Duration performed well in 2017 as the yield curve flattened. Treasury yields rose from 1.21% to 1.88% on 2-year notes while yields dropped on 30-year treasury bonds from 3.04% to end the year at 2.74%. The high yield sector outperformed with equities, followed by long municipals, intermediate municipals, and intermediate government and agency paper. The following table summarizes the fourth quarter returns for some major Merrill Lynch Bond Indices.
Tax Cuts: Additional Late Cycle Fiscal Stimulus
During the financial crisis of 2008-2009 the economy could have benefited from a significant shot-in-the-arm from fiscal policy. Instead, the Fed was required to do most of the heavy lifting during this time to stimulate economic growth. They cut the Fed Funds rate to zero and engaged in several aggressive rounds of quantitative easing (QE’s) which resulted in a massive increase in the Fed’s balance sheet, as well as low interest rates for several years. Now more than 9 years after the collapse of Lehman Brothers on September 15, 2008 the Federal government has cut tax rates for corporations and most individuals to get the economy growing faster. We expect these tax cuts to stimulate the economy in the short term which will cause short term rates to rise.
Will the Rate of Inflation Rise?
We expect upward pressure on prices in the near to intermediate term due to the following factors:
Our research shows inflation tends to be a late-cycle phenomenon. Since the fiscal stimulus is coming more than 8 years after the beginning of this economic recovery with the above-mentioned conditions we should see some upward pressure on prices this year. There are, however, factors which may lead to disappointing economic growth in the years ahead.
We do have some concerns about the economic outlook, and we are not as excited as the equity markets about the tax cuts. We see the following headwinds:
The recent tax cuts have created a sense of euphoria in the equity markets as investors believe the cuts will serve as a driver of economic growth. While we believe they may stimulate growth in the short term, we are concerned about the previously mentioned headwinds for the economy and their drag on economic activity.
The Effect of the Tax Cuts on the Muni Market
The recent tax bill affects the Muni market in several ways. First, refundings of tax-free issues to generate cost savings will not be allowed. This will restrict the yearly issuance of new Muni deals by as much as 25%. This reduction in the supply of bonds will create a “scarcity” of Munis. Next, the scarcity of Munis will mean tax-frees should trade at lower ratios compared to the taxable universe of bonds. For example, during the financial crisis long AAA rated 30 year Munis traded at yields of over 110% of long UST bonds with similar maturities. These ratios have already declined to about 90%, and will probably fall to around 85% during the year. This means tax-free bonds should outperform taxable bonds this year. Finally, the new limits on deducting state and local taxes on taxpayers returns will probably increase the demand for Munis. This is especially true in high tax states.
We were pleased to see the House version of the tax bill which eliminated the use of private activity bonds did not prevail in the tax bill that was passed. The massive infrastructure needs in our country can be easily financed in the Muni market. These needs have been put on hold since the financial crisis due to budget strains caused by reduced tax revenues and unfunded pension liabilities. One way to finance many of these projects is to utilize private activity bonds and Public Private Partnerships. The participation of the private sector will help reduce the stress for municipalities trying to do it all on their own.
Although we have spent the last year reducing duration by allowing most of our portfolios to shorten on their own, we still believe we are in a low interest rate environment for a long period of time due to the economic headwinds mentioned previously. Our barbell strategy has worked well as the yield curve has continued to flatten.