The State of States September 30, 2014

This week marks the start of fall with the autumnal equinox. In coming weeks, nighttime hours will gradually surpass daytime hours throughout the United States. Similar to the shift in the number of daytime and nighttime hours, state revenues have evened in recent months and the upside surprises of recent years are fading.

After several years of growth, state tax revenues are slowing. The Nelson A. Rockefeller Institute of Government reported that overall state tax revenues declined by 0.3% during the first quarter of 2014, and a preliminary reading for the second quarter 2014 shows tax revenues are on track to decline by 0.8%. A drop in personal income taxes drove declines while sales taxes and corporate income taxes, the two other major drivers of state tax revenue, continued to increase. A spike in tax collections in 2013,  following an increase in tax rates, is the main driver of slowing personal income taxes as it makes year-over-year comparisons more challenging. The surge in 2013’s revenue gains was unlikely to be sustained.

It is not uncommon for revenues to slow as the economy matures and we do not view the slowdown in state tax revenues as worrisome for municipal bond investors. Withholding taxes, a more current gauge of the trajectory in revenues, increased 5.6% during the first quarter of 2014 with 37 states showing gains and only four showing declines. Personal income taxes consist of both income and investment taxes and therefore can fluctuate depending on strength in the stock market.

Measuring withholding taxes can therefore provide a clearer picture of the underlying trend in personal income tax revenues. For the first three quarters of fiscal year 2014 (which began on July 1, 2013), revenues have increased 2.8%. We would have to witness much sharper revenue declines before default risk may become a factor again in the municipal bond market.

California, New Jersey, and Illinois

For the new 2015 fiscal year that began July 1, 2014, the flat overall revenue trend appears to be continuing based upon a small subset of sampling. Revenues have been a mixed bag with states such as Idaho, Indiana, Vermont, Wisconsin, New Jersey, Florida, Minnesota, Arizona, and Virginia slightly lagging budget forecasts, while California, Maine, Missouri, and Washington have been modestly exceeding forecasts.

Among notable state progress, California’s revenues continue to improve while New Jersey and Illinois face challenges. California state general obligation (GO) debt was upgraded to Aa3 in June 2014 by Moody’s as a reflection of the better revenue picture and followed upgrades by both Standard & Poor’s (S&P) and Fitch in 2013. Conversely, New Jersey state GO debt has been downgraded more than once in 2014 and most recently here in September by both S&P and Fitch, as revenues disappoint and the state’s pension burden continues to grow. Illinois not only has the lowest pension funding level among states but also faces a decline in revenue as a temporary increase in tax rates, which helped boost Illinois debt back in 2011, is set to expire at the end of 2014 and revert back to lower rates — a negative for bond holders. While Illinois state GO debt trades at a notable
yield premium to the average AAA-bond yield, New Jersey debt yields are relatively narrow to the AAA average and yield differentials may widen to compensate for risks. Meanwhile, California has seen its bonds outperform
as yield differentials narrow.

A Change in Season for Supply

Slowing revenue growth is likely to increase the chance the low supply environment of 2014 will persist, but a seasonal increase is currently underway. As is typically the case, the start of fall ushers in a period of increased issuance [Figure 1]. New bond issuance has been very low in 2014 but has still tracked the pattern of the recent five years. Each of these years has held very close to the seasonal pattern with some slight variation. In 2010, issuance was well above average and, along with credit quality fears, sparked a subsequent year-end sell-off, while 2013 fall issuance was slow to get going due to the taper tantrum sell-off and lingering market caution.

At $11.3 billion, forward issuance remains well above the $8.2 billion weekly average of the past five years and may slow municipal performance. Municipal bonds outperformed Treasuries during a two-week bond market
downturn to start September. Although bond prices rebounded slightly last week, the combination of lower yields and higher valuations may slow, or  reverse, the advance of municipal bonds.

Municipal-to-Treasury yield ratios are near their most expensive indications of the year [Figure 2]. We do not expect a repeat of the 2013 sell-off, but after a strong start to 2014, the combination of lower yields, higher valuations, and a seasonal increase in supply may drive much lower returns. Returns may gravitate closer to the negative 0.3% return of the Barclays Municipal Bond Index witnessed from August 29, 2014 through September 19, 2014 than the 7.5% witnessed year-to-date through the end of August 2014.

Once the seasonal supply surge fades, slower state revenue growth and still tight local government budgets suggest that new issuance may remain subdued over the longer term. Therefore, lower issuance may lead to still higher valuations for municipal bonds as supply remains constrained. Data from the Federal Reserve released last week showed the municipal market shrank by 0.2% during the second quarter of 2014, continuing a trend that began in 2010. However, over the near term higher valuations may present a challenge in the face of a seasonal supply increase. A change of seasons should be noted by municipal investors, as a seasonal increase in new issuance may be a catalyst to lower returns after a strong 2014.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

 

Current Conditions Index September 23, 2014

Over the past week, the LPL Financial Current Conditions Index (CCI) fell nine points, but it remains in the range of recent post recession highs. Despite the pullback, the level of the CCI remains consistent with the recent spring bounce, signaling the U.S. economy may be emerging from the modest, but steady, economic growth of recent years.

During the last week, the index’s decline was driven by retail sales, shipping traffic, and the VIX (a measure of stock market volatility), while mortgage activity saw the most improvement.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

 

Fall FOMC Watch September 16, 2014

On Tuesday, September 16 and Wednesday, September 17, 2014, the Federal Reserve (Fed) will hold the sixth of its eight Federal Open Market Committee (FOMC) meetings of the year. This meeting will include a press conference by Fed Chair Janet Yellen and FOMC members’ forecasts for the economy, the timing of the first fed funds rate hike, and the level of the fed funds rate at the end of 2014, 2015, 2016, 2017, and in the long run. In recent years, markets have been conditioned to expect a greater possibility of policy changes at meetings accompanied by press conferences and new forecasts and, as a result, market participants have increased their odds that the Fed will change “something” at this meeting.

Although we continue to expect the Fed will again cut the pace of its bond purchase program (quantitative easing or QE) and remain on pace to exit QE by the fourth quarter of 2014, the odds have increased in recent weeks that the Fed will take some additional action. Arranged from most likely to least likely (in our view), at this week’s meeting the Fed could:

Move to a more “data-dependent” rather than a “time-dependent” promise to keep rates low. Yellen and most other Fed officials have gone out of their way to remind the public that the Fed’s QE program and the extraordinarily low rates are “data dependent,” and yet the FOMC statement continues to hinge on that “considerable time,” or time-based guidance. A subtle shift away from time-based to data-based rate guidance could be one outcome of this week’s meeting.

Change the bar and “dot plot.” At one of her press conferences earlier this year, Fed Chair Yellen referred to the FOMC members’ forecasts of the first rate hike and fed funds rate levels at year end 2014, 2015, 2016, and in the long term as the “dot plots.” To be clear, the timing of the first rate hike appears on a bar chart, while the forecasts for the level of the fed funds rate at year end are found in the dot plots. At the June 2014 meeting, 12 FOMC members said 2015 was the first hike, while one said 2014, and three said 2016. The bar and dot charts are likely to include 2017 this time. The June 2014 dot plots placed the fed funds rate at current levels at the end of 2014, 1.13% at the end of 2015, and 2.50% at the end of 2016. After identifying them as such, Yellen immediately told the public to not pay any attention to them, but of course financial markets and the financial media can’t seem to resist. Given the recent data — and public pronouncements of FOMC officials on when they thought the first rate hike should occur — there is likely to be some movement toward a rate hike sooner rather than later and a higher end point for fed funds in both the bar and dot plots this time around.

Drop the “significant underutilization of labor resources” language from the FOMC statement. This language was inserted into the statement released after the July 29 – 30, 2014, FOMC meeting and was likely designed to focus the market’s attention away from the headline labor market indicators — such as the unemployment rate and the nonfarm payroll job count — and on the broader set of labor market indicators often cited by Fed Chair Yellen and Fed staffers. Although several of the Yellen indicators have indeed improved since the July 2014 FOMC meeting, the majority of the Yellen indicators still suggest that the broad labor market is not back to normal. Our view is that although this description is unlikely to be dropped altogether, it could be softened a bit to reflect the ongoing — albeit slow — improvement in the labor market.

Omit from the FOMC statement the promise to keep rates low for a “considerable time” after QE ends. This is a close call. The recent run of better-than-expected economic data for the second and third quarters  of 2014, along with recent comments from Fed officials (both hawks and doves), support this view, but the sudden shift in policy implied in omitting these words seems out of line with the Fed’s recent gradualist approach.

Provide the public with an update to its “exit strategy,” first outlined in 2011. In our view, the sooner the Fed does this the better it will be in the long run. However, our read of recent comments from Fed officials, the June and July 2014 FOMC statements, and the minutes of the July 29 – 30 FOMC meeting suggest the FOMC subcommittee that was set up to review the exit strategy most likely has not had enough time to complete its task. With the next FOMC meeting (October 28 – 29, 2014) not scheduled to have a Yellen press conference or a new forecast, the final FOMC meeting of 2014 (December 16 – 17) is the likely date for the Fed to announce the long-awaited update to its exit strategy. If the Fed were to announce that a press conference would accompany the October FOMC, that would likely signal to the markets that the Fed was preparing to announce its exit
strategy in October.

The one common thread to the potential changes from the Fed is how the economy is tracking to the Fed’s forecast, and when all of the slack in the economy — as measured by the output gap [Figure 1] — will be taken up. If the economy (as measured by growth in inflation-adjusted gross domestic product [GDP]) continues to grow at around 4% as it has, on average, in the economy — as measured by the output gap [Figure 1] — will be taken up. If the economy (as measured by growth in inflation-adjusted gross domestic product [GDP]) continues to grow at around 4% as it has, on average, in the second and third quarters of 2014, the output gap is likely to close much more quickly than the Fed now assumes, and the Fed will likely be raising rates in the early part of 2015. If GDP decelerates in 2015 and 2016 to the 3% pace forecast by the FOMC, the Fed is likely to begin hiking rates later in 2015 — perhaps in Q3 or Q4. If, however, the economy returns to the below average 2% pace of growth seen in 2011 – 2013, the Fed could be on hold until late 2015 or early 2016. We are continuing to watch our Yellen indicators, including the unemployment rate, the job quit rate, and the output gap, to gain insight in whether the Fed will raise rates sooner than expected.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Midterms May Mean More Gains for Stocks September 9, 2014

With the midterm elections now just two months away and campaigning starting to heat up, we thought we would share our current views on the political landscape and what it may mean for U.S equities. In our two Outlook 2014 publications for this year, we posited that the U.S. economy and corporate profits may drive the stock market higher and investors could turn their attention away from policymakers in Washington, who were such a distraction in 2013 and earlier in the current economic expansion.

We continue to see opportunities for further stock market gains over the course of 2014, as discussed in our Mid-Year Outlook 2014: Investor’s Almanac Field Notes, based upon fundamentals rather than the potential for sweeping legislative change. Although our analysis of stock market performance around midterm elections is very supportive of our positive stock market outlook, it is not a key driver of that outlook.

This Election’s Impact May Be Smaller Than Usual

We do not expect politics to have a big impact on the stock market this fall for two reasons:

• There is not much uncertainty for the elections to remove. Markets hate the uncertainty that changes in Washington’s political landscape tend to bring. But there is no debt limit debate until March 2015 or spending cuts that need to be addressed over the near term as in recent years.

• Divided government will likely persist no matter the election outcome. Neither party is likely to gain a distinct advantage. We (and the consensus) fully expect that the election will leave us with a still divided government. Major policy initiatives such as tax reform or entitlement reform (as necessary as they may be) are unlikely to get done by the next Congress regardless of midterm election results.

It is highly likely that Republicans will maintain control of the House, where they currently hold a sizable majority that may widen. In the Senate, professional political forecasters and our contacts in Washington put the odds that Republicans regain control at between 60% and 70%.

The Senate Battle

To win the Senate, Republicans would need to win six of the 21 contested seats currently held by Democrats (assuming incumbent Republicans hold on to their 15 contested seats). If so divided government in Washington would persist for at least two more years, with a Democratic president and Republican Congress until the 2016 presidential election. Several of the contested seats currently being held by Democrats are in traditionally Republican-leaning (so-called red) states, which, along with fewer seats to defend, redistricting, and the latest polls, suggest Republican control of the House and Senate in 2015 – 2016 is more likely than not.

If the Republicans do not take control of the Senate, then a divided and gridlocked Congress returns. Although Washington is probably more likely to get some things done with Congress entirely under Republican control, especially as the Obama Administration moves more into legacy-building mode, major market-moving reforms are unlikely in either scenario.

This Doesn’t Mean Nothing Will Get Done

This outcome doesn’t mean policy is irrelevant and that nothing will get done in Washington over the next two years. A continuing resolution this fall will be needed to fund the government until after the 2014 elections. This may begin to turn the market’s attention to the next debt ceiling deadline in March 2015, which could have some political brinksmanship attached to it, although a default is very difficult to envision. We do not believe the Republicans have the appetite for another budget standoff that could result in another government shutdown or, worse, default. In addition, there appears to be bipartisan support for changes to energy policy that could come in 2015, regardless of the makeup of Congress. Infrastructure, immigration, and housing finance reform are also areas of potential compromise.

Stocks Embrace Midterm Elections

Though not a key piece of our positive outlook for the S&P 500, stocks seem to love midterm elections. Since World War II, the market’s reaction to midterm elections has almost always been positive, even when the balance of power has shifted in one or both houses of Congress — as would happen this year if the Republicans take the Senate. As shown in Figure 1, the fourth quarter in any year has been a good time to own stocks, but the fourth quarter during midterm election years — the quarter that begins on October 1, 2014 — has historically been a really good time to own stocks.  In fact, 14 of the last 16 fourth quarters during midterm election years have seen the S&P 500 Index move higher, by an average of 8%.

A change in control has not changed this dynamic. In four of the five years that midterm elections resulted in a change in power (1954, when Democrats took the House; 1986, when Democrats took the Senate; 2002, when Republicans took the Senate; and 2006, when Democrats took the House and Senate), fourth quarter returns were positive, much like those in midterm election years when no change in power took place. Interestingly, in the only two midterm election years since World War II during which U.S. equities did not experience a fourth quarter rally (1978 and 1994), the Federal Reserve (Fed) was aggressively hiking interest rates.

• In 1978, the lead-up to the Islamic Revolution resulted in strikes and unrest in Iran. In November 1978, a strike by Iranian oil workers reduced production from 6 million barrels per day to about 1.5 million barrels. At the same time, foreign oil workers fled the country. In the United States, inflation hit 9% in the fourth quarter of 1978 with no signs of slowing down as it approached double digits. In response to surging inflation, the Fed was aggressively hiking rates, with a total increase of 1.25% in the fourth quarter alone, pushing the policy rate up to 10%.

• In 1994, the S&P 500 turned in a roughly flat fourth quarter on the heels of a shift in power to the Republicans. However, the performance was less of a reaction to the election results than to rising fears of recession amid the Fed’s aggressive hiking of short-term interest rates and a corresponding run-up in long-term interest rates (to nearly 8% from below 6% at the start of the year). Although the Fed is currently withdrawing stimulus by phasing out quantitative easing (QE), we do not expect the Fed to raise interest rates until well into 2015. As a result, we do not expect the Fed to disrupt the stock market during the fourth quarter as it did during the fourth quarters of 1978 and 1994.

Bottom line, the resolution of election uncertainty — and ending the predominantly negative rhetoric surrounding the campaign — has historically been a positive for the stock market and may help the S&P 500 reach new highs during the final stretch of 2014. And ending uncertainty seems to matter more to investors than the actual election results.

Bond Yields Around a First Rate Hike September 2, 2014

Last week’s Federal Reserve (Fed) news was a reminder that the Fed remains on course to raise interest rates about one year from now. The release of minutes from the July 29 – 30, 2014, Fed meeting and Fed Chair Janet Yellen’s remarks at the Fed’s annual Jackson Hole Symposium were less market friendly than anticipated. The double dose of new information from the Fed was a modest disappointment for bond investors who expected a more market-friendly tone. Bond markets remain mispriced for an eventual Fed rate hike, and last week’s rise in high-quality bond yields was a reminder of the interest rate risk facing bond investors.

A rate hike remains about one year away, according to both Fed guidance and interest rate futures markets, but it still raises the question of when bond markets will move forcefully in response to Fed interest rate hikes. Yields have declined for most bonds, year-to-date, but expectations for higher interest rates have not wavered.

When Will Rates Rise?

So when will bond yields really move in response to Fed rate hikes? Over the last 20 years, bond yields began to increase approximately four to six months ahead of the Fed’s first interest rate increase [Figure 1]. The 2-year Treasury note is among the most sensitive to Fed changes to the fed funds target rate and therefore is a useful guide to market reaction.

A steadier rise in interest rates occurs once the first rate hike has passed, but in 1994, that steady rise began roughly two months before the first increase. Figure 1 shows the number of trading days, so adding back weekends gets us to calendar days and the four- to six-month period mentioned above.

The reaction among longer-term bonds, such as the 10-year Treasury, is similar but not identical. In 1994, the reaction in the 10-year yield came closer to three months prior to the Fed’s first rate hike, while in 1999 and 2004, the reaction came similarly four to six months before [Figure 2]. Like the 2-year yield, the rise in the 10-year yield was steadier just after the first rate increase in 1994 and 1999, but in 2004, a 1.0% rise in the 10- year yield was constrained to a period just before and after the first rate hike.

In 2004, the 10-year Treasury yield began to decline again despite ongoing Fed rate hikes leading a befuddled Alan Greenspan to famously label it a “conundrum.” Intermediate and long Treasury yields, however, resumed their rise in 2005, in response to continued Fed interest rate hikes before peaking in 2006.

Another takeaway from Figure 2 is that the rise in 10-year yields was more limited in time span. In 1999 and 2004, the 10-year yield peaked within one to three months after the first rate increase — a reminder that longer-term bonds are less influenced by the Fed and more by economic growth and inflation expectations. In 1994, the 10-year Treasury yield peaked 10 months after the first rate hike — perhaps a reflection of an aggressive and quick Fed rate hike schedule (which is not expected in the current environment) and the Fed continuing to emphasize a go-slow approach.

Caveat Emptor

Of course, every historical period is unique, reaction may not follow historical form, and investors need to beware. The prevailing environment is quite different from others and involves a range of Fed stimulus that may be halted or reversed as the Fed gradually attempts to normalize policy. Bond purchases are expected to end in October 2014, and the Fed may eventually change its guidance from being on hold for a “considerable” period to signaling that a rate hike is drawing near. Both events may act as a catalyst to higher yields.

Other Fed tools, such as paying interest on excess bank reserves and the reverse repurchase facility, cloud potential market reaction. Additionally, the latest indication from the Fed is that it may maintain an overnight interest rate range, rather than set a specific rate, which may soften the potential market reaction.

We believe the rise in interest rates may begin sooner in anticipation of an interest rate hike. Bond valuations, although off the peak of early May 2013, remain very expensive by historical comparison, and the bond market has already priced in a Fed that may take longer than anticipated to raise interest rates. Along with lower yield levels compared with history, this makes the bond market vulnerable to rising rates. Timing such a move is very difficult, even with history as a guide. We favor a defensive stance in the bond market capitalizing on year-to-date strength and positioning with short to intermediate bonds to protect against the threat of rising interest rates.

 

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC