- The stock market generated a strong return in the third quarter, led by health care and technology, while trade worries limited gains for energy and materials stocks.
- MLP stocks have gained traction in the market since late March.
- Our view remains that the disconnect between MLP stock prices and MLP cash flows will narrow over time.
Market Overview and Outlook
The stock market generated a strong 7.7% return in the third quarter despite trade conflicts and numerous bouts of financial and political uncertainty across the globe. The Alerian MLP Index finished the period up 6.6%.
Concerns over the broad-based implications of U.S. trade policy continued to dominate the financial news flow. The first half of the quarter was marked by the U.S. dollar reaching new highs, oil prices declining and the yield curve flattening. A trade settlement with Mexico and Chinese intervention to stabilize the yuan in late August settled the markets’ fears somewhat. The dollar finished the quarter little changed, while oil re-established its upward trajectory late in the period, reaching $73.25 per barrel for WTI crude, up 20% for the year to date. Yields on the 10-year U.S. Treasury climbed as investors gained confidence in the sustainability of a strong U.S. economy, overcame fears of slumps in emerging markets and settled further in to a global monetary tightening cycle. As expected, the Federal Reserve raised short-term interest rates by 25 basis points to 2.25% in late September.
The best-performing sectors of the S&P 500 were health care, information technology (IT) and industrials. Energy, materials and the interest-rate-sensitive real estate and utilities sectors lagged. Health care names appeared to benefit from sector rotation while economic strength helped industrial and discretionary stocks. Trade worries limited gains for energy and materials stocks.
U.S. economic indicators are uniformly powerful. Unemployment — at 3.7% in September — continues to be strong and jobless claims hit a five-decade low during the quarter. Unemployment is currently at levels below the commonly accepted non-inflationary rate, putting the Federal Reserve on inflation watch. Wages rose 2.9% and 2.8% in August and September, respectively; levels not yet alarming but the highest of the current cycle. The powerful September ISM indicates real GDP growth of over 4%. Consumer confidence hit a new cycle high and September’s seasonally adjusted annual rate of auto sales was 17.4 million, the best in several months. Capital expenditures were also the highest of the business cycle, helped by incentives in recent tax reform. Share repurchases for the S&P 500 were $191 billion in the second quarter, the highest ever.
MLP Market Outlook
After a rocky and volatile first quarter, MLP stocks have gained traction in the market since late March. Based on fundamental and valuation tailwinds, we remain positive in our outlook for MLP stocks over the balance of 2018 and into 2019.
Since the end of March, MLP stocks have generated a total return of almost 20%, compared to the S&P 500 returning 11%, utility stocks returning 6% and REIT stocks returning 7% over the same period. Despite this outperformance, MLP stocks remain attractive looking at both fundamentals and valuation.
U.S. energy production growth remains robust. Oil production is up 15% year over year, natural gas production is up 12%, and natural gas liquids production is up 16%. The surge in U.S. production has not resulted in oversupply. In fact, inventories of crude oil and natural gas in storage are 12% and 20% below year-ago levels — despite such a large increase in production. Given declining inventories and continued robust demand, we would not expect a significant decline in oil and natural gas prices over the balance of 2018.
"MLP stocks remain attractive looking at both fundamentals and valuation."
While U.S. energy production growth rates may slow heading into 2019 due to infrastructure bottlenecks (primarily in the Permian Basin of West Texas), we expect production growth to continue; such infrastructure bottlenecks are a clear signal from the market that growth opportunities to build new pipeline, storage and processing facilities will continue for at least the next several years.
Despite the rebound in MLP stock prices since late March, MLP stock valuations remain attractive. The sector currently trades at a 22% discount to its historical EV/EBITDA multiple, a 33% discount to its historical price/discretionary cash flow multiple and a 18% premium to its historical average yield — despite sound balance sheets and robust energy infrastructure fundamentals in the U.S. Our view remains that the disconnect between MLP stock prices and MLP cash flows will narrow over time.