Market Analysis: Pent-Up Energy
Markets have gotten headline fatigue. Perhaps, there is a point at which the noise becomes so cacophonous that it is simply easier on the ears to listen only for the signals.
Whatever the reason, while each day brings some new distraction, whether it concerns Iran, North Korea, Russia, Italy, trade with China, or the Robert Mueller investigation, over recent weeks equity investors have begun to focus on corporate earnings. Those earnings’ signals have continued to show strength in the global economy.
Important signals are not, however, restricted to bottom-up company fundamentals. For many, the Federal Reserve and the European Central Bank are sending out the important ones. We agree, and are intently focused on inflation expectations, interest rates and US dollar exchange rates, ourselves.
Bring that all together—earnings, inflation, rates—and you start to build a sense of the billion-dollar question: where are we in the business cycle? You also uncover some potentially attractive investment opportunities.
We believe we are entering the late phase of an unusually long business cycle. Historically, that has meant rising inflation and higher commodity prices. Broad commodity benchmarks are up strongly over the past couple of months and well ahead of global equity markets so far this year. Recent strength from energy, precious metals and industrial metals have paced these markets.
Importantly, after many years in “contango” (where later-dated futures trade more expensively than near-dated ones), the majority of commodity futures curves have moved towards “backwardation” (where the later-dated contracts are cheaper).
That makes commodity futures more attractive for investors, because they start to earn what is called “roll yield”. More fundamentally, rising prices at the front of the curve reflect that demand is beginning to put a strain on supply, or at least that hedgers, producers and investors are moving back towards a more “normalised” relationship after years of weak demand.
This is the late phase of the business cycle at work.
Higher commodity prices likely means growing earnings for commodity companies. Let us focus on the energy sector, in particular.
WTI crude oil is up more than 40 per cent over the past 12 months, and even after the recent pullback it remains above $65 per barrel. The first quarter 2018 US earnings season revealed substantial earnings growth from energy companies over the same period last year, and the estimate for the sector’s earnings growth in 2018 is among the highest in the S&P 500 Index. Yet valuations, while they have recovered considerably over recent weeks, still appear dislocated from the underlying strength in energy commodities.
Furthermore, the sector is in acute need of capital. Supply can only meet rising demand if the infrastructure is in place to move it to customers. Evidence is mounting that the sector has a lack of pipeline and related assets to accommodate the recent rapid growth in production and rising consumption, however. Many pipeline providers structured as Master Limited Partnerships (MLPs) have struggled to fund that infrastructure because they have been out-of-favour with investors, elevating their cost of equity.
We think that makes pipeline providers especially interesting. MLPs offer attractive yields, particularly after regulators indicated in March that certain tax treatment may be changed, a ruling that created confusion in an already depressed sector, but which we believe is unlikely to cause lasting structural damage. Regardless of legal structure, pipeline providers in general are toll-takers, which makes them less exposed to the full volatility of the underlying commodity price—yet many have a meaningful proportion of their revenue with automatic escalators linked to inflation. The sector also has an important role to play in transporting US shale gas, and therefore in the transition towards less carbon-intensive power production.
Energy may be an emerging opportunity, then. In addition, the dynamics of that sector hold important lessons about the late phase of the business cycle as a whole.
There are many areas of the economy where investment has been subdued, leaving a shortfall of capital to meet rising demand from business and consumers. For a time, increasing investment can improve productivity and increase the economy’s capacity to respond to higher prices—moderating inflation and extending the business cycle in a benign feedback loop. Releasing such pent-up energy can result in strong momentum as the cycle matures.
That momentum will be described by signals coming from earnings, inflation and rates.
It is encouraging to see investors’ attention rightly turning back to those signals.
Erik Knutzen is Chief Investment Officer, Multi-Asset Class at Neuberger Berman, which is a member of The Gulf Capital Market Association.