Blue State or Red State, Muni Market Faces 2016 Election Impacts

While the surprise victory of Donald Trump in the U.S. presidential race has created its fair share of uncertainty in the fixed income markets, there may be more clarity regarding potential impacts on the muni market from both the presidential election and from state and local elections. First, we expect that some form of federal income tax reform will be adopted by the next Congress. Second, we also expect that infrastructure funding will be a key theme of the Trump administration. However, municipal governments have already been ramping up their infrastructure efforts, and voters sent a signal in state and local elections that they are willing to pay (or have someone else pay) for more infrastructure. 

Federal Tax Reform
One area where there seems to be a clear consensus between President-elect Trump and GOP congressional leaders is that of federal income tax reform. Expectations are for top tax rates to be cut to 33%, along with a reduction in tax brackets and further tax code simplification. One stumbling block could be that deficit hawks in Congress are concerned that tax cuts will be matched, not with spending cuts, but with new spending initiatives. We expect that, ultimately, deficit issues will be addressed and that tax rate cuts will be enacted. 

Despite some analysts’ stated concerns that lower rates will diminish muni demand, we expect that there will still be strong demand for tax-exempt munis even if the top tax rate is cut to 33%. Muni investors already include taxpayers in the 33% and 28% tax brackets, and the tax-free income munis generate will likely continue to be an attractive investment option. This, coupled with the historically low volatility that munis exhibit and the relative yield advantages versus other global fixed income options, leads us to believe that munis will still make sense for investors.

We’ve also heard rumblings of a potential cap or elimination of the tax-exempt status of muni interest as a way to offset the cost of fiscal stimulus. Given the importance of the municipal market for the infrastructure projects discussed below, we believe the likelihood of a change is low.

Federal Infrastructure Spending
We expect infrastructure, which the President-elect emphasized in his acceptance speech and in policy briefs, to be a cornerstone of Trump economic policy. The Trump policy imitative includes spending $1 trillion over 10 years to rebuild “crumbling U.S. infrastructure.”  Targeted facilities include airports, hospitals, roads and bridges, water systems, and inner cities. The source of much of Trump’s infrastructure funding would be investment tax credits, which would call for Congress to adopt $137 billion of tax credits to attract private investment for airports and roads that generate revenues for investors.

The Trump proposal would provide incentives for more of the public-private (“P3”) infrastructure partnerships that are already taking place. There have been numerous airport and toll road P3 projects that leveraged equity investments to construct new or replace aging facilities, and recent P3 projects include bridge replacements. While P3 projects could be effectively utilized, there may be pushback from constituents who face new or higher taxes, tolls or fees for further enterprise funded projects.

While the investment tax credits would provide another tool to leverage funds to improve U.S. infrastructure, the Trump proposal does not address current shortfalls in federal infrastructure funding. Funding for highways, for example, continues to be an issue as the source of federal highway grants, the gas tax, has not kept up with project commitments, and congressional Republicans have balked at spending more money for infrastructure. Speaker of the House Paul Ryan has indicated that Congress has already increased spending in the recent Highway Bill, so there may be pushback from GOP members at the suggestion of spending more money. Funding more infrastructure may prove even more difficult if the revenue loss from tax cuts cannot be offset by other expenditure reductions.

State and Local Government Infrastructure Spending
For all the talk about new infrastructure initiatives from the Federal government, state and local governments and their associated enterprise agencies are the organizations that play the central role in developing and managing U.S. infrastructure. While the Federal government appropriates a significant amount of money for infrastructure, most projects are managed at the state and local level. Most infrastructure funding is also generated at the state and local level, either directly or with local matching of federal grants. While the new president and Congress determine a new direction for the Federal government in 2017, municipal issuers will be in the midst of ramping up their infrastructure spending.

That state and local governments will be increasing their funding commitments was apparent in the vote. Across the country, $175 billion of new taxes were authorized by voters just for transit projects. Voters added $55 billion of new authorizations for state and local bonds, including $9 billion alone authorizing the state of California to issue state GO debt for school construction.

The primary vehicle for state and local government debt is the tax-exempt municipal bond market, and we expect the muni market to continue to be the foundation for infrastructure funding. We also expect muni issuers to be prudent in accessing the muni market with their increased debt authorizations. Typically, state and local governments try to avoid flooding the market with debt from new authorizations. For example, California still had over $26 billion of GO debt authorization prior to the election, and some of those projects were authorized by voters a decade ago. 

We will continue to monitor both tax reform and infrastructure initiatives, as they will have an impact on both the demand for and supply of muni bonds.