States Facing Impediments to Projected Increases to Growth of Sales Tax Revenues

State and local tax revenues have continued to grow, but as the business cycle matures, revenue growth has been slowing. One indicator of slowing tax revenue growth has been the downward trend in sales tax revenue growth. In FY ’15 total state sales taxes grew by 4.6%, but in FY ’16 that growth fell to 1.5%. Based on an analysis by the Rockefeller Institute of Government, states had expected a rebound in FY ’17 sales tax revenues, with a median projected increase of 3.1%. While there is some variation in actual collections between the states, sales tax collections this year have been disappointing. In California, for example, YTD state sales tax revenues had been expected to increase by 4.6%, but FY ’17 sales tax collections have been flat, having grown by only 0.1% over YTD FY ’16 collections.

Even in states that may be more dependent on income taxes, sales taxes are a key component of state tax revenues as they help diversify a state’s revenue sources. They are even more important in no-income tax states such as Florida, Texas and Washington where they represent the largest General Fund revenue source. There has been some hope that state sales tax growth will improve in FY ’18, but the outlook is mixed right now. States have been a bit more optimistic in their expectations, as the median estimate of FY ’18 sales tax growth has increased to 3.5% from the 3.1% forecast for FY ’17. Retail sales and consumer spending, however, have been lackluster so far in 2017, even as the start of FY ’18 approaches. Consumer spending was flat in the first quarter of the year, but there are hopes for a spending rebound in Q2 that will carry over into the new fiscal year. April retail sales came in below expectations with a 0.4% increase, but February and March sales estimates were revised upward, and there are expectations that Q2 spending will increase to 3%. 

Spending could be helped by a federal stimulus combining lower tax rates and new infrastructure initiatives coming out of Washington DC, but those policies may be delayed given other legislative and political priorities. We will continue to track the development of federal policies that could help offset factors that the Wall Street Journal described as impediments to the growth of consumer spending: increasingly uneven distribution of wealth, as well as lower levels of consumer debt that have offset another driver of consumer spending, wage growth.

Sources:  California State Controller, Morgan Stanley, Rockefeller Institute of Government, Wall Street Journal

Just the Facts Ma’am, Just the Facts

A flurry of political drama and controversy roiled the markets last week. On Wednesday, in reaction to this drama, 10-year treasuries fell 10 bps, the S&P was off by 1.8%, gold was up 1.9% and even the corporate market widened a bit. However, in the long-term we believe that markets focus on the facts, much like Sergeant Joe Friday from the series Dragnet, who is best remembered for his famous line: “Just the Facts Ma’am, Just the Facts.” Jack Webb was the original Joe Friday, but the character may be most often associated with Dan Aykroyd, who took on the part in the 1987 film.

In channeling Detective Friday, we see the facts supporting two points. First, since the economy is doing fine we may not see a long-lasting reaction to recent political news. The economy is arguably at full employment, corporate earnings are strong and U.S. GDP is moving ahead at a slow and steady pace. The rest of the world is also on an upward trajectory, with GDP in Europe and even Japan surprising to the upside. Second, the market has been discounting this political drama for some time. Both the dollar and the inflation expectations have been fading since the election, so it appears that controversy is increasingly being priced into the markets. Little of this controversy is a surprise. 

Drama is always amusing and sometimes even a little worrisome. But as we have discussed before, the U.S. and worldwide economies began to reflate sometime in early to mid-2016 and the trend appears to be continuing. Despite the political drama happening, not just in the U.S., but all around the world, we will stick with Joe Friday’s advice and just focus on the facts!

Sources: Bloomberg, The Financial Times. Barclays Global Research

Earnings Reflation – The Bulls Are Running!

When it comes to corporate bond management we can get bulled up about higher revenues and earnings. It is always easier for companies to make interest and principal payments when earnings are going up! And when earnings are higher it can certainly help bond spreads tighten, as we have seen over the last few quarters. As the first quarter earnings season comes to a close it appears we chalked up another strong result with much higher revenues and earnings for investment grade bond issuers, as represented by the S&P 500. With most all companies having now reported, 1Q17 saw revenues increase by 8.7%, while earnings increased by 15.5% compared to the same time last year. The leaders included energy and financials, and only telecommunications came in with negative revenue trends. The great results from this last quarter were not just a one-time event but have been building over the last few quarters.

So why are we seeing such strong growth, and will it continue?  This earnings reflation can be attributed to several events. In early-2016 we saw oil hit a bottom at around $25 a barrel, and growth off this low base has been impressive. About the same time, China increased stimulus to its economy, which also helped a number of sectors. Finally, we can give the Federal Reserve and other central bankers some credit for many years of aggressive monetary accommodation. If you keep the punch bowl out on the table long enough the party should eventually pick up! 

S&P 500 Revenues and Earnings: Recent Trends and Projections

Though the party is still ongoing, we may need to find a few new catalysts if we want the positive revenue and earnings trends to continue. New catalysts could include a boost from better earnings and GDP growth in Europe and around the world, as well as the potential for regulatory relief and tax reform in the United States. We shall see. It is hard to extrapolate such a strong trend into the future, but bullish equity analysts are doing their best!

Source: Bloomberg, Financial Times, Barclays

Munis Shrug Off Concerns

2017 has been a good year so far for municipal bonds. Despite investor concerns entering the year about a multitude of issues, including tax reforms, rising rates and a continuation of fund outflows, the municipal market has managed to outperform all other investment grade market segments. This has been driven primarily by a strong technical environment that has provided support to the market, and to a lesser degree, by a reversal of the cheapness and underperformance we saw at the end of last year. The strong technical environment is quite simply demand outweighing supply. So far this year new money issuance has underwhelmed expectations for a material increase. At the same time, a decline in refunding issuance has also helped keep supply low. The higher interest rate environment means that there are fewer eligible deals to be refunded. The net effect has been a drop in total issuance this year relative to the last 2 years (though it is worth noting that despite last year’s record issuance, the year actually started off slowly and only reached the record due to a major surge that began late in the 3rd quarter). Meanwhile, demand has been relatively consistent and supported by generally positive mutual fund inflows.

Traditionally, March is a seasonally weak month for municipals, as individual investors sell positions or redeem fund shares to help with tax bills due in April while issuance tends to be higher relative to other months. This year we witnessed no such weakness because demand handily absorbed a lower than average swell in issuance. Now we are headed into what is traditionally a very strong period for the market, when coupon payments and maturity cash flows pick up from June through August, concurrent with a decline in issuance as a majority of local governments focus on passing budgets (typical fiscal years run from July 1 to June 30). Barring an acceleration in tax reforms with details that are particularly detrimental to the value of munis, we would expect a continuation of the strong relative performance from the muni market over the summer months. Another risk, though not our base case, would be that a jump in rates sparks another spurt of fund outflows – though this would create opportunities for our clients should it occur.

Source: Fidelity Research, Citi, Bloomberg

Puerto Rico Debt Restructuring Filed in Federal Court as Expected But No Apparent Impact on Overall Muni Market

The financial oversight board overseeing the restructuring of the Commonwealth of Puerto Rico’s municipal bond debt approved the filing of a petition in federal court on Wednesday that would initiate a court-sanctioned restructuring process.  The Puerto Rico Oversight and Management Board was authorized by the federal PROMESA legislation last year to develop a plan to restructure the Commonwealth’s debt, and while it did not authorize Puerto Rico or any other state to file for Chapter 9 bankruptcy protection, it did authorize U.S. territories, including Puerto Rico, to seek similar relief in federal courts, if necessary. Puerto Rico’s filing is the first under the PROMESA legislation.

The filing is one more step in the long process of restructuring Puerto Rico debt, and occurred after the freezing of lawsuits over Puerto Rico debt expired last week. With the expiration of the lawsuit stay, numerous creditor lawsuits have been filed challenging the Board’s approval of a plan in March that would make drastic cuts in the Commonwealth’s debt service payments.  Lawsuits have also been filed challenging the Board’s filing for court protection.

SNW’s exposure to Puerto Rican debt continues to be limited to bonds issued by their Housing Finance Authority, where debt service payments are backed by the U.S. Department of Housing and Urban Development. These bonds continue to carry an investment grade rating and have not seen a material change in price since we initiated the position a few years ago. Principal and interest payments on these bonds are not impacted by the restructuring news. 

The reaction to the filing from Puerto Rico stakeholders has been mixed, falling along lines of who owns what type of Commonwealth debt. Moody’s Puerto Rico analyst feels that the filing was a positive step overall for bondholders as the restructuring process under the federal court’s jurisdiction will be more orderly than having a proliferation of lawsuits from multiple factions.  

While the management of the restructuring process in federal court could be more orderly, Puerto Rico still does not have authority to file Chapter 9.  So instead of being heard under Chapter 9 bankruptcy proceedings, this would be the first case under the PROMESA legislation.  Without legal precedent, there are questions about how the case would proceed, particularly as there are different factions of bondholders who may own debts that appear to have more bondholder protections than others.  The case will become even more complicated with the inclusion of Puerto Rico pension obligations into the process.

The filing was not unexpected by the municipal market, and it did not appear to have an impact on muni pricing.  Bloomberg News also reported that the prices of actively traded Puerto Rico GO bonds were not impacted by the filing.

The SNW investment team will continue to monitor the potential impacts of Puerto Rico’s debt restructuring on the municipal bond market.  We also track other distressed municipal credits, but we believe the applicability of Puerto Rico’s debt restructuring has more limited impacts on credits such as the state of Illinois’ despite comments made by some pundits.  Illinois as with other states still does not have authority to file Ch. 9 bankruptcy protection nor any other mechanisms such as PROMESA to file for bankruptcy-like protection.  Illinois has not repudiated its debt and we don’t believe it is likely to do so.  It also has an economy that is much stronger than Puerto Rico’s, and the state has sufficient resources to maintain solvency once it overcomes its political stalemate.  Even without bankruptcy authorization, there is a possibility that Illinois GO debt could be downgraded to junk status, but we would expect that they would still pay debt service on their debt obligations.

Source:  Bloomberg News, Moody’s, Reuters, Puerto Rico Financial Oversight and Management Board