February’s swift stock market correction[note]We refer to February’s decline as a mini-crash in that computerized trading drove wild price swings on February 5th that was reminiscent of the Flash Crash of 2010. Technically February’s decline was simply a correction in that it was only 10% from peak to trough, a far smaller decline than what occurred on October 19, 1987.[/note] relieved the market’s extreme overbought and low volatility conditions. With interest rates rising, the stock market has headwinds that will remain problematic; however, earnings are benefiting from lower taxes, reduced regulation and synchronized global economic recoveries. Master Limited Partnerships (MLPs) are being negatively impacted by stock market weakness and rising interest rates; however, they have some compelling characteristics which will drive positive returns in this new challenging market environment. MLPs have high distribution growth prospects, attractive tax advantaged yields and should benefit from their correlation to the rebounding hydrocarbon production growth in the United States.
The Big Picture for Equities:
The chart below shows the significant upward move in the S&P 500 since 1993, with the bulk of the move occurring after March 2009. The chart also shows the two significant declines of over 50% in the S&P 500 associated with Tech Bubble 2000-2003 and Financial Crisis 2007-2009 bear markets.
The seismic change occurring in the capital markets today is the reversal in the direction of interest rates. Interest rates have been declining since 1981 and have bottomed in July of 2016. Now they are rising. The investing public has not digested the implication of this regime change. Not only has the 36-year bull market in interest rates reversed, interest rates have been pushed to unprecedented and artificially low levels by the extraordinarily accommodative policies of global central banks in response to the Financial Crisis. Since 2009, global central banks have accumulated $15 trillion in assets [note]Yardeni Research, Inc. 2018, February 27.[/note] and pushed interest rates to surreal negative levels. Today, there are $9.7 trillion in negative interest rate bonds[note]$9.7 Trillion in negative interest rate debt. Fitch Dec. 11, 2017.[/note] and this is down from $12 trillion at their peak. Artificial price regimes are not durable in the global capital markets. The enormous risk to asset prices, particularly stocks, bonds and real estate, is that interest rates are a key driver to their valuation. The enormous wealth created for holders of stocks, bonds and real estate from the 36-year bull market in interest rates will now be repriced as interest rates rise. Rising interest rates are now a headwind to stock, bond and real estate prices, and February’s stock market correction demonstrates that this rising rate environment is anything but academic.
MLPs are correlated to stock, bond and commodity prices. However, MLPs’ high distribution yields provide a defensive characteristic that will reward MLP investors. MLPs performed well in the Tech Bubble 2000-2002 equity bear market as investors sold momentum stocks and sought safety in stable high yielding MLPs. Alternatively, MLPs performed poorly in the Financial Crisis 2007-2009, because their highly leveraged balance sheets generated concern during the banking and mortgage crisis. MLPs’ attractive yields, growing distributions and correlation to the resurgent US energy markets make them a sensible income vehicle in this bond bear market. Due to the 2014-2016 oil collapse, MLPs experienced a significant decline and bear market, but are recovering with resurgent US oil production.
The chart below shows 10-year US Treasury yields peaked at 15.84% in August of 1981 and bottomed in July 2016 at 1.37%. Bond giants Bill Gross[note]Bill Gross https://en-us.janushenderson.com/retail/bill-gross-investment-outlook-bonds-men-its-about-time/?utm_campaign=Bill_Gross_Investment_Outlook&utm_medium=Email&utm_source=Salesforce&utm_content=Retail[/note] and Jeff Gundlach[note]Barron’s Jeff Gundlach of DoubleLine Capital Markets November 21, 2016. https://www.barrons.com/articles/gundlach-bond-yields-could-hit-6-in-five-years-1478929496?mg=prod/accounts-barrons[/note] have written that we are in a bear market in bonds and that interest rates will go much higher. Where interest rates will settle once this global central bank accommodation is removed and this economic cycle has ended is difficult to predict; however, 6% on the 10-year US Treasury bond yield by 20214 seems reasonable.
The $15 trillion in asset purchases by global central banks and the resulting $9.7 trillion in negative interest rate bonds have created a bond bubble that inevitably will be unwound. Now that interest rates are rising, it is both hopeful and naive to think this bond bubble can be unwound in a slow and controlled manner. This bond bear market commenced in July 2016 with 10-year US Treasury yields at 1.37% and have more than doubled to 2.91%. If wage and commodity prices continue to rise, inflation will increase interest rate risk and concomitantly risk to stocks, bonds and real estate.
The chart below shows improving wage inflation. In the last year, the minimum wage has been raised in 18 states, tax cut related bonuses have been paid and unemployment hit new lows. These developments should add to wage inflation and appear to be gaining momentum.
Financial analysts look at cash flows. Cash flows can be defined as the income your portfolio generates that you can use for living expenses. Cash flow can also mean the less tangible EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization.) We recommend MLPs, because they generate the first type of spendable cash flow. More importantly, MLPs generate more cash flow, more tax advantaged cash flow, growing cash flow and inflation hedged cash flow, than any other income alternative we know. Consequently, when we foresee potentially difficult markets in the future, we believe MLPs will appreciate because investors will invariably move their assets into MLPs because they will want to hunker down with more growing, tax advantaged and predictable cash flows that can support their lifestyle.
If our forecast for higher interest rates and commodity prices is correct, most assets classes, particularly stocks, bonds and real estate will stop performing [Read: decline in value.] In a rising rate environment, finding income vehicles that are not at risk of declining in value will be challenging. This will be especially difficult for individuals looking to their stock and bond holdings to fund their living expenses, like retired people. Bonds will decline in line with their duration risks. Floating rate or bank loan investments can provide attractive income with lower interest rate risk than bonds by virtue of their income increasing with interest rates. Similarly, securities with high dividend or distribution growth, like MLPs, can provide growing income which reduces interest rate risk.
During the Great Recession equity market bull market, traders used the term “TINA” to explain the stock market’s continued appreciation. “TINA” stands for “There Is No Alternative”. Traders explained that stocks had to go up because money markets and bonds had such low yields, “there is no alternative” investment to allocate their capital. In the months and years ahead investors conclude MLPs offer the best inflation hedged income profile compared with REITs, utilities, bonds and stocks. This will lead investors to see MLPs as the best income investment in a rising interest rate environment.
Below is a list of the most common income vehicle available to investors: bonds, the S&P 500, utilities, REITs and MLPs.
MLPs offer far more income than REITs, Utilities, Bonds and the S&P 500. Additionally, MLPs’ income is tax advantaged, growing, and hedged against inflation. As of March 1st, the Alerian MLP index yields 8.16%.
Timing the MLP Market:
Below is a chart of the Alerian index (AMJ) since 2013. It shows the MLP index declining in 2014 and bottoming in January 2016, consistent with the decline in oil. MLPs had a strong 2016 as oil recovered, but surprisingly struggled in the first year of the Trump Presidency. We attribute MLP’s 2017 weakness to continued corporate restructuring and rightsizing, as the sector adjusted to the much lower oil price environment. Ironically, the United States has grown market share in the global hydrocarbon production market and is now a world leader in oil and natural gas production. This provides a solid foundation for price appreciation for MLPs.
The MLP sector appears to have bottomed in November and had a solid bounce in December and January. Unfortunately, February was particularly weak as the equity and bond markets traded poorly. Since MLPs are largely a retail investment product, MLPs were especially weak as retail investors quickly dumped their shares with the spike in volatility. Further, Macquarie Infrastructure Company (MIC) cut its distribution last week, and that hurt the argument that the sector had bottomed. Nonetheless, we are confident MLPs will provide good security, income and capital gain potential in the years ahead.
The chart below shows the Alerian index pulling back to levels close to November’s bottom. With improving oil prices and hydrocarbon production volumes, the fundamental case is improving for MLPs which suggest this is an excellent time to add to MLPs.
The MLP Fund Flow chart below reflects the poor inflows throughout 2017 following a solid year of inflows in 2016. Further, it the chart shows strong inflows in December and January, after the tax law was passed and fears of an adverse tax law was eliminated. Historically, when mutual funds show outflows, it is a very good contrary indicator that a bottom has been made in the sector and it is a timely moment to invest in that sector.
Kondratiev Cycles and Perspicacious Market Insight:
One factor that could exacerbate the rise in interest rates is the growing prospect of commodity and wage inflation. For years, many have speculated that the unprecedented global central bank stimulus would have caused inflation, but that did not prove out. Kondratiev Cycle theory reconciles the shift from a deflationary environment to a rising interest rate environment. Coincident with the maturing of the information age (cycle), the deflationary benefits of technology are dissipating and the economy is shifting into an inflationary cycle. This shift is manifesting itself in wage growth and higher commodity prices.
Below are examples of Kondratiev waves:
- (1600–1780) The wave of the Financial-agricultural revolution
- (1780–1880) The wave of the Industrial revolution
- (1880–1940) The wave of the Technical revolution
- (1940–1985) The wave of the Scientific-technical revolution
- (1985–2015) The wave of the Information and telecommunications revolution
- (2015–2035?) The hypothetical wave of the post-informational technological revolution
With the strengthening economy, wages and commodity prices are rising. Higher prices increase inflation and inflationary expectations which will further drive interest rates higher. This sequence could create a negative feedback loop where rising rates increase the funding cost of our $21 trillion federal deficit and drive interest rates higher still.
The good news is that this new cycle may drive higher economic growth which will drive higher tax receipts and help to get the massive Federal debt back under control. Another benefit of this rising interest rate regime is that it could help to reduce the wealth disparity between the wealthiest Americans–who have benefited from the great bull markets in stocks, bonds and real estate in recent decades–and the middle and lower economic classes. In the months ahead, traders and the media will increasingly focus on the bond market, commodities, and economic data–like wage inflation and economic growth–to see if the Federal Reserve can deflate this bond bubble without disastrous consequences.
Reversion to the Mean:
Market academics believe that stock prices revert to their mean average price over time. This is typical bull market-bear market cyclical behavior that is applicable to stocks, sectors and entire markets. As such, we believe there is a compelling argument that a reversion to the mean is most fitting for the stock market and for MLPs. The stock market as shown below by the S&P 500 in red has rallied 167% since July 2009. The MLP sector (AMJ), shown below in green, is up 8.8% since July 2009. From the July 2009 start date until September 2014, MLPs consistently outperformed the S&P 500. The XLE Energy ETF shown below by the thick black line is up 12% since July 2009. The XLE, like the AMJ, rallied until oil prices experienced a huge bear market from July 2014 until January 2016 when West Texas Intermediate declined 75% from $107/bl to $26/bl.
Oil prices have been rising since January 2016 and are over $60/bl. The energy sector has largely recovered and should appreciate as the US energy sector enjoys strong global exports, reduced regulation and improved business operations resulting from the downturn’s requisite restructuring. Consequently, we anticipate a reversion to the mean which will bring the S&P 500 down and MLPs (and energy stocks) will rally in the coming weeks, months and years.
IGA’s MLP SMA Performance:
February was a terrible month for MLPs. The Alerian MLP index declined 9.69%. The Alerian MLP ETF declined 11.4%. The IGA MLP SMA composite declined 14.65%. Our performance was hurt by overweighted positions in American Midstream Partners (AMID) and Calumet Specialty Products Partners (CLMT), two high beta restructuring plays. The sector’s weakness had to do with the general market decline and spike in volatility. While disappointing, MLPs are attractive stable high yielding utilities in an expensive volatile stock market.
If you consider IGA’s MLP SMA return profile since 2000, after fees we have returned 14.09% since inception. During that same period the S&P 500 returned 5.83%. It is only since oil collapsed in 2014, that there has there been a pronounced divergence in performance between the S&P 500 and the IGA MLP SMA returns. On a one-year basis, we trailed the S&P 500 by 35.45%. On a three-year basis we trailed the S&P 500 by 18.8%. On a five-year basis the IGA MLP SMA performance trailed by 12.97%.
We now believe a reversion to the mean is at hand. Today, March 1st, the AMZX was up 0.34% and the S&P 500 was down 1.33%. (The Dow Jones Industrial Average was off 420 points or 1.68%.)
Below is a chart of the S&P 500 index, IGA’s MLP SMA composite, the Alerian MLP Total Return index and the Alerian ETF since 2000. In spite of February’s poor monthly performance, MLPs and IGA’s MLP Separately Managed Account performance have solidly outperformed the S&P 500 for the last 17 years. It is only since the oil collapse in 2014 that MLPs have underperformed the S&P for any protracted period. We now believe that MLPs will outperform and separately managed accounts are the smart and tax efficient way to invest in the sector. Further, MLPs are due to rebound and a reversion to the mean will punish those not in MLPs and those in the S&P 500.
The table of performance below shows our 17-year MLP investment history. It compares the IGA MLP SMA performance to the Alerian benchmark and the S&P 500. We are now in a period like 2000 and 2001 where the S&P 500 begins to decline sharply and MLPs begin to outperform.
The New Era of Higher Inflation and Commodity Prices:
Below is an ominous chart suggesting we are entering a period of higher inflation and lower financial asset appreciation as measured by the S&P 500. Higher commodity prices could hurt bond prices and hurt asset valuation broadly speaking. This chart is one of the reasons we introduced Kondratiev Cycle work to provide an explanation for the changing environment.
Please contact us if you have any questions or concerns about the market. A secular change is occuring in the market where interest rates are rising and stocks, bonds and real estate are declining. A strategic repositioning of one’s assets could profoundly one’s investment future like similar transitions in 2000 and 2008.
Tyson Halsey, CFA