Annual Outlook – 2018

The Tale of Two Markets: The Paradoxical Markets of 2018:

When reading analyst forecasts, thinking of what we are seeing at MainLine West, and reviewing historical data, I couldn’t help but feel paradoxical in my muni market outlook. I see all of the uncertainties surrounding the fixed income markets in 2018, yet to me the muni forecast appears clear and quiet as we start the New Year. Is this due to chaos at year-end caused by tax reforms? Is this because I think munis are white swans and can do no harm? Or, is this due to working at a higher elevation and my brain is not getting enough oxygen? My guess is it’s a little of all three.

Please be patient, as I take you through the concerns of the investing world, present the positives we see in the muni market, and then hopefully guide you into the safe harbor of 2018 Muni-land.

2018 Fixed Income Outlook Intro:

Uncertainties that surround the taxable rate investing community:

Fed tightening, is it late/early/legit? How will the market react?
- How many more rate hikes?
- Will the yield curve invert?
Economic growth and inflation? How much? Tax reform effects?
- Do we finally see inflation?
- Are we at the end of the credit cycle as growth begins to slow?
Overseas growth rates, trade negotiations, and how they influence our markets?
- How will they influence interest rates?
- What will the dollar do?
Political risk – Does anyone think this is going away?
- Fiscal stimulus – infrastructure program first on the political agenda in 2018.
- What does twitter say?

2018 Muni Outlook Intro:

Analysts and Money Managers are always trying to find that unknown “thing” they’ll be the first to predict that will propel their performance into the top quartile. For years, we have heard about “Black Swans” and feel after the year-end events in the muni market and, looking at the obvious trend going forward, we should focus more on the “grey rhino”.

The “grey rhino” is a highly likely event that others have ignored. They are investment items that people know about, but are not talking about. The worst thing you can do is ignore them.

For example, investors ignored the consequences of tax reform and its impact on issuance as we neared year-end. As we head into to 2018, we now see this reversing itself. Sometimes the obvious happens, it just takes an individual to step back and look at the landscape, instead of the tea leaves. You can’t be afraid to invest in the obvious. The Grey Rhino in 2018 is the outperformance of the muni market, again

We feel munis are primed for a strong start in 2018 and then, during the second half of the year, it may become time to prepare for a change of tide in the years to come. As we look at the concerns above, we will discuss why we like munis in 2018 and discuss the following:

Review Tax Reform, and its ramifications going forward.
Why we feel the fear of higher interest rates is unwarranted, and that munis are in a position to outperform.
Focus on the impact of munis in a Fed tightening market and its yield curve.
A new evolving muni market – how tax reform will change the market for years to come.
Preparing for 2019/2020 end of economic and credit cycles.
Finally, an infrastructure program in 2018? Could this be our black swan?

A December to Remember- Tax Reform:

	$ Issuance
Average Issuance	$34 Bln
Max 1985	$ 54 Bln
December 2018	$62 bln

I think it would be rude to start an Outlook for 2018 without first putting some sanity into the end of 2017. The threat of tax reform unleashed a panic of issuance and caused the professional community in muni-land to work over the holidays. Here is a brief review of tax reforms as they relate to munis, how they impacted the market in 2017, and how they will impact it beyond.

The Tax Reform Basics:

The highest tax rate has been reduced from 39.5% to 35%. As the average municipal investor appears to pay 28%, this will most likely not have an impact on muni value or demand.
The reduction of the corporate tax rate to 20%. This may limit some demand from Banks and Insurance firms.
Municipalities will no longer be able to advance refund bond deals. Only current refundings are allowed.
The provision to disallow private activity bonds (muni bonds issued by entities not associated with a municipality – for example hospitals and colleges) was eliminated from the bill in its final form.

The Impact on the Muni Market at year-end:

In a rush to issue advance refunding bonds and private activity bonds, issuance maxed out at a record level of $62 billion for December. This far surpassed 1985’s record of $54 billion before the 1986 Tax Reform Bill.
This created an imbalance in supply and demand, and a frenzy of issuance where pricing and allocations were inefficient. There were a lot of good deals available, as historical spreads were replaced by the need to get deals done.
Why did DC take away the ability to advance refund? We think it was big brother trying to look after little brother. The ability to understand and quantify whether advance refunding is beneficial or not for an issuer is difficult. It appears that Congress felt the Wall Street Bankers were taking advantage of the municipalities by having them advance refund unnecessarily; this ultimately cost taxpayers, while benefitting Wall Street.

Ramifications Going Forward.

This December issuance pushed bonds that were going to be sold in 2018, into 2017. We feel it has eliminated 15% to 25% of 2018’s issuance.
This lower issuance amount will probably only impact the market for the next two to three years, as these are the usual advance refunding candidates. After that, issuance should return to pre-tax reform levels, unless other changes are made.
There will likely be a slight decrease in demand going forward, as banks and insurance companies reevaluate their tax-exempt holdings with the new lower corporate tax rates. Tax rates are not the only factor used in their decisions to purchase munis, but analysts do think it will have a minimal impact.

Interest Rate Outlook 2018:

The end of the interest rate bull market appears to be the word from the investing world. We feel this appears premature. The forecast is the following:

Analysts are estimating three to four more rate hikes in 2018 as the US economy continues to grow, Euroland and Japan finally see growth, and China and emerging markets continue to lead the way.
Many feel this growth will lead to inflation, which will lead to higher interest rates.

We do feel rates could go up a bit in 2018, but not enough to turn muni returns negative. Why?

We feel three to four increases is a little aggressive unless inflation actually does show up. We think any potential increase in rates and inflation will be limited due to the following reasons:
- Demographics – the aging population and its need for fixed income investments and will slow GDP growth.
- Inflation will remain tame. Technology is and will continue to keep prices down (i.e. labor costs). The use of robots will continue to grow, as well as, aggregation of services and products (i.e. Amazon).
- Low rates internationally will keep US rates down. Until rates overseas increase, the US fixed income market will continue to attract money, and this demand will keep rates from going up too far.
- We also see only two rate hikes, as the curve is already getting flat and its impact on the economy will start to show in slowing GDP growth.

Munis have historically outperformed during a Fed tightening environment. Given the supply/demand technicals we see ahead in 2018, we expect this year to play out that scenario once again. Below, is a chart showing the change in yields at various spots of the yield curve for munis and taxable rates during the last Fed tightening from 2004 thru 2006.

BP Change in Rates During Last Tightening (7/01/04-7/01/06)
	5 Yr	10 Yr	15 yr	20 Yr
AAA Muni Rate	80	25	0	-24
USD Libor Swap Rate	143	68	36	21

The long-end of the muni curve performed pretty well during the Fed tightening 2004-2006.
The intermediate area was unchanged.

We feel munis are primed to perform well if rates rise in 2018. Below is a chart showing the relationship between munis and taxables for various relationships:

	5/5 Yr	10/10 Yr	15/15 Yr	20/20 Yr
Current	71%	81%	91%	95%
Avg Spread (1)	72%	81%	84%	92%
Min Spread (1)	21%	67%	70%	73%
Last Tight(2) Min	91%	77%	81%	84%
1/1/2017	70%	100%	109%	117%
(1) Data from 6/1/91 to 1/1/18.
(2) Time Period 7/01/04 to 07/01/06 and 400 bps of tightening.
(3) Data: Muni rates from AAA MMD, Taxable from USD Libor Swap rates.

Muni ratios are currently cheap from 10 years on out, versus their historical average, as well as their levels at the last Fed tightening.
Munis have outperformed already, as we look at ratios from 1/1/17 to now. For example 15-year ratios went from 109% to 91% over the year. This is because taxable rates went up 4 bps, while munis went down 33 bps.
The average ratio for 15 years is 84%; during the last tightening the ratio reached 81%. This shows us there is move room for munis to do well versus taxable investments as they are at 91% now.
We do feel concerned with the short-end of the muni market (5 yrs and shorter). Evaluations look rich and the last Fed tightening saw this part of the curve way underperform.

Yes, rates will likely drift up but we are not about to return to a high rate environment. There remains too many headwinds for higher rates, and a lot has changed since the years of a 5% 10-year yield. Munis historically have done well and we feel are technically sound enough to do so again.

The Muni Yield Curve – Inversion? Not in munis!

As the Fed continues to tighten and the curve continues to flatten, munis will not follow the taxable curve. This is because munis are built differently than taxable bonds. Due to the callable nature of most municipal bonds, an inverted curve (yields for bonds greater than 10 years being lower than yields on bonds shorter than 10 years) is mathematically impossible. Below is a chart showing the historical yield spreads for two spots in the curve under various relationships:

Minimum curve spread from 2 to 25 years since 1991 shows a positive spread of 46 bps.
Last Fed tightening from 7/1/04 to 7/1/06, the minimum spread was 76 bps.
At this point, we are at 97 bps in spread, so there is still room for more flattening. However, considering we were at 177 bps a year ago, my guess is we are close to as flat as we will get.

So where do we like to invest on the curve in 2018? Looking at the history of performance and current valuations, we are very comfortable in the intermediate area of the curve. We think this area could remain unchanged by year-end in price, and the investor will just book the yield on the bond. This is not a bad outcome for a fixed income market that may see higher interest rates by year-end.

Political Risk and Munis:

Political risk is always present, and is always a threat. The Tax Reform at the end of 2017 proved that. As we go into 2018, munis have shown they are an important financing vehicle and their tax-exemption is safe. This doesn’t mean private activity bonds won’t be viewed again as not valid, but otherwise munis appear to be in favor. Now, comes the discussion of a major infrastructure program. This could be our black swan!

Infrastructure: We discussed this as a potential factor in our 2017 Outlook. While it did not materialize in 2017, it sounds like it will be the next program Trump and the crew will be looking to make some noise about.

Trump has recently expressed interest in expanding the role of municipal bonds as part of a $1 trillion ten year program. It appears this includes the use of private activity bonds and heavy reliance on States and local governments issuing bonds. The provisions include the following:

Encourage private investment in public projects and the expansion of the use of private activity bonds.
Allow advance refundings, eliminate any alternative minimum tax, and lift volume caps on private activity bonds.

This plan would provide more tax-exempt bonds to the municipal market as grants from the US Government cannot exceed 20% of the project’s cost. This means bonds or “spend as you go” must make up the other 80%.
If this plan does pass (as is) and is accepted by the market, it could rebalance the supply/demand profile we liked and hurt the techinicals going forward.
There remain many questions about a potential infrastructure plan, and its impact on the muni market. We will need to continue to monitor and plan a full review next month.

Munis – The Evolution of a New Market?

The impact of tax reform will do more than just change demand and supply. Here are our thoughts on what we see happening in the years to come:

Lower supply for the next three to four years.
- Supply down to 2011 levels at $330 bln – down 19% from 2017.
- Increase in new money issuance, but refunding issuance down.
- Slow start in issuance for 2018 after a record $62.1 bln in December (vs $54 bln previous record).
Lower demand for munis going forward from banks and insurance companies. Probably not a big drop, but chances are they will hold fewer bonds with the lower corporate tax rates.
Lower Ratios for munis versus taxables going forward.
- Less supply and little change in demand should lead to outperformance for munis going forward and lower yield ratios.
- Curve continues to flatten in a rising rate environment; muni math takes over and limits our flatness.
Prerefunded bonds outperform and an increased need for tax-exempt cash products to take their place.
- VRDN’s could see an increase in demand from mutual funds as they find a liquidity replacement for Prerefunded bonds.
A change in the structure of the average municipal bond. We think you will see fewer 5% coupons, and 10-year callable bonds being issued.
- Use of shorter calls – This allows the issuer to current refund the bond sooner, keeping its desire for financial flexibility.
- Use of lower coupons – This allows the issuer who want to keep a 10-year call to reduce debt service costs at the expense of less financial flexibility.
We still feel there is a threat that private activity bonds could be banned from the muni market in the future. This would take away more supply, as hospitals and non-state colleges will no longer have access. We feel this is a shame. What are the two costs that continue to increase and hurt the average family the most? Healthcare and higher education. If these entities cannot issue tax-exempt, their costs will increase even more.

Muni Outperformance? Yes, but be careful!

Pick the right part of the muni curve – Currently munis are rich on the short-end, cheap on the intermediate to long-end:

Last tightening munis outperformed with the 15-year being unchanged, long-end showing a slight decrease in rates, and the short-end increasing in rates.
Looking at the current relationship and the historical performance, the short-end of the muni scale is set up for a severe underperformance. If taxable rates don’t change, +50 bps increase in the muni rate represents fair value in a tightening environment.
On the other side of the scale, +15 year rates are set up for good out performance. Taxables could go up 50 bps, and munis remain unchanged to represent value in a tightening environment.

Watch for the tide to roll out at some point, and the muni landscape to change. The technicals set up well for the next 3 to 6 months. We feel there is a chance munis get over-valued at some point. Investors will, once again, be reminded of the white SWAN qualities of munis and over bid.

Yes, I still believe in the qualities of munis as a sleep well at night investment in times of uncertainty. That is where we are at this time. I also believe the chaos at year-end set munis up technically and fundamentally to have a good 2018 relative to other fixed income assets. Finally, the lack of air along with plenty of blue sky in Denver, makes me feel good that we can have a paradoxical fixed income outlook in 2018.

If you trust me, then let’s stay with that sleep well at night theme that has worked well since 2007/2008. I think you will feel well rested by the end of 2018.