2020: It Was the End of the World As We Knew It (But Munis Did Fine)
I think we are in good company wishing 2020 good riddance. The “fear-of-not-knowing” has dominated life and financial markets for most of the past year. From the health and economic impact of the novel Coronavirus, to unprecedented market volatility, to months of doubt about a second stimulus package, we have found ourselves looking for answers during much of 2020. A global pandemic that none of us saw coming turned our personal and professional lives upside-down. As most of the country hunkered down for safety and basic necessities were in short supply, it initially felt like the end of the world. Even R.E.M.’s 1987 hit resurfaced toward the top of the music charts.
While the spring’s COVID-19 case counts seem like a mere foothill compared to today’s mountain, many of the uncertainties we faced in March and April have dissipated. Back then, there were many significant unknowns. How contagious was the virus; how did it spread; how deadly was it; what could we do to protect ourselves; were there effective treatments? The unknowns were so significant that we voluntarily shut down wide swaths of our economy out of desperation to contain the virus. Our economy plunged, with gross domestic product (GDP) down over 30% during the second quarter – a magnitude comparable to the Great Depression.
In response, financial markets writhed in volatility even greater than that which we endured during the Global Financial Crisis (GFC). Other than in cash and Treasuries, there was no place to hide since most credit sectors experienced their sharpest downturn on record as investors fled for safety. In the process, Municipal mutual funds suffered record redemptions of over $40 billion during the second half of March. The 10-year municipal-to-Treasury yield ratio spiked at 300%, more than twice its GFC high. Even generic triple-A rated five-year municipal bonds plunged almost 10% in price from March 9th to March 23rd.
The investor fear that overwhelmed markets spurred the Federal Government to enact a record-sized relief package, the $2.2 trillion Coronavirus Aid Relief and Economic Security Act (CARES Act). The Federal Reserve (Fed) also joined the relief efforts by cutting short-term rates to zero, initiating over $3 trillion of asset purchases, and activating a wide range of credit-support programs. These efforts helped quell liquidity fears and, as the U.S. flattened the curve after the first wave of infections, investors became more comfortable. Valuations continued to improve over the summer when positive developments emerged on potential vaccines.
Rising infections and hospitalizations, social unrest, a tumultuous presidential election, and months of uncertainty about a second aid package did not disrupt investor optimism. Neither did the termination of the Fed’s Municipal Liquidity Facility (MLF). After all, only the State of Illinois and New York’s Metropolitan Transportation Authority (MTA) borrowed from it. Investors remain focused on the end of the crisis as multiple vaccines have now successfully crossed the finish line and are in the early stages of distribution.
Consequently, yields and credit spreads have fallen dramatically from the spring. Municipal fund inflows have remained consistently positive over the past few quarters, reversing the weakness earlier in the year. This has left many fund managers scrambling to invest. A relative dearth of tax-exempt new issuance has served to heighten the competition for new supply, acting as a catalyst for the ongoing market rally. Despite broadly expensive valuations, we still added several attractive opportunities during the quarter including Salem Keizer School District zero-coupon bonds, New Jersey American Water bonds, New Jersey General Obligation bonds, a prepaid natural gas floater backed by Bank of America, and a range of state housing finance authority securities.
Now is not the time for complacency, neither about the coronavirus nor the municipal market. We do not find solace in low market volatility and tight credit spreads. In fact, they make us more cautious as valuations provide a slimmer safety margin. Yes, 2020 was full of loss and hardship, but among the pandemic, widespread social unrest, and the contested Presidential election, the year could have easily gone worse. We are cautiously optimistic that the worst is behind us, but we are cognizant that we will face many lasting credit impacts from the crisis. Some of these challenges can be more readily quantified, while others may take years to fully grasp.
The pandemic has left a deep financial scar across the muni sector that will be felt for years to come. Some sectors like transportation will continue to face significant challenges even as the economy improves. Others may recover more quickly, but we should remember that it took roughly five years for most states to recover from the GFC. The revenue shortfalls have also led to a rapid depletion of reserves, erasing a decade of savings in a flash. For those without strong safety cushions, deficit borrowing has provided short-term relief at the cost of long-term leverage. Where borrowing and spending reserves were not enough, many credits were forced to make tough budget cuts, which in many cases will amplify social risk through a reduction in services. Finally, December’s stimulus package failed to provide direct aid to states and cities. With a Democrat-controlled Congress, we expect state and local government assistance is much more likely, but not guaranteed. Combined, these factors leave the muni sector financially vulnerable to further economic headwinds and with fewer tools the address the next downturn.
Looking ahead, the demographic challenges facing municipals are harder to measure. The expansion of remote work, education, and healthcare have caused major shifts in migration and spending patterns. It is unclear how much of this will be a short-term blip as opposed to a long-term change, but the impacts are already being felt. States with high costs of living like California and New York were experiencing outmigration patterns prior to COVID from both residents and corporations, alike. We anticipate this trend will accelerate. For decades, states competed with their neighbors on the basis of their relative costs of living. Should remote work trends continue, high-tax states may be forced to reconsider their tax policies to maintain their competitiveness. This outmigration trend will also likely prolong the economic recovery for many areas, while speeding up the recovery for beneficiaries.