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Vaccine distribution and a transition in Washington are likely to dominate the narrative as we begin the new year, but investors are already looking to the back half of 2021 for optimism.
- Economic data has softened, reflecting the impact of the second surge of Covid-19, but the more targeted approach to restrictions in most jurisdictions has helped to dampen the impact as compared with earlier in the crisis.
- Risk ruled to close out the year, as the winners circle broadened out to include a few of the previously underloved asset classes, setting the stage for what is likely to be a robust cyclical rebound in 2021.
- Municipal bonds hardly ever command the spotlight, but the drumbeat of calls for state and local aid from Democrats over the last several months has done just that.
"No matter how hard the past, you can always begin again." - Buddha
It is hard to remember a year that was as universally challenging as 2020. With widespread business closures and a massive spike in unemployment, pressure to support those in need extended to every corner of our economy, from the federal government to local food banks. The travel industry ground to a halt, and millions of professionals found themselves at home, often with their children, and unsure of what the new working world will look like. Science stepped in with two feet, as vaccine researchers around the world raced to find a solution, and health professionals quickly determined standards of care to help limit the severity of Covid-19 cases. Yet, the markets churned higher, encouraged by the scientific progress, but more importantly by the massive monetary and fiscal stimulus injected into the global economy. As 2021 begins, the economic hangover from the pandemic remains, and there is still significant work to be done to support those who remain disadvantaged. There is also the herculean task of producing and distributing vaccines worldwide in order to stem the tide against a virus that is already exhibiting the propensity to mutate. So while the sun is shining brighter on the horizon coming into 2021, delivering progress will continue to require the best efforts of politicians, health care workers, and citizens alike.
As mentioned, an expected deceleration of economic data has occurred over the last 8 weeks, concurrent with the second surge. However, the relative resilience of the manufacturing economy has remained consistent, and is likely to continue to shine against the backdrop of constrained consumer activity over the next 2-3 months. While November’s ISM Manufacturing print moderated to 57.5 based on lighter new orders, the ISM Manufacturing survey for December unexpectedly increased to 60.7 for the month, well above the November print. 16 out of 18 industries posted growth, and the new orders gauge came in at 67.9, its best reading in over 15 years. As for the consumer economy, the December ISM Services PMI rose to 57.2 from 55.9, with 14 out of 18 industries reporting growth. New export orders and inventories rose meaningfully in the month, while employment and prices both declined. Business owners surveyed indicated that while some areas of demand have increased, there remains meaningful uncertainty as to how much demand will be impacted by the second surge. While much has been made about the unleashing of consumer demand in the back half of the year, the steady improvement in manufacturing points to a broader, more robust recovery even if Covid-19 lingers longer than expected.
Consumers, for their part, are expressing their desire to spend in different ways. The housing market has been strong for the last six months, but the dual pressures of limited supply and rising prices appears to have finally impacted the red hot U.S. housing market in November. As supply fell to 1.28 million homes – which roughly translates to 2.3 months of supply - prices rose by +14.6% year-over-year in the month. In addition, homes are selling after an average of 21 days on the market, the lowest on record. As a result, existing home sales fell -2.5% month-over-month from October to November, although they were still up +25.8% year-over-year. Conversely, U.S. retail sales were down -1.1% in the month of November, on widespread softness in discretionary spending. This was a more significant decline than anticipated, and compounds a downwardly revised decline of -0.1% in October. The back-to-back decline is reminiscent of the first wave of Covid-19, when lockdowns resulted in a massive decline in consumer spending.
This decline in consumer spending has occurred in tandem with deterioration in the employment market. Non-farm payrolls fell for the first time since April, as the second surge forced restaurants and other hospitality businesses to limit capacity or shutter altogether. Non-farm payrolls fell by -140k, much worse than the -50k decline expected by economists. The unemployment rate, for its part, was steady at 6.7%, as was the participation rate, at 61.5%. Demographically, the unemployment rate increased for teenagers and Hispanics, while the unemployment rate for all other group was essentially flat. On a positive note, the number of persons identifying as permanently unemployed fell in the period, although at 3.4 million, the figure remains much higher than February’s 2.1 million level. In addition to the losses in leisure and hospitality, job losses were reported in private education and government, while job gains in professional services, retail, and construction were reported. While there is evidence that job losses should be replaced by job gains as the economy enters into the second quarter, the December jobs report clearly points to the need for continued support for those dislocated by the pandemic.
As for the markets, the strong performance of risk assets continued into the end of the year. While many were expecting the value rotation to take hold to close out the year, instead other underperforming parts of the market, such as domestic small cap and emerging markets stocks, were the places to be if one was looking to outperform the S&P 500 index in the fourth quarter. While not necessarily a growth to value rotation in terms of index performance, investor flows into these other asset classes are being driven by the belief that the global economy is shifting quickly into recovery mode, and thus there is the desire on the part of investors to add to cyclical exposure. As for bonds, the returns remain someone muted, as expected following the shift to zero interest policy here in the United States, and low, zero, or negative interest rate policy elsewhere in the world. Commodities attempted to rebound in the fourth quarter, on expectations of future inflation, but they have a long way to go following the sharp decline in energy prices early in the year.
In focus: Municipal math
A critical sticking point over the course of months of stimulus negotiations has been the Democrats’ cry for enhanced state and local aid for areas hit hard by Covid-19 related restrictions and lockdowns. With businesses closing, workers losing their jobs, and retail spending down meaningfully, the tax revenues for municipalities were expected to decline in 2020. In fact, these concerns led to significant dislocation in the municipal bond markets in March and April, and resulted in the creation of a backstop by the Federal Reserve in order to ensure proper functioning within those markets.
The concern seems straightforward enough. Municipal bonds are tied to revenues generated from taxes generally, or from revenues derived from specific projects or revenue streams. The former type, known as general obligation bonds, are deemed to be more secure as taxes can be raised if necessary to increase revenues and pay coupon payments. Revenue bonds often pay a higher yield, as the cash flows from those bonds could be viewed as less stable depending on the underlying project or revenue source. Both types of bonds can be hindered by economic recessions, especially if high unemployment, business failures, and low consumer activity persist for an extended period of time – all three of which were a concern earlier in the year.
The challenge, however, lies in the math behind the municipals. State and local governments do not have the flexibility to run a budget deficit, so every year, revenues are estimated and programs are funded based on those expected revenues. Should estimates turn out to be too rosy, there is a shortfall which translates to funding cuts for programs or use of rainy day funds built up during better times – well, at least in most jurisdictions (but that’s a topic for a later date). Social programs for assistance, too, tend to be used more during times of economic distress, compounding the pressure of lower revenues. Finally, there is little transparency throughout the course of the year, and reporting is lagged – so it is difficult to price in real time the impact the pandemic is having on municipal finances.
With all that said, however, municipal bond defaults over time are incredibly low. Our view is that defaults will be incrementally higher over the next several quarters, but certainly not widespread. A focus on high quality issuers with a history of excess cash flow and appropriately conservative budget estimates is an appropriate way to garner exposure to an asset class that makes sense for investors in higher tax brackets, even in a low interest rate environment.
What we're watching
Decelerating economic data and a slower than anticipated vaccine roll-out could create pressure on risk assets in the near term.
Risk assets performed incredibly well in 2020, especially when taking into account the deep decline in global economic activity. While the economy should accelerate into the back half of 2021, the beginning of the year could produce some choppiness in risk asset performance, as investors determine if U.S. stocks, in particular, have gotten a bit ahead of themselves. Our intent is to remain focused on the longer term, as we believe this pressure will be short-lived.