SL Advisors Talks Markets

Confronting Asymmetric Risks

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The Fed’s mid-week policy meeting will punctuate a busy earnings week. Sell-side analysts continue to ratchet down earnings forecasts. Factset reports bottom-up 2023 earnings expectations of $226, down over 10% compared with last spring when Fed tightening started to have an impact.

Energy continues to be a bright spot, providing positive surprises in 4Q earnings released so far. Companies continue to return capital to shareholders. Chevron tripled its planned buybacks to $75BN over the next five years, drawing more economically illiterate criticism from the White House for not plowing this money into increased production. Incoherent energy policies and fair-weather friendship aren’t inducing Chevron CEO Mike Wirth and other energy executives to alter their capital allocation.

The broad equity market isn’t cheap, based on the Equity Risk Premium (ERP). Stocks are vulnerable to higher interest rates. Fed funds futures project a peak in Fed policy this summer with rates coming down later this year. By contrast, the FOMC Summary of Economic Projections (SEP) released on December 14 pushes that scenario back around a year.

Fed funds futures six to twelve months out differ as much as 1% from the FOMC. Data since the last SEP has been on balance slightly weaker. So a surprising move in futures to more closely align the two would leave the stock market vulnerable, especially given the trend towards weaker earnings forecasts.

Morgan Stanley strategist Michael Wilson is cautious because of the Fed outlook, although Robert Kad, who heads up their MLP and Energy Infrastructure research, is gloriously bullish on his sector.

Midstream energy infrastructure should be resilient to higher rates. Yields of 5-6% are already attractive, but more important is the embedded inflation hedge that is in many pipeline tariffs. Inflation expectations remain low considering recent history. Risk here is also skewed to the upside. Wells Fargo has estimated that half the industry’s EBITDA is linked to inflation protected contracts.

European demand for LNG imports jumped last year, but over the long-term emerging economies are likely to grow consumption. The Gas Exporting Countries Forum expects natural gas to increase market share from 23% to 26% by 2050 while global energy demand increases at 0.7% pa. Thanks to Stephen Stapczynski of Bloomberg for pointing this out.

The University of Michigan consumer survey revealed the uncertainty consumers have about the inflation outlook. Although households expect it to return to 2% based upon the average of responses, the range of expectations is the highest it’s been since the 1980s. The difference between the 25^th and 75^th percentiles for 5-10 year inflation is 4%. Over the next year it’s 8%. There’s not high confidence that it’s returning to 2%.

Benign inflation forecasts, which are similar in the bond market, represent asymmetric risk. Inflation isn’t going to trend below 2%. Retirement planning should be based on 3% and scenarios should be run with higher rates to test how well an investment portfolio will meet one’s spending needs. There are several reasons why conventionally reported inflation figures aren’t a good basis on which to plan growth in living expenses (see Why You Can’t Trust Reported Inflation Numbers). The most obvious is the hedonic quality adjustments that are routinely applied to the CPI to reflect improvements in quality. CPI tries to measure a basket of goods and services of constant utility. Quality improvement at the same price is treated as a price cut.

Hedonic quality adjustments are made to a wide range of products such as clothing, electronic goods and housing. The problem this creates for a consumer is that if a jacket, iPhone or rental property provides better quality at the same price, you don’t have any money left over even though your utility has risen. If you plan on replacing your iPhone regularly in retirement, it’s going to cost you more even though the Bureau of Labor Statistics calculates iPhones are cheaper (because they’re better).

Returning to the ERP – based on the past two decades, the S&P500 is somewhat expensive compared with bonds. Low inflation expectations and optimistic futures create asymmetric upside risk to interest rates, and downside risk to earnings, forecasts for which are trending lower. Both leave stocks vulnerable.

For now, Factset bottom-up earnings for 2023 is for 3% growth over 2022. Flat earnings and ten-year yields back to 4% where they were in November would require a 15% drop in the S&P500 before the ERP was back to its two-decade average. We’re not selling stocks for long-term investors, but the risk asymmetry suggests little need to rush purchases.

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

SL Advisors Talks Markets

Behind Soft Natural Gas Prices

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Most of the commodity questions we get relate to crude oil, since its price reflects energy investor sentiment and can move midstream prices. When oil and pipelines are down, people want to know why the volume dependency of midstream cashflows isn’t visible in stock price performance. The correlation between the two is unstable (see Energy’s Asynchronous Marriage).

Pipelines are even less correlated with natural gas. This is partly because there are enormous global price disparities. US LNG exports are growing but still constrained by insufficient liquefaction capacity to satisfy global demand. Hence US natural gas prices are far lower than European and Asian benchmarks.

Gas prices have been sliding in recent weeks, confounding some who think Europe’s pivot away from Russian pipeline exports should create immediate incremental demand. The main reason is weather. Just before Christmas the US experienced a cold snap which boosted domestic demand, but since then it’s been a relatively mild winter. The same has been true in Europe, where fears that rationing might be required before winter’s end are receding.

Most of the US has seen milder weather as defined by Heating Degree Days (the average of the day’s high and low subtracted from 65, or 0 if negative). Only the Rocky Mountains and west coast have been different. California’s relentless rain is being blamed by some on global warming, but it reaches the mountains as snow which I can personally attest is creating great skiing conditions.

The milder winter is curbing demand for natural gas, most clearly seen in the 17% drop in the residential and commercial category compared with a year ago. Exports are also less than forecast. The Freeport LNG plant is the 2^nd biggest such facility in the US behind Cheniere’s Sabine Pass. Restarting operations there following the fire last June has also taken longer than expected, curbing demand for natural gas supplies to be converted into LNG. The company is sticking with its latest forecast that it’ll be back up by the end of January.

Looking ahead, LNG demand will assuredly grow and the weather will fluctuate. The Energy Information Administration’s Short Term Energy Outlook sees US LNG exports averaging 12.1 Billion Cubic Feet per Day (BCF/D) this year and 12.6 BCF/D in 2024. They did trim this year’s forecast modestly because of the delay in Freeport’s restart.

US LNG export capacity won’t grow significantly for another couple of years, but by 2030 will have almost doubled in a decade. This will help close the price gap between US natural gas and other global benchmarks, although even then LNG exports will represent less than 20% of domestic demand.

Australia vies with the US and Qatar for top LNG exporter. But LNG exports have become a political issue down under, because such a big portion of production is flowing overseas that it’s boosting domestic prices. In recent years Australia’s federal government has contemplated export curbs. These are vehemently opposed by the gas industry which argues they may be forced to violate contractual obligations. Partly as a result of political pressure, Australian LNG exports are expected to dip this year.

The Netherlands is also planning to curb exports, but for different reasons. Their Groningen gasfield, the largest in western Europe, has been widely linked with earthquakes. There have been up to 100 annually since 1980, ranging as high as magnitude 3.6. Several years ago tremors in Oklahoma were attributed to fracking, although blame was eventually pinned on improper wastewater disposal not the fracking itself.

But fracking is not used in Groningen, and it appears that the removal of natural gas itself destabilizes the ground. 160,000 damage claims have been submitted by residents of the area. The Dutch government has been promising to halt gas production there since 2018 and now sounds as if they will finally follow through.

The timing is awkward because Groningen borders Germany and supplies the northwest of the country. The EU pressed the Dutch to increase production following Russia’s invasion of Ukraine. Depending on Europe’s supplies Groningen may continue production until October 2024 but not beyond that.

Political pressure in Australia and the Netherlands will enhance the prospects for US LNG exports both to Europe and Asia.

Following Sunday’s blog critical of Kinder Morgan, some readers asked why we have any position in the company at all. We’ve been critical of their returns on invested capital for several years (see Kinder Morgan’s Slick Numeracy) and they’ve long been an underweight for us.

Today the company’s poor investment history is well known by analysts if not acknowledged by the board since they just elevated a long-time member of the management team and former CFO Kim Dang to CEO. We’ll look for signs of improvement. Their Enhanced Oil Recovery business (EOR) was an unwelcome source of EBITDA volatility, but with the Inflation Reduction Act increasing tax credits for CO2 capture including from EOR, there’s some chance for this segment to become more interesting.

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

SL Advisors Talks Markets

The Slow Death Of 60/40

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On the weekend the WSJ highlighted contrasting views of the 60/40 portfolio between Goldman Sachs and Blackrock. The classic asset allocation had its worst year in nominal terms since the 2008-9 Great Financial Crisis (GFC) and adjusted for inflation the worst since the Great Depression.

It shouldn’t be a surprise. Bond yields have been too low to justify the discerning investor’s capital for many years – a point I made in my 2013 book Bonds Are Not Forever: The Crisis Facing Fixed Income Investors.

The Federal Reserve owns $7.3BN in treasury bonds and Mortgage-Backed Securities (MBS). These holdings are a result of Quantitative Easing (QE), which Ben Bernanke first unleashed in response to the GFC. At the time this was a controversial move that many (including me) thought would be inflationary. Bernanke understood better than anyone how the monetary system would respond. It was a unique moment and QE should have been a one-off.

But in 2020 Jay Powell took it to a new level before the prior QE holdings had run off. Now one must conclude that any economic downturn will be met with Fed balance sheet expansion. The current lethargic pace of balance sheet reduction will likely be reversed with the next recession. This partial debt monetization is becoming permanent. It’s a consequence of too much debt.

Japan is the biggest foreign holder of US treasuries with $1.1TN. China is second at $0.9TN. Along with the Fed, for these investors a return ON capital is unimportant – they want a return OF capital. The old fear that China might dump their holdings is irrelevant with QE. Selling a $1TN of bonds would be destabilizing, but who now doubts the Fed would step in and take the other side?

Inflexible investment mandates that require fixed income allocations regardless of return prospects are another source of excess demand for bonds.

The result is that return-oriented bond investors are competing with substantial capital disinterested in a return. Bonds had some good years following the publication of my book warning investors to take their capital elsewhere. The adjustment away from fixed income is slow. But last year was a wake-up call. Paltry yields left diversification as the only justification for owning bonds. But their correlation with stocks has been rising sharply. The ascendancy of TINA (There Is No Alternative) caused this. The tyranny of pygmy interest rates and consequent shift to equity risk increased the stock market’s vulnerability to rising rates.

Over the past decade the Barclays Agg returned just 1.3% pa, versus 12.2% for the S&P500.

Today’s higher yields suggest a better decade ahead. But much depends on inflation. At 3.5% the ten year treasury note offers just 1.5% above the Fed’s long term inflation target of 2%. This is below the real return of the past hundred years. And it relies on inflation quickly returning to 2% and remaining there.

Inflation expectations are encouraging. Like many banks, JPMorgan expects falling inflation this year and is forecasting CPI of 2.8% in 4Q23. Ten-year TIPs yield 1.3%, implying a 2.2% embedded inflation rate in the bond market. The University of Michigan consumer survey regularly confirms this benign outlook.

The broad consensus on price stability isn’t easily ignored. It’s possible that return-insensitive buyers noted above are distorting the message unconstrained bond yields might offer. But Wall Street analyst and household views are harder to explain away. Nonetheless, having endured two years’ of high inflation a cautious investor should assume something above 2% in the future if only to compensate for the risk that these forecasts are wrong. A saver assuming her annual living expenses will increase at 3% into retirement will quickly find equities offer the only hope of keeping up.

60/40 was finished years ago. I haven’t owned a bond in probably two decades. There’s no point. Neither do any of our SMA clients. Instead they hold cash as a diversifier. 90-day treasury bills averaged 0.8% over the past decade, 0.5% less than the return on the Barclays AGG over that time but with no risk. Cash is a risk enabler. It supports increased exposure to equities which is the only chance savers have to maintain purchasing power. Bonds offer risk with an inadequate return.

Yields are still too low. The Congressional Budget Office forecasts sharply rising Debt:GDP over the next thirty years. US taxpayers are benefiting from investor inertia, since long term yields aren’t commensurate with the debt outlook.

In BlackRock vs. Goldman in the Fight Over 60/40, the WSJ finds Blackrock believes it outmoded while Goldman defends the indefensible. However, Goldman’s asset management business asked Is the 60/40 Dead? in October 2021 and warned “investors should at the very least recalibrate expectations.” Even within Goldman Sachs, reasonable people can disagree.

For more on how a combination of stocks and cash can replace fixed income, see The Continued Sorry Math Of Bonds, which we published around the same time. Adding midstream energy infrastructure to the equity portion of the stocks/cash barbell will, in our opinion, further boost its performance.

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

SL Advisors Talks Markets

Bearishness Is Holding Back Energy

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Michael Wilson, Morgan Stanley’s chief equity strategist, thinks stocks could fall 22% this year. Wall Street is bearish, and the mood has spread to consumers. Earnings forecasts are falling and households report expectations close to the depths of the 2008 great financial crisis. A lot of smart people are negative. We don’t spend any effort positioning for the economic cycle – when recessions have struck they’ve usually been unexpected. If the US slips into one later this year it’ll be the most anticipated in living memory.

Fortunately, Morgan Stanley like most firms encourages disparate opinions and does not enforce a “house” view in its public pronouncements. Hence Robert Kad, who heads up MLP and Energy Infrastructure research is publicly, even giddily bullish on the sector. Of the companies they cover, which is most of them, he expects a median one year price return of 21.9%. With dividends he expects 29.1%. Kad is so bullish that he even expects those companies that are ranked Underweight to deliver a total return of 17.1%.

Some readers may think your blogger is the most relentlessly optimistic on pipelines. When investors ask me to offer an estimate for one year returns, I meekly offer 6% dividends plus 3% growth plus 1% in buybacks, or 10%. I have to confess that Kad’s bold optimism casts a pall of inadequacy over my forecast compared with his fearless proclamation of the opportunity that is presented.

JPMorgan’s Jeremy Tonet expects a median one year total return on his coverage group of 23.5%. Wells Fargo’s Michael Blum is more constrained, expecting a 13% price return on their Overweight group

We agree with Kad’s reasoning – the sector’s free cash flow yield is 2X the S&P500 and well above those of all major sectors. The boost to carbon capture from increased tax credits in the Inflation Reduction Act should cause a rethinking of terminal asset values as pipelines remain key to the energy transition. Sluggish growth in US crude production looks likely as areas mature and capital discipline persists among E&P companies. China is emerging from its three year lockdown, Russian exports are falling with the price cap imposed in December, and the Administration has completed its sale from the Strategic Petroleum Reserve (SPR). Oil looks like a risky short. The US rejected offers of crude to replenish the SPR as too high or the wrong grade. The White House attempt to trade oil is likely to leave it unable to cover earlier sales profitably.

The energy sector’s P/E ratio is 0.6 of the S&P500, the lowest in over twenty five years according to Yardeni Research. Energy analysts are bullish, but the market is not. The three headwinds of shale overbuild, fears of stranded assets and covid demand destruction inflicted such financial trauma on investors culminating in 2020 that the cathartic rebound continues amid skepticism. Retail investors are not yet contributing net inflows into sector funds, although the year-end bounce we postulated (see Will The January MLP Effect Beat Negative Sentiment?) is working. Sector analysts are more bullish than investors.

Last month Tallgrass bought the Ruby natural gas pipeline which runs from the Rocky mountains west to California, out of bankruptcy. Combined with the Rocky Mountains Express (REX) pipeline Tallgrass owns, this creates the potential for natural gas in the Marcellus to move across the country to California markets where prices are high even as Californian politicians seek to reduce its use. Tallgrass likely assesses the Golden state will be using gas for a long time yet.

In other news, AQR’s Cliff Asness wrote an eloquent criticism of private equity valuations. Increasingly, the absence of a regular mark to market is being regarded as a welcome absence of volatility instead of simply an absence of information. Blackstone (see Is BREIT Marked To Market?) recently raised $4BN from University of California (UC). Far from endorsing Blackstone’s valuations, the terms which include close to a guaranteed 11.25% return to UC, suggest that’s what it took to raise new money.

Lastly, a photo from Vail where my younger daughter and I are on our annual ski trip with good friend, client and instructor Bill Edwards. Bill’s a retired orthopedic surgeon from San Antonio that I’ve known for twenty years. We’ve spent many enjoyable ski vacations in his unfailingly good company. Every year he generously sees improvement and I really think he’s right. Any skiing competence I exhibit is down to him; the falls are my own work (or as he says, a failure to listen).

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

SL Advisors Talks Markets

Last Year’s Most Popular Blog Posts

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You might think last year’s 39.5% outperformance of the S&P500 by the pipeline sector was a record but in 2016 the margin was 42.0%. This followed a harrowing 41.0% underperformance the prior year. However, the past two years have been the best on record, with the American Energy Independence Index (AEITR) beating the S&P500 by 27.0% pa.

Our most popular blog posts of 2022 were those that covered the positive fundamentals underlying midstream energy infrastructure. Yields are historically tight to the ten-year treasury according to research from JPMorgan, which might make the sector appear rich to some. However, payout coverage is much healthier than in the past, with free cash flow yields almost 2X dividends. In Even After A 30% One Year Return, Pipelines Remain Cheap we highlighted this, as well as the higher incidence of distribution cuts among MLPs than their c-corp cousins.

Renewables receive so much media coverage that it’s tempting to believe they’ll solve all our energy problems. In Hydrocarbons Support The Four Pillars Of Civilization we reviewed Vaclav Smil’s latest book How the World Really Works which explains why global demand for steel, cement, plastic and fertilizer will drive continued growth for reliable energy. Solar panels and windmills are little use in manufacturing any of these vital inputs to modern society.

Russia’s invasion of Ukraine exposed western Europe’s strategic blunder on energy security, led by Germany. The loss of Russian natural gas led to a scramble for LNG not more windmills. In Energy Realism Is Spreading we examined the bullish long-term prospects for US exports of LNG.

The Hard Math Of The Energy Transition looked at the economics behind carbon capture, which received a boost from the Inflation Reduction Act passed in the summer. US climate change policy relies on subsidies aimed at rewarding emissions reduction instead of carbon taxes, and it’s creating business opportunities for midstream to sequester carbon underground, invest in hydrogen and produce emission-free LNG.

Natural gas continues to be our most important source of energy. On December 23 US demand set a new high of 155.7 Billion Cubic Feet per Day (BCF/D) according to S&P Platts, above the prior daily high of 150.2 BCF/D on January 30, 2019. Last year the US tied Qatar for top LNG exporter at 81.2 million tonnes, with Australia just behind at 80.5. The US was ahead during 1H22 until the Freeport terminal shut down because of a fire. Its resumption is likely to make the US the biggest exporter this year.

High energy prices have been a drag on growth in much of the world. Although American motorists felt some pain from rising gasoline prices early last year, in America Dodges The Energy Crisis we explained how abundant natural gas has insulated most of America from the experience of western Europe. Massachusetts continues to import LNG at high global prices from foreign countries because of ill-considered opposition to natural gas pipelines.

Tellurian’s Charif Souki has failed to create a second Cheniere. Souki’s compensation is among the highest in the industry in spite of Tellurian’s slumping stock price and diminishing odds of completing its Driftwood LNG facility. His compliant board has embraced pay for performance in advance. We asked What’s Next For Tellurian?

We started posting regular videos last year too. ESG Is A Scam was especially popular.

ESG has become an easy target. The three components (Environmental, Social and Governance) are not bad objectives, and every investor must favor stronger governance. But ranking companies based on “ESG-ness” is a scam perpetuated by companies like S&P creating metrics for corporate qualities. Every company can obtain a good ESG rating because no common standard prevails. The Dow Jones Sustainability Index looks past Lockheed Martin’s business of delivering products that blow up things and people, deeming them worthy of index inclusion year after year.

Our most watched video, What’s the deal with natural gas? explained why it represents the world’s best opportunity to reduce emissions, by phasing out coal. Natural gas investors own the most important element of a successful energy transition. The only way global emissions will fall is if emerging economies led by China reduce their reliance on coal. Natural gas is the clear winner.

We don’t always stick to energy and interest rates. A year ago we calculated that ARKK’s Investors Have In Aggregate Lost Money, because unfortunately the inflows to Cathie Wood’s fund came mostly at high prices. Since then ARKK has lost an additional 60%.

In December we asked Is BREIT Marked To Market? because valuations on its portfolio are both more stable and immune to the travails impacting publicly traded real estate. Perhaps mindful of the incongruity of such stability, their most recent monthly NAV was –1.2%.

Our engagement with you through blog posts and videos is the highest in our history. Continue to post comments, either publicly or directly to me, anytime you’re so moved. We welcome all constructive feedback.

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