Grinding it out
Bond market plods ahead amid looming uncertainties.
September’s run-up in long yields, a late-summer slowdown in economic activity on the delta variant’s spread and indications that Democratic tax increases may be smaller than anticipated took a little shine off the municipal bond market’s still solid year-to-date performance during the third quarter. Returns for the S&P Municipal Bond Index and the S&P Municipal Bond High Yield Indexes were small and slightly negative for the three months, -0.26% and -0.04%, respectively—a bit below the meager 0.09% return for the Bloomberg U.S. Treasury Index. Municipal bond flows remain solid, as do credit fundamentals, with many state and local governments cash rich due to transfers from the various Covid relief packages and rising tax revenues. Covid cases appear to be rolling over in much of the country, although the late summer spike presented challenges to travel and certain services-related segments of the muni market, including Airports, Senior Care providers and Hospitals. Looking ahead, further significant increases in Treasury yields could cut into muni demand, as could smaller-than-expected tax increases. Although the scale of the budget reconciliation bill is up in the air, we anticipate corporate and individual tax rates will rise somewhat to fund greater health, education and climate-related spending. Also, when the D.C. smoke clears, we anticipate the bipartisan infrastructure bill will pass, producing more federal funding to assist municipal entities undergoing more infrastructure projects in coming years, increasing muni supply and infrastructure investment above what otherwise would have occurred. — R.J. Gallo
The past three months in many ways were a replay of the first six. Overweights to lower-quality, shorter-duration credits (notably high yield and BBB corporates) and a rising-rate positioning bias made for another quarter of competitive performance relative to benchmarks. Our defensive duration posture has allowed the bulk of our fixed-income strategies to achieve positive year-to-date returns on a gross basis, despite indexes that are predominately negative. We’re mostly sticking with these strategies as we close out the year on the belief long yields will rise further and credit fundamentals will remain strong. After September’s modest spread widening (the yield gap relative to comparable-maturity government securities), emerging markets could be setting up for a nice run, aided by improving vaccination rates and higher prices for the resources/commodities developing countries provide.
We did shift to neutral on investment-grade (IG) corporates in late September, mainly because at 1 standard deviation below the median, the spread is so tight that the benefit of trying to squeeze a little extra alpha from this trade may not be worth the risk. Adding to this neutral bias: the duration of IG corporates nearly doubles that of high yield, exposing it to greater volatility if long rates turn up too much. Even short bursts up can be painful. That said, flows into the asset class—and into bonds generally—show little or no signs of slowing down.
Putting aside the D.C. drama over trillion-dollar infrastructure packages and the debt ceiling (having lived with this spectacle for so long, we want to see the final act first), three questions give us pause:
- Transitory for longer? When Fed policymakers incorporated average inflation targeting into their policy-setting factors, saying inflation may need to run hot for some time to bring average PCE inflation up to its longtime 2% target, they really didn’t provide much guidance. Are they looking at an average going back three years? Five? 10? The answer matters. Inflation is running very hot—PCE is at a 30-year high—and the “transitory” (the Fed’s word, not ours) nature of recent price increases don’t seem so transitory. Markit and ISM surveys show vendor cost pressures intensifying. So, how long is transitory? The Fed’s been vague. It keeps raising its PCE forecasts for this year and 2022. It was at 1.8% and 1.9%, respectively, last December. It’s now at 4.2% and 2.2%. The reality is the Fed can keep moving the goal posts, meaning if you’re in the non-transitory camp, you may never win the “how long?” discussion. But if it wants to hang out at 2.25-2.5% through next year to get to a 2% average, the bond market isn’t priced for that.
- Who is going to buy bonds? One of the curiosities in a year with an equity market that, until the past month, keeps setting new highs as the bond market wrestles with inflation has been the ongoing robust flow of money into bonds. Inflation and bonds don’t typically go together. With the Fed signaling taper is likely to start this year, possibly next month, and with negative real yields almost across the curve, it’s hard not to worry that flows at some point could turn negative. It is possible the economy stumbles, causing a sell-off in the risk markets that gives bonds a boost. That’s not our base case—at least, not for the remainder of this year. It could be that investors, seeking to protect equity gains, may park some of them in bonds, where a bad year is typically close to a bad day in stocks. This is not an issue that keeps me up at night—yet. But I’ve always found the TINA (There Is No Alternative) argument for bonds to be a flimsy one.
- A third mandate? Democratic progressives are pushing the Fed to essentially add a third policy plank—the elimination of climate risk and advancement of racial/economic justice—to its dual mandate of maximum employment and price stability. The Fed has taken steps to address the concerns, joining an international network of global financial regulators focused on climate change in late 2020 and redefining its framework of maximum employment metrics to include “broad-based and inclusive.” That hasn’t quieted critics, many of whom want to replace Powell. U.S. Sen. Elizabeth Warren last month called the Fed Chair “a dangerous man,” causing his reappointment odds in bidding markets to plunge from above 80% to 60%. The Fed has a lot of distractions right now—two hawkish regional Fed presidents recently retired amid concerns about trading activity—so a more dovish turn into areas heretofore outside its nonpartisan realm could be potentially unnerving for the market.
Although the answer on Powell’s reappointment could come any time—some think he may be a bargaining chip for President Biden in discussions with progressives over the fate of the multitrillion “soft” infrastructure reconciliation bill—the three above items are more 2022 concerns than ones for the next few months. Hence, our somewhat “holding” pattern strategy as we close out the year. But we remain vigilant, focused on the questions that worry us and committed to a disciplined investment process that seeks to mitigate potential risks whenever and wherever they arise.