Munis take worst pounding since Meredith Whitney
Investors spooked by possible lifting of tax-exemption; ‘armageddon concerns’
December 21, 2012
The $3.7 trillion municipal market is poised for its steepest monthly decline since 2010 as investors spooked by threats to the debt’s tax-exempt status withdrew the most money in almost two years.
Demand from individual buyers, who own about 70 percent of U.S. local debt, collapsed last week as yields set four-decade lows. At the same time, talks between President Barack Obama and congressional leaders over a deal to avert tax increases and spending cuts set to start in January included measures that may cap munis’ tax exemption. Investors pulled $2.3 billion from muni mutual funds this week, the biggest exodus since January 2011, Lipper US Fund Flows data show.
State and local debt has lost 1.9 percent this month, on pace for the worst return since December 2010, Bank of America Merrill Lynch data show. That’s when banking analyst Meredith Whitney predicted “hundreds of billions of dollars” of muni defaults, helping propel 29 straight weeks of fund outflows.
“So much has changed in a week,” said John Dillon, chief muni strategist in Purchase, New York, at Morgan Stanley Smith Barney, which handles about $150 billion in local debt. “It’s the reality that the exemption is not fully in the clear.”
While Whitney’s forecast proved incorrect and the default tally is set to be the lowest since at least 2009, the selloff in the past two weeks threatens to end a five-month rally.
Muni bonds surged after the Nov. 6 U.S. election, pushing yields to the lowest since 1965 as buyers including Bill Gross of Pacific Investment Management Co bet that Obama would raise the top federal tax rates to curb deficits.
Investors then switched their focus to another aspect of Obama’s policies — his proposal to limit the income-tax deduction on local debt to 28 percent. Analysts at Citigroup Inc. said this month that such a move could reduce the value of the market by $200 billion and cause investors to demand an extra 0.6 percentage point of yield.
Yields on AAA munis due in 10 years reached 1.8 percent yesterday, the highest since August, data compiled by Bloomberg show. The interest rate touched 1.4 percent Dec. 6, the lowest for a Bloomberg Valuation index that began in January 2009.
“The market had been embracing the concept of higher marginal rates and completely discounting any mitigation of the value of the tax exemption,” Dillon said. The yield reversal “makes me think of back when we had the muni Armageddon concerns in late 2010,” he said.
Institutional bondholders such as mutual funds put $1.4 billion of munis up for sale last week, the most since Dec. 14, 2010, data compiled by Bloomberg show. That was less than a week before Whitney’s default forecast on CBS Corp.’s “60 Minutes.”
Munis have fallen faster than Treasuries this month, with local-debt underperforming federal securities by the most since August 2011, Bank of America data show.
The yield on benchmark 10-year munis is about even with that on Treasuries. The ratio of the two exceeded 100 percent this week for the first time since Nov. 8, showing munis have cheapened relative to federal debt.
“Municipal ratios relative to taxables had gotten too expensive,” said Craig Pernick, a senior managing director at Chevy Chase Trust Co., which oversees about $1.2 billion in local debt in Bethesda, Maryland. The company “had not been active at all” in munis in November as yields fell, he said.
Analysts such as Michael Zezas at Morgan Stanley warned this month that buying munis with yields at four-decade lows might be a losing bet.
“The market may be ignoring a real threat of a cap to the muni tax exemption in 2013,” Zezas wrote in a Dec. 4 report.
Efforts to avert the more than $600 billion in tax increases and spending cuts set to start next month deteriorated yesterday. The White House warned business leaders this week that talks between the president and Republican House Speaker John Boehner were regressing.
“Municipals more or less have been a sacred cow that — along with mortgage interest and charities — have not been touched,” Pernick said. “If there’s going to be a grand bargain, municipals may not have that status.”
Bill Gross: Pimco’s investment picks and pans
The Pimco chief offers insight into where his firm will be investing if growth falls below 2%
By Bill Gross
December 4, 2012
You didn’t build that………. 332
I built that ………………….. 206
Well, I guess that settles it: you didn’t build that after all. Or maybe you did, but not all of it. Or maybe like the convoluted John Lennon above “you think you know a yes, but it’s all wrong. That is you think you disagree.” Whatever. Rather than an economic mandate, November’s election was more of social commentary on the Republicans’ habit of living with eyes closed. Their positions on what Conan O’Brien labeled “female body parts” – immigration, gay rights and student loans – proved to be big losers, and they will have to amend rather than defend those views if they expect to compete in 2016. I suspect they will. Political parties are living social organisms that mutate in order to survive. We will see straight talking Chris Christie or Hispanic flavored Marco Rubio leading the Republican charge four years from now versus a reenergized Hillary Clinton. It should be quite a show with a “No Country for Old (White) Men” caste to it.
But whoever succeeds President Obama, the next four years will likely face structural economic headwinds that will frustrate the American public. “Happy days are here again” was the refrain of FDR in the Depression, but the theme song from 2012 and beyond may more closely resemble Strawberry Fields Forever, as Lennon laments “It’s getting hard to be someone but it all works out.” Why is it so hard to be someone these days, to pay for college, get a good-paying job and retire comfortably? That really was the economic question of the 2012 election towards which very few specifics were applied from either side. “There’s a better life out there for us,” Governor Romney bellowed to a crowd of thousands in Des Moines, Iowa just days before the election, but in truth he never told us how we were going to achieve it or, importantly, why we weren’t realizing it in the first place. The president’s political mantra of “Forward” was even more vague.
Their words were mum if only because the real cause of slower economic growth lies hidden in a number of structural as opposed to cyclical headwinds that may be hard to reverse. While there are growth potions that undoubtedly can reduce the fever, there may be no miracle policy drugs this time around to provide the inevitable cures of prior decades. These structural headwinds cannot just be wished away as we move “forward” whether it be to the right, the left or dead center. Last month in a major policy speech at the New York Economic Club, Fed Chairman Ben Bernanke concurred that the U.S. economy’s growth potential had been reduced “at least for a time.” He in effect confirmed PIMCO’s New Normal which has been in place for three years now, laying the blame in part on the financial crisis, diminished productivity gains, and investment uncertainty due to the near-term fiscal cliff. We do not disagree. However, there are numerous other structural headwinds that may reduce real growth even below the New Normal 2% rate that Bernanke has just confirmed, not only in the U.S. but in developed economies everywhere.
Developed global economies have too much debt – pure and simple – and as we attempt to resolve the dilemma, the resultant austerity should lower real growth for years to come. There are those that believe in the “Brylcreem” approach to budget balancing – “a little dab’ll do ya.” Just knock a few percentage points off the deficit/GDP ratio, they claim, and the private sector will miraculously reappear to fill the gap. No such luck after 2–3 years of austerity in Euroland, however. Most of those countries are mired in recession and/or depression. Political leaders there should have studied the historical evidence presented by Carmen Reinhart and Ken Rogoff in a critically important paper titled, “Growth in a Time of Debt.” They conclude that for the past 200 years, once a country exceeded a 90% debt/GDP ratio, economic growth slowed by nearly 2% for both developed and developing nations for an average duration of nearly a decade. Their work displayed below in Chart 1 shows the result in the United States from 1790–2009. The average annual U.S. GDP rate growth, while clearly influenced by the Great Depression, was -1.8% once the 90% barrier was exceeded. The U.S., by the way, is now at a 100% debt/GDP ratio on the basis of the authors’ standard measuring yardstick. (Note as well the 5½% average inflation rate during the same periods.)
In addition to sovereign debt levels which were the primary focus of the Reinhart/Rogoff studies, it is clear that financial institutions and households face similar growth headwinds. The former needs to raise equity via retained earnings and the latter to increase savings in order to stabilize family balance sheets. The combined need to increase our “net national savings rate” highlightin last month’s Investment Outlook is a long-term solution to the debt crisis, but a near/intermediate-term growth inhibitor. The biblical metaphor of seven years of fat leading to seven years of lean may be quite apropos in the current case with the observation that the developed world’s growth binge has been decades in the making. We may need at least a decade for the healing.
Globalization has been an historical growth stimulant, but if it slows, then the caffeine may wear off. The fall of the Iron Curtain in the late 1980s and the emergence of capitalistic China at nearly the same time was a locomotive of significant proportions. Adding two billion consumers to the menu made for a prosperous restaurant, increasing profits and growth in developed economies despite the negative internal effects on employment and wages. Now, however, these tailwinds are diminishing, producing an airspeed which inexorably slows relative to the standards of prior decades. Is it any wonder that markets now move up or down as much on the basis of policy changes coming out of China as opposed to the U.S. or Euroland? If China and the accompanying benefits of globalization slow, so too may developed economy growth rates.
Technology has been a boon to productivity and therefore real economic growth, but it has its shady side. In the past decade, machines and robotics have rather silently replaced humans, as the U.S. and other advanced economies have sought to counter the influence of cheap Asian labor. Almost a century ago, Keynes alerted the economic community to a “new disease,” what he called “technological unemployment” where jobs couldn’t be replaced as fast as they were being destroyed by automation. Recently, Erik Brynjolfsson and Andrew McAfee at MIT have affirmed that workers are losing the race against the machine. Accountants, machinists, medical technicians, even software writers that write the software for “machines” are being displaced without upscaled replacement jobs. Retrain, rehire into higher paying and value-added jobs? That may be the political myth of the modern era. There aren’t enough of those jobs. A structurally higher unemployment rate of 7% or more is the feared “whisper” number in Fed circles. Technology may be leading to slower, not faster economic growth despite its productive benefits.
Demography is destiny, and like cancer, demographic population changes are becoming a silent growth killer. Numerous studies and common sense logic point to the inevitable conclusion that when an economic society exceeds a certain average “age” then demand slows. Typically the dynamic cohort of an economy is its 20 to 55-year-old age group. They are the ones who form households, have families and gain increasing experience and knowhow in their jobs. Now, however, almost all developed economies, including the U.S., are gradually aging and witnessing a larger and larger percentage of their adult population move past the critical 55-year-old mark. This means several things for economic growth: First of all from the supply side, it means productivity and employment growth rates will slow. From the demand side, it suggests a greater emphasis on savings and reduced consumption. Those approaching their seventh decade need fewer cars and new homes. Almost none of them have babies (thank goodness!). Such low birth rates and a significant reduction in demand have imperiled Japan for several lost decades now. A similar experience will likely turn many developed economy “boomers” into “busters” within the next several years.
I’m fond of reminding PIMCO’s Investment Committee that you can’t buy GDP futures – at least not yet. Hypotheses about real growth rates, no matter how accurate, must be translated into investment decisions in order to justify the discussion. Before doing so, let me acknowledge that these structural headwinds can and will likely be somewhat countered by positive thrusts. Cheaper natural gas and the possibility of reversing or even containing the 40-year upward trend of energy costs may be a boon to productivity and therefore growth. There is talk of the U.S. being energy independent within a decade’s time. Housing as well may be experiencing a multiyear revival. In addition, unforeseen productivity breakthroughs may be just over the horizon. How many gloomsters could have forecast the Internet or any other technical breakthrough before it actually happened? Jules Verne we are not.
But if a 2% or lower real growth forecast holds for most of the developed world over the foreseeable future, then it is clear that there will be investment consequences. Shown below, as recently published in a TIME Magazine article by Rana Foroohar, is a PIMCO list of future Picks and Pans based upon these ongoing structural changes:
• Commodities like Oil and Gold
• U.S. Inflation-Protected Bonds
• High-Quality Municipal Bonds
• Non-Dollar Emerging-Market Stocks
• Long-Dated Developed-Country Bonds in the U.S., U.K. and Germany
• High-Yield Bonds
• Financial Stocks of Banks and Insurance Companies
The list to a considerable extent reflects the view that emerging economy growth will continue to be higher than that of developed countries. Their debt on average will remain much lower, and their demographic age much younger. In addition, the inevitable policy response of developed economies to slower growth will be to reflate in order to minimize the impact of the aforementioned structural headwinds. If successful, reflationary policies will gradually move 10 to 30-year yields higher over the next several years. The 30-year Treasury hit its secular low of 2.50% in July and such a yield may seem ludicrous a decade hence. Investors should expect future annualized bond returns of 3–4% at best and equity returns only a few percentage points higher.
As John Lennon forewarned, it is getting harder to be someone, and harder to maintain the economic growth that investors have become accustomed to. The New Normal, like Strawberry Fields will “take you down” and lower your expectation of future asset returns. It may not last “forever” but it will be with us for a long, long time.
Bill Gross is the founder and managing director at Pimco. This commentary originally appeared on the firm’s website.