Guest post by: John Hallacy, John Hallacy Consulting
Introduction
Many factors will shape the markets this year including the Fed Outlook and the election cycle among a sea of considerations. Adopting an optimistic stance should bear fruit this year.
Looking ahead into the prospects for the year requires a true objectivity that many of us just do not have in our possession. We are too besotted with information overload. The media harps on themes that they want us to absorb and to integrate into our thinking. We can all recall how common the refrain was last year that we would enter a recession at some point during the year. The rate tightenings set the stage for the more pessimistic outlook.
It turns out that being the optimist proved to be the correct stance in the markets. Those who had the conviction to extend tenors of their investments were well rewarded with the onset of the rally at the end of 2023 around the November timeframe.
The year of 2024 will have many overlapping events and layers of factors to consider. We would like to consider each factor in a vacuum. But the truth is the varied factors interact in entropy and cause a different outcome than what may be anticipated. However, let us consider the critical factors for the markets each on their own because other approaches are too random.
The Fed as key consideration
Parsing what the Fed will do in the months ahead and at each of the meetings is of critical importance. We witnessed how quickly the tone can change at the last Fed meeting of the year last year. A major rally ensued. Assuming inflation will be tamed, we should assume a more dovish tone out of the Fed even though some of the initial enthusiasm has been dialed back.
The Fed continues to be the principal factor for most participants. Many are now anticipating easing by as early as March but most pundits are forecasting the start of easing by June. The Fed has attempted to calm the enthusiasm by still maintaining that the call will be made upon review of the quality of the data. The central consideration remains whether inflation will continue its downward trajectory. There has been measurable progress towards the 2% goal. However, the progress from here on has begun to encounter more challenges. There are no signs that the 2% goal will be abandoned even if it takes until 2026 to be fully realized.
The soft-landing scenario is becoming a reality. Employment gains are slowing and the unemployment rate is expected to slowly climb in the days ahead. Wage growth is also moderating. And as we know, the federal largesse for individuals has largely run its course. We will see more savings decline and greater borrowing and credit levels if rates stay in the moderate range. Housing has benefitted from lower rates but supply has remained constrained. There have been more articles saying that we are becoming a nation of renters.
The recent release of the Minutes put forth some of the key assumptions going forward. The Fed sees unemployment remaining flat through 2026. A slowing in Real GDP is anticipated especially after the higher readings in the last two quarters of last year. The critical PCE is estimated to be less than 3%. The 2% target is within sight. And the de-risking of the Fed’s balance sheet will continue until an acceptable level of holdings is reached. The monthly sales of Treasury and MBS paper are not expected to unsettle markets. But at the same time, Treasury sales will continue to ramp up to fund the deficit.
Slowing property value growth will affect local GOs
Local tax yields are dependent on solid growth in assessed valuations. Given the tight housing market and the sharp decline in commercial properties, tax growth will not keep up with built-in inflation in government on the expenditure side.
The slowing growth in property values would be expected to have an impact on local taxation. Assessed valuation growth does not remain robust unless there are property turnovers. This trend would be expected to influence local general obligation bonds at the same time operating expenses continue to climb.
At the state level, we have already been made aware of growing budget gaps that will need to be solved by the start of the new fiscal year for most states on July 1. Reporting by NASBO will be important to monitor closely this year.
Political calendar will shape perceptions of future actions
Many political events will be taking place throughout the year. The outcome of these events will impact the policy debate regarding taxation, government spending, debt issuance, and budgetary balance. Any additional credit events at the federal level could have an impact at the state and local level. Spreads may widen offering some new opportunities for investors.
The political calendar may prove to be one of the most unpredictable factors this year. There are many questions about who will be on the ballots and who will have the best chance of winning. Since we cannot predict what will happen with any accuracy, we need to focus on what the policy choices will be among the parties.
Many features of the 2017 tax cuts are scheduled to expire in 2025. What will become of those critical considerations will be decided by election outcomes and what party will be in the majority in Congress in each house.
We know one tenet to ring true. If tax rates increase, the municipal tax exemption will be more valued again. In recent experience, there has not been any talk about altering the municipal tax exemption. But the consideration or discussion of the topic always comes to us around the time of elections and critical budget deliberations.
Shutdown or no shutdown
A government shutdown would have many implications for municipal operations of all kinds. Yields may be susceptible to being forced to widen given all of the uncertainties that would surround such an event.
As for the completion of the federal budget, we know that the obstacles are many and that compromises are hard to envision now. We know that the balance is considerably out of sight with a $1.7 trillion deficit in the most recent year. Assuming Social Security and Medicare are off the table, where will the cuts fall? Funding the aid for the wars and making strides on improvements at the border are also very costly items. The two-step deadlines are approaching apace and most participants do not want to see another Continuing Resolution. We will have volatile days ahead. A government shutdown may not be ruled out at this point.
As for the national debt that continues to grow appreciably and must be financed there are also no solutions without pain. Fortunately for the Treasury, rates have moderated and the treasury auctions have to date gone smoothly. There may be some challenging days ahead if some of the foreign buyers review their buying practices.
Municipal volume to grow modestly
Calendar year 2024 should be a solid year for issuance at about the $380 billion level. Presidential election year issuance is often somewhat restrained regardless of what rates are doing. Some of the federal infrastructure projects may start disbursements that may lead to more issuance.
As for the municipal market, the volume estimate for the year is $380 billion plus or minus $10 billion in either direction or just a modest uptick from this year’s result. Corporates should also do well with moderating rates and refinancing needs in the forefront. The anticipated climb in M&A activity may lead to some debt financing. However, many of the contemporary trends feature cash and equity-funded approaches.
Presidential election years are not always that robust for the markets. If some windows for financing options are altered by policy there may be a small rush to market in the affected sectors. If there are any significant tax changes that develop, these actions are more likely to be implemented in 2025.
Yield curve normalization
It is bound to happen at some point during the year assuming the short-end rates continue to moderate. More attractive long-term rates should move investors further out the curve.
Another crucial factor is whether the yield curve will be “normalized” once again. The moderation of rates on the shorter end has cut into the degree of inversion. But exactly when the curve will adopt the upwardly sloping shape is anticipated but cannot be known at this point. Before this event happens, investors will work to position their investments to benefit from the change when it happens.
Wrap up of last year
One must talk about the recently completed year to reach any sound conclusions for the new one progressing. Last year turned out to be a better-than-average year after being “saved” in the last couple of months of the year when the Fed’s intentions became clearer. Issuance reaccelerated with the moderation in rates. Rates are anticipated to continue to moderate this year with the outcome of some more issuance expected.
Every year is marked by its own trends and market tones within the year. This year will be no different, especially with the presidential election pending. To know what will be different we look to history for clues.
This past year was the most affected by the Fed and the path for rates. There was more distance from the height of the pandemic and credit problems did not crest as expected. However, on the corporate side there were several significant bankruptcy filings, some of which had to do with exceptionally elevated levels of debt versus other factors. The bank crisis in the Spring faded quickly after there were only three listed institutions that were affected.
In the municipal market, the total issuance for the year of $379 billion was a decrease of only 3.1% from the prior year’s level of $391 billion. The year did not start out that well. The first two quarters were down significantly in volume. The first quarter was down a significant 23% from 1Q22 and the second quarter was down 10.4% from 2Q22. The third quarter was flat. The fourth quarter was responsible for the bulk of the recovery in deal flow. Fourth quarter volume increased a sharp 30.6% over the prior year. Refunding activity also recovered the most in the quarter.
Clearly, rates provided the catalyst for the activity. With the Fed pausing, and the market chatter anticipating cuts next year, the fixed income markets rallied appreciably. Those who were holding out for better rates before year-end now signaled that it was time to sell.
Most states sold less in 2023
Many states chose to refrain from issuing more debt in 2023. We may see more states holding the line on issuance in 2024. However, lower rates could change the issuance behaviors.
Volume in 2023 was down in thirty-two states and up in eighteen states. A small group of states had volume increases that were quite high at greater than 20% including: ID, NC, OR, RI, TX, VT, WV, and WY. Complaints about the lack of supply were few in these states by year-end.
The top five issuers in the municipal market in descending order for 2023 were TX, CA, NY, IL, and FL. With the influx of population into Texas, issuers across sectors were quite active including school districts and MUDs (municipal utility districts). Florida with its population influx was also quite active across the board but issuance at the state level has been quite conservative. The others on the list are represented on a perennial basis.
CDIAC in California reported that 80% of the transactions in the state had at least one rating over the period from 01/01/08 to 12/31/22. Transactions with two or more ratings declined to only 27% of the volume. Transactions with three or more ratings represented less than 1% of the volume. It would be interesting to see what the trends would be in other states. But, with four primary rating agencies, there is sufficient business to pursue.
Near term outlook
Technological improvements and moderating rates poise the market for sound performance this year despite some of the other factors that are not controllable.
It has become clear that there will be continuous technological improvement in data and workflow in the municipal market. Many vendors are now vying to fulfill the needs of the participants. The number of CUSIPS in the market at approximately 1.6 million means the municipal market in many ways is the perfect candidate for AI applications. AI would certainly assist with the painstaking task of bond selection in assisting the Buy-Side among other tasks.
Machine-readable audits and budgets remain a goal over time. The analyst’s role would be simplified with such a system and there would be greater transparency. But there are the costs of implementation to consider.
Tracking spreads has always been a chore. Any technological improvements in this regard will be highly valued. Retail does not have access to a lot of proprietary technology, but the improved features provided by the MSRB are quite praiseworthy.
Lower rates during the year are bound to move investors further out on the curve. We are already seeing some larger deals coming to market that will require more serial and term bonds out on the longer end. We have made sound progress on inflation and do not expect any significant backtracking before year end.
Have a constructive year investing in 2024.
More about John Hallacy
John is an accomplished municipal and fixed income analyst, respected and recognized by the industry with over 35 years of experience at major financial firms including S&P’s Global Ratings, FGIC, Bond Investors Guaranty, Merrill Lynch, MBIA, Bank of America, Assured Guaranty, and most recently The Bond Buyer. A leading expert in state and local fiscal affairs. John’s experience includes ratings, insurance, public finance and sell side research.
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