Q4 2020 – Presidents Have Consequences
Not to be outdone by the first and second quarters of the year, the fourth quarter of the year seemed like a fitting end to 2020. President Trump contracted COVID, he skipped the second debate against Joe Biden (because it was going to be a virtual format), and it came out that President-Elect Biden’s son may have engaged in foreign dealings that resulted in tax reporting problems. The year could only be properly punctuated by President Trump refusing to concede the election and it felt like the agreement to allow for the peaceful transfer seemed half-hearted. As an indication of the unity we can expect in 2021, many politicians are trying to see if there is time to impeach President Trump again, or invoke the 25th Amendment to the Constitution, to get Donald Trump out of office before President-Elect Biden’s inauguration on January 20th. A natural response to that olive branch is that President Trump announced he will not attend the Biden inauguration. The tragedy and violence that occurred on January 6th at the U.S. Capitol was unacceptable and violence is not the vehicle by which a message should be carried. Violence typically means the message cannot stand on its own merit. In 2016, many of President Trump’s supporters voted for an agitator and a disrupter, and that is exactly what we got. It feels like the country needs to tone the rhetoric down, but civil discourse is not our expectation for the coming years (aspects of social media and one’s ability to curate exclusively confirming information will contribute to that end).
Tragically, the number of COVID-related deaths in the United States is approaching 400,000 and a new strain has emerged that is believed to be 50% more contagious, according to WebMD. Although the vaccines offer a light at the end of the tunnel, renewed risks could reignite calls for additional social and economic restrictions. The pandemic continues to cause some individuals and families to live under tremendous stress. Some businesses have fallen through the cracks of the various safety net programs that have been devised. A real risk exists that changes in consumer preferences may cause long-term damage to certain geographic areas and economic sectors. There has been a meaningful trend of people moving out of high tax states and urban areas, and they are relocating to lower tax states and away from some of the major cities. According to a 2020 study by United Van Lines, the top five states with outbound moves were New York, New Jersey, Illinois, Connecticut, and California. The top five inbound states were Idaho, South Carolina, Oregon, South Dakota, and Arizona.
"Although the vaccines offer a light at the end of the tunnel, renewed risks could reignite calls for additional social and economic restrictions."
The Fed’s new policy of targeting a long-term average rate of inflation of 2% may have already had an impact on the market. It would appear the market believes the Fed, as longer maturity Treasury yields have climbed while shorter-term rates remain anchored by the low Fed Funds Rate. Longer Treasury yields may simply be reflecting the increase in energy prices, along with an 8% appreciation in residential housing values in many areas of the U.S. and used car prices took a meaningful price jump with prices at the end of the 3rd quarter up as much as 15% as compared to the year prior (according to Cox Automotive). It is believed that the housing trends are driven by COVID inspired goals, having more room and the opportunity for social distance, and the explanation for the automobile price appreciation is attributed to the stimulus checks. It will be truly fascinating to see how a year of being cooped up, socially distanced, less mobile, and remotely working will change lifestyles and consumption patterns. For some, it has been a year of being reminded of “simple pleasures,” others have thrived in the virtual environment, some people have floundered due to the state of constant uncertainty, and sadly many people have struggled with isolation and loneliness.
Observations and Outlook – Eat, Drink and Be Merry
2021 offers the prospects of the pandemic subsiding and “certainty” regarding the political direction of the Unites States. A change in the direction of the political pendulum will occur, but the narrow majorities in both houses of Congress may temper the magnitude of the changes. Alternatively, the handful of moderate politicians may be showered with so many political opportunities, or “wins” for their constituents, that it will result in increased spending so the House, the Senate, and the President can finally “get things done.” If we look at the various plans that were mentioned on the campaign trail, the “things” will involve infrastructure spending, additional stimulus dollars for some individuals, possible debt relief programs, the promise of increased healthcare services (including a single-payer option – “Biden-care”), and money to benefit schools, higher education institutions, challenged municipalities, help for healthcare systems, and many other compelling causes such as environmental justice (Green New Deal).
To raise the funds to partially pay for the new efforts we will need to increase taxes in many forms. As a presidential candidate, Joe Biden indicated income taxes would increase for those making more than $400,000, as well as a hike in the corporate income tax from 21% to 28%. He also advocated for taxing capital gains at ordinary income rates for those making more than $1 million a year. There are additional tax increases but the “heavy lifting” from a revenue generation standpoint would be shouldered by those three increases according to the Tax Foundation. Those increases should produce roughly $200 billion a year over the next decade. In total, the Tax Foundation estimates the entire tax plan would raise $3.3 trillion over the next decade. Their conclusion was that the cumulative impact of the taxes would be to “shrink the long-run size of the U.S. economy by 1.62% due to higher marginal tax rates on labor and capital.” As some people interpret the Tax Foundation to be critical of increasing taxes, it is worth looking at the Moody’s analysis, often cited by the Biden campaign, of the various political outcomes of the recent elections. Under a “blue sweep” scenario, Moody’s surmises that over the next decade, the Biden plans would add half of a percent to GDP as compared to their Trump scenario, and would come at the expense of annual deficits in the range of $2 trillion to $3 trillion and a debt-to-GDP ratio that increases from the 100% measure at the start of 2020, to roughly 130% in 2030 (in full disclosure, the current policy scenario - Trump with a divided Congress – Moody’s estimates the ratio would grow to 125% in 2030). Since the U.S. is looking at a 2020 deficit of nearly $4 trillion, on a $20 trillion economy, we may hit a ratio of 120% to 130% before the end of the pandemic. According to the St. Louis Federal Reserve, that measure of indebtedness was as low as 64% in 2008. A change of this magnitude in a slow-growth world, and with alternative “reserve currencies” becoming more probable, suggest to us the future consequences will be significant.
"To raise the funds to partially pay for the new efforts we will need to increase taxes in many forms."
Beyond simple dollars and cents, there will be a pendulum swing in other areas. Specifically, the Federal Reserve and Treasury focus may shift from Wall Street to Main Street and there is apparently an appetite among prominent democrats for an increased regulatory environment. Since regulation often benefits larger entities (as a barrier to entry for small competitors), it will be interesting to see how this plays out. Greater levels of regulation often increase the cost of goods and service delivery. Small employers, without easy access to the capital markets, experienced great challenges during the pandemic. Yelp, the online review entity, says that since March, 164,000 businesses on their website have closed, nearly 100,000 of them permanently. The incoming administration should be focused on job creation. According to the Small Business Administration, small businesses account for 64% of net new private sector jobs and make up 49.2% of private sector employment. Burdensome regulation could act counter to what should be a broadly shared goal.
President-Elect Biden has named former Federal Reserve Chair, Janet Yellen, as his choice for Treasury Secretary. The market seems to interpret this favorably and clearly she has a strong background in public service and academia. She is a champion for what she’s called “extraordinary fiscal support” to get through this pandemic and she has said deficit spending is affordable given the current extraordinarily low interest rates. Janet Yellen has generally been supportive of tighter financial regulation. Again, if a goal of the President-Elect is access to credit and fuller employment, it seems like it would be a questionable move to hike up regulation on banks when the economy is attempting to recover. Yellen’s record indicates that she will target the “shadow banking” industry (investment banks that are outside of the Feds purview) and in specific, “leveraged lending,” which is lending to businesses that are already highly indebted. The concern seems to be that job losses could result if the borrowers start defaulting. If the businesses close because they don’t have access to capital from willing lenders, wouldn’t the result be much the same? As Treasury Secretary, Yellen would be instrumental in managing trade policy. In the past, Yellen has been in favor of liberalizing trade policy and has indicated that determining when a country is manipulating a currency is “difficult and treacherous.” Soon, Secretary Yellen will help to determine what happens with the tariffs levied against Chinese imports, she will help decide if the Trump administration protections for American intellectual property will continue, and she will likely have significant input on whether China will be labeled a currency manipulator (which serves little purpose, other than to be a finger in the eye of China).
The possible change in focus from Wall Street to Main Street, especially when considered with the potential underpinnings of the Fed’s 2% long-term inflation goal, may be frustrated by the ballooning debt and deficits. A goal of letting the economy “run hot” for periods of time was that it was believed that a benefit of the tight employment environment was that real wages, wage growth relative to inflation, increased for a broader swath of the workforce, especially low-skilled Americans. A potential problem with Janet Yellen’s view that deficits are fine because the current level of interest rates is low, is that it misses the impact of interest rates rising, which is a reasonable biproduct of massive fiscal spending and extremely accommodative monetary policy. Stated another way, we could become victims of our own success. If we let the economy run white hot, borrowing costs could increase, offsetting some of the benefits of the short-run economic gains with either short-term increased interest costs, or worse yet, the addition of long-term debt. According to TreasuryDirect, the total interest cost for Treasury obligations in fiscal year 2020 was nearly $523 billion, down from $575 billion in 2019, likely resulting from plummeting interest rates in early 2020. As a rough estimate, if interest rates were to reverse, while the principal amount outstanding increased by approximately 20%, our annual interest cost on our debt could approach $700 billion. Add another $20 trillion to $30 trillion to the debt over the next decade and at a point, we have enjoyed a lot of consumption and left the next generation in a debtor’s prison. This all seems to accelerate if we lose the enviable position of being the world’s sole reserve currency. Count on that in our lifetime.
"If we let the economy run white hot, borrowing costs could increase, offsetting some of the benefits of the short-run economic gains with either short-term increased interest costs, or worse yet, the addition of long-term debt."
Near-term, we expect rates will rise as the COVID vaccine becomes more widespread and the new round of stimulus dollars start to circulate. This could be further amplified by democrat plans to rapidly get additional $2,000 per person stimulus checks in the hands of voters. As an indication of the state of consumers, a Financial Times survey conducted in June of those with incomes under $100,000 found that roughly half planned to use the money for basic expenses and just under half planned to save the money. It suggests that the pandemic is hitting some families hard and others who have been less impacted are cautious about the prospects for their financial future. Of the respondents, only about 10% planned to make discretionary purchases. It may indicate that the pesky “demand” problem the government has had for more than a decade may persist. You can give people “free money”, but can you make them spend it? The December ISM Manufacturing release, which had a surprisingly high reading of 60.7, up from 57.5 in November (a reading above 50 suggests growth) may tell a related story. The market interpreted the fact that a measure of manufacturing customer inventories was at 37.9 suggests that both demand and inflationary pressure will ramp up in the future, but what if the manufacturer’s customers are keeping inventories skinny because they are being cautious about their economic futures? Caution seems to be the most prudent path as the pandemic has made a mockery out of most forecasts.
Our short-term call for higher interest rates, followed by an economy that stalls and falling interest rates, is partially due to stimulus programs, Fed/Treasury support and vaccine euphoria, but it is also influenced by mean reversion influences and the expected flow of information in the coming months. Sequentially, we should start with the flow of information and how that may season growth expectations. As we near February, March, and April, when people will have stimulus dollars in their hands, year-over-year comparisons may start to suggest strong levels of inflation. Given the massive economic contraction in early 2020, comparisons in 2021 versus the same months in 2020 will suggest rapid growth. Any comparison to “zero” looks terrific and these “base effects” run the risk of making the market too optimistic about the true and sustainable pace of growth.
Once investors start to extrapolate the growth metrics that come from the economy moving from being flat on its back to a standing position, market yields may trend higher and fixed-income yields should climb. There is a lot of potential energy that could cause the move to have some heft behind it. In late December, Bloomberg data showed that more than 70% of global debt had yields that were below 1%, with almost 30% of the debt having negative yields. The breakeven rate (a measure of inflation expectations derived from U.S Treasury Inflation Protected Securities (TIPS)) indicated that inflation is anticipated to exceed 2%, the highest reading since 2018. The resulting 10-year Treasury real yield (the difference between a coupon paying 10-year Treasury and 10-year TIPS) fell to a record low of minus 1.12% at the start of 2021.
Also of interest, credit spreads (the additional yield investors demand for taking on credit risk as compared to a like-term Treasury) have significantly recovered to the point they are nearly where they were at the start of 2020 (before the pandemic-related panic). The combination of low Treasury yields and modest risk spreads at the end of 2020 have resulted in yields for high-risk borrowers reaching the lowest on record. This seems tenuous as a significant part of the recovery was based on Fed purchases in this area to support prices and offer high-risk companies access to the capital markets. This could be an area of volatility in 2021. Low yields have driven market-rate coupons of most debt lower, which adds to the interest rate risk of the sector. At the same time, some large (formerly investment grade) “junk” bond issuers, who in the past were able to issue long-term bonds, have pulled the average maturity of the “junk” bond indexes farther out, further adding to the interest rate risk of the sector. If the incoming Treasury Secretary and the Fed pull their support away from this sector while the interest rate and credit risk volatility has increased, it could spell trouble.
"If the incoming Treasury Secretary and the Fed pull their support away from this sector while the interest rate and credit risk volatility has increased, it could spell trouble."
It leads to the main reason why we expect the growth story will stall out. Much of the massive debt assumption in the market in 2020 was for survival, not to fund productivity improvements and future growth. Saddled with “unproductive” debt and in the face of an uncertain longer-term demand picture, along with an increased regulatory and tax environment and unrelenting global competition, it seems unlikely that businesses will be aggressive with both hiring and expansion decisions.
Although we are supportive of a tight labor market to encourage broader economic participation and wealth for more Americans, private sector job growth may be elusive. We do not anticipate that public sector jobs and private sector subsidies will be able to compensate on a net basis for the lack of job growth. There may even be push-back on off-setting public job creation efforts due to fairness concerns. According to a 2017 study by the non-partisan Congressional Budget Office, for those with a bachelor’s degree, Federal workers receive wages that are 5% better than their private sector counterparts and their total compensation is 21% higher. Federal workers with a high-school education have wages that are 34% higher and total compensation is 53% better than private sector workers. If jobs become scarce, expect people to concern themselves with such matters.
Since we have covered a lot of ground in the preceding paragraphs, it is worth summarizing our expectations. We anticipate rates will move higher as some strong growth numbers grab headlines and eventually trail lower than current levels. This forecast may translate into a 10-year Treasury yield that trends toward 1.50% and may see a spike that dabbles with 2.0%. As debt burden concerns emerge, along with stubbornly low long-term job creation numbers, and the degree of economic damage caused by the pandemic become evident, a slow-growth reality will set in and yields may fall in late 2021 or early 2022. We see the largest risk to this forecast coming from the Fed embracing yield curve control and other measures to keep yields low and further obfuscate market prices.
Municipal Bond Market – If They Can Make It Here, They Can Make It Anywhere
As a reward for making it this far, we will start with the punchline to this section. There will be massive challenges for small segments of the muni market, but at the end of all of this, we expect investors will see the credit risk aspect of municipal bonds as one of the safest broad asset classes in the market (independent of Treasuries). More than a decade ago, most municipal market deals came with insurance and a “AAA” rating, making it a homogeneous (high quality) market driven by the level of interest rates (a “rates” market). Following the Great Recession and the demise of most of the bond insurers, investors needed to learn how to perform credit analysis on these varied issuers and the muni market traded more based on sector risk and an individual issuer’s credit risk (it became a “credit” market). It is currently thought of as being a “credit” market. Given the relatively small number of “essential purpose” issuers that we expect will have issues because of the pandemic, we expect that the market will split and the part of the market that is rated “AA” or “AAA” will become a “rates” market, while the “A” rated and lower part of the market continues as a “credit” market.
The risk that we are focused on in the muni market is substitution risk. This can come from alternatives to how people access the goods and services they desire. This risk may be the credit risk key for the near future. For example, if someone wants to work in Manhattan but technology has made it so they can commute electronically as opposed to figuring out the transportation myriad related to where they can afford to live and where the employer is situated, a risk has become introduced to the transportation system, Manhattan area (New York City) sales tax collections and property taxes (as area businesses lose customers, their ability to pay astronomical rents decreases). Another example would be if students warm to online learning. Assuming online degrees are rewarded in the job market as well as in-person learning, students who are satisfied with a different type of education delivery, and while meeting their social needs away from a campus setting may save a lot of money by accessing their college education through non-traditional means (using pre-pandemic norms as a benchmark). The commonality of the two examples is that they have massive fixed-costs and sticky variable costs that cause massive challenges when revenue (demand) proves to be more volatile than previously thought. In some cases, substitution may help to save some sectors. Healthcare systems may benefit greatly in a single-payer environment if they can address some needs and manage the care queue with virtual visits. We will be spending considerable energy trying to reimagine how public and quasi-public services will be accessed, along with tracking changes in preferences in 2021.
"The risk that we are focused on in the muni market is substitution risk."
As mentioned earlier, there appears to be a migration out of some of the largest cities. In New York City, where they have a city income tax, the city’s Independent Budget Office (IBO) says the top 1% of taxpayers, roughly 30,000 families, pay $4.9 billion in taxes which is 42.5% of the total. The IBO has forecasted that income tax revenues will drop by 10%, or $1.3 billion. Manhattan office vacancies hit a 21st century record at the end of 2020, hitting 15.1%, the highest since 1999 according to commercial property firm, Savills. New York’s Metropolitan Transportation Authority (MTA) has said that daily ridership has declined 71% on a year-over-year basis. One of the MTA board members forecasted that long-term ridership is expected to reach only 70% to 80% of pre-pandemic levels. The MTA has $45 billion in debt and expects a deficit of $16 billion deficit through 2024. To address the shortfall, the MTA has borrowed the maximum allowed by the Federal Reserve’s Municipal Liquidity Facility ($2.9 billion, 20% of 2019 revenue). In addition to massive service cuts, we anticipate that a Federal bailout will be needed because we can’t imagine how they can generate enough revenue (taxes and fees) to close the gap. Chicago faces somewhat similar challenges. There will likely need to be an extension of the amortization of the debt for municipalities with large fixed-costs and a relatively narrow revenue base.
The $280 billion in college and university debt may also be an area of challenge. According to the National Student Clearinghouse Research Center, through the end of October, freshman enrollment is down 13%. Total undergraduate enrollment is 4.4% lower. For the first time in 20 years, colleges are dealing with back-to-back revenue declines. Colleges and universities sold a record $40 billion in debt last year, a good number of which were the “scoop and toss” strategic restructurings designed to extend amortization and reduce debt-service costs. Given the need for revenue assistance, we expect this will limit the calls for forgiving some portion of the $1.7 trillion in student debt and will more likely translate into more grants for current and future college and university students. Higher education institutions will be more concerned with future revenue than they will be concerned with past revenue as the next crop of students may be getting comfortable with distance learning “substitutions.”
"For the first time in 20 years, colleges are dealing with back-to-back revenue declines."
The muni market saw a lot of volatility in 2020. Yields went from being the lowest in four decades to the highest in more than five years and ended back near the low levels established at the start of 2020. Liquidity, driven by flows of assets out of munis and then flying back into municipal bonds, was the main driver of the extreme moves. The combination of what is usually low levels of issuance in the first three months of the year (the January Effect) along with an expectation of higher tax rates should be supportive of muni bond prices, keeping yields low. As an asset class that typically lags the Treasury market’s moves, we anticipate the current unattractive yield level will persist until Treasury yields move substantially higher. At which time, and once investors see their values decline, funds may flow out of munis and yields should close the gap with the Treasury market. If history is a guide, yields may get too high as compared to like-term Treasuries.
Strategy and Summary
This quarter our strategy is more of a homework assignment. If the utility you get from your municipal bond portfolio is mainly in the form of producing a tax-efficient stream of income, then we suggest that you sit tight and wait for a better yield environment to continue constructing the portfolio of loans (bonds) you extend to highly creditworthy municipal entities. If you see all investments through a total return lens, then it may be time to reduce your risks in the asset class (particularly interest rate risk). The main challenge of trying to get in and out of the municipal bond market at the “right” time is that occasionally when you want to sell, liquidity can be depressed, and you may not achieve the prices indicated by the entities that offer price estimates on your holdings. More likely, when timing the market with individual bonds, during the spikes in yields, there are often few bonds available to purchase (during the 2020 liquidity crisis, issuers stopped issuing bonds and institutions only sold what was needed to address investor outflows to mutual funds).
As always, our goal in writing this piece is to offer a thoughtful perspective on the current dynamics at play in the fixed-income markets, as well as a best guess as to how the economy and the markets will intersect in the coming quarters. The pandemic has made nearly every forecast worthless in 2020 and our political reality and division has made a mockery of all of us. Given the significant changes that are underfoot, against the backdrop of extreme elements of the state of the current market environment, we expect uncomfortable volatility at times in many corners of the financial markets. We encourage investors to revisit the muni market when “AA” rated munis in the 10-year to 15-year range offer yields of roughly 1.50% to 1.80%. With a high degree of confidence, we think the market swings will take us to those levels, if not beyond.
Finally, our last assignment to our valued readers, please find someone with whom you disagree and make an effort to have an agreeable conversation. Perhaps start with the nice weather we’ve been having, your favorite part about them, or nice thing they said about you that carried you for an entire day.
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