Oil Prices Down, Iran Deal Unrelated
Dear Valued Clients and Friends,
In a weird way, it’s been a challenging month. Stock and bond markets have mostly done okay and the supposed large-tail risks from earlier this month (Greece, China, etc.) have mostly blown over (for the time being). Yet earning season is putting out strong numbers for some companies and disappointing numbers for others. Some entire sectors have suffered ongoing price declines. (We address this dynamic with MLPs below in the commentary.) With the ebbs and flows of earnings, the volatility around global macro events, the certainty that Fed actions are totally uncertain, and a market dislocation in what we perceive to be a very attractive space (midstream MLPs), the reality is that one cannot help but be convicted for the sin of short-termism. We have a great responsibility to filter out noise (previously discussed in market commentaries), to put the long-term interests of our clients above short-term ego stimulus, and to communicate heavily. This heavy communication sometimes interferes with the focus on what really matters – what our fiduciary responsibility is really to – and that is the long- term investment success of our clients. To that end, we tirelessly work with great confidence that our principles and devotion to fundamentals trumps all. With that said, let’s get into it…
Earnings season thus far has been very hit or miss – some big successes and big disappointments. The energy earnings collapse was massive in producers and integrateds; opposite story in storage, transportation, and refiners. MLP distress continues and will require patience. A month? A year? Longer? Maybe. But current prices relative to distributable cash flow is irresistible. Surrounding fundamentals are pleasant, to say the least (economics of natural gas liquids; project growth; volumes; declining cost structure of the producers; etc.). Chances exist for a September rate hike from the Fed (more people believe they will than believe they will not), but we remain skeptical. A December lift-off is more likely, but also not assured. Either way, we think the point of pain in markets (pain that surpasses regular volatility) is when slow, small, immaterial rate hikes turn into quick, sudden, material ones. The impact of rate hikes includes volatility for investors in risk assets, but it includes material increase in cash outflows for those borrowing money in short-term rates. The solution is not to not do it, necessarily, as much as it is to be aware of it. Inflation-protection is a tricky animal for risk averse investors, because the best hedges against it have a lot of downside themselves! Greece is out of the headlines only in the most temporary of senses. Ultimately, debt erasure or a GREXIT are the only alternatives we see. The short-term spurts in high growth non-dividend payers causes us no reservations when we look at the long – term superiority of dividend growth equity investing both in total return and risk reduction.
Why do you believe that the recent oil price decline is unrelated to the Iran deal and more related to the dollar rally?
The days that the actual deal came out oil did not sell off. The bigger leg down has been in parcel with the rally in the dollar since the Euro/Greece agreement a couple weeks ago. (Had a GREXIT taken place, well, we believe the Euro would not be in the same sell-off mode.) In the chart below the blue line represents dollar weakness, so think of it as the inversion of the dollar strength. It shows you all you need to know about oil and correlation.
So why don’t you give us some weekly considerations in the MLP sector?
I did a lot of study this week on the state of the MLP space in 2009 in contrast to where it stands now. Valuations are right now quite similar to where they were. And yet, balance sheets are orders of magnitude better now than they were then, and growth of volume outlook is massively stronger. Valuations in this space are done using a Price-to-Cash Flow/Growth metric. The timing of when commodity prices move and alter investor sentiment is totally unknown to us. What is known are valuations.
Does this chart indicate that MLPs are a screaming buy? We would say yes, but we would not say that it tells you anything about timing. Sentiment is bad in the space right now and we have no idea when that will reverse. The ugly sentiment is, as we have written about in these very pages, a result of a combination of the: a) less MLP-savvy investor who entered the space in 2012/2013, and b) fear that declining commodity prices will hammer profitability of the producers and therefore hammer the volumes by which tolls are extracted which feed the pipeline business model.
This fear is unfounded in our opinion, based on the dramatically falling production costs by which the producers profit is based, and based on the reality that falling prices increases demand, always and forever. Economic opportunity around U.S. natural gas liquids which sell for double the price overseas is not going away. MLPs fund themselves largely off new equity issuance, and new equity issuance has slowed in the midst of this negative sentiment, creating a negative feedback loop. Why do MLPs need ongoing new equity issuance? Because their structure requires ongoing distribution of cash flow to us, the owners. So we benefit from that lovely cash flow, but suffer when equity raises are slow (putting downward pressure on prices). These things ebb and flow and create the price consequences day by day that they create. But what really drives long-term prices? Projects. Pipeline projects that generate fees. For all the negativity in the space, we cannot find an example of projects being cancelled in the midstream world in which we live.
Do you think there is nefarious action at play with the MLP sector?
This is a tricky subject because it is silly to speculate on things we do not know, and one person’s “nefarious” is another person’s “opportunistic”. Rather than engage the conspiracy theories about hedge funds and shorts and other such conjecture, we would rather discuss what we do know: The highly leveraged closed-end space is a dangerous, dangerous animal. There are both technical and fundamental (and essentially mathematical) issues at play here. The idea that a highly-leveraged, closed-end fund would ever offer “free” yield on top of the already super-sized distributions of MLPs, and that there would not be a corresponding danger to this, was preposterous. If ever a space did not call for leverage closed-end structure, it is one like MLPs where the very structure complicates things on steroids. Yes, we believe this is adding to the pressure and market dislocation.
What is the number one reason to LIKE the Industrials right now?
Perhaps the only reason we can find is that no one seems to like them. We often find best value when sentiment is most negative. Certainly macro headwinds exist and the thesis that QE and other stimulus plans have brought a lot of future growth into the present, leaving a less-than-rosy forecast, is not without legitimacy. The China growth slowdown is a factor. Structural concerns exist in the U.S., Japan, Europe, and emerging markets. And yet, bottom-up, we believe some opportunities can be found. It is not likely that the space has yet washed out, but in due time a contrarian play will be in order here with good company selection.
What is the latest in your forecast for the Fed and the September meeting and the first interest rate hike?
Consensus is saying that there is a high chance of a quarter-point rate hike in September, and almost inevitable chance at the December meeting if it doesn’t happen in September. We believe there is a low chance of it happening in September (which is not the same as no chance), and a decent chance it happens in December if it doesn’t in September. Let’s call attention to Janet Yellen’s quote last week in Senate testimony of the timing involved in their first rate hike: “If the economy evolves as we expect, economic conditions likely would make it appropriate at some point this year to raise the federal funds rate target, thereby beginning to normalize the stance of monetary policy.” We believe the general rule of thumb we have applied throughout this process has served our clients well – expect the Fed to be later than expected, not earlier than expected, and position accordingly.
Will portfolios decline if the Fed raises rates in September?
There are several schools of thought around this issue. The school of thought you should subscribe to is the one that admits it does not know (ours). Yes, there could and should be elevated volatility around a Fed rate hike, but as we saw with QE3 ending, and before that QE2 ending, oftentimes the market prices in the inevitable ahead of time, and oftentimes the volatility around a Fed action proves to be short-lived. What we would be bolder in forecasting is that if and when the small, slow, tiny, practically significant quarter-point rate hikes turn into sudden, larger, more material rate hikes, then we believe markets would be due for meaningful correction. Good luck timing any of that.
Where would the greatest impact of Fed rate hikes be felt?
As we have written on these pages and elsewhere, the greatest impact will be on those borrowing money in short-term financing. Stockholders have to deal with the volatility of the prices in things they own, but borrowers have to deal with real life increase in cost of funds. Many (hopefully most?) borrowers understand this inevitability. Borrowers who do not, or whose leveraged situation cannot withstand the financial impact, will be the ones most affected.
Well, who exactly borrows money at rates affected by the Federal Funds rate?
Oh, the United States government, for example. And every state in the country. Most cities. Most counties. Way too many homeowners. Many companies. (Though corporate balance sheets seem to reflect the most intelligent balance sheet management of any party mentioned herein.) And margin borrowers, of course.
Where do you think the zero interest rate policy has actually benefited the economy?
Let us give you a few data points that we believe can safely be interpreted as largely assisted by the zero interest rate policy:
- The Experian Consumer Default Index was 0.88%, as of Friday – lowest in history. Would that be the case with higher rates?
- Auto sales have increased from 9 million (annualized) in May 2009 to over 17 million now (also annualized). Would that be the case with higher rates?
- High yield bond defaults sit at record lows around just 1%, with the vast majority of lenders having been able to re-finance debt at lower costs before it came due. Would that be the case with higher rates?
So where has the negative come from with zero interest rate policy? The economic philosophy one has matters here. We are not Keynesians, meaning, we do not see demand manipulation as the be-all and end-all of economics. We think that if policy incents someone to borrow today to buy something they otherwise wouldn’t, it has merely pulled demand forward, meaning a purchase they make now is a purchase they won’t make later. Most importantly, we believe the price of money is a signal to the economy – to the borrower, to the lender, to the entrepreneur, to the supplier, to the investor, etc. – and when the price of money is distorted, it leads to distorted actions and behaviors which carry negative consequences. A lower than normal interest rate policy has been needed out of the financial crisis, and one could argue a zero interest rate policy even had some legitimacy in the immediate aftermath, but our concern is for the distorted behaviors that the sustained zero rate policy has created.
What if the Fed puts the genie back in the bottle just in time and we escape this period with no visible consequences of distortion or bad behavior? Then we will admit we were wrong this time and that the Fed pulled it off brilliantly!
Have past rate increases caused recessions?
When short-term rates come up past longer-term rates (what we call an “inverted yield curve”), it has nearly always caused a recession. So far there exists a decently steep spread between the short rate and the longer rate.
Why own any inflation-protected bonds at all if we are concerned about interest rates rising?
It is really just a hedge against inflation surfacing that is significantly outside of expectation. TIPS (government treasury bonds that adjust principal up in line with inflation) do indeed still possess interest rate risk, and yet should inflation surface at a quicker pace than rates can increase provide an effective math hedge against inflation. Now, in a deflationary environment they can get walloped (see: 2008), so these are hardly vanilla government bonds, but we believe they are appropriate right now in the spirit of protection. With that said, do more opportunistic vehicles exist to protect against inflation? Yes. In theory, and without a perfect correlation, we believe an investment in the government debt or the currencies of the big commodity countries (Australia, Canada, for example) can do the same, but with much greater downside and volatility.
Do you consider the Greece mess now behind us?
We can only hope you are joking. We believe that the very immediate headline-worthy drama has subsided for the time being, but want to make very clear that we do not believe the ultimate Greek saga ends until they either leave the Eurozone altogether to pay their debts with their own depreciated currency (Grexit), or their creditors reduce their debt levels. Of course we could be wrong, but there is not even a potential option C beyond that highly binary outcome. Would we dare to time this? No. The sustainability of can-kicking is not to be under-estimated. For those wondering what the next flare-up could be as the ECB continues heavy levels of QE, we are watching the pending Spanish elections. If the leftist anti- austerity crowd grows into more mainline European member countries, the whole dynamic could change there.
Do you ever question the long-term efficacy of your pro-dividend equity philosophy vs. the high growth non-dividend equity options that are doing so well right now?
No. Never. Like literally, never.
What’s your interesting factoid of the week?
This is the first year since such things have been tracked (covering 66 years) that so far there are more down days than up days in the S&P 500 and yet it is up on the year (barely). In 16 years there were more down days than up days but in all those cases the index had a negative return. It will be interesting to see how this holds.
Quote of the Week
“Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market.”
~ John Maynard Keynes
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So with what, please enjoy your week. We are one week closer to an MLP recovery than we were a week ago. And we have another week to look forward to, times that we won’t get back, and therefore should be enjoyed to their fullest. Please reach out to us any time. Onward and forward we go.
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