Our 2016 Outlook anticipated a relatively tranquil investing environment. We advised investors: "stay the course." The Bloomberg Barclays Municipal Bond Index returned 3.30% in 2015, a mark we thought could be matched in 2016. Prior to the November election, the market was on pace to rival the previous year's return (3.12% through November 8th). However, the surprising Trump victory has led to higher interest rates, thereby erasing most of the gain achieved through the first ten months. The Index returned 0.25% for the year.
When asked what municipal bond investors should anticipate in 2017 following the recent correction, we have been advising them to seize opportunity amidst the volatility. The municipal market is now conducting its own "post-election sale." Prices have been discounted approximately 5% since November (see graph on page 3). We believe early 2017 may present an opportunity to lock-in higher tax-exempt yields. SMC's mantra for 2017: "Stay the Course & seek out opportunity".
Staying the course is still relevant for 2017, with a slight adjustment. The reaction to volatility should be to lock in higher yields. Bond markets wasted little time sounding the alarm over the possibility of higher growth, lower tax receipts, wider deficits, and the impact of large-scale fiscal stimulus. Markets are also prone to overreaction. The Presidential election's outcome drew a sharp reaction and the municipal market experienced a loss of over 4% for the month of November. Discounted bond prices created interest from opportunistic buyers during December and the market's return turned positive for the month. The municipal market closed out the year with a positive return.
Also, year-end tax loss selling, which added to the downward price move, has concluded. January reinvestment could help move prices higher. Perhaps a period of equanimity will ensue in the weeks ahead, leading to a rebound in security valuations. At least recent municipal market history suggests so.
With a new U.S. administration taking office, 2017 looks to be a year of many unknowns and the investment horizon more unpredictable. For anxious financial markets, the developing "Trump Revolution" raises numerous questions that will not be answered quickly: tax restructuring, infrastructure spending, regulatory reform (Obamacare), pension liabilities, and new municipal debt issuance are considerations. Agenda advancement should be slower than many are now anticipating, and outcomes possibly not determined for a long time. The knee-jerk bond market reaction to the election outcome is over-done in our view. As 2017 unfolds, financial markets should return to a more balanced position.
Another concern for financial markets is the prospect of a multiple interest rate hikes by the Federal Reserve in 2017. Our view is more moderate, and doubt there will be four rate hikes next year as projected by the Fed. Short-term rates were raised once in 2015 and once in 2016. In both years, our forecast was below the consensus call for multiple moves. We project two increases of .25% each for this year. Furthermore, multiple rate hikes could prove to be too much for consumers and would be reflected in higher borrowing costs. The housing market, already showing signs of stress, might be further hindered by rising mortgage rates. Inflation is not a significant concern in our view so the Fed should be less aggressive to act.
Both U.S. and global economic growth is expected to remain on a sub-par trajectory in 2017. Entering the ninth year of recovery, domestic growth is still forecast to be less than 3%. Europe's economy must contend with Brexit fallout and Japan is stagnant, resorting to negative interest rates to spur its economy. A stronger USD will further affect our trading partners. Perhaps most impacted will be emerging market nations, led by China, that will be paying more for commodities (priced in USD). Rising oil prices could be another growth obstacle.
The technical posture of the municipal market is generally quite favorable during the first quarter of the year. January and February are particularly noteworthy months due to the comparatively large amount of municipal bonds maturing and coupon payments received. Investors have money to spend. Also, the sale of new bond issues is slow in the early weeks of the year; the calendar of deals typically doesn't begin to significantly build until March. Early 2017 issuance is expected to be exceptionally light. The recent spike in interest rates will likely keep some borrowers on the sidelines until later in the year when the market will hopefully stabilize.
Even without the recent disruption effect, there will be less new municipal debt marketed in 2017. Issuance is projected to be less than $400 billion, significantly below the record $440 billion sold this year. Of course, the great unknown is the willingness of investors to buy in view of future political uncertainty. Stay tuned.
Lower individual and corporate tax rates could be the most significant change impacting the municipal market and investor behavior. Pundits predicting that tax-exempt interest rates will have to adjust higher are wrong. Historically, when individual tax rates were lowered, the correlation between tax-exempt and U.S. Treasury yields did not necessarily adjust to compensate. (For example, the 1986 Tax Reform Act lowered the top rate from 50% to 33%. After initially widening, the ratio of municipal-to-U.S. Treasury yields widened, but ultimately reverted to the prevailing level.) Furthermore, rumor of the possible elimination of the federal tax-exemption on municipal bond interest appears doubtful. Meeting earlier this month with a delegation from the U.S. Conference of Mayors, Mr. Trump expressed support for maintaining the tax-exemption.
Over the past decade, the municipal market has endured only four periods when performance fell by at least 5%. The first was during the 2008 financial crisis. A 60 Minutes television segment, predicting "a spate of defaults" for municipal debt issuers, led to a second significant market decline in late 2010. In May 2013 Federal Reserve Chairman Ben Bernanke announced the Fed would begin to reduce its aggressive Treasury debt purchasing program. This announcement resulted in the infamous bond market "Taper Tantrum." That resulted in the third significant municipal market correction of the last decade. The fourth correction commenced the morning after last month's election of Mr. Trump.
The graph above highlights the catalyst and timing of each significant drawdown within the context of the municipal market's 10-year advancement. Note the pace of the market's recovery following each of the first three instances. If what is past is prologue, we should expect the market to rebound following any significant sell-off, providing opportunity to lock in higher yields. While it is too early to declare that the bottom to the correction has been reached, we are encouraged by the market's ability to stage a modest advance during the past month, even in the wake of significant year-end tax loss bond selling and persistent mutual fund withdrawals.
We believe that adherence to an "all weather" investment strategy continues to be the correct course to follow. SMC's approach attempts to achieve a positive portfolio return and limit downside risk, even if rates increase. We seek to accomplish this by employing portfolio management techniques that capitalize on the steepness of the short and intermediate maturity tenors of the municipal yield curve. With the passage of time, the roll-down effect provides a buffer against the effect of rising interest rates. In addition, the run-off of maturing securities enables the portfolio manager to redeploy cash proceeds by purchasing higher yielding bonds. Also, adherence to a portfolio structure process with a goal of maintaining a weighted duration below the benchmark helps mitigate relative price volatility. There is also a benefit to this strategy when interest rates reverse course and move lower; the investor capitalizes from rising security valuations and profits from time erosion—the roll-down to lower interest rates (higher prices) along the curve and shorter duration.
As 2017 trading commences, U.S. financial markets face more than the usual number of unknowns. Typical economic and technical uncertainties will likely be overshadowed by Washington politics. The aftermath of the Trump election win has propelled stocks further into record territory at the expense of bonds. Meanwhile, municipal bond yields have climbed to their highest level in more than two years. In view of market behavior over the past two months, we are now very skeptical of dire 2017 market prognostications. If political uncertainty diminishes, the period of heightened early volatility should also moderate as the year unfolds. Whatever the path, market performance over the past decade makes a compelling argument to "stay the course" again in 2017.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management ("SMC FIM"), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
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