Changes in tax policy (federal, state and local), tariffs and market volatility were key defining features of 2018 that will continue to reverberate in 2019.  Understanding when these changes hit the budgets and planning cycles of both government and private sector highlights what we are in for over the next few months.  In this context, some key dates in March (think end of federal debt ceiling suspension, 90-day tariff deadline and Brexit) are likely to foretell a bumpy spring and summer.  We take these in turn.

Tax Policy and Municipal Bonds

The loss of advance refunding in the Tax Cuts and Jobs Act (TCJA, signed in December 2017) has affected overall volume in the market, being down 22% in 2018 over 2017.  But this only tells part of the story.  Anticipation of the change led to a surge in borrowing in the final quarter of 2017 ahead of TCJA implementation and, at the time, the fears that private activity bonds too would be eliminated. 

Loss of the deduction of state and local taxes (SALT) above $10,000 created distortions as well.  Taxpayers pulled forward tax payments into 2017 which led to a surge in revenues for state and local government in spring 2018, on a cash basis.  This is a one-time event, so investors should watch what state and local governments do with their bounty.  (For example, expanding recurring spending with one-time revenues is not a good idea while investing in infrastructure and other one-time improvements is likely to offer better long-term benefits.)

We point to a useful analysis of these timing changes from Lucy Dadayan, formerly of Rockefeller Institute and now with the Tax Policy Center.  Analysis of the potential impact of the loss of the SALT deduction by the Government Finance Officers’ Association and other major state and local organizations can be found here. 

Happily, many states added to their “rainy day funds” over 2018.  (See discussion from Brian Stiglitz of the National Association of State Budget Officers here.  PewTrusts also studies state rainy day funds here, but primarily focussed on 2017, which misses the big tax revenue surge in 2018.)

Further, reduction in the corporate tax to 21% has led to a pronounced reshuffling of holders of municipal bonds away from banks.  From Q4 2017, U.S. Chartered Depository institutions unloaded nearly $40 billion in municipal bonds.  A drop of 29% in private placements is also indicative of the loss of value in underwriting transactions directly for banks. On the other hand, property and casualty and life insurance companies were affected by lower tax rates but these two classes of muni investors modestly increased holdings by about $9 billion and $3 billion respectively. 

Timing

The influence of tax reform on state and local budget-making, much of which takes place in spring for July 1st fiscal years will be tricky going into FY2020.  Budget estimators will need to decide how much of the 2018 impact (FY2019) was due to the tax code changes and how much due to a steadily improving economy.   

We do not expect much certainty or help from the federal government in this process. Congress and the White House appear to be operating in two ways: lurching from month to month with short term agreements and limited resolution of key policy issues (think healthcare, disaster management such as flood insurance or dare we say, infrastructure?)  or hitting a wall of gridlock — such as the current government shutdown.

Tariffs (and the government shutdown)

The latest Federal Reserve Beige Book (released December 5, 2018 but covering data through November) mentions tariffs 39 times.  Mostly, interviewees found that the cost of inputs in manufacturing and other sectors of the economy have gone up, but those costs have not yet fully made their way to higher prices for consumers. For example, companies in the Richmond district reported “Manufacturing and services firms saw a sharp increase in input prices, which were attributed to tariffs, shipping costs, and some higher business-to-business and recruitment costs.” (p.2)

Effects, however, are expected to spread from manufacturing inputs to end users such as retail consumers and food and drinking establishments going forward.  The report stated, “Looking ahead to 2019, retailers expressed significant uncertainty about the impact that tariff increases will have on prices –beyond some point, they will pass the increases on to consumers… Massachusetts restaurant menu prices were up 2.6% from a year ago.” (p.A-2)

What does this mean for the municipal market investor? Unless, and until the trade war with China is resolved in a satisfactory manner, we could see lower sales and income tax revenues in Q1 2019.  In addition, given the slowdown in the Chinese economy, there is reduced hotel and various entertainment related activity from venues that cater to Chinese tourists.  On Bloomberg radio, Jan. 1, Bert Flickinger, Managing Director at Strategic Resources Group, commented that tariffs would have a major effect on “gateway cities” and that “stores and shoppers will be paying more in 2019”.  He is already seeing Chinese luxury shopping in decline.  In this context, Apple’s announcement of lower than expected sales in China is not surprising.

In addition, the government shutdown has stressed many federal employee budgets, curtailing spending by some 800,000 workers (380,000 estimated furloughed and 420,000 essential employees working without pay). When the shutdown began, employees were initially given boilerplate language they could bring to their creditors to ask forbearance.

Whichever way the tariffs and the shutdown ultimately play out in Q1 2019, these man-made events add sand in the gears of the economy’s slow and fragile recovery.

Market Volatility

Here too, timing of the capital market’s ups and downs is critical to what’s in store for 2019.  As most states and local governments were putting their FY 2019 budgets to bed in July 2018, capital markets were still in a happy place.  As losses from October through December roll through investors’ holdings, a number of negatives are likely to emerge.

  • First, public pension funding levels, also subject to market volatility and returns are likely to suffer as losses fail to meet most plans’ 7% earnings targets. 
  • Second, income and capital gains taxes are likely to be weaker than expected. 
  • Finally, Opportunity Zone investments, created in the TCJA and motivated by the offer of federal capital gains credit (which idea was born during that happy time in the capital markets) are likely to be less robust than expected.   At least some of the end-of-year sell-off is attributable to investors taking losses to offset capital gains, leaving less need to shelter gains in Opportunity Zones.

A Few Key Dates

  • March 1 is the end of the 90-day agreement to suspend a third batch of tariffs the president and his men have proposed.  Whether there will be an agreement, a further postponement or whether the tariff hard-liners prevail is tough to predict.   Needless to say, this perpetuates an uncertain business operating environment and volatility in capital markets.
  • On March 2, suspension of the debt ceiling expires.   As we have become used to, “extraordinary measures” may postpone a federal liquidity emergency for a number of months, perhaps into summer or fall, depending on cash flow strength. On the other hand, weaker income taxes at the federal level, higher borrowing needs to meet a $1 trillion federal deficit and the need to pay taxpayer refunds may shorten the liquidity window.
  • A hard Brexit happens on March 29 if there is no agreement on an exit plan by Parliament.
  • Many financial economists see an inverted yield curve in the near future, and econometric studies at least, show this event as a precursor to recession.
  • There’s more, with perhaps less headline visibility but economic impact nevertheless.  For example, the deduction of medical expenses that were greater than 7.5% of adjusted gross income reverted to 10% on December 31st. 
  • Sequestration for the federal 2020 and 2021 budgets returns on October 1st. 
  • And then there’s the package of remaining tax benefit “extenders” that seem to get retroactively renewed each year – like trick candles on a birthday cake. 

Municipal Market, on the Brighter Side

On the bright side, state and local governments are picking up the flag when it comes to infrastructure improvements and solutions. Bond market volume was up 16% in 2018 for infrastructure borrowing at the state and local level, which is economically stimulative.  We expect new money volume to grow going forward.

In November, (outside the Beltway) voters approved bond issues and tax hikes to maintain and improve the quality of life in their communities. Notably, voters approved measures to solve problems of homelessness and unaffordable housing – which portends more bond volume to come.  In San Mateo, California, for example, voters approved a unique $33 million bond issue by 60%.  Proceeds will be used to build 100 below-market rental housing units for teachers and staff for the Jefferson Union High School District. The bond issue won the Bond Buyer’s “deal of the year” award in the smaller issuers category.

As the Denver Post reported, voters there approved several tax increases, including sales taxes to support both parks and mental health services.  San Francisco’s voters passed Proposition C to provide funding for the homeless.  Mountain View voters, where Google has its home, approved a “head tax” to pay for affordable housing and transportation improvements.  In contrast, Seattle reversed a head tax that was intended to fund projects to help reduce homelessness.  You can read about this unusual reversal (think Amazon) here.  California voters rejected a state measure to roll back gas tax increases that were approved a year ago.  California voters also rejected a proposal to lower property taxes for seniors while Louisiana voters approved property tax hikes. 

Relative Value

Revenue growth is favorable for continued credit quality in state and local governments.  While the municipal market does typically follow treasury rallies and losses it has been less reactive to federal reserve policies over the last 18 years – offering better yields for investors such as 4% on a taxable equivalent basis.  The taxable municipal market, which mirrors the credit strengths of tax exempt bonds, has been yielding more than treasuries, providing safe opportunities for investors that aren’t looking for the tax exempt provision.  We link to a recent blog post from The Rieger Report that clearly lays out the case for relative municipal performance.  In sum, lower supply and good demand may bend the curve somewhat but on a relative basis the muni market remains quite attractive.