Third Quarter 2020 – Fed Policy, Politics, and a Pandemic
The Federal Reserve has responded to this crisis with exceptional speed and effectiveness. Although the lines of separation between the “independent” Fed and the U.S. Treasury Department have been blurred, the various sources of support have resulted in elevated stock market values, low Treasury yields and tight risk spreads (the incremental yield non-governmental borrowers pay to borrow as compared to the yield on a like-term Treasury security). Fed Chairman Powell has said that the Fed has done much of what it can do, although it has room to increase the magnitude of the programs, and that the balance of the efforts to bridge the gap between now and the end of the pandemic falls on the shoulders of fiscal spending programs.
The Fed has been such a dominant part of the economic stability and recovery that additional developments over the quarter are worth highlighting. In August, the Fed announced a new twist on their inflation stance. In short, the Fed will seek inflation that averages 2% over time, allowing for periods that overshoot that goal. The shift to a broader maximum employment goal may result in the benefits of a strong labor market flowing through to low and moderate-income communities. Late in this most recent economic recovery, and possibly related to stimulus program benefits, we recently saw real wage growth topping 4.5% on an annualized basis (cheap oil may play a role as well). For the new Fed 2% target to gain credibility, we must first be in the enviable position to experience inflation above 2% and we will need to see the Fed demonstrate the willingness for inflation to exceed the past levels of comfort during future business cycles. Since the Fed first announced their inflation target of 2% in 2012, inflation has averaged a mere 1.4%. It seems that additional policies have been taken off the table, and others, left on the table, by this Fed. Specifically, it appears that negative rates are not likely under this Fed but that restricting the yields on some Treasury securities, known as “yield-curve-control,” remains a possibility. Something to watch in the future will be if the concepts of yield-curve-control and fiscal dominance (discussed last quarter) intersect. We have started down the path of a potentially politicized Fed and expanding this dynamic could result in a stabilizing institution becoming a prize of the unstable politicians.
"We have started down the path of a potentially politicized Fed and expanding this dynamic could result in a stabilizing institution becoming a prize of the unstable politicians."
A very honest conversation can be had about pursuing a Fed policy that is heavily weighted toward modest inflation that may benefit people with assets (streams of cashflow) over people who live paycheck to paycheck (income from labor). The challenge may be that as we allow inflation to run hotter than has been the case in the past, the economic drag resulting from servicing our national debt may act as a natural governor on the economy. The Congressional Budget Office estimates that the U.S deficit will be roughly $3.7 trillion this year. That would push our outstanding public debt to more than $20 trillion, or sadly equal to 100% of domestic GDP. Disciples of Modern Monetary Theory (MMT) suggest that Japan has a debt to GDP ratio of well over 200% and they have enjoyed low borrowing costs for a long time. The problem with MMT is that it works, and it likely works well while the world is awash in central bank liquidity, until it doesn’t work.
Several Fed officials have suggested that the necessary nuanced aid needed to address corners of the economy that are particularly hardest hit by the pandemic are in the hands of the politicians and fiscal stimulus. Unfortunately, we are stuck in a point in time in the U.S. when we are a collection of groups, rather than a collection of people trying to get to the other side of a tough chapter in modern history. We won’t dedicate much space to address the progress of the political solutions because our hired problem solvers are more concerned about not handing the other side a political victory in a presidential election year. If something is “good” it isn’t good enough (even if both sides agree it is directionally positive). Don’t look for material fiscal assistance until after November 3rd (especially while President Trump and Speaker Pelosi are spending valuable time calling each other crazy).
Observations and Outlook – Are We There Yet?
Whether it has been organic, orchestrated, or accidental, 2020 has been a year of chaos. The Fed’s efforts have been one of the few sources of nearly catatonic calm on the markets. The Fed has its share of critics, but the simple truth is that the financial markets have run smoothly since they stepped up to provide numerous sources of liquidity to several corners of the economy. Yields on most fixed-income securities are low, risk spreads are near pre-pandemic low levels and equity valuations are near all-time highs. Chairman Powell indicated that “the recovery has progressed more quickly than generally expected” but has also said that “the path ahead remains highly uncertain.” The Fed’s forecasts indicate that GDP will contract by 3.7% in 2020 and we could see growth of 4% in 2021, but that interest rates will stay low through 2023 (when 4 of the 8 FOMC members expect we will see the next rate hike).
The combination of the Fed’s outlook and the new 2% long-term average inflation target will likely result in “anchored” short term interest rates (the short end of the yield curve) and more drama as it relates to the yield on longer term bonds (the long end of the yield curve). If we see 4% growth next year some market participants who see the 2% average as a Fed slogan, rather than a change in philosophy, will inevitably conclude that the Fed is “behind the curve” and that inflation will get out of control. Such sentiment could result in greater price/yield movements in the long end of the yield curve. Given how low yields and risk spreads are currently, along with the fact that low current market coupons on bonds have resulted in longer bond durations increasing by nearly 50% over the past couple of decades, portfolio market values could see unsettling swings.
"Given how low yields and risk spreads are currently, along with the fact that low current market coupons on bonds have resulted in longer bond durations increasing by nearly 50% over the past couple of decades, portfolio market values could see unsettling swings."
Trumping the short-term periods of mania, we think the longer-term trend will be for yields to be pinned at low levels for an extended period. An investment theme we have held for a long time is that debt is often disinflationary. Increasing debt in the U.S. appears that it will be continuing for as far as the eye can see. If we succeed in creating an economy of rapid growth, we will be a victim of our own success in the form of increased costs of servicing our $20 trillion in debt. The truth is that central banks have plenty of firepower to tamp down unhealthy levels of inflation but as we have seen for more than a decade, the tools in the toolbox to fight economic pessimism are more limited. Add the potentially disinflationary influence that imminent technologies that 5G networks, quantum computing and artificial intelligence represent, and we expect the long run will involve low yields.
The economic recovery on the other side of the COVID tragedy will offer statistics that will understandably confuse the market. We are already seeing some outsized numbers. In August, used car prices rose by 5.4%, the largest gain since 1969. The core CPI, a broader measure of price movements, increased 0.4% in August, following a 0.6% increase in July, the largest monthly jump in nearly three decades. For those with students about to enter college, it may be a bit of a relief that college tuition and fees fell by 0.7%, the first decline since 1993 and the largest decline since 1978. Clearly there is economic pain and stagnation in the hospitality and some areas of the service sector that will persist until the worst of the pandemic is behind us. As the fall election races come to a conclusion, additional stimulus dollars will be spent promoting strong growth numbers that will roll through the economy.
Now for the uncomfortable subject of the Presidential election, at a time in our history when people seeking racial justice burn down the buildings of innocent business owners, militia groups allegedly target public officials, and first responders are broadly demonized using an indiscriminate brush, the country is left feeling exhausted. That doesn’t bode well for the incumbent. Even if the polls didn’t properly capture the true number of voters for President Trump in 2016, the margin of advantage that former Vice President Biden has suggests there is a good chance of changing the occupant at the White House. If Joe Biden wins the presidency the next important influence will be whether Republicans retain the Senate, or if there is a “blue sweep” and Democrats control both houses of congress. Divided government should mean that the U.S. experiences muted changes and a sweep likely means higher tax revenues needed to fund the election year promises made by the Biden campaign. If we are wrong and President Trump retains the job, the divided government scenario (with modest future changes) applies. The nightmare scenario is that we get into a legally contested election or an election that is subject to voter interference, fraud, or intimidation. We have had election outcomes that were delayed due to procedural challenges and although it was discomforting, it was livable. The other worst-case scenario would be a shock to both the markets and the sensibilities of those who feel all eligible voters should have an equal say in their representation. Our expectation is that rates flounder around the current levels for a short while, move higher as some strong growth numbers grab headlines and eventually trail lower than current levels.
Municipal Bond Market – Tall Tales and Troubled Truth
Headlines would suggest that municipalities are on the brink of disaster as a result of the COVID lockdowns and added expenses related to addressing the pandemic. Some areas of the municipal market are certainly facing dire challenges. Specifically, private student housing issuers, nursing homes, hotels, development deals and other tourism-centered issuers may be headed for trouble. Many other issuers that are sounding the alarm bells are either not letting a crisis go to waste or they are reluctant to enact creative or unpleasant solutions. We will discuss how the vast majority of reasonably run municipalities will have nearly pain-free options available to them, while mismanaged and poorly managed may find that this is the event that cause them to “run out of runway.”
Estimates for the added expenses and revenue shortfalls generally range from $400 billion to as much as $900 billion. What’s a half a trillion dollars among countrymen? Perhaps a small tweak to the first relief package in March offers a good down payment to meeting the needs of a broader swath of municipalities while sticking future generations with the smallest tab possible. In the earlier aid packages, only municipal entities with more than 500,000 residents could tap the $139 billion program. Roughly 25%, or $35 billion of the funds have been allocated. It may be a reasonable solution to release some of the remaining $100 billion to smaller units of government before burdening future generations with potentially inefficient alternative political solutions. It seems to be the case that some entities want to use this crisis to nationalize the poor decisions of the past while others are genuinely trying to function in an unthinkable multi-front battle. School districts, public universities, airports, and municipal hospitals are essential to both fighting the virus and, while moving toward normalcy, have been saddled with massive expenses and may need additional assistance beyond the $160 billion that they received in the earlier rounds of aid. Reasonable people could disagree on whether the added revenue should be generated locally, nationally, or if the municipality should just borrow their way out of the problem.
"It seems to be the case that some entities want to use this crisis to nationalize the poor decisions of the past while others are genuinely trying to function in an unthinkable multi-front battle."
Looking at the revenue picture for municipalities may provide some perspective. If you adjust for the change in the tax filing date from April to July, state tax revenues were nearly flat. We were surprised at that until we considered the impact that the CARES Act relief funds (stimulus checks and enhanced unemployment benefits) had on personal incomes. Roughly two thirds of unemployment benefit recipients earned more on assistance then they earned while working. As a result, retail sales (and related sales tax revenues) were down in the second quarter of the year, but they rebounded by June and they continued to grow in July and August. Finally, for most well-run municipalities, property taxes represent the most important source of revenue. On a year-over-year basis, property taxes are only down 3%, which translates to a shortfall for the past two quarters of approximately $100 billion. In addition to municipal entities tapping their rainy day funds, tabling some capital expenditures and perhaps borrowing to fill cashflow gaps, there seems to be a need for some degree of federal assistance on the order of $100 billion to $400 billion (on top of the $100 billion in unused aid funds mentioned earlier). Given the fluidity of both the problem and the cure, it makes sense to offer the aid over time and with very specific parameters. Why allocate COVID relief funds for any purpose other than COVID-related hardships?
Through mid-September, of the 32,000 issuers that Moody’s and S&P rates, fewer than 1% of the issuers received downgrades this year. As two of the more respected municipal rating agencies, they don’t seem like they are anticipating a muni meltdown anytime soon. That is with good reason. As we mentioned last year in an edition of Insights, municipalities had built their reserves to a level that was much stronger than was the case in other recent downturns. Issuers with some degree of creativity (or capable advisors) have many tools available to them to get them through this cashflow difficulty. Many issuers in the riskier areas of the municipal market issue bonds with a debt service reserve fund that will often carry the debt service costs for a full year of operation if needed. Other such issuers, issue bonds that have an annual debt service cost (principal and interest) that is a modest percentage of the “profit” before interest expense and taxes (referred to as interest coverage). Lastly, some revenue bond issuers simply maintain a robust cash position to weather the storm.
For those issuers without ample safety mechanisms, there is the simple “scoop and toss” refunding solution. Cashflow borrowing (financial engineering) is often looked at as a danger sign but in the context of a pandemic and abruptly shutting the economy down, while incurring unexpected costs, a bit of unconventional borrowing may be a very appropriate solution. Since municipalities often issue serial bonds (i.e. a maturity each year for 10 years) it is not going to materially change the debt burden to issue bonds that cover interest costs and push principal payments out a few years. Some of this type of issuance has already been done and the longer it takes to eradicate the virus, the more of these deals will likely come to market for reasonably run entities. Chronically poorly run issuers may need to access the market through a conduit entity if the capital markets are unwilling to extend them credit.
"Cashflow borrowing (financial engineering) is often looked at as a danger sign but in the context of a pandemic and abruptly shutting the economy down, while incurring unexpected costs, a bit of unconventional borrowing may be a very appropriate solution."
We have highlighted the chronic shortcomings of Illinois and Chicago for more than a decade. Illinois is rated one notch above “junk” status (BBB-) by S&P, with a negative outlook. The state’s pension plan is roughly 40% funded, they have an unpaid bill backlog of $7.65 billion, they have just borrowed on a short-term basis $2.25 billion from the Fed, S&P says that 15% of their budget comes from “speculative revenues,” and their 2021 budget includes a placeholder for $5 billion from expected federal assistance. Beyond that, their population is shrinking, regional unemployment hit 12.6%, their Miracle Mile has been ransacked twice and their politicians don’t seem to be getting any better. Recently the CFO of Chicago said they didn’t plan to touch their $900 million in reserves to help to close the roughly $2 billion budget hole anticipated over the next two years. The rationale for the non-move was that “although it may feel like it’s raining, it still may pour.” It sounds like Chicago is waiting for the federal government to solve their problems. It also seems as if it is about time for the day of reckoning for the state of Illinois bondholders, pensioners, and other stakeholders to begin the restructuring process.
New York was particularly hard hit by the pandemic. As a major city with a massive public transportation infrastructure, the combination of fears and changed working behaviors related to both the virus and the current “quality of life” challenges that some urban areas are experiencing, the future financial health may be tenuous. Ridership of some forms of public transportation are down between 70% and 80%. Even with the decline in utilization, violent crime is up nearly 300% since last year, robberies have risen 16%, and vandalism has grown by 24%. With those kinds of numbers, workers who can work from home will and sadly, the businesses that support those workers will close. Bankruptcy filings have increased 40%, resulting in nearly 6,000 shuttered businesses. A business group in New York City, the Partnership for New York City, estimates as much as a third of New York’s 230,000 businesses could permanently close. If the city doesn’t stem the business closures and quality of life issues, the current $9 billion revenue shortfall won’t be the last. Since New York City is reliant on a city personal income tax, this perfect storm could result in structural problems that may cause additional rating downgrades following the downgrade to Aa2 on October 1st. Cities that don’t make residents and workers feel safe will simply find themselves with fewer residents and workers. Crime statistics and population trend estimates may become an increasing part of municipal credit analysis as they are often a precursor to financial distress.
So why is an essential purpose municipal bond still a great asset for some investors? Because much of the turbulence that is expected in the municipal bond marketplace, that won’t likely happen, is currently priced into the market. Currently AAA-rated 10-year maturity general obligation municipal bonds yield 120% of the yield of a 10-year Treasury bond. According to Bloomberg data, since the start of 2011, that metric has averaged about 86% and we are more than two standard deviations away from the mean. That measure is simply the stated yield, not the grossed-up yield to reflect the value of the tax exemption for a particular investor. If you are comfortable moving from the AAA level of quality to the low AA area and extend maturity from 10-years to 14 years, the ratio may hit 200%. Municipalities have a long history of low default rates. We don’t anticipate a near-term change to that legacy of essential purpose issuers.
Strategy and Summary
Since yields and other market dynamics have remained generally intact since last quarter, our strategy is largely unchanged from last quarter. In line with our broader interest rate forecast, episodes of panic may cause investors to flee the muni market and that should present a buying opportunity. At current levels we feel “AA” rated munis in the 13-year to 15-year area represent a good value, with yields of roughly 1.80% as compared to a 10-year U.S. Treasury yield below 0.80%.
The Fed has telegraphed that short-term rates rates will remain low for the foreseeable future. As outsized growth expectations emerge in response to some of the inevitable massive recovery statistics that are likely going to roll through the headlines, market participants will drive volatility in the long end of the yield curve. The market’s ability to digest the Fed’s new policy paradigm will be a source of price fluctuations as we look forward. If our Presidential election forecast is correct, Joe Biden’s plans for tax increases and likely interest in offering greater amounts of aid to municipalities should result in muni bond yields falling, relative to Treasuries, and purchases at current levels may look quite attractive. It may also drive some institutions to return as “go to” buyers of the municipal market. Related to that, if we find a strong liquidity environment, we will be looking to sell some shorter holdings for the purpose of extending portfolio maturities, where appropriate.
"The Fed has telegraphed that short-term rates rates will remain low for the foreseeable future."
Let’s hope that in our year-end edition of Insights we have the luxury of a clearly decided election. An alternative outcome is the last thing the markets will appreciate and as a Country hopefully seeking out some unity and healing, it is what most Americans seem to need.
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