Finding Goldilocks: Is the Economy Just Right?

• On the heels of the Fed’s decision to put interest rate hikes on hold, the U.S. economy resembles Goldilocks: hot enough to spur profitability but cool enough to avoid tighter monetary policy to ward off inflation.
• After nine years of slow but steady economic expansion, total revenue in most states has recovered from pre-recession lows.
• States with fast-growing populations typically have strong labor force growth, above-average economic growth rates and increasing tax revenue, which helps fund infrastructure, education and various government services.
• As investors realize the effects of tax reform, the trend of strong demand for tax-exempt investments should remain robust throughout the year, enhancing the potential for attractive returns.

Munis have long been a solid investment choice for investors seeking wealth preservation and steady income. Specifically, investment-grade munis have offered clients access to high-quality debt with lower default rates relative to other bonds. However, while munis are a familiar asset class, their most attractive features are often understated or overlooked.

We believe the tax exemption of the income is the most important benefit of municipal bonds. While many investors understand the concept of tax-free income, the stark contrast between the after-tax returns of taxable and tax-exempt bonds isn’t fully appreciated.

A Goldilocks economy is one where the economy is hot enough to spur profitable business growth, but cool enough to keep the Federal Reserve from using contractionary monetary policy to ward off inflation. Like Baby Bear’s porridge, it is an economy that is “just right” for stocks and bonds. We believe that with Fed Chairman Jerome Powell announcing that the central bank is on hold from further interest-rate increases for the rest of 2019, the first quarter of 2019 ushered in the Goldilocks environment.

For now, it appears that the Fed has managed to pull off a soft landing. While international growth appears to be slowing, the U.S. economy has settled back into a slow but steady growth rate. The first quarter of 2019 was a good one for the tax-free bond market. Interest rates for 10-year investment grade municipal bonds decreased nearly 0.40% since the beginning of the year—leading to one of the best quarterly returns since the first quarter of 2014.

Come July, the U.S. economy will officially be labeled as having had the longest period of expansion in the post-World War II era, according to the National Bureau of Economic Research. Since the end of the
“great recession” in the second quarter of 2009, the domestic economy has expanded at an annualized rate of 2.3%. Historically, growth during economic rebounds has ranged between 1.5% and 6.9% with an average rate of growth of 4.1%. We believe that the subpar nature of this recovery has prolonged the cycle, as the tempered growth rate has kept the economy from forming a boom-bust scenario. From the standpoint of municipalities, the slow but steady nature of economic growth has allowed many municipalities to financially set their houses in order.

After nine years of slow but steady economic expansion, total revenue in most states has recovered from pre-recession lows. Compared to last year, states’ financial conditions for fiscal 2019 are showing marked improvement, somewhat easing the pressure on their ability to meet constituents’ demands for expanded social services. Improved credit conditions allowed states to appropriate increased funds toward education (elementary and higher education) and Medicaid services.

After modest increases in 2016 and 2017, general fund revenue increased 6.2% in fiscal 2018, according to the National Association of State Budget Directors, propelled by a sharp increase in personal income tax collections. Forty states reported revenue ahead of projections in 2018, as compared to only 18 states in 2017. Budget surpluses also allowed many states to set aside funds—either rainy-day or stabilization funds—to temper any unexpected economic downturn. Twenty-six states have more reserve funds set aside to weather the next economic downturn relative to the peak levels of fiscal 2007. Only eight states ended fiscal 2018 with less reserve funds than a year ago.

States with fast-growing populations typically have strong labor force growth, above-average economic growth rates and increasing tax revenue, all of which helps fund infrastructure, education and various government services. The fastest-growing states in the 10 years ending 2018 were predominately in the West and South. The Northeast and Midwest were home to some of the slowest- growing populations, with West Virginia and Illinois experiencing population decreases.

Despite the overall health of the economy, indebtedness continues to be a problem for some states. When assessing a state’s total debt load, we look at total outstanding public debt as well as unfunded public workers heath care and pension liabilities. The average debt load of the 50 states calculated as a percentage of total personal income is 6.9% for unfunded pension costs, 4.2% for unfunded healthcare liabilities and 3.7% for payment on outstanding public debt. Alaska is the most indebted state with a combined debt level of over 50% of the state’s total annual personal income. Alaska is followed by Hawaii, Illinois, New Jersey and Connecticut as the most leveraged states where credit oversight is warranted.

From a financial standpoint, most municipalities appear to be in the sweet spot of this economic recovery. Stronger revenue growth and modest spending increases have allowed most municipalities to put their financial houses in order while adding to rainy-day reserves. While a few states continue to struggle, the Goldilocks economy has afforded us numerous investment opportunities and allowed us to focus on areas where financial health continues to improve.

With a limited need or desire on the part of municipalities to add to debt load, supply of new issuance supply remains modest while the public’s demand for tax- free income remains strong. We expect that as investors realize the effects of tax reform, the trend of strong demand for tax-exempt investments will remain robust throughout the year, enhancing the potential for attractive returns.