Smiles, Everyone, Smiles - Welcome to 2023

There is nothing like starting off a new year with a reference to 1970s/1980s TV. For those of us able and willing to recall that iconic favorite, Fantasy Island, who could forget that often quoted and spoofed opening line, “The plane! The plane!” as intoned by Mr. Roarke’s right-hand man Tattoo from atop the bell tower. For some market participants, perhaps having more normalized volatility this year is nothing short of fantasy, but we prefer to suggest that the type of enduring market disruptions of 2022 is not likely to backdrop the investment narrative of 2023. We do not mean to say that volatility will be absent in 2023, but we do believe that softening economic data points and a relaxation in the monetary tightening hype will temper market disruption. The December CPI release, which followed a below-consensus advance for November, came in just about picture perfect with consensus expectations on the mark, revealing further retrenchment in retail price pressure and reaffirming successful monetary policy efforts to rein in the highest inflation in 40 years. Although retail prices remain unacceptably elevated, we view the current CPI trajectory as favorable in terms of breaking the inflationary hold on our national economy and signaling unequivocal evidence that we have retreated from peak inflation as well as showing support for moderate rate hikes at early-in-the-year policy meetings. The first policy meeting of 2023 will take place January 31 – February 1 and just after the release of the fresh CPI data, futures contracts tightened in somewhat to more fully price in a 25-basis point lift in the funds rate.

What we are now observing is somewhat of a divergence between Central Bank messaging and market expectations, particularly as a number of Fed officials are staying the course with targeting an above 5% funds rate while the trading ranges of current Treasury bond yields coupled with an inverted yield curve and the pricing of futures contracts seem to be signaling a rate cut in the second half of 2023. We suspect that Chair Powell and his team will remain nimble enough to shift policy accordingly should the data warrant such action. For now, we are not suggesting that a pause or a pivot is imminent, but we do believe that rates will likely become sufficiently restrictive before year-end, perhaps sooner than some expect, with the funds rate possibly at or near 5.25%, yet the evolving data points could very well align more closely with market expectations and displace the tighter for longer narrative in favor of a pathway to easier policy.

While early in the year, bond market performance is well in the green, consistent with our outlook for the opening weeks of 2023. In true fashion, munis have been following the Treasury market’s lead with strong, yet under-performing, returns as munis tend to lag a bond market rally. Admittedly, munis have been buoyed by a constructive technical backdrop with demand, including heavy reinvestment needs, outstripping available supply. If it were not for these technical conditions, the performance spread between UST and munis would likely be wider. We suspect that bond yields could trade in a range with limited downside from here. We do think that there is a near-term scenario where munis could outperform should the weekly calendars remain manageable and demand holds in. For now, primary deals are seeing good reception and are getting well-placed. Nevertheless, we will be on the look-out for growing supply and any cracks in the demand profile, which could alter the performance course for munis. While the beginning of an extended cycle of inflows may not have arrived yet, we do think that we have seen an end to the lengthy duration of negative flows and that at the very least, intermittent inflows can be expected. Should our outlook come to fruition, it would likely be accompanied by less volatility, less selling pressure (AKA less bid-wanted activity), and relatively less secondary trading volume compared to the experience of last year.

While muni rates have moved lower over the past week, the asset class still offers attractive yield and income opportunities with defensive attributes ahead of a possible economic contraction and even a jump in interest rates. Such opportunities, in our judgment, should have staying power, particularly if tax-exempt yields hold to a trading range. Continued evidence of abating inflationary pressure and expectations for some type of economic slowdown should keep the interest in munis very much alive. Month-to-date, munis are earning 2.14%, with noted out-performance on 15-year and out maturities, signaling a reduced focus on monetary policy and advancing inflation. The out-performance demonstrated by munis for December as well as for all of 2022 set the 2023 stage for fairly rich tax-exempt valuations with relative value ratios at the lower end for the year and further away from fair value. Presently, the 10 and 30-year benchmark ratios stand at 67% and 91% respectively. We would note that these valuations are meaningfully cheaper than those available throughout most of 2021. While more relative value centric investors may exercise some patience and wait for cheaper ratios, that may take a while to arrive, available absolute yields are rather compelling, even if ratios dip a bit lower. We would suggest that a dramatic shift in technicals, whereby new issue deals encounter placement headwinds, could boost long ratios back to parity.