During the third quarter, the global economy largely remained on a path of recovery characterized by above trend growth and labor market improvement. The U.S. economy continued to lead with GDP from the prior quarter registering at 6.6% and an unemployment rate which fell from 5.9% to 5.2%. After a slow start to the recovery, the U.K. and the euro-area economies grew faster than expected as consumers ramped up spending in the aftermath of lockdowns. Despite overwhelmingly positive news, investors still found themselves grappling with new uncertainties thanks to the rise of the COVID delta variant and a potential slowdown in China’s economy. Fears over the global impact of a Chinese slow-down were exacerbated by reports of new government intervention in the economy, most notably in the real estate sector, as well as the imposition of tougher restrictions on carbon emissions. This led to a sharp sell-off in Chinese equities and the default of a leveraged property development firm, Evergrande.
Given the substantial improvement in U.S. growth and unemployment over the past several months, the Federal Reserve strongly signaled that it would begin to taper its asset purchases and reduce the monetary stimulus it has provided to the economy. Barring a meaningful reversal in the labor market, it seems highly unlikely the Fed would not begin reducing its purchases in the fourth quarter. Globally, central banks are setting their own path, with the European Central Bank (ECB) taking a more cautious stance while Norway became the first major Western central bank to raise its policy rate. Though central banks may differ in terms of interest rate policy, all share in the same common belief that inflation will be transitory and moderate as the recovery continues and supply-chain issues subside. This has certainly been the case in the U.S. where price pressures have eased as supply has come online; however, shortages in key components, such as microchips, has kept prices firm which may be exacerbated by the holiday shopping season.
Domestic rate volatility, which was muted through much of the quarter, suggests that the economic recovery and positive news outweighed any uncertainties over the last 3 months. As a result, the 10-year Treasury yield traded in a tight range between 1.19% and 1.36% from mid-July to mid-September. However, the subdued summer came to an end abruptly as stronger growth and inflation fundamentals caused yields to break-out to the upside. In the waning weeks of the quarter, and in the aftermath of the Fed’s taper signal, Treasuries began a sell-off that pushed yields above 1.50% for the first time since June. Municipal yields tracked the Treasury market and were effectively range bound for much of the quarter as the 10-year AAA yield traded in a tight range, between 0.83% and 0.94%. The summer lull ended in the last days of the quarter when the 10-year AAA yield spiked from 0.95% to 1.13%, finishing at the highest level of the year and producing negative monthly returns for only the second time in 2021. Municipal credit spreads were also contained for much of the quarter; however, the riskiest parts of the market finished modestly wider as investors flows turned negative in the last week of the quarter, breaking a 30-week streak of positive inflows.
Third-Quarter 2021 Performance Highlights
- The Thornburg Municipal Strategies were flat to slightly negative on a total return basis for the third quarter of 2021 as September produced only the second negative monthly return this year. The late-quarter spike in yields, and corresponding decline in prices, offset the coupon income collected during the quarter. Municipal yields finished the quarter higher with the 10-year AAA closing at 1.13% after beginning the period at 1.00% and falling as low as 0.82% during the quarter.
- Rising yields resulted in duration being a detractor from performance across all strategies. Shorter duration fared better than longer duration strategies which is to be expected in this type of environment. Strategies are positioned with neutral durations as the Fed’s tapering of asset purchases could be a near-term catalyst for fixed income volatility.
- Municipal credit has experienced a renaissance after showing incredible resiliency in times of economic stress. Issuers are in strong financial positions, flush with cash and struggling to spend Federal aid. This has not gone unnoticed by investors which has attracted investor attention and resulted in record breaking flows over the last 24 months. The long-term trend of lower quality outperforming higher quality reversed at the end of the quarter and as a result our bias towards higher credit quality was a contributor to absolute performance during the quarter.
Current Positioning and Outlook
The fourth quarter of 2021 is shaping up to be the Federal Reserve’s first test in threading the economic needle. Chairman Powell has offered the markets a level of transparency and consistency in messaging as he attempts to shift the FOMC’s monetary policy stance. The communication plan has been successful thus far, as the credit markets avoided the sell-off that occurred in 2013 when Bernanke’s comments on reducing asset purchases sent prices reeling. We believe that unless there is a geopolitical event or huge hiccup in the labor market recovery, the Fed will be steadfast in reducing its purchases in the fourth quarter. While the plan for tapering may be clear, the second step of raising interest rates is less so. The Fed does not seem overly concerned by inflation in the short-term and medium term which has allowed them to focus instead on returning the economy to full employment. If the Fed is using the pre-COVID level of 3.5% as the benchmark it must attain to raise rates, then the labor market recovery is woefully inadequate thus far which may explain why Fed forecasts show rates rising as far out as 2024. This is important because the municipal market has been insulated from rate volatility this year but has not been immune.
Municipal issuers have recovered faster than expected from the pandemic and economic shutdowns and many now finding themselves in the best financial position since 2007. Municipalities have spent the economic expansion to righting the financial ship and by amassing rainy day funds that were approaching record levels pre-pandemic. By controlling expenses, finding new revenue sources, and avoiding the temptation to take on more debt, issuers came into the crisis in a very strong position which allowed them to weather the storm. During the pandemic, personal income taxes were more stable than expected thanks to higher income earner’s ability to transition to work-from-home. Property taxes have held up well due to the real estate boom that has been fueled by low interest rates and a serendipitous ruling by the Supreme Court in 2018 opened new revenue source and allowed states to collect sales tax on online purchases. The online sales tax has added billions to state coffers leaving many struggling to find ways to spend Federal aid they received earlier in the year.
With credit fundamentals the best in over a decade, there is still a need to exercise caution. Municipalities are flush with cash, but few seem interested in using those dollars to address long-term issues. With mid-term elections on the horizon, politicians have an incentive to do what is popular, and if history is a guide, we can expect they will do just that. At the same time, the market has also seen a dramatic increase in high yield municipal assets that has outpaced high yield muni issuance and forced managers up in credit quality to support distribution yields. The migration into BBB and A-rated bonds has collapsed spreads across sectors, such as healthcare, which have traditionally offered incremental yield over other high-quality sectors in the market. Purchasing a bond in those sectors at little or no spread could lead to trouble if yields increase and at the same time credit spreads widen. Suddenly downside risk in prices is compounded by both factors which will be painful for some but create opportunity for us to take advantage of.
If there are any regrets over the last 18 months, it would be our cautious approach during the early stages of the pandemic and not being overly aggressive in the early stages of the recovery. Both would have served us well; however, to do either would be a departure from our core philosophy and the process that is foundational to our success. We do not attempt to completely mitigate downside risk because it is impossible to do without forgoing any upside potential. Instead, we prepare for the possibility of a market dislocation by positioning portfolios for upside participation when inefficiencies become easy to exploit. Strategy positioning has moved towards the preparation phase of the cycle as the Fed has signaled an eagerness to being tapering asset purchases. The strategies have maintained their duration and credit quality positions while cash balances are building so capital can be redeployed if an opportunity presents itself. Valuations across both equity and fixed income markets are at levels that do not ensure a correction will occur, however levels suggest the market is more vulnerable.
Thank you for investing in Thornburg municipal strategies.