As we say goodbye to 2023, we do so with recognition that the year was replete with unfulfilled expectations – good and bad. 2023 will leave an indelible mark upon the investor community as the volatile swings in valuations were reminiscent of the market dynamics of 2022, thanks to the Fed’s aggressive and unprecedented tightening sequence specifically orchestrated to break the grip of the highest inflation levels in 40 years. When it comes to monetary policy, 2023 will likely go down in the books as one of the most historically relevant years with almost every one of the eight sessions commanding global attention. 2024 FOMC meetings have the potential to upstage should a material policy shift emerge. Adding to the mix of moderating inflation data, we are witnessing a visibly resilient economy that seems to satisfy those in the “soft landing” camp, ourselves included. . It has now been almost 22 months since the Fed began tightening and we reiterate the point that the full impact of the aggressive rate hikes has yet to fully make its way through the economy, yet the cycle has allowed bond investors to obtain positive real yields for the first time in 15 years while capturing a defensive response to inflationary pressure, and has seen the bond markets do much of the heavy lifting for the Central Bank. Outsized inflation has proven to be a stubborn adversary, yet 2023 saw the effects of the Fed’s aggressive tightening cycle producing consequential results with achieving price stability, but without the traditional spikes in unemployment – a rationale for a “soft-landing.” The Fed Chair is orchestrating one of his best performances so as to preserve the Central Bank’s mission of taking inflation down to target while arriving at a soft-landing, and we expect future “dot plots” to take account of softening economic conditions. Central to our 2024 outlook, a recession is not in our base case forecast through at least the first half of 2024. If recession does occur, we expect a fairly mild and short-lived contraction. Our views are based on the demonstrated resiliency that our economy has placed on display throughout the past year. Admittedly, growth performance is visibly uneven throughout the regional economies and we are observing diverging employment trends among sectors and business lines. However, job formation is still evident, albeit at a slowing pace, unemployment remains sub-4%, and wage gains have generally been moderating. While levels of consumer confidence and engagement have been showing signs of dilution, it remains our view that the U.S. consumer will continue to drive economic resiliency, even into the next recessionary cycle. However, participation can be tempered by expanding levels of consumer debt, thinner savings, marginalized availability of fiscal stimulus resources, and a resumption of student loan payments. Since the September FOMC meeting, the number and timing of rate cuts have shifted to a more dovish bias, yet the futures contracts seem to be getting ahead of Central Bank messaging. At the moment, there is approximately 130-basis points of easing priced into 2024, yet we question whether there will be sufficient economic softening to warrant such anticipated rate cuts and our base case calls for more moderate easing in the new year. The strong payrolls number for December actually reduced 2024 easing expectations by about 20 basis points.
Quotation from Aenean Pretium
A shift in flow patterns may not be present in the opening weeks of 2024, but we do expect to see more intermittent inflows with possibly an enduring string of positive flows to follow
A dramatic repricing for fixed income in 2023 altered the asset allocation strategy with bonds taking on a higher profile given rather compelling and competitive yield and income opportunities, resulting in more than renewed contemplation over the 60%/40% asset allocation mix. UST returned negative performance in 2021 and 2022, and saw red in 2023 until green shined through, and we remain bullish on fixed income in 2024. The final quarter of 2023 reversed what was likely going to be another year of fixed income losses thanks to a shift in monetary policy sentiment. For 2023, munis returned 6.4% while UST earned 4.05%. Given much better paying cashflows, munis have now earned their place beyond a portfolio diversifier on a tax-adjusted, risk-adjusted, and even on a performance-adjusted basis and the more predictable income streams could offset risk-asset volatility for a growing base of natural fixed income buyers. While muni performance ended 2023 in the green thanks to a late-year directional shift in yield bias, the attractive cash-flows that have characterized much of 2023 have created a strong “carry” component to performance, providing an offset to the principal losses as well as defensive attributes ahead of a potential recession. From our vantage point, municipal security allocations in 2024 should be rewarded as the potential for total return performance is quite real given the relative likelihood of less market volatility and reasonable prospects for booking something more than “carry” attribution. This should come given our expectations for a cyclical shift to positive fund flows, likely with accompanying spread compression, as demand for product by a more active (led by mutual funds), and perhaps expanded (more foreign buyer interest), buyer base accelerates in 2024, and as monetary policy mayhem dissipates in a meaningful way. This outlook should pave the way for more normalized bid-wanted activity. 2023 was the year of the unforeseen banking crisis, which thankfully did not have systemic implications and ended with limited casualties. Nevertheless, a number of muni institutional buyers kept to the sidelines with an unwillingness to take on duration risk as the uncertainties surrounding both monetary policy and banking conditions continued to mount.
Sustained favorable technicals throughout much of 2023 were largely accretive to performance and munis can be expected to outperform UST with “net negative supply” conditions potentially extending this outperformance in 2024, yet such anticipated outperformance may be challenged given what we expect to be a march towards looser monetary policy with a higher probability of intermittent rallies. Technicals in the new year should be underscored by pent-up demand across both issuer and investor communities. 2024 is an election year, and we do not expect any new substantive fiscal policies having outsized spending priorities to emerge from Washington, D.C. Deficits and higher debt service costs on government debt matter, but they may matter more in 2025. Generally speaking, legislative inertia is often viewed favorably by the financial markets. With core elements of the 2017 Tax Cuts and Jobs Act (TCJA) scheduled to sunset at the end of 2025, there will likely be demand implications for municipal bonds with marginal Federal tax rates reverting to higher pre-TCJA levels, termination of SALT limitations, and changes to AMT exemptions and phase-outs, all of which could alter investment strategies in 2024. Regardless of which party wins the presidency, Congress is likely to remain split with thin margins of control. Should the GOP retain majority of the U.S. House of Representatives, we would expect climate change initiatives and spending priorities to stay out of that chamber’s core agenda. While the threat to the muni tax exemption for certain issuer types may become elevated (such as the tax-exemption on private activity bonds), we are not expecting material implications for the asset class. As we think about munis in 2024, we do so with stronger optimism relative to this time last year given a better economic outlook. As a strategic response to a potential shift in economic and interest rate conditions, however, municipal bond investors can take steps to mitigate the effects of portfolio devaluation by staying focused on the defensive attributes offered by municipal securities.
We would note that part of the more recent outflow activity can be ascribed to 2023 tax loss harvesting and now that this activity has reached a cyclical conclusion, pure market technicals should eventually be a driving force for lighter outflows and even an extended period of positive flows. With rising demand against a backdrop of contained supply, investors can take advantage of the yield and income attributes being offered by the muni asset class. A shift in flow patterns may not be present in the opening weeks of 2024, but we do expect to see more intermittent inflows with possibly an enduring string of positive flows to follow. Investors are advised to pay close attention to spread relationships, especially if outflows linger with higher ratios, presenting meaningful buying opportunities. Throughout 2023, relative value ratios remained a good distance from their historically tight levels of 2021, yet were still lower than their longer-term averages over the past 40 years. The attainment of fair value was generally elusive in 2023, but we can say that after ratios found themselves stuck in expensive ground for much of the earlier part of the year, the value play did become more compelling last year, only to find ratios growing more expensive at year-end. Muni credit can be expected to demonstrate further resiliency in 2024 as the economy continues to exhibit strength, albeit becoming softer throughout the year. Fiscal austerity should remain visible in 2024 as many municipal issuers are still carefully balancing their debt requirements against a number of other budgetary needs competing for limited resources, not the least of which are pension and OPEB liabilities. Unfunded pension liabilities, typically tethered to equity market performance, and advancing OPEB obligations will continue to be a financial drag for certain municipal budgets and waning availability of stimulus funds will present budgetary challenges for certain obligors that currently exhibit constrained demographics and marginal reserve balances. As we think about muni credit, we can take comfort with the fact that there is a diversified pool of highly-rated obligors. Overall, muni credit quality continues to stabilize with a number of sectors meeting or exceeding pre-pandemic financial and operational performance. California’s current budgetary challenges will necessitate difficult decisions with certain levels of state aid on the potential chopping block, yet we do not foresee systemic credit implications across state finances. While state/local revenue collections will likely be lower in 2024, forecasts have to take account of artificially elevated budgeted amounts previously attributable to pandemic-related support, which will now result in more realistic figures being drafted.
Certain revenue/enterprise credits will continue to stabilize in a post-shutdown environment. We continue to like the airport sector and when considering this area of the market, it is important to see a strong track record of maintaining ample liquidity, consistently strong margins, a clearly defined strategic mission with an ability to adapt to shifting airline routes, a manageable cost structure, and a diversified carrier and overall revenue base. Certain cohorts within the hospital sector continue to experience above average margin compression given inflationary conditions, heavier spending needs and staffing deficiencies, yet the overall sector is in better credit standing year/year. Stronger hospital credits would generally offer a robust balance sheet, consistently favorable margins, geographic diversification with a sound footprint, a clearly defined mission statement, and well-entrenched physician networks. The ability to adapt to shifting caseload priorities, such as to lower margin ICU admissions from more profitable elective surgeries, has become an evolving credit consideration. It would make sense for quality investors to consider those higher education credits exhibiting brand recognition, a strong and nimble balance sheet, adequate revenue diversification, manageable capital needs, and a competitive menu of academic offerings. Evidence of relative adaptability to online/remote instruction will remain as an important credit attribute. Defaults/ Chapter 9 filings can be expected to increase in 2024, but should be primarily confined to the usual cast of characters such as certain types of project finance, conduit housing bonds, and lower quality healthcare/senior living financings. We can expect a rise in technical defaults with an increasing percentage of this group falling into actual monetary default with higher impairment experience.
Name:
Jeff Lipton
Title:
Managing Director, Head of Municipal Credit and Market Strategy
Contact
(212) 667-5365 [email protected]
85 Broad Street
26th Floor
New York, New York 10004
