Economic Perspectives: Federal Debt: A Fiscal Year End Update
FAQs on the Markets and Economy
Has inflation started to respond to the Fed’s interest rate hikes?
Not yet, inflation is still running hot.
The September’s gain in Consumer price index (CPI) was up 0.4% Month-over-month (MoM) and 8.2% Year-over-year (YoY), down from 8.3% last month. Core inflation (which excluded food and energy prices) jumped to 6.6%, marking a 40-year high.
Core-service inflation continues to explode higher; prices rose 0.8%, the largest monthly increase of the cycle. This was driven by housing costs, which had their largest jump of the cycle. Although the market price in housing has turned a corner, the price data for CPI has built-in stabilizers for the CPI calculation and do not show the moderation. For example, since the pandemic’s start, home prices are up over 40%, rents are up over 20%, and CPI rent is up only 11%. Another area for higher inflation has been with medical services responding to higher wages.
September’s CPI gain was more substantial than expected. This report cements the need for a 75 basis points (bps) increase in the federal funds rate at the Fed’s Nov 2 meeting (that has been our base case for a while but wasn’t fully priced into the market). There will be two more CPI reports before the December 14 FOMC meeting. It will give the Fed more information going into the meeting, in which they currently plan a 50 bps hike.
Is the worst for markets behind us?
Investors have had few places to hide in 2022, with both equity and fixed-income markets simultaneously recording three consecutive negative quarters for the first time in over four decades.
Unfortunately, we think volatility looks set to continue near term. Investors still have a long list of uncertainties to ponder, including slowing U.S. growth and overly optimistic earnings estimates, rising financial stress abroad, Europe’s increasing energy crisis, and the ongoing Russia-Ukraine war. Most importantly, the persistence and breadth of inflation have provided an unwelcomed reminder to markets that rates may stay higher for longer than anticipated.
For some time now, CNR has maintained our above-consensus views on recession probability, the upward path of interest rates, and geopolitical risks. It is now clear that central banks around the world will raise interest rates even further than our above-consensus forecasts had implied, making the current tightening cycle the most aggressive in three decades. Given this, we now see the global economy entering a recession next year and the probability of recession in the U.S. rising to 60%.
The prospect of even tighter monetary policy in the near term points to the potential for a sharper slowdown in economic and corporate profit growth than is currently factored into market expectations. As a more challenging outlook for both the economy and corporate earnings is discounted, stock markets could continue to grind lower, even if government bond yields do not rise any further.
Historically, the S&P 500 has declined about 31% in a bear market, which means the current bear market low of about 25% is still well below average. Bottoming will likely be a process that could take some time to play out, with further swings in sentiment as investors gain greater clarity on the outlook. Looking forward, we continue to think that inflation and the response from policymakers will ultimately determine the direction of travel for markets ahead. Until a pattern of lower inflation readings is established, equities are likely going to have a hard time mounting a sustainable rebound, and bonds could remain under pressure.
Is the labor market responding to the Fed’s raising of interest rates?
The Fed’s goal of raising interest rates has been to slow down consumer demand, leading to lower price pressures.
Nonfarm payroll development decelerated in September to 263,000 from 315,000. Consequently, there’s an extension of the slowing down in labor need, bringing the three-month alter to 372,000 (see chart).
Wage growth continues to decelerate, which is good news for the Fed. The monthly gain was just 0.3% for the second month. The yearly change dropped to 5.0% from 5.2%. For comparative purposes, most of the past expansion was between 2% - 3%. But the pace of wage gains has been slowing since March; the recent three-month change annualized is just 2.4%. But this decline is not consistent with the Employment Cost Index data or the Atlanta Fed Wage Tracker, which are better measurements of wages, so there is no victory to be declared yet.
Gradual improvements cannot be mistaken for a completed journey, and the Fed has yet to see significant weakness in the labor market from its rate hikes. This month’s gain in NFP and the decline in the unemployment rate (3.5%) support the case for continued aggressive Fed hikes. The Fed’s current plan implies a 75 bp hike in November and a 50 bp hike in December.
Do we expect municipal credit deterioration from Hurricane Ian?
According to risk modelers, Hurricane Ian caused significant damage to property and infrastructure across parts of Florida that could reach tens of billions in insured losses.
While it is too early to determine the particular impact on the most affected issuers, the availability of federal/state aid, insurance proceeds, and other resources generally support credit quality. A federal disaster declaration will release FEMA funds to local governmental communities and enterprises (LGs). FEMA relief funds reimburse at least 75% of eligible infrastructure repair and replacement storm-related costs. But due to timing lags in FEMA, in the near term, LGs will rely upon their internal liquidity and, more importantly, state assistance to fund emergency response, clean-up, and restoration needs. Favorably, given the storm-prone nature of Florida, over the years, many LGs developed planning practices and policies with contingencies to counter unforeseen circumstances. These efforts are critical in helping manage their credit quality.
The fiscal position of Florida State should guard its credit profile against potential economic and financial fallout from the storm but also enhances its ability to help its LGs. The revised financial outlook released in September 2022 shows general state reserves anticipated for FY 2022-23 of more than $17B (with additional funds in various Trust accounts), providing ample flexibility. The state’s $500 million allocation towards disaster response will assist with the aftermath. Recently, the Governor announced the state’s commitment to subsidizing a significant share of the costs of LGs to alleviate financial pressure and accelerate rebuilding (e.g., transportation/utility infrastructure). We expect LGs to lean on their internal cash balances and, in some instances, access bridge loans or short-term debt to meet their operational needs until aid and other support are received.
We will monitor the situation closely but don’t expect material rating pressure for most issuers. It is unlikely that missed payments will occur from fundamental erosion in the capacity to pay debt service. According to Municipal Market Analytics, Florida has experienced only a single investment grade [safe sector] default in the last fourteen years (the Santa Rosa Bay Bridge), which the Governor recently cured with a full repayment. Thus, the state demonstrates historical support for its LGs. Over the medium-to-longer term, economic tax and customer base changes are key factors, and the uncertainty associated with the state’s insurance market will likely have implications. Nevertheless, we see limited credit impact on high–grade issuers at this time.
Important Disclosures
The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial infor-mation. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been inde-pendently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
There are inherent risks with equity investing. These include, but are not limited to, stock market, manager or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.
Investing in international markets carries risks such as currency fluctuation, regulatory risks and economic and political instability.
There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with in-vestments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.
Investing involves risk, including the loss of principal.
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
Non Deposit Investment Products are: Not FDIC Insured, Not Bank Guaranteed, May Lose Value
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Readers are cautioned that such forward-looking statements are not a guarantee of future results, involve risks and uncertainties, and actual results may differ materially from those statement. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
Past performance or performance based upon assumptions is no guarantee of future results.
Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment adviser and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
INDEX DEFINITIONS
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading pub-licly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.
Muni Bond: A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. These bonds can be thought of as loans that investors make to local govern-ments.
Bloomberg Barclays U.S. Corporate High Yield Bond Index: measures the USD denominated, high-yield, fixed-rate corporate bond market.
Dow Jones Select Dividend Index: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio and the trading volume. The components are then weighted by the dividend yield.
CBO: A collateralized bond obligation (CBO) is a type of structured debt security that has investment-grade bonds as the underlying assets backed by the receivables on high-yield or junk bonds.
Moody’s: Moody’s Corporation (MCO) is the holding company that owns both Moody’s Investors Service, which rates fixed income debt securities, and Moody’s Analytics, which provides software and research for economic analysis and risk management. Moody’s assigns ratings on the basis of assessed risk and the borrower’s ability to make interest payments, and its ratings are closely watched by many investors.
Penn Wharton Budget Model: Penn Wharton Budget Model’s (PWBM) tax policy simulator allows policymakers, members of the media, and the general public (“users”) to see the impact that potential reforms to tax policy will have on many the economy and the federal budget.
NDMC: National Drought Mitigation Center (NDMC) The National Drought Mitigation Center’s mission is to reduce the effects of drought on people, the environment and the economy by researching the science of drought monitoring and the practice of drought planning.
NOAA: The National Oceanic and Atmospheric Administration (NOAA) is an American scientific and regulatory agency within the United States Department of Commerce that forecasts weather, monitors oceanic and atmospheric conditions, charts the seas, conducts deep sea exploration, and manages fishing and protection of marine mammals and endangered species in the U.S. exclusive economic zone.
USDA: The United States Department of Agriculture (USDA) is the federal executive department responsible for developing and executing federal laws related to farming, forestry, rural economic development, and food.
The SIFMA Municipal Swap Index: The Securities Industry and Financial Markets Association Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obli-gations (VRDOs) with certain characteristics. The Index is calculated and published by Bloomberg. The Index is overseen by SIFMA’s Municipal Swap Index Committee.
CalPERS: The California Public Employees’ Retirement System, also known as CalPERS, is an organization that provides numerous benefits to its 2 million members, of which 38% are school members, 31% public agency members, and 31% state members.
4Ps: The 4P analysis is a proprietary framework for global equity allocation. Country rankings are derived from a subjective metrics system that combines the economic data for such countries with other factors including fiscal policies, demographics, innovative growth and corporate growth. These rankings are subjective and may be derived from data that contain inherent limitations.
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