Market Overview: 4Q2016
Various government data releases showed a mixed view of the economy in the third quarter, and investor attention remained focused on the timing and scope of future U.S. Federal Open Market Committee (FOMC) interest rate hikes. Municipal market performance turned negative for the first time in over a year due to higher interest rates and significant new issue supply. Municipal index returns were negative across most of the yield curve with longer bonds posting the weakest returns. Lower-rated bonds generally outperformed those with higher ratings.
Muni new issue activity spiked in the third quarter. Notably, underwriting activity jumped to the highest level for any September since 1986. Volume increased about 45% to $35.7 billion from $24.6 billion in the same month in 2015. Year-to-date through September, total new issuance has amounted to $334 billion, exceeding the same period in 2015 by 4.6%. The increased supply has generally been well received by both institutional and retail investors.
At its September meeting, the FOMC elected not to raise its key interest rate, keeping it at a range of 0.25% to 0.50%. Three members voted in favor of an increase but others were concerned that the core inflation rate was too far below its target of 2.0%. Policy makers were encouraged by a strong job market and healthy economic growth but noted, “The committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives…” 1 The next meeting is scheduled for early November but it is unlikely that the FOMC would raise rates right before the U.S. presidential election, in our opinion.
In September, the Commerce Department reported that the third estimate of second quarter U.S. Gross Domestic Product (GDP) came in at 1.4 % annual rate, which was slightly above consensus expectations. The report showed that a measure of business spending, nonresidential fixed investment, rose at a 1% rate versus the prior estimate of a 0.9% decline. The upward revision was due to a much smaller decline in structural investment than previously estimated, as well as an increase in intellectual property investments. A change in private inventories was a smaller drag on growth than previously estimated, due to a larger contribution from farm inventories last quarter. Overall, the inventory change subtracted 1.16% from the GDP advance for the second quarter, smaller than the previously estimated drag of 1.26%. Consumer spending, which accounts for about two-thirds of the economy, rose at a 4.3% pace in the spring, compared with an earlier estimate of growth at a 4.4% annual rate. The second quarter’s gain was still the largest increase in household outlays since late 2014. 2
According to the Bureau of Labor Statistics, nonfarm payrolls rose a seasonally adjusted 151,000 in August, trailing the 180,000 predicted by economists surveyed by Bloomberg News. August traditionally has been a difficult month for jobs numbers and 2016 has proved no exception. The average for the year is 181,500 and 204,000 for the past 12 months. Private job growth was just 126,000 in August. The unemployment rate was unchanged at 4.9%. A more encompassing rate that included discouraged workers and those holding part-time jobs for economic reasons held steady at 9.7%. 3
Outlook
Despite disappointing economic growth for the year thus far, we believe the U.S. economy has sufficient momentum to continue expanding. While GDP could improve in the fourth quarter, it appears likely that growth could be relatively subdued for 2016 as a whole. Turning to the FOMC, the possibility of a rate hike in December seems a bit more probable given recent comments by policy makers and slightly better economic data. Given this backdrop, we do not expect U.S. Treasury yields to move sharply higher in the short to intermediate term.
Technical factors for the municipal bond market remain promising, in our view. Fifty-four consecutive weeks of muni mutual fund inflows illustrates the robust demand coming from retail investors. We expect total new issue tally for 2016 to amount to approximately $425 billion.
We believe that this level of issuance should be well received by the market, given the attractive relative value that municipal bonds offer when compared to comparably rated taxable fixed income alternatives.
Puerto Rico Financial Control Board Composition
Although the PROMESA legislation passed in June, the Obama administration only recently named the seven members of the financial control board that will oversee the restructuring of Puerto Rico’s $70 billion debt burden. Those selected are under close scrutiny by many observers with a vested interest in their work. How would we describe them? Fairly diverse, in terms of professional background.
The board’s elected chairman, Jose Carrion, is an insurance executive who comes from one of Puerto Rico’s most prominent families. Carlos Garcia was the former president and CEO of the island’s Government Development Bank. Jose Ramon Gonzalez is the president of the Federal Home Loan Bank of New York. Another member, Andrew Biggs, is an American Enterprise Institute scholar and major critic of “social insurance;” he has previously endorsed cutting public pensions. Arthur Gonzalez is a professor at New York University School of Law and previously served on the U.S. Bankruptcy Court for the Southern District of New York. David Skeel is also a law professor, at the University of Pennsylvania Law School, and is a supporter of Christian legal scholarship. Finally, Ana Matosantos, the only woman on the board, has been a director of the California Department of Finance and deputy director of budgeting for the state. At this point, it is not clear if these board members will be more commonwealth- or creditor-friendly. The board recently concluded its first meeting and is awaiting a financial blueprint from Governor Padilla’s administration that may help form the basis for negotiations with creditors going forward.
– Steve Cowie, Senior Credit Analyst—Municipal Fixed Income Team
1
Bloomberg News, September 21, 2016, “Fed Aims for December Rate Hike on Growth.”
2
Reuters, September 29, 2016, “Revised GDP growth gains 1.4 percent, stronger than expected.”
3
Source: Bureau of Labor Statistics.
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