The second quarter of 2021 seemed to play out exactly as planned. Vaccinations were in the arms of nearly everyone who wanted one, causing more than the 60% of the vaccinated population to resume “life as usual,” and the stimulus dollars were being spent with vigor. As a result of supply chain disruptions and various cashflow enhancements, there were too many dollars chasing too few goods and services, and signs of inflation were abundant. The base effects we have been warning of since the start of the year became the exact signs that many market experts point to, in concert with the Fed’s broadened full-employment mandate and 2% inflation average target, as their basis for concluding the Fed is behind the curve. A reopening “re-growing pain” emerged. In some industries, workers were hard to come by, resulting in creative work-arounds – such as lunch service being dropped at many restaurants. Not surprisingly, wage pressures started to build and compared to June of 2020, wages have grown by 3.6%. As speculated in last quarter’s edition of Insights, where we posed the question “will the policies hurt those it is designed to help?” the Fed’s preferred measure of consumer price gains rose 3.9% in the twelve-month period ended this past May. At best, the average worker’s position has remained stagnant as a result of the current monetary and fiscal policies, at a time when the Federal Government has been in the business of mothballing legions of lower-wage and lower-skilled workers.
A person would reasonably wonder why bond yields are lower in the face of a pandemic that is mostly past the U.S. and the economy is moving toward pre-pandemic levels of activity. As broad concerns about the pandemic subsided, the reality of an ever-changing world seemed to set into the psyche of the markets. As is often the case, these developments can be seen through a fatalistic eye, or through the scope of curiosity. It seems that many people are seeking the maximum amount of drama or temporal importance. There are concerns about the Delta variant of COVID, which to this point is generally a non-issue for the vaccinated population. Cyber-attacks on both our infrastructure and economic engine have pierced the illusion of safety, order and control that our dependence on systems has brought into reality. The current hot war has been waged using ones and zeros in cyberspace where state actors believed to have cyberwarfare groups inside of their military. Today it is pipelines; if things get worse in the future, it could be one of the “too big to fail” banks or one of the categories of “don’t touch” assets on the list that President Biden gave to Vladimir Putin at their recent meeting (let’s hope he gave Mr. Putin a fake list).
As broad concerns about the pandemic subsided, the reality of an ever-changing world seemed to set into the psyche of the markets.
For now, the most serious sources of uncertainty seem to center on the areas of politics, inflation and the labor environment. The demonization of those who do not vote as you do seems as if it will be a part of our reality for a generation, or longer. The two camps that seem to be forming are the collectivists and the individualists. The separation influenced our response to the pandemic (negatively), and it seems to have forced the interpretation of most aspects of life into diametrically opposed views. Even inside of a major political party it appears that those who are in the center are seen as power hungry or obstructionists. Perhaps the centrists believe that “moves around the center” and at a gradual pace may be healthier for our country in the long run, rather than hard shifts to the extremes upon a regime change. Bipartisan theatrics sadly reduce the prospects of a healthy political dialogue in the future, and it may harden the prospects of the “to the victor go the spoils” approach we currently enjoy. The political landscape is certainly a source of massive uncertainty, plan on that being a constant. Since both inflation and the labor market weigh heavily on our outlook for the balance of the year, we will address them at length in the next section.
Observations and Outlook – Finding an Equilibrium
In order of sequence, we think that the second half of the year will offer an evolving degree of false certainty including: politics, a developing inflation story, the employment environment and Fed policy. In July through September, the physical and social infrastructure investment plans will be the hot topics. In late June, President Biden announced a bipartisan agreement on the physical infrastructure deal for a mere $579 billion, a significant reduction from the nearly $2 trillion sought. As several senators looked on, proud of their achievement in finding common ground, President Biden announced the bipartisan deal would only be signed if it were accompanied with the $2 trillion social infrastructure spending. Apparently, there was not a meeting of the minds. The battle that now ensues is not Republicans versus Democrats, rather it seems the final deals will be hashed out between the progressive and moderate Democrats. Our expectation is that the progressives will determine it is better to get a combined package of $3 trillion, than it would be to walk away empty-handed. The current Senate “deal” being discussed involves $3.5 trillion in social spending and the $579 billion bipartisan deal that addressed traditional infrastructure, but key moderate senators were not a part of the negotiation so the final deal will likely be smaller. Mid-term elections are just around the corner and another hit of spending will be helpful to their re-election efforts. Two “wild cards” to watch out for include a “scorched earth” event where progressives decide the infrastructure investments must exceed $4 trillion (to meet green energy, healthcare, affordable housing, home care, citizenship and tax fairness goals) or they will accept no deal. That outcome would indicate a disturbing reinforcement of the idea that “those who don’t think as you do are obstacles.” Compromise has become old-fashioned. The other possible unexpected outcome is an extension of the enhanced unemployment benefits to give working families the chance to get the “right job,” rather than just any job. Such a program could easily be intertwined with any number of moves toward a universal basic income effort. We think both events would cause major market disruptions. Mechanically, look for Democrats to pass the legislation in the Senate using budget reconciliation to get around the filibuster. Congress will vote on an outline of the tax and spending program in July, but they likely will not take up the final legislation until September.
Inflation concern is an area we can get behind as a topic for reasonable discussion and disagreement. There are areas where dramatic signs of inflation exist, but in many cases, they will prove to be transitory. A couple of other areas have yet to be determined, or they have exhibited signs of inflation in segments of the economy that we believe is less prone (or postured for) price corrections.
There are areas where dramatic signs of inflation exist, but in many cases, they will prove to be transitory.
The Fed’s expectation that broadly inflation will be transitory has driven the continuation of their accommodative stance. Real GDP growth expectations for 2021 are 6.6%, with the second quarter annualizing at what is expected to be an annualized peak of 10%. It would be the strongest year for growth since 1983. The same base effects that are making the growth and inflation numbers look so strong this year will likely make the growth and inflation numbers look underwhelming in 2022 (and that too may feed into political strategy). Mark Zandi, chief economist at Moody’s, estimated that without more spending programs, growth could slip to 1.5% to 2% in the second half of 2022. Others have speculated that the passage of more spending could add between 0.5% and 1.5% to GDP.
To this point, most of the signs of inflation have been in the area of “goods” rather than services. Whereas “goods” have seen growth accelerate 5.3% over the past year, the strongest number since 1991, the (more important) “core services” inflation number is up a surprisingly modest 0.30%. Much of the recent rise in the CPI data is explained by reopening areas, such as airfare, used vehicles, vehicle rentals and sporting admissions, all up 10% from March to April. Commodities made headlines earlier in the year. Lumber in particular saw futures prices hit roughly $1,700 and have since plummeted to just over $700. The issue with lumber was not a lack of timber, but a bottleneck at the mills and transportation challenges. It is a good example of how supply shortages can lead to dramatic signs of inflation that are subsequently addressed. Many of these “out of control” signs of inflation will turn out to be transitory.
Perhaps less transitory is the impact that lumber prices had on new home construction, which may have trickled through to the existing home and rental markets. The soaring lumber costs added roughly $35,000 to the cost of a new single-family home and accounts for 17% of the average home’s construction cost. Low-cost financing is also contributing to buyer’s ability to tolerate increasing purchase prices. According to the website Apartment List, the median rent has increased 9.2% for the first six months of 2021. In addition to commodity cost increases, it is believed that Millennials are beginning to form households at a greater pace and due to work location flexibility and livability preferences, there may be in increase in demand for non-urban living. The March 2021 release of the Case-Shiller Housing Price Index showed that existing home prices increased more than 13% as compared to a year earlier. Combine the increased housing costs with elevated fuel costs, which based on supply and demand dynamics should see price support for some time, and the average person may feel the nagging effects of non-transitory inflation chiseling away at their disposable income. The substitution for high rents is not a quick or easy transition, it involves saving money for a down payment on a house or changing legislation to reduce the requirements to benefit from U.S. government agency-backed mortgage financing. Expect housing costs to be a pain point for the foreseeable future.
The 800-pound gorilla in the room is the most important cost that will drive all other forms of inflation: labor costs. There may be some legitimacy to the claim that childcare is hampering the employment pursuits of some job seekers, but the enhanced unemployment benefits, where roughly 2/3 of the recipients are better off collecting benefits and not working, explains why we have 7 million more job seekers looking for work opportunities than was the case before the pandemic. Less mentioned is the fact that businesses report that they have 9.2 million available positions, 2 million more than in February of 2020. Also of interest, private sector job “quit” rates are the highest they have been in more than 20 years. Perhaps high-quality workers, or those with special skill sets, are using the current labor market to switch jobs and possibly increase wages. For low-skilled labor, their best hope may be that government efforts to sideline some lower-wage workers will artificially increase their future pay. According to Forbes website, a Minnesota resident who is receiving enhanced unemployment benefits, receives the equivalent of more than $17/hour. Many people say that wages are a sticky cost, but in low-wage and low-skill tasks, turnover tends to be high and over time, productivity enhancements can be implemented. As an example of how the market is addressing employee scarcity challenges, Southwest Airlines announced they are increasing their wages to $15/hour. Around the same time, FedEx announced that they were increasing capital spending by 20% over the next year to invest in 16 automated facilities. Labor markets hold the key to the more meaningful long-term inflation outlook and the Fed’s resulting policy reaction. Unfortunately for all the job seekers out there, an odd development that caused average hourly earnings to spike last year, possibly resulting from employers laying off their lowest-paid workers first, may cause wage growth headwinds. Once the pandemic-related labor market safety nets are removed, a glut of lower-skilled and lower-wage workers will hit the job market in September, possibly causing unemployment numbers to get worse and it could very well drag hourly earnings growth numbers lower.
Labor markets hold the key to the more meaningful long-term inflation outlook and the Fed’s resulting policy reaction.
Fed policy has been extremely accommodative throughout this pandemic episode. They must operate in a way that maintains credibility, while supporting their dual mandate (full employment and price stability) while not causing market dependence on monetary stimulus. Real yields, as measured by the 10-year Treasury yield minus the headline inflation rate have dipped as low as negative 3.7% in 2021. For context, over the past 70 years, real yields have only been lower for 10 months (during 1974 and 1980). Through their security buying programs and other credit spread manipulation efforts, as compared to the current level of inflation, it almost costs nothing to borrow money – even for “junk” rated borrowers. Some of the Fed efforts may have contributed to the most worrisome areas of inflation. Specifically, the Fed purchasing $40 billion a month of new mortgage-backed securities has kept mortgage financing costs near all-time lows. Cheap financing factors into overall home price “affordability” and as a result purchase prices have quickly moved higher. If inflation shows convincing signs of being transitory, the Fed will need to do a masterful job of coaching the market to believe that moving toward a self-sustaining economy is actually a good thing. We expect it will be a bumpy ride as economic signals confirm and refute whether inflation is well-behaved and in line with the Fed’s stated targets.
We expect it will be a bumpy ride as economic signals confirm and refute whether inflation is well-behaved and in line with the Fed’s stated targets.
There are signs that the market has belief that the Fed may be pursuing the correct course of action. The yield curve has flattened which suggests that people expect that at a point, the Fed will remove some accommodation and raise short-term rates. It also indicates that the outlook for “run-away” inflation is muted. Through the Fed’s “Dot Plot” released after each meeting, the current expectation of the voting members of the FOMC anticipate two rate hikes in 2023. Perhaps even more interesting is the start of discussions regarding the eventual tapering of asset purchases, which is now anticipated to start at the end of 2021 or the first half of 2022. Perhaps we may be reading into things too much, but we find it worthy of watching that only two more FOMC members will have to vote to move their dots into 2022 to have a majority of FOMC members anticipating a rate hike in 2022. The Fed has many tools to fight inflation; it is disinflation that has plagued them for much of the past 13 years. We anticipate after a short visit with inflationary pressures during the next six months to a year, the Fed will have to continue the struggle with disinflation while trying to ween the market off its dependance on monetary stimulus.
In the near term we expect that “shock and awe” spending will cause interest rates to rise in the next six months. Once the government unsustainable spending smokescreen allows for clearer price signals and the realization of how the investments will be funded, we may resume demand softness next year. For context, President Biden is proposing a 25% expansion of government spending, from 20% of GDP before the pandemic to 25%. The “trickle up” economic model, where money is transferred from savers and investors to consumers, should weigh on future productivity growth, and by extension it may be an economic drag. Offsetting some of the future disinflationary pressures may be the adoption of green energy mandates. That is not to say we don’t like having environmentally friendly options and technology, but just about every new technology is expensive at first, and mandates will hurt lower income families disproportionately for a while. For them, it will be a phantom inflation in that they will simply pay more for no functional benefit (but it will be up to the individual to decide if altruistic utility outweighs the diminished functional utility).
Muni Market Developments – Something New and Something Old – Both are Bad
Related to the political and government spending environment, the unpleasant business of picking up the tab for all of this fun is in the back of the minds of many people and institutions. It is very likely that marginal tax rates for some individuals and most institutions will increase. Interest in tax-advantaged sources of income has been strong for most of 2021, as evidenced by the relentless flow of money into municipal bond mutual funds. Perhaps it is a prudent bet on the part of municipal bond investors. Tax rate increases are a near certainty and following the last spending plan, where states and local governments were awarded roughly six to seven times their COVID-related revenue shortfalls, the creditworthiness of many municipal entities is on the rise. The resulting demand environment has made municipal bonds questionable from a historical relative value perspective and to a degree, we feel some investors have become complacent about creditworthiness of their holdings. As we mentioned last quarter, the money showered on municipal entities is one-time money and some issuers, such as Illinois, high-tax areas of the country, and large transportation agencies appear to have long-term headwinds. At a minimum, we anticipate risk spreads will widen in some of these areas, but it may drive the entities to make some critically bad decisions.
In the near term we expect that “shock and awe” spending will cause interest rates to rise in the next six months.
The prospects for running into the arms of bad decisions may be made possible in part due to some of the language in the bipartisan infrastructure proposed legislation. In particular, the bipartisan deal mentions the term “asset recycling,” which must be a label that polls better than the old label of public private partnerships. Basically, it involves giving control of public assets (often monopoly assets) to a private entity in exchange for a lump sum payment. As an asset class, or an investment category, we find it intriguing, from a resident and taxpayer angle, it has the distinct prospect of offering an appalling outcome. We have discussed the topic in the past, but it doesn’t take too much thought to understand the danger of transferring the operation of monopoly public assets to an entity with a profit motive, all so that politicians don’t have to deliver unpopular truths. A great example of this concept was the 2008 deal that the City of Chicago did with an investor group to offer a 75-year lease on the city’s parking meters. The city received $1.16 billion to have control of 36,000 parking meters. Only 11 years into the deal, the investor group had already collected about $500 million more than their initial investment. It is estimated that the city priced the deal roughly $1 billion too low. Resident have complained about a doubling in the cost of parking, broken meters and other service disappointments. Perhaps more worrisome is the long-term risk that politicians get to play with large lump sum payments, sluff-off on-balance-sheet debt and incur more on-balance-sheet debt in its place. The sad truth, that will be lost on most people, is that the cashflow burden still falls on the populace for the original public asset. As an example, if a municipality sells a toll road to free up money for more light rail transit, commuters will still have to pay (probably more) for using the toll road, but they will also have to pay, in some capacity, their fair share of the investment in the new trains. In the debt-financing model currently widely used, we have a sense of both the direct and overall debt burden on a particular population. In the asset recycling model, it is difficult to quantify the total cashflow burden assessed to area residents as they move about their lives. Assets that are ripe for “recycling” involve anything that involves revenue, subsidy or has a monopoly position. Examples are most public transit assets, stadia, convention centers, municipal power generation, airports, ports, bridges, and municipal water and sewer systems. As an asset manager, the difficulty in tracking the true debt burden on a given population is a challenge we are already contemplating if asset recycling becomes widespread.
The prospects for running into the arms of bad decisions may be made possible in part due to some of the language in the bipartisan infrastructure proposed legislation.
Speaking of recycling, a President Obama-era program may also be revived through the bipartisan infrastructure deal. There has been mention of “direct pay” bonds. It is another effort to encourage an alternative to the current dominant method of financing municipal projects. Essentially, instead of offering municipal bond buyers a tax advantage, which drives down the borrowing costs from a municipal bond issuer’s perspective, they are looking to have municipalities issue taxable bonds and the Treasury will make subsidy payments directly to the issuers. During the Obama presidency, there was a debt ceiling battle that culminated in the federal government shutting down, and municipal borrowers not getting their payments from the Treasury. It triggered an unusual call feature in some related bond issues, which led to unhappy investors and issuers had to quickly arrange replacement financing. It was a mess, and we don’t expect “BABs 2.0” to take hold due to the number of needless moving parts. As we have said in the past, the elegance of states not taxing Treasury interest earnings, and the federal government not taxing state and local bonds was perfect. The ability to tax/subsidize, or tax/subsidize differently offers the prospect of exacting excessive influence.
Strategy and Summary
As the virus is becoming a historical event for many Americans and the political field of battle is progressing along the lines we expected, our outlook and strategy are unchanged from last quarter. We expect that some sticky signs of inflation, a Fed with a broadened mandate, and “shock and awe” spending will manage to see yields climb in a transitory way. We expect that 10-year Treasury yields will again move into the range of 1.50% to 2.0%. Munis will seemingly be somewhat stagnant for the rest of the year since the relative yields as compared to like-term Treasuries is fairly unattractive, which should limit the prospects of further price appreciation. To the positive, the future higher-tax environment should keep municipal bond yields from increasing dramatically. If you can find 2% municipal yields around the 15-year area, that represents the buying opportunity in our opinion.
The experiment of stuffing found money in voter’s pockets to see if we can finally move the “demand” needle will be interesting to watch unfold. Demand stimulation has been mostly unresponsive for more than a decade. We wonder if everyone who wants a Louis Vuitton bag (no matter if it is self-funded or taxpayer provided), has one, will nobody want one? Conspicuous consumption seems to have stalled out with the Yuppies and subsequent generations appear to prefer to live a smaller life with larger experiences and possibly we have been trained through the past 13 years that a lower risk life is a happier life. It feels like we will be throwing a big party in the short run and be disappointed with the consequences in the long run. The “trickle up” economic model will likely leave us with higher deficits, more federal debt, reduced investment and a resulting lull in productivity and surprisingly modest real growth. As the market realizes the trajectory of our economy, yields will follow those expectations lower as well.
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