At a time when unemployment is at a low and inflation is relatively tame, it is appropriate to contemplate when the turn in the economy may come. This contemplation may appear to be just academic, but I have been reading about the timing of the reversal more often of late. Part of the rationale for this thinking is the changing shape of the yield curve.
There is little doubt that the curve will continue to flatten. Short rates continue to rise in the midst of global concerns about trade and political stability that serve to keep yields on the longer end relatively benign. In the municipal market, we are still working with the implications of a much reduced supply with a surfeit of buyers.
Is the emergence of an inverted yield curve really a harbinger of difficult times to follow? I can readily summon cases of old that support the argument. Although it was a very long time ago, the most pronounced inversion in my time in the market was in 1982. I recall Los Angeles County coming to market with a one year cash flow borrowing in the late May early June time-frame with a 12% handle that was well in excess of long rates. By the end of that year, unemployment peaked in December and we were headed into recession.
Of course the Fed had a role back then in the movement in rates as it does now. We continue on the path of gradual tightening at present. A real rate shock does not appear to be in the plan at the moment. However, in order to avoid the super heating of the economy we may be subject to a tightening of 50 basis points versus 25 basis points at one of the future Fed meetings. Such a move was a favorite of Chairman Greenspan when he was voicing concern over “irrational exuberance.’’
More than one commentator has noted that the equity market has disconnected from economic events at times. Earnings have been strong and M&A activity has re-accelerated. But we fully accept that the stock market is not necessarily correlated with all economic events. We know through painful empirical experience that sentiment can change precipitously and a correction in market levels can be swift.
I just do not fear an inversion at this point in time, even though the distance to be covered in rates could be discharged apace. Still, we should remain diligent monitors in this technical regard.
Another fundamental focus on the economic front is the ongoing vitality of the Phillips Curve. The trade-off between unemployment and inflation has been more pronounced in earlier periods. Some might maintain that the Phillips Curve has taken a holiday. At present, we are collectively benefiting from record low unemployment and relatively tame inflation. We know that the Fed would appreciate even a bit faster growth in inflation. If inflation accelerates, we would hear more talk of the necessity of the Fed to take action with more speed.
The Phillips Curve may not be irrelevant, but it does appear to be dormant at the moment. Once again, this circumstance could change rapidly.
Another perspective may be ascertained by contemplating demographics. Baby boomers are in full swing on the retirement trend.
A refrain I often hear anecdotally is that Boomers have too many possessions. As a cohort, they are more interested in shedding earthly possessions and simplifying their lives. At a certain point, Boomers become greater consumers of healthcare than other services or products.
On the other end of the spectrum, younger cohorts have lower rates of family formation on average versus historical norms. This trend directly translates to less buying of goods and services. The recent increases in mortgage rates have been driving the real estate markets. In many markets there are laments over supply and high prices. The construction industry has also been cautious in its approach to creating supply. The latter has also been affected by ongoing conservatism in underwriting standards by the banks. Although there is sensitivity there, no banks want to return to the dark days of 2007-2008.
In the face of all of these concerns, we are happy to report that the municipal market continues to do well. All parties except Issuers would like to see a bit more yield. We also continue to be mildly concerned that there may be a contraction in market participants at some point later in the year. Such a contraction may develop because of technological advances if for no other reasons.
Municipals remain a relatively safe harbor. It would take much higher rates that would bring losses that would change the tone in the market. We remain on cruise control, avoiding speed bumps while keeping a watchful eye on global developments.