Market Review and Outlook 3rd Quarter 2013
The discouraging headlines of the summer of 2013, including the Detroit bankruptcy, financial instability in Puerto Rico, possible tapering of quantitative easing, and slow economic growth, could lead one to conclude that the bond market was having a difficult time. The reality, however, was a quarter of positive returns. During the 3rd quarter, the Barclays 5 Year Municipal Index returned 0.87% and the Barclay’s 1-10 Year Municipal Index returned 0.58%.
One of the keys to our outperformance was our decision, early in the quarter, to add exposure to seven year maturity and longer municipal bonds. Our analysis suggested that these bonds had been overly penalized by the market.
This analysis was borne out as longer bonds began to outperform in the last weeks of the quarter as long rates receded from highs reached in August. Although multiple factors contributed to this change in broad market sentiment, the initial catalyst was the Fed’s decision that the economy did not yet warrant a reduction in quantitative easing. Also contributing to the positive move were several factors ranging from the micro, such as supply and demand in the municipal market, to the overall macroeconomic condition.
Market technicals improved as new issuance of municipal bonds dropped sharply and large fund redemptions receded from a high reached in late August. Today, the redemptions continue but at a modest pace. In the past month, there have even been
a few positive numbers showing that purchases exceeded sales of the large municipal funds. One would have thought that substantial mutual fund sales would have shifted the supply and demand dynamics of the municipal bond market considerably, but this is not the case. Demand for high quality municipal bonds remains firm and the number of primary market offerings continues to be relatively low. The substantial decline in new issues is in part due to a climate of fiscal austerity in most state and local governments and a smaller number of large public infrastructure projects.
Looking to the macroeconomic picture, concerns that growth could be sufficient to prompt the Fed to start tapering its purchases of Treasuries and mortgage backed securities were premature. Unemployment, officially at 7.2%, is significantly improved from the depths of the recession but is still indicative of weakness and below the Fed’s target level. Furthermore, several economists question the quality of the ‘improvement’ given the increase in discouraged job seekers. Supporting this impression is the decline in the labor force participation rate to 63%, which is lower than at any time since the 1970s. The momentum of economic activity has leveled off from earlier in the year but there are few concerns of returning to a recession and inflation remains in check. Pockets of relative strength include the housing sector, auto sales, and other interest rate sensitive areas.
While the financial difficulties of a few municipal issuers such as Puerto Rico and Detroit continue to make headlines, the financial condition of the majority of municipalities is improving and this improvement can be largely attributed to a rebound in tax receipts. This does not mean that these two troubled issuers are not disconcerting. Addressing their financial weaknesses will be challenging and may set precedents for the limited number of other municipal issuers facing similar problems. Detroit filed for Chapter 9 bankruptcy on July 18th; and while there remains the possibility that the bankruptcy court will find a technical reason that the filing is not valid, this will not change the reality of the situation; the city’s economic activity is insufficient to allow for the timely payment of all of their obligations. Less clear is how the city or the court will prioritize the repayment of these debts. Puerto Rico is facing a similar situation, weighed down by debt far heavier than its current economic activity is likely to support. The situation in Puerto Rico is complex but they have a little more time to find a solution. Because municipal bankruptcies and defaults are so rare, these two situations are likely to be important to the municipal market both for their size and for their potential to set precedents.
While the 4th quarter appears poised to be a continuation of the 3rd, with slow but steady growth, low inflation, and an accommodative central bank, the factors with the biggest bearing may be political. On October 1st, immediately following quarter-end, the country became riveted by a congressional budget battle which, when parties failed to come to agreement, curtailed many of the normal non-essential functions of government after Congress failed to enact appropriation legislation for fiscal year 2014. While congressional leaders reached an accord on October 17th, many feel that increasing political intransigence may cast a measure of doubt on an otherwise healthy economy. Lastly, the term of the current Fed chairman, Ben Bernanke, expires in January. The current Vice-Chairperson, Janet Yellen, has just been nominated as the next chairman. The confirmation process is likely to be contentious but most observers believe she will be confirmed. Assuming this is the case, it is likely that as chairman she will have a dovish bias. This approach, when combined with any economic damage caused by the government shutdown, will, many believe, lead to a continuation of the Fed’s accommodative policies provided inflation levels remain well within their acceptable range (2% or less, annualized), and unemployment levels remain higher than desired.
The opinions expressed herein are solely attributable to Samson and should not be construed as an offer to buy or a solicitation to sell any securities. Inherent in any investment is the risk of loss. All factual information and statistical data in this document were obtained or derived from public sources. Samson makes no representations that such information or statistical data is accurate or complete. No person to whom a copy of this document has been delivered should rely on any such factual information or statistical data as being accurate or complete and should not undertake any investment program based on such information contained in this document. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Past performance is not indicative of future results. All estimates, opinions and analysis in this document constitute judgments made by Samson as of the date of this document and are subject to change without notice. Samson has no obligation or duty to inform any person to whom a copy of this document has been delivered of any change in any estimate, opinion or analysis in this document or to update the document on a going forward basis.