Will April Demand Showers Bring May Performance Flowers?

The second quarter of 2023 is underway and the financial markets are looking for guidance away from the volatility that had enveloped much of the first quarter. The banking stress appears to have abated, yet the collateral damage in terms of potential additions to the troubled list along with ongoing customer skepticism despite stabilized depositor flight, would likely keep the quality bid very much in play. When the FOMC meets in less than four weeks, policymakers will not only have to consider fresh inflation and growth data, but the geopolitical landscape as well, potentially bringing in shifting demand metrics given new exposure to advancing oil prices and China’s ongoing reentry onto the global economic stage. Just as we were beginning to see evidence of disinflationary movements, reduced oil output elevates unknown consequences for the overall inflation backdrop, potentially catalyzing above-forecast CPI prints. We do believe, however, that the overall easing inflationary trends should offset the exposure to rising energy price pressure. The effects of contracting credit conditions would likely have disinflationary implications, and we think that the fall-out would likely help to move real rates of inflation closer to the Fed’s target as opposed to achieving 2% on a strict policy basis. In any event, 2% should remain elusive for a while, and we may have to settle into an inflationary range that is off-policy.

Fed funds futures contracts continue to change, reflecting the news of the day with direct implications for policy actions. Comparing real-time contracts with those of a week ago, we see modest easing in the probability of a 25-basis point rate hike at the May FOMC meeting, likely incorporating the recent announcement from OPEC+ and ongoing banking uncertainty, with all of the attendant trappings for future growth expectations. Admittedly, the OPEC+ development along with banking-related fatigue can be viewed as wildcards, leading to unintended adjustments in the futures contracts as well as to revisions in the Fed’s summary of economic projections in regards to inflation and growth. There is further room for divergence between the Fed and the financial markets, particularly if Central Bank officials argue for more restrictive policy. However, we would consider any material disruptions in accessing credit as a visible signal to evaluate downside risks to the economy. Between now and the commencement of the next “Blackout Period” ahead of the early-May FOMC meeting, there is plenty of runway for policymakers to speak their minds, and potentially add intended/unintended confusion to the markets. While our base case still calls for recession, which could arrive late 2023/early 2024, the banking unrest coupled with geopolitical concerns and potential kinks in the consumer armor could weigh on the depth and duration of the recession, requiring more immediate easing policy from the Fed.

Munis continue to move in sync with UST as bonds react favorably to recent economic data points signaling slower growth and easing labor market conditions. The flight-to-quality-trade seems to be alive and well. We were pleased with last month’s muni performance against a backdrop of March madness. Munis returned 2.22% in March, underperforming the 2.89% earned on UST. So far in April, munis are returning 73 basis points, while Treasuries are earning 1.11%. Once again, munis are largely sticking to the text book as the asset class generally underperforms a bond market rally. We are cautiously optimistic that positive performance can continue for munis, especially as reinvestment needs build heading into the summer months. Muni high yield trailed the broader muni index in March, signaling resistance to a meaningful downward migration in credit quality, and still-present duration and rate sensitivities. Long ratios are slowly offering better relative value, but still remain a distance from being fairly valued. Fund flows, while still decidedly negative, are far away from the outsized withdrawals that backdropped 2022. Should flows shift to a positive bias, the downward impact upon long ratios would be meaningful. Admittedly, our forecasts for greater in-flow activity have yet to come to fruition, yet we remain hopeful should volatility normalize and the value of the asset class stays more consistently center stage.

Although there is demand for product, such demand is uneven and quite discerning, from both a retail and institutional perspective. While longer duration and lower-bound investment grade cohorts outperformed the broader muni market in March, we caution those performance minded investors seeking duration extensions and/or downward moves along the credit curve to stay true to investment objectives and suitability requirements. Pure relative value plays do have a role in this market, but we encourage appropriate security and structure selection. March proved to be a challenging month for issuance given the volatility tied to the FOMC meeting as well as to the collateral damage left by the SVB fallout. Last month, overall issuance dropped by 30% year-over-year, with both tax-exempt and taxable volume down significantly. Until volatility subsides, near-term supply will be difficult to predict, and we suspect that a number of issuers will be day-to-day awaiting the more advantageous access points. Having said this, there will likely be compelling entry points for refundings should rates move low enough.