Muni Technicals Weaken, but Relative Performance Holds Steady

When evaluating the municipal market, a consistent topic of conversation for us is the technical environment, which is basically a measure of supply and demand.

Municipal bond funds and ETFs have exhibited a fairly consistent pattern over the last 10 years whereby redemptions occur during periods of rising Treasury rates. The last few weeks have been no exception. Since late August, the 10-year U.S. Treasury yield has risen from around 2.8% to 3.2%. The two main data providers on fund flows, Lipper and ICI, have reported that muni funds and ETFs have faced outflows for seven straight weeks through 11/7, the first sustained period of outflows since immediately following the 2016 presidential election.

On the supply side, in October the market absorbed two of the heaviest weeks of supply this year, as several large new issues came to market.

Despite these headwinds, the municipal market generally remained on stable footing. As shown in the chart below, the ratio of municipal bond yields versus Treasury bond yields (a proxy for municipal richness/cheapness) remained fairly close to August levels, before any outflows had occurred. Credit spreads, or the additional yield demanded by investors to take municipal credit risk, have also remained relatively stable and currently sit at the YTD average. Looking at total return performance of the market broadly, the ICE/BAML municipal master index has performed in line with the ICE/BAML Treasury index in recent weeks.

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It is expected that technical factors will become more supportive through January, as supply is expected to slow. With Treasury yields having stabilized and the midterm election cycle behind us, we would expect the pace of outflows to slow or reverse as well.

Both the market’s ability to absorb outflows and an uptick in primary supply without a major hiccup should be viewed as positive. Coupled with the improving technical environment, performance relative to Treasuries is likely to be supported through the end of the year.

Sources: Barclays, ICI, Lipper

Jobs Report Indicates Labor Market Remains Healthy, Fed to Stay on Track

Employers added 250,000 jobs during October, continuing the healthy pace of hiring that we’ve seen over the last several years. In fact, jobs have been added for a record 97 consecutive months. The unemployment rate was steady at 3.7%.

The main headline in the report however, and in most papers over the weekend, was wage growth. Average hourly earnings rose 3.1% year/year, the largest gain since 2009. Earlier last week the employment cost index, another proxy for worker compensation, showed a tick up as well.

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Many economists have been waiting for wage growth to emerge after years of steady hiring. And while a print above 3% may indicate some tightening in the labor markets, we are still far away from the 4%+ figures seen in past economic expansions. Of course, those types of wage gains were present during periods of higher inflation. As we discussed on our recent Q3 webcast in early October, wage growth tends to coincide with inflation, not lead it. With inflation around 2%, it makes sense that wage growth, while increasing, is still well contained.

We watch these figures with great interest as they have implications for the Federal Reserve. A healthy labor market and inflation at the Fed’s 2% target makes it very likely that the Fed will continue on its steady path to policy normalization. This means another four rate increases by the end of 2019. It also means that with economic fundamentals at the Fed’s targets, market volatility, like what we saw in October, will not necessarily knock the committee off its path. We will hear from the Fed this week after its November meeting. All indications are that the committee will hold rates steady and will next raise the fed funds rate in December.

With these dynamics in play our broad market outlook, which is highlighted by a flat yield curve environment and pockets of market volatility as policy normalization takes place, remains unchanged.

Source: JP Morgan, WSJ

2018 Harvest Opportunities Are Bountiful in the Municipal Market

The fall harvest season is upon us here in the Northwest, and not just at the pumpkin patch. In the municipal market, the rising interest rate environment during 2018 has created opportunities to harvest losses in certain municipal holdings. Referred to as tax loss harvesting, the trading strategy involves selling a bond that has declined in price due to increasing interest rates, and then subsequently reinvesting into a similar bond that has also declined in price. The loss that is realized is an asset that can be used to offset gains in other parts of client portfolios.

Municipal bonds are well suited for tax loss harvesting because the wash sale rule for munis is not overly restrictive. As long as the bond purchased is slightly different from the bond that was sold, such as having a different maturity date, coupon or issuer, the wash sale rule does not apply. This means, for example, that if we hold a 5% coupon bond issued by Northeast Independent School District in Texas that matures in 2025 and is trading at a loss, we can sell the bond and replace it with a Dallas ISD bond with a 5% coupon that matures in 2025. Both Northeast and Dallas school districts are located in Texas, have Aa1 ratings and consistently trade in a very similar manner, which makes us indifferent to any minor differences between the two holdings.

Over the course of 2018, we have identified and executed swaps in client accounts to generate tax loss assets. The recent spike in bond yields has likely created more opportunities to harvest losses. We will be actively searching for more loss harvesting opportunities in the coming weeks, as we believe the opportunity to harvest losses is one of the key value adds for a separate account manager. However, it is important to note that loss harvesting is only prudent in situations where transactions costs can be minimized and another bond with similar characteristics can be purchased at fair market value. We will likely not be harvesting losses in credits where we have high conviction and that are not replicable based on current market opportunities.

Overall, this opportunity, if pursued properly, can add value for our clients, and we’ll be trying to maximize this value over the coming weeks.

Why Higher Treasury Rates Are Challenging the Muni Market

We have written many times this year on the support the municipal market has received from the provision in last year’s tax bill that eliminated advanced refunding transactions. Through September, tax-free municipal issuance is down approximately 14% versus the first nine months of 2017. Lower supply is one of the reasons why municipals have produced flat returns through September, while most other investment grade sectors have sold-off with the rise in interest rates.

Of course, this positive technical environment has not just been due to a supply reduction, but also because of steady demand. For much of the year, flows into municipal bond funds has been solid, with net flows (inflows minus redemptions) hovering in slightly positive territory.

This dynamic has changed over the last four weeks. For the first time since late 2016, the muni market has now experienced four straight weeks of net outflows. According to Lipper, flows for the week ended 10/17 were ($636mm), which brought the four-week average to ($495mm).

Unsurprisingly, this has coincided with a rise in Treasury yields. Historically, when US Treasury rates experience a sharp move higher, municipal flows turn negative. Because the municipal market has such a large retail investor base, we tend to see reaction based selling. In other words, when bond prices are selling-off, retail is quick to reduce exposure.

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So far in this redemption cycle, the market has held-in fairly well. We typically assess market health not just on overall performance versus other investment grade sectors, but also on how lower-rated credits are performing relative to higher-rated credits, the subscription levels of new issuance and our anecdotal trading observations. In all three areas, we haven’t seen anything that would cause significant concern. We will be paying close attention in the coming weeks however, not just how the market is trading, but how fund flows are evolving.

Source: JP Morgan, Lipper

Substance in the Age of Spin: IMF Economic Projections

The International Monetary Fund (IMF) is the real deal. It is the global institution whose core mission is to monitor economic activity, policies and financial markets around the world and to offer support to economies in trouble. The IMF is highly capable and credible, and its analysis is data driven.

The IMF, in its semi-annual outlook published last week, is projecting global growth of 3.7% for 2018 and 2019, which is 0.2% lower than the forecast from April. Growth is turning over. The United States is still a bright spot due to extraordinary fiscal stimulus (tax cuts), yet U.S. forecasts are also weakening from 2018 to 2019 due to recently announced trade measures. In the euro area, including the United Kingdom, growth is expected to slow further to below 2%. Growth in many energy exporters has been lifted by higher oil prices, though growth was revised down for Argentina, Brazil, Iran and Turkey, reflecting tighter financial conditions, geopolitical tensions and higher oil import bills. China and a number of other Asian economies are also projected to experience somewhat weaker growth by 2019 due to recently announced trade measures. Notably, China’s growth is projected to slow to 6.2% in 2019 from 6.9% in 2017.

Chart: Real GDP Growth by Country Group (year over year)

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Risks are to the downside in IMF projections due to elevated policy uncertainty, among other factors. Rising trade barriers, a reversal of capital flows to weaker emerging market economies and higher political risk are beginning to slow growth. Also, financial accommodation could tighten rapidly in advanced economies if trade tensions and policy uncertainty expands.

At SNWAM, our base case scenario is similar to the IMF’s, as we are calling for continued yet slowing U.S. economic growth. Risks to growth are increasing, and last week’s stock and bond sell-off is a reminder that it’s best to be cautious; financial markets can turn down well in advance of economic weakness. TV spin economists offer amusing stories and keep us watching, but we will stick with data and analysis from our dull and cautious experts – substance over spin.

Source: IMF World Economic Outlook, October 2018