Insights

Q3 Review – Easy Does It

During the third quarter of 2024, economic expectations and bond yields sank lower.  Some disappointing job numbers were the basis for the Fed to begin telegraphing that a change in policy stance was needed.  U.S. job openings fell in July to the lowest level since the start of 2021. Layoffs rose to the highest number since early 2023. Of note, the ratio of jobs per job seeker declined to one job per job seeker.   As a sign that confidence about the ability to get a job has waned, the “quits rate” (people who voluntarily leave jobs remained near the lowest levels since 2020.  The Fed vacillated between communicating that they would be fine with diminishing the pace of progress of their fight against inflation if it was required to get ahead of a material future downturn in the employment environment and then shortly thereafter saying that both the employment and inflation risks were balanced.

Data reinforcing the idea that the consumer was exhausted by core expense increases exceeding wage gains, led many corporate earnings calls to reference consumer strain.  The return of the $5 Value Meal at McDonalds was touted with the fanfare one might expect in a World Series Champion’s parade. Politicians and popular culture promoted new ways to express old ideas.  Shrinkflation, greedflation, and value-seeking shoppers are sure to be new additions to the Webster’s Dictionary.  More to the point, a segment of consumers is under pressure, and they are needing, not necessarily wanting, to change purchasing habits.  Credit card balances are near record highs and the interest rate that applies to credit card balances averages more than 20%. The formerly abundant job market is becoming balanced, and it appears to be moving toward an environment of scarcity.      

In September, the Fed pleased the markets with an outsized initial rate cut of 50 basis points.  At the time, the gap between the Fed Funds Rate and the yield on the two-year Treasury was an indication that Fed policy was likely too restrictive, relative to the pace of inflation.  Ignoring the stubborn influence that shelter costs have had in measures of inflation, broadly the Fed has made significant progress in their fight against inflation.  Headline CPI growth on a year-over-year basis was 2.9% in July and the Core CPI grew by 3.2%.  Given the degree of restriction that the Fed Funds Rate was exacting on the economy, along with inflation numbers that were making significant progress toward the Fed’s long-term goals and the softening employment environment, the Fed’s outsized move seemed to be prudent, and it achieved any goal they may have had to not surprise the market.   The sentiment that the Fed “had the market’s back” drove bond yields higher and stocks enjoyed an advance back to record high values.

Over the course of the quarter, 10-year Treasury yields fell from 4.39% to 3.78% and 10-year high quality municipal yields declined more modestly from a yield of 2.86% at the start of the quarter to a yield of 2.63% as the quarter ended.  Taxable bond indexes experienced year-to-date total returns through the end of the 3^rd quarter of between 4.45% to 4.65% and municipal bond indexes experienced total returns of between 1.0% to 2.70% for the year-to-date.  The strongest returns for bonds have been focused on the lower quality investment grade space, with “BBB” municipal bond indexes experiencing year-to-date returns of 4.2%, and taxable bond indexes of that quality producing returns approaching 6%.    

Q4 Interest Rate Outlook – Maestro, Or Perhaps the Gang That Can’t Shoot Straight

Our fixed income investing theme for 2024 was driven by the idea that sticky sources of inflation would drive yields higher in the first half of the year, as the market concluded that the Fed would not be able to get this bout of inflation under control.  The expectation for the back half of the year was that a restrictive policy, in the form of higher borrowing costs, would eventually weigh on the consumer and some institutions that operate at the margin, and signs of an economic slowdown would become more widespread.  In practice, housing and owners’ equivalent rent defied the influence that higher borrowing costs had on home affordability, which should have put downward pressure on pricing.  The lack of an adjustment in home prices may have created price support for single family housing substitutions.  Population growth has been referenced by the Fed and above-trend growth could also offer support for pricing in the face of decreased affordability, higher borrowing costs, and higher prices.  Market expectations for roughly seven rate cuts at the start of 2024 turned to an expectation for almost no rate cuts mid-year and upon the weak job report for the month of July, the anticipation for multiple rate cuts became the base case once again.  If it weren’t for the outsized rate cut in late September, immediately followed by a surprisingly strong job report in early October, our 2024 rate forecast would look quite sound. 

Broadly we are seeing continued inflation in services and some disinflation for goods.  Housing and protein at the grocery store are areas that contribute to the inflation pain that people continue to feel.  It may be that whether you are talking about the feeling of misery in the form of elevated prices for housing and food, or if you are considering the higher “prices” that interest rates represent, the “shock” of operating in a higher price environment may have a half-life. The misery may be there, but at a point you learn to operate in a higher “price” environment.  People change their buying habits to adapt to the price realities. Dinner out with friends may be adjusted to hosting friends for dinner at home.  Interest rates are higher than where they have been for much of the past 20 years, but they have been roughly 50% to 100% higher than the current environment during periods of prosperity during the past 30 years.  That is not to say that consumers are immune to higher borrowing costs.  Credit card balances are near record highs and the average interest rate applicable to credit card debt is now greater than 20%.  At a point, “price” matters in the supply/demand equation but markets and people can operate beyond the boundaries of rational economic behavior for periods of time.

"Whereas we can celebrate people having wages that allow them to improve their quality of life, the “negatives” are that the wage cost pressures may flow through to prices of goods and services, and it may stimulate an updraft in spending..."

Turning our focus to one of the rates that the market will be watching closely, the Fed Funds Rate will determine the near-term fate of both stocks and bonds.  An often-watched indicator of the appropriateness of Fed policy, the Taylor Rule (a calculation of where the Fed Funds Rate should be as a function of inflation and the output capacity of the economy) as presented by the St. Louis Fed suggests that the current Fed Funds Rate is nearly perfectly positioned.  This may be problematic for the Fed because Chair Powell’s comments, and the dramatic start to this easing cycle, have positioned the market to expect additional rate cuts in 2024, and roughly another 100 basis points of easing in 2025. Since the 50 basis point cut in September, the economic data have put the Fed in an uncomfortable position.  As we look at the Fed’s dual mandate of price stability and full employment, we have seen over the past two weeks surprise numbers that suggest the job market is robust and the progress toward wrangling inflation has modestly reversed.  The September Non-Farm Payroll number came in above all analyst estimates, with job growth of 245,000 jobs as compared to expectations of 150,000 and the unemployment rate fell to 4.1%.  Perhaps even more problematic for the Fed, wage growth was 4% on a year-over-year basis.  That is not a bad development on its face, but in the context of the surprise uptick in inflation in September, where Core CPI increased 3.3% and Headline CPI increased 2.4% on a year-over-year basis, consumers are experiencing real wage growth and employers are feeling continued wage cost pressures.  Whereas we can celebrate people having wages that allow them to improve their quality of life, the “negatives” are that the wage cost pressures may flow through to prices of goods and services, and it may stimulate an updraft in spending; both are developments that could impede the ability of the Fed to make progress toward their long-term average inflation goals of 2%. The prices of goods, on a year-over-year basis continue to be a source of disinflation, and the areas contributing to the updraft in inflation continue to be in the services sector. Food, shelter, and apparel were some of the largest percentage growth contributors to inflationary pressures. Since 4.1% unemployment is generally thought to be “full employment” and with the short-term pause in progress toward the Fed’s inflation goals, the Fed may have put themselves in a difficult position regarding how to communicate to the market and what policy moves are appropriate, especially given the long lag that Fed policy tends to have on the economy. We don’t subscribe to the idea that the Fed is stuck with an obligation to engage in an easing cycle.  That said, the FOMC voting members are human decision-makers and they can make the same decision “anchoring” mistakes we all often make (anchoring your forecast for the future on your past expectations). On that basis, it may be difficult to suspend additional eases, which may put the inflation-fighting goal at risk until the data offer a clear policy path direction.  After all the talk of being cognizant of the failed policy of the 80’s and the tough medicine required during the Volker years to “break the back” of inflation, it will be interesting to see if the current Fed policy rhymes with the mistaken policy of past.         

The unknowable issue going forward is whether real wage growth will result in more spending or less misery.  From the vantage point of people who don’t worry about interest costs on credit card debt and elevated food, shelter, and clothing costs, the question seems dramatic. For the people with little room in their budget for unforeseen expenses, it is the question.  Having wages surpass inflation by 1.6% is marginally nice but it may be a meaningless influence on some people’s ability to spend.  Although people at the margin have been repeatedly told that the economy is strong and they should be feeling good, they simply don’t. In September, consumer sentiment fell by the most in three years.  The Conference Board’s measure of sentiment declined by 6.9 points to 98.7, the largest drop since August of 2021.  Concerns about the labor market and the broader economy caused measures of current conditions and expectations for the next six months to decrease as well.  The percent of consumers who said jobs were plentiful decreased for a seventh straight month to 30.9%, which is the smallest reading since March of 2021.  It is the longest stretch of declines since 2008.  The percent of consumers who said jobs were hard to get hit 18.3% which is also the highest reading since early 2021.  Consumers may be wiser than they are given credit for because small business owners, responsible for roughly 50% of the jobs in the U.S., became more pessimistic about profitability and business conditions in August.  For a better understanding of what elevated amounts of debt and relatively high interest rates mean for a broad swath of consumers, we should dig into some related statistics.  In the second quarter of 2024, overall household debt increased by $109 billion to $17.8 trillion.  Balances on credit cards rose by $27 billion to a total of $1.14 trillion.  Auto loan balances rose by $10 billion to $1.63 trillion. That all adds up to a lot of trillions. Total consumer debt in delinquency stands at 3.2%.  The share of auto loan balances that are more than 30 days delinquent increased to 7.95%, the most since 2010.  The percentage of credit card debt that is delinquent rose to 9.05%, the most in roughly 12 years. Balances on home equity lines of credit increased for the ninth consecutive quarter to $380 billion, the highest level since 2019 and approximately 20% above the level that was in place in late 2021.  People are choosing to (or needing to) tap credit and the cost to finance that credit is historically high.  Admittedly, we may be in an unusual state where there is a “Goldilocks” economy. You can point to a lot of metrics and conclude that there aren’t any obvious signs of weakness, but many people in the economy may not be enjoying the existence that the numbers would suggest. We expect diminished misery may be the dominating sentiment that may arise from the current mix of low unemployment, stable prices, and elevated debt burdens.  

"Although it is difficult to predict what geopolitical influence will do for both the domestic and global economies, trade policy and the risk of trade wars are emerging as a risk to growth."

The upcoming election seems like it will pose a smaller risk to bond yields than what could have been the case.  Our concern had been that single party rule would have led to continued deficits and an elevated debt burden for the U.S.  Increasingly, it is looking like there will be a divided government.  That suggests some of the 2017 tax cuts may expire in 2025 and some election year spending promises will fade back into the fantasyland from which they came.  That landscape doesn’t position us to solve large problems, it is more postured to react to crises, but it tends to offer markets the perceived safety of modest policy changes and a more modest increase in the federal debt, now topping $35 trillion.  There will almost certainly be malinvestment with the next administration, but the truly offensive use of scarce resources may be tabled for future unserious politicians. Although it is difficult to predict what geopolitical influence will do for both the domestic and global economies, trade policy and the risk of trade wars are emerging as a risk to growth. Short term, tariffs can nudge change, improve unequal footing, and raise revenue.  It also can act as a more widespread tax, seemingly without the political process needed to raise taxes and bringing it into the light of day. Longer term, if trade policy and tariffs are used as a baseball bat to antagonize trade partners, it can be destabilizing as it can siphon from global growth and living standards.  A functioning trade relationship between competitors is a better place from which to negotiate as compared to a position where benefits of economic cooperation don’t exist.  The world is awash in existing and potential conflicts.  Recently it came out that the intelligence community brought the probability that Russia would use tactical nuclear weapons against Ukraine as high as 50% during the conflict.  Those are odds that since the 1980’s were unthinkable.  Intelligent trade likely plays a role in improved global peace.  There seems to be an elevated risk of global conflict that would quickly turn our Goldilocks economy into something much less “perfect.”

Our outlook for interest rates is that consumer sentiment and the cost of credit will pull down consumer demand.  The recent job market strength and stable inflation numbers will give way to a slowing consumer.  In response, yields will have the standard knee-jerk reaction to trend lower.  Mothballed campaign promises and the prospects of divided government resulting in some tax cuts expiring in 2025 may offer hope for diminished deficits and a slowing in the growth of the federal debt.  That could allow the longer end of the yield curve to trend lower and shorter-term rates will track with an eventual resumption of the Fed’s easing cycle.  The central question is whether the Fed can kill inflation without some economic pain. That is a feat that has been achieved about 10% of the time in modern history.  Optimism and yields may see some life once election uncertainty passes. Once we pass the uncertainty, hopefully before January of 2025, reality should set in, and we should see yields fall. A mild recession of between one and two quarters remains our base case (if we can have two quarters of negative growth without it being a “recession” we think it is fair to call for a one quarter contraction to be a recession in the eyes of the population).  We can imagine a scenario where 10-year Treasuries retest the 4.50% area and drift below 3% during the weakest part of 2025. Long-term, especially if the U.S. loses its last remaining “Aaa” debt rating from Moody’s, the trajectory of borrowing costs, feels like a move higher is the more natural state.  That wouldn’t be without consequence.  Currently, the cost of federal debt interest payments account for 13% of public spending.  The U.S. needs to position itself for growth and some degree of fiscal discipline, because the path of austerity seems to present a challenging future for unserious people with their deserved representatives.        

Municipal Market Developments – A Tsunami of Supply Meets a Mountain of Demand

For months, the supply of new issue municipal bonds has been approximately 140% of the average issuance levels for the past year.  In isolation, it should have resulted in muni bond yields that were elevated as compared to like-maturity Treasury bonds.  In practice, muni yields are low as compared to Treasuries.  The glut of supply is believed to be a function of issuers trying to get ahead of the uncertainty of the election and the potential for capital markets to temporarily freeze if the election doesn’t go smoothly. It may be the case that the strong supply is merely pulling end of the year issuance forward.  What is likely keeping a lid on municipal bond yields is the strong demand, as measured by flows into municipal bond funds (and increasingly, ETFs and separately managed accounts account for the vehicle through which individuals gain their exposure to munis).  What may be driving the interest in municipal bonds is the anticipation of the expiration of some of the 2017 tax cuts.  Moving toward higher tax rates makes tax-advantaged income more valuable.  Perhaps too nuanced may be the fact that in many areas of the bond market, risk spreads (the additional yield you earn over a like-term Treasury for accepting credit risk) are historically stingy.  If the economy slows, investors will typically expect defaults to increase, and risk spreads will widen (which can put bond values under pressure). Municipal bonds historically have a fraction of the default experience that like-rated corporates have.  Our observation is that municipal bond prices move more often in response to concerns about liquidity rather than expectations for credit defaults (that observation is limited to “essential purpose” issues, not issues that are exposed to the competitive pressures of a market, such as arenas or nursing homes). 

If the economy slows, all credit exposures should see some scrutiny and municipal bond spreads should widen.  We don’t expect that will be an issue for the muni market broadly, but it could cause some indigestion for the “junk” area of the municipal bond market, where returns have been the most interesting this year, but where spreads are more than one and a half standard deviations “tight” relative to long-term averages. The recent euphoria could be unwound and turned into underperformance if the economy stalls.  Another area where reversion of recent positive developments could cause alarm is municipal pensions.  In part due to the strength of equity markets, and possibly due to funded status related favorable discount rates for the liabilities, public pension funding ratios have risen from 70% two years ago to 81% as of late.  If the stock market experiences a correction, certain knock-on effects could arise with the applicable discount rate and funding ratios could slip. Typically, stock markets have a bias toward growth, so this isn’t a major concern for ACG but it may garner headlines.  There are some areas of challenge that are not a surprise and some that may be concerns that come out of the blue.  First, we have discussed at length the challenges that small private colleges are experiencing.  This year 15 institutions have disclosed technical or payment defaults, as compared to 17 institutions for all of 2023.  Demographics are not friendly for higher education so we expect the difficult operating environment will persist.  The payor mix and employment cost challenges will continue to be a headwind for hospitals, nursing homes, and retirement community facilities, so we are more than cautious about that space.  The last area of challenge that is to be expected is the perennially poorly run municipal entities.  We don’t often say great things about Chicago’s fiscal house, so we will be kind by congratulating them for shedding their “junk” rating in 2022, but we are not surprised to report an expected $1 billion budget shortfall over the next couple of years and the school district refused to make its pension contribution.   

"In the coming years we will hear about budget challenges for the usual cast of characters and new to the stage will be some of the large school districts."

The difficulties that will seemingly come out of the blue are centered on the impact of removing the Covid fund punchbowl from municipal entities that took one-time funds and applied them to ongoing expenses, or they temporarily masked chronic budget issues with a short-term influx of funds.  Large and low-income-focused school districts will be particularly hard hit. Of the $190 billion in Covid funds that were targeted at K-12 school districts, according to The Edunomics Lab at Georgetown University, labor was the largest expense category with between 50% and 60% of the fund allocation.  Schools had until September 30^th to earmark any remaining funds that were to be spent by the end of January 2025.  The Edunomics Lab estimates that as Covid funding subsides, 384,000 full-time jobs at public schools will be at risk.  Related to the loss of Covid funds, Chicago public schools are facing more than a $500 million deficit in both fiscal 2026 and 2027.  San Fransisco’s school district expects a $400 million deficit over the next few years and San Diago anticipates a $176 million deficit during the 2025-2026 school year.  To address the loss of Covid funds and demographic shifts, San Fransisco is looking to eliminate or merge 11 of the district’s 121 schools.  The district must cut $113 million in costs by the end of the 2025-2026 school year to avoid a state takeover.  In the coming years we will hear about budget challenges for the usual cast of characters and new to the stage will be some of the large school districts.  We expect it will gain attention, but it will not have a contagion effect for the municipal bond market.

Although it doesn’t merit much space in this strategy piece, to proactively inform readers, discussion about the continuation of the tax-advantaged status of municipal bonds may arise in the coming months.  Municipal issuers don’t want it, because the failed Build America Bond Program soured issuers on the federal subsidy approach that backfired during a government shutdown (during which municipalities didn’t receive the payments on which they were depending).  Investors don’t want it, because some people simply enjoy the simplicity of having a stream of income that is not impacted by changing tax rates.  Finally, Federal debt is not taxed at the state level and state municipal debt is not taxed at the Federal level.  It is a pretty elegant lack of influence between Federal and state governments.  Changing that relationship would likely be a net negative for the Federal government and the true cost of Federal debt.  The conversation seems to come up once a decade and it typically goes nowhere.  We don’t expect this time would be any different.

Strategy and Summary – Gravity Always Wins

It may be that the Fed made a large first move in the easing cycle to give themselves space to let policy continue to work.  It could also be the case that the strong move allows for Quantitative Tightening to continue to quietly shrink the Fed’s balance sheet for the next crisis response. In response to Covid, we pumped unfathomable amounts of stimulus into the economy.  What if the challenges that the school districts mentioned earlier are facing from the abundance of funds followed by the hollow reality of normalcy, are a microcosm of what may be expected by the domestic economy?  Growth feels like the only elixir that can keep the economic hangover at bay.  Reshoring production, productivity gains that should arise from AI, strategic investment in semiconductors, and addressing demand for green energy technologies, may stimulate growth but perhaps not in time for gravity to exact a natural response to the massive stimulus of the past several years.  Worse yet, what if individuals and institutions have been conditioned to think that the degree of deficit spending is sustainable?  Given enough time, what goes up eventually comes down.  Interest rates rose in response to stimulus and as that influence is removed, the equilibrium for interest rates should be lower.

As mentioned earlier, the updraft in inflation relative to expectations along with the belief that the Fed has the market’s back offers a near-term basis for rates to trend higher.  Declining job market confidence, elevated prices for unavoidable segments of household budgets, and the cost of credit should drag the pace of consumer activity lower. We expect inflationary pressures and longer bond yields will follow.  We may not experience an official recession in 2025, but whether it is one quarter of contraction or two quarters, the average person on the street will feel like they are in a recession.  The historically stingy spreads mentioned earlier should normalize and that will likely eat into bond returns, even if there are total return gains that arise from interest rates falling.  This may become a larger influence if the end of the Fed’s Bank Term Lending Facility (BTLF) that eased liquidity burdens during the difficult environment that banks experienced in early 2023.  As the Fed reduces rates, the appeal of the BTLF decreases and banks may pay down loans more rapidly, which will effectively drain liquidity from the banking system.  Less liquidity typically means either less available credit or a higher cost of financing. We are not predicting it will cause a credit crunch, but it would make credit marginally less available.  In the face of a pause in the Fed’s rate moves, caused by a solid job market and stable yet above target pace of inflation, a barbell strategy continues to be a preferred strategy.  The short segment of the strategy will see lower yields, but not as fast as originally expected, and both the political gridlock and slowing economy should pose less of a risk for the longer maturity part of the strategy. Yields are historically high as compared to the past 20 years, so lock that in and there is a good chance for some price appreciation as the market reacts in a normal fashion to a slowing economy.  A longer-term risk remains to long bonds if we can’t get our fiscal house in order, but the immediacy of that risk seems to be an issue for another day.  Whatever the outcome of the election, there may be peace in the simple truth (whatever your political leaning may be) that the end of the world as you know it is not the end of the world.

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