2019 Municipal Market Outlook

If the state of the U.S. economy left you scratching your head at the end of 2018, you’re not alone. For every positive economic development – like improving GDP and productivity numbers, full or near-full employment and the strength to absorb a fourth interest rate hike in December – we also saw increased stock market volatility, a fourth-quarter freefall in all major indices and an end-of-year government shutdown. To find out what all this means for the municipal market in the New Year, we turned to Baird Municipal Analyst Mike Schnetzer and Senior Fixed Income Analysts Craig Elder and Dave Violette for their perspective.

Baird: What have been the key drivers of volatility in the market over the past few months? Has that volatility affected the muni market?

Dave:
The sources of volatility are the regular cast of characters – trade with China, Brexit, a slowdown in the economy, the budget deficit, domestic and foreign politics. There just happens to be more of it right now. The interesting thing is that munis haven’t been particularly volatile. It tends to be a very steady-Eddie asset class.

Craig:
While corporations are issuing as much debt (bonds) as possible right now, the muni supply is down this year. Why is that the case?

Dave:
Year-over-year comparisons can be misleading right now – you’ll recall the huge spike in supply at the end of 2017, ahead of the tax reform legislation. Based on the number of ballot referendums approved in October, I’d say new money issuance is on the rise.

Baird: Is there a driver of volatility that impacts the muni market more than the stock market?

Mike:
Yes. Between funds and separately managed accounts, the municipal market is almost 70 percent mom-and-pop or individual investors, and individual investors can sometimes invest with a herd-like mentality. Anything that might spook them could have an outsized impact on the municipal market.

Baird: We talked about the 2017 tax reform legislation a moment ago. A year later, what has been the effect on the municipal market? 

Mike:
The biggest change for the municipal market was the reduction in the corporate tax rate to 21 percent. With this lower corporate tax rate, banks and property and casualty insurance companies – institutions that traditionally have benefited from the muni market’s tax advantages – have felt less of a need to participate, though this has been offset somewhat by increased participation by life insurers and overseas investors. Going forward, if it becomes clear that the Fed’s monetary tightening is taming inflation or if economic weakness emerges, then I’d expect investors to warm up to duration and high-credit quality, which are both municipal bond characteristics.

Baird: Could tax reform change with a newly bipartisan Congress?

Mike:
There has been some talk about Democrats pursuing a rollback of tax reform, though I view that as a heavy lift with a Republican president and Senate. Another possibility is the president and Congress could come to some agreement on an infrastructure package – that could have implications for the municipal market.

Baird: After four rate increases in 2018, what do you see happening with the Fed in 2019?

Craig: 
The Fed projected two rate hikes in their mid-December press conference. With the economies in China and Europe slowing, and the U.S. economy cooling down somewhat, it seems unlikely that we’d have the kind of growth in 2019 to warrant four more rate hikes. In fact, at the time of this writing, according to Fed Funds futures, there is a 56 percent chance of a rate cut by the end of the year.

Dave:
Right now, the market-implied probability of even one hike in 2019 is less than 20 percent. So if the Fed came in and raised rates two, three or four times, that would likely surprise the market and flatten out that long end of the yield curve.

KNOW YOUR TERMS

A yield curve is a graph depicting a bond’s yield as it matures. It typically slopes upward to account for additional risks investors take when purchasing longer-term bonds.

Baird: What would a flat or inverse yield curve signify, and how would it affect the municipal market?

Dave:
Basically, if the yield curve inverts, it would signal a slowing economy and low inflation. However, it’s important to remember that the average time lag between when you see an inverse yield curve and its economic effects is about one to two years. Plus, while the Treasury curve has inverted before recessions – think 1981, 1991, 2000 and 2008, for example – there have been flattened yield curves where recessions have not followed, so it's best to think of it more as correlation than causation.

Craig: 
That’s right – there’s an old economists’ joke that inverted Treasury yield curves have predicted nine of the last eight recessions. All joking aside, the market has traditionally focused on a two-year/ten-year Treasury note inversion as an indicator of a market correction. Now it seems the market has shifted focus to a three-month/ten-year Treasury note inversion as a better predictor of a recession.

Mike: 
Municipal yield curve inversions are uncommon. Municipal yields follow Treasury yields directionally but not as dramatically, and I’d expect just a continued flattening of the curve for 2019.

KNOW YOUR TERMS

A market correction occurs when an index or stock falls 10 percent or more from its peak.

Baird: If there were a market correction, what would it look like and how would it affect the muni market?

Dave:
In my opinion, a market correction is a process, and we’ve seen some signs already. You won’t see it in Treasurys and municipals right away, as they are considered to be safer assets compared to equities, but you're absolutely seeing it in other markets – commodities, equities, credit. The widening credit spread that we've seen in corporates has not hit munis, but I would watch it. Corporate credits have risen a fair amount, but they still are below historical norms.

KNOW YOUR TERMS

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. A widening credit spread is often seen as a precursor to a correction.

Mike:
On this topic of a market correction: Let’s say we enter a recession in the next couple of years. It’s worth remembering that municipals are going to follow the business cycle to some degree. So if the economy were to start to roll over, unemployment would spike, consumers would pull back on spending, property values would begin to flatline or decline and tax receipts would drop, and that is credit-negative for municipals. If it’s a run-of-the-mill 10 percent equity market correction, munis should benefit, but if we're talking about a full-blown recession, munis will not be immune.

Baird: From an investor perspective, what do you see in individuals and institutions looking to do in 2019?

Mike:
We think as the year progresses and the current rate hike cycle comes to an end, we would expect investors to increasingly become comfortable with adding duration. Similarly, should the market begin to anticipate a recession, municipals in general should benefit from a flight to quality, meaning demand for them would increase. As it becomes evident that the cycle is nearing an end, we would expect investors to incrementally add duration and increase credit quality, and municipals should be a beneficiary of that.


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Investors should consider the investment objectives, risks, charges and expenses of each fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus, contact Baird directly at 866-442-2473 or contact your Financial Advisor. Some of the potential risks associated with fixed income investments include call risk, reinvestment risk, default risk and inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bond’s price and its yield. Bond prices will fall as interest rates rise and vice versa. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates.