The muni market has underperformed Treasuries over the past few weeks, but mainly because the Treasury was getting some “risk-off” support that didn’t fully spill over to other sectors. More about that below. Nevertheless, the long-term muni market has had a very solid run, with yields down roughly 30 basis points since early May.
Clearly, one factor in that rally of roughly 13 weeks was the limitation on new-issue supply, which was down 13.2% year-over-year through July. Now it is important to note that new-money issuance was actually up during that period, by 7.4%, even as refunding issuance virtually collapsed (-41.8%). However, we cannot help but believe that with all of the new impetus around the need for infrastructure building and rebuilding, that new-money issuance would have been up by a significantly larger amount if not for the uncertainty regarding a planned Federal role under new Federal legislation. It seems very likely that many states and governments would have borrowed more if they were actually more fully committed to spending on infrastructure as part of an integrated plan. The evidence of reduced state/local activity this year was well identified in a very recent article in The Economist. According to the article:
“Government infrastructure spending in the second quarter fell to 1.4% of GDP, the lowest share on record. According to Thomson Reuters, investment by American municipalities in the first seven months of this year, at $50.7 billion, was nearly 20% below the same period in 2016. Private-sector infrastructure funds show a similar trend, according to Preqin, another data provider: deal volume in the first half of 2017 fell by 7.5%, year on year, to $36.6 billion; the number of deals fell by a quarter.”
We suspect that the component defined as “investment by American municipalities” is only a fraction of total investment, give that new-money borrowing in the muni market—which excludes the portion of projects paid for outside the muni market, including from current budgets—is already $105 billion. Nevertheless, the Economists’ point that total spending on infrastructure projects as a percentage of GDP is at historical lows would appear to make sense.
What, then, pulled infrastructure spending so much lower versus last year? One obvious potential culprit is the ongoing pension funding challenge. However, state and local pension fund returns actually increased sharply in the 2017 fiscal year just completed, versus fiscal 2016. The economy didn’t get screamingly better, but it did continue to grow. So, what held back state and local infrastructure spending? It seems very likely that along the lines of Beckett’s “Waiting for Godot,” governments were waiting for the promised Federal infrastructure plan to take shape. For many government planners, it may seem imprudent to start a project that will have to be funded completely from state or local resources if, just around the corner, there will be a plan which identifies specific types of Federal and private sector support for many projects.
Having said that, we concede that there are some mixed signals in the difference between sharply reduced aggregate spending and a modest increase in borrowing. Nevertheless, it seems clear to us that, if a number of state and local governments were not waiting to see what any Federal plan would look like, their total spending on infrastructure would be higher, and so would their borrowing for new-money projects. So, it seems likely that new borrowing for state and local projects will ultimately increase, once governments have a better handle as to 1) whether a federal program is likely, 2) what form it may take, and, 3) what types of projects are likely to be supported. Then, they will likely expand their borrowing to help reverse the recent shortfall described by The Economist.
Meanwhile, refunding issuance has fallen, and it can’t get up.
For a number of reasons related to the Great Recession, we expect that refunding issuance will stay very sharply lower for a 5-year period, which appears to have already started. Looking at the Thomson Reuters Data, the reasons are:
1. New-money issuance minus taxable borrowing (which is essentially all for new projects) dropped sharply in 2008 as the impact of the Recession on state and local governments was fully felt—from $245 billion to $184 billion.
2. Then, in 2009-10, new-money issuance minus taxable issuance dropped sharply again, as Build America Bonds ate up a significant share of total issuance in the two years that they were available. Taxable issuance went from $24 billion in 2008, to $85 billion in 2009 to $152 billion in 2010, before collapsing to $31 billion after the BABs authorization ended.
3. New-money issuance minus taxable issuance dropped again, from $184 billion in 2008 to $177 billion in 2009, to $129 billion in 2010, to $115 billion in 2011. The latter drop occurred because many issuers rushed into the market in 2010 to take advantage of the 35% BABs subsidy, leaving less funding to be done after the program closed.
4. In terms of potential refundings, however, there is another key factor resulting from the heavy use of BABs: once the program got going by April/May 2009, the market began to bifurcate by maturity. An extremely large portion of bonds with maturities longer than 11 years or so were done as BABs, while bonds for the same issuer with maturities 11 years and in for the same issuers were done tax-exempt. As a consequence, the proportion of paper from May or so 2009 to December 2010 that was of a long enough maturity to be refundable (given omnipresent 10-year calls) was extremely small.
The bottom line, then, is that the richest source of refunding paper—long-maturity new-money paper with first calls over the next two years or so—is starting to decline sharply, with the amount of long new-money paper about to be called set to decline in 2018, the 10-year anniversary of the first drop in long new-money issuance, and to quite literally collapse for the two years after that. Given that refunding issuance begins to occur most frequently roughly two years before bonds’ first call date, it seems clear that the 2008-2011 drop in new issuance that would be refundable is already affecting refunding supply, to a degree. Refunding issuance, year-to-date, is off 41.8%. The year-over-year drop in refundings and the resultant void will continue, we expect, until 2020 or so. The aggregate impact is that total supply, which is down 13.2% so far in 2017, will continue to dwindle unless new-money issuance rebounds significantly. Perhaps some portion of the void will be filled once the outlook for a Federal Infrastructure program becomes clearer, but the negative momentum in total supply seems unlikely to reverse any time soon.
The outlook for yields, generally, and for muni yields specifically, is about as uncertain as we can recall.
We have begun to observe an interesting anomaly in the long-term bond markets, including munis: Yields have stayed in a fairly narrow trading range, even as the number of factors that could affect yields has increased significantly. In our minds, these factors include:
- An increased disparity of view regarding the need for the Fed to tighten, either by selling assets or by increasing short-term rates. A portion of this disparity relates to differing viewpoints regarding the implications of automation for wages and inflation, even as unemployment reaches levels that would otherwise cause labor costs to increase.
- The uncertain outlook for timely passage of a debt ceiling increase, needed by September.
- The seeming dichotomy between the message coming from stocks—which appeared extremely optimistic for the economy—and the message from bonds, which hasn’t seemed to incorporate worries that a strong economic outlook would lead to a need for significantly more Fed tightening.
- An uncertain outlook for Administration initiatives on cutting taxes/tax reform and infrastructure spending that might help economic growth.
- The uncertain potential impact of the new Korean crisis; and,
- A very wide range of views as to where rates stand in terms of longer-term economic and demographic patterns, including the implications of an aging population and potential downward pressures on jobs and labor costs from technological change.
Toward that end, we recently received another example, as a new major study from the Bank for International Settlements suggested that aging populations will push interest rates higher. (“Demographics will reverse three multi-decade global trend” by Charles Goodhart and Manoj Pradhan, BIS Working Papers No 656 August 2017)
But will it?
According to the authors, as summarized in Bloomberg, “A three-decade rush of new workers from Asia and other emerging markets has juiced returns for bond investors thanks to weak price growth, creating a sweet spot for capital owners that’s now reversing,” the authors write.
But demographic trends are poised to be the driving force for the price of labor and capital across large economies and a graying population will in turn drain savings ratios and offset a corresponding reduction in investment spending, which tends to fall when demand is lower.
That dynamic should spur a rise in the effective cost of capital, or real rates, the authors reckon, pushing back against a view held by Fed researchers that real rates will stay low amid weak potential growth.
We remain doubtful about the case they make, however. We would lean to the Fed researchers’ view for one not-so-simple reason: in examining the BIS study, we cannot find the treatment we would have hoped for, regarding the implications of technological change. Yes, there is lots on savings rates, investment rates, demographics, and the like. Nevertheless, all of this leaves us hungry: what happens as spectacular and accelerating technological inputs rear their multiple heads? We are strong believers that there will be rapid changes in supply/demand patterns within the economy as technological change/AI dampen income growth and increase output, generating an increasing “output gap” and increased income disparities that many observers (including us) expect to severely dampen inflation. We wonder whether the BIS authors account for that potential impact.
Be that as it may, we think it is important to recognize just how many disparate forces there are that can affect interest rates, both over the near-term and over the long-term. For now, we recognize that yields—on munis and elsewhere—remain low by historical standards, but we also recognize just how under-invested most individuals are. The household sector plus nonprofits hold roughly $12 trillion in ultra-low-yielding short-term assets, according to the Federal Reserve plus some small CSG adjustments. Given this underinvestment, we would encourage investors to continue to rebuild fixed income portfolios, but we certainly wouldn’t be in a huge hurry to do so all at once.