For those that have received questions about the relevance of owning TIPS during periods of increasing inflation, I have broken down how they work and why we do not own them at this time.
Conclusion: why we do not currently own TIPS
1.) We do not anticipate annual inflation above 2.14% over next ten years (breakeven at parity)
2.) TIPS performance driven by factors similar to Treasuries
3.) TIPS are an expensive insurance; drastically underperform during periods of low inflation
As I mentioned in this morning’s meeting, attached is the updated Guide to the Markets from JP Morgan. I have included some of the most timely and relevant charts below.
We constantly see different ways to depict the narrative, but I found this interesting. The author uses equity flows as the proxy for investor movements, indicating a “following of the crowd” type scenario.
The simple conclusion drawn from this illustration is that a balanced portfolio that remains balanced over time tends to outperform. The more investors move in and out of cash or “less risky” assets in an attempt to time market movements, the more likely they are to miss out on the upside or lose on the downside.
Continue reading “Market Volatility and Sticking to Strategic Allocation”
Last week, the Federal Energy Regulatory Commission changed a ruling that will affect the revenue and cash flow for a few MLPs. Below discusses the policy change and what it means for the industry going forward.
The general consensus is that there will be a limited number of companies directly affected by the change, and the market selloff in the space was an overreaction. Nearly all management companies have provided commentary to this point, with the majority downplaying the negative effects of the ruling.
1.) What was the policy change that took place?
On March 15th, the Federal Energy Regulatory Commission (FERC) ruled that FERC regulated MLP owned pipelines can no longer recover the cost of income taxes in setting tariffs on interstate pipelines. Even though MLPs do not pay taxes, they were able to add in the tax rate of shareholders. Airlines fought this rule and won a change to the tax law. Therefore, the rate that MLP owners of FERC regulated natural gas and oil pipelines can charge customers must be lower to solve for the same ROE, reducing some MLPs’ cash flow and dividends.
There are four different price rate methodologies used currently. Only companies using the cost of service method will be affected. The cost of service is the revenue a regulated pipeline must collect from customers to cover its costs to operate. Following the announcement, income taxes will no longer be part of the total cost equation, implying that total cost of service will be lower, thus reducing cash flows from an asset.
2.) Which assets are impacted?
The only pipelines that will be affected are those which are currently regulated by the FERC and cross state borders. Additionally, these assets must use the cost-of-service method for pricing in order for the ruling to have a negative impact.
Management companies have come out and downplayed the effects of the change, noting that only a small portion of assets would be impacted. Based on a few different estimates, a worst case scenario would lead to an approximately 4.5% reduction of income due to decreased pipeline tariffs. Below is a flow chart showing the assets that will be negatively affected.
3.) How will TORIX be affected and what are their thoughts moving forward?
Looking at their holdings, Tortoise estimates the EBITDA reduction will be 2% or less. These numbers are based on current EBITDA and do not account for any new projects. Because new projects have tended to use market-based rates, they would generally not be affected by the ruling.
Tortoise MLP and Pipeline fund holds 25% (or less) of MLPs and owns 75% (or more) of C-Corp companies, so they have lower exposure to MLPs than the Alerian Index which is 100% MLPs. If a pipeline is publicly owned, it can be structured as a MLP (Master Limited Partnership) or a regular corporation (C-Corp). MLPs have a tax advantage when raising capital as the MLP does not pay taxes and can yield more.
This FERC tax rule change and Trump’s Tax Cuts and Jobs Act of 2018 have reduced the tax efficiency of MLPs relative to C-Corp firms, but have not eliminated the advantage. Depending on a MLP’s assets and finances, it may make sense for some of them to convert into C-Corps. Tortoise can own MLPs or C-Corps and can take advantage of any mispricing around potential changes in corporate structure.
With the selloff in the MLP space last week, we believe that Midstream energy company valuation are very compelling and continue to offer attractive yields. The yield of the Alerian MLP index is now at approximately 8.5%, which is compelling given REIT and utility yields are below 4%. While TORIX yield (3.16%) is lower than AMJ’s, the fund has outperformed the index by over 30% during the past two calendar years, showing the benefits of owning C-Corp midstream firms.
Currently, these tax law changes have placed a cloud over MLPs and the midstream energy space for investors. Despite this fog, fundamentals remain strong as the price of oil is above $60, gas and oil volumes continue to grow and MLP enterprise value to EBITDA valuation is attractive (see below charts). While we are disappointed in year-to-date performance, we are being patient and waiting for investor sentiment to improve.
US production of crude oil and natural gas has been strong:
MLP valuations remain low – close to 2 standard deviations below the mean:
Peter Malone, CFA
Research Analyst
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Good Afternoon,
Attached is the most recent “Uncommon Sense” piece put together by Michael Arone at SSGA. The theme is the recent increase in volatility, and he discusses the following three points:
1.) Investors have relied on the “Fed Put” during the market run-up, and he believes this remains in play with the new Fed Chair, Powell
2.) We are still in a Goldilocks market environment, with modest “not too hot, not too cold” growth
3.) Fundamentals continue to be the driver of growth in the stock market, and the numbers continue to be solid
MONTHLY MARKET MONITOR FEBRUARY 2018
Attached is the Monthly Market Monitor put out by Eaton Vance (through the end of January). Note that any return numbers do not account for trading at the beginning of this month.
Below are three charts related to our discussion in this week’s meeting
Good Afternoon,
Attached is another summary perspective on tax reform put together by Fidelity. This piece addresses the positive short and long term implications of the tax reform and discusses how the multiplier effect changes the magnitude of increases to U.S. GDP growth.
Thank You,
Pete
Market volatility is the rate at which prices increase or decrease over a certain period of time. One way to measure the implied volatility of the S&P 500 is the VIX.
The VIX is a volatility index comprised of options, with the price of each option reflecting the market’s expectation of future volatility. Increased put prices will indicate an expectation for greater volatility. It is important to note that the VIX measures 30-day implied volatility so this is not a tool used to predict long term market movements. Below is a link that breaks down the equation used to measure the VIX:
https://www.cboe.com/micro/vix/vixwhite.pdf
In this piece, the goal is to get a perspective on the low volatility levels experienced in 2017 and set expectations for what may occur as volatility begins to tick upward. While we are not predicting a major market correction in 2018, we want clients to be aware that it makes sense to expect increased volatility. In turn, we want to emphasize that maintaining a diversified portfolio provides downward protection during periods of equity selloff.
Good Morning,
Attached is the most recent chart pack put out by SSGA.
In recent weeks, the U.S. Federal Reserve has discussed plans to “unwind its balance sheet”, the next step in its attempt to roll back quantitative easing efforts. In this piece, our goal is to provide a better understanding of what this means, explain the goals of the new action, and discuss possible market implications in the short to intermediate term.
