While the US equity market is at record highs, we have become more positive on the market and the economy in recent letters. Fears that a Smoot Hawley trade war scenario have not played out and the administration’s successful negotiations with Mexico, Canada and South Korea, suggest that the administration’s trade gambit is increasingly likely to succeed. This is great news as it relates to a major potential change in US and China relationship, reversing years of easy trade terms and putting a stop to unsustainable intellectual property theft. Like the administration’s multi-pronged defense policy noted last month, China is using all its levers to keep the best terms for itself. Consequently, it is no surprise that China’s trade negotiations will not be resolved until after the November midterm elections when Congress’ Republican majorities may be lost. At that point China could drive a better deal for itself with a weakened Trump Presidency.
We believe that the acceleration in earnings growth attributable to the tax cuts will be short lived and will lead to a deceleration in earnings growth in 2019 compared to 2018’s. The outperformance of US market and economy should moderate in 2019. We expect that with the resolution of trade disputes and a moderation of US earnings growth, foreign markets and emerging markets, in particular, will experience improved performance.
A decelerating in US economic growth will also lead to a weaker dollar. A weaker dollar will lift gold and commodity prices. Consequently, we are allocating toward gold, commodities and foreign markets and away from US equities.
Valuation and Risk:
If the risk to the market is not clear, we have our Fed Model pictured below. While we anticipate continued US equity strength into 2019-20, the deceleration in the earnings line pictured in the second panel should be monitored. It was not until those earnings line began declining in August 2000 and 2007, that the markets turned downward for two of the worst bear markets in history.
Stocks are at historically high valuation levels. This exceptional valuation level is justified due to historically low-interest rates. Note how in the chart below shows the Shiller market valuation CAPE ratio exceeding the 1929 peak level.
Stocks are expensive based on the Shiller CAPE ratio. Current valuations exceed levels of 1929 but interest rates are lower. Interest rates are low and have been declining for years. So while the US equity market is expensive, low-interest rates make it a reasonable risk.
Unfortunately, if rates continue to rise and S&P earnings decelerate or decrease, the market could roll over. While we do not expect this to occur until 2019-2020, this could change quickly. One troublesome risk is that commodity prices lead to higher inflation and rising interest rates.
MLPs and Corporate Governance:
To hedge against inflation and own income generating assets, one sector we advocate is midstream MLPs. Historically MLPs offer high tax-advantaged income growth from stable midstream assets. We have been buying MLPs for our clients for 17 years. We expect the resurgence in US oil and natural gas production will provide strong demand for infrastructure and increase transported volumes which will drive MLPs higher.
Unfortunately, one investment and a former big winner American Midstream Partners, LP (AMID) has proven to be a great disappointment. On September 28th ArcLight Energy Partners Fund V, L.P. made a $6.10 bid for American Midstream Partners (AMID) to go private. We believe the price is absurd given UBS’s $11/unit valuation on April 30th before several material positive developments.
AMID’s stock price was hammered following the Board of Directors recent decision to cut its distribution by 75% and led to a 46% decline in it’s unit’s price since July 26th. With the LP Units now stabilizing and the end of quarter “window dressing” selling was occurring, ArcLight made this bid. While the transaction makes great sense for ArcLight, it is at the expense of AMID unitholders who expect the board and management to maximize their units’ value. It appears that ArcLight is failing its fiduciary responsibility to AMID shareholders. This transaction comes at the expense shareholders, like our clients, many of whom were attracted to the distribution, retired and in a poor position to take a capital loss.
Below are the material positive developments since UBS valued the units at $11 on April 30th:
- New capital allocation and business plan dated July 27th, 2018. “That is intended to significantly reduce leverage, provide capital for strategic growth opportunities, and create long-term value.”1
- Cancellation of a bad merger with Southcross Energy Partners, LP on July 30th, 20182
- The sale of a marine terminal and ratings upgrade by Moody’s on August 1, 20183
- And a potential transaction with Enterprise Products Partners, LP (EPD) the MLP industry leader which will allow AMID to grow its Gulf of Mexico gas assets and enterprise much more rapidly. CEO, Lynn Bourdan III, had worked at Enterprise Products.
In light of these developments and UBS’s $11/unit valuation4, we believe AMID units shares should be fairly valued at $12-14. Income Growth Advisors’ MLP strategy performance has been savaged by AMID, but if the AMID’s conflicts committee, corporate governance, moral persuasion and/or market factors prevail, AMID should quickly recoup its recent losses.
To capitalize on the opportunity to buy undervalued emerging market exposure and receive a good yield, we are buying TEI Templeton Emerging Market Income Fund. With its 7.7% yield and recent 19% decline, this is a good value in a yield-starved world.
We welcome all questions and comments.
Tyson Halsey, CFA
- Houston Business Journal Jul 30, 2018.
- HOUSTON, Aug. 1, 2018 / PRNewswire.
- UBS Shneur Gershuni, CFA April 30th, 2018.