We expected that the pandemic would be nearing the end as we moved into the last part of the year. Covid variants, continued illnesses and “breakthrough” cases deferred our return to normal. According to Forbes.com, the number of U.S. Covid deaths in 2021 has exceeded the number in 2020. Forbes.com also cited that 65% of the U.S. population is at least partially vaccinated and the journal Nature, estimated that as of the end of August, 31% of the population has had Covid. Hopefully the combination of vaccination benefits with the natural antibodies from those who have had Covid mean we are heading toward normalcy. What the summer spike accomplished was to dampen some of the “reopening” economic enthusiasm, and it was a decent rationale for delaying the return to office pressures many workers were likely dreading. The tangible good news we can celebrate as the quarter ended was the number of new daily cases started trending lower. Currently we are experiencing roughly 100,000 new daily cases, down from more than 150,000 over the summer months (data provided from cdc.gov).
Keeping rates low was for the purpose of keeping borrowing costs low, while also encouraging consumption over saving.
Last quarter, we opined that the major market moving factors would include the Fed’s actions, progress toward major spending/investment legislation, and the state of inflation. The Fed has indicated that they will taper their asset purchases as we get closer to the end of the year. The market took this as the Fed becoming more hawkish, concluding that interest rates would trend higher because the Fed was behind the curve in fighting elevated inflation, or the fact that the Fed was going to reduce their asset purchases meant that a major buyer of Treasuries and mortgage-backed securities was about to step out of the market and the natural level of yields would likely increase. Although communication of the change was well done, it seemed as if many people assumed that as soon as the Fed was done tapering, they would start to raise the Fed Funds Rate. Chairman Powell very clearly articulated that the tests, measures, and triggers for the removal of accommodation for asset purchases and raising the Fed Funds Rate were distinctly different. The two “levers” were for distinctly different purposes during this economic downturn. Tapering is merely decelerating stimulus, while rate increases generally are viewed as monetary tightening (understanding that some would say a Fed Funds Rate below the level of inflation is stimulative). Keeping rates low was for the purpose of keeping borrowing costs low, while at the same time encouraging consumption over saving. The asset purchases during this episode were to make the bond market function properly. In March of 2020, Treasury security liquidity was impacted greatly. The “buy just about everything” (including sectors they claimed were beyond the red line just days before) approach to asset purchases may have been well-executed, but since bond yield credit spreads are near their historical lows and the liquidity in most corners of the bond market is healthy, the end of the asset purchase program seems appropriate.
The evolving political landscape seems as messy as ever.
The evolving political landscape seems as messy as ever. The debt ceiling issue arose again, with the expected date that the U.S. would default on its debt being October 18th, if the limit isn’t extended. As of now, it looks like they will punt the ceiling expansion out to December, so we can worry about defaulting again in January. As the Country becomes more divided and extreme, the game of political “chicken” gets riskier each time. This time around, we anticipate that the limit will be extended, and Republicans may use the goodwill to trim some of the size of the spending/investment plans down. Our current expectation is that the social infrastructure bill will end up around $2 trillion and the bipartisan (traditional) infrastructure bill will remain at its current $550 billion, according to whitehouse.gov. Last quarter we said that “shock and awe” spending would influence inflationary pressures and impact near-term growth expectations. The passage of $2.5 trillion in new spending probably has a similar effect to the previously hoped for $4.5 trillion. Getting progressive and moderate Democrats to get to an acceptable place of compromise may be difficult but, in the end, midterms are coming, and the politicians need to show that they “got stuff done” so something significant will be passed using the budget reconciliation in the next few months.
Over the quarter, it seemed that the inflation picture was evolving further. Housing is turning out to be the pain point we identified and expected (due to low financing costs and significant population migration trends, along with volatile materials costs). Through the end of July, the S&P CoreLogic Case-Shiller index of property values nationwide increased 19.7% on a year-over-year basis, the largest spike in more than 30 years. The Phoenix, Arizona market was particularly hot, experiencing a surge of 32.4%. As we detailed last quarter, rents are increasing at nearly double-digit rates as well. The likelihood that a hybrid workplace model is a long-term trend in some industries suggests that the upper half of the housing market will see continued interest, especially in areas and pockets of the market that have been desirable as of late. A concern for the lower half of the market is that zoning law changes could risk making starter homes unattainable for younger people. To explain further, if cities eliminate single-family housing, investors may bid up starter homes, knock them down and build multi-family housing. Sure, you have increased housing density, but you have created incentives for prices to climb, you have made potential owners into renters, the opportunity to gain sweat equity has vanished, and one of the largest wealth accumulation vehicles will be out of reach for many young people.
Wages are the area that we feel is most uncertain. In September, enhanced unemployment benefits concluded. Although the Biden administration suggested that states could choose to use their stimulus dollars to continue the benefits, to this point, we don’t see evidence that any states are choosing to do so. Perhaps the fact that the number of unfilled job vacancies in the U.S. exceeds 9.2 million (as of mid-August, per fred.stlouisfed.org) as compared to the number of unemployed persons in the U.S. at just under 8.4 million people (as of the end of August, per bls.gov) suggests that the enhanced unemployment benefits have outlived their usefulness on a broad basis. Absent government intervention, it seems that there will be large numbers of workers seeking employment. The development to watch will be as people decide they need to find a job (against the backdrop of rising prices) will they demand wages that are an improvement on an inflation-adjusted basis, or will they be price takers as to the value of their time? In the first quarter of the year, we saw real wage growth measure approximately negative 2.5% and has settled in the second quarter to something closer to negative 1%. Rising prices of commodities, especially energy/oil costs, are applying pressure to employers and employees alike. Employers have hobbled along in a scarce and skewed labor environment for more than a year and a half and are facing multiple input and operating cost pressures. It seems that in the current wage environment, this “staring contest” favors the employers.
Observations and Outlook – Perhaps “Transitory” Inflation Lasts Longer Than Expected
We have offered the concern that the same extraordinary measures we have employed to help people, risk hurting those same people at the end of this pandemic episode. In our opinion, it would have been more compassionate to telegraph to people that stimulus and unemployment benefits were going to move toward a more normal state (if in fact, that is where we are headed). Inflation is often defined as too many dollars chasing too few goods. We have given millions of people a pay raise to stay at home; some of those same people were formerly producers of goods and services. Our solution, which was likely appropriate for a time, increased the number of dollars out in the economy, at the same time increased the consumption of goods, while restricting the ability to produce and provide goods and services. Unwind the dynamics and it would seem that some degree of stagnation lies ahead.
The main winner in an inflationary environment may be levered investments with fixed financing.
As the political realities avail themselves, including both the spending/investment plans, as well as the normalization of the labor environment, so too will the duration of the transitory nature of broad inflation. If people are incented to stay home and collect benefits, that should continue to drive inflationary pressures we have previously detailed. The spending/investment plans seem like they will primarily pressure commodity prices, but some of the broadly defined social infrastructure could have spill-over effects that may replicate the current situation. It seems like the bias is toward some path that will continue the pockets of inflationary pressures we have seen for several months. Absent some amount of infrastructure spending, the base effects that have resulted in the strong inflation numbers on a year-over-year basis as of late could reverse and translate into weak levels of inflation in the coming year. Sticky areas of inflation, such as housing costs, as well as backlogged areas of expenses, such as shipping and transportation costs, should place a floor on how low inflation may go. Some areas of dramatic inflation may have reached levels that suggest a degree of price reversion is in order for meaningful pockets of inflation. On a year-over-year basis, here are some eye-popping numbers: Natural gas up 110%, West Texas Intermediate Crude Oil is 91% higher, coffee (a fuel of another type) increased by 80%, aluminum spiked 64%, sugar rose by 40%, copper is 39% higher, corn up by 37% and lumber prices have increased 12%. Viewed another way, imagine if those rates of price increases persisted? Legions of people would lose ground from a purchasing power and quality of life angle if wages didn’t grow dramatically. If input costs, operating costs, and labor costs all rose meaningfully, where would that place businesses and institutions if price increases could not be passed on to customers, as has been the case during many of the whiffs of inflation we have experienced over the past decade? The possibility of a volatile path of inflation creates a lot of potential paths and the prospects for above-trend inflation to make the average person’s life better is doubtful. The main winner in an inflationary environment may be levered investments with fixed financing. If you financed an asset in a low yield environment and paid off the fixed-rate debt with inflated/devalued dollars, your returns could be amplified and at a minimum, the cost of servicing your debt should be less painful. Such a scenario would be bad for bonds, but that is not our expectation over the long term. Our expectation is that the sticky and backlogged areas of inflationary pressure will clash with other pockets of price pressures that will mean-revert toward lower prices, and although nobody really knows where it will settle, growth on the order of 1.5% to 4% seems to be a fair estimate. The low end of that estimate is based on no additional stimulus and the high end would result if all the spending passes (the $2.5 trillion mentioned earlier), plus some extension of unemployment benefit enhancements.
Taking a slightly longer view of inflation, the Fed’s “Dot Plot” estimate of when they will need to raise short-term yields is at a 50/50 split between rising rates in 2022 versus a need to hike in 2023. It is noteworthy that this is a large change from recent guidance that suggested 2024 as the timing of the next rate hike. We believe that recent comments about the Fed’s role in addressing wealth and income inequality issues, along with past comments that may indicate that the Fed increasingly views itself as a contributor to a collection of global central banks, suggest a bias toward accommodation. Let’s face it, the world is addicted to cheap money. People feel it is only fair that they finance large purchases at 3%. Over the past seven years, the Fed noticed that as the unemployment rate fell at the same time inflation was modest, lower-skilled laborers experienced real wage growth. To replicate that environment, it may be the case that the Fed will try to let the economy run hot in the hope that unemployment trends lower. Perhaps the real magic came from low inflation and a focus on employment opportunities for moderately skilled labor.
Bid/ask spreads may widen, meaning market liquidity may diminish and the cost to sell a bond may rise.
Our call for an updraft of interest rates doesn’t have to do with run away inflation, but rather, for some more mundane and mechanical market issues. As the Fed begins to reduce asset purchases, bond desks may choose to reduce risk exposures, which may force yields higher than would be the market effect if the impact of the reduction of the Fed’s purchases were considered in isolation. Around the time of the start of the taper, bond trading desks may need to reprice risk tolerance as the ability to sluff off risk to a captive buyer (the Fed) subsides. Bid/ask spreads may widen, meaning market liquidity may diminish and the cost to sell a bond may rise. Some corners of the bond market may experience greater impact as compared to the broader bond market. The more technical influence that could work to drive bond yields higher has to do with negative convexity hedging on the part of mortgage-backed security servicers and some holders. Convexity hedging involves selling Treasuries to compensate for the impact that rising rates have on the duration of mortgage-backed securities (as people prepay mortgages at a slower pace in a rising rate environment, it extends the interest rate risk of a mortgage-backed security). Morgan Stanley analysts estimate at current yield levels, each basis point of increase in the 10-year Treasury yield translates into approximately $4.7 billion of selling pressure as a result of convexity hedging. Mechanically, it is a feedback loop that could result in a short-lived updraft in yields in three to six months. As rates rise, they must hedge; the selling pressure causes rates to rise further, resulting in more hedging.
Our outlook is for annoying and painful pockets of inflation, but broadly acceptable levels of inflation, spikes in yields due to mechanical issues that collectively settle lower based on the weight those influences have on the bulk of the population as they suffer through negative real wage growth. By the end of the year, the 10-year Treasury may see yields touch 1.70% and as the taper becomes fully underway, the 10-year Treasury yield could top 2.0% in 2022. Longer-term, there will be a troubling push-pull battle between the disinflationary influences of technology, the cost of moving forward with green energy initiatives (new technologies are expensive), and the largest challenge of them all, the diminished value of human capital. It feels that the pandemic has expedited the trend toward making humans devalued, at least from a commercial and aspirational aspect. Some schools are doing away with “F’s” or are making grade assessments a pass/fail, people are understandably gaming emergency unemployment benefits (and their fellow citizens in the process) and the resulting work ethic of people who have the perspective that employers are lucky to have employees show up, is underwhelming. It is difficult to imagine a productivity boom and future excellence emerge from such an environment. The future looks like it will involve pockets of well-paid vocations, such as the trades, technology jobs and professional services, against a backdrop of a lot of jobs that people just will not be willing to pay much to fill because automation and other substitutes for a particular service are readily available. It is possible that the pandemic afforded us a window into our future, with a population of producers and a contingent of kept consumers.
Muni Market Developments – Status Quo Prevails
On the whole, the muni market is in good shape. The American Rescue Plan provided $350 billion of stimulus dollars, which were largely not needed for most states and local governments. As of late August, $238 billion of the funds were distributed, but in many states, dollars are not yet flowing to projects. Some states are using funds to repay their unemployment trust funds, others are addressing EPA-required water and sewer system enhancements, and other municipal entities are deliberating and disputing how the funds should be used. The important take away is that many municipal entities experienced unexpected budget surpluses in 2020 and the added stimulus dollars affords them an added amount of strength.
There are sections of the municipal bond market that may face structural challenges and the bad actors of the past didn’t get enough stimulus dollars to change their trajectory. Major transit systems with large, fixed costs and diminished utilization may need to make significant changes. At previous service levels, the subsidy to fund the systems may need to increasingly be shouldered by the government and taxpayers. The New York State Comptroller says that the Metropolitan Transit Authority, that received $14.5 billion in federal aid may run out of aid dollars in 2025. The ridership has recovered to only 50% of the weekday usage that was experienced in 2019. Many people are actively seeking a hybrid workplace model, or are leaving urban areas altogether, so hitting 70% of the 2019 utilization would be a lofty goal. Service cuts, dynamic pricing, and increased local government support may be in the future of some of the large transportation systems.
Although conventions may recover to a degree, it will be years, if ever, until business travel and convention activity recovers.
Another victim of changing tastes may be hotels and convention centers. Many convention centers are funded, partially, through taxes on area hotels. Although leisure travel has largely recovered, business travel is a long way away from the levels seen in 2019. Taxes on Las Vegas’s 150,000 hotel rooms are down 61%. Convention center revenue is 90% lower. Specifically, the convention center hosted 93 events in 2019 and had revenue of $54 million and so far 2021 has had 12 events and generated $5.2 million in revenue. Although conventions may recover to a degree, it will be years, if ever, until business travel and convention activity recovers. The efficiency of virtual attendance is so beneficial that, even though “facetime” benefits are lost, many participants will demand a virtual option. Related to underutilized hotel rooms, a use has emerged that we predicted last year. In New York and California, there is discussion being had about buying hotels and converting them to low-income housing and shelters for those with housing insecurity challenges. With an acquisition cost of between $275,000 to $500,000 per room (plus refurbishing costs), it seems to be a questionable use of government/taxpayer funds. A more creative solution would be to place the same funds in a land bank structure and refurbish properties (borrowing from the Habitat for Humanity model) in an effort to build stability and some equity upside for low-income people who take care of a property and may benefit from price appreciation as the property cycles into the private real estate market. Finally, in addition to caution that should be exercised on credits that are exposed to the transportation revenue and business travel, colleges are an area that should see revenue pressures as those who don’t value the social aspects of the college experience, or see value in the product itself, seek alternative educational paths. Unless the cost/benefit analysis gets removed from the equation, it seems that small, generic, and liberal arts colleges will be challenged beyond the demographic lull in college-aged people they will start to experience starting in 2025.
From a credit standpoint, we expect the status quo, with the noted exceptions. Viewed through the prism of performance, we expect the seasonal increase in issuance, along with the current moderately poor relative value position of munis, to result in a bit of upward price pressure over the next couple of months. Many issuers and underwriters ramp up issuance in October and November before the holiday season and year-end. If taper-related pressures drive Treasury and corporate bond yields and spreads higher sooner than anticipated, the negative performance may impact asset flows into municipal bond investments. It has been more than 70 weeks since the last meaningful outflow from municipal bonds. As we have indicated in the past, opportunities in the muni bond market tend to arise when investors see negative performance on their statements and pull money from their municipal bond funds. They sell after the loss has already occurred and that tends to push muni yields even higher for a short period of time, often causing the relative value position to be so compelling that even foreign investors enter the market. We expect the greatest likelihood of that occurrence is in 2022. A potential “canary in the coal mine” may be recent asset flows out of municipal high yield funds, following the second consecutive month of negative returns. If past Fed tightening cycles offer any information about how the next one plays out, municipal bond yields as compared to similar maturity Treasury bonds tend to fall as people seek the dampened price movements that munis often offer as compared to many other areas of the fixed-income markets. As tax rate discussions suggest that rates will increase for some investors, the value of tax exemption may increase, which should lend further structural support for municipal bond prices.
Strategy and Summary
Traditional infrastructure investment has been needed for some time.
It feels like there is a real risk that a stagflationary economic environment could result from the sticky sources of inflation met with negative real wage growth. Policy errors, like those used in the 1970’s, could be the treatment that makes the patient sicker. Compassionate people can help their fellow citizen in ways that do more harm than good, although a well-communicated bridge to normalcy may be the healthy path back to a sustainable economic and labor environment. Traditional infrastructure investment has been needed for some time. The cyber-attacks on our infrastructure suggest that basic utilities, communication infrastructure and other basic government deliverables need to be “hardened” to potential disruptions. The double positive of investment/spending in this area comes from continued reliable delivery of basic services while stimulating productive job activity. Reasonable people can debate the size and scope of social safety net needs. We expect that trillions will be spent on both areas, which may perpetuate the current state of consumption, resource utilization, and modest real wage improvement. Inflation may not be as transitory as the Fed originally thought, but the weight of price increases should guide inflation to a more reasonable level over the next year or two.
The opportunities that are ahead seem as if they will be the result of mechanical issues that may occur around the time the Fed begins to taper their asset purchases. We suggest buying the updrafts. Treasuries have seen a significant move since we started writing this piece, but we expect that 10-year Treasury yields will exceed 1.70% at a point in 2021 and in 2022 we could see yields exceed 2.0% that may be coupled with spread widening in corporate bonds. 15-year municipal bonds are seeing yields of 2%. Long term, that may prove to be a good level but based on asset flows that could follow losses that investors may experience in the coming quarters could take yields up to 2.50%. Tax rates for some people and businesses will likely trend higher, and the “Trump tax cuts” may roll off between 2025 and 2027, so a tax-free 2.5% will likely be worth more in the future.
Parting Thoughts – Us Versus Them
Many of the tensions for the past several years have been born of an “us” versus “them” mindset, perhaps through the encouragement of people and groups that seek to factionalize our society. This may benefit some from an economic or power perspective, but it certainly does not further the feeling of collective being (kinship) that seems to have existed locally, nationally, and possibly globally not long ago. That vantage point may be a convenient interpretation coming from a place near the top of the global economic hierarchy. It may be that humans are naturally tribal in nature. It seems boring and “small” to surround ourselves with people who are just like us. It does not seem to be the path to our best individual “self,” or collective “selves.”
If you want the opportunity to feel hope and to be optimistic about what humanity can aspire to, might I suggest a TED Talk (at ted.com/talk) given by Fr. Gregory Boyle, the founder of Homeboy Industries in Los Angeles. Homeboy Industries is the largest gang rehabilitation and re-entry program on earth. Fr. Boyle helps men and women from 1,100 Los Angeles gangs. He has created an environment where people who used to shoot at each other now bake bread and cookies, and learn to make a living, together. Many positive things can be learned from Mr. Boyle and the gang members he serves. Above all, he says we don’t demonize those who we know. Social media seems to be the antithesis of this, in that much time is spent judging those whom we don’t know.
There is no “us versus them,” it is just “us.”
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