Week of 8/15/2022

Inflation Begins to Cool…Inflation Expectations Fall… Central Bankers Commit to Rate Hikes…Chicago Budget Gap Narrows…MTA Congestion Pricing Advances… Positive Near Term Outlook on Unrated Island Bonds…

Inflation Begins to Cool… July Consumer prices were unchanged from a month ago. Led by lower fuel prices, the surge in consumer price index simmered down to a 8.5% year-over-year growth, down from a June peak of 9.1% price gains. Recession fears have pummeled the price of gasoline to under $4 a gallon, down 20% from a June peak. U.S. gasoline demand in recent four weeks has dropped 6% from a year ago per Energy Information Administration. The federal government has lent more supply via strategic petroleum reserves. Energy costs are still high and contribute 3 percentage points to year-over-year growth CPI growth. Core prices, which strip out volatile energy and food costs, were below forecast and rose 0.3% in June and 5.9% relative to a year ago. Goods inflation is slowing, reflected in lower used car prices and airfares. Fewer Americans are planning big-ticket purchases, a contrast from last year when sales outpaced inventories which drove up goods prices. Since then, congestion at U.S. ports has eased significantly and freight costs have dipped. However, services prices are stubbornly high as the U.S. labor market has lost seven million workers relative to pre- COVID-19 levels. High rents, which contributed 1.9% to July CPI, are an outcome of lower home affordability. With both consumer and producer prices in July lower than expectations, investors are looking for more signals to see if inflation has peaked.

Inflation Expectations Fall… An early indication that headline consumer prices could fall in August comes from lower prices at the pump. Encouraged by lower gas prices, the median expected year-ahead inflation rate fell 0.2 percent points to 5 percent in August. That is the lowest reading since February, but still above the level of 4.6 percent registered 12 months ago. Median long run inflation expectations, at 3 per cent, remained in the range of 2.9-3.1 percent, which is where it has been for the past year, per a University of Michigan survey. A separate survey by the Federal Reserve Bank of New York finds that expectations for future inflation have recently declined.

Central Bankers Commit to Rate Hikes… “Inflation is too high but it is always important to start seeing it come down a little bit,” San Francisco Fed president Mary Daly said there is a case for a smaller rate hike of 50 basis points in September. Chicago Fed president Charles Evans echoed that inflation is “unacceptably high”. Minneapolis Fed president Neel Kashkari seeks a 4.4% fed funds rate in 2023, although bond markets expect a peak fed-funds rate of 3.5% by mid-2023. “What you try to do is try to get inflation down on a sustained basis, and then you have the freedom to loosen,” Richmond Fed president Tom Barkin added “If you can get to our target for a number of months, that’s what we would like to see.” The Federal Reserve is staying on its path of aggressive rate hikes for now. Fed Chair Powell has confirmed that it would make decisions ‘meeting by meeting’. By the time the Fed meets next in September, additional readings on inflation and unemployment will be at hand. Traders now see a 50-basis-point rate increase next month as more likely than 75 basis points earlier estimated.

Chicago Budget Gap Narrows… Progress towards structurally balanced finances is evident as Chicago faces the smallest budget gap in years. Heading into budget talks, Chicago has a $128 million budget gap in Fiscal 23, much lower than earlier forecast. Fiscal 23 budget shortfall was forecast to be $306 million in May-22 and was estimated to be as high as $867 million a year ago. Last year, Chicago closed a $733 million Fiscal 22 budget shortfall. It now expects to end Fiscal 22 with a $130 million surplus, a cushion for next year’s spending. Chicago revenues are expected to grow in Fiscal 23, but could decline 2.4% in 2024 leading to larger future shortfalls. Chicago plans to use $152 billion of America Rescue Plan funds in Fiscal 23. Chicago will look to close the budget gap through cost savings, financial reforms, and a tax-increment financing surplus declaration that could also boost Chicago Public Schools. City Council will weigh on Mayor Lightfoot’s call to hike property taxes by 2.5%, which is well below the 5% annual cap. Chief Financial Officer Jennie Huang Bennett described the gap as “very small” compared to the corporate fund budget of more than $5 billion. “It’s an imminently, you know, achievable gap for us” to close.

MTA Congestion Pricing Advances… If approved, New York City could be the first U.S. city to adopt congestion pricing. A $23 toll for driving in Manhattan’s central business district during peak hours is recommended by the Federal Highway Administration. The new tolls could boost transit ridership by 2% and bring in about $1 billion incremental revenue for MTA. MTA faces a $2.6 billion budget shortfall in 2025, when COVID-19 related federal aid runs out. “Unless there is an additional influx of city, state or federal aid, the MTA is facing stark options for closing its budget gaps that will impact riders,” New York State controller said. Farebox revenue covers only 30% of MTA operating costs, down from about 50% pre-COVID-19. Congestion-based new tolls are central to MTA’s $51 billion multi-year capital plan, which includes a toll revenue secured $15 billion bond financing. With federal approval, the MTA board could adopt the new tolls that could be implemented in 2023. MTA CEO said, “We are now moving forward quickly to get this historic program up and running.” MTA is a regional economic engine. Tri-state governors are likely to provide crucial feedback on the toll plan.

Positive Near Term Outlook on Unrated Puerto Rico Bonds… The largest bondholders carry a positive outlook near term on the Island’s newly restructured general obligation bonds that are unrated. Tax collections have outperformed, the Island economy has expanded every month since March 2021, and unemployment is the lowest in at least 46 years. There are risks such as the eventual fading of the federal oversight board which ensures that Island budgets are balanced. “Those are all very valid and important things to be watching over time,” a Nuveen portfolio manager added “But in the near term, the fundamental momentum is very strong and the willingness of the federal government to continue to support Puerto Rico is very strong.” PIMCO echoed, “In most cased the fundamental credit quality actually improves as an entity goes through bankruptcy. This is very much true in the case of Puerto Rico.” Over 75% of Puerto Rico’s newly restructured general obligation bonds are held by mutual funds. Higher yields of Puerto Rico bonds have not gone unnoticed. High-yield Puerto Rico bonds are down 7.9% this year compared to a 6.7% decline in the broader higher-quality muni market. Having gained 4.7% in July, high yield Puerto Rico bond gains have continued in August.

Compare 30-Year taxable U.S. Treasury yield 3.10% to 30-Year tax-exempt muni bond yield “AAA” 2.98%; “AA” 3.49%; “A” 3.90%; “BBB” 3.72%. For investors in the 35% tax-bracket, a 3.7% tax- exempt yield is equivalent to a 5.7% taxable yield. Top rated long-term tax-free bonds yield 96% of comparable taxable U.S. Treasuries.