The recent government machinations in Italy and the consequent market reactions in sovereign bonds and currencies are reminiscent of the fallout earlier this decade from developments in Greece. Although Italy’s GDP is not growing as fast as officials would desire, the finances are not encountering as much difficulty as Greece. What are the implications for the municipal market?
The volatility that was on display earlier this week with Italian bonds could easily happen here once again. We have a significant mid-term election that has the possibility of redirecting fiscal and monetary policy until 2020. Although we have a federal budget agreement for a couple of years, factors could change rapidly after that period of bipartisan agreement.
Of course, we are not concerned about any currency change, but we are focused on a stronger or weaker dollar. Though a somewhat weaker dollar may serve to support more trade, it is far from clear whether we are going to have a renegotiated NAFTA and whether or not we will have much higher tariffs on foreign goods, including up to a potential 25% on imported vehicles.
Municipals rallied significantly along with Treasury equivalents as Italy has veered. In some aspects, municipals even out-rallied the taxable markets. We reversed course after the last couple of days as the equity markets recovered from the initial shock.
The initial reactions in the municipal market could have been even more pronounced. Underlying the bid in the market and the market tone is the sharp reduction in municipal supply. Supply YTD is running about 22% below last year’s volume. This condition begs the question: what will happen when we have a spike in supply with one of the many percolating event risks taking place simultaneously? I trust that you already know the answer. Spreads have the tendency to widen holding other factors constant.
The market has not violently overreacted because we know that the economy is in fine shape at the moment. Corporate earnings have been strong, as we have just witnessed through the cycle, and unemployment is at a decade-plus low. We are just ever vigilant about what domestic policies or global forces may upend the balance.
The bid side for municipal paper remains strong, in part due to the continuing positive flows to the mutual funds. In the new tax environment, even though some demand is undoubtedly affected by the reduced corporate rate, many individuals leaving out high net worth individuals are more affected by the cap on SALT deductibility. There are few alternatives to the favorable status of the tax exemption.
The recent volatility has proven that many municipal investors are in the product for the long haul. They need that coupon. It hasn’t caused municipal investors to either pile in or to flee from the paper. The only real component of the buyer base that can exhibit this behavior and to take advantage of dislocations is the institutional side.
There is no real fear of contagion in our market at present. Despite a cautious approach to acting as principal and taking on more exposure, the broker-dealers have been providing ample liquidity. Bid lists are often posted and have been withdrawn or cancelled at times. The lists that are out there tend to be well bid. We do not see this changing, given the present tone.
Of course, the FED is a stabilizing force when the markets are in flux. The FED has been careful about tightening and slowing the application as the data dictates.
If the Eurozone is to be challenged by a potential exit by Italy, there is no doubt there would be a marked reaction in the markets. We would expect that municipals would react in a partially correlated way with the Treasury market. However, given the probable supply scenario remaining at a lower level, we would not expect municipals to overcompensate. What is instructive about the situation in Italy is that fiscal policy can be radically changed in swift fashion. We await the mid-terms for clues about the future course for the market.