The biggest question for long term investors is why bond yields remain so low. The Equity Risk Premium (see Stocks Are Still A Better Bet Than Bonds) has favored equities for most of the time since the 2008 financial crisis. Inflation expectations remain well-anchored and are noticeably lower than a year ago. Investors don’t expect it will even rise to the Fed’s 2% target within the next three decades, despite the Fed’s professed objective to overshoot this.

Should inflation, and therefore interest rates, move surprisingly higher, a key support for the bull market would be knocked away.

.avia-image-container.av-1bre2l5-926e5055344e0b1cde01f488b70acd63 img.avia_image{ box-shadow:none; } .avia-image-container.av-1bre2l5-926e5055344e0b1cde01f488b70acd63 .av-image-caption-overlay-center{ color:#ffffff; }

Betting on higher inflation, or even worrying about it, has been a wasted effort for as long as any of us can remember. My own career began in 1980, around the time inflation peaked. Bond yields have been falling ever since. Jim Grant’s Interest Rate Observer has been warning of resurgent inflation for this entire period. That he retains so many subscribers shows how erudite prose beats accurate forecasts.

The most likely outcome remains low inflation. However, it’s safe to say that few investors are prepared for a surprise. Should it happen, the resulting market response is likely to be traumatic.

.avia-image-container.av-1g2fcih-1414604053d7fdbae99dd3de995be324 img.avia_image{ box-shadow:none; } .avia-image-container.av-1g2fcih-1414604053d7fdbae99dd3de995be324 .av-image-caption-overlay-center{ color:#ffffff; }

There are reasons to worry. M2 is rising faster than at any time in the past 50 years, exceeding even the inflationary late 70’s and early 80’s. The link between money supply and inflation appears to have broken, and any analysis of current conditions must consider that Covid has affected everything. Nonetheless, 24% year-on-year growth means something.

The Federal deficit, invariably nowadays the subject of hand–wringing but inaction, is forecast to be $3.3TN this year, at 16% of GDP the highest since 1945. The Congressional Budget Office expects total debt outstanding to reach 109% of GDP by 2030, exceeding the 1945 peak at the end of World War II. Unlike then, it is expected to remain at elevated levels.

.avia-image-container.av-lafnq1-8b0be4ab1da7e333d0bae38d5aa55f26 img.avia_image{ box-shadow:none; } .avia-image-container.av-lafnq1-8b0be4ab1da7e333d0bae38d5aa55f26 .av-image-caption-overlay-center{ color:#ffffff; }

Fiscal discipline has gone because there are few votes to be had in it. Past and present fiscal profligacy has caused little visible damage, as measured by the bond market. The burden of proof increasingly lies with the advocates of prudence.

Believers in Modern Monetary Theory (MMT) should be pleased. MMT holds that countries with a fiat currency, the prevailing global standard nowadays, can never go bankrupt. This is because the government can always issue itself money to pay any bill. Therefore, deficits don’t matter, as explained by Stephanie Kelton in The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy (you can read our review here). Or at least, deficits don’t matter until excessive government spending leads the economy to exceed its productive capacity, which is inflationary.

MMT remains at the fringes of political discourse, embraced by the same progressive Democrats who love the Green New Deal (see The Bovine Green Dream). It’s not conventional economic policy.

And yet, the deficit trend suggests that we are embarking on a great MMT experiment. $1TN is now a round lot for stimulus spending, rebuilding our creaking infrastructure, forgiving student debt or combating climate change. Proposing less betrays a lack of urgency. Derisively low bond yields deny fiscal conservatives their most potent weapon. MMT advocates must retain a disciplined silence, in case the rest of us comprehend that we are unwittingly doing their bidding.

Years of costless Federal profligacy have caused voters to become so disinterested in budget discipline that inflation is the only remaining constraint. We will continue testing the limits until we get a different result. MMT has become our fiscal policy. Higher inflation is assured, eventually. We don’t know when, but until then fiscal hawks will remain defenseless, disarmed of empirical arguments.

Therefore, every investor needs to consider how their portfolio will cope with higher inflation.  Though the timing of such is unclear, it is inevitable. Gold and Bitcoin suggest that some see warning signs ahead.

The point of investing is to preserve purchasing power. For years, simply earning positive returns was almost sufficient. Companies with pricing power offer some protection. If inflation is 5%, Coca-Cola will pass that through to customers, like so many companies with a strong brand and barriers to entry.

Real assets are another good choice. The rising cost of pipeline inputs (steel, concrete, labor) will increase the value of what’s already built. The next few years will in any case see few new pipelines. President Biden and relentless legal challenges from environmental extremists will add value to existing assets that have become hard to replicate.

This is why planned spending on new pipelines is continuing its downtrend. Investors are welcoming the resulting boost to free cash flow, which has spurred a series of buyback announcements (see Pipeline Buybacks To Shift Fund Flows).

Oil is a global commodity whose recent price rise is partly to compensate for a weakening US dollar. Natural gas is similar, although relatively high transportation costs allow greater regional price disparities. And much of the North American pipeline network operates with tariffs that include inflation adjustments.

Inflation remains dormant, but America is probing for the conditions which will change that. MMT proponents are getting their wish. Pipelines offer protection for every portfolio.

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

.flex_column.av-jjrmf7ps-c67a8c8c03a15c49af60226d5c45e3c8{ border-radius:4px 4px 4px 4px; padding:10px 10px 10px 20px; background:url(https://sl-advisors.com/wp-content/uploads/2018/07/HOME-BGBANNER-hero.jpg) 0% 0% no-repeat scroll ; }

#top .hr.hr-invisible.av-jjkejdzy-45d69def6fcd4634d81723d4107c2a5c{ height:50px; }

#top .av-special-heading.av-invvzk-d00c8e18aac6fd8649fdb65c6504194d{ padding-bottom:10px; } body .av-special-heading.av-invvzk-d00c8e18aac6fd8649fdb65c6504194d .av-special-heading-tag .heading-char{ font-size:25px; } .av-special-heading.av-invvzk-d00c8e18aac6fd8649fdb65c6504194d .av-subheading{ font-size:10px; }

.flex_column.av-gfk55z-cfa40890899002d120ab9817fb5108db{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1nx1oi8-b8d9ed4742fd52f42325ec000eb96214{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-kltcg-2f01ec30835c8acfc74b2fa0a5186148{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1m3dkhc-298a495128037194497e80bda1ae9e36{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1tbskhc-cf3d071178d927d5372ae2396cafb1e4{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1m70b9s-7a6e0c0db3d7d351435c3430298f788b{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1txelqo-273b75cce2c3e5242998ddb200c6bb80{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1qtj968-dfc0aa456919280123e9a25aa575f961{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1rg7vbk-95e6110de8987d49cdc1abd7f6551dce{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1jglcz4-06e931b62d3543f8189d9aee55cd3c3e{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1lx4imo-e790dbd8a5ba9edf31224196060f46d6{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1fpboc0-5e1fcd2bb8d0f865dc26055df0e2b6a6{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1o63gwg-a7fc6c10d1ccba204eaaa84f29084c80{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1s4zi34-00203e1eba3190c9c4f8361922ffcd1f{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1tip73k-c58e383e8024eb6ad8b95dc78e6191b6{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1ttjab4-e08fea9e0f9358536dbe8fc19f44dd10{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1jdsmfk-90a9106b68aa3f0873345286312e35fd{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-60yknk-27d740842d27acf39382b6eaba0243d9{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1tgwwa8-dd1c84d2b07d471ec9a51ecc847e3a46{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1pyikk0-1e129a6003487b7dcfcd1f71b1bbd3cd{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1k2mecw-d0f96672c5ce56899f2a6718b1b9d32c{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1oqtcr4-ff24d3b487efbb9c18f67500862efa4d{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1jcjm28-1937c84a7363b96ca4fc2a0b8768ef07{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1peiemo-db7c2c452efd7370cbc8bd90b59df517{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-6jpq7k-03e8129146cebd404e21cf0b398a64ec{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1kqz100-1a2be29abfc9e0cac3ca77782162a416{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1nd7y28-33ba5f1f53103579d5bfe4c6b49e84ab{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1tdzvf4-5cc4606dc83f0527376b632d557c87b6{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1u00wsw-fbbb0e15a7c421e553d19afecceab272{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1ix8rtc-0ec04eaf71235e8c80cf061b44a2cf67{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1qegzkg-5b2b257faee7d47d6e1fe267a81b332d{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1r9lyi8-5ef918d3573606f9d3949b4acf7f2f89{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1l19trk-e497991d552cca7a42c208776ce5cae0{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1wgk2gg-b708cbccdd0ab37d0ca3f5811cdebebb{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1qdp4hc-0ac0919b9187814995fbcb1f46fa5c0d{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1k29je8-4638faed86f7dd299d4fe861f3ec7538{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1jfn2eo-c910d10560000b157bf0902ff73e26bf{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1u0574g-cbd1e2b0f87a205fdd1ca6c665375fe4{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1g4zdjk-61d32c7ca44fffd16903ebb9bbfe6295{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1fx061c-f188f0278833e960be7720bb866ae3c3{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1q77hzk-27d535d89dd402d41a9dabe7d57f1000{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1kx5xow-4fc01b4b2b030eb4c07727e4ba5ebcc3{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1pxbpcg-45dde2d9c009f14a709977488de29d27{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-5qnrw0-c4d6c5d394dbd76ad4936e4e2ebd6ec5{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-5m960g-e3d82377d6c7e0cbdd3ef6bea20ee810{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1m3jzyo-a0450076bb5a2d253594af156a7e4f01{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1nxgomo-6315b4a24e3d6f371149aa4d6dd982e1{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1lzg3w0-f27401f236c660b63600b6d039b44580{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1fbg9xs-896c85f87af56186830f12844c48e77a{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1n736j4-2169b8c777fd46df57417f675c811725{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-1mj19ow-9bd43b3cac5be3d24cb805e8b978fe5a{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-6etz1s-ec66caa59d3c446776e9de2183a77de3{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-101-9170da25a4f50295e9396a5a59f4fb29{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-98-625e505fb05e0037701fa257417eeb93{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-95-55ea39678b95b8d14a289c1ed9377b90{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-92-23cc62e706b9726e917d660263225730{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-89-13b37e2b8e67954616ceaa5e0c91c63b{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-86-378616137eb1d0a469a7ebde5b940738{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-83-4fe72035a5e1075e80bcc2cb376f8af4{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-80-f6850ca07ed8fe12008e6f8dbc1e9030{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-77-7c878b68b9f1f085c7751f7561f3d92c{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-74-a8c2868faf0554f7734ba44eaa5b0fef{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-71-c6373bd57bfff63a293965edfc0c31f6{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-68-95bf2d5767f470e54b408c2a3f73ec45{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-65-f465e0f5b5f676be7079808a5bac6748{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-62-ea023e8868889113f0a755a294d4c268{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-59-32c4db566b004cdf6bb2ee2ed095ab26{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-56-7cf081404ff19f8200327a651f7f808b{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-53-b481727e38a2f876434a1eb7abe136a8{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-50-7a828eb72ae7760e4886965aa2b4820f{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-47-0861fec6dd6dbab6250fc05e59abbbb0{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-44-3fd71d819bce0e0695ce8abfd1fa81a0{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-41-5e4968d9aae05f827ae9cfaa159260d8{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-38-b1b9e0bdb0e46c10edd1e95d0c32fb32{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-35-328e47a33436a78b7a651cb547efb1f2{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-32-1fd98619dae0c6dc10943e80366e4089{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-29-2e144d6349f7c9ef03f2c64f3f5fc0e2{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-26-8789455dd07c9e2a8dd195e7d5650002{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-23-1a5d3160eec895dbc338bb9f84ac717d{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-21-4af05941b912ccadf4dbeff3fabcec3a{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-18-9799ea1d6084affa127bb0d6f8ccd9cc{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-15-a1061c443f40bccf4edb140962a9dfad{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-12-f4b860746b3e50492a7bda42c4267043{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-9-466233a3ec3c6b99d3dd6e1470f1900f{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

.flex_column.av-gfk55z-6-f83cf3b4b191bddea1af6649a2221161{ border-radius:0px 0px 0px 0px; padding:0px 0px 0px 0px; }

In a single week in mid-November, from 15^th to 22^nd, $317MM flowed out of MLP mutual funds. It was an extraordinary exit over such a short period, second only in recent history to the first week of December 2015, when $340MM bolted. That was a time when every seller was motivated while buyers were scarce. Within two months the sector bottomed and began the glorious 2016 rally.

Nonetheless, the collective mutual fund exit in mid-November represented fully 1.5% of the $20BN in such funds.  In its way it was a run on the bank, punctuated by the apparent absence of a crisis anywhere else. Over that same time period, the S&P500 rose 0.7%, the S&P Energy Sector ETF (XLE) rose 0.5% and the Oil Services ETF (OIH) rose 1.5%. MLPs underperformed all of these, as they usually did in November, dropping 0.2%. For the month as a whole, redemptions totaled $473MM, more than 2% of the assets held by MLP mutual funds.

Earnings season had passed. Big fundamental news was sparse. Oil jumped from $55.50 to $58 on hopes of an extension to OPEC’s production cuts, further confusing MLP investors who learned to fear oil’s moves when it was falling and find the recent rally especially galling. Most notable that week was the announcement by Norway’s $1TN sovereign wealth fund of plans to divest from oil and gas stocks by the end of 2018 – a wholly sensible idea given the source of their wealth is natural gas. Most parts of the energy sector rose in the days following this announcement, whereas MLPs reacted as if Norway’s entire divestiture was going to fall on them. For this and other reasons, 1.5% of the capital in MLP mutual funds saw enough to exit. Oil and energy stocks were higher but MLPs weren’t, challenging equity analysts to explain the inexplicable. Understanding the 2017 performance of energy infrastructure stocks so clearly lies with the investors, not the operating companies.

Some investors are selling to create tax losses with which to offset gains elsewhere in their portfolios – it’s been a good year if you’ve had any kind of diversification away from energy. The progress through Congress of tax reform has created some uncertainty. With little sensitivity to PTSD-suffering MLP investors, Bloomberg ran an article unhelpfully titled The Senate Tax Plan Sets a Trapdoor for MLPs. Corporate taxes are coming down; while Congress deliberated, it was unclear whether MLP investor tax liabilities might benefit from pass-through treatment (a lower rate), or  not. But there never was a plan to increase taxes paid by MLP holders, although Bloomberg had a good headline.  Nevertheless, for much of November MLPs faced some uncertainty about their ultimate tax treatment. Such is current sentiment that many potential buyers were inclined to wait for clarification while sellers often opted for immediate action. In this sector but few others, those holding securities hold greater conviction about their disposal than do holders of cash about its deployment. Late Friday night, Republicans passed the Senate Tax Bill and included a 23% deduction for pass-through entities. With a big pass-through cut in the House bill as well, MLP investors can now be optimistic they’ll receive a favorable tax outcome.

MLPData had some interesting figures supporting the gradual exit of traditional MLP investors from the sector. They report that last year 9MM K-1s were issued, down from 11.1MM in 2009. Moreover, in 2016 only 27% of those went to individuals compared with 33% the prior year. There are fewer MLPs as we’ve noted before (see The American Energy Independence Index), since most of the big ones have concluded they’re not a good source of growth capital. Increasingly, energy infrastructure is owned by regular corporations (“C-corps”).

Some people interpret this shift as demonstrating greater institutionalization of MLP ownership via ETFs and mutual funds. But we disagree – the money those funds are investing is still largely retail. These funds widened the investor base by providing MLP exposure without a K-1, albeit usually with dreadful tax inefficiencies (see Some MLP Investors Get Taxed Twice). The big difference is that 1099 investors don’t possess the long term perspective of a K-1 investor, because ’40 Act funds don’t come with the same tax deferral opportunity. The resulting broader investor base is less tax-motivated, and therefore more inclined to trade their positions. Energy infrastructure used to be the exception – the transition away from traditional, K-1 tolerant investors with long holding periods has created one of the market’s most volatile sectors.

If you need to experience extreme schadenfreude before buying, energy infrastructure provides a target-rich environment. The rally late last week was long overdue and shows some signs of improving sentiment although valuations remains depressed. The positive fundamentals are exceptionally well known to current holders, starting with America’s march to Energy Independence powered by the Shale Revolution (see Energy Production Supports MLP Outlook). It represents American capitalism at its very best (see America Is Great!). Fundamentals are improving, leverage is coming down and valuations reflect excessive pessimism. Many current investors are confused. It was a volume business but higher volumes no longer help. It became a crude-oil linked business until oil rose.  OPEC uncertainty, pass-through tax treatment concerns, MLP seasonals, tax loss harvesting, price technicals, and fund flows all weighed on sentiment. For quite a few in mid-November, confusion overwhelmed conviction. Those sales looked smart at the time. As tax loss selling abates, the calendar turns and the U.S. breaks more records in hydrocarbon production, the good feelings will be fleeting.  Aleviating concerns, on Thursday, OPEC extended production cuts until the end of 2018 and signaled a strong commitment to cooperation among leading members. Passage of tax reform has further provided much improved clarity as well as a boost to after-tax returns. Sentiment and prices have every reason to continue improving.

The managements of Energy Transfer Equity (ETE) and Williams Companies (WMB) are engaged in a high stakes poker game. It’s an absorbing spectacle. Last May WMB announced plans to buy in its MLP Williams Partners (WPZ). As with Kinder Morgan, they felt their size as well as the drag from Incentive Distribution Rights (IDR) from WPZ to WMB was making it hard to identify accretive growth projects. Kelcy Warren, ETE’s CEO, made an unsolicited offer for WMB and after fending him off for several months WMB eventually agreed, grudgingly, to be acquired in September. They dropped their earlier plan to merge with their MLP.

Almost immediately ETE was struck with buyer’s remorse. The deal terms included an $8.10 cash payment from ETE for each WMB share, and as MLPs sank this $6BN payout represented an increasing percentage of the deal as well as an unneeded strain on ETE’s balance sheet. ETE had crafted a complex transaction. They were keen to maintain the GP/MLP structure, since Kelcy Warren clearly recognizes the value in an MLP GP (see Energy Transfer’s Kelcy Warren Thinks Like a Hedge Fund Manager). However, ETE couldn’t simply issue new units to exchange for WMB shares to satisfy the non-cash component, because ETE is a partnership that generates a K-1 and WMB shareholders wouldn’t want to exchange their shares in a corporation generating a 1099 for LP units. So ETE agreed to exchange 1.5274 shares in the newly formed Energy Transfer Corp (ETC) for each WMB share.

ETC is supposed to track ETE for two years following the transaction close through a mechanism designed for the purpose, but it’s a novel approach and it’s unclear how they’ll both trade after that. The complexity shows how keen Kelcy Waren was to buy WMB and so retain their MLP as a stand-alone vehicle still generating IDRs for its GP. But as ETE, WMB and MLPs generally fell, ETE’s CFO Jamie Welch apparently began looking for modifications or even a way out of the deal without having to pay a break-up fee. In fact, Jamie was visible in telling WMB shareholders they should reject the transaction, and last month he was fired.

Whether Jamie was fired because he crafted a poor deal or because he was using the wrong strategy to change it, Kelcy Warren soon went on the offensive. In quick succession ETE announced two transactions designed to make ETE and its doppelganger ETC less valuable by enriching senior management at the expense of other ETE/ETC shareholders including, should the transaction close, WMB shareholders.

On March 10^th Energy Transfer announced a limited offering of convertible units available only to insiders and on preferential terms. They followed this up with a substantial grant of new shares by way of compensation to ETE management to take effect after the closing of the WMB transaction. Both moves served to make ETE/ETC a less valuable currency to WMB shareholders, but the collateral damage was to all the existing non-insider owners of ETE. The clear message to WMB’s board is, sit down with us and renegotiate this deal or we’ll make it progressively less attractive to you.

What was unsaid publicly was no doubt communicated clearly in private; these terms stink and if you disagree we’ll make them worse. If WMB walks away they have to pay ETE a 1.5BN break-up fee, unless it’s voted down by WMB shareholders. If both companies agree to break up, ETE has to pay WMB $410MM, the same fee WMB had to pay WPZ when that deal was cancelled. There is no provision for ETE to walk away, so they’d likely face  a lawsuit for substantial damages if they did. Considering the deal originally valued WMB at $43.50 compared to its Friday close of $15.52, you’d think pursuing such a lawsuit would be challenging. More recently, to confirm what a bad idea the merger was, ETE took its earlier forecast of $2BN in annual synergies down to roughly zero.

Apparently the WMB board never was that enthusiastic about the deal in the first place, with CEO Alan Armstrong opposed while activist hedge fund manager Keith Meister was in favor.

Kelcy Warren has become a billionaire through the Energy Transfer family of businesses which he founded in 1995. The deal’s proponents on WMB’s board, including Keith Meister of Corvex, are struggling to show that their earlier advocacy was astute given the subsequent collapse in both stock prices. These billionaires now rather resemble elephants dancing in a cramped tea room; the question for investors is how to avoid being the crushed china set in the process, for both men hew to their fiduciary obligations only as long as more important considerations don’t intervene.

Two years ago Keith Meister showed his true colors with alarm company ADT, when in April 2014 he relied upon a stock buyback for which he’d advocated to sell his big ADT position back to the company. ADT’s stock price subsequently sank 30%. ADT’s CEO Nareen Gursahaney was shown to be inept (see ADT and the Ham Sandwich Test) while Keith Meister created further obstacles for those who believe all hedge fund managers are misunderstood altruists.

So ETE’s strategy is one of devaluing its acquisition currency to the point that it’s unattractive, while WMB’s is one of holding out presumably in the hope of a big break-up fee. And yet, since what’s good for ETE must be good for WMB, it’s obvious that there’s a shared interest in reducing the cash portion of the deal in exchange for more equity. The outline of an agreement is clear to everybody, but so far a WMB board that was split and an ETE management that has completely changed its mind cannot put their egos aside and find common ground. It’s mostly about the capital structure of the combined entity. If they get that right both sides will win. But it also shows that there’s more than one way to handle the funds of public shareholders. Few players in this story are showing themselves to be responsible stewards of client capital. In years to come, situations like this will beg the question: how would Buffett have handled it. Whatever the answer, it won’t be like this.

We are invested in ETE and WMB.

Later this month John Wiley will release Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. Some might say that one book is enough for anybody to write, but I must confess the experience following release of The Hedge Fund Mirage in late 2011 was sufficiently positive that I decided to indulge my audience’s patience once more. Recent sales and media coverage related to The Hedge Fund Mirage have no doubt been supported by continued mediocre hedge fund returns delivered at great expense. The industry remains a soft target.

Bonds are harder to criticize. For one thing, bond investors really have done well for a very long time. There is no “Bond Mirage” to be written. Bill Gross may have had a hand in more wealth creation for clients than anybody. However, as comfortable as it is to invest in what’s been working well, the math of current yields represents a substantial constraint on anything like past performance repeating itself.

The most important step to getting a book published is a business plan which should include an assessment of other books on the topic. Although ruinously low interest rates are a topic on which millions of savers can quickly commiserate, Amazon’s offerings of bond books are heavily biased towards telling you how to buy bonds and which ones. The view that fixed income deserves a radically small portion of an investor’s assets is not one that has many proponents. As with hedge funds, much of the continuing support for owning bonds comes from those with a self-interest to maintain. In the last few months we have come across some extraordinarily poor advice.

One large firm acknowledged the poor return prospects in fixed income but still valued their diversification qualities (i.e. they’ll lose money when your other investments are profitable, which is supposed to be helpful). Another published a chart showing the uncannily strong relationship between the yield on ten year treasuries and the subsequent ten year holding period return (yes, really!). The author of that particular insight probably also marvels at just how reliably bond yields rise when prices fall (and vice-versa). Whether fixed income returns after taxes and inflation are modestly negative (the most likely outcome) or worse, the originators of the insights listed above will work hard to present the results to clients positively. They’ll need to avoid numbers though, because that’s unlikely to help. Adjectives such as “decent”, “acceptable under the circumstances” or “OK” will be favored over more measurable assessments.

One friend showed us a taxable trust for which she’s the beneficiary that retains a substantial fixed income holding yielding 1.5% — coincidentally the same as the management fee charged by the trust company (pun intended). The U.S. Treasury and managers of the trust are both doing well out of this arrangement, although unfortunately my friend is not.

While there’s plenty wrong with low interest rates, the approximately thirty year bull market in bonds has coincided with two other evolutionary shifts. One is that debt outstanding has, by any measure, soared to levels that until recent years would have been believed unsustainable. When other significant public obligations such as Medicare and unfunded public pensions are included along with consumer debt we collectively owe more than twice the size of the U.S. economy. The second is the steady growth in financial services, including securities trading, money management and banking of all kinds. Since the peak in inflation in the early 1980s we have a substantially bigger banking sector and far more debt, but approximately unchanged median per capita GDP. In short, there’s not a lot to show for all this borrowed money and frantic trading.

How this all resolves itself is unclear, but the Federal Reserve sees ultra-low interest rates as part of the solution. Indeed there is so much debt and so many borrowers that providing a return above inflation would seem to be against the public interest, a needless waste of money. To the extent that the Fed, and by extension the U.S. government, can control it they’re likely to side with borrowers over lenders and maintain low rates. The evidence so far is that they can pursue such a strategy indefinitely. Inflation is a time-honored solution to excessive debt. Combined with financial repression, a regime of rates maintained artificially low, this can allow debt to be repaid at a negative real cost. Whether rates and inflation move up together or remain low together, yields below inflation plus taxes appear inevitable.

The growth in financial services supported the growth in debt, through financial engineering that sliced up obligations to meet every conceivable investor’s taste. Markets developed for derivatives of all kinds from interest rate to credit risk and complexity combined with leverage in a profitable waltz until the music stopped in 2008. Although the benefits of this bigger financial sector are hard to identify in the rest of the economy, banks were hardly to blame for the financial crisis. Government policies that subsidized debt and promoted overinvestment in housing were a significant factor. However, the aftermath which included the TARP program created a popular perception that Wall Street nearly blew up Main Street.

The public policy response against banking is well under way, justified by the imperative of avoiding a repeat. Under such circumstances it’s hard to imagine a return to the pre-2008 interest rate regimes that generally provided reasonable returns to lenders. A “better bargain for the middle class” for which President Obama recently called, probably excludes interest rates high enough to compensate lenders for inflation and taxes. Bonds Are Not Forever does not take political sides. Saving for the future transcends politics, and both blue and red investors need to coolly assess the populist shift in Washington’s policy response to banking.

The question facing bond investors is, how to respond to this steady transfer of real wealth from savers to borrowers. Three central banks (U.S. China and Japan) own almost $6 trillion of U.S. government debt and they remain significant buyers. In addition, by maintaining short term rates at virtually 0% the Fed keeps additional downward pressure on longer term rates. Their motivation is not commercial, but low benchmark rates tug most other rates down, limiting the opportunities for a commercially driven bond investor.

Hence, the radical advice to abandon the bond market as irretrievably distorted by government activity. If the Fed wants to own bonds so badly, let them own the lot! Take your ball and go elsewhere, to a place where the rules of private sector supply and demand still operate. The Equity Risk Premium, often reproduced on this blog, is a simple visual explanation of our bond-free investment philosophy at SL Advisors as well as the inspiration for the book. Bond yields are highly unattractive compared with the earnings yield on equities. The odds of bonds beating stocks over the long run are extremely poor. Meanwhile, the need for stable investment income is as strong as ever. Bonds Are Not Forever explains why investors should have low expectations for fixed income returns, and SL Advisors runs strategies designed to meet the need for stable investment income without using fixed income. Quite simply, the book explains the philosophy behind our investment business but also seeks to entertain the reader along the way. Clients of SL Advisors can expect to receive their autographed copy within a few weeks.

One opinion shared by many investors nowadays is that stocks are risky, and the near term outlook is especially unclear. Today’s Wall Street Journal profiles a financial adviser in Chicago, Jeffrey Smith, who spends much of his time persuading clients that they should remain in equities in order to achieve their long term investment goals. One client apparently found his mind wandering to Edvard Munch’s painting titled,  “Scream” as he contemplated the many potential disasters waiting in the wings. Mr. Smith’s cause can’t be helped by daily headlines from Washington which largely serve to remind investors what a dysfunctional place it is. The very creation of a Fiscal Cliff was ill-considered, representing as it does a totally blunt instrument to control future deficits. While the original intent was to force tough decisions on a reluctant Congress so as to avoid automatic tax hikes and spending cuts, in fact the focus is really just on avoiding its consequences. News reports show that the most likely outcome is higher taxes on the 2%, some spending cuts and no doubt solemn commitments to do the heavy lifting of budgetary discipline next year.

It’s not what was intended but is the best we can expect. Congress created the cliff and Congress can modify it. It’s not really a tool to force action.

In fact, there’s little reason to be long term optimistic on the U.S. fiscal outlook. Opinion polls regularly expose the incongruity of voters’ desires for improved fiscal prudence combined with broadly unaltered tax policies and entitlements. On top of which, while there’s much hand wringing about the future there’s little visible cost to current policies. If Congress and the Administration did miraculously come together on a meaningful plan to achieve annual deficits of 2.5% of GDP (thought by many to be a long term sustainable target) bond yields could hardly fall very far in response. When Clinton raised taxes in the 90s to reduce the deficit interest rates fell and softened the blow somewhat. No such payback is likely today. So low expectations on this issue are appropriate.

Nonetheless the Math of equities remains compelling. $22 in the S&P 500 will deliver the same after tax return as ten year treasury notes held to maturity, assuming 4% dividend growth on the former. You can make your own synthetic bond with $78 in 0% yielding cash and $22 in 2% yielding equities. Even a disastrous 50% collapse in stocks would cause an $11 fall in your portfolio value or 11%. It would only take a 1.25% rise in bond yields to cause a similar 11% loss in ten year treasuries.

Choosing the stocks/cash combination with its range of possible outcomes instead of the fairly certain loss of purchasing power through bonds requires a long term perspective. However, that is the most reliable way to maintain the purchasing power of your savings.

Most recently we invested in Dollar General (DG). For some time we’ve followed this company as a comparison to Family Dollar (FDO) which we have owned in the past (although not at present). DG has better sales per square foot, operating margins and growth than FDO, but in recent months its valuation has slipped to where it’s now comparable to FDO. These businesses tend to hold up fairly well during tough economic times and although DG is weaker today following its earnings release we think it represents an attractive investment.

The challenges facing the Euro zone including most recently Italy seem so enormous and intractable that it’s easy to contemplate previously unimaginable outcomes. Der Spiegel reports that the German government is preparing for a possible Greek exit from the Euro. The currency was designed without an exit – it’s unclear how Greece could extricate itself. A weekend nationalization of banks with all deposits converted to drachma? The new currency would immediately collapse from its initial level as unwilling holders of drachma sold, and in any case the days and weeks leading up to such an event would no doubt see a sharp run on deposits from Greek banks. As it is there’s a tax on money leaving the country. And we read every day that supporting Italy will require the IMF and a reinforced EFSF. What will happen if Italy can’t refinance its debt, €250BN of which rolls over in 2012?

But you don’t need to bet on disasters to see downside for the Euro. Just muddling through and avoiding any of the crisis scenarios is going to involve slower growth. The Austerity Solution so favored by the EU and IMF is assuredly lowering GDP growth in the region as well as consumer confidence. The growth differential between the U.S. and the Euro-zone continues to widen. JPMorgan now forecasts +1.7% 2012 GDP growth in the U.S. versus -0.6% in the Euro-zone. Solutions and non-solutions seem to lead to the same place. The next 10% move in the exchange rate looks far more likely to be lower.

The Financial Times notes that Liquid Natural Gas (LNG) tanker ships are experiencing increased demand, one of the very few areas of shipping for which that is true. The rest of the shipping industry has shot itself in both feet as every operator positioned for a 10% increase in market share, which has crushed shipping rates through overcapacity and made the sector even less friendly than U.S. residential construction (if that’s possible). But the virtual shutdown of the Japanese nuclear energy industry following the earthquake has increased Japanese demand for LNG imports and is raising prices. Regrettably, producers of domestic natural gas in the U.S. are not direct beneficiaries because the U.S. currently has no facilities at which natural gas can be compressed for export, but greater global demand is a positive over the long term (i.e. 3-5 years).

Still on the subject of shipping, we continue to be invested in Aegean Marine Petroleum (ANW). They provide bunker fuel to the shipping industry and so operate a very different business model than their customers. Their stock price has been beaten down with their peers, although they continue to generate operating profits and just reported a third quarter of solid margins. If you can believe their book value (assets are ships and fuel inventory) the stock trades at a 40% discount. On their earnings call last week management asserted that market value for their ships was no lower than carrying value – much of the fleet is recently purchased so that ought to be true, although they did take a loss versus book value on the sale of one vessel in the third quarter. Even after rallying on last week’s earnings it still trades at less than 7 X ’12 estimated earings. We continue to hold a modest position in ANW.

Berkshire Hathaway (BRK) remains one of our biggest holdings, for reasons articulated the other day. Warren Buffett’s appearance on CNBC this morning was never boring, and he revealed an investment in IBM which is not a stock we would have bought ourselves. Many large cap U.S. stocks appear attractively priced, and the dividend yield on the S&P500 (SPY) remains more attractive than long-term government or high-grade bonds. The equity risk premium is not as wide as it was but remains nonetheless attractive in favoring equities over fixed income.

Disclosure: Author in Long EUO, BRK, ANW, SPY