Recognizing Opportunity Through the Noise

Market participants are fixated on the next FOMC meeting scheduled for September 19-20 and, of course, the obvious question to ask is, “will the Fed hold the target range for its funds rate steady between 5.25%-5.5% or lift the benchmark by another 25-basis points?” Whether Chair Powell and team vote through a rate increase this month, the actual decision is expected to take on less significance than the impact of Mr. Powell’s post-meeting press conference. The September gathering will deliver a revised summary of economic projections (SEP) which should give an updated and deeper view into the Central Bank’s thought process since the June FOMC. The broader take on the economy with the SEP can be expected to promote the soft-landing narrative as the threat of recession has significantly receded with an advancing likelihood now tied to a late 2024 event. We anticipate somewhat stronger projections for GDP growth in 2023 and 2024 with the SEP, with above-target growth possibly in store for 2025. We expect more modest changes to the new unemployment and PCE inflation projections from the individual policymaker assumptions made in the June SEP. Given the evolving data sets and uncertain global conditions, we believe that the relevant SEP medians are prone to adjustments well into next year. The risks of a weakening Chinese economy made complicated by widening discourse and potential economic de-coupling between Washington and Beijing (jury still out on this), along with volatile oil price shifts, could give rise to unforeseen world-wide stress.

Looming prospects for a government shutdown early next month and a UAW strike (on the heels of a recently inked deal between United Parcel Service and its union workers) may yield growth and inflationary consequences that could alter fresh SEP and other projections. The employment data may reflect variable results, but it remains the cornerstone of our national success story and the driving force behind the soft-landing scenario. The level of consumer engagement will remain a key barometer of overall economic activity and can be expected to influence monetary policy as the Fed encounters less data consistency over the coming months. The recently-released Fed Beige Book continued with a familiar theme of slowing economic momentum with an expected broad easing in business wage increases. Companies across the U.S. are becoming less able to extend their higher costs to their customers according to the Beige Book and some of the Central Bank regions exhibited draws on savings and an increased use of installment debt. Against this backdrop, price advances are showing signs of moderating, with noted improvement in the core personal consumption expenditures index. Taking account of economic standing with growth and inflationary performance, we think that the Fed is in a good position ahead of this month’s FOMC. In our view, there is no sense of urgency to act in any direction as the Central Bank has the runway to either leave rates where they are or to put through another 25-basis point rate hike. Should policy be taken to a more restrictive level, that may bring the current tightening campaign to a natural conclusion, or if the Fed takes a break, that could also bring Chair Powell and team to the finish line. In any event, the Fed can afford to be patient and would be well-advised to preserve its flexibility as it slows demand and brings inflation down to target, while staying at or close to peak interest rates. Certainly, the Fed can boost rates a bit more, and then allow the more restrictive level to stay put for a while and drive the pace of inflation even lower.

August ushered in higher bond yields with all cohorts of fixed income posting negative performance last month, largely due to hawkish rhetoric and Central Bank commitment to drive inflation down to target at seemingly all costs. Treasury prices were also impacted by some stronger-than-expected data points and upsized Treasury issuance. Today’s available absolute yields are able to offer attractive and predictable cash flows that can offset fixed income price erosion in investor portfolios brought on by the Fed’s tightening cycle that began in March 2022. Munis have now earned their place beyond a portfolio diversifier on a tax-adjusted and risk-adjusted basis, and we believe that we will see a return to a performance-adjusted basis. Given how expensive munis had become, it came as no surprise that munis showed more pronounced price weakness. September so far is continuing the trend towards higher bond yields as the FOMC nears, and while the losses continue to mount, munis are currently outperforming MTD. While the muni market has been behaving efficiently, the available cash awaiting deployment would seem to suggest a greater desire to enhance portfolio allocations. We expect more involvement now that summer vacations are over and buyer focus is in place. We also think that retail will find it hard to avoid these compelling yield levels and even better relative value opportunities available in the secondary.

The summertime technicals have become less constructive as expected given tapering reinvestment needs, and net negative supply over the next 30 days stands at about $4.89 billion, which may not be enough of a supply deficit to help with relative performance throughout the month. Having said this, ratios have moved somewhat closer to fair value and this adds to the attraction of the muni asset class. We have yet to witness flow conviction, but it is not for a lack of available cash, but more to do with investor hesitation. While the muni market may not be chock full of excitement today, the stars seem aligned to capture deployable cash. Timing the Fed’s end game for tightening is quite challenging, but we are of the opinion that we are close to peak rates during the current cycle. We do understand, however, that there are a number of factors that can catalyze higher rates and impede fund deposits, ranging from a resurgence of inflationary conditions to governmental and political acrimony, particularly as we enter the general election cycle. Here the message would be to dust off sidelined cash and be prepared to deploy capital opportunistically. Given the confluence of favorable technical and credit muni market conditions, there is a price to be paid for inaction.