Who imagined that the supply chain that feeds, clothes, shelters, and transports us would be subject to this sequence of events over less than half a decade? We did a “Google Trend” search on the term “unprecedented” and found the peak frequency during the week of March 15, 2020 when the potential impact of COVID-19 pierced our collective imagination and financial markets gyrated. In June, 2021, the Bureau of Labor Statistics wrote an article captioned: “COVID-19 ends longest employment recovery and expansion in CES history, causing unprecedented job losses in 2020.” (CES stands for the Bureau’s collection of Current Employment Statistics). In 2018, ten years after the Great Recession, Standard and Poor’s wrote: “When the Credit Cycle Turns, U.S. States May Be Tested in Unprecedented Ways”. Little did we know.
Tariffs that were imposed in the last presidential administration were largely kept by the current administration. These have served to increase costs here in the US and weaken international trade relationships. The COVID-19 pandemic reduced demand for gasoline in the US by 50%, idling supply for months, followed by Russia’s unprovoked war of destruction in Ukraine. Sanctions on Russia and abject destruction of production capacity in Ukraine have disrupted global agriculture serving the middle east and northern Africa and energy resources going to the EU and elsewhere. If this seems remote, it’s not. Hunger has a way of destabilizing the political map and diverting time, attention, and financial resources away from other issues.
These events have occurred against a backdrop of extreme weather events that destroyed homes and productive capacity. Forecasts are for a continuation of these extremes.
Remarkably, on the positive side, state and local governments have maintained their credit quality. Fixed income interest rate hikes will reduce bond valuations for current holders but may create buying opportunities for those with cash to deploy in the coming months. Favorable efforts to “bring production home” will eventually increase jobs and taxable values.
We review these unprecedented events with an eye on supply/demand impact on state and local financial conditions and cover both markets and credit. We end with a brief discussion on the Infrastructure Investment and Jobs Act (IIJA).
The Cost of Tariffs
Tom Lee and Jacqueline Varas wrote in an article for the American Action Forum: “Trade barriers such as tariffs increase the cost of both consumer and producer goods and depress the economic benefits of competition, inhibiting economic growth.” Best known were the tariffs that the last presidential administration imposed on imported steel and aluminum from China but also other producing countries around the world. President Biden has replaced “tariffs on European steel and aluminum and Japanese steel with a ‘tariff-rate quota system’ but has kept in place the tariffs for most other countries, including China”. Lee and Varas estimated that these tariffs “increase consumer costs by roughly $51 billion annually” in their March 24, 2022 analysis. The US Geological Survey showed that the US increased raw steel production from 73 to 87 million metric tons from 2020 to 2021. In contrast, China’s production grew from 1,060 in 2020 to 1,100 in 2021, comprising nearly 60% of global production. India and Japan each produced more than the US, while Russia and Ukraine combined produced 94 million metric tons of raw steel, or 5% of the global total in 2021. Based on three National Bureau of Economic Research studies (here, here and here) and Lee and Varas’ analysis, the US consumer paid 100% of the increased costs.
Enter COVID
In addition to the drop in gasoline usage, auto manufacturers were unable to buy chips for new cars beginning in April-June 2020 when the pandemic hit according to Chad P. Bown in a presentation to the Peterson Institute for Global Economics, “Global Economic Prospects: Spring 2022”. At that time, demand for semiconductors shifted over to computers, communication devices and other consumer usage. Bown also noted that following imposition of tariffs on China in July 2018, US imports from China fell from 57% to 43%. The Texas freeze at the beginning of 2021 also disrupted semiconductor manufacturing. Climate concerns led BP and Exxon to curtail investing in more carbon production. China’s recent COVID lockdowns have affected telecom equipment, semiconductors, and other electronics.
COVID also prompted a migration from dense urban areas to less dense cities, suburban and exurban communities. This migration prompted demand for automobiles (and dogs for pets), durable goods and housing – each of which were in short supply (maybe dogs were plentiful, not sure).
State and local government revenues have seen unexpected growth from internet retail sales and property value growth from demand for housing that exceeds supply. Despite the succession of unprecedented crises in the US and globally, state, and local government finance has persevered, with pockets of strong performance. States and local governments entered the COVID period with adequate rainy-day funds. Following the onset of COVID, who would have predicted that sales taxes would soar? The combination of Wayfair decision that allowed state and local governments to charge sales taxes on internet purchases plus a sudden need to outfit work-from-home and school-from-home spaces, along with much-needed streaming entertainment contributed to the surge. As most readers know, we shifted from buying services and experiences (travel, concerts, restaurants, etc.) to goods purchases. Unprecedented demand for goods plus labor shortages have clogged our ports, as is well-known.
Whither Climate Adaptation and Mitigation?
Before COVID and the war in Ukraine, the US (and EU) were on a trajectory to reduce fossil fuel consumption in favor of renewable resources. Financial markets have moved to implement ESG (environment, social and governance improvements in alignment with the “Principles for Responsible Investing”). Reducing carbon emissions have been a major imperative promoted by the UN IPCC and many other groups, under threat of more frequent extreme weather events, sea level rise, and a diminution of the quality of life in many locations around the world. (For more on this topic, see the following.). Although tariffs had already begun to create semiconductor shortages, production of electric vehicles (EV) and hybrids had already taken root and efforts to reduce fossil fuel consumption by many companies, institutions and individuals were making progress.
Now it appears that carbon emission reduction has taken a back seat to ramping up oil and gas production to help lower the cost of gasoline. The President recently announced a waiver to allow mixing 15% ethanol into gasoline between June 1 and September 15. Administration officials expect a savings of 10 cents/gallon. This mix was previously restricted during summer months over concerns that it increases smog in the heat. Corn producers in Iowa are happy.
But Extreme Climate Events are Increasing in Frequency and Severity
Over several months in the spring of 2019, damaging floods in the Midwest affected nearly 14 million people. (See New York Times visualization from September 11, 2019; there might be a paywall.) The article quotes the National Oceanic and Atmospheric Administration (NOAA) Water Center director as what lay ahead was “potentially unprecedented” … even worse than the Great Flood of 1993. In 2019 there were 14 events exceeding $1 billion. Damage from continuous flooding occurring in the Midwest were estimated to cost more than $6 billion. Timing of the storms affected the planting season across the agricultural Midwest and headquarters of the US Strategic Command, located in Nebraska, saw flood waters rise to seven feet deep.
Hurricane Uri hit Texas in early 2021 with an unprecedented ice storm that narrowly escaped a complete breakdown in the state’s energy distribution system. The state is now preparing a $3.4 billion securitization to address and smooth out the spike in energy costs from last year. Unlike the rest of the US, Texas operates its own electric grid (ERCOT, or Electric Reliability Council of Texas) and perhaps suffered the largest problems from the storm. Oklahoma is expecting to issue $3 billion of taxable debt in the next few months, and Louisiana and Arkansas have passed securitization laws for similar reasons. These borrowings are designed to provide cost recovery for the utilities that were affected. In a report authored by energy technology company, Intelometry, (funded by NRG) (as reported in the February 28, 2022, Bond Buyer) 67 investor-owned utilities and cooperatives (excluding members of ERCOT) have requested nearly $14.5 billion cost recovery from the state Public Utilities Commission. After Texas, the next largest cost recovery request comes from utilities in Oklahoma which seek $3.1 billion cost recovery. Kansas utilities have requested more than $1 billion. Standard and Poor’s lowered ratings on about half the utilities that are members of ERCOT because of the storm and yet-to-be-demonstrated winterization as well as market volatility protection.
When Hurricane Ida caused catastrophic damage stretching from Louisiana to New Jersey, in September 2021, the Bond Buyer wrote, “Ida’s Floods Unprecedented for Northeast, but Likely will be Replicated”. Quoting David Rosenblat from the New Jersey Department of Environmental Protection, “It may be a different animal… but it’s the animal it’s going to be in the future.”
We agree. Forecasts for the upcoming hurricane season, (June 1-October 31) are above average with between 19-22 “named storms” expected. (For more detail, see article here)
War in Ukraine
Ukraine and Russia account for 30% of the world’s exports of wheat, 19% of corn and 80% of sunflower oil. Ukrainian wheat exports have supplied Egypt, Indonesia, Bangladesh, Turkey, Tunisia, and Lebanon. Egypt and Turkey import 70% of their supply of wheat. Russia and Ukraine combined produce 70% of the world’s neon, which is used in the production of semiconductors. Ukraine halted production of neon gas after the Russian invasion. One of the companies is located in Mariupol and previously exported to Taiwan, Korea, China, Germany and the US “with 75% going to the chip industry” according to Siliconrepublic. We note that the remaining Ukrainian population in Mariupol has been sheltering in a steel manufacturing plant. The second neon plant is in the port city of Odessa, currently under attack. If Odessa experiences the same horrific destruction as Mariupol, these companies could go under, and chip prices could rise further. The Odessa plant produced highly purified neon gas, necessary for lasers to etch design into silicon wafers. China is a producer of neon as well, however lockdowns due to COVID have created further disruption. According to the Siliconrepublic report, major producers such as TSMC, Samsung and Intel tend to have strong reserves of stock necessary for production. However, a protracted “hit to the supply chain arising from the Ukraine conflict could prove detrimental to their businesses too.” An earlier article from Fortune Magazine just ahead of Russia’s invasion of Ukraine, detailed the range of other elements that serve as inputs to semiconductors.
In January, Intel announced plans to invest $20 billion in Ohio for two new chip factories. This project is expected to create 3,000 jobs at the plants with 7,000 construction jobs during the build out period. Production is expected to come on-line in 2025. Unlike most other states, Ohio many local governments levy income tax so these communities stand to benefit from higher revenues. According to the announcement, this will be the home to Intel’s first new manufacturing site in 40 years. Intel also plans to invest $100 million in partnership with Ohio’s universities, community colleges and the National Science Foundation to build a pipeline of of people with expertise to serve the plants and ancillary activities. There is one significant caveat, “The scope and pace of Intel’s expansion in Ohio, however, will depend heavily on funding from the CHIPS Act.”
The CHIPS Act has not yet reached the President’s desk although the Senate first passed the legislation last June. The House passed its version at the beginning of February and is only now organizing the conferencing of differences with the Senate. The White House says funding is an urgent national security concern.
The price of fertilizer, which relies on natural gas for production, has skyrocketed, affecting the cost of agricultural production. According to Bloomberg, Russia and Belarus represent the second and third largest producers globally (China is fourth). Brazil is the largest importer of fertilizer and exports soybeans, coffee, and sugar products. Standard and Poor’s recently upgraded the bonds for an Iowa fertilizer plant to investment grade, based on “high selling prices amid strong market conditions”.
China is purchasing more gas and wheat from Russia, dampening the impact of sanctions.
Inside and Outside the Beltway – Infrastructure Investment and Jobs Act
We are skeptical that the roll out of the IIJA will produce the rosy growth that some are expecting in municipal bond volume, or even contribute to exuberant GDP growth. The $1.2 trillion Act includes $550 billion new money and was passed in November 2021; funding was not approved until March 15th. The American Traffic Safety Services Association noted that states just received authorization to start spending on April 1st. States have until August to obligate their funds for projects. However, US DOT, charged with handling discretionary grants and appropriations is short-handed and seeking to hire more than 1,000 personnel. Just this week, the White House issued guidance on IIJA and other federally funded infrastructure projects. The guidance follows an earlier federal “Build America, Buy America” approach. That means materials used to build infrastructure must be made in the U.S. or a waiver must be applied for and approved by the Executive branch.
Unlike prior stimulus programs, IIJA funding flows through states and not directly to local governments. Aside from sluggish roll out at the federal level, the states must gear up to manage and process distribution to local governments and special authorities. Here too, there are staffing shortages. Plus, in our hyper-partisan environment (and leading up to mid-term elections) some state governors and legislators have adversarial relations with their local governments. We question whether funding will ultimately get to the neediest projects at the local level in the amounts necessary to make a difference. Not to heap on more troubles, broadband expansion to rural areas, construction of EV charging stations could see some “white elephants” as chip shortages are likely to continue for some time – perhaps beyond the five-year distribution period of IIJA. We would not be surprised to see recissions of unspent IIJA monies, should Republicans achieve a “trifecta” of control over the presidency and both houses of congress.
Further, the cost of construction materials has gone up, making cost estimates and timelines for grant applications uncertain for applicants. For just one example, in 2021, lumber prices grew from $370/thousand board feet to $1700, before falling back slightly. Given inflation in housing values and facing a likely economic slowdown, we would not be surprised to see ballot initiatives to cut or limit taxes crop up.
Elsewhere, the federal government is funding three public-private-partnerships (P3) projects through the Army Corps of Engineers. These include restoration of eco-systems in Denver, Los Angeles and the Port of Brownsville Texas. The IIJA provides funding to complete the Fargo-Moorhead diversion project to alleviate chronic flooding and overflow from the Red River.
Rates and the Municipal Bond Market
In each of 2021 and 2020, total municipal bond volume topped $480 billion, some of which was driven by greater taxable issuance, given tight spreads across taxable and tax-exempt interest rates. It became possible, following the loss of tax-exempt advance refunding, to accomplish refinancing with taxable bonds. Higher rates have now made this approach uneconomic in 2022 and overall issuance has been down during the first three months. January 2021 was down by 10% over January 2020, February down 19% year-over-year and March down 18% YOY. As is often the case when primary market volume is sluggish, secondary market volume picks up. We note that Q1 secondary market trading volume was up year-over-year 20% in January, 18% in February and 44% in March. We also note that use of bond insurance was up in 2020 and 2021 (7% and 8% of total volume) from prior years, perhaps reflecting investor worries about the multiple crises we have been discussing. This compares with an average of 5% from the prior seven years.
Central bankers have acknowledged that climate change could create financial instability. SEC Chair Gensler is asking corporate borrowers to start reporting climate risk in their financial statements. While the SEC cannot order municipal borrowers to report, the Municipal Securities Rulemaking Board has requested comment on what data on climate they should be asking for from borrowers. The Texas freeze and subsequent Standard and Poor’s utility downgrades is one example of climate risk that compromised credit quality. Should more examples like this arise, we could see specific disclosure guidance.
At the federal level, rising rates increase the cost of borrowing and the deficit. The Committee for a Responsible Federal Budget estimated that the federal government will spend an average of $545 billion per year on interest payments. A 50 basis point increase in interest rates would increase these costs by $105 billion per year. “Interest rates that are two percentage points above the Congressional Budget Office’s forecast could push debt as a share of GDP up to a record 120 percent by FY 2031…”.
If there’s one major casualty to the sequence of crises, particularly war in Ukraine and sanctions on Russia, it is progress on reversing carbon emissions. Recent efforts to re-open oil rigs and gas production have rewarded states in the oil patch with higher revenues, but also reinforce the negative effects of climate change. Amped up agriculture in the U.S. breadbasket will also reward those states with increased economic activity and revenues. Fingers crossed that this storm season will defy current forecasts.
