After a relatively benign 4th quarter, characterized by a risk-on mentality, market uncertainty ramped up heading into year end on the heels of the recently identified omicron Covid variant closely followed by a hawkish inflation pivot by the Federal Reserve. In a holiday-shortened session on November 26, equity markets took a beating, high yield credit spreads widened, and Treasuries rallied in a classic “flight to quality” trade as markets digested news out of South Africa that a new Covid variant had been identified. Understandably this brought concerns over the potential impact to the global economy. These fears continued into the following week with high-grade corporate issuers pulling deals and equities posting the largest back-to-back selloff since October 2020 to wrap up November. Against this backdrop it would not have been surprising to see some weakness in municipals, however, they were unfazed by the broader selloff in risk assets. The situation gets somewhat murkier as it relates to the Federal Reserve. While omicron is certainly not to be taken lightly, the larger concern for bond holders is, and will likely remain, uncertainty and volatility surrounding the direction of monetary policy.
Municipal markets shrugging off bad news is certainly not a new theme; that said, the market’s reaction to omicron was a reminder of the resiliency of the asset class in the face of continued pandemic-related pressures. Currently, municipals are the only area of U.S. fixed income markets, except High Yield, in positive territory on a year-to-date basis, up 1.38% (Bloomberg Municipal Bond Index). Municipals performed admirably in the face of omicron up 0.85% for the month November. On a relative basis, municipals are ahead of corporate bonds by 231 basis points (bps) year-to-date (Bloomberg U.S. Corporate Investment Grade Index) and have outperformed treasuries by 317 bps (Bloomberg U.S. Treasury Index). Some reversion would eventually be expected as there is a finite limit to continued relative outperformance, but one could make the argument that municipal credit fundamentals, current valuations, and constrained supply create a supportive environment for the asset class heading into 2022.
Municipal credit fundamentals seem to be on sound footing. At this time, it does not look like omicron will have a drastic impact on economic growth in 2022. A growing U.S. economy — even if slightly slower than anticipated — should bolster state and local revenues. While the new variant could be more communicable than previous variants, initial reports are that symptoms are mild. In addition, U.S. markets, and municipals specifically, have shown an ability to withstand multiple variants including the delta variant. While some travel restrictions have been put in place, it looks like a return to economy-wide lockdowns are unlikely. In addition to an economic backdrop that could support revenue growth, recent market investment returns have eased pension burdens on state and local government and rising home valuations should increase property taxes. Municipal credit should also benefit from fiscal tailwinds such as the $130 billion in direct aid in the American Recue Plan of 2021 and the more recent Build Back Better plan which could ease the burden on infrastructure spending in areas such as roads, bridges, mass transit, and water and sewer systems. Even before Build Back Better, state and local finances were showing drastic improvement and any additional influx of federal money would likely firm-up fundamentals even further.
Outside of credit fundamentals, valuations look better than they have for a good portion of the year, notwithstanding the more recent autumn selloff. From August 1 to October 31, broad municipals were down 1.37%. After taking a three-month breather, returns rebounded in November, up 0.85%; but even after the November rally 5-, 10- and 30-year benchmark yields remain above their respective two-year averages. After the sharp interest rate drop sparked by the omicron variant, municipals also look appealing relative to Treasuries. The short-end of the municipal yield curve continues to remain muted but the 5-, 10- and 30-year municipal-to-Treasury ratios now all sit above their averages over the last year. The 10-year municipal-to-Treasury ratio, currently in the 75% range, sat at just 67% on November 23, the day before the announcement that the first omicron case had been identified. Continued constrained supply should also provide some tailwinds in the near term. December redemptions represent a 25% increase over November, while total principal and interest in December represents the third highest total of the year. Based on current new issue estimates, this likely leaves the market without the supply needed to cover demand for the first time since August. The supply/demand dynamics do get murkier heading into 2022, with some expecting the Build Back Better Plan to increase new issuance as state and local governments leverage federal aid. However, that is not necessarily a given and would likely take some time to play out. Municipal markets likely have a long road to travel before excess supply becomes a problem.
While municipals have been somewhat immune from broader, pandemic-related volatility that does not mean there are not risks to the asset class over the horizon. Omicron may pose some challenges heading into the new year, but the bigger source of uncertainty seems likely to remain inflation and monetary policy normalization. Chairman Powell acknowledged early last week during the Senate Banking Committee hearing that it might be time to “retire” the use of the word “transitory” in describing current inflation. This was taken by many in the market as a pivot in monetary policy that could require rate hikes sooner rather than later and added to the omicron-induced volatility. Powell also acknowledged that risks associated with pandemic-related price pressures have increased and are impacting the broader economy, possibly requiring a faster-than-anticipated tapering of asset purchases. Even with a rather surprising miss on labor data last Friday it seems the market is expecting a faster-than-anticipated path to normalization. Omicron is likely to continue to be a fixture for the foreseeable future. That said, with the current information at hand, we would continue to view the potential for interest rate/monetary policy volatility as the overriding concern for most municipal investors, which in turn would lead us to continue to favor short duration holdings with a preference for credit over duration.