Week of 5/2/2022

Wall Street Mulls Municipal Bond Losses, Valuations… U.S. Economy Slows…California Surplus Grows… New York State Rating Upgrade…Robust Reserves Boost State Flexibility…Supreme Court Upholds SALT Cap… Lawmakers Seek Lower Fuel Prices…

Wall Street Mulls Municipal Bond Losses, Valuations… Divided on how to approach the municipal bond market, which has lost 8.7% this year per index returns, some Wall Street strategists are optimistic that a turnaround is near, while others believe it could take longer. Mid-year, a time when investors seek to reinvest cash coupon and principal payments lends strength to the municipal bond market, while tax season selling during March and April brings weakness, historically. In April, 7.5% fewer municipal bonds were issued. This month’s tax-free bond volume will fall short of reinvestment potential by $9.5 billion, Citigroup added “May is expected to bring a significant uptick in technical support, after two months of negative cashflow.” Bank of America strategists are optimistic that “a reversal should be around the corner as we leave April behind.” Outflows from municipal bond funds have continued for eleven straight weeks, bringing speculation that the outflows from the $3.9 trillion municipal bond market could be “closer to the end” if inflation has peaked. State and local government bonds are cheapest since November 2020 on a relative basis with the thirty-year benchmark tax-free bonds yielding about 106% of comparable- maturity Treasuries. All eyes are on bellwether 10-year U.S. Treasury yields as an aggressive rate hike of 50 basis point is widely anticipated this week, along with Federal Reserve shrinking its balance sheet. A Schroders PLC analyst stated “There’s still potential for more pain in the muni market.” There is no question that the credit quality of states and local governments is the strongest in recent years.

U.S. Economy Slows… U.S. GDP shrank 1.4% in the first quarter of 2022, defying consensus forecast of 1% growth and significantly down from 6.9% growth prior quarter. The GDP decline coincided with an accelerating rise in prices, termed as ‘stagflation’. The Fed’s preferred inflation measure, personal consumption expenditures, rose 7%, when its target is 2%. Despite strong personal consumption and business spending, GDP was pulled lower by a growing trade deficit, which hit a record high in March as import volumes and prices surged. The slowdown comes as the Federal Reserve embarks on aggressive tightening of financial conditions. U.S. growth is threatened by the highest inflation in 40 years as the Russia-Ukraine war has exacerbated commodity prices. New COVID-19 related lockdowns in China foretell persistent supply chain issues. This is the first economic decline in the United States since the pandemic lockdowns in mid-2020.

California Surplus Grows… An unprecedented discretionary surplus of $68 billion, almost double of last year’s level, takes the Golden State from strength to strength. Soaring tax collections have led California revenue to outperform expectations by 12.5%. Lawmakers are seeking to keep a large chunk of the surplus in reserves as a cushion in economic downturns. Newsom, a first- term Democrat running for re-election this year will present a budget in mid-May. Notwithstanding a massive surplus, lawmakers are looking at several plans to hike taxes on wealthy Californians. To pay for climate change and public health, two new personal income tax surcharges on Golden State millionaires could feature at the November ballot. California general obligation bonds yield about 3.3% tax-free for 30 years, equivalent to over 5% taxable yields for higher tax brackets.

New York State Rating Upgrade… Moody’s lifted the rating of New York State to ‘Aa1’ from ‘Aa2’, one notch below ‘Aaa’. Governance and ‘agile financial management’ scored high marks from Moody’s. The Empire State has bolstered reserves and projects balanced budgets for the next five years. “The state’s moderate leverage will allow it to absorb some increased debt for its own needs and those of the MTA, and various budget management tools that provide financial flexibility will enable the state to achieve budget balance if developments cause the state’s revenue and spending trends to diverge from the baseline,” Moody’s added. Governor Hochul stated “These upgrades show the strength of New York’s financial management as we continue to build back stronger than before.”

Robust Reserves Boost State Flexibility… Heading into an economic slowdown, state rainy day reserves will be stronger than what they were pre-COVID-19. 25 U.S. states forecast reserve levels of at least 10% of expenses, compared to only 19 meeting this threshold in Fiscal 2019 per National Association of State Budget Officers. California’s reserves are well over 25% of its expenses, while Florida’s reserve levels are close to 40% of expenses. In Connecticut, reserves will handily exceed the statutory cap, and excess reserves to the tune of $2.6 billion could be available for supplemental pension payments. New Jersey expects ending reserves to be at 8.6% of appropriations at the end of Fiscal 23, a material improvement over historical levels closer to 4% or less. U.S. GDP growth is expected to be slower, about 3.2% in 2022 and 2.1% in 2023, S&P forecasts. In the wake of inflation hitting generational highs, state revenues have largely been reported as better than forecast and have remained strong. As federal aid money tapers off and interest rates climb, state revenue growth could wane. Higher reserves will be important for all U.S. states, particularly those depending on economic growth for budgetary balance.

Supreme Court Upholds SALT Cap… United States Supreme Court has taken a stand on the SALT Cap, a divisive issue that has roiled politicians and HNWs. The nation’s top court declined to review a petition by New York, New Jersey, Connecticut and Maryland that sought to end $10,000 caps on deduction of state and local tax (SALT) from itemized federal tax returns. States’ petition claimed that tax-deduction cap amounted to congressional overreach and an infringement of states’ rights to set taxes. Attorneys general for four states argued that “a deduction for all or a significant portion of state and local taxes is constitutionally required because it reflects structural principles of federalism embedded in the Constitution.” A repeal of the SALT cap could reduce federal tax revenue by $620 billion between 2018 and 2028 per the Tax Policy Center. The top 1 percent of U.S. earners, those making $755,000 or more, would receive over half of any SALT cap repeal. The White House’s recent $5.8 trillion budget plan didn’t propose relief from the SALT cap.

Lawmakers Seek Lower Fuel Prices… The U.S. House hopes to vote on gasoline price bill in the coming weeks. To counter high inflation, Democratic lawmakers are pushing to beef up Federal Trade Commission’s ability to stop gas price manipulation. A U.S. House panel held a hearing to chide Big Oil for price gouging after the Ukraine war- related surge in crude oil price at the expense of Americans. A gas-tax holiday is on the table as well as other elements to address supply chain issues. Republicans are seeking expanded fossil fuel production domestically. Lower gas prices could score high marks from voters ahead of the November mid-term elections.

Compare 30-Year taxable U.S. Treasury yield 2.89% to 30-Year tax-exempt muni bond yield “AAA” 3.05%; “AA” 3.71%; “A” 3.87%; “BBB” 4.19%. For investors in the 35% tax-bracket, a 4.2% tax-exempt yield is equivalent to a 6.4% taxable yield. Top rated tax-free bonds yield 106% of comparable taxable U.S. Treasuries.