As many of us enter another week of stay-at-home orders, others are starting to see an easing of lockdowns. The Trump administration recently outlined three phases of re-opening the economy, putting the onus on governors to utilize state data on new infections to determine when to start Phase I. Over this past weekend, some non-essential businesses resumed operations in Georgia, Oklahoma, Alaska, Texas, and South Carolina, provided they meet social distancing protocols. This begs the question – where do we go from here?
In a recent blog post by the Congressional Budget Office’s Director (Available here: https://www.cbo.gov/publication/56335), it seems U.S. economic projections for 2020 are quite dire, though we are expected to eventually bounce back in 2021. To summarize:
- The coronavirus shutdown has induced the steepest economic downturn on record and has pushed the U.S. budget deficit to an estimated $3.7 trillion, or 18% of GDP, its highest level since WWII.
- As there will almost undoubtedly be some degree of social distancing through the first half of 2021, the federal debt held by the public is expected to hit 101% of GDP by the end of the 2020 fiscal year (September 30), up from 79% at the end of FY 2019.
- The U.S. economy will likely shrink by 12% in the second quarter and by 40% if the economic shutdowns persist for the rest of the year.
- Job losses are currently estimated at 27 million, wiping out a decade’s worth of job creation, and increasing the second quarter unemployment rate to 14%. Unemployment is expected to increase to 16% in the third quarter and then decline to 9.5% by the end of 2021 as businesses start to re-open.
- One silver lining is that interest rates are projected to fall so low that the federal government’s net borrowing cost will decline, despite the dramatic increase in borrowing by the U.S. Treasury (primarily to fund the $3 trillion stimulus package). The CBO sees the 10-year treasury yield hovering at about 0.7% through 2021
- Economic activity is expected to recover, but only gradually. U.S. GDP is expected to contract 5.6% from last year and to grow 2.8% in 2021.
To be fair, all projections detailed above rest on assumptions that are “subject to enormous uncertainty,” including the extent to which COVID-19 is brought under control in the coming months and the possibility of a subsequent re-emergence. With respect to the last bullet, the initial read by the U.S. Commerce Department on first quarter U.S. GDP was negative 4.8%, marking the largest decline in economic activity since 2008 and the first contraction since 2014. It also marks an end to steady expansion for the U.S. economy since mid-2009, which was one of the longest on record. Driving this decline are the largest drop in consumer spending since 1980 and the fastest decline in business investment since 2009.
Okay – so it appears the current U.S. economy is contracting, but some experts believe it will eventually bounce back. Will it look the same as it did before COVID-19? In seeking to answer this important question, the Munk Debates recently hosted a series of virtual conversations with author Malcolm Gladwell, CNN’s Fareed Zakaria, Allianz chief economic advisor and former CEO of PIMCO Mohamed El-Erian, as well as others (their interviews can be found here: https://munkdebates.com/dialogues). Given the focus of our bi-weekly Market Commentary, Mr. El-Erian’s interview was very thought provoking. To summarize his thoughts:
- On the corporate side, we are seeing a massive entanglement of government and the private sector. Necessary – yes – but we are implementing these unprecedented measures without any regard for why we’re bailing out certain industries, on what terms we are doing this, what the respective roles of these players are in the future economy, and what the exit strategy looks like? He calls this response “Active Inertia,” which in crisis management means you realize you need to do something different, but you end up doing the same thing over and over again. According to him, we have reacted very quickly and with major effort, but we are doing things for the pre-COVID-19 world, not the world after. Part of what we may see post-COVID-19 is a swing from companies stressing efficiency to focusing on resiliency, including reorganizing their global supply chains in favor of making things more local. Additionally, consumers may emerge from these lockdowns more risk-averse, and depending on how things are post-shutdown, we may end up with a consumer mindset similar to that seen after the Great Depression.
- Central banks are remaking the rules of finance and impacting people’s day-to-day lives in a way we haven’t seen before. Because of what happened in 2008, central banks (like the Fed) have a “whatever it takes” approach and are now involved in every market except equities, because they feel they have no choice but to step in to maintain the functioning of financial markets. These actions may have unintended consequences. For example, there is the perception that because of how the Fed has acted, the investor class – the so called 1% – has weathered things pretty well. Meaning, those that own assets have been conditioned to believe that the Federal Reserve will always come in to stabilize things and reduce volatility. This is the so-called “Fed put,” resulting in a “heads I win, tails you lose” scenario, whereby either the economy recovers a lot quicker than expected (and by extension asset prices) or the Fed comes in and bails them out.
- If the Fed enters the equity market (which El-Erian believes is possible given their involvement in the high yield market), we may end up with “zombie companies” and “zombie markets” – companies that are only kept alive through government subsidies and markets where capital is not efficiently allocated. The benefits of capitalism – namely price discovery and the efficient allocation of capital – will be moot at this stage, because the Fed will no longer be a central bank but rather a fiscal agency, exerting even more control over the price of financial assets.
- We have stumbled into “Big Government.” At the moment, we have a temporary form of Universal Basic Income in the $1,200 stimulus checks sent out to Americans. We also seem to have unlimited big government because of our massive deficits. Undoing this will take years.
- Certain industries will suffer from deflationary forces going forward, primarily because of lower consumer demand, e.g. airlines, sporting events, hospitality, and transportation.
- There will be downward pressure on the housing market as there will be fewer buyers.
- The chances that we tip from a recession into an actual depression are at about a 5 out of 10 and will largely depend on two things: 1) Health – if we cannot contain the virus and we end up with a W-shaped curve due to economic starts and stops; and 2) Market Accident –the Fed (along with other central banks) makes a policy mistake, leading to a global depression and global financial crisis.
It appears the general consensus is that the global economy will look different than it did pre-COVID-19. Exactly how different will depend on the length of time we’re in crisis mode. What we do know so far is that the economies of the West have been brought to a standstill because of the lack of a rigorous testing regime and sufficient supply of personal protective equipment, staff, and equipment to take care of the most acutely ill.
States and Chapter 9 Bankruptcy Protection
Recently, some prominent officials in Washington D.C. suggested there was support for allowing U.S. states to declare bankruptcy. States are not presently authorized to file under Chapter 9 of the U.S. bankruptcy code. In fact, the U.S. Supreme Court previously found Chapter 9 unconstitutional in 1936 for violating the sovereignty of states. We note the issue was also raised during the 2008/2009 recession and was dismissed over concerns it would likely unsettle bond markets, raising borrowing costs for even fiscally sound states. However, states may craft legislation that allows their underlying jurisdictions to file for bankruptcy under Chapter 9, though not every state currently allows this.
Yes – the COVID-19 pandemic has left many states with looming budget deficits, ongoing (and now probably increased) unfunded pension liabilities, and high fixed costs. But these challenges should not be equated with insolvency. Generally speaking, states have broad powers to control their own taxation and spending and may have access to rainy day funds. In any event, there is no indication that there is broad-based support to amend the bankruptcy code to allow states to declare bankruptcy. Further, the federal government and Federal Reserve are providing unprecedented support through direct fiscal aid and facilities for emergency liquidity.
Interest Rate and Municipal Market Trends
The U.S. Treasury yield curve incrementally flattened last week with yields falling for maturities 7 years and longer and increasing for shorter maturities. The municipal bond market diverged from treasuries, as yields increased last week due to investor concerns over market volatility, ongoing concerns about the pandemic, and widening of credit spreads. Even so, longer-term tax-exempt yields are now almost back to levels seen at the beginning of 2020, which is still close to the bottom of the historical 10-year range.
This past Friday, MMD AAA yields increased 5 basis points at both 10 years (1.28%) and 30 years (2.13%), which remained relatively unchanged as of Monday’s close (April 27th). As The Bond Buyer noted earlier this week, “After a week of large issuers bringing sizable deals, Friday did not fully commit to a more stabilized muni market.” Ratios of tax-exempt to comparable treasury yields are still well outside of historical norms. The ratio at 10-years is nearly 250%, which would typically represent a buying opportunity.
However, it seems investors are still preferring general obligation and essential service revenue bonds over those secured by economically sensitive sales tax revenues or annual appropriation pledges. There is a clear distinction in the marketplace with respect to credit. Moreover, a number of media outlets have reported that disclosures of unscheduled draws on bond reserve funds doubled over the past week. Unsurprisingly, these draws occurred primarily in the health care (senior living), hospitality and convention sectors, all of which are suffering the most acute impacts of the COVID-19 shutdowns. Nonetheless, more speculative and high-yield credits are experiencing far greater challenges accessing capital at reasonable levels, as investor appetite for risk has waned. Indeed, high-yield municipal bond funds continue to struggle even as net flows into municipal bond funds in the aggregate have re-emerged again after several weeks of outflows across the entire sector.
Underwriters tend to get more selective in these periods of market volatility, primarily due to the difficulty of price discovery. Although competitive sales have priced well and with fairly tight bidding, there is the expectation of increased new-issue volume due to absolute low yield levels. Meaning, the market believes issuers will likely seek to take advantage with both new money and refundings over the coming weeks and months because yields are still very close to historical lows. Even so, because of the market volatility, we urge all issuers to maintain flexibility as they approach pricing and sale dates.
Lastly, the Federal Reserve’s Federal Open Market Committee (FOMC) concluded its policy meeting this week. As expected, the FOMC took no action, leaving the target range for the fed funds rate at 0.00% – 0.25%. The effective fed funds rate is presently 0.04%.
Glimmers of optimism may have found their way into the U.S. markets last week, as respective state plans to reopen non-essential businesses and other activities continue to take shape across the country. Georgia is at the front end of this trend, providing an opening to non-essential businesses on Friday (4/24), provided social distancing protocols are established. Much of the rest of the nation plans to open in May and June based on statements and expirations of peacetime emergency orders expiring.
Municipal investors are in the midst of a rapidly evolving landscape. Not long ago, cash and cash-like instruments were yielding as much or more than alternative termed products through the majority of the investable interest rate curve. Further, absolute yield levels have collapsed in just the last two months. Pools, money market funds and other cash-like investment products will soon approach yields of 0.00% after fees, with returns on U.S. Treasuries under 20 basis points out to one year. There is incremental return to be gained by moving out a bit on the yield curve. For instance, there is an almost 100% increase in yield from 1 – 3 years on the Treasury curve.
During these times, it is important to carefully examine municipal investment portfolios to ensure investments are protected and provide a reliable source of income, even if that income potential has diminished. An understanding of your financial profile, risk tolerance and cash flow is crucial to establishing the confidence in laddering a portfolio with slightly longer duration. Additionally, it’s a good time to get educated on alternatives to the most traditional investments, such as U.S. Treasuries, agencies and brokered CDs, which don’t necessitate increased risk exposures. Expanding your view can prove valuable, although it may require amending your investment policy to widen the universe of permissible investments. Our advisors can partner with you to review policies, construct cash forecasts and build durable portfolios that reflect current conditions. While cash has the highest liquidity, it will soon have the highest opportunity cost.
Ehlers would like to remind our clients at times like this that the market and rates fluctuate, even recessions are inevitable. Our recommendations may vary based on circumstances, but it is always wise to maintain a balanced portfolio that provides reliable income with the ability to seize on opportunities when they present themselves. We continue to focus on safety of your principal, liquidity needs through asset allocation strategies, and an eye towards a competitive rate of return.
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