In the end, the second quarter was somewhat uneventful. There were many twists and turns that could have derailed the economy, and our forecast, but in the end some degree of sanity prevailed. The banking system challenges, and concerns of contagion that closed out the first quarter of 2023, subsided. Debt ceiling talks resulted in an outcome that many pundits, from whatever their vantage point, deemed to be a bad deal (so in the end it may have been a more balanced outcome than any side would have determined to be a “victory”). After the end of the negotiation, it seems like politics has been proven to be more of a practice of lying to each other’s faces, claiming victory for your ”team,” and using gamesmanship to achieve the original position as the new brand of politics in the U.S. The student loan debt jubilee effort is a prominent example of the state of political negotiations, but the State of Wisconsin provides a particularly dramatic example of the deterioration of reasonableness. Wisconsin allows for the Governor to delete verbiage as a part of his or her veto powers. Wisconsin’s Governor, Tony Evers, eliminated text to alter the opposing party’s omnibus spending bill that funded the schools for the 2023–24 and 2024–25 school years, and funded them through 2425. Funding the schools for the next 400 years may sound fantastic but given a major urban Midwestern school district has seen enrollment drop by 20% over the past 5 years, some aspects of society may be calling for more choice, an evolved offering, or something different than the status quo. It seems like a clever political win, but it violates a social contract that existed between generations, the same logic that said if a school building was an asset for a generation, then it should be financed over a generation. Apparently, there is no longer a “spirit” of an agreement or negotiation, we can anticipate gamesmanship, related litigation, and violent policy changes to become a part of our legacy.
"...so the chances of a rapid and painless decline in inflationary influences shouldn’t be expected anytime soon."
As a result of the uncertainty being temporarily swept aside, stocks climbed higher and bond yields rose. Inflation is decelerating, but far less than the Fed would like. In the span of just over a couple of months, the market went from expecting the Fed to cut rates in 2023, to an expectation of a near certainty that the Fed will hike at least once in July, with some probability of another hike around November. For some added context, the market started the second quarter with the banking system challenges fresh in their minds, thinking that a cascade of bank failures would ensue. Our big calls for 2023 were that inflation would be “stickier” than both the Fed and the market were expecting, and that there was a greater likelihood of additional rate hikes this year as opposed to any cuts. Midway through the second quarter nearly 50% of the CPI components were growing by more than 5% on a year-over-year basis, while only a quarter of the inputs are growing at a pace that is below 2%. Unemployment remains historically low at 3.6%, so the chances of a rapid and painless decline in inflationary influences shouldn’t be expected anytime soon.
10-Year Treasury yields started the first quarter at 3.47% and ended up at 3.84%. 10-Year AAA-quality municipal bond yields began the quarter at 2.27% and ended at roughly 2.54%. Through the end of the second quarter, the most broadly watched taxable bond indexes experienced returns on a year-to-date basis of 1.60% to 2.10%, while many municipal indexes saw returns of 1.10% to 2.20%.
Observations and Outlook – Here Comes the Head Fake
As we get started with the third quarter of 2023, it seems the Fed can nearly abandon half of their dual mandate, price stability and full employment, for the near-term. Although a slowing in some of the job metrics has materialized, unemployment is currently 3.6% and wages are growing at an annualized rate of 4.4%. The decelerating aspect of the job market comes from recent downward revisions to the April and May job growth and the slowest pace of nonfarm payroll growth since late 2020. The quarter should play out as a whirlpool of tight monetary policy, colliding with loose fiscal policy, mixed with nonuniform economic results and waves of vacillating market sentiment.
"A two-year pandemic will turn into a four-year debt forbearance in a strong job environment."
Monetary policy will be restrictive. Even if the Fed doesn’t raise the Fed Funds rate 25 – 50 basis points more this year as is anticipated, current Quantitative Tightening (QT) balance sheet reduction efforts are expected to result in roughly a $1 trillion shrinkage of the Fed’s balance sheet. The Fed Funds Rate is in restrictive territory so borrowing costs are starting to weigh on some consumers and corporations. Although unemployment is very low and wages are climbing, there are efforts to continue the series of stimulative fiscal policies, not-too dissimilar to the stimulus programs that topped off the end of the pandemic and likely contributed to this bout of inflation. Student loan debt forgiveness is said to help more than 40 million Americans. Following the debt ceiling negotiations, where student loan payments were to resume in October, the Supreme Court struck down the Biden Administration’s student loan forgiveness policy. In response, the Administration has a “no consequences” solution. Borrowers who miss payments will be spared many of the usual consequences of non-payment until October of 2024, which is somewhat close to the November elections. Loans will not go into default and delinquencies will not be reported to the credit reporting agencies. A two-year pandemic will turn into a four-year debt forbearance in a strong job environment. It is relevant to the collision between monetary policy and offsetting fiscal policy because the debt forgiveness jubilee would represent nearly half a trillion dollars of stimulus. As an opportunity to irritate as many readers as possible, one could argue that the past two Administrations engaged in fiscal and deficit spending long past the point that was reasonable. The difference may be that at the current time we are trying to get the inflation genie back in the bottle and previously it was thought we might never see inflation again. Sadly, we are going to train some portion of 40 million people to “work the system” and that it is fine to not pay your debts because everyone else is doing it. It feels like a future recession of character may be born out of our current solutions to problems of many non-needy people. On a short-term basis, the “no consequences” solution improves student loan borrower’s cashflow by approximately $300 per month (Source: US News & World Report, as of March 2023). That has been and will continue to be a lot of additional dollars circulating around in the economy.
Away from stimulative fiscal efforts, economic releases and persistent strength will likely make the third quarter the one where the crescendo of calls that the Fed is behind the curve and, that they may not have the tools to fight this brand of inflation, rises to the top of the headlines. Despite recently elevated mortgage rates, the consequences of 2022’s second and fourth quarter’s decline in residential investment has contributed to a shortage of existing homes for sale. What has been a drag on GDP growth may contribute to the sticky inflation that we anticipate will present itself in the 3rd quarter of 2023. Institutional buyers of residential homes have been on the sidelines for much of this year as price increases and financing costs have resulted in institutional buyers acquiring 90% fewer homes in the first couple months of 2023 as compared to the same period in 2022. If rates or prices fall, look for institutional buyers to jump back into the market, which should create a natural price floor. Without the institutional buyers housing demand has exceeded supply and as of April, new listings of existing homes remain 20% below the levels of a year ago. Past underinvestment, limited supply and robust demand suggest that housing could be a contributor to stubborn signs of inflation.
Base effects, the result of comparing a growth statistic to a particularly outsized number experienced during the preceding year, will likely make the June 2023 headline CPI number look like inflation is subsiding. In late July, the Fed is expected to hike the Fed Funds Rate one more time (by 25 basis points). We expect the same base effects that make the market think inflation is significantly slowing, will reverse in July and August. The combination of a Fed rate hike that the market may interpret to be ineffective, with base effects that show inflation is not steadily in decline should precipitate a market reaction that the Fed is behind the curve and that the inflation genie can’t be put back in the bottle (because this brand of inflation is different). Stocks, which are fully valued by historical measures will likely send a temporary signal of strength as short positions have diminished and recent “high” levels and valuations may be carried even higher due to the regret of not being along for the ride up the “wall of worry” and the age-old “FOMO” (Fear of Missing Out).
As mentioned last quarter, our thesis continues to be that the weight of restrictive Fed policy, both in the form of quantitative tightening and through previous and upcoming Fed Funds Rate hikes, along with negative money growth supply and a more smoothly functioning global supply chain means fewer dollars may be chasing an adequate number of goods and services. Money supply shrinkage often heralds recessions, and U.S. M2 money supply is shrinking at the fastest pace since the 1930s. Also adding to the weight of the situation is tighter lending standards on the part of community banks, and an unknown degree of carnage that banking system exposure to commercial real estate may cause to bank profits and lending capacity to diminish. Banks with less than $100 billion in total assets have 14.4% of their assets in commercial real estate, nearly twice the exposure of banks with between $100 billion and $250 billion in assets, with 8.15% in commercial real estate loans. About 15% of U.S. banks now exceed the 2006 FDIC guidance on commercial real estate loan exposure. Banking system liquidity may be further challenged by continued Fed QT efforts (moving at a pace of roughly $1 trillion per year) and banking system reserves that may be drained out of the system as the U.S. Treasury fills its coffers with approximately $1 trillion in debt issuance, following the inability to issue debt leading up to the debt ceiling crisis. It has been estimated that the banking system needs to have $2.5 trillion in deposits at the Fed and currently reserves stand at $3.2 trillion. Clearly the Fed has injected liquidity when needed (such as the Reverse Repo Liquidity Facility) but it rarely elicits market confidence in markets when the Fed must run to the rescue.
"Perhaps the plan is to lose money slowly but make it up in volume."
Another theme we have expressed for the past few quarters is that the zombie companies and the zombie consumers are coming for us (we have even presented the idea of zombie governments, but their pockets are so deep that we don’t think the weight of higher rates will impact them in the short run). 55% of the smallest quintile companies in the Russell 2000 (small cap index) are unprofitable. In the top quintile of the largest companies in the same index, a surprising 20% of companies are unprofitable. It makes us wonder why people are paying such high multiples for stocks when many of them are not profitable. Perhaps the plan is to lose money slowly but make it up in volume. As sources of stimulus and liquidity are drained from the economy, it feels like zombie corporate borrowers, and stocks of unprofitable companies are poised for difficult times. Currently the junk rated debt sector is pricing in a default rate of roughly 4.6%. If a recession occurs, it would be reasonable to see high yield defaults move closer to 8%. Risk markets seem priced for perfection and some disappointment seems to be more of a sure thing, rather than achieving “perfection.” Zombie consumers may be moving in step with struggling corporations. Consumers may be changing behaviors as they have whittled-down savings that were accumulated during the pandemic, they have added to their credit card balances, and now they are “trading down” on basic goods. General Mills recently issued a profit warning, saying that consumers are substituting brand names for lower-cost alternatives. General Mills’ volumes fell in the last fiscal year in all categories except for North American foodservice. When people ditch their Honey Nut Cheerios for Honey O’s, you know consumer behavior is changing, eventually their psyche will follow subconscious trades and substitutions. Other signs of a discretionary recession, meaning trading down or skipping unnecessary expenses, are upon us. In a poll released at the end of May, 83% of Americans think the economy is fair or poor, and 72% expect it to get worse. According to Citigroup, through April, U.S. credit card spend on “Luxury” was down nearly 40% from a year earlier. Black Box Intelligence says that casual dining traffic has declined by 5.4%. Consumers may be encouraged to eat at home more because according to the Bureau of Labor Statistics, May restaurant price increases were 8.3% annualized as compared to the growth in cost of retail food, which grew at 5.8% annualized. The pain of inflation may finally be overwhelming people. According to economists at the University of California at Berkley, the inflation-adjusted value of assets held by the middle class has fallen 6%, or $2.4 trillion, or $34,000 per middle-class adult. We have known that savings rates were falling, and consumer debt is at or near all-time highs, but balances on home equity lines of credit rose by $3 billion in the first quarter of 2023, the fourth continuous quarter of increases after nearly 13 years of declines. As consumers’ bad feelings turn to changed behaviors, corporate profits should sink, and a recession seems to be the most reasonable outcome.
Municipal Market Developments – Wait for it…
Munis seem to be on track to earn coupon-like returns. We anticipate that a return of 4% to 4.5% for the year is reasonable, but the 3rd quarter may cause some indigestion on the path toward the year-end returns. 2024 seems to be shaping up as a “good” year for bonds. Our expectation continues to be that there may be an upcoming muni moment. If the market determines that the Fed has no control over this brand of inflation, an idea we don’t expect will have staying power, and if a liquidity crunch occurs around the same time, we anticipate a multi-year buying opportunity could present itself. Central banks get what they want in the end and munis are a special asset class, in that they are essential services (if you are buying the “right” ones), revenues tend to be stable, and in the event of a shortfall, the populace will tend to support essential purpose projects. Most people we know are supporters of running water and flushing toilets (especially where they reside).
"Specific areas to watch for distress include transportation systems, nursing homes and hospitals, and higher education (especially private colleges)."
In an economic slow-down, people will suggest that “this time it’s different” but it rarely is the case. Municipal bonds supported by revenue sources that are subject to the competitive pressures of a marketplace are generally riskier than school district general obligations, water and sewer revenue bonds, or other essential services. Projects for which there are substitutions or risks of changing tastes, such as university revenue bonds, are simply riskier. Most poorly run municipalities are slow-motion car crashes that can be identified and avoided. Pension challenges will plague some mismanaged municipalities for decades. It has been a problem that was decades in the making and it will take a long time to unwind the burden of underfunded liabilities. It is a sad violation of the contract between generations mentioned earlier in this piece. Chicago’s pension burden climbed to $35 billion last year. The city’s pensions range from being 19% funded to 40% funded. This compares to the average municipal pension being funded at just above 70% of their liabilities. Specific areas to watch for distress include transportation systems, nursing homes and hospitals, and higher education (especially private colleges). Mass transit systems are in tough shape. It is said that ridership has returned to 70% of pre-pandemic levels, but some crafty systems are offering free fares, so the ridership numbers should be seen through a skeptical lens. New York recently approved a massive bailout of their system. San Francisco’s BART ridership has only returned to 40% of its pre-pandemic levels, yet they have plans to add a second trans-bay tube at a cost of $29 billion and they want to do line extensions at an added cost of $9 billion. We may caution investors as they evaluate bonds in this sector. In recent quarters we detailed the issues facing health care credits and we have been identifying higher education as a problem area for some time. These sectors will be challenged for the foreseeable future. Bain and Co. Inc. released a report that said the number of distressed institutions in higher education is up 70% from a decade ago. Unless the “consumer” aspect of higher education decision is removed, school closures will be significant and municipal buyers should be cautious about exposures away from top tranche schools.
What can municipal bond investors expect in a recession? A softer employment environment will reduce income tax collections and both dampened inflation and reduced economic activity should decrease sales tax collections. Many states are well-positioned for such a slow-down. Thanks in part to the superfluous $200 billion of federal government aid provided by the American Rescue Plan, balances in rainy-day funds for 37 states reached an all-time high at the end of fiscal 2022. In the middle of the second quarter, credit rating upgrades for municipalities outpaced downgrades by a 5-to-1 margin. The market doesn’t seem concerned about muni safety as relative value for much of the muni market remains generally unattractive. Patience sums up our current municipal bond strategy.
Strategy and Summary
Near-term we expect base effects to produce a market sentiment that suggests inflation is behaving, followed by a reversal that head-fakes the market into thinking that the Fed is fighting inflation with insufficient tools. Fiscal policy has the ability to muddy the waters. Even if the student loan jubilee efforts turn into a forbearance extension of roughly a year, that is a stimulus of between $144 billion (assuming the average student loan payment is $300/month and there are 40 million loans) and $400 billion of debt is forgiven. The third or fourth quarter of this year seems to be shaping up to be the moment when liquidity and financing become scarce, risk spreads widen, and broad risk appetites are recalibrated. Leading up to the stress, we have a bias toward quality and liquidity, but as we’ve said many times in the past, bond portfolio management in our view is about portfolio construction and “tilting” toward safety or risk. The bonds you want to own, during the time you want to be a buyer, may not be available and market bid/ask spreads (the difference in price or yield between where dealers will buy bonds and where they sell bonds) may not cooperate with the timing of your preferred portfolio moves. It seems like 2023 will be the year of planning, adjusting, and constructing the portfolio in the current “higher” yielding environment, along with formulating the plan to participate in the dynamic environment we expect for the balance of 2023.
ACG’s research suggests that owning quality bonds with longer duration near the conclusion of a Fed tightening cycle historically has produced some of the more compelling forward returns of most of the return factors we track. Offsetting this opportunity is the fact that risk spreads are currently tight (risk spreads are the incremental yield investors earn for holding a non-Treasury bond as compared to a like-maturity Treasury). We think spreads will “adjust” higher from the current state which is approximately a full standard deviation “tight” as compared to the relationship for the past decade (using “A” rated corporates with at 10-year maturity). If this correction occurs, we will likely be enthusiastic about fully expressing our bias for high-quality long-duration assets. In the meantime, a barbell strategy of some short and liquid holdings and longer duration should position appropriate investors with a portfolio that has strong earning horsepower and the ability to be opportunistically nimble over the remainder of 2023, to set portfolios up for a potentially exciting 2024.
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