Podcast recorded October 11, 2017

September Market Recap

Podcast Transcript

Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today I am joined by Sara Chanda, one of our portfolio managers, and we will give an overall market recap as well as an update on the muni environment. We will be covering both the month of September and the quarter. So, Sara, let us start with an overall market picture. September was an active month domestically, with the FOMC meeting, additional clarity on President Trump's tax plan and the rash of hurricanes. Can you provide some color?

Sure Natalie, so September, as you said, was a very busy month on many fronts so we will start at the top. As expected, the FOMC did not adjust rates during its September meeting, but did announce it will begin shrinking its balance sheet beginning in October. Early September was also met with multiple Fed speakers offering more dovish remarks while the Fed Chair, Janet Yellen’s comments later in the month were viewed as more hawkish. The probability of a December rate hike closed out August at 33% but spiked at the end of the month to about 70% or so. The FOMC does expect to hike rates three times in 2018 and the market right now is only really pricing in one hike.

Okay, so while the market is anticipating a Fed move at year-end, does the data support continue tightening?

So, over the month we saw inflation numbers. They remain weak, primarily due to the lack of wage growth, but they did show some improvement in August readings with the headline CPI rising about 4/10 of 1%, that is month over month, and 1.9% year-over-year and that was really attributed to an increase in energy costs and marks the largest jump in CPI since January. If you look at core CPI, that rose 1.7% year-over-year, while core PCE which is what the Fed tends to look at, that fell to 1.3% year-over-year. So, both are still below the 2% target. And that said, while the Fed has been looking for evidence that inflation is ticking up, its overall desire to normalize rates may overwhelm any data.

I see, well switching gears now from the Fed to policy, we spent most of the year waiting for clarity from the administration regarding tax reform. Any developments there?

Yes, that is true, so at the end of the month, the GOP did release their blueprint for taxes, which includes the following: First is to cut the corporate tax rate to 20%, that is from 35%. The second would be reducing the number of brackets to three, the highest dropped from 39.6 to 35%, and the others would be 12 and 25%, respectively. The third will be a one-time tax for companies looking to repatriate their cash and then fourth for pass-through entities they would cap the tax rate at 25%.

So, with all that said, how did Treasuries respond for the month?

Over the month of September, Treasuries hit both the lows and highs for the year as concerns over North Korea, coupled with pro-growth inflationary fears on the back of the Trump tax reform. After dipping to the lows, Treasury yields rose across the curve. The 2-year closed at 1.5% while the 10-year dropped to about 2.04% and then spiked up to a 2.33% at month end.

Okay, well before we discuss the municipal market, let us kick off the tax-exempt discussion with the hurricanes in the affected areas.

Yes, so we closed out August with Hurricane Harvey hitting Houston and we entered September with both Irma and Maria hitting Florida and the Caribbean, specifically Puerto Rico. So not since 2005 have we seen such a devastating hurricane season. So while we continue to monitor the hardest hit areas closely, most of them except for Puerto Rico will manage without too much economic impact, that’s really supported by both the federal government in the form of FEMA and in the case of Houston, the state support to make up the difference.

Well I know many areas were affected, including some small Caribbean islands, but you mentioned Puerto Rico which endured the most destruction with Maria. What is the status?

So post-Maria, the situation was dire with no electricity across the entire island, limited fresh water and no airlines and limited communications. Given the situation, any debt-related discussions had been tabled and that includes PROMESA litigation. The current 3.5 million person population really is at risk of shrinking further in the coming months if aid and rebuilding is delayed and slowed. And looking at Bank of America, at the end of September this report came out and they were saying the economic loss estimates have ranged between $30 billion to $106 billion on the high-end, and as of month-end, the government had awarded just $44 million in grants and FEMA provided about $17 million in aid, but the island along with Florida and Texas will have access to nearly $7 billion in FEMA accounts. That is as of the end of September.

Okay, well has there been spread widening on Puerto Rico-related credits as a result?

Yes, so we tend to look at the Puerto Rico GO, the 8% of 2035, that was a $3.5 billion-dollar issue that came back in March 2014. That is really a barometer for the credit and over the month prices dropped from a high $.59 on the dollar down about $.49. The bond prices actually plummeted further after President Trump in October stated that considering the devastation post hurricane, the administration was going to have to wipe out the debt and so the GOs actually hit a new low of $.32.

Okay, well thanks. Well, moving to the overall market, there have been months where municipals have been in more of a holding pattern. However, we saw that reverse over the month of September with Yellen's more hawkish stance combined with the unveiling of Trump's much-anticipated tax plan.

That is right. So, in light of Yellen's comments munis did track Treasuries. We hit year-to-date lows across 10- and 30-year ranges earlier in the month. Munis reversed course with short dated bonds spiking between 12 and 24 basis points, while the 10 year and longer-range rose about 8 to 13 basis points. So, over the month, the 5 to 7-year range was the worst performer. AAA 10-year hit a year-to-date low of 181 and that is before retreating to about 2% by month end, and just recall that the high watermark for the ten-year AAA muni is about a 249.

Okay, well when we spoke last, ratios were challenged with the front end of the curve hitting low mid-60 and causing us to look at crossover opportunities. How did ratios end the month of September?

So, while we did close out on historic lows and shorter data maturities during August, the ratios did improve over the month, really most notably in the 1 to 5-year range closing out in the higher 60 to 70% in 2 to 5 years. The 10- and 30-year range, finished up at 86 and 99%, respectively. That is really at or near the three-month average. And while ratios remained lower earlier in the month we did continue to cross over into taxable munis and Treasuries when we found the opportunity.

Well, post-election last year, we saw ratios spiked dramatically as the market started to factor in tax reform. How has the market reacted to the new tax plan?

While the plan is still limited with details, and there are some potential risks to the market, munis have seen little impact to date evident in the current ratios that we are seeing. The biggest risk to munis would be the elimination or reduction of the exemption and the proposal right now keeps that exemption intact. The elimination of the state and local tax deduction would impact high income tax payers and bolster the allure for munis, while a reduction in the corporate tax rate may dampen demand from the banks and the property and casualty companies.

Okay, well moving now to talk about technicals. Supply has been trending lower all year, so is it safe to assume that continued in September?

Yes, so September supply totaled about $27 billion. That is down about 34%. We missed the $30 billion mark, which actually had been the average for the last five or six years and while supply has been ticking lower, this is actually the largest monthly drop of the year. So year-to-date issuance through September is off about 17% or so, for a total of $268 billion. So, if we look to annualize the remainder of the year, assuming roughly $30 billion for the last three months that gets us in line with most Street estimates which range between $365 and $375 billion for the year.

And let us flip over to demand. How did demand look over the month?

So, is continuing on the trend that we have been seeing, at month end weekly funds actually posted a total 11 consecutive weeks of inflows. That could put the year-to-date aggregate flow for about $13 billion or so.

And how about returns? With the exception of June, have municipals posted positive returns?

Yes, so after a string of positive monthly returns, that was actually since December 2016 and again June was the exception. Municipals did post negative returns in September. The Bloomberg Barclay's Muni 1 to 10 Blend actually finished the month with a total return of -51 basis points. The seven-year range performed the worst, down 78 basis points followed by the long bond off 70 basis points while short maturities, that is one year, held in the best, only down 12 basis points. And then in similar fashion to prior months, lower quality outperformed with BBBs up five basis points as lower rated states like Illinois and New Jersey fared the best, while AAAs fell 62 basis points.

Well we provided a thorough recap on the month, would you mind giving some stats for the quarter as well?

Sure, so munis overall outperformed Treasuries in the short to intermediate maturities that did cause ratios to touch historic lows in August. Q3 supply was down about 26%. That marks a big dip compared to the first two quarters, which saw volume drop only 9% and 15%, respectively, so for the quarter, $87 billion was issued compared to $116 billion for Q3 of 2016, which is a 25% drop year-over-year. And while the new money issuance had been ticking up higher over the year, there was some slippage in Q3, so now we are only up 3% year-to-date. On the fund flows side they were positive for the quarter and as we mentioned over the past several months, demand has been bolstered by the high level of maturities rolling back into the market, which averaged about $20 billion a month over the quarter. However, that is going to start to slow by month end and then essentially low supply spread tightening, and lower quality states and longer duration were the key drivers of returns over the quarter.

And how about a credit update?

Credit fundamentals are expected to remain flat with a stable environment. However, since the recent hurricanes, coastal areas are at more risk to extreme weather events and at some point the government's capacity to rebuild will diminish, and so that really should be factored into long-term credit analysis. So, in fact, when we review coastal communities, we do look for some of those that are introducing adaptation initiatives to become more climate resilient. So many of these were actually started or were accelerated after these extreme weather events and some examples would include climate change considerations, integrated and developed plans, oyster reef restoration in degraded coastal areas, and then lastly amending flood and zone ordinances for potential sea level rise.

Okay, well turning to some specific credits we have spoken about extensively, Illinois and New Jersey have pulled fiscal levers and spreads have roared back, now posting year-to-date total returns that exceed 7% through September, but states like Connecticut and Pennsylvania remain challenged. What is the latest?

In Connecticut, Governor Malloy continued to aim for a budget resolution but vetoed the $40.7 billion Republican-led budget that passed the general assembly. Per Bank of America and Merrill Lynch, since July the state has been operating under an Executive Order and the governor warned that if a budget that he could sign by October 1st did not pass, municipal aid would be cut by $968 million or so. In Pennsylvania as expected, S&P downgraded the state to A+ from AA-minus-negative, as the state nears its fourth month without a revenue plan to offset its $32 billion budget, while lawmakers still contend with a $2.3 billion budget gap. So, over the month, spreads widened roughly 15 basis points on the news.

Okay, so clearly a lot going on both in munis and in the broader market. After a stellar performance for most of the year, benefiting mainly from muted supply and strong demand, as we wrap up Q3 it seems like there are more headwinds facing munis. What is our outlook and how are we positioned into year end?

So, while there has been a real lack of supply, that has really been the theme of the year, we may see more issuance in October evident in the monthly average, which sits at about $40 billion since 2009. So that, in combination with the SLGS window reopening, we may see some supply uptick, but there has been a considerable amount of refunding supply that had been pulled forward and it is now trending 40% lower year-over-year. So, we may continue to see supply fairly muted in this lower range. However, any uptick in supply may weigh on the market is that maturity flow starts to slow. So, with credit fundamentals flat and credit spreads tight, we do continue to keep a higher quality of bias in the portfolios. For our intermediate tax efficient strategies, we continue to moderate our modest barbell structure, given the curve flattening that has already occurred and we have been keeping our duration neutral to the index.

Okay, thanks Sara. We hope that you in the field have found this informative and we look forward to you joining us at our next podcast. Thank you.




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