Final Quarter With Munis In The Lead

As the final quarter of 2022 is now underway, we certainly do not have any lofty expectations that the volatility, which has kept the financial markets in turmoil throughout much of the year, will suddenly fade away. The Fed’s unyielding efforts to take inflation down to its 2% target have now assumed an “all hands on deck” posture from virtually all policymakers, even from those officials that were historically aligned with a more dovish bias. It would seem to us that the Fed is working overtime as it sends an unequivocal message to the financial markets that clamping down on inflation is priority number one, even at the expense of pulling the economy into recession. A repricing of financial assets will likely continue to define 2022 as the higher interest rate narrative overrides recessionary fears, at least for now. The U.S. Central Bank is pursuing a tightening sequence of unprecedented proportion with the focus now on the November 1-2 FOMC policy session. With three consecutive 75 basis point rate hikes on the books, the Fed may find itself with little choice but to go another three-quarters of a point. Overall, there is nothing contained within the September jobs report or September inflation prints that would justify a course correction at the upcoming policy meeting and in fact, officials will likely dwell on the enduring presence of wage advances as a key factor in support of entrenched inflation.

As we find ourselves recalibrating our risk metrics and our overall outlook for fixed income asset valuations, we recognize that we are in very good company and that buzzwords such as pivot, pause, and pain evoke varied time horizons and interpretations. We expect the time will come when a divergence in policy bias will emerge with a more normalized dot plot distribution. However, the funds rate stands at the lower end of what qualifies as restrictive policy and so for those stakeholders wishing for a pivot, continued patience is advised. Without clear and consistent evidence of abating inflationary pressure, the Fed is unlikely to hit the pause button and with prospects for higher energy prices, the move to more restrictive rate territory becomes potentially more urgent. As policy grows more restrictive, recessionary fears will likely intensify with our stated risk of the U.S. economy falling into recession now revised at over 50% over the next twelve months. With this in mind, our economy remains visibly more resilient compared to the European economy and we maintain our call for a relatively shallow and short-lived contraction.

Although fixed income securities have endured double-digit losses year-to-date as measured by the Bloomberg Barclays U.S. Aggregate Bond index, they may continue to offer investment ballast as an offset to the more volatile price gyrations across risk assets. We posit that a 30% to 40% asset allocation strategy into fixed income is appropriate, with munis consuming much of this allocation should tax-efficiency, preservation of capital and portfolio diversification drive the investment thesis. With this in mind, we are not suggesting that munis are immune to the inflationary bite and ensuing tighter monetary policy. In fact, a repricing of the asset class has produced negative returns of historic proportion with year-to-date losses approximating 11.4%. Withdrawals from municipal bond mutual funds have occurred for nine consecutive weeks with the pace of outflows failing to ease as we anticipated. Nevertheless, the negative muni returns compare favorably to the year-to-date losses for UST and corporate bond securities. Relative value ratios have been staying within a range and while they have been inching lower over the past few trading sessions, cheaper valuations offer investment opportunities, particularly with 10-year and out tenors.

Clearly, the muni story is all about rates, with credit yet to be a driving consideration for performance. Although September will be memorialized as one of the worst months on record, we do see light at the end of the muni tunnel. This is not to say, however, that the pain is disappearing with a return of cash deposits into muni mutual funds and more convincing flashes of green on the performance screen. For this to occur, we would need to see the presence of a sustained market rally, which would require at the very least a stabilized rate environment. However, we believe that we are moving closer to the highs on yields and that the asset class has room to benefit from a generally sound credit profile. Current absolute yields are attractive and ratios are approaching levels that can draw active interest from crossover buyers. Technically, this month is not expected to deliver the typically heavier weekly calendars that the market has grown to expect from October, as many issuers remain sidelined through Central Bank uncertainty. New issue muni syndicate deals are seeing good interest with aggressive bidding on a number of names as well as favorable pre-sale business. Retail continues to pick and choose with selective buying holding course as long as the purchase is a good fit. Money seems to be getting parked on the short end as a conservative strategy. Tax loss swapping of deep discounts out long is evident with retail and there is strong institutional interest for 5% coupons 10-15 years out.

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