered in emerging Asia where coal use is high, this dirtiest form of energy is benefitting from strong demand. China represents half the worlds’s growth in power demand. Even last year they saw healthy growth, contrasting with widespread reductions due to Covid.

40% of this year’s growth in electricity demand will be provided by coal. China’s refusal to agree to a G20 communique phasing out coal is easily understood when considered alongside these figures from the IEA.

Even though coal continues to retain its outsized share of world electricity production, the opportunity for natural gas to offer a meaningful alternative remains immense.

Tellurian CEO Charif Souki mentioned this in a recent video. Confirming the positive long term outlook for natural gas, Shell became the third company to sign up with Tellurian to purchase 3 million tons per annum of natural gas.

The American Energy Independence Index (AEITR) includes North America’s biggest pipeline companies. We believe the sector offers solid inflation protection as well as continued upside from growing global demand for US natural gas.

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

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

Energy Mutual Fund

Energy ETF

Inflation Fund