Market Update

Spring Is in the Air – We’ll see if the Fed Agrees

Spring is an optimistic time of year, with the smell of grass and fresh flowers, longer days and bright sunshine. And it is so predictable – it happens every year!

If only the economic cycle were as predictable! Recessions happen infrequently and the last one ended in June of 2009.

One of the classic tools for predicting recessions is the NY Fed’s “Probability of U.S. Recession Predicted by Treasury Spread – Twelve Months Ahead.” This model uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead. As you can imagine, the Fed has been tracking and analyzing this data for decades and it does a pretty good job.

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As the data indicates, it is hard to see a recession in 2019 with the U.S. economy still so strong. But as the chart also shows, the risk of a recession can rise or fall suddenly for any number of reasons. What we take way from this data is treasury spreads indicate the economic cycle is at least in late fall: leaves are turning red and gold and there is chill in the evening air.

We will get an update from the Fed this week when the Federal Open Market Committee meets to set monetary policy. The post-meeting statement and press conference will provide insights into the FOMC’s thinking on both the economy and interest rates. We don’t expect any changes to the Fed Funds Rate, but like so many previous meetings, all eyes will be on the dot plot, which highlights committee members expectations for future rate moves.

Markets also do a good job of anticipating the changing of the season and will move ahead of an actual recession. We note investment grade credit spreads appear to have reached their cyclical tights in February 2018, and the last S&P 500 top was in September 2018.

In the coming weeks we will start getting outside more often to enjoy the sunshine, and we will also ensure portfolios are getting ready for cooler weather.

Source: NY Federal Reserve

Munis Continue Their Hot Streak – Creates Opportunities for Crossover Investors

The municipal market has started off 2019 in a strong way, with tax-exempt municipal bonds now trading at some of the richest valuations versus taxable bonds on record. Driven by robust demand (as measured by mutual fund inflows) and light supply (as measured by new issuance), the positive technical environment has been one of the main drivers of the rally.

To measure the relative value of tax-free munis versus taxable bonds, we often analyze the ratio of municipal yields versus Treasury yields. As shown in the chart below, this ratio has dropped over the past 12 months, particularly for short to intermediate maturities such as five and ten years.

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While there are no immediate signs of this trend reversing, these absolute yield levels have created an opportunity for crossover investors to sell munis, purchase taxable bonds, and increase the after-tax yield generation on their portfolios. For example, the after-tax yield for investors in a mid-level tax bracket is 0.19% higher on a 1-year US Treasury Note as compared to a 1-year AAA municipal bond.

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The after-tax yield advantage is even more dramatic for corporate and taxable municipal bonds, which carry additional yield because of a credit spread premium.

These relationships are particularly relevant for our Blend Strategy, which has the leeway to invest in a mix of taxable and tax-free bonds. After increasing our allocation to tax-free municipals in the winter of 2017 during a muni market sell-off, we’ve been slowly capturing municipal outperformance by selling munis and buying taxable bonds. We executed on another leg of this trade last week as the after-tax yield opportunity has become too good to ignore.

Source: Barclays, Bloomberg

Equity Market Impact on Public Pension Funding

As we discussed on our 2019 Market Outlook Call in January, we are expecting more variability in the performance of various municipal sectors this year after what was a benign environment in 2018. The reemergence of pension funding issues is one of the reasons why.

Public pension systems have benefited from positive investment performance during the current long-running economic expansion. Investment performance has been driven by strong equity returns. For example, the total return of the benchmark S&P 500 index has exceeded 300% over the last 10 years. Equity returns do not always follow a straight line upward, however, as evidenced by the 13.5% decline of the S&P 500 in Q4 of 2018. While the Q4 equity sell-off has unfavorably impacted pension returns, most pension contributions and funding ratios are based on fund balances at the end of the fiscal year, which (fortunately for most municipalities) occurs on June 30. This will potentially enable the pension systems to offset some mid-year losses during the subsequent two quarters of the fiscal year.

The impact of the sell-off on pensions will be driven by each plan’s exposure to equities and the potential for a rebound in equity prices in Q1 and Q2. According to Bloomberg, through Wednesday February 6, “The median government employee pension, whose assets are heavily weighted toward U.S. stocks, lost 7.5 percent in the fourth quarter, according to data released…by the Wilshire Trust Universe Comparison Service. Public pensions have lost 4.9 percent since the beginning of the fiscal year on July 1.” While these returns are certainly unfavorable, equity returns since January 1 have benefited plans that are invested in equities. Through the first five weeks of the new calendar year, the total return of the S&P 500 has been approximately 9%. With the rebound this quarter, the return of the S&P 500 since July is now back in positive territory at about 1.5%.

As there is a high level of volatility in equity prices, the prospects for improved funding levels over the next few months to the close of the fiscal year are uncertain. Despite market volatility, the strong gains in equity prices have driven investment returns and improved funding levels for a vast majority of pension systems. We are more concerned for those pension plans that have continued to flounder in a period of economic expansion and solid investment returns. We expect that the systems most negatively impacted will be those sponsored by state and local governments who make annual pension contributions at levels below actuarially determined contributions. Potential market downturns will exacerbate their low funding levels, and further pressure those systems. Examples of such pension systems include the states of New Jersey and Illinois, as well as the City of Chicago.

Source: Bloomberg

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

Jackson Hole – Summer Home to Our Central Bankers

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The Jackson Hole Federal Reserve Economic Symposium, held last weekend in Wyoming, is the only time of year when U.S. Central Bankers get to loosen their ties, breathe a little fresh air and wax philosophically about monetary policy. But let’s not get too excited—it’s no Burning Man!
 
We care about Jackson Hole as we hunt for short-term clues as to the speed of rate hikes and the destination for fed funds rate over the next few years. We all wonder if the Fed will pause raising rates for emerging market mayhem, if higher inflation or lower unemployment will push higher the fed funds target rate, or whether the committee is more likely to just gradually, modestly and carefully raise rates and shrink its balance sheet as the economy continues to improve?
     
Jay Powell, chair of the committee, clearly indicated there is no clarity. The world is uncertain, and the Fed’s crystal ball remains cloudy as it constantly tries to navigate between “moving too fast and needlessly shortening the expansion, versus moving too slowly and risking a destabilizing overheating.”  Mr. Powell reiterated the Fed’s talking points, that “if the strong growth in income and jobs continues, further gradual increases in the target range for the fed funds rate will likely be appropriate.”  Though he was quick to note that this is the consensus view, there are differing opinions on the committee. The markets interpreted his comments as mildly dovish, and stocks rose as the dollar fell.
     
Despite the good short-term news, Mr. Powell also commented on a number of longer-term structural challenges facing the U.S. economy that generally can’t be fixed by raising or lowering the fed funds rate. Real wages (particularly for medium- and low-income workers) have grown quite slowly in recent decades, economic mobility in the United States has declined and is now lower than in most other advanced economies, the U.S. federal budget deficit is unsustainable and there is continuing low productivity. More interesting side bar conversations included challenges to the economy stemming from monopoly power and corporate consolidation, the potential for technology to reshape how retailers set prices and the trade-offs between stability and competition in the banking sector. We shall see if these trial balloons get any traction!
 
Ultimately, it was no Burning Man in Jackson Hole, with no disruptive technologies announced or new visions for the future proposed. But when it comes to central banking, maybe cautious, conservative and calm is the best course.
 
Enjoy the last days of your summer.

Sources: The Federal Reserve, the Wall Street Journal, Bloomberg, the Financial Times