Inflation is probably the biggest known risk facing equity markets today. Last week’s CPI report was expected to be high and still exceeded expectations. The 4.2% year-on-year increase in the All Urban Consumers index (CPI-U) was boosted by comparisons with a year ago. The Fed, and many economists, have warned of the transitory base effects as weak readings from the start of lockdowns drop out. The CPI-U less food and energy is running at 3% p.a., although as is often pointed out eating and driving are not optional even if their costs are volatile. Most striking was the 0.9% monthly jump in CPI-U ex food and energy. Used cars and trucks were up 10% and contributed a third.

The Fed expects inflation to temporarily increase before supply constraints ease, moderating price hikes. Investors aren’t so sure, given the Fed’s stated willingness to tolerate higher inflation until they’re sure we’ve reached full employment. Under such circumstances, the term structure of interest rates should reflect a premium above the Fed’s guidance. The FOMC projects an unchanged policy rate through at least 2023, whereas eurodollar futures are priced for tightening at the start of 2023 and 0.75% by year’s end.

We’ve noted before the FOMC’s poor forecasting record, even of their own policy rate (see Bond Market Looks Past Fed). Markets are skeptical about the Fed’s resolve to maintain expansionary policies in the face of rising inflation. It’s analogous to when a central bank defends a currency peg. Credibility counts for much, and the 0.75% gap between market rates and FOMC projections measures the degree of investors’ disbelief.

Price hikes are visible everywhere. Many corporations report price pressures. Warren Buffett noted that suppliers were increasing costs to them which were being passed on and accepted by customers of Berkshire’s many operating businesses. Hiring is hard. The non-farm payroll report fell well short of the one million jobs expected, but rising hourly earnings suggest more labor tightness than the 6.1%  unemployment rate implies. There’s reason to suspect that job growth was constrained by insufficient availability of qualified people.

Criticizing the Fed is a time-honored self-indulgence but not very profitable. More useful is to figure out how to act on it. Partial debt monetization synchronized with excessive fiscal stimulus is so obviously designed to cause inflation that investors should align themselves with the government’s actions, not their benign inflation forecast.

Total Federal debt is $28TN. Its cost of financing will increasingly drive America’s fiscal outlook. Many will be surprised to learn that the Congressional Budget Office (CBO) expects net interest expense as a % of GDP to fall over the next few years – a consequence of higher yielding securities maturing and being replaced. The average rate on government debt will fall from 2.1% last year to 1.2% in 2023 before climbing back up to 2.2% by 2030.

Fiscal conservatives will identify much of concern in this. Ten-year market-based inflation expectations are above 2.5%, a level the CBO doesn’t expect even in a single year. In March the CBO forecast the ten-year treasury will average 1.1% this year, whereas it’s already averaged 1.4% over the first four months or so.

Moreover, the CBO forecasts that the Federal government’s real cost of debt, defined here as the average rate less CPI-U inflation, is about to go negative and remain there for the next decade. U.S. Debt:GDP is forecast to reach 107% by 2031, the highest in the nation’s history. Is it reasonable to expect that the U.S. will borrow at negative real rates with such a fiscal outlook?

As sobering as these charts are, the MMT crowd (see Modern Monetary Theory Goes Mainstream) will press to exploit the underutilized borrowing capacity negative real rates imply.

This is why the Fed’s continued bond buying is poorly advised. The risks to America’s fiscal outlook are skewed in one direction. It’s likely that the CBO’s projection of negative borrowing costs for the next decade will require continued growth in the Fed’s balance sheet. The Fed may be right that inflation will return to 2% next year, but they face asymmetric risks.

Prudent management should have prompted them to dial back as soon as it became clear that the stimulus checks were being distributed coincident with the vaccine. They should have withdrawn when there was no political pressure to continue. If fiscal profligacy drives rates higher, MMT proponents (i.e. progressive Democrats) in Congress will be quick to pressure the Fed back in.

But the Fed didn’t — and America’s fiscal outlook increasingly relies on negative real rates to fund its debt, which means higher inflation, more debt monetization, or both. As Washington pursues additional spending on infrastructure and welfare, further increases in borrowing are the path of least resistance.

Markets are adjusting to the new normal. Pipelines are cheap and may be one of the few sectors to offer inflation protection.

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

The media is not short of simple solutions for climate change. Solar panels and windmills have been cheaper than natural gas for so long in the popular narrative that you’d think utilities are willfully pursuing lower profits by not blanketing the country with them. The industry that provides over 80% of our energy is often demonized by extremists who drive to protest pipelines.

There are some whose concern is more thoughtful. Bill Gates recently laid out the many economic and technological challenges to reducing Global Greenhouse Gases (GHGs), and avoided the politics which is bigger than the other two (see Not Just Another Billionaire With A Plan). Recently Mike Cembalest, Chairman of Market and Investment Strategy at JPMorgan Asset Management, published Future Shock: Our 11^th Annual Energy Paper. As in the past, Cembalest partnered with Vaclav Smil, author of numerous excellent books on energy stuffed with facts and figures.

The sober analyses by Gates and Cembalest are much more useful than shrill soundbites from the Sierra Club. Cembalest notes that, “Absent decarbonization shock treatment, humans will be wedded to petroleum and other fossil fuels for longer than they would like.” Gates (albeit unintentionally) and Cembalest are bullish about the long term future of oil and gas, a point not lost at JPMorgan which remains overweight energy stocks.

Right on cue, 1Q21 pipeline earnings reaffirmed the continued growth in free cash flow and stability of the sector. Williams Companies (WMB) beat expected EBITDA by 7%, and raised its full year guidance by 2%. Its stock yields 6.5% and its payout is covered almost 2X by distributable cash flow. Enterprise Products Partners (EPD) beat estimates by 14%. It yields 7.7%, 1.7X covered. Cheniere Energy (LNG) beat estimates by 43% and raised full year guidance by a conservative 5%. Energy Transfer (ET) enjoyed a one-time gain of $2.4 BN from the Texas power outages, beating EBITDA expectations by 88%. This helped them reduce debt by $3.5BN.

The energy transition is slow, for all the reasons regularly cited in this blog. Mike Cembalest provides further insight. Decarbonizing the transportation sector by switching to Electric Vehicles (EVs) is a goal in most developed countries. Its apparent imminence has damaged many reputations for forecasting acuity. Norway is a special case with 62% penetration of EVs in light vehicle sales. Taxes and subsidies heavily favor EVs; Norway’s electricity (97% hydropower) is 40-70% the cost of their European neighbors, and if Norwegians only bought EVs their subsidies would be the second biggest government expenditure.

U.S. EV penetration is low at 2%. Americans drive farther, enjoy cheaper gasoline and use less public transport than other countries. and trucks/SUVs are 75% of light vehicle sales. All the Tesla owners I know love them, but my small group of friends isn’t representative. Comparing the EV with its equivalent internal combustion engine counterpart (i.e. Ford F150 with the F150EV etc) shows EVs to be almost twice as expensive.

The energy transition comes with a substantial increase in power consumption, which is intended to be supplied with solar and wind. Sunny and windy places are often not where electricity consumers live – on top of which solar and windmill farms require substantially more land than conventional power plants. A report last year from Princeton University estimated that U.S. annual transmission investment would need to triple over the next three decades.

Massachusetts is trying to import hydropower from Quebec, but it first has to travel through New Hampshire where environmentalists recently persuaded authorities to deny construction of the necessary transmission lines. In Russell Gold’s Superpower (see our review here), he chronicled the challenges faced by Clean Line in getting windpower from Oklahoma to Tennessee. The book ended with the assets being sold to NextEra Energy, and after continued delays and expensive court battles the project was abandoned.

Widespread battery storage is a critical supplement to the intermittency of solar and wind, where 20-30% capacity utilization is common versus 85% for natural gas power plants. Batteries are getting cheaper to be sure, but Mike Cembalest illustrates the daunting economics by comparing the cost of building an oil storage tank ($15-$18 per barrel of capacity) with the $510,000 cost of a Tesla Megapack holding the same 17 kWh of energy.

The stark truth is that combating climate change will require enormous public investments, substantially higher energy prices and altered daily lives for many. This shouldn’t be surprising – if it was easy we’d have done it already. The biggest failure of climate extremists has been to misunderstand the cost and to avoid talking about it. It’s why Joe Biden promises well-paying green jobs. Higher electricity prices and Federal eminent domain to build inter-state transmission networks isn’t so appealing.

Climate Czar John Kerry’s discussions with China acknowledge where much of the future growth in GHGs will come from. The 2001 entry of China into the World Trade Organization brought enormous access to cheap goods as production of what the west consumes moved east. Today, China’s industrial sector uses more energy than America’s and Europe’s combined. More than half comes from coal.

Gates and Cembalest are both deeply concerned about climate change. Their work on the subject examines the substantial changes required for the world to reach its stated goals on reduced GHGs and global warming. Few who care about the issue seek to build public support for the costs involved, which is why progress is slow.

Our conclusion from reading both is that the world will be reliant on fossil fuels for many decades to come. Migrating away from coal to natural gas remains well within reach, and has led to most of America’s reduction in emissions. The pipeline sector isn’t just recovering from the Covid collapse of last year, but is beginning to reflect a more realistic outlook.

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

ESG is in the eye of the beholder. There are multiple lists of stocks that score well on Environmental, Social and Governance metrics. My favorite is Lockheed Martin (LMT), a perennial member of the Dow Jones Sustainability Index. If building weapons to blow up people and property can be done in a sustainable way, then ESG is a generous mistress (see Pipeline Buybacks and ESG Flexibility).

There are currently 138 ESG ETFs traded on U.S. markets, with almost $90BN in AUM. The most important thing about ESG investing is that it’s growing faster than the market. A cynic might regard the rush by CEOs to demonstrate ESG-ness as driven by asset flows rather than altruism. ESG-driven investors can note with satisfaction the market-beating performance of such funds. The largest ESG ETF is the iShares ESG Aware MSCI USA ETF (ESGU), with $15BN in AUM.

The pipeline sector offers 7% yields, growing free cash flow and strong recent performance. It has been out of favor more often than not in recent years, but Joe Biden’s arrival at the White House has ushered in rising energy prices with less growth spending (see Is Biden Bullish For Pipelines?). Investors are warming to policies that encourage parsimonious funding of new projects, something that eluded them during Donald Trump’s presidency.

Some may avoid pipelines because of historic volatility, although operating performance last year was scarcely affected by Covid. The energy transition deters others, although a pragmatic desire not to wreck the economy means natural gas retains its bright future as part of the solution to reducing emissions. A third cohort thinks fossil fuel companies are bad, even though it’s how the world has reached today’s living standards. There’s a belief that the energy sector has much to apologize for.

It may surprise this last group to learn that ESGU has a 2.5% weighting to energy, virtually indistinguishable from the S&P500’s 2.6%. ESGU holds Kinder Morgan (KMI), Cheniere (LNG), Oneok (OKE), Targa Resources (TRGP) and Williams Companies (WMB), all components of the American Energy Independence Index. Relative to the S&P500 it has modest overweights in Chevron (CVX) and Exxon Mobil (XOM). It also overweights Nextera Energy (NEE), one of the largest producers of electricity from natural gas.

ESGU has some interesting underweights, including Alphabet (GOOG) and Microsoft (MSFT) both companies with plenty to say about their ESG credentials. Clearly ESG-ness isn’t a binary issue, or Facebook’s dual share class would knock them out on the Governance scale. Instead, it trims them to 1.81% in ESGU versus 2.06% in the S&P500. Berkshire Hathaway (BRK) is ESGU’s biggest underweight, at 0.84% versus 1.47%. Those omitted from ESGU are an eclectic bunch, including Tyson Foods (TSN) and Boston Scientific (BSX). The complete absence of airlines in ESGU fueled some of its outperformance. Covid crushed the sector rather than any ESG shortcomings.

These differences are trivial, which means ESGU looks a lot like the S&P500 and tracks it closely. For the past couple of years, their daily returns are 0.99 correlated, and ESGU has outperformed by 2.1% p.a. It’s unlikely that ESG-run companies offer better long-term performance than the market. More likely is that investors just want to own them a little more, which is boosting their stock returns.

Index providers continue to compete to be the market standard for ESG-ness. Current standards vary. Since probably every member of the S&P500 has ESG slides in its investor presentation, it’s hard to avoid virtue-claiming companies.

If ESG doesn’t impact operating results, then eventually ESG funds will underperform the market because buyers will have overpaid. But for now, metrics from the past two years tempt the virtue-signaling investor – good odds of roughly tracking the market, some chance to beat it and the claim to morally higher ground than one’s peers.

The substantial overlap between ESGU and the S&P500 simplifies the choice facing an ESG-motivated investor. ESGU’s portfolio signifies approval of almost the entire S&P500. There’s no discernible difference in virtue between an investor in ESGU or the S&P500 itself. What ESGU does offer is a small bet on continued flows into ESG funds.

ESGU’s energy holdings represent an endorsement. An investor hesitating to take advantage of the high yields and growing free cash flow of pipelines because of a misplaced concern that her liberal friends may frown can point to ESGU for absolution.

Energy, and pipeline companies specifically, sit at market weight or better in many of the biggest ESG funds. They should – coal to natural gas switching in the U.S. has done more than renewables to lower emissions over the past decade. U.S. exports of liquified natural gas offer other countries the opportunity to emulate our success. Pipelines are ESG.

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

Last week Kinder Morgan (KMI) reported earnings, which included around $1BN in one-time gains from the Texas power outages in February. Natural gas prices increased briefly by more than 100X. KMI had natural gas available, so profited from selling it to power companies who had commitments to meet. Energy Transfer (ET) is expected to report a large gain for the same reason when they report. Oneok is another candidate. This is part of the optionality that the pipeline business offers.

They also announced a modest dividend increase. The Alerian MLP ETF (AMLP) has cut distributions in half since 2015. Corporations cut by less, and KMI’s 3% hike is another small confirmation that the sector’s dividend cuts are in the past.

If global warming is already causing extreme weather events such as February’s cold snap, then not all the financial outcomes will be negative. KMI and ET may be the first examples of the profits that can be made from weather uncertainty.

Enterprise Products Partners (EPD) benefited last year when propane demand rose sharply. This was the result of a drop in Indian refinery production of gasoline, from which propane is often derived. Once again, a large footprint in the business provides flexibility to exploit market opportunities.

The energy transition offers commercial opportunities, although profiting from weather uncertainty isn’t a reliable business model. As the U.S. Administration increasingly engages more with foreign governments on climate change, the pursuit of practical solutions offers many more opportunities than simply building windmills and solar panels everywhere.

Phasing out coal globally is the biggest. China, the world’s biggest emitter of global green house gases (GHGs), announced that it plans to reduce coal share of power generation to 56% this year – an enormous figure whose only positive attribute is that it’s falling. They still plan to add coal power plants “moderately and rationally.”

An interesting paper was posted on China’s National Energy Administration (NEA) website, authored by their Director. It links the energy transition with energy security, offering a useful perspective on how Chinese policy may evolve. Renewables may be more attractive to China than most countries, because several of the rare earth minerals required are relatively abundant in China (see Some Surprising Facts About Energy). In this way, renewables can improve China’s energy security.

The U.S., which produces enough oil and gas to satisfy domestic demand, faces a loss of energy security in growing its renewables portfolio, a choice that Chinese planners must find mystifying.  China also produces around 93% of the coal it consumes. The NEA paper makes it clear why this is likely to remain a significant source of Chinese power generation for the foreseeable future.

Nextera Energy is well known for its large portfolio of windmills for power generation. But they’re also one of the largest generators of electricity from natural gas in the U.S. They’ve been upgrading some of their power plants to be more efficient and reduce emissions. They’re finding that the reliability of natural gas counters the intermittency of renewables.

President Biden last week hosted a virtual Leaders Summit on Climate. Hs remarks touched on many opportunities to reduce emissions including carbon capture (see Capturing More CO2). KMI operates the biggest CO2 pipeline network in North America, and Section 45Q tax credits are set to reach $50 per ton for CO2 permanently sequestered underground.

Coal is set to gain market share from natural gas over the next couple of years, reversing the main source of U.S. GHG reductions of the past decade (see Emissions To Rise Under Democrats). On current trends the Biden administration will claim many successes but will not be able to show any actual reduction in emissions. Targeting coal power plants remains one of the opportunities to show near term results.

Just about every pipeline company has plans to participate in the energy transition. Coal-to-gas switching, capturing CO2 and perhaps even using hydrogen are among the initiatives being considered. Yields of 7% remain too high given the stability and outlook these businesses offer.

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

“Coiled, ready to go.” is how JPMorgan CEO Jamie Dimon described consumers last week. “Consumers have $2 trillion in more cash in their checking accounts than they had before Covid.” he added. Borrowers are in such good shape that JPMorgan reported a 4% drop in loans when they released their quarterly earnings. Stimulus cash is being directed towards debt repayment.

The inflationary result of a consumer spending boom and low interest rates is the biggest uncertainty confronting investors. There’s plenty to worry about. Federal debt:GDP is set to exceed the levels that followed World War II. The level of Covid stimulus is several multiples of the estimated loss in output. Larry Summers, who headed the National Economic Council under Obama and was Clinton’s Treasury Secretary, has called it “substantially excessive,” and in case his views weren’t clear added that fiscal policy is the “least responsible” in 40 years.

Rising inflation shouldn’t catch anyone by surprise – and sure enough March CPI jumped 0.6%, 2.6% year-on-year. Ex-food and energy it was only 1.6%. Will this be sustained, and at what point will the Fed feel compelled to react?

The base effect – a depressed March 2020 CPI because of the sharp economic contraction – means annual comparisons will look high for several months. This will not trouble the Fed. Prices for all kinds of commodities are rising – hot rolled steel has tripled in a year, and while this reflects a rebound from severely depressed prices, it’s also more than doubled compared with two years ago. Copper, lumber and carboard tell similar stories.

March Retail Sales jumped 9.8%, boosted by spending at bars and restaurants as restrictions are being eased.

Moreover, many small businesses report trouble hiring people, in part because the recent $1.9TN Covid relief plan continues $300 per week Federal unemployment benefit on top of whatever the state pays.

Although signs of pricing tightness are everywhere, a review of Fed chair Jay Powell’s comments on inflation show numerous reasons to ignore them. Year-on-year comparisons simply reflect a rebound from sharply depressed levels. Tight commodity prices are a function of supply challenges that are being erased as people return to work. Consumers’ spending power will boost demand for a few months before dissipating.

Moreover, the Fed will never react to housing inflation, because house prices don’t figure in CPI, or the Personal Consumption Expenditures (PCE) index, their preferred measure. Owners Equivalent Rent (OER), the survey of what homeowners think they could rent their house for, doesn’t track house prices and doesn’t reflect any actual transactions (see Why You Can’t Trust Reported Inflation Numbers). So it’s a meaningless index, and because of the weight OER occupies it artificially depresses CPI by 2% and the PCE index by 1%.

Finally, although the unemployment rate is 6%, it was 3.5% in February 2020 with no discernible impact on inflation. Given the Fed’s focus on ensuring maximum employment, they’re unlikely to raise rates before unemployment drops at least that far again, unless there are clear signs of wage pressure. Any tapering of bond buying is likely to await actual evidence of inflation. This is a subtle but important shift – the Fed isn’t going to act based on a forecast of inflation. They plan to be late.

Financial advisors have few tools with which to protect against rising inflation. Shorting bonds is inefficient because of the large amounts needed to create much protection, and few are licensed to use interest rate futures for clients. Stated inflation is also likely to lag the actual inflation experienced by most people, due to the flawed use of OER noted above.

Not surprisingly, since this is a blog focused on the energy sector, pipelines are one of the few sectors that offer meaningful protection. Dividends are stable, yielding 7%. Announced buybacks across the sector add up to a further 2% return. A drop in yields to 6% would add another 14% in appreciation, so a one year return of 20% or more (7+2+14) is plausible.

In addition, pipelines have tracked the ten year treasury yield reliably this year, with both rising together during 1Q21 and both moving sideways more recently. And if the Fed moves too slowly once inflation finally appears, the commodity sensitivity embedded in midstream energy infrastructure should provide additional upside.

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