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Well, It’s January, So The January Effect is Already Over
A rally in the stock market and a sell-off in Govies, where the 10-year Treasury yield flirted with 2.60% for the first time since March of 2017, hit the municipal market hard this week.
Macro Market Points:
The dynamic of minuscule supply thus far in January versus the largest December in nearly 30 years underscores the odd dynamic market participants are currently dealing with (see chart below on visible supply). Last week saw just more than $1 billion in competitive supply and only a single negotiated deal more than $100 million. This is very atypical for a January and would suggest strong performance, especially given the historical precedent of strong January performance.
However, secondary bids-wanteds were very telling with several days last week over the $1 billion mark, and perhaps what was most interesting is what was being sold. We noted a lot of short-call structures (tax reform) along with selling in the intermediate range. This is an item we’ve discussed for some time now as tax reform changes will have a broader impact on the intermediate part of the curve but benefit the ever growing separately managed account (SMA) space.
The market saw more than $1 billion in inflows to mutual funds, according to Lipper. Funds are a lagging indicator. We do not expect funds to see this type of interest after the result of this past week are made more clear and performance is reported.
Bloomberg data shows only 6 states with projected positive supply outlook over the next 30 days. This would suggest performance should improve next week, especially given the Lipper figure.
Direct evidence of market challenges this past week was a benchmark-influencing triple-A rated Fairfax County, Virginia competitive deal that was trading out of the gates on Wednesday 10-basis points weaker than originals. Massachusetts GO did not fare much better with similar cuts and challenges with its 5% coupons.
This is not a knock on these credits but an indication of dealer response to the current market uncertainty/volatility along with the massive amount of bids-wanteds noted above.
Moving forward, supply does not look to be increasing in the coming week and we expect continued volatility given:
- Low supply (which reduces price discovery) and continued limited secondary liquidity;
- Concern about Federal Policy as it pertains to global politics;
- Headlines about a potential infrastructure bill on the way;
- The likelihood of daily and then weekly outflows reported after very poor performance this past week; and
- Uncertainty regarding the outlook for inflation and Fed policy.
Where Elections Will Matter for Credit
We generally do not take a partisan view of election results and state and municipal politics. We do, however, observe and analyze them closely for their potential impact on credit as the result of the power structure, ideology, and financial effects of changes in individual entities’ political structures. As nationwide politics have become more partisan and polarized, changes in governments have become more important as ideology becomes an increasingly larger factor in the type of policies chosen for pursuit by office holders. We believe that this will continue to be the case in 2018 when a highly charged national political landscape cannot help but bleed into the elections for state and local office.
In Illinois, the highly ideological Gov. Bruce Rauner has announced that he will run for a second term despite questionable popularity and a record level of budgetary dysfunction. In Alaska, the incumbent is a political independent who plans to seek another term. Gov. Bill Walker’s lack of major party affiliation (he’s an Independent) could easily lead to a three-way race, which always complicates matters whenever it occurs. Connecticut is unique in that its incumbent governor has announced his retirement at the end of his term. Gov. Dannel Malloy has likely read the handwriting on the wall as his efforts to address the State's long-standing structural budget issues mostly due to unfunded pension liabilities have led to historically high unpopularity ratings.
Maine, New Mexico, Nevada, Florida, Michigan, and Ohio are term limit situations where changes could be meaningful.
Tax Reform Already Creating Problems for States and Locals
The obvious pressure is expected to come from the lack of deductibility of payments of taxes to state and local government, resulting in a tax increase that could offset some or all of the benefit of a cut in rates. Implementation as required relies on yet-to-be-promulgated guidance from the Internal Revenue Service. This information will not be available for some time despite the January 1 effective date for the law's provisions. January is typically the time for gubernatorial State of the State addresses when many if not most governors take the opportunity to lay out their budget goals and priorities for the upcoming fiscal year. All of those negotiations and plans will be impeded by the extended roll out of federal tax reform guidelines.
States like New York, New Jersey, and California are actively exploring work-arounds to help taxpayers who no longer benefit from the SALT deduction. NY is exploring a shift to higher payroll taxes which are deductible to employers along with a tax credit scheme to be revenue neutral. NJ and CA are looking at the establishment of charitable trust mechanisms to replace state and local taxes. These ideas are fraught with potential legal and regulatory hurdles. As these ideas are fleshed out and the specific legal/regulatory issues emerge, we will be in a better position to evaluate their viability.
Missouri Examines New Transit Funding Options
A Missouri state task force released proposals for funding transportation needs in the 21st century. The task force's recommendations are in line with current trends in thought in the sector.
A central recommendation is that the State increase its motor fuel taxes. To account for inflation over the past 20-plus years, the motor fuel tax would have to be 27 cents today for it to have the same purchasing power as it did in 1996. This means that the excise fuel tax can purchase only 47% of materials and labor necessary for road construction that it purchased in 1996, the last time the state increased its motor fuel tax.
The other proposals include: increased registration fees for electric vehicles; excise fees or taxes on electric charging stations and systems; increases to non-fuel transportation user fees (drivers’ licenses, vehicle registrations, etc.) which haven’t been adjusted since at least the 1980s; index highway-user fees (e.g., motor fuel tax, licensing & registration, etc.) to account for inflation; revising the vehicle-registration schedule to be based on fuel efficiency (MPG) instead of on horsepower; dedicate a portion of revenue from sales taxes on internet purchases for transportation purposes; utilize optional express managed lanes on highways in metro areas to increase capacity, reduce congestion, and improve travel reliability; consider better authorization for tolling on major bridges to pay for needed construction; consider mileage-based road-user charges; further capitalize the state infrastructure bank; and enable local construction excise taxes.
What it Means for Issuers: The above are examples of how the current climate in Washington is having large effects on state and local governments from their budget planning to maintenance of their infrastructure to social services. Federal policies have vast implications on issuers and the new tax cut law is a shining example. While issuers retained private activity bonds in the law, there were many other losses, including advanced refundings. Now, with the likelihood of less federal funding support for infrastructure, at least in the near-term, issuers will need to find alternatives to fund their own infrastructure and plan for their future funding needs. Absent direction (and money) from the federal government, this issue will be of importance in many sectors -- from the above Missouri transportation funding example, to water and wastewater to schools to airports to hospitals, among many others. The ratings agencies and credit analysts will be monitoring these issues as well and we believe there will be credit implications felt across the country. As 2018 progresses, we will continue to monitor how the law is affecting the municipal industry and give examples of when issuers take matters into their own hands.
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Joseph Krist is a Partner at Court Street Group Research who has spent his career researching, analyzing and writing about municipal credits for both buy and sell side clients.View author