Financial markets have remained relatively subdued through the final weeks of summer. August has historically been one of the least volatile months of the year. Municipal market performance was little changed this month as indicated by the Barclays Municipal Bond Index return of just 0.19%. SMC does not anticipate meaningful disruption to the market’s performance through the remainder of the year; interest rate volatility is expected to remain muted due to a persistent technical structural imbalance. We do not expect any Federal Open Market Committee (FOMC) action in September, and continue to monitor economic and market conditions regarding potential action in December.
Historically low tax-exempt yields have been sustained by very strong investor demand. As of August 26, 2016, there have been an uninterrupted 47 weeks of inflows into municipal bond mutual funds totaling $45 billion. Flows are expected to stay positive as long as municipal bonds continue to offer tax advantaged incremental yield compared to many domestic and international fixed income asset classes.
State and local governments' new money bond issuance has continued to decline; in the graph above, the "net issuance" line indicates that negative net supply materialized earlier this summer. Sustained interest rates at or near their historic lows may induce more bond refundings, which would intensify supply contraction. This activity results in demand/supply imbalance which is supportive of the municipal market.
Infrastructure, including roads, highways, water and wastewater systems, and transit programs are amenities that are utilized daily by the vast majority of the population. They constitute a sizeable allocation of municipal investment. While the need to maintain and expand this infrastructure escalates with growing demand, the means to fund these programs remain questionable. State and local governments are ultimately responsible for their infrastructure by virtue of system ownership. While federal programs assist and subsidize these systems to a degree, investment levels have declined as system utilization has increased and budget austerity measures have limited funds. Federal assistance, which has typically absorbed a little less than a third of the total costs, could provide the impetus. Municipal borrowers continue to take advantage of low interest rates, having already sold about $275 billion bonds through the first half of the year. Municipal analysts predict over $400 billion of new debt will reach the market in 2016, and if municipal issuers take advantage of current low rates to finance new projects, the supply of new issuance might even surpass the annual record of $433 billion issued in 2010. Net issuance could turn positive.
Last month's Commentary focused on pension liability issues and the negative impact on municipal governments' ability to spend on infrastructure and other needs. However, infrastructure spending may generate industrial growth and promote economic development that could possibly increase tax revenues for governments seeking to fund projects. SMC expects the use of funding mechanisms such as fuel, motor vehicle and sales taxes to be likely revenue sources. State loans and subsidies via revolving funding programs are possible alternatives or could supplement tax revenues. Lastly, the use of Private Activity Bonds (PABs) and other public and private partnerships remain viable funding for essential assets.
Over the past several years, pressure from voters to control government spending led state and local borrowers to pocket much of the savings achieved from debt refinancing. Recently however, willingness to step up spending for public works projects has increased. New money bond deals (supporting new projects as opposed to paying off outstanding bonds) accounted for over 40% of new municipal bond sales through early August 2016, compared to 35% for the same period last year, and the forward calendar for new municipal bond sales reflects an increase in new construction and facilities programs.
Consider the bigger picture and its impact on municipal finance. After several futile years, global central banks have been unable to stimulate significantly more economic growth or inflation. Dramatic short-term interest rate cuts and large-scale purchases of government and nongovernment bonds from banks have not produced meaningful results. Nearly one-third of global sovereign debt currently carries a negative yield. Despite resorting to extreme measures such as charging investors to hold their money, many European and emerging market economies are on the verge of recession. Central banks, including the United States Federal Reserve, have advocated for additional fiscal stimulus including tax cuts and added government spending, possibly in the form of extensive and expensive roads and transit development projects.
Domestically, an increasing number of economists, business leaders and academics are calling for significantly more big ticket spending. These pleas are being echoed by the two presidential candidates. Hillary Clinton has outlined her plan for a national infrastructure bank and an additional $275 billion to be spent over a five-year period on construction. The investment plan would focus on large-scale projects such as bridges and highways. Funding would come primarily from a tax surcharge on high-income taxpayers. The Clinton plan is similar to one previously advanced by President Obama which stalled due to Republican opposition in Congress. However, if the Democrats retake either the House or Senate, enactment of a major infrastructure spending plan would appear plausible.
Donald Trump's claims of spending more than twice Clinton's proposal does bring along with it possible funding sources. Mr. Trump has been very vocal about utilizing low interest rates to the government's advantage, which leads SMC to consider that debt financing is a possibility under the proposal. If the Trump infrastructure program takes the form of grants and loans to state and local governments then the municipal market might be in for a significant pick-up in debt issuance. While creating high wage jobs and helping spur economic growth, debt financing would certainly increase the federal deficit, although Mr. Trump has vowed to reduce the national debt but with no timeline specified. Given the candidate's real estate background and fondness for big construction projects, he might aggressively pursue infrastructure programs where his expertise could be utilized.
As the rhetoric leading up to the November election intensifies, we hope to hear more specifics from the candidates regarding their infrastructure plans. Both candidates are pledging federal funds to facilitate their respective plans. Opinions differ whether projects should be financed and controlled at the federal level or by state and local governments.
While Presidential candidates will hopefully be elaborating in greater detail about possible solutions to generate growth and jobs, the fact remains that much of what municipal infrastructure requires will be done at the state and local government level. With that in mind, SMC's focus on local and state issuers includes an assessment of the financing tools available to them to make cogent infrastructure funding decisions and the possible effect on the overall health of the issuer.
Neither candidate has defined the estimated size of the infrastructure shortfall. Municipal analysts cite a 2013 study from the American Society of Civil Engineers (ASCE) as the best estimate. Once every four years, America’s civil engineers provide a comprehensive assessment of current infrastructure conditions. The review issues grades for the various types of projects as well as an overall grade. U.S. infrastructure received an overall grade of "D+" from the ASCE in the most recent assessment and spending is projected to fall $1.4 trillion short of the $3.3 trillion needed through 2025.
Infrastructure investment as a percentage of GDP has been on the decline since spending for the national highway system was enacted 60 years ago. Last year the total of state and federal government spending was 3.4% of GDP, less than half at its peak. With mounting pressure on pension costs and slackening revenue growth, infrastructure needs have been ignored. Maintaining a stance against increased spending does not make the problems go away. Deferred maintenance often costs more in the long run. Years of less spending may lower the level of debt in the near term but it only postpones the inevitable.
The dilemma surrounding infrastructure is that everyone agrees we need to fix and build roads, bridges, etc., but nobody wants to pay for it. Change might be in the offing. While deficits will still matter, sub-par economic growth and stagnant wages for many workers are greater concerns that could prompt greater investment. Just listen to the candidates.
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