The economy is heating up. The second quarter GDP was revised upward to 4.2% from 4.1%. Walmart, the nation’s largest retailer, reported second-quarter sales of $128 billion and same-store sales growth of 4.5%–the highest growth rate in ten years, demonstrating that the economic pick-up is being felt by most Americans. The stock market is pushing higher despite high valuations and plans by the Federal Reserve to unwind its massive Financial Crisis accommodation. The news media’s coverage of the highly partisan political environment provides ample uncertainty. Some coverage suggests the President should be impeached. Other coverages strike fears that the administration’s trade policies will lead to another Great Depression triggered by global trade wars, like those that inspired by the Smoot Hawley Tariff Act of 1930.
It is hard to predict this November’s election outcome; however, this election will likely be a historically consequential referendum on Donald J. Trump and his “Make American Great Again” policies. Consequently, this historically volatile September-October timeframe will be particularly unnerving.
The Administration’s unconventional approach to trade policies may be less precarious than some think. The United States is the biggest economy in the world and the benefit of our size and strength give the United States a stronger negotiating position than many realize. China’s equity markets are under pressure while the US equity markets are at all-time highs. We believe there is more logic to the administrations hardball tactics than is generally appreciated. Larry Jeddeloh of the Institutional Strategist highlighted a fundamental change in our national defense policy in Barron’s last month. According to The National Defense Strategy published annually by the Department of Defense “A long-term strategic competition requires a seamless integration of multiple elements of national power—diplomacy, information, economics, finance, intelligence, law enforcement and military.” The debut of the words-elements “economics and finance” in the assessment and “the re-emergence of long-term, strategic competition between nations” are a clear turning point in our national defense policy. This administration is now fighting a multipronged global war where economics and sanctions are part of the equation. The United States is now approaching the world in the same calculated self-interested manner that Russia, China, Iran and North Korea are. Our aggressive tariff gambit against China is part of a multi-pronged strategy including North Korea. Further, the administration is aggressively using sanctions against countries like Russia, Iran, North Korea, Turkey and select individuals (Russia) to apply pressure in an unprecedented manner. If the United States succeeds in reversing unfair tariffs and stops China’s systemic theft of US intellectual property, the economic prognosis for the US brightens significantly.
The one potential Achille’s heal to the market is a resurgence in inflation. A global economic reacceleration in 2019, combined with a tight labor market and rising oil prices are likely to awaken inflation from its decade long slumber. This would push interest rates higher creating a tension between rising rates and increasing earnings. Should that happen, a Grantham-like melt-up scenario could play out with the S&P 500 rallying to 3500 and 10-year US Treasury rates rising to 6% before a 50% 1987 style decline in 2020-2021.
The top panel of charts below shows the Fed Model aka “Risk Premium” for the S&P 500 is still in a comfortable 3% range. The Risk Premium compares 10-year US Treasury bond yields to S&P 500 (earnings) yields and provides a metric to determine if stocks are worth “the risk.” In the blow-off scenario described above, the bottom panel of the charts below would show the green 10-year US Treasury yield rising above the blue earnings yield line and score at or below 0% like 2000.
On Tuesday November 6, the mid-term election will determine the government’s path forward. Many believe if the Democrats take control of the House of Representatives, an effort to impeach the President or impede him via litigation will ensue. On the other hand, people generally “vote their pocket books” and that should be good for Republicans; however, the historical precedent is for the minority party to prevail.
Given the market’s risks and likely volatility in the coming months, we favor investing in undervalued sectors like energy, natural resources and banking. Emerging markets including China, Argentina, Turkey, Iran, Venezuela and North Korea could also be attractive.
The energy industry is enjoying a healthy recovery and midstream energy Master Limited Partnerships will benefit from growing infrastructure demand. Natural gas companies are well positioned for growth as they provide cleaner energy to power world growth. Crude oil offers a cyclical investment opportunity and MLPs are corelated to oil. Oil prices are in a bull market run that could lead to prices as high as $200 by 2020. The $200 price target first appeared in energy expert Dr. Philip K. Verleger, Jr.’s July letter $200 Crude, the Economic Crisis of 2020, and Policies to Prevent Catastrophe. Verleger points to the International Maritime Organization’s (IMO) regulation, known as IMO 2020 as the catalyst to the global economic crisis. IMO 2020 mandates the reduction in the sulfur limit on bunker fuel from 3.5% to 0.5% by January 1, 2020. Verleger argues the IMO regulation will impact 50,000 ships, half the refiners in the world [if conditions remain unchanged] and cause a global economic crisis.
Other factors also point to higher oil prices. The bear market in oil prices, since 2014, led to significant under-investment in energy exploration and development and this reduced the industry’s supply capacity. Furthermore, oil supply disruptions from Venezuela and Iran could exacerbate an under-supplied market when the global economy might be reaccelerating.
All these factors bolster the case for MLPs. Income Growth Advisors’ clients have enjoyed excellent returns by investing in Master Limited Partnerships through tax efficient separate accounts. Our clients’ success is reflected in our 17-year record. Unfortunately, American Midstream Partners, LP (AMID) cut its distribution despite effusively positive commentary from the management, prompting about a 50% decline in the MLP in late July. This decision hurt our clients and our record. Our position was oversized since we had bought both JP Energy (JPEP) and AMID at the sector bottom in early 2016. With both positions doubling or tripling and then merging, the position was easily our largest. Those purchases contributed to our impressive 77% trailing 12 month returns that were featured by Amey Stone in a profile published in Barron’s on March 2, 2017.
Due to its high yield, and the fact that it had become our largest position, we sought reassurance that AMID was growing and that the distribution would not be cut. We flew to New York in December 2017 and met with the management team at the Wells Fargo MLP conference. We spoke with the company on several occasions and emailed CEO Lynn Bourdon himself during the spring. We queried the supporting role ArcLight Capital, its General Partner and a large energy private equity firm, that had provided cash to AMID when its cash flows did not cover the distribution. In fact the day we received a research report from UBS suggesting a distribution cut might make sense, we began selling AMID; however, we also followed up with AMID’s IR who persuaded us to stop selling the units. The rest is history. Perhaps the management does not appreciate the importance of the distribution to its MLP holders.
As infuriating as this event is, we have added to our holdings of AMID. Since most MLP buyers are income-oriented retired investors, a distribution cut usually leads to broad-based selling regardless of valuation. On a market capitalization to distributable cash flow basis, AMID trades at four times compared to top MLPs which trade around 10 times. AMID is selling non-core assets and has identified nearly one billion in accretive transactions. AMID’s cash flows did not change due to the cut, but now the stock is now half-priced and will be able to direct about $64,000,000 in distribution savings to accretive transactions. With the distribution cut, Southcross Energy Holdings, LP and South Cross Energy Partners LLC “Southcross” terminated its merger agreement that now appears ill-conceived with AMID. This termination now positions AMID to buy Southcross’s most synergistic and attractive assets at bargain prices as Southcross appears headed for bankruptcy.
On August 15, ArcLight Capital purchased 597,728 shares at a cost of $6.16 per share. This is an important insider purchase by a sophisticated institution. AMID is showing healthy organic growth. Additionally, industry leader Enterprise Products Partners, LP and AMID announced a transaction agreement which augurs well for AMID. Based on its deep value and transaction prospects, AMID should double in the next year and triple in two years. Current buyers can pick up shares from distressed and disgusted retired investors at fire-sale prices near $6. AMID is a classic value investment; it is cheap and unloved. Compared to AMID’s November 9th 2017 close of $13.20/unit, the company’s units are down 55%. Now, the highly photographed CEO’s conference call quotation of November 9, 2017, “Quite frankly folks, this train is leaving the station. I hope as investors, you are as excited as we are about our future and if you stay with us or you get on board quick, because we have an exciting and successful journey ahead of us, and we’re not waiting around” should be acted upon.
Below are our returns showing long-term outperformance to both the S&P 500 and the Alerian MLP benchmark. The unusual underperformance this year is due to AMID. However, for those clients who can stomach it, we will continue adding to the AMID position and expect to recoup our AMID losses and performance.
We welcome your calls and questions.
Tyson Halsey, CFA