Navigating the potholes while making America great again
Municipal investors remain cautious as President Trump’s agenda comes to life through legislation and his proposed budget. Economic recovery across the country has been uneven with weak energy markets, growing healthcare and technology sectors and diminishing manufacturing employment. President Trump’s agenda will continue to support this trend as those areas with a strong defense presence will benefit while states with expanded Medicaid programs and institutions receiving federal research dollars will be hurt.
The replacement of the Affordable Care Act (also known as ACA or Obamacare) — which is still in question — would result in the loss of funding for Medicaid expenses that can represent up to one-third of a state’s budget. The reduction in climate-change support and the reversal of the Clean Power Act could provide relief for coal-producing regions while slowing the growth rate of renewable resources. Education, research and development, climate change, cultural arts and foreign aid are some of the largest programs negatively impacted by the President’s proposed budget. President Trump’s budget focuses increased funding for the military, support of Veterans Affairs and Homeland Security.
The Administration introduced the American Health Care Act (AHCA) hoping to repeal and replace the ACA. Despite the recent failure to push approval through the House, the potential is still there to negotiate passage. The introduction of the AHCA addresses the major components of the ACA that are under attack. States will bear the cost, having to address the loss of federal funding for Medicaid. The Congressional Budget Office’s (CBO) review of the initial AHCA bill indicated potential federal government savings of $337 billion by 2026. Despite these savings, the largest factor in lack of support for the AHCA was the CBO’s estimate that 24 million people could lose health insurance by 2026. Will the repeal of the ACA help the U.S. economy? One study dated January 2017 by George Washington University reported that the elimination of federal funding for Medicaid expansion could result in the loss of 2.6 million U.S. jobs in 2019 and $6.8 billion in state and local taxes between 2019 and 2023. Local governments are fearful of the push-down effect as states will be forced to address their budgets as Medicaid payments from the federal government represent nearly one-third of a state’s budget. So, the economic benefits of repealing the ACA are highly questionable.
On March 16th, the President presented a spending plan that provides a more detailed look at his “Make America Great Again” campaign. The proposed spending increases defense spending by $541 billion or 10% over the previous budget. The President’s plan will be negotiated through Congress with a final budget to be released in May. The expiration of the current spending bill is quickly approaching, on April 28th, as the last Congress was unable to reach a formal budget. It’s likely that a new spending bill, through fiscal year ending September 30, will be addressed the last week of April when the legislature returns from recess. This will push tax reform until later this year under the fiscal 2018 budget.
The President’s budget proposal addresses discretionary spending. This accounts for approximately 30% of the total federal budget. The remaining 70% is mandatory spending that includes Medicare, Social Security and interest on federal debt. Under the proposed budget, more than 10 agencies will experience double-digit declines in their budget to offset the increased spending in the Department of Defense, Veterans Affairs and Homeland Security. The Environmental Protection Agency (EPA), State Department, Agricultural Department and Labor Department are expected to realize the greatest cuts in spending.
Among the beneficiaries of the budget proposal are those states with the largest defense presence, such as Virginia, California and Texas (see chart). Among those with the most to lose are higher education institutions receiving funding from the National Institute of Health, which supplies funding for research and medical centers. Also losing are rural areas that benefit from federal support of educational and cultural programs, such as the Corporation for Public Broadcasting and National Endowment for Arts, and subsidy programs sponsored by the U.S. Department of Agriculture. Support for President Trump’s agenda is not clear, evidenced by the delayed vote for the repeal and replacement of the ACA.
States and local governments have experienced changes in federal policies and spending levels in the past. Their sovereign powers provide the tools necessary to address changing financial resources and spending. States are able to push down greater responsibility to the local level. Monitoring regional and local economic trends along with political willingness to make appropriate changes when necessary will provide investment opportunities along the way. The municipal market continues to demonstrate a strong credit backdrop with defaults remaining at historically low rates. Municipal investors will continue to benefit from the strong framework of municipal governments as well as the attractive yields offered in the tax-exempt market.
The first quarter of 2017 ended on a sour note with March municipal bond returns barely in positive territory. The Bloomberg Barclay’s Municipal Bond Index returned 0.22% for the month. However, first-quarter returns remained firmly in positive territory with the index returning 1.59% over the first quarter. On the macro front, the two biggest events were the failure of Congress to repeal and replace Obamacare and the Federal Reserve Board’s (Fed) interest rate hike of 25 basis points (bps) — putting the Fed Fund’s target range at 0.75-1.00%. The Fed hike had little impact on the markets as it was widely telegraphed by the Fed. The failure of the House Republicans to pass the American Health Care Act, which would have repealed Obamacare, was viewed as an indication that the Trump Administration may have difficulty passing its agenda. As a result, the fixed income markets backed off inflation expectations leading to declining yields, which have continued through the month of April. Further attempts will be made to repeal Obamacare, but it appears to be a high hurdle. For now, the Trump Administration is moving on to tax reform, which we will be closely following.
Sector performance was unremarkable for the past month. However, over the quarter, lower-quality bonds easily outperformed high-grade bonds. The Bloomberg Barclays Muni BBB Index returned 2.18% and the High Yield Muni Index returned 4.06% over the quarter. The best performing sub-sector was the HY Tobacco index, which returned 13.12%. We did not see any significant change in hospital spreads from the failed GOP challenge to Obamacare.
Supply and demand
The market saw another light month of municipal issuance: about $30 billion. This is down 30% from last year and 19% from the 10-year average. For the quarter, issuance totaled $88 billion, down 12% from last year’s first quarter. Last year was a record high year of issuance for the municipal market. Low supply continues to support municipal bond prices.
Flows into municipal bond funds and ETFs surprised us to the upside over the past month; March saw about $1.4 billion flow into municipal funds and ETFs. Year to-date we are at a solid $8 billion of net inflows.
The municipal curve was virtually unchanged over the past month — a bit lower on the short end and higher out long. Over the first quarter, municipal yields were about 10 to 25 bps lower on the 1- to 10-year portion of the curve due to strong retail demand. The best returns over the quarter were on the 5- to 7-year spots of the curve. The Bloomberg Barclays Five and Seven Year Indices returned 1.90% and 1.95%, respectively.
- Favoring slightly shorter duration and defensive positioning primarily due to potential turmoil surrounding President Trump’s tax reform efforts. Also, fiscal policy stimulus and trade restrictions could increase inflation expectations. There may be better opportunities to buy munis over next several months than currently exists. We are expecting a vacillating market.
- A definitively more hawkish tone from the Fed of late. The Fed tightened for the third time in March since they began the cycle in December 2015. The latest hike puts the Fed Fund’s target rate at 0.75-1.00%. The market is expecting two more hikes this year at a measured pace. This pace is much slower than historical moves. A typical tightening cycle in the past would be about 300 bps of tightening over a 12-month period.
- Municipal fund and ETF flows continue to surprise us on the upside. If there was not so much uncertainty on the policy side, we would be longer duration to take advantage of the solid demand.
- Retaining barbell structure with municipal floating rate notes on the short-end of the curve and fixed coupon bonds on the longer end of the fund’s investment horizon. We earn more incremental credit spread on the longer end but remain duration neutral. Since the Fed began tightening, the curve is flatter with short rates higher and long rates lower. We will continue to monitor inflation expectations for a reduction to our long-end exposure.
- Daily and weekly tax free floating rate notes remain at elevated yields, providing attractive yields to interest rate sensitive investors. The weekly municipal floating rate index (SIFMA rate) is at 0.89% versus 0.04% in April 2015. Tax-exempt money market and ultra-short funds are at very attractive yield levels for risk-averse investors.
Credit and structure
- Lower-quality bonds posted the best performance over the quarter. We continue to look for undervalued A and BBB rated bonds, which could outperform this year if we see sustained positive flows into municipal high yield funds.
- The higher yield (wider spread) of the lower quality bonds also helps performance.
- We continue to focus on bonds with 4 and 5 percent coupons due to their defensiveness.
- We are less concerned about general underperformance of the hospital sector with the failure of the GOP to repeal and replace the Affordable Care Act. We will continue to look for undervalued securities in the healthcare sector.
- We are being more selective in the higher education sector. National demographic trends are working against this sector, with fewer high school graduates, particularly in the Northeast and Midwest. Also, strained state budgets are squeezing the funding to public higher education schools. Look for institutions with good demand due to name recognition or a niche, like a good engineering school.