Yields on long-maturity Treasuries hit record lows in January driven by a strong U.S. dollar and developments in Europe.
January 2017 Market Commentary
The 20,000 Yard Line
After a lively January of NFL playoff games, the New England Patriots and Atlanta Falcons headed to Houston for Super Bowl LI. It turned out to be a landmark game for Pats quarterback Tom Brady, who set a slew of passing records while leading his team to a gigantic comeback. Of course, the market just made some history of its own: On January 25, the Dow Jones Industrial Average soared over 20,000 for the first time on record.
In January, riskier assets continued to benefit from expected growth prompted by pro-business policies from President Donald Trump. Throughout the month, equities saw sporadic days of weakness and Treasury rates oscillated as investors began to wonder when the “Trump trade” would run out of steam. Nonetheless, equities had a strong month overall given a raft of positive economic data and oil production cuts related to an OPEC agreement struck late last year.
In economic news, manufacturing data came in strong. The ISM beat expectations and increased from 53.2 in November to 54.7 in December – a new high for 2016. The increase occurred despite the strong dollar that typically makes U.S. exports more expensive to foreigners. Nonfarm payroll employment rose by 156,000 in December, which was slightly weaker than expected. That said, the Bureau of Labor Statistics announced a positive revision to the prior month and strong wage growth of 0.4 percent for December. Wage growth was up 2.9 percent year-over-year.
The consumer showed signs of life. Retail sales grew 0.6 percent, following a 0.2 percent gain in November, mainly due to a strong 2.4 percent growth in auto sales that was mostly driven by discounting. In housing, new home sales fell 10.4 percent below the revised November rate of 598,000 due mainly to high prices from tightening inventory.1
The Treasury curve ended the month little changed from the end of 2016. The 10-year Treasury rate fell early in the month due to some questioning of whether the post-election equity rally had legs. Later in the month, the 10-year turned higher as Fed Chair Janet Yellen and FOMC members alluded to remaining on course for a potential three rate hikes in 2017. Additionally, China continues to sell Treasury bonds to prop up a weakening yuan.
In its January 31-February 1 meeting, the FOMC maintained the target federal funds rate at 0.5 to 0.75 percent. Inflation continues to increase steadily but slowly, which helped guide the Fed toward its opinion that “…. economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”2 Inflation remains slightly below the Fed’s 2 percent target. The PCE price index rose 0.2 percent in December (0.1 percent excluding food and energy), and it rose 1.6 percent for the year (1.7 percent excluding food and energy).3
Entering February, markets remain strong but investors are watching the new presidential administration closely. Investors are pricing in a potential cut in the corporate tax rate and GDP growth, but Trump’s trade protectionism policies, which prompted an executive order formally rejecting the TPP, and a strained series of communications with Mexico are bringing out concerns of a potential trade war. In addition, an appreciating U.S. dollar is concerning multinational companies. For example, construction and machinery firm Caterpillar Inc. said in its 4Q16 earnings release that a strengthening dollar in recent months has caused it to lower FY17 earnings expectations.4 Other uncertainties include the upcoming Fed moves, the specifics behind the U.K.’s exit from the eurozone and the French elections later this year. Some investors are responding by increasing cash holdings. Global fund managers have increased cash to 5.1 percent versus a ten-year average of 4.5 percent, per a January 17 survey from Bank of America Merrill Lynch.
Tax-Efficient Market Review
In Super Bowl LI, fans’ jaws dropped as the Atlanta Falcons, which dominated the first-half scoring, saw their lead vanish in the second half and ultimately lost the game. Municipal bonds also had much different “halves” of January. The first two weeks of the month were strong, as the well-telegraphed “January effect” kicked in. Typically, municipals benefit from strong seasonal trends in January (Figure 1) due primarily to lower supply and higher reinvestment-related demand, given principal payments coming due in January that leave investors with cash to put to work. Despite higher supply, municipal prices peaked midmonth as the deals were absorbed easily by January principal maturities and coupon payments, and proceeds from tax-loss harvesting being re-invested. Many deals were oversubscribed and saw their yields lowered.
During the second half of the month, the municipal market struck a negative tone, especially at the long end of the curve. The 10-year and 30-year AAA GO bond yields increased 16bps and 17bps, respectively from January 13 through the end of the month. In addition to the risk-on sentiment in markets that sent equities higher and pushed Treasury rates up, the elevated municipal supply may have contributed to the slowdown. January usually has lower supply, but this time supply was unusually high – even stronger than in December. Issuance for the month totaled $31.6 billion, more than 20 percent higher than in January 2016.5 That total includes $14.4 billion of new money issuance, up 37 percent from the same month in 2016.
Meanwhile, refunding issuance declined 26.4 percent to $7.4 billion. The strong issuance may be partly due to issuers wading back in after an issuance slowdown in December caused by increasing Treasury rates and rising concerns about tax reform. Municipal supply fell in December as municipal yields, ratios and spreads rose.
On the demand side, the negative municipal mutual fund flows that started in November reversed in the middle of January (although inflows were subdued). For the period ending February 8, Lipper fund flows were once again negative, totaling -$2.235 million. Demand was not necessarily out of the woods completely, though. MMA noted that the 10-day average of offering par amount peaked at more than $19 billion in January, and bids wanted remain high.
For the month, municipal yields were flat to lower at the short end of the curve, and slightly higher in the intermediate and long ends. The best performance in the month was in the five-year maturity, based on total rate of return data from MMA. Longer maturities did not fare as well due to policy uncertainty and concern over tax-reform that may negatively impact municipals.
Looking at municipal performance versus Treasury bonds, ratios fell in the two-year, three-year and five-year maturities, and increased slightly in the 10-year and 30-year maturities. Ratios are not significantly different from their one-year averages despite risks in municipals from tax reform and other uncertain policies. Therefore, in our view, the market is not pricing meaningful tax reform into municipals at the moment.
For credit fundamentals, we think municipals are stable, but our “as good as it gets” theme continues to hold. At the state level, we expect continued weakness and we will keep monitoring the states most impacted by pensions, oil price declines and slow economic growth. In December, Moody’s Investors Service forecast state tax revenue growth of 2-3 percent for the subsequent 12- 18 months, below the five-year average of roughly 4 percent.6
We think that high-quality Local GOs will continue to be insulated from state credit weakness. Many local GO credits receive limited state aid and are located in areas where home prices and property taxes have surpassed their pre-recession peaks.
Government Credit Market Review
Financials in the Game
Investment-grade corporate spreads remained rangebound in January, as they have been since December. The Bloomberg Barclays Credit Index tightened 2bps to 116bps in January. The index outperformed duration-matched Treasuries by 9bps. Metals, Home Construction, Midstream, Paper and Building Materials were the best performers. Wirelines, Retailers, Cable Satellite, Tobacco and Railroads fared the worst, per Barclays.
The big story for the month in investment-grade corporate bonds was supply. U.S. investment-grade issuance rose to $176 billion, the highest on record for any calendar month.7 Companies likely front-loaded issuance to take advantage of low rates before potential Fed rate hikes later in the year and possible unfavorable tax reform. The weighty supply was driven by large deals such as Microsoft, which priced a hefty $17 billion multiyear deal in January to fund general corporate purposes.8 The technology company holds more than $100 billion in overseas cash and, potentially, companies with large overseas cash balances could issue less as the year goes on, due to tax reform that could provide access to cash offshore, per JP Morgan.
More than half of January issuance came from Financials, which issued $93 billion. The supply surge was partly due to the release of the final TLAC rule, which removed some uncertainty for Banks on issuance requirements. Given the strong supply, Financials saw sporadic pressure throughout the month, but overall the sector tightened 3bps in January9 and deals were well-received.
We have a stable outlook for U.S. Banks due to strong capital, liquidity and asset quality indicators, partially due to banks’ efforts to shore up capital following the financial crisis. In recent earnings releases, JP Morgan, Bank of America Merrill Lynch and Morgan Stanley all posted solid earnings for 4Q16, as improvement in capital markets revenue benefited the Banking sector. Good loan growth, improved credit quality and expense discipline also supported results. As discussed in our recent blog post, “Is a Dodd-Frank Rollback Good or Bad for Bank Bondholders?”, we are closely watching news on a possible rollback of Dodd-Frank bank requirements.
In line with the risk-on sentiment across asset classes, crossover credits repeated their December positioning as the best ratings performers, while Aaa-AAA credits were the worst. With strong performance in BBBs since the beginning of 2016, the BBB/A ratio ended January at its lowest level since July 2015, indicating a shrinking spread gap between BBB and A bonds (Figure 2). However, the ratio still remains elevated relative to historical periods, Barclays data shows.
Demand for high-grade bonds remains strong, as investors continue to look for yield in U.S. debt markets. Investment-grade bond funds reported an inflow of $4 billion for the period ending February 1, bringing year-to-date inflows to $8.4 billion, per Lipper. Future demand could be boosted by the return of foreign buyers, as dollar hedging costs cheapened after year-end.
We continue to see weakness in investment-grade corporate fundamentals, as large industrial corporates have taken advantage of accommodative central banks and re-leveraged and corporates are now in a declining credit phase. The market is now expecting two rate hikes in 2016. Rate hikes could obviate loose monetary policy as a tailwind for corporate credit. On the other hand, U.S. government pro-business tax and regulatory policy could buttress corporates, but the outcome of Trump’s tax and regulatory policies is uncertain.
The Trump Policy Playbook
Some fans enjoy white knuckling through down-to-the-wire football games that are rife with unpredictability and surprising twists. In markets, investors often try to eschew unpredictability, but policy question marks in the Trump administration have led to a broad swath of unknowns.
In municipal bonds, we think the main risk is tax reform that could threaten the municipal tax exemption or lower corporate taxes, which would potentially devalue the municipal tax exemption for corporations. Uncertainty also looms surrounding revisions to the Affordable Care Act that could be a credit negative for Hospitals, and infrastructure spending that could boost municipal supply depending on the financing mechanism for the new projects.
On the corporate side, trade/immigration policy could impact firms such as toy companies, which rely on production in factories outside the U.S.; oil companies, which import a substantial slice of inputs from abroad; or any multinational companies with significant overseas cash balances.
In general, a high degree of uncertainty surrounds Trump’s plans. For corporates, we see positive catalysts primarily related to potential tax cuts, cash repatriation and deregulation. However, some market participants are questioning whether expected GDP growth reflected in the recent flight higher in equity markets is overdone. Additionally, we note that the U.S. continues to face weak productivity growth, which may not necessarily be addressed by fiscal policy (Figure 3).
In January, we did not change our tax-efficient duration targets, and we remain duration-neutral. At the state level, we expect continued weakness from pension problems and other risks, and we are closely watching states facing high debt levels and budgetary problems, such as Connecticut, Illinois and New Jersey. We think the vast majority of Local GO credits are in solid shape, but we continue to think that further significant improvement in credit fundamentals is unlikely.
In Government Credit, we remain modestly short duration relative to benchmarks. We continue to target an overweight to higher-quality credits, and we see opportunities in Banks. Overall, we continue to focus on high-quality Banks, Utilities and industrial credits that have leverage or rating targets.
 The U.S. Census Bureau and the U.S. Department of Housing and Urban Development, as of January 26, 2017.
[2 The Federal Reserve, as of February 1, 2017.
 Bureau of Economic Analysis, as of January 30, 2017.
 Caterpillar Inc., as of January 26, 2017.
 The Bond Buyer, as of January 31, 2017.
 Moody’s Investors Service, as of December 8, 2016.
 Bank of America Merrill Lynch, as of February 1, 2017.
 Microsoft Corp., as of January 30, 2017.
 Bloomberg Barclays, the Intermediate Investment Grade Corporate Index, Financial Institutions, OAS, as of January 31, 2017.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.