The Mysteries

July 2023 equity and bond markets continued their divergence, with the S&P 500 benefiting from the continued outperformance of large cap tech and growth stocks, while fixed income markets lagged.  The Federal Reserve’s economists acknowledged on July 26th that the US is no longer likely to enter a recession.  Despite rising interest rates and a Federal Reserve that wants to be restrictive, the Chicago Fed’s National Financial Conditions Index which measures U.S. financial conditions in money markets, debt and equity markets and traditional and shadow banking, indicates that financial conditions are looser than average. Indeed, on July 28, 2023, the NFCI was at its lowest point in 2023.  We see from multiple data points that the US economy is fine, from oil prices up 18% in July to rising Pending Home Sales in June to strong leisure travel.  After encouraging CPI, PPI and PCE deflator data in July, equity investors are assuming that inflation has been vanquished, and the Fed is done raising rates.  We’re in a minority in believing that the rates are likely to trend higher for longer, especially given the continued $1.7 trillion in stimulus from the Infrastructure Bill and the Inflation Reduction Act and other inflationary pressures such as a weak dollar, with the Euro up 14.0% versus the dollar year-over-year and the Chinese renminbi strengthening in July. We would not be surprised to see a 6% fed funds rate if the Federal Reserve is truly serious about returning inflation to 2%. Since protecting our capital is critical in our investment process, almost risk-free money market yields of 5.17% set a high bar. Still, we continue to see investable stocks and bonds at attractive valuations despite the equity market’s exuberance.

It is certainly true in shipping equities. Six weeks ago, markets were convinced that there would be little to no demand for VLCCs and due to the incipient recession, oil would fall to $60.00 per barrel. We were told by experts that the Saudi oil cut was futile. Some tanker stocks reached their 2023 lows.  On the other hand, we saw opportunities and we bought.  Fast forward to this week, and oil prices are 18% higher and crude tanker equities are more rationally priced.  The talking heads rave about Amazon being up 7.18% in the last 30 days, while DHT, FRO, INSW and TNP increased by 16.43%, 18.08%, 16.70% and 17.72% respectively over the same time period and have received little general attention.  Economists and business school professors believe markets are efficient and investors are rational.  We are under no such illusions, both on the short and long sides of investing.  Irrational valuations can last minutes, days, months, or years, depending on the market’s dominant narrative and potential catalysts. They are not guaranteed to correct themselves as quickly as they did in the example of crude tanker equities.  It is why we maintain strict discipline in taking losses where we are wrong or are right too soon, which are the same things ultimately.

We believe in the need to address climate change through thoughtful decarbonization. On the other hand, we are starting to see data points that confirm our belief that poorly designed and aggressive decarbonization policies are inflationary and ineffective. We have written in the past about renewable diesel, which generates significantly more carbon emissions than conventional energy over the full cycle than if you look at the tailpipe alone. In July, we saw further examples of the impact of suboptimal policy choices:

  • Offshore wind is delayed as costs increase.  The average cost to build 1MW of wind turbine capacity in the EU has increased by 38% in the last two years.  In addition to significant steel and concrete, offshore wind requires copper, zinc, manganese, chromium, nickel, molybdenum, and rare earth minerals which have had average price increases since 2020 of 93%.  On July 20th, Vattenfall AB, a Swedish utility, cancelled a wind farm planned in the North Sea, which would have provided power for 1.5 million UK homes, after costs for the technology soared by 40%.  It chose to take a $537 mil write-off instead.  In the US, Commonwealth Wind, owned by a subsidiary of Iberdrola, just reached a deal with three utilities to terminate its contract and pay a $48 million fee. Northeastern states are now considering agreements that would allow inflation-adjustments, and New Jersey recently passed a bill redirecting up to $1.0 billion in federal tax money to the developers of Ocean Winds 1. Elected officials remain committed to offshore wind, they just haven’t figured out how to tell electric consumers it isn’t free.
  • On July 21, The New York Public Service Commission approved rate increases for the next three years for electricity of 9.1%, 4.2% and 1.4% and natural gas of 8.4%, 6.7% and 6.6%.  Consequently, in January 2024, New York City and Westchester residents will be paying 13.6% and 15.7% more for electricity and natural gas year over year.  Rhode Island Energy has proposed a 24% rate increase from October 1, 2023, to March 2024. In both instances, these increases are being driven by their decarbonization strategies.  New York shut down their nuclear capacity, and neither will allow pipelines to be built. In Rhode Island, they import natural gas from Europe by ship that is approximately 300% more expensive than US natural gas.  Both states are committed to offshore wind. Those who are on fixed incomes, the poor, blue collar or working classes of both states will bear the financial impacts of their policies, unless of course, wages and government transfer payments rise dramatically.

Renewable energy is clearly not as cheap as advertised.  The Boston Globe wrote on July 26th about the phenomenon of ICING, which is parking a gasoline engine vehicle in a spot reserved for EV charging, as a form of class warfare.  The average household income of a Tesla Model X owner in 2022 is $146,623 per year versus the US median income of $70,784. Tesla owners skew 50 years old plus, are 87% white, and 88% likely to own their own home. We foresee political resentment, given the average car payments for new and used cars in Q2 2023 are up 32% and 46% versus 2019, making new cars affordable for only the wealthiest Americans and used cars consuming a higher percentage of the income of the less affluent.   As investors, we don’t know the extent of political pushback as living standards continue to decline for the majority of Americans and Western Europeans.  We are convinced that conventional energy will remain globally in demand for those countries focused on improving the material well-being of their populations. China adds more C02 emissions than the UK generates annually, and in 2023 is on track to smash their coal import record set in 2013. We believe some of the answers include nuclear power and hybrid vehicles, instead of forcing 50% of the new cars sold in the US to be pure EV by 2032, renewable diesel, or offshore wind.  As investors, we know that if something cannot go on forever, it will stop, but like irrational valuations, the mysteries, we don’t know how and when.