Inflation, recession, fears of broader banking crisis occupy Q1 | Cumberland Comment
The year started off calmly, although the Ukraine invasion and other escalating conflicts, plus the knock-on risks of supply chain issues, have not abated. Unfortunately, increased violence has become part of the global fabric, though it is somewhat overshadowed now by inflation, fears of banking-crisis contagion and recession.
Cumberland participated in a “Ukraine: One Year Later” conference series with the Global Interdependence Center and University of South Florida Sarasota-Manatee, Part 1, on Feb. 16-17. Speakers from the military and those with international expertise brought a particularly sobering outlook and expectations for the future. Additional segments explored investments and financial markets, with the highlight being a keynote address from Cleveland Federal Reserve President Loretta Mester. (See cumber.com/market-commentary/youtube-presentations-russo-ukraine-series). Her comments about future interest rate hikes sent some ripples through financial markets that day. Part 2 was held on March 9 and has also been posted online. The replay of March 23, Part 3, is expected to be published soon, so keep an eye out for that on our website cumber.com or our YouTube channel at this “Ukraine: One Year Later” playlist: youtube.com/playlist?list=PLu1JZIQ1mPrvJCpMDyndDkj4eOOMIYzlA.
Cumberland will also be participating in the upcoming in-person event at USFSM, “Cryptocurrency and the Future of Global Finance”, on April 20-21 (interdependence.org/events/browse/cryptocurrency-and-the-future-of-global-finance).
Banking
The “banking crisis” that saw the demise of SVB, Signature Bank, and Credit Suisse appears to have been subdued as governments stepped in to help stem withdrawals and provide stability to banking systems. However, the crisis did spur increased volatility. (See John Mousseau’s quarterly commentary, “Bond Volatility Rules the Quarter,” cumber.com/market-commentary/bond-volatility-rules-quarter). The inversion of the yield curve, induced by the Fed’s interest rate increases, has meant that higher short-term rates have caused investors to move to higher-yielding mutual funds and other banks and institutions offering higher rates for savings. Meanwhile, many banks lent or invested in longer-dated securities that have declined in value as the Fed has raised rates.
This Catch-22 has resulted in a mismatch of assets and liabilities, with deposits being quickly mobile, while longer-term Treasury bond investments, although very liquid, have lost value with the rapid rise in rates. The banking crisis has unfolded on the heels of the demise of some crypto assets. As David Kotok likes to mention, you never see just one cockroach. (See “50 Years & More of Bank Failures + SVB,” cumber.com/market-commentary/50-years-more-bank-failures-svb.) Investors and people in general are sensitive to the fear of greater inflation, although inflation seems to be ebbing while the fear of recession is growing, including in Europe. (See Bill Witherell’s assessment, “International Equity Markets in Q1 2023,” cumber.com/market-commentary/international-equity-markets-q1-2023.)
If inflation ebbs and the yield curve returns to its normal upward slope rather than being inverted, we are apt to see a change out of deposits and money market funds into longer-dated investments. Timing may be important. It may be time to extend the maturity of investments, for there will not be 4% 2-year Treasury yields available for long. Timing is a big question, and putting all your eggs in the short-term basket can present reinvestment risk. When a 6-month or 2-year CD matures, what alternatives can you invest in? Mid-term (belly of the curve) and long-term munis in the 20–30-year range have compelling ratios when compared with Treasury yields.
Munis and banks
Municipalities have numerous connections to regional and local banks for needs such as cash management, payroll, tax collection, underwriting, trustee services, and credit lines. However, in a March report, Moody’s finds that material risk is limited. Rated municipalities, in general, are fairly insulated, having reduced their exposure to banks since the financial crisis. Rated issuers have conservative cash-management procedures and diversified deposits among regional banks so that they are at low risk should a single institution collapse. Lessons municipalities learned during the financial crisis included avoiding counterparty risk from swaps used with variable-rate demand bonds whose short-term rating is based on the bank’s providing funds in the event of a remarketing.
Although bank debt has increased, where the municipality gets a loan directly from a bank instead of issuing municipal bonds, bank loan maturities may be shorter and could present rollover or refinancing risk. Moody’s additionally notes that smaller, unrated municipalities have greater risk of exposure to a single bank; however, they also site examples of these entities being supported by their local banks in times of stress.
Oil markets
The Ukraine war has impacted supply chains, and particularly for oil. With Europe cut off from Russian oil supplies, the U.S. and others picked up the slack, despite climate-warming worries. The war has also highlighted India’s ties with Russia. The recent surprise OPEC cut in production targets has also increased oil prices. The U.S. has already begun increasing oil and gas production capacity; however, it takes time to increase production, and obstacles such as contributing to a warming climate must be addressed. States that should benefit from the changes include TX, ND, LA, and Alaska, with the approval of the Willow Pipeline.
Recession risks
As recession risk increases, credit spreads generally widen. The S&P US Investment-Grade Corporate Bond Index yield spread to the 10-year Treasury has increased to 180 bps at the end of Q1 2023 from 112 bps in Q1 2022. The spread was 285 bps at the end of Q1 2020, at the height of the pandemic market response, and declined to 47 bps at the end of Q1 2021.
The distribution of global corporate bond ratings is lumped in the BBB area, while the muni bond rating distribution is solidly AA. One can also observe muni spreads; however, with different maturities, state tax rates, and other structural features, it is more difficult to glean recession risk from them.
States and local municipalities are in a good financial position if we enter a recession. According to the National Association of State Budget Officers (NASBO), fund balances reached new heights in fiscal 2022, after having grown sharply in fiscal 2021. At the end of fiscal 2022, state reserves, including rainy day funds, totaled $343 billion. Based on enacted fiscal 2023 budgets, state reserves were projected to decline some from lofty levels by the end of the fiscal year (ending for most states on June 30). The lower 2023 fund-balance projections included tax rollbacks but not the increase in revenues many states have been experiencing. While not all states would necessarily have to tap their reserves in the event of a recession, having a robust rainy day fund is a helpful tool many states rely on to manage fiscal uncertainty.
State ratings
During the first quarter of 2023, Illinois was upgraded by S&P to A- from BBB+ and by Moody’s to A3 from Baa1. Both agencies assigned stable outlooks, while Fitch changed the outlook to positive from stable on its BBB+ Illinois state rating. S&P noted Illinois' commitment and execution to strengthen its budgetary flexibility and stability, supported by an accelerating repayment of its liabilities and the rebuilding of its budget stabilization fund to decade highs. On the negative side, S&P pointed to a slowing of statutory pension-funding growth. Moody’s also noted the improvement in metrics and observed that challenges include heavy long-term liability and fixed-cost burdens that constrain the state's financial flexibility and contribute to a weak financial position compared to other states.
The state has come a long way from the low BBB ratings in 2017. That period followed a decline from low AA ratings in 2009 resulting from poor budgeting and expanding liabilities. Illinois remains the lowest-rated state and continues to have one of the worst-funded pension systems despite the progress that it has made.
In early April Moody’s and Fitch upgraded New Jersey’s ratings to A1 and A+, respectively. S&P followed shortly thereafter with an upgrade to A from A-. NJ had endured a string of downgrades to the BBB category due to poor budgeting and pension underfunding. The upgrades reflect better budget management and progress in reducing NJ’s pension liabilities. New Jersey, like Illinois, also happens to have one of the worst-funded pensions of the 50 states.
S&P raised the outlooks on the ratings of the states of Kansas (AA-) and Louisiana (AA-) to positive from stable. The improved outlook for Kansas reflects improved budgeting and growing reserves. Louisiana’s trend to positive is based on the state's significantly improved reserve balance, including funding of a new reserve account coupled with improved pension-funding discipline.
New York City was upgraded to AA from AA- by Fitch, with a stable outlook (state AA+). The upgrade recognized the city’s improved financial foundation coming out of the pandemic, which places NYC in a much stronger position to manage through future economic downturns, including near-term challenges resulting from an expected deceleration of revenue growth.
The rating is in line with that of Moody’s and S&P at Aa2 and AA, respectively; and both have stable outlooks. The New York City economy is, of course, a big driver for the economy of New York. The state is rated AA+/Aa1/AA+ by Fitch, Moody’s, and S&P, respectively.
Muni supply
Muni supply of $391 billion in 2022 lagged almost 20% below 2021 supply, and by some estimates 2023 supply is on track to be down another 10% to 12%. Rapidly rising interest rates are the biggest culprit. Not only do municipalities not want to borrow for projects at higher rates, but their ability to refinance higher-rate debt with tax-exempt bonds been disallowed since the Tax Cut and Jobs Act of 2017. There have been consistent efforts by the municipal bond community to convince Congress to return to using advanced refunding bonds. On March 28, the Investing in Our Communities Act was introduced in the House. The legislation would reinstate tax-exempt advance refundings. The bill was sponsored by House Ways and Means Committee Member David Kustoff (R-TN), and House Municipal Finance Chair Dutch Ruppersberger (D-MD). For more detail on this bill, you can view bdamerica.org/news-items/dc-update-legislation-to-reinstate-tax-exempt-advance-refundings-introduced-in-house.
At Cumberland Advisors we are active managers generally utilizing a barbell structure to adjust our duration depending on our interest rate and credit market outlook. The barbell looks to include both shorter-maturity and longer-maturity bonds in a portfolio. We utilize high-quality munis with an average rating of AA, because their ratings generally change less and have more liquidity in the market than lower-rated bonds do. We try to seize opportunities to take advantage of dislocations in the marketplace. For example, short-term Treasurys are yielding much more than comparable munis, so we may invest in short-term Treasury securities or even taxable munis in tax-exempt accounts. At other times, we may put tax-exempt munis in a taxable account. In these uncertain times, with increased volatility and expectations of credit weakening, we remain predominantly invested in AA munis.
Patricia Healy, CFA, is senior vice president of research and portfolio manager at Cumberland Advisors. She is part of a team that conducts portfolio construction, analysis, trading and research for both tax-free and taxable bond accounts. She has extensive fixed-income credit analysis experience, including working at credit rating agencies, banks and investment-management firms.Contact her at feedback@cumber.com or 941-926-6279.
This article originally appeared on Sarasota Herald-Tribune: PATRICIA HEALY: It may be time to extend the maturity of investments
