This Market and Policy commentary is part of Court Street Group's Perspective. A PDF of the full report is available here.
Generic municipal benchmarks saw an increase in yields this past week anywhere from 3 to 7 basis points, generally in line with Treasury market movement. On Friday, the monthly payrolls report came in much lower than expected - largely attributed to the two hurricanes that rocked the Southeastern United States and its Territories. In an odd market move, the market sold-off briefly early on Friday morning but then rallied back to end the day mostly unchanged.
We attribute this largely the Trump impact on markets. While bond markets have largely lost ground over the past 30 trading days, there continues to be a hovering uncertainty (and risk-on trade) as a result of this President.
Speaking of which, the President’s comments on Puerto Rico put the GO 8s of 2035 at all-time lows (more on this below and view chart for more information).
As we enter the final quarter of the year we point to a few items:
Supply is now nearly 20% below last year’s lackluster pace. September was two-thirds lower than the last September -- a generally large new-issue month.
Flows of cash into mutual funds posted a negative figure this past week of just about $140 million -- the first cash lost in more than a month. This is not surprising given the market losses over the the past month but something to keep an eye on.
Looking forward, October usually brings a lot of supply into the marketplace (anywhere from 10% to 12% of the annual haul). If supply were to see an uptick we could expect continued pressure on yields to move into higher ranges. Next week’s largest deal is from the North Texas Tollway Authority, a $2.6 billion deal and the next biggest in size is from the San Francisco Airport Commission, at $896 million.
Ten Thoughts for a Gloomy Day Off the Coast of Malta, by George Friedlander
We suspected this might happen. First, that, while vacationing in Italy and points east in the fall, we would hit a rainy patch, and second, that so much new “stuff” would be swirling around that we could use said rainy patch to lay out some new or amended ideas. So, here are 10 somewhat interrelated ideas and the promise that we shall return to most of them in expanded fashion—when we come back.
1) Infrastructure Plan to Come?
According to new comments out of the Administration, the bare-bones outline of an Infrastructure funding or financing program may come as soon as next week—or it may not. It may include a privatization strategy—or it may not. (See #5 below.) It may be linked to Tax Reform, in the hope that it can be used to induce Democrats to support some form of Tax Reform—or it may not. (We expect not, since the portions of Tax Reform that may be opposed by many Democrats may be much bigger, and vastly more costly, than proposed Federal support for Infrastructure spending.) It may properly distinguish between funding and financing—or it may not. In any event, we expect this process to continue into early 2018, at the earliest, so we will have many more opportunities to comment in much greater detail in the weeks ahead. See our thoughts on Infrastructure from last week here.
2) Tax Reform vs. Tax Cuts
This week, the House is voting on a Fiscal Year 2018 budget while at the same time the Senate is debating its own version—and there are a number of stark differences.
In our view—and that of Maya MacGuineas, president of the Committee for a Responsible Federal Budget, the differences are profound. With the Republicans in Congress beginning work on so-called “Tax Reform,” it is important to make the distinction between such reform and what is simply a tax cut. And, in our view, those differences have extremely important implications for 1) the outlook for the enactment of a tax bill, and 2) the implications for state and local governments should any such legislation be enacted into law.
As Ms. MacGuineas notes, for all the years of GOP lawmakers calling for balanced budgets, at least on paper, the House budget would reach balance, while the Senate budget would not.
The House also expedites a down payment on deficit reduction by calling for more than $200 billion in spending cuts from reconciliation. That, she notes, is far more than the Senate’s minimum target of $1 billion in savings. Yes, one.
Now, while we would differ considerably, we suspect, from the committee as to how spending cuts could be achieved, we do agree that a bill which simply slashes taxes by increasing the Federal Deficit is not really reform—it does nothing to improve economic incentives in the current tax code, and it does nothing to offset lower revenues through the “base broadening” that was a cornerstone of prior tax proposals. The Senate bill then is simply a tax cut with important potential implications for state and local governments over both the short-term and the longer term. A deficit-enhancing tax cut would, we suspect, generate more inflation, and induce the Fed to raise rates more aggressively than under true tax reform.
As The Committee notes: “Both budgets rely on vastly overstated economic growth numbers, but the Senate budget includes those assumptions in a way that will actually make the debt worse … No independent economist or forecaster anywhere is predicting the kind of sustained economic growth that would be necessary for tax cuts to be self-financing, and Congressional leaders should not be banking on it as policy. In fact, tax cuts that add to the debt will suppress economic growth, not unleash it…If the current Senate GOP budget—or anything close to it … If lawmakers are unwilling to pass a budget that would truly put our debt on a downward path and address both tax and major entitlement reform, members of Congress should at least reject adding trillions to the national debt on massively exaggerated promises of economic growth and take an approach that more closely resembles the House budget.”
A key issue in the distinction between the current Senate plan and true Tax Reform is the lack of offsets to the sharp cuts in taxes being proposed. These cuts come through a sharply lower corporate tax rate, through deep cuts in the tax rate on pass-through entities, through elimination of the corporate and individual Alternative Minimum Tax (AMT), through cuts in tax rates on high-income individuals, and through elimination of the estate tax even on a portion of an estate that has avoided being taxed even once. There is no double taxation issue for the part of an estate that benefits from step-up in the basis of a capital asset from the time it was purchased. If a stock was purchased at $10 per share and is worth, say $200 per share, the $190 per share increase in value remains untaxed, except under an estate tax, if the owner dies without the stock being sold. The same is the case with unsold real property, a significant portion of the value of many large estates. There is no double taxation in these cases under an estate tax. We fail to see how such a change represents greater tax equity, or how it would lead to a higher national economic growth rate.
A) It is extremely difficult to envision how tax cuts will add appreciably to economic growth while the unemployment rate is already tight, and the U.S. and global economies are already awash in surplus unspent capital.
B) The Fed will surely be poised to incorporate the impact of a deficit-increasing tax cut in its plans to raise short-term interest rates, and such a change in plans would likely result in higher Federal borrowing costs—which would also be passed on to state and local governments in the form of higher muni borrowing costs; and,
C) To the extent that projections of the economic upside from tax cuts fall far short, as we anticipate, we expect strongly that future Congresses will feel compelled the offset a portion of the newly created deficit by cutting programs, including the types of programs that currently pay for some portion of state and local activities. How, for example, would the benefits of any theoretical infrastructure program be maintained if a future Congress is seeking to find ways to offset new deficits resulting from tax cuts? We suspect that the now-infamous Federal Budget proposal introduced earlier in 2017 provides a template.
Finally, we note that the case for this entire exercise may become politically more difficult if a) the tax cuts have to be eliminated after 10 years to stay within Reconciliation rules required by a balanced budget, and b) little or nothing is done to enhance the efficiencies or economic motivations that true tax reform are supposed to generate.
There is a double taxation issue in the Tax Cut plan. Recent tax cut proposals are supposed to increase efficiently and fairness specifically by reducing Federal taxes that generate double taxation. However, state and local tax deductibility exposes a higher share of an itemizing taxpayer’s income to federal taxation because it adds back mandatory payments of state and local taxes already paid as taxable income—and that is clearly double taxation.
The good news, such as it is, is that a substantial number of Federal lawmakers, particularly in the House, are beginning to resist the full elimination of deductibility of state and local taxes that can currently be deducted. A number of schemes for doing so have been proposed, including leaving the deduction alone, or giving taxpayers a choice of deducting these payments or mortgage interest payments—or something in between. However this is handled, we are becoming somewhat more confident that at least a portion of deductibility will be preserved—assuming that a tax bill is actually enacted. Joseph Krist discusses the deductibility issue in Credit Focus.
Corporate vs. individual provisions in the tax plan. The battle over the relative implications of the tax plan for corporations versus individuals is going to be a fierce one, we suspect. For one model of the projected relative benefits for corporations and individuals, one early analysis was done by The Urban-Brookings Tax Policy Center. By their estimates, essentially all of the net cut in tax revenues occurs on the corporate side, while individuals’ tax revenues actually go up modestly over the 10-year period. Their analysis, including a comparison of corporate and individual tax revenue changes by year, can be found here.
Now, we note that Republicans in Congress have already objected strongly to this analysis. Nevertheless, we expect that over time, work from the Urban-Brookings Tax Policy Center will continue to be part of the debate.
5) Will Trump really move away from privatization as a way to provide additional infrastructure?
More about this to come, but just a few points for now. First, we were greatly surprised at the rapid turn by President Trump away from privatization as playing a significant role in expanding our nation’s infrastructure. On the other hand, we note that one comment on this was made while sitting adjacent to Vice President Pence, who comes from a state, Indiana, where a significant number of privatizations have failed, and had to be bailed out in some fashion. In our view, privatizations, properly designed, can play at least a moderate role in providing funding and financing for state and local infrastructure projects—albeit surely not the dominant role. So, we are not at all convinced that this strategy is off the table. How will it look in any final infrastructure bill? At this point we can’t tell, but we will have some additional thoughts in coming weeks and months.
6) The case for P3s—technological change makes them more effective. One issue related to the likely growing role for Public-Private Partnerships that has, in our view, been under-discussed is the likely impact of accelerating technological change on state and local projects. Again, we will return to this issue in much greater detail at a later date, but our main points are as follows:
Rapid technological change has the potential to both make infrastructure projects more effective and efficient, and to disrupt long-term projects by introducing rapid, disruptive changes in infrastructure needs—for example, through Transportation as a Service, as we discussed previously.
As these changes occur, governments are going to need to work much more closely with technologically savvy private companies, from the beginning of project development, right through operational management. In many cases, the result will be a transition from traditional design/bid/build infrastructure processes to design/build, or even design/build/manage.
As a consequence, we believe that it is extremely likely, or even inevitable, that state and local governments hook up with private vendors in order to a) utilize the most modern technological applications, b) prepare for future changes in optimal technology, and, c) “smooth out” the impact of disruptive change as it occurs. We simply do not envision a way for governments to accomplish this that does not lead to closer working relationships with a whole host of major technological vendors, from design/architecture through project management and adaptation to change.
7) A Brief Comment on CDFA’s Disaster Recovery Bond Proposal.
As discussed in a press release dated September 15, The Council of Development Finance Agencies (CDFA) is calling on Congress to create a permanent, special category of federal tax-exempt bonds, to be known as Disaster Recovery Bonds, which can be used by states and municipalities to support recovery efforts in the areas affected by disasters, both natural and man-made.
“Tax-exempt bonds are a vital instrument enabling states and municipalities to invest in public infrastructure and support recovery efforts after major disasters,” said CDFA President & CEO Toby Rittner. “With storms like Harvey and Irma becoming a more regular occurrence, Congress should act to create a permanent category of tax-exempt bonds so that recovery efforts don’t stall following a disaster.”
If implemented by Congress, Disaster Recovery Bonds would provide permanent, additional authority for state and local governments to issue private activity bonds, as was done on a temporary basis after 9/11, Katrina, Sandy and a number of other major disasters. We note that the case for such a program is consistent with our frequently published view that tax-exempt financing can be a highly efficient way to provide low-cost financing for needed governmental projects. And of course, the need for access to such low-cost financing post disaster is particularly urgent in light of this year’s horrendous hurricane season.
8) Federal vs. state/local efficiency—can block grants and other shifts in responsibility and funding really help?
The question as to whether the Federal Government or state and local governments can provide services more efficiently came up again—in spades—in light of the attempt to radically change the Federal role in healthcare, including turning of Medicaid payments to the state into block grants. An article on the site Route 50 takes on this issue in considerable detail.
But there is little evidence that the states are more efficient administrators than Washington is, and some evidence that they might be less so. “The basic argument for state efficiency is based more on hopes and prayers than on clear evidence, across the board,” said Don Kettl, a professor of public policy at the University of Maryland. Delegating programs to the states would likely result in greater disparities in what programs offer and slimmer budgets overall, more than any radical improvements in efficiency.
As a general point, Kettl and other political scientists agree, despite its reputation for bureaucracy and incompetence, the federal government runs pretty well, and where it runs poorly it tends to be stifled by outdated rules and regulations.
“The underlying argument is that the federal government is unwieldy and inefficient,” said Kettl. “That’s not true.””
In our view, there are a great number of challenges involved with turning funding for a specific purpose and turning it over to the states. One important issue is that block grants are typically set at a lower dollar amount than was provided directly before the transition—under the potentially mistaken assumption that the states could do more with less. That might be true in a few states, but many state governments do not have the expertise assumed to be available to instantly be more efficient. In such cases, service levels will simply deteriorate.
Further, in many cases, money distributed via block grants will not sit still. Using Medicaid as an example, especially in states with budgetary pressures, Medicaid block grants will compete within state budgets with a) Pensions, b) Employee health benefits, which are zero funded in most states, c) Infrastructure spending, d) Essential services of all sorts, and, e) keeping many healthcare facilities fiscally solvent, and other potential needs. Quite simply, the money isn’t escrowed. There are lots of ways to move it around within a budget.
9) 10 ways technology is changing disaster response.
In a really important article (in our view), the online magazine TechRepublic notes a list of 10 ways that technological change is already improving disaster response, and is likely to continue to do so in the future.
Factors include a) Internet-connected sensors, b) drones, c) machine learning, d) social media, e) shelter innovation, f) remoted-activated technology and five more. The article can be found here.
Our point in this is that within all of the challenges and complexities generated by technological change there are a host of potential benefits, that come within the framework of “smart city” innovation, and as above, the capacity to respond more efficiently to unexpected new needs.
10) One final issue for future comment: Expected changes in management of the Fed will have an uncertain impact.
We noted last week that a number of Federal Reserve Governors are beginning to consider more closely the possibility that technological change may be limiting potential future increases in inflation.
This discussion becomes more important in light of the discussions in the press that possibility a hawk, such as Kevin Walsh, might take over as Chairman of the Fed. Our only points on this for now are twofold. First, that in our view, a more hawkish stance by the Fed might not push long-term rates higher, if it simply slows growth or reduces asset bubbles, without having a significant impact on inflation. And second that, ironically, more hawkish management at the Fed could hurt any potential positive impact of tax cuts by “taking away the cookie jar” just when stronger growth is needed.
George Friedlander is Managing Partner at Court Street Group Research. He has more than 40 years of experience as a lead strategist in the municipal industry, previously at Citigroup.View author