Increasing Exposure to MLPs
Over the past two months, the global economy has performed better than we anticipated in the second quarter. Despite a meaningful tightening in financial conditions, increasing trade tensions, and rising sovereign credit risk in Italy, we have not seen renewed deterioration in global economic data. On the contrary, our leading economic indicators have stabilized over the past month, suggesting that the global slowdown experienced in the first half of the year may be coming to an end.

Somewhat surprisingly, this stabilization seems most apparent in emerging markets, where we would have expected to see more negative developments given the underperformance of currency, equity, and credit markets. Furthermore, bank lending surveys from the United States and Europe show supportive demand and supply conditions, with ongoing easing in lending standards in both regions. However, market sentiment remains quite fragile for the moment, suggesting that global equities are likely to remain vulnerable to aforementioned risks.

As a result, we maintain our modest underweight to global equities. Similarly, after having hedged our EM currency exposure for the past few months we decided to close our EM local fixed income position, as we expect some additional underperformance in the medium term due to U.S. dollar strength, and rising inflation due to currency weakness. In credit markets, we maintain a large underweight to U.S. credit, in favor of event-linked bonds. We are moderately overweight duration in developed markets as we are seeing some signs of inflation stabilization. Furthermore, we added exposure to MLPs in early June and late July, funded out of large-cap U.S. equities.

Adding Exposure to MLPs

Over the past four years, while the S&P 500 Index has posted cumulative total returns of about 60%, MLPs have lost about 20%, for a whopping gap of 80% versus core U.S. equities.1 We believe this trend may be coming to an end, with MLPs now offering attractive valuations and improved fundamentals as a result of a long and painful healing process. To be sure, this healing process may not be over yet, but it is certainly very advanced. Overall, we believe this asset class could benefit from several tailwinds, in terms of long-term fundamentals as well as cyclical and near-term positive catalysts.

From a long-term fundamental perspective:

  • Cheap valuations versus S&P 500: Infrastructure MLPs currently trade at an EV/EBITDA discount of about 7% and 11% versus their 10-year and 5-year averages, respectively. In contrast, the S&P 500 trades at a premium of 21% and 15% versus its 10-year and 5-year average (Exhibit 1).

Exhibit 1: Attractive MLP Valuations, Especially Compared to Core U.S. Equities

Exhibit 1: Attractive MLP Valuations, Especially Compared to Core U.S. Equities

  • Restructuring: While still ongoing, restructuring has gradually taken place in the past couple of years, with elimination of incentive distribution rights, which reduce the proportion of cash flow allocated to limited partners at high absolute dividend levels, capital structure simplification, increasing adoption of self-funding models, and a focus on return on invested capital.
  • Rising U.S. production: U.S. crude oil and natural gas production continues to grow and it is expected to set new records, supported also by rising export growth. Volume increases should drive positive operating leverage for midstream companies (Exhibit 2).

Exhibit 2: Rising U.S. Production Means Increasing Volumes for MLPs

  • Infrastructure constraints: This will require ongoing infrastructure spending over the next few years.

Recent positive developments:

  • FERC final ruling: In mid-July, the U.S. Federal Energy Regulatory Commission (FERC) issued a final ruling on the MLP treatment of the income tax allowance, providing more flexibility compared to the initial version. This should result in a less pronounced reduction in rates for cost of service pipelines than originally estimated based on the March ruling (see a recent blog from the SteelPath Team for more).
  • Q2 earnings season: Results were good, benefiting from strong volume growth, higher distributable cash flow, and increasing distributions versus the previous quarter.

Conclusion

We believe the current macro regime of slowing growth has been historically consistent with bonds, credit, and equities delivering similar returns, therefore arguing for limited dynamic tilts between traditional asset classes. However, our Global Allocation strategy continues to express large deviations from a traditional 60/40 allocation, with sizable relative value exposures within asset classes, representing about 30% of our portfolio. This includes positions in small caps, mid caps, and MLPs versus large-cap U.S. equities, and event-linked bonds versus developed markets credit

 
  1. ^Relative performance between the Alerian MLP Infrastructure Index and the SP 500 index from August 2014 to August 2018.

The Alerian MLP Index is a float-adjusted, capitalization-weighted index measuring master limited partnerships, whose constituents represent approximately 85% of total float-adjusted market capitalization. The S&P 500 Index is a broad-based measure of domestic stock market performance.