It’s been a shaky start to the new year as the 10-year treasury has climbed back above 4.0%. The S&P 500 finally has surpassed its January 2022 all-time high, and the 10-year treasury sits at 4.2% as of this writing, up ~35 basis points from its recent trough in December.
Interest Rates vs S&P 500
Source: Bloomberg and S&P Global
Ultimately, interest rates will be the primary driver of stock price performance in 2024, in our view. The resilience of the U.S. economy has put doubt regarding when the Federal Reserve will start lowering rates, by how much and by how many. We fear that those expecting a rate cut in March and six rate cuts this year may be disappointed. The December Federal Open Markets Committee projections call for just three cuts or a
75-basis point reduction in the Fed Funds rate from the current range of 5.25% to 5.50%.
The first half of this year may be choppy until there is clearer visibility to the first rate cut. The recent spate of strong economic reports only forestalls that eventuality. Hence, good economic news may be bad news for stocks.
FED Forecast Signals Rate Cuts in 2024
Source: Federal Open Market Committee
ENERGY: UNDER-LOVED, UNDER-APPRECIATED, AND A CONTRARIAN PLAY
Technology stocks once again lead the market higher while energy brings up the rear. To start the year, the S&P has appreciated 1.5% while the energy sector has declined 4.3%. Granted, it’s still early, but it feels to us that the fear of missing out and the buzz around artificial intelligence can propel these technology stocks higher… until it doesn’t.
On the other hand, energy stocks are under-loved, under-appreciated, and a contrarian play. Energy has been factored less in the S&P as it’s weighting has dipped to 3.7% from 5.0% just a year ago. In contrast, the Information technology sector (Apple, Microsoft, Nvdia, et al) represents 30% of the S&P 500. Urgency: Institutional investors must own the technology stocks or risk underperforming the market. The risk of not owning energy is not that great.
THIS BEGS THE QUESTION—SO, WHY OWN ENERGY?
1. Energy demand for fossil fuels and clean energy is growing due to population and economic growth.
2. Oil and natural gas prices are near the bottom of their trading ranges. Historically, the best time to buy energy stocks is when commodity prices are low, not high.
3. Financial discipline is here to stay. Energy companies are generating attractive returns and free cash flow. That is cash flow from operations is more than enough to cover capital expenditures and the excess can be used to fortify balance sheets and return cash to shareholders.
4. Leverage is low. Debt to Ebitda (a common measure of leverage) is below 1.0x for the S&P 500 energy sector, more than one half of the metric of two years ago. For comparison, the S&P 500 is 1.4x and the Information technology sector is just 0.30x.
5. Valuation is compelling. The energy sector sports a 4.3% yield versus 1.5% for the S&P 500, trades at half the price to earnings multiple, 10x Vs 20x projected 2024 earnings, and energy’s free cash flow yield (free cash flow per share divided by stock price) is 9.0% Vs 3.5% for the S&P 500.
6. It pays to be a contrarian. We’re not fans of following the crowd. We believe investors should allocate at least 4% (the approximate market weight of the energy sector) of their equities portfolio to energy stocks. Stock market strategists expect the S&P 500 to appreciate 5 to 10% this year, given historically rich valuations and anticipation of a soft economic landing. Against this backdrop, the energy sector looks compelling given its dividend yield plus growth, potential for upward revaluation, and underweight in many institutional portfolios.
SAM’s Infrastructure Income and Energy Transition Strategies’ focus is on the midstream energy subsector. It is our preferred way to invest in energy given its modest exposure to fluctuations in commodity prices, stable and growing cash flows, strong balance sheets and relatively high dividend yield approximating 6.0% (based on the Alerian Midstream Energy Index).
HIGHER FOR LONGER INTEREST RATES ARE BAD NEWS FOR UTILITIES AND CLEAN ENERGY STOCKS
For utilities and clean energy companies that are capital intensive and rely on external capital to fund their businesses, the rise in interest rates has been a headwind. It’s always a challenge to get timing right, but interest rates are destined to end the year lower and we expect these two sectors will outperform once the Fed signals its first rate cut.
Our two favorite stocks in these areas are NextEra Energy (NEE-NYSE) and Chart Industries (GTLS-NYSE). The former owns Florida Power & Light, the premiere U.S. utility and NextEra Energy Resources, the largest U.S. originator and operator of wind and solar facilities. The latter is a global manufacturer of equipment critical to the production of LNG, hydrogen, and carbon capture.
DISCLAIMER:
Clean energy stocks are NOT for the faint of heart, given their volatility and inverse relationship to interest rates. We DO believe that they can deliver outsized gains relative to their risk once interest rates begin a sustained decline.
RENEWABLES GROWTH TO ACCELERATE
In 2023, renewables accounted for approximately 22% of U.S. electric power generation [i.e., 874 billion kilowatthours (kWh) out of a total of 4,017 billion kWh], according to the U.S. Energy Information Administration (EIA). The EIA expects solar and wind energy to be the key growth drivers of U.S. power generation over the next two years, as published in its latest Short-term Energy Outlook report. Specifically, solar power generation will grow 75% to 286 billion kWh in 2025, and wind power generation will grow 11% to 476 billion kWh in 2025. Notably, the agency expects natural gas (42% market share) will continue to be the largest source of U.S. electricity generation during this time. The SAM Infrastructure Income and Energy Transition Strategies hold NextEra Energy, Clearway Energy (CWEN-NYSE), and Brookfield Renewables (BEPC-NYSE) to participate in the growth in the renewables sector.
U.S. Annual Electric Generating Capacity (2018–2025)
Source: U.S. Energy Information Administration, Short-Term Energy Outlook (STEO), January 2024
ELECTRIC VEHICLES LOSING MOMENTUM
Hertz Global Headings, Inc (HTZ-NYSE) plans to reduce its U.S. electric vehicles (EVs) by 20,000, or approximately one-third of its fleet during 2024. The adjustment to the company’s strategy reflects lower than expected demand for rental EVs and higher than anticipated repair and damage costs for EVs relative to its gasoline automobiles. Indeed, both globally and in the U.S., sales growth of EVs is slowing. To be clear, EVs continue to grow market share relative to internal combustion engine (ice) vehicles, just at a slower rate.
Hertz was likely early and overly ambitious in adopting EVs given the lack of charging infrastructure and range anxiety. Additionally, potential consumers may:
· Find the price tag prohibitively expensive (even as manufacturers offer discounts to offset reduced government incentives).
· Be concerned with battery degradation and reduced battery performance in cold weather.
· Just prefer the sound of their internal combustion engine.
THE BOTTOM LINE? The government can’t mandate consumer choice.
Sales of electric vehicles in the U.S. surpassed one million in 2023 (1,189,051 to be exact) but still only represented about 7.6% of total U.S. sales of cars and light duty trucks (source: Cox Automotive). According to Bloomberg research, this is still well below its penetration rate in Europe (16%) and China (25%). Cox Automotive forecasts that EVs’ market share will grow to over 10% in 2024. Additionally, electrified vehicles (EVs, Plug-in Hybrids, and Hybrids) in aggregate should represent nearly 24% of the market in 2024. Given their affordability and absence of range anxiety, it’s unsurprising that sales of hybrid vehicles are starting to outpace EVs. SO, WHY BOTHER WITH EVS? Because governments want zero emissions that hybrids can’t deliver.
WHAT THIS MEANS FOR CRUDE OIL CONSUMPTION: Evercore research opines that EVs can result in 4 million less barrels per day of oil consumed by the end
of the decade, but total oil consumption should continue to grow. For context, global oil consumption approximated 101 million barrels per day in 2023.
U.S. Electric-vehicle Sales, Change from a Year Earlier
Source: Wall Street Journal and Motor Intelligence
DECEMBER REVIEW: MARKET RALLIED ON EXPECTATIONS OF FED RATE CUTS IN 2024
The rundown:
· SAM’s Infrastructure Income Portfolio produced a return (net of fees) of -1.0% compared to 4.5% for the S&P 500 and 2.1% for its customized benchmark as of 12/29/23.
· SAM’s Energy Transition Portfolio generated a return (net of fees) of 2.4% versus 5.4% for its customized benchmark as of 12/29/23.
· Midstream underperformed in December with a total return of -0.5%, as measured by the Alerian Midstream Energy Index (AMNAX).
· Utilities posted modest gains and the clean energy sector outperformed, generating a total return of 1.5% and 10.8%, as measured by the Philadelphia Stock Exchange Utility Index (XUTY) and the S&P Global Clean Energy Index (SPGTCLTR), respectively.
· In December, 10 out of 11 sectors in the S&P 500 reported a positive performance with the exception of Energy (i.e., -0.02% monthly total return). Energy performance was negatively impacted by lower commodity prices. December month-end WTI crude oil and Henry Hub natural gas prices were solidly below the ~$75 per Bbl ($71.89) and ~$3.00 per MMBtu ($2.58) levels, respectively, which was down ~5% and down ~6% from last month.
2023 Total Return
Source: Bloomberg, NASDAQ and S&P Global
RESULTS: SINCE INCEPTION & ONE YEAR (2023)
SAM’s Infrastructure Income Portfolio produced a return (net of fees) of 63.4% and 6.5% for the periods since 11/10/20 inception and 1-year (2023), respectively. This compares to a total return of 61.1% and 2.6%, respectively, for its customized benchmark and 40.8% and 26.3%, respectively, for the S&P 500 as of 12/29/23.
SAM’s Energy Transition Portfolio generated a return (net of fees) of 0.8% and -9.9% for the periods since 4/29/21 inception and 1-year (2023), respectively. This compares to a total return of 1.7% and -6.5%, respectively, for its customized benchmark and 18.2% and 26.3%, respectively, for the S&P 500 as of 12/29/23.
Sam Partners’ Infrastructure Income and Energy Transition Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality midstream energy companies, utilities and clean energy companies that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of ~5% and growth potential of ~5-7%; while the Energy Transition Strategy that is more heavily weighted with clean energy stocks and aligns with favorable ESG ratings, offers investors a current yield of greater than 4%. In a world searching for yield, we believe these Strategies offer a compelling value proposition.
IMPORTANT DISCLOSURES
Siegel Asset Management Partners is a registered investment adviser located in Plainview, New York. The views expressed are those of Siegel Asset Management Partners and are not intended as investment advice or recommendation. This material is presented solely for informational purposes, and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness, or reliability. All information is current as of the date of this material and is subject to change without notice. Third-party economic, market or security estimates or forecasts discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates or forecasts. Certain products and services may not be available in all jurisdictions or to all client types. Unless otherwise indicated, Siegel Asset Management Partners' returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.