During the final weeks of last year bond market bears were in their glory. Interest rates moved higher following the surprising November presidential election outcome. Expectations of lower corporate and individual tax rates, significant regulatory reform, infrastructure spending and an overhaul of the Affordable Care Act fueled a multi-month surge in stock valuations. These prospects also triggered a significant sell-off in global fixed income markets. Bond investors were fearful that strengthening economic growth and the prospect of escalating inflation pressures could force the Fed to raise interest rates faster than previously anticipated.
Domestic fixed income bond markets have performed much better than feared. Municipal securities have outpaced U.S. Treasury bonds through July. The Bloomberg Barclays Municipal Bond Index has returned 4.40% this year versus 2.04% for the U.S. Treasury Bond Index. We believe the relative outperformance is mostly attributable to the municipal market’s strong technical position which we highlighted in our May Commentary (“Muni Cash Hoard”). If the first half of the year’s performance can be sustained through year-end, 2017’s achievement will support the consistent long-term positive performance legacy of the municipal asset class.
Since the election, global stock markets have been on an upward trajectory. Bonds, however, have exhibited more erratic price performance. Following a significant post-election decline, fixed income markets reversed course the month following the election and have achieved a positive return despite two Fed-initiated short-term interest rate hikes. Long-term interest rates have been declining at a faster pace than intermediate-term yields, leading to the flattest yield curve configuration since 2007, just prior to the start of the last recession. Historically, a flattening of the Treasury yield curve has generally signified a recession, while a steeper yield curve has often been the result of heightened inflation expectations. Based on its current configuration, investors appear to be less worried about the risk of inflation and are now possibly anticipating weakening economic growth.
Strong underlying support due to a favorable market technical position should not be minimized. For the three-month period lasting from June through August, municipal bondholders will have received $44 billion in cash proceeds from maturing bonds and interest payments. The issuance of new state and local government debt has been in decline and is forecast to contract by $40 billion during the same period, creating $84 billion of potential net buying power. Year-to-date municipal supply is estimated to already be 12% below last year. At the same time, the continuation of consistent cash flow into tax-exempt mutual funds over the past several weeks shows investors are not being deterred by current interest rate levels.
The preponderance of recent economic data reinforces our view that the U.S. economy is destined to remain on the same lackluster path that it has been tracking for the past several years. Second quarter GDP increased by 2.7% following a 1.2% expansion in the first quarter, raising domestic growth so far this year to just below 2%, close to the lower band of the Fed’s 2% to 3% target range. It still appears to us that the economy will struggle to get to the upper end of the range for the year. As confirmed by the latest employment readings, there is little pressure on wages. While eight years of post-recession recovery have helped propel equity valuations to multiple new highs, overall economic growth has proven to be less lofty.
We believe the financial markets are now coming to terms with the likelihood that there will not be any significant legislative initiatives coming from Washington this year. Eight months after commencement of the “Trump Trade,” financial markets could be preparing for a second-half adjustment. We do not foresee any significant regulatory, tax or healthcare reform occurring before year-end. In our view, the old adage, “The more things change, the more they remain the same,” is once again ringing true in Washington.
Investors focused on tax-exempt portfolio positioning can be expected to focus on a duration profile below the benchmark. The aggressive move by investors to buy short-term (1-4 years) maturities this year has rendered intermediate-term (5-10 years) maturities more attractive. The peak in incremental annual yield pick-up occurs in nine years at approximately 15 basis points over the eight-year term. Significant curve-flattening occurs beyond ten years, which reduces the added compensation for duration extension. In fact, 10-year bonds offer 76% of the yield available from 20-year bonds.
Premium coupon (4-5%) bonds offer a number of attractive features. These bonds are more defensive due to their premium pricing structure and additional coupon income, which will provide a cushion in the event interest rates rise. When accessible, certain callable, “kicker structure” bonds (securities bearing optional call dates between three and seven years) may provide added yield benefit relative to non-callable bonds. Municipal credit spreads have tightened further this year. Strong investor demand has been a driving force in the narrowing of yield differentials between investment-grade and lower-rated issues. Investors may seek bonds in the "A-rated" credit category recognizing their potential for attractive relative returns.
We now believe the tax-exempt market will prove to be less volatile over the balance of the year. Not only have expectations for significant healthcare reform, tax overhaul and government spending on infrastructure been weakened, but the growing distraction over Russian involvement in the U.S. presidential election and growing dysfunction within the White House appear be taking center stage in Washington. We do not anticipate much headway being made on the legislative front. A relative quiet period ahead should be in store for the municipal market.
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