Munis in Focus: 2018 Municipal Market Outlook

SUMMARY

  • We believe U.S. economic expansion and federal tax cuts will be generally supportive of municipal credit fundamentals in 2018.
  • After a surge in muni issuance in December leading up to tax reform, we expect a decline in issuance this year, which we anticipate would provide a tailwind for valuations.
  • Banks and insurance companies, paying less in federal taxes, will likely require higher relative yields and lower prices on tax-exempt municipals before becoming net buyers during outflow periods. And with the risks of a cyclical inflation overshoot rising, a pickup in interest rate market volatility could test this new muni liquidity paradigm.
  • In our view, a modest duration underweight and an emphasis on portfolio liquidity will provide the ability to turn municipal valuation overshoots into opportunities.

We expect policy will continue to drive municipal bond markets in 2018, if more constructively than in 2017. Municipal investors may remember 2017 as the year of unrealized policy fear. While the threat of tax reform and its potential to reduce the value of the muni exemption for retail investors ­loomed large, ultimately it had little impact on individual municipal bonds.

For 2018 and beyond, more significant policy changes – including limitations on certain muni issues, curtailment of the state and local tax (SALT) deduction and the reduction in corporate tax rates – we anticipate will influence supply and demand and underscore the need for an active approach. In our Cyclical Outlook for the next six to 12 months, PIMCO’s top global macro and investment experts identified three areas of risk that we believe municipal investors should watch this year:

  • Late-cycle fiscal stimulus. We estimate that U.S. fiscal expansion will contribute close to 0.5% of GDP in 2018, with the economy already operating near full employment.
  • Rising risks of wage and/or price inflation. Global structural forces are still weighing on inflation, but cyclical pressures and the risks of an overshoot are rising.
  • Risk of monetary policy overkill. We expect the Federal Reserve to hike three times this year, the European Central Bank to begin signaling hikes in 2019 and the Bank of Japan to curb balance sheet expansion and/or tweak its yield curve control policy toward a steeper curve.

Against this backdrop of fiscal expansion and reduced monetary accommodation, PIMCO plans to position for pockets of interest rate and price volatility that may give rise to active opportunities in the muni market. We expect to be moderately underweight duration and will look to apply the best bottom-up ideas while maintaining the flexibility and liquidity to take advantage of opportunities presented in more difficult market conditions. At the start of 2018, credit spreads in lower-quality municipal assets look attractive versus other U.S. credit alternatives.

Issuance set to decline after December surge, creating a performance tailwind

December 2017 marked the single largest month of issuance in municipal market history, with $64 billion in supply, surpassing the period just before tax reform in 1986. With not-for-profit healthcare, higher education, private activity bonds and advanced refundings all on the chopping block in dueling House and Senate tax reform proposals, issuers rushed to market to beat the year-end deadline, effectively “pulling forward” issuance from future years.

When the dust settled, advanced refundings ­– which allow municipal issuers to refinance debt with call dates greater than 90 days ­– were the only form of issuance to get the ax in the Tax Cuts and Jobs Act. These issues represented 22% of primary supply in 2017, and while it’s hard to gauge exactly how much future healthcare, higher education and private activity bond issuance was pulled forward into 2017, we think a decline in total primary supply of 25% or more in 2018 seems probable. This could create a tailwind for municipal asset performance over the cyclical horizon.

We believe such declines in municipal issuance could firm into a lasting trend. A number of factors have constrained supply over the past decade, including the 2009–2010 federal Build America Bonds (BABs) program, which diverted callable federally tax-exempt income muni issuance into taxable noncallable bonds, along with a dip in issuance in 2011 amid global market volatility. All told, we expect there to be less callable tax-exempt debt eligible for refinancing into longer-duration primary supply over the next three to four years, which will support valuations on outstanding bonds.

In our view, only a large-scale national infrastructure program that taps the traditional tax-exempt municipal bond market to finance new assets or improve existing ones could significantly expand future supply. However, we think this may prove difficult in 2018 given the need for bipartisan support and an already crowded legislative agenda.