MuniLand: Don’t Fight Demographics

Demographics can drive secular trends, and the SNW Team has positioned our strategies to benefit from a key mid-term secular demographic trend. That trend is accelerating household formation and increasing the number of first-time homebuyers. Demographic analysis suggests that after years of decelerating household formation the trend may reverse due to the important echo boomer cohorts of 30- to 34-year-olds and 25- to 30-year-olds finally leaving their parents’ basements, forming households and becoming first-time homeowners. It just so happens that the municipal market is well positioned to serve this population.

Housing Finance Agencies are in the crosshairs of the burgeoning first time homeowner demographic. As a reminder, the purpose of HFAs is to provide first-time and low- to moderate-income households with mortgage assistance and counseling. Housing Finance Agencies issue tax-exempt debt and use the proceeds to fund mortgages. HFAs take advantage of the arbitrage opportunity between the tax-exempt and taxable markets to provide cheaper mortgage financing relative to commercial banks, which increases demand for their product. 

The best part of HFA bonds are their strong credit qualities. Even if the business cycle shows signs of age or the interest rate environment becomes less accommodative, HFAs exhibit very high balance sheet strength, excellent mortgage loan characteristics, strong historical loan performance, flexible yet strong bond structures and active management of delinquent mortgages. We are overweighting the Housing Sector of the municipal market because of these solid credit factors and the positive demographic trends, which support our view of a stable to positive fundamental sector outlook. In addition, yields available in the sector are quite high versus other options in the municipal market, making HFA bonds an attractive option.

Wait for it…

Last week the European Central Bank Governing Council met, and we all waited for news on when the EBC would start to taper its bond buying program and raise rates. Hints had been dropped; just recently Draghi declared deflation vanquished and growth is picking up, although inflation has been tame. 

We were all waiting for the news…and are still waiting for it!

In last week’s official statement Draghi mentioned conditions may be ripe for a new look at the level of accommodation. “The incoming information confirms a continued strengthening of the economic expansion in the euro area, which has been broadening across sectors and regions…while the ongoing economic expansion provides confidence that inflation will gradually head to levels in line with our inflation aim.”

The ECB has plenty of room to ease, as accommodation is still at extraordinary levels. The ECB’s deposit rate is stuck at minus 0.4%, that is, the ECB charges banks to hold its money, and the ECB is still purchasing 60 billion euro of securities monthly. With growth and inflation looking better, it appears tapering is just around the corner.  

The next ECB Monetary Policy Meeting is September 7th, and as usual the council will need to accurately read, not only the financial data, but also the mood of the markets. Too strong a statement on tapering and the markets could sell off like the U.S. taper tantrum in 2013. Too weak a statement and investors will wonder what is wrong with the European economy. It is not easy reading the mood of the markets, and mistakes happen.

The larger picture shows that Europe is slowly recovering from the financial crisis. Yet, in many ways Europe’s recovery is years behind that of the United States, as measured by GDP, inflation, unemployment and the strength of the banking sector. Normalization of rates in Europe would be positive. No central banker wants to go into the next recession with negative rates and a ballooned balance sheet. 

But summer vacation is breaking out all over Europe, so we will just have to….wait for it!

Source: The ECB, The FT, Bloomberg

Janet Yellen’s Dovish Swan Song

Last week Janet Yellen made her final scheduled semiannual monetary report to Congress and the Senate. Her position as chair expires on February 3, 2018, and President Donald Trump has a team looking for a possible replacement. We will have to wait and see who will next lead the Federal Reserve.

Janet Yellen’s testimony was widely considered to be dovish, and the markets ended the day with equity and bond prices higher. In light of persistently weaker than expected inflation data, Yellen left the door open for a more gradual rise in interest rates than what was previously anticipated. As she said in her prepared remarks, “With inflation continuing to run below the Committee's 2 percent longer-run objective, the FOMC indicated in its June statement that it intends to carefully monitor actual and expected progress toward our symmetric inflation goal…Of course, considerable uncertainty always attends the economic outlook. There is, for example, uncertainty about when—and how much—inflation will respond to tightening resource utilization.” 

Yellen gave further lift to the markets by reiterating that any reduction in the Federal Reserve’s balance sheet will be gradual, and there is no firm date for when this tapering will begin. However, expectations are that tapering will begin in 2017. All this dovishness seems strange to us. We were so accustomed in recent years to the Fed playing the hawk among worldwide central bankers. Yet now Yellen appears more dovish while there is an increasingly hawkish tone from Europe, the U.K. and Canada.

The Federal Reserve’s small change in policy is interesting, but in reality, the impact of recent news is not as important as the fundamentals: central banks around the world remain highly accommodating, worldwide GDP growth is positive and looking up in many areas, and inflation expectations are subdued. All these fundamentals create an attractive environment for fixed income investors, regardless of the dovish tone of Yellen’s swan song.

Source: The Federal Reserve, Bloomberg, The Financial Times

State Budget Fireworks Highlight the Start of the New Fiscal Year for States Still Working on Revenue and Spending Packages

As of last Thursday afternoon, at least seven states had not adopted operating budgets for the 2018 fiscal year, which started on July 1: Connecticut, Massachusetts, Oregon, Rhode Island, Pennsylvania and Wisconsin. The states of Maine and New Jersey had also failed to adopt budgets in time for their new fiscal year, and each had a partial government shutdown for a short period of time. 

While the SNWAM Investment Team maintains a stable outlook on the State GO Sector, and while debt service on GO bonds and other debt has not been threatened for those states that still have not adopted budgets, credit pressures on states have increased. State tax revenues are growing, but at lower rates than in the past and expenditure demands are growing, particularly for retirement benefits, which include rising pension contributions. We have also noted that political discord in some statehouses has been an impediment to achieving consensus on budget priorities, and that states controlled by one political party have not been immune from budget delays.

For some states, the budget delays reflect deeper credit issues. In Connecticut (General Obligation Bonds rated A1 by Moody’s and A+ by Standard & Poor’s), for example, the state’s fiscal cushion has dwindled due to an underperforming economy, growing debt levels and growing budget gaps that have caused revenue declines despite the state’s high wealth levels. Moody’s downgraded the state’s GO rating on May 15. Pennsylvania (GO Bonds rated Aa3/AA-) had its GO ratings placed on Rating Watch for downgrade by S&P last Thursday, as the rating analysts are concerned that the commonwealth will not be able to enact a structurally balanced budget. The legislature has passed a spending plan, but it has not been able to adopt a revenue package to close a $2 billion budget gap.

The budget problems of other states pale in comparison to the budget crises that the state of Illinois (GO bonds rated Baa3/BBB-) has faced. The state failed to adopt budgets for the 2016 and 2017 fiscal years, and last week the budget stalemate in Springfield crossed into its third fiscal year. The state has endured numerous ratings downgrades and was on the precipice of falling to junk bond status without a balanced budget for FY ’18. The legislature finally adopted a budget four days into the new fiscal year, but on the July 4 holiday, the governor vetoed the budget package because it included an income tax hike without other reforms that the governor felt were crucial to the long-term economic health of the state. In a last ditch effort to avoid the downgrade, the Illinois legislature overrode the governor’s veto. Although the state now has a budget, it still has a lot of work to do to improve its credit quality. Prior to the veto override, both Moody’s and S&P had placed their ratings of state GO bonds on a Downgrade Credit Watch, and the state may still be at risk for downgrade because of the volume of unpaid bills, low pension funding levels and potential revenue shortfalls.

Source:  Bloomberg News, Moody’s, National Conference of State Legislatures, Standard & Poor’s

U.S. Employers Keep Adding Jobs but not Giving Raises

The U.S. added 222,000 jobs during June, which handily beat economist expectations and was an improvement from the 152,000 jobs that were added in May. The unemployment rate (UE) rose by a 1/10th of a percent to 4.4%, but remains low by historical standards. The increase in the UE rate was due to more labor force participants, which is a “good” reason as it indicates more people are actively looking for work. Absent any other details, these numbers point to a very healthy job market with little in the way of slack. There is one statistic, however, which continues to shine a negative light on the labor market—the lack of substantial wage growth. Average hourly earnings for June came in at 2.5% year over year, below economist estimates and just 0.2% above May’s level. In past periods of strong employment, average y/y hourly earnings growth has been in the 3-4% range. The correlation breakdown between a low unemployment rate and strong wage gains has been puzzling economists and may be contributing to the lack of overall inflationary pressure in the economy. Despite this economic conundrum, the Federal Reserve appears to be pushing ahead with their plans to let their balance sheet shrink. Minutes from their June policy meeting were released last week and strongly hinted that the wind-down will begin in September. Moving forward, the number of jobs being created appears to have the most bearing on Fed policy, but inflation, or lack thereof, can’t be too far from Fed official’s minds. 

Source: Bloomberg