It's Not All Muni Roses, But The Box Of Chocolate Has Investors Coming Back For More

While we can agree on the overall downward trajectory of the inflationary pace, there are many components that form the disinflation narrative and admittedly confusion can challenge the best of us, especially when the process is not necessarily conventional. We can distinguish between goods disinflation and services disinflation, with the former being more transparent and partly supported by easing supply chain disruptions, yet its momentum may be ebbing, and the latter charting an extended journey at the center of the job formation process. Disinflation can have powerful implications, but let’s all be reasonable here. The downward path of inflation will not likely occur in linear fashion, but it will stay the course, albeit more slowly than what many stakeholders would prefer. Futures traders are striking a more active recalibration of the Fed’s terminal funds rate as the market convergence with Fed-thinking gains momentum. The most desired outcome, of course, would be to avoid recession altogether and achieve that widely debated “soft landing”, but a mild and short recession should be well-tolerated given the resilient attributes of our national economy. Futures contracts are fully pricing in a 25-basis point rate hike at the next meeting with expectations approaching additional 25 basis point increases at both the May and June policy sessions. Let’s keep in mind that these contracts provide implied rate changes and implied absolute rates. They constantly shift on market sentiment, and should the pace of inflation slow with greater momentum, sentiment would improve and thus lead to softer expectations for higher short-term rates. 

The Fed remains steadfast in its commitment to bring inflation down to its 2% target, an aspirational goal indeed, but one in which the Central Bank deems essential to achieve price stability and one that requires more restrictive rates. The out-sized payrolls print for January certainly created a policy headwind for the Fed, recognizing the potential for added upward inflationary pressure caused by sustained labor market tightness. The current rate mantra reflects some iteration of a longer/higher policy that will be sure to have impactful consequences for the financial markets as well as for the national and global economies and if a more restrictive range is needed, we suspect that the Fed will act swiftly and decisively. Data-dependency requires a nimble-enough position to shift expectations and alter the investment calculus.  Barring an unforeseen economic mishap, we do not foresee a pivot in the rate trajectory this year, but a pause is not out of the question pending forthcoming economic data points. While we continue to believe that the 10-year UST is not poised to test new highs during the currently ongoing Fed tightening cycle, we could see a return to a 4-handle should inflation demonstrate further resistance to slowing its rate of growth and the forecasted terminal rate moves higher.  

Munis are currently experiencing a technical conundrum with supply not keeping pace with demand. Heavy market volatility was the norm in 2022 as the Fed elevated short-term interest rates away from near-zero in order to quell the highest inflation in forty years and was the driving force behind a 20% reduction in municipal bond issuance last year. January volume was down year/year as conventional “January Effect” traditions took hold against a still hesitant issuer backdrop. State and local governments greatly benefited from multiple rounds of fiscal stimulus, much coming from the American Rescue Plan Act, that provided operational support and filled the void left by revenue displacement during the heart of the pandemic. Interestingly, certain municipalities have exhausted these funds while others are still sitting on excess stimulus cash. With economic recovery in place during 2022, the Federal dollars combined with generally improving revenue collections to strengthen a broad cross section of credits. During the January bond market rally, muni technicals catalyzed tax-exempt out-performance as fixed income posted positive returns. Sentiment shifted in February with the out-sized payrolls report for January and now with the latest CPI and retail sales prints, a return to positive performance may be challenged over the short-term. While fixed-income losses are being booked February month-to-date, technicals continue to drive muni out-performance and we think that such dynamic will endure throughout the foreseeable future. 

Muni out-performance elevates relative value concerns as munis have grown very rich relative to Treasuries along most of the curve. The 10 and 30-year benchmark ratios currently stand at 60% and 87% respectively. We have often compared relative value ratios over the past six months to those ratios booked during 2021, a time of very expensive muni conditions. Looking at this comparison today, we note that the current 10-year ratio is actually lower than what it was throughout most of 2021. Ratios would likely move higher with munis cheapening up as the muni calendar builds and if typical April 15 selling occurs as investors seek to raise cash to meet their tax liabilities. The retail investor continues to be discerning awaiting better entry points and valuations with ample sidelined cash seeking more rewarding deployment. For those awaiting more compelling opportunities, it would be a good time to tighten up credit quality across existing portfolios. It is advisable to trade out of those local credits that lack employment and tax base diversification as well as display limited budgetary flexibility. Many of these issuers may have exhausted their allocation of stimulus funds, which would further weaken financial standing. We would also prefer those local credits having stronger pension funding levels over those that display low coverage of pension liabilities. 

We suggest a focus on those revenue bond issuers that have restored revenue performance at or close to pre-COVID operating levels. Inflation has created higher operating expenses for a number of enterprises, and we can specifically cite healthcare providers now contending with higher costs for medical supplies and equipment. We would support those hospital credits that display robust balance sheets with recurring positive operations and adequate margins of protection along with a strong management team able to articulate a sound mission statement.