Munis Can Enter 2023 With Pride

Market volatility has gripped this year with unrelenting force as Central Bank policy shifted to high tightening gear in order to arrest runaway inflation of historic proportion. Daily trading sessions in the bond market have been rife with wide swings in valuations, yet we can say with certainty that the march towards higher interest rates has given rise to historically attractive fixed income entry points. It’s been quite a while since returns offered within this space have been competitive against risk assets and given our call that bond yields are at or close to peak levels, opportunities abound to employ more rewarding asset allocation strategies in support of defensive portfolio construction. As we think about the remaining weeks of 2022 and the start of a new year, we must do so within the context of continued Central Bank policy and anticipated volatility that is likely to backdrop investment decisions. Having said this, we view the coming months through a less disruptive lens as the financial markets should now have a clearer outlook of the Fed’s tightening trajectory. While last month’s CPI data may very well represent a defining moment in the current tightening sequence, the last thing we want to do is get lulled into a false sense of security that the market bears have gone into hibernation for the Winter. Convictions should not rest with one monthly data point, but we do argue that the October print does support the thesis that inflation has likely peaked and that Central Bank policy intervention, which admittedly has more work to do, is having a constructive impact. Let’s be clear, the Fed needs to remain focused on bringing inflation down and that means a higher funds rate which could still peak at 5%.

We must take account of the aggressive policy moves made to date and recognize that the Fed has arrived at a place where policy risks have been appreciably elevated. The time has arrived to reduce the pace of rate increases as front-loading has made a dramatic impact and staying the course with such out-sized rate hikes could yield harsh consequences for our nation’s economic footing. In the Fed’s view, a pause is not on the immediate horizon, but less aggressive tightening makes sense with the final terminal rate being the ultimate end-game. In our view, overall inflationary pressure should continue to abate with cooling labor market conditions, evidence of retreating housing prices in a growing number of residential markets, and a broader easing of supply chain bottlenecks. The fixed income markets have been doing a fairly good job of pricing in Federal Reserve Bank policy and valuations are trying to show where they want to go directionally. While we agree that further rate hikes are appropriate, we do recognize that the Fed is at or approaching “sufficiently restrictive” policy and this should help to infuse some refreshing stability into subsequent trading sessions.

As market participants navigate through the remaining weeks of 2022, we expect munis to maintain their out-performance over Treasury securities despite higher rates creating negative year-to-date returns across all fixed income asset classes. We will be especially curious to see if muni fund flows can at the very least slow their pace of withdrawals, and at most can reverse course to stage perhaps intermittent inflows. The muni market is being teed up to enter 2023 from a relative position of strength. Credit quality remains strong across the broad array of muni sectors, absolute yields and attractive and competitive cash-flows provide a compelling argument to put sidelined cash to work, better relative value opportunities support future investment performance, and market technicals should bolster out-performance. Taxable equivalent yield calculations make the value proposition that much more apparent. Month-to-date, key fixed income cohorts are earning positive returns, largely tied to ebbing inflationary pressure and more attendant yield stabilization.

While muni performance will end the year in the red thanks to rising bond yields and accompanying price erosion, the attractive cash-flows have created a strong “carry” component to performance, providing an offset to the lack of any price appreciation as well as defensive attributes ahead of a potential recession. This will likely extend into 2023, although we expect far less price erosion and perhaps there may be opportunities to experience some price advancement. Should our expectations for munis come to fruition, munis would be in a good position to outperform other fixed income options in 2023, yet would become somewhat richer. With the current out-performance, relative value ratios have declined with the 10 and 30-year benchmarks now at 81% and 95% respectively, still well within that fair to attractive value range. Heading into 2023, muni credit will be generally secure and future prospects will be closely tied to the overall growth trajectory of the national economy. For 2022, recession has been averted, but we do see the possible emergence of a contraction, albeit relatively modest, in the second half of next year. While our outlook still calls for a “braced landing”, that could be revised should inflationary pressure trend lower and Fed policy shape up to engineer that elusive “soft landing”. Let’s understand that bond yields are not likely to drop as quickly as they have advanced. We have checked many of the “bullish” boxes in favor of tax-exempt investment opportunities from credit standing, a likely peak (or close to) in bond yields, and relative value to attractive cash flows, portfolio diversification and defensive attributes. This combination should take muni performance out of the red and set up 2023 for positive returns, which for now we project to be in the mid-single digits.

For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.