The muni landscape heading into a downturn
Tune in to hear Dr. David Kelly and Richard Taormina, Portfolio Manager, discuss the outlook for municipal bonds in today's current environment.
David Kelly:
Welcome to Insights Now. A series of conversations designed to shine a light of clarity on the complex world of investing. After significant monetary tightening over the past year, the Federal Reserve has now hiked rates all the way up to a range of five to five and a quarter percent, for this tightening cycle may finally be at a close. With an elevated risk of a near-term recession, markets are now expecting the Fed to pivot to rate cuts before the end of the year.
For investors in an environment where economic conditions are looking precarious and rates may soon be headed downwards, an active approach towards fixed income exposure is particularly important. In today's episode, we're going to focus on municipal bonds, which may be an effective way for investors to access high quality and attractive tax exempt deals and portfolios, particularly when headed into a downturn. To discuss this, I'm joined today by Rick Taormina, a portfolio manager for several municipal bond strategies here at JP Morgan Asset Management. So Rick, welcome to Insights Now.
Rick Taormina:
Thanks for having me, David.
David Kelly:
For starters, let's get a sense of your thoughts on the current environment. How do you view the balance of risks in the economy and marketing conditions right now?
Rick Taormina:
It's interesting. On the economy, we feel the risks are to the downside and actually as bond investors, that's great. So we feel that there's a wind behind our backs here. I think when we look at the economy, we really feel that we're almost between two crises or obviously we're battling with a deposit crisis at this point, trying to work a solution to that piece.
But really when we look at what's going forward and what really is in the windshield for us, we do see senior loan officer surveys, auto loans, and a whole bunch of consumer products that really are going to get their situation tightened dramatically because of the deposit crisis. So we almost feel we're in this period where we're going to have to get comfortable with where the deposits are, and then we're going to have to address what those next series of events will be. Commercial real estate is another one that's top of mind, so I think there's going to be a lot going on over the next six to nine months that we're going to have to read and really navigate the markets carefully, but I think that it should all be good for your bond investors.
David Kelly:
It sounds like a pretty bumpy ride and markets are currently pricing in a pretty sizable pivot from the Fed with multiple rate cuts before the end of the year. Do you think this is going to happen?
Rick Taormina:
I think it really depends. As you talked about the bumpy ride and how bad it gets, I think one thing that we feel is that the trajectory is really bringing those rate cuts forward. So we actually think that in September you could see the first cut by the Fed followed by several maybe throughout the balance of the year.
I think as we start to see the credit conditions tighten here, we have to keep in mind that when the Fed historically is stopped, the difference between the Fed funds rate and the inflation rate, today's inflation rate, is roughly two and a half percent. Now, when we do the math today, you're looking at one and a quarter, but I think one of the things that investors have to realize is that the tightening of what has just happened within the banking system, we feel is the equivalent of another one to one and a half percent of tightening. So when we add those two together, that was one of the reasons we felt very strongly that the Fed would stop the hiking cycle. And now it's a question of what happens to those other knock-on effects that we talked about, if you will, that crisis two that's going to be in our windshield, and how that draws the Fed to start the cutting cycle to offset those downturns in the economy.
David Kelly:
So a difficult time in the economy, but possibly a good time for high quality fixed income. As a portfolio manager for municipal bonds, two parts really, first of all, what are the biggest things affecting the muni market right now and how has your approach to managing muni portfolios changed during this cycle?
Rick Taormina:
Sure. When we look at how we're managing through this cycle, two of the things that are really the big influence of this year have been the technicals, really supply and cash flow. So supply has actually been quite light, and there's a couple of reasons driving that. One is that municipalities just have so much cash in their balance sheet, they don't need to borrow as much, and two, let's face it, rates were high, for their variance point, so they know that the Fed was fully engaged, which usually will mean that they will slow the economy and rates will eventually fall. So they've taken their time to put project money to work, and that has impacted supply to the downside.
The second piece is cash flows. Cash flows, especially in separately managed accounts has been tremendously strong. Folks trying to come in and lock in those higher rates ahead of what we anticipate a lower rate environment if we go into an economic downturn. When we look at how we're managing portfolios, we've moved out durations. We're about a year longer than we were this time last year. We are also, as you mentioned, high quality duration. High quality assets are really where we're focused because we want to have credits that we'll be able to ride through what we think will be an economic down turn here. So really scrubbing portfolios and making sure that we really know what we own and we're comfortable with it while trying to take advantage of the rate environment.
David Kelly:
One thing we've noticed, we have a chart on page 42 of our guide to the markets, which shows just how upward sloping the tax equivalent yield curve is compared to a very inverted treasury yield curve at this point. Is there an opportunity here or is there something very wrong here?
Rick Taormina:
We think it's actually a tremendous opportunity. I think when you look at the treasury curve, it's inverted because we have the Fed was in a hiking cycle and that mark was anticipating that that would slow the economy, so the long end started to come down, hence that inversion. On the muni side, why we think there's such a great opportunity. The reason why the curve is so steep is because that was due to outflows in 2022. When we look at outflows, we had roughly 140 billion come out of the muni market exiting mutual funds. The next closest year was almost 70 billion, so almost double what it had been, and that caused opportunity, when we look at where the cash flows came out of, it was mostly intermediate, long and high yield mutual funds, and that caused that curve to steepen exactly like you pointed out.
We think if you can buy paper out there in that three and a half to four and a half percent range, if you look at those taxable equivalent yields, like you point out, that is rivaling historic equity performance. And if we think we're going into an economic downturn, we don't feel that equities will survive a as well as long fixed income. Hence the reason why we moved out in duration and we want to lock in those yields. So definitely an opportunity for folks to come in then embrace those yields.
David Kelly:
Can we talk a little bit about taxes? I mean, how are you thinking about state taxes and then also federal income taxes when it comes to investing?
Rick Taormina:
Sure. I think it's really what you keep at the end of the day, and obviously the federal tax hit is the big hit. So that's why we feel so strongly about municipals in here. It's not only a credit play, but obviously it's a tax play. On the state side, it's really interesting and it really depends on the state you're located in and really where the valuations are.
In certain states like California where they have a very high upper tax bracket, you're oddly enough better off buying treasuries and paying the taxes than you are in municipals in the very front end of the curve. If you go out in that 20 year space, you're better off on the municipal side. So what we try to incorporate as we're looking at different locales around the country is looking at those tax rates, doing the after tax calculations, and seeing what makes the most sense for investors. I think you'll find once you're out past 10 years, it almost always makes sense in the higher bracket. It's really that very front end of the curve that gets a little distorted because of cash flows in demand. So really if you're looking to lock in long, I think you're better off in tax exempt paper at this point.
David Kelly:
One thing that sort of never changes is debt and taxes. So let me talk about debt. We often get talked about the sustainability of federal debt, particularly in the context of higher interest rates, but how are things looking in terms of debt at the state level? Do you have any worries about debt levels?
Rick Taormina:
Yeah, it's interesting. I think if you go back and you do a flashback, many years ago, the muni market and the treasury market were actually the same size. Now the treasury market's eight X the muni market. So we think there's some scarcity value there, and I think when you look at what debt the municipalities have, especially at the state level, they're actually in very good shape. When we look at rainy day funds are at all time highs and multiples of any other time when we started to enter into an economic downturn, and we think that's going to provide enough cushion for them to ride through this. You've even seen states like New Jersey, Illinois, and Connecticut actually all get upgraded over the past year, and that's something that we really haven't seen in many years. So the states look really strong going into this downturn.
David Kelly:
Many years ago, I used to work for the State of Michigan actually, in their office of Revenue and tax analysis, and I was so aware of all the constraints being put it on states in terms of their ability to run deficits at all. And when I think about how federal debt has just ballooned over the great financial crisis and the pandemic recession, I think it's a really interesting point about just how different state debt conditions are compared to the federal debt conditions.
Rick Taormina:
Yeah, they just can't lever up like the federal government can. So it really provides a ballast to their balance sheet. And I think if they use their revenue wisely, which we're seeing them coming out of covid, be very, very focused on how they're spending their dollars and truly put them in a really nice spot here going into what we think will be a light recession.
David Kelly:
So state balance sheets look pretty healthy, but what about cities? I mean, did you differentiate between city credits and state credit?
Rick Taormina:
We do. So typically as we head into a recessionary period, we actually underweight states because they're the most economically sensitive and we actually overweight local geos. The reason why we do that, is because local GOs are much more dependent on their local taxes and real estate taxes, which tend to be more stable. Now, one thing we are obviously looking at, we do feel that we are going to have some commercial real estate issues throughout the US. We do feel that some of the consumer loans will also come under pressure as the job picture starts to get a little bit more difficult over time as we go in the recession. So we are cognizant of what municipalities are doing to combat, for example, office space and what they're going to do with the return office and how robust return office will be in different locales.
And we've actually seen that vary across the country. Here in New York City, they're actually going to have a surplus of around 8 billion. So New York City looks pretty good. In other areas we're more concerned about rental real estate and what that means to prices and everything as such when in terms of rentals and how that plays out. So it's really a case by case basis, but that's why we have a huge credit team to be able to parse through and really pick the winners and separate the ones that are going to have more difficulty going through this downturn.
David Kelly:
If you can turn back to the sort of demand for bonds, again, retail investors have been very active recently, of course with higher rates, and that's contributed to very strong inflows into money market mutual funds. But retail flows also tend to be very important for the muni market. So what are you seeing there?
Rick Taormina:
Yeah, it's interesting. The shape of our curve is really because of those flows. So as you mentioned, there's a tremendous amount of money coming in to the front end. If you look at our curve, it almost looks like a smiley face with a little tail at the end. And the reason why it has that bottom trough there is because of the retail flows in SMAs. At points during the past year, they've pushed municipal treasury ratios to around 50%. And that's why I commented for some states, you're better off buying treasuries and paying the taxes.
What we really want to do in terms of the curve and really take advantage of where the flows have gone and really what opportunities that has opened up, we really want to be barbelled. So we want to own the very front end, because that's following the treasury curve, which is inverted, and we want to be out in that 10 to 20 year part of the curve because that's the area that's just beyond where we see most of the SMA flows. And if you actually assemble that barbell, you wind up with 30 to 40 basis points more than if you would be bulleted in that two to six year part of the curve. So really playing the curve dynamic here, I think investors can really get a higher yield and actually set themselves up for what we think will be an economic downturn, and that will force rates lower, and they'll be able to capture some of that appreciation further out the curve.
David Kelly:
So looking more at sort of from a bigger picture perspective, when we think about asset allocation in general, how should investors think about a muni allocation in the context of a broader fixed income allocation?
Rick Taormina:
Sure. I think anytime you have a period where we feel that you're going to have economic weakness, you want to have high quality fixed income within the portfolio. I think 2022 is a prime example where municipal core actually outperformed taxable core by almost 250 basis points. One of the reasons for that is that municipals are a high quality instrument. I think when you look at how states are, their balance sheets look right now, they are in better shape than they've ever been going into an economic downturn. And that really is dating back to the eighties when New Jersey was actually a triple A rated credit. So I think when we look for an overall asset allocation, the first question is what is the tax bracket of the investor? And then the second question is, what other asset classes within fixed income can you layer into that portfolio to make sure that you have high quality duration for the next year or so going through the period? And municipals just fit that piece. So I think it should be really a fairly sizable allocation when you're building portfolios in fixed income for the hive taxpayer.
David Kelly:
But finally, Rick, the risk of recession has increased. We've talked about this a good deal about the potential for downturn, but how much your outlook from munis change if we actually end up in a recession soon?
Rick Taormina:
Typically, municipal credit lags corporate credit by about six to nine months, and that's why we're really kind of pounding the table on having municipals going into the recession. Now, as we go into the recession, it depends on how severe the downturn is, right? We've been through '01, '07, and '08 where the impact on municipal credit was really pretty severe, but I will say the sheer amount of cash from the three large government programs that municipalities received has really given them an outsized cushion that they really haven't had in decades. So when we look at it, I think municipals will be able to ride through this. Whether it's a garden variety or even a medium recession, I think they'll be able to run through it quite strongly.
If we get into a really severe recession, obviously we're going to have to have municipalities that are going to be really adept at trying to navigate and what levers they can pull. I'll give you an example. California is going to have a 22 billion deficit this year. What they're doing is they're cutting programs, they're deferring some maintenance and they're bonding out. They're actually not spending any cash, which is actually going to give them even more cash to spend if we get into a worse economic downturn. So it's not only the trajectory going in, but it's how the municipalities navigate it going through, and that's something that we're going to be watching and altering portfolios in an active way as we go through this next period.
David Kelly:
And we'll be watching too. Listen, thank you so much, Rick, for your insight on all of this, and thank you all for listening.
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Disclaimer:
This content is intended for information only based on assumptions and current market conditions and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting, or investment advice. Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing. The value of investments and the income from them may fluctuate, including loss of capital. Past performance, and yield are not indicative of current or future results. Forecasts and estimates may or may not come to pass. JP Morgan Asset Management is the asset management business of JP Morgan Chase and Company and its affiliates worldwide.
RISKS OF INVESTING IN ULTRA-SHORT MUNICIPAL INCOME ETF.
The risk of a municipal obligation generally depends on the financial and credit status of the issuer. Changes in amunicipality’s financial health may make it difficult for the municipality to make interest and principal payments when due. Under some circumstances, municipal obligations might not pay interest unless the state legislature or municipality authorizes money for that purpose. Municipal obligations may be more susceptible to downgrades or defaults during recessions or similar periods of economic stress.