Waking Up After A Thanksgiving Nap
December 2, 2021 | Cameron Parkhurst
I trust you had a relaxing and happy Thanksgiving break, and that each of you were able to spend time with family and friends this year. Thanksgiving is always a good time to reflect on the years past, and to think about what is most important. For us, beyond family and health, it is you, our clients, and the strong mutual relationships we have built. We are very thankful to have you all and to be able to help you in your business growth.
Our traders and portfolio managers took a Tryptophan induced nap after Thanksgiving dinner, and it appears that the markets did as well. Both volume and volatility dried up in the days preceding Thanksgiving. However, when the markets awoke from their slumber, we began to see a lot of activity. There was much banter about inflation, the Fed possibly accelerating the tapering plan and walking away from their “transitory” stance (as we expected), market volatility and a new COVID variant for starters. All of these will have large-scale market impacts as we enter 2022 and thus, we will take a few minutes to follow up on what we have presented in past commentaries and provide important updates to our overall thesis.
All of the market related items discussed above interact with each other through feedback loops. However, one of the very important discussion points is a follow-up on inflation, and whether it is transitory or not. As we have stated repeatedly in previous missives, we do not think that what we are seeing out there is transitory at all. Waking up from their own Thanksgiving nap, the Fed sure seems to be changing their tune regarding how they are labelling this recent inflationary environment. Jerome Powell, the Fed Chair, seemingly corrected his position early in the week during his Senate Banking Committee speech. He indicated that he believed inflation was a major risk to both financial markets and the overall economy, and that the Fed could accelerate the wind down of asset purchases.
In our opinion, the Fed has historically been behind the eight ball in policy responses and in their communication around final decision making. Many times, this has equated to quicker than advertised changes in policy, which can be interpreted as “flip-flopping”, and can act to provide destabilizing forces/uncertainty when the best medicine would be total clarity by the Fed. We ultimately saw destabilization in the markets early in the week with the stock market down substantially, volatility in Treasury markets and falling commodity prices for starters.
The inflation fears and interpretation of how the Fed may act over the short term, coupled with the recent COVID-19 Omicron variant spreading, has indeed caused market volatility. Being fixed income geeks, we evaluate all markets, but focus on Treasuries as a foundation and then let everything else fall into place behind that. After having a fairly boring Q2/Q3 2021, the treasury markets have begun to see upward yield momentum. More importantly, volatility has increased, and we are seeing wider swings in Treasury yields than we had seen in months prior. Volatility in the “ultra-safe” Treasury debt markets typically will percolate through to other markets, including equities. The feedback loop here can be in slumping equity valuations, and driving a fear trade, bringing Treasury rates back down. Thus, there continues to be this food fight between bonds/inflation/Fed/equities that is helping to make markets more volatile generally speaking and is having market pundits question when rate hikes might actually happen.
Speaking of the Omicron variant, this fifth wave cannot be ignored. Many analysts seem to believe that Omicron could be much more severe/contagious than the Delta variant proved to be. The world is slowly getting fully vaccinated, including children. However, with each new variant comes the potential for updated boosters and further research into pill vaccines. As an active virus, there will always be mutations going on if not eradicated, and we can expect to see long term lingering effects from COVID-19. This new variant seems to be causing a growth scare to a larger extent than other variants, and has the potential to cause economic shutdowns, travel bans and exacerbate ongoing supply chain problems. Thus, getting new variants, including Omicron, under control, also weighs heavily on the economy and markets.
Switching over to fixed income, and specifically municipals, we have continued to see a sense of calm with the growing Treasury volatility. There have been a few days of yields having some volatility but moves have been muted. Trading desks have continued to be methodical in their approach here, and there have not been “fire sales”, as we saw in March of 2020.
Munis, both taxable and tax free, have held up well in 2021, and really since the first COVID shock that we saw in early 2020. Please see the latest published annualized return numbers across the fixed income landscape. Munis certainly do seem to be leading the way, with lower credit producing higher returns than investment grade issues.
As Treasury rates have moved higher, with muted moves, we have seen muni rates follow. This has led to higher rates generally, comparing late 2020 to where we are today in 2021, and along the way we have seen munis become a bit more attractive as a percentage of Treasuries.
With clients coming to us with new fixed income needs currently, munis are still providing good value in comparison to taxable bonds for the higher tax bracket clients. With taxable munis also affording good spreads in relation to comparable Treasuries and over other spread products (such as corporates), for those who may be in moderate tax brackets, we will run tax equivalent yield calculations. In most cases, moderate brackets are utilizing taxable bonds currently, as we gain a little post-tax yield that way.
Finally, for this discussion, we wanted to highlight a little bit of information regarding what we are seeing in the muni landscape generally as we exit 2021. We will likely cover this in much greater detail in a missive that will share our thoughts leading into 2022 and should be distributed towards the end of the month. The key bullet points that have helped prop up the muni market in 2021 are a modest increase in year over year supply, state and local municipality stimulus, record flows into muni funds and ETFs, strengthening of balance sheets at the state and local level and general credit increases post COVID downgrades. Additionally, when looking at trading desks and trading volume, we see some important points to discuss.
With rampant government stimulus throughout 2021, we have seen municipalities really gain balance sheet strength. The chart above shows the general uptrend in ratings changes in municipal debt throughout late 2020-2021, after the initial wave of muni-wide downgrades with COVID fears percolating quickly through the muni bond landscape.
Additionally, munis have a luxury that lies in the “stickiness” of tax revenues. 10% of the workforce pays the bulk of most state taxes, and most of the high wage earners have
adapted to remote business even while being forced away from offices recently. This is reflected in a breakdown of state tax receipts relative to 2020, as seen below. The tax receipt picture is certainly rosy and should help to prop up overall muni bond ratings going forward.
Combining this with a muni default chart that we always feel extraordinarily important, it helps to tell the story on why we favor munis. States also have the ultimate ability to raise taxes, reduce services, etc., to maintain budgets. Thus, defaults on high investment grade municipal bonds are rare.
With all of the above, we continue to believe that taxable and tax-free muni investments are well suited for those buy and hold investors, or those taking specific tactical strategies in order to have principal preservation and income generation in their portfolios.
As we approach the trading period toward the end of the year, you may also see us reach out to you to conduct global portfolio reviews. We will primarily evaluate the ever-evolving credit stories in portfolios but may also look to any areas where tax loss selling can help clients. This will not be widespread in 2021 unless there had been recent purchases prior to rates ticking up, or if there were covid related credit issues (many of which have rebounded substantially). However, we always like to go through the exercise prior to the calendar rolling over. If there are any clients that need portfolios shored up prior to the new year, please don’t hesitate to send them over, as we all know volume can dry up around the holiday period.
Please take time to digest this information and reach out with any questions or needs.
Also, please don’t hesitate to leverage us in any capacity during your asset gathering endeavors for current or prospective clients.
Your PeachCap Fixed Income Team
The above summary of statistics/prices/quotes has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The information and opinions herein are for general information and illustrative use only. This data is not meant to replace Adviser's portfolio management/performance reporting systems. Please consult Adviser performance reports for actual performance data. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. Past performance is no guarantee of future results. Market risk is a consideration if sold prior to maturity. May lose value. Not insured by any federal agency. Subject to availability and price change. Securities offered through PeachCap Securities, Inc., member FINRA, SIPC, MSRB registered.