October delivered more of the same for global markets, with stocks appreciating, volatility declining, and bonds trading sideways. The S&P 500 rose 2.32% for the month while the MSCI ACWI Ex US index rose 1.87%. Emerging market equities continued to perform well, with the MSCI EM index rising 3.41% during the month. The Barclays US Aggregate Bond index was up 0.05% and has now returned 3.21%, YTD, through the end of October.
With equity market volatility remaining well below long-term averages and new leadership coming in at the Federal Reserve, investors have turned a closer eye towards fixed income markets over the last few months. We have noted in prior commentaries that expectations for future rate hikes were likely too low. For example, back in September, Fed Funds futures were pricing in just a 15% chance that interest rates would be at 1.75% a year out. Since that point in time, the probability has jumped to 45%. Similarly, there was a near zero pricing in of rates hitting 2.0% by next August. Now, Fed funds futures markets are pricing in a 20% probability that we will see rates of 2.0% late next year, implying strong odds that the Fed will raise rates 3 to 4 times between now and then.
The jump in future rate hike expectations is due in part to global growth continuing to exhibit strong momentum. German manufacturing PMI is at its highest level in six years. Eurozone and U.S. consumer confidence is at current cycle highs.
Also contributing to more hawkish Fed projections is a continued push higher in inflation. As Eurozone and emerging market economies have rebounded over the last year, and U.S. labor markets have continued to move towards full employment, the output gap (the spread between potential economic growth and realized economic growth) has tightened. As the global economy has come closer to realizing or exceeding full potential growth, core inflation has started to rise.
Wage growth is a key part of core inflation, and over the last year wage growth has started to show signs of life across widespread metrics and anecdotal observations. After languishing in the 2-3% range for much of the recovery, wage growth has moved closer to 4% over the last year.
Anecdotally, some companies have been reporting a pickup in wage inflation during the recent round of quarterly earnings. Restaurant chain Texas Roadhouse increased its outlook for labor inflation from mid-single digit year over year growth to 7-8% year over year growth. Bank of America recently downgraded Chipotle not based on a weak reaction to the queso cheese roll out but in anticipation of labor costs eating into their margins over the next two years. With U-6, a measure of unemployment and underemployment, at decade low levels, there is bound to be a continuation of wage growth.
This turns us back to where the Federal Reserve goes from here. While there was consternation over who Janet Yellen’s successor would be, Jay Powell is likely to manage the Fed in a very similar manner to Yellen. He may lean more hawkish than she has in her tenure, with a view to hike rates closer to 4 times a year instead of the 1-3 pace over the last few years, but this may also come as a result of the economy being further along in the economic cycle rather than an explicit bias on his part. In a speech in June, Powell said “If the economy performs about as expected, I would view it as appropriate to continue to gradually raise rates…inflation has been below target for five years and has moved up only slowly toward 2 percent, which argues for continued patience, especially if that progress slows or stalls.” In other words, Powell sees continued room for moderate rate hikes as long as inflation remains subdued.
At present, the Fed is projecting 3 rate hikes in 2018 (assuming they hike in December). As long as labor markets and inflation remain on their current trajectory, the Fed is likely to meet this target. Where the market, or economy, may test the new regime at the Fed is with two scenarios: (1) if there is a correction in stocks early in the next calendar year and (2) if inflation consistently holds above 2.0%. On the first scenario, we could easily see a narrative form where the markets start to correct and test the Fed’s resolve in staying committed towards their rate hike target or whether they back off the target to assuage equities. Traditionalists scoff that the Federal Reserve has any mandates other than stable inflation and full employment, but their behavior has often shown a preference for assuaging market volatility by pulling back on their forward-looking rate targets when markets get choppy.
To give an example of this, in June of 2015, the Fed projected hitting 3.0% on the Federal Funds rate by the end of 2017. In March of 2016, their end of 2017 projection was shaved down 100 bps to 2.0%. What changed in that 10 month window? Unemployment fell from 5.3% to 5.0%. Core CPI rose from 0.18%, year over year, in June of 2015 to 0.88% in March of 2016. The underlying pillars of the Fed’s two mandates - inflation and job growth - only grew more supportive of them sticking to their rate hike guidance, however, global stocks (measured by the iShares ACWI ETF), fell nearly 14% from June of 2015 to February of 2016. While this may seem redundant (of course the Fed wants to be supportive of stocks), we wanted to draw the example out to keep the focus on how the interplay between stocks and the Fed might play out going forward.
We could easily envision a scenario early on in the new year where economic growth moderates a bit (per usual in Q1), the Fed has aspirations to keep their year-end rate target at 2.0%, but equity traders push stocks lower in response to soft economic data but also to test the new Fed chair’s mettle. Will the Fed stay the course in spite of a potential rise in equity volatility? From our perspective, this is likely to be the key question if there is the beginning of a correction in the early parts of next year. Economic growth is steady, the job market is faring well, and consumers are feeling confident heading into the holidays, so the primary risk, outside of some geo-political shock, is how a new Fed regime might respond to an uptick in equity volatility.
Moving on to investment markets, one area of prolonged pain for investors has been Master Limited Partnerships (MLPs). While year to date performance has been disappointing relative to the broad equity market, we continue to believe the long-term return is favorable relative to other asset classes in spite of the whipsaw that investors have experienced over the last two years. First, current spreads within the asset class are favorable relative to historical comps.
When spreads have been between 500 to 550 bps, returns over the following twelve months have averaged 17.99%. At 539 bps as of the end of October, MLP spreads also compare favorably to other yield-centric assets. High yield bonds are trading at a spread of 355 bps to Treasuries. Investment grade bonds are trading at a spread of 133 bps. REITs, as measured by the Vanguard REIT ETF (VNQ), trade at a spread of 250 bps. Utilities, as measured by the SPDR Select Sector Utilities ETF (XLU), trade at a spread of 79 bps.
MLPs are also one of the few asset classes that are trading at the low end of their historical valuation range. At present, MLPs are trading around 1 standard deviation below historical average valuations.
During the pre-commodity crash market from 2010 to 2014, they traded in a range of average valuations to 2 standard deviations above average. By comparison, REITs and utilities are trading at between one to two standard deviations above their long-term average valuations, precisely when interest rates are rising and funding is going to become tighter.
To be certain, MLPs are undergoing a transition in business model and ownership characteristics. The former approach of paying out dividends regardless of cost, leverage, or growth has changed to make sure distributions are manageable but also balanced with growth opportunities and funding capex. Barron’s recently noted that the MLP investor base “is shifting from retail holders to institutions, leading to greater focus on governance and balance sheets, rather than distributions. Until a few years ago, many partnerships sought to maximize distributions, so they relied almost entirely on fickle capital markets to fund expansion.” Though this transition is bringing hiccups to the equity market, it will be beneficial to the asset class over the long-term.
With respect to transport volumes, the primary driver of MLP cash flows, growth has been steady in spite of range bound trading in crude oil. U.S. oil production is set to exceed 10 million barrels per day next year, its highest level since 1970. Rig counts have picked back up due to enhanced drilling efficiencies, which supports volume push for the midstream sector.
Natural gas consumption, YTD, is down slightly (5%), but natural gas exports have accelerated this year, rising 38% from last year. Electric vehicles are sometimes cited as a concern that U.S. demand for crude is going to tail off at some point, and thus hurt energy infrastructure companies. Any such transition is a long way off and even when EVs do make up the majority share of cars on the road (Bloomberg projects this to occur in 2040), it would only displace around 8 million barrels of crude demand, a day, or around 7% of total demand. Even in that case, electric vehicles still need to be powered by some form of energy source, be it solar or fossil fuel. Though solar will be much more cost effective at that point in time, natural gas will still remain a dominant source of fuel supply for the grid that supports electric vehicles. In summary, we believe that though there are some secular forces at work that will pull on the fossil fuel share of global energy sourcing, fossil fuels still have a key role to play in energy consumption over the next decade. As a result, there will continue to be a need for pipeline and infrastructure projects to support energy transportation and, ultimately, the MLP business model.
Finally, a catalyst for energy markets that has been overlooked for the last three years, but is now coming to the forefront is turmoil in the middle east. We won’t pretend to be experts on the inner workings of the Saudi royal family, but the recent ‘corruption crackdown’ does not lend confidence to stability increasing in the region. Long gone are the days of any negative mid-east headline sparking rumors about the Strait of Hormuz being closed and an instant $5 spike in oil prices, but we could see a return of the ‘risk on’ stance in energy markets given mid-east developments. It also doesn’t hurt that the U.S. commander in chief is not exactly a calming presence when it comes to geo-political negotiations.
The whipsawing in MLPs has been hard to stomach, but the valuations, income, and persistence of the business model make the asset class attractive for long-term investors. Given the sharp discount in valuations relative to both historical averages as well as other areas of the equity market, we believe the asset class should remain a part of a well-diversified portfolio, in spite of the weak returns this year.
Stocks continue to perform well into year end and barring any major geo-political events, look to be setting up well for a seasonal rally to close the year. Emerging markets continue to post strong performance, led by a rebound in earnings and economic growth. Bonds of many stripes have performed well this year, with core bonds returning a little over 3.0% through the end of October.
We continue to view the trajectory of Federal Reserve policy as the major catalyst for how the economy and stock market will move over the next few years. The new Fed chair, Jay Powell, is cut from the same cloth as Janet Yellen in that he will likely take a more dovish angle towards raising rates, but is cognizant that any uptick in inflation may necessitate a slightly faster rate hike schedule than what markets are accustomed to. To be clear, we do not anticipate rates moving up aggressively, but believe that the pace may be closer to 4 rate hikes a year instead of 1-3. We could envision a scenario where the Fed is put to the test early next year, if equity markets correct and investors look to see if the forward projections for rate hikes are brought down.
In spite of whipsaw trading and disappointing year to date performance, we continue to believe master limited parternships are one of the more attractive return opportunities in U.S. equity markets. Valuations are below historical averages and are attractive relative to other income oriented vehicles. The business model continues to make economic sense and will have a place in the economy even if electric vehicle use increases significantly. Lastly, the balance of risk in the middle east seems to have shifted from one that is bearish oil (i.e. not adhering to production cuts) to one that is more bullish for oil (regional tensions have picked up and could hinder supply).
Investment Advisory services offered by Independent Financial Partners (IFP), a Registered Investment Advisor. WhartonHill Investment Advisory and IFP are separate entities.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data is via Morningstar as of 10/31/2017 unless otherwise noted.