Running On Empty

Running on Empty was recorded by Jackson Browne in 1977 and set as the title track of the artist’s live album released in the same year. Debuting as a single in early 1978, Running on Empty spent over four months on the U.S. Billboard Hot 100 chart. In 2010, Rolling Stone Magazine ranked it at number 496 on its list of “The 500 Greatest Songs of All Time”. While the literal significance of Running on Empty captures the time when Jackson Browne drove the daily short-distance trip from home to the studio with a near-empty gas tank when making his Pretender album, the more philosophical interpretation conveys restlessness or perhaps even exhaustion, yet still with a sense of hope for a better tomorrow. With this in mind, we posit that market participants are likely suffering from monetary policy fatigue with a growing chorus signaling conclusion to the Fed’s tightening cycle. The ongoing concerns over future economic growth and the potential for further bank displacements with tightening credit conditions have set market expectations for a Central Bank pause beyond this week’s FOMC meeting. Overall business capital spending and investment will likely show continued pullback, especially if credit and overall financial conditions reveal meaningful erosion. Admittedly, inflation still has a long journey to the Fed’s 2% target, yet there needs to be meaningful recognition of slowing growth conditions as well as existing credit developments and the potential for further banking-related stress. 

The markets can be expected to elevate the debt ceiling issue to heightened levels of concern absent an immediate-term resolution, and failure to act, with an inability to pay debt obligations when due, would certainly have catastrophic domestic and global implications. Even negative sentiment without actual bank failures can wreak havoc upon confidence and result in a tighter credit environment, and while Washington is expected to favorably act, sentiment can also suffer erosion should the debt ceiling issue remain unresolved through much of May. A crisis in confidence could certainly resonate throughout the global economy and call into question our commitments made to multiple stakeholders.  Should a highly unlikely payment default on U.S. debt occur, severe economic contraction, a devaluation of the dollar, and skyrocketing borrowing costs would ensue. The combination of an aggressive monetary policy tightening campaign and SVB et al has pushed lending standards to more restrictive ground, and the Fed must consider the potential for additional lending dislocation. Against this backdrop, we support a pause beyond May and prefer to re-evaluate the economic trajectory and financial conditions for the June FOMC meeting. Whether or not the Fed sees greater risk of recession given the evolving banking events and outcomes, there is little denying the observation that growth will suffer collateral damage. Throughout the past week, UST securities have been trading beyond a previously tighter range with greater volatility, bouncing among reaction to a flight-to-quality bias, economic data prints, an approaching FOMC meeting, and Treasury market offerings. Munis, following a heavy sell-off given the unsustainable richness of the tax-exempt curve, with greater corrections on the short-end, have settled into a very tight trading range with relative stability ahead of the FOMC meeting. The frothy price levels on the short-end of the muni curve actually made similar maturity UST securities more compelling on a tax-adjusted basis.  

Even though April volume fell by 24% year/year (per Refinitiv data), led by a 69% drop in taxable issuance, munis lost 29 basis points last month, under-performing the 5-basis point loss posted by UST. Year-to-date, munis are also under-performing UST and corporate bonds, 2.52%, 2.59%, and 3.06% respectively, although we would add that the performance spread has narrowed in favor of munis over the past few trading sessions. We would posit that April muni performance would have been meaningfully worse had supply taken on a more normal trajectory. The reasons for the continued monthly declines in supply range from existing stimulus funds available to many municipal governments and enterprise units to ongoing monetary policy uncertainty, which has taken rates higher and kept refunding opportunities scarce. For much of 2023, many issuers have been sidelined for one reason or another, and we do not see a meaningful break from this trend anytime soon. However, Federal stimulus funds will not last in perpetuity, and at the very least, monetary policy is likely close to or at (post May FOMC) the end of its tightening sequence, and if the market gets its way, rates may shift downward later this year – a big ask and subject to a range of conditions. Should rates drop enough, we can expect to see a resurgence of refunding activity. Furthermore, new-money issuance declined by about 38% in April year/year, and issuers would likely elevate new-money debt if there are compelling arguments to lock in lower long-term financing terms.  Parsing the performance data for April, seven-year and in maturities underperformed the broader index given the richer valuations and greater attendant corrections on shorter tenors during the muni sell-off. The out-performance demonstrated by taxable munis (35 basis points) in April reflected expensive prices on exempts relative to the cheaper valuations available on taxable muni alternatives with ratios favoring the latter, particularly on shorter areas of the curve. Year-to-date, taxable munis are returning 5.14%, outperforming the broader muni index as relative value opportunities support taxable performance, and even outperforming the UST and corporate bond indices for the same time period.

Technical conditions should improve with expanding demand amid heavier reinvestment needs, thus setting up the month of May for better performance, with single-digit positive returns a very real possibility. This technical support should continue into June and July, with anticipated positive returns in those months as well. While issuance may advance, we expect the market to manage the supply fairly well amid a more stable rate environment. This month may see some type of return to positive fund flows, but we are not signaling a cyclical shift just yet. As we move throughout the month, better value opportunities may be found on longer dated exempts and even on mid-range investment grade cohorts with a focus on certain revenue bond structures. We do not expect any material dislocations to the muni market from the First Republic developments as JPMorgan is expected to retain at least most of the securities. However, we will be monitoring BlackRock’s liquidation of muni bonds previously held by SVB and Signature Bank. The sale of these securities will be made in tranches and will take place over time. We suspect that market pricing has already accounted for what should be an orderly liquidation of muni assets, but we are prepared to experience a degree of market dislocation.  We continue to posit that the muni asset class is well-positioned and should outperform other fixed income investment classes through an anticipated recession with respect to credit, even though muni credit has effectively peaked. Munis will offer defensive attributes to an investment portfolio, and we suspect that institutional buyers will consider munis more closely. For the individual muni investor, the unfolding First Republic events, along with previous banking scenarios, should bring about calm and help to keep financial stability in place and disruptive market forces at bay.