Market Commentary: Essentials and Potentials

Published January 8, 2019

The U.S. Department of Agriculture features 29 agencies with 95,000 employees located in 4,500 offices across the U.S. and abroad and a budget of $145 billion including mandatory spending programs for crop insurance, nutrition assistance, and certain commodity support programs totaling $122 billion and discretionary spending programs totaling $23 billion for such things as boll weevil eradication, farm labor housing grants, and feral swine management. One of the massive buildings comprising its Washington, D.C. headquarters on the National Mall was in fact the largest office building in the world when it was completed in 1936. Today, one might expect corridors there to be empty as the government has been partially shut down for 19 days and only essential federal workers in the affected agencies are reporting for work. As it turns out 58,986 USDA employees or 62% of the department’s workforce is still on duty because they are either deemed essential — like Forest Service firefighters — or financed from mandatory appropriations, multi-year discretionary funding, or user fees.

Federal government funding is the topic of much discussion across the land once again this week. The majority (75%) of the government has been fully funded through September ($900 billion of $1.2 trillion). Federal banking agencies such as the FDIC and Comptroller of the Currency are funded by bank assessments and are open for business; the Federal Reserve is funded entirely by market activities and unaffected by the shutdown. But the Departments of Homeland Security, Justice, Agriculture, State, Commerce, Treasury, Interior, Transportation, and Housing and Urban Development have been without funding since December 22. The Federal Aviation Administration, Internal Revenue Service, Food and Drug Administration, NASA, EPA, Securities and Exchange Commission, and Smithsonian museums are all agencies technically closed in the midst of what is now the second longest shutdown on record. It only takes three more days to set a new one.

Approximately 800,000 of the 2.1 million federal workers employed in all 50 states have been furloughed. 420,000 are deemed essential and are working without pay. 380,000 deemed non-essential are on unpaid leave. States with employees and government contracts most affected are California, Texas, the District of Columbia, Virginia, Maryland and Florida. Their combined salaries exceed $1.4 billion per week and are likely to be paid in arrears once the President and Congress reach agreement on the terms of a spending bill. At this writing those terms are elusive, but an agreement will eventually be forged on the $5 billion in Homeland Security border wall funding sought by the President. In the meantime, “essential” feds including approximately 3,200 Secret Service agents, 13,709 FBI agents, 47,000 transportation security officers, and 52,000 IRS employees remain on the job.

The new year started off well for both stocks and bonds when Fed Chair Jay Powell gave the financial markets a very generous gift on the 11th day of Christmas. Instead of the traditional pipers piping, he offered promises of patience. While once again citing the strong economy and low inflation, he said that the central bank was ready to change course significantly as necessary. These words were just what the markets needed to hear after the December rate hike and months of worries over trade wars and slowing growth overseas. 2018 was a year of wild financial market swings and the final month of the year saw a significant selloff in equities. The Dow lost 2,211 points in December, closing at 23,327, and finished the year 1,391 points below where it started. The S&P 500 closed at 2,506, a loss of 253 points on the month and 166 points on the year. The Nasdaq ended at 6,635, a loss of 695 points in December and 268 points from where it began 2018. Oil closed at $45.41 per barrel, a price that fell $5.52 on the month and $15.01 during a year in which America became the world’s largest producer. Gold gained $61.06 an ounce in December to end the year at $1,281 but this was $21.22 below where it began last January.

Volatility in the stock market as measured by the Chicago Board options Exchange SPX Volatility Index increased from 16.44 to 36.07 and settled at 25.42 in December, above the daily average for the year at 16.64. Bonds rallied along with gold in December as investors moved to safer assets. Treasury yields dropped 30 basis points across the curve and muni yields fell by an average of 20 basis points. The 2-year Treasury yield closed at 2.48% and the 10-year finished at 2.68%. The 30-year yield slipped below 3.00% several times last month but ended at 3.01%. The 2-year AAA municipal general obligation bond yield fell 14 basis points to 1.78%, while the 10-year dropped 23 basis points to 2.28% and the 30-year yield closed down 20 basis points to 3.02%. On the month, investors withdrew $46.9 billion from taxable fixed income funds and $69.7 billion from U.S. and global equity funds. A net of $197 million was added to high yield muni funds but municipal bond mutual funds as a whole lost $2.9 billion.

December muni issuance totaled $22.1 billion, well below the $69.5 billion record level set in the final weeks of 2017 before the new tax reform law eliminated advance refundings and tax credit bonds. Trading averaged $11 billion per day, slightly below the $11.6 billion average for the year. In 2018, SIFMA reports that $338.3 billion of municipal bonds were issued by competitive and negotiated sale and private placement; this was nearly 25% below the $448 billion issued in 2017. In response to market volatility, mutual fund investors shuffled and reallocated their money between stocks, bonds and cash. In the end, Lipper reported that a net of $136.9 billion was added to taxable money market funds, $49 billion was added to taxable fixed income funds, $15.2 billion flowed into tax-exempt money market funds and $1.7 billion to high yield muni funds. $4.7 billion was withdrawn from equity funds, and $1.3 billion was redeemed from all muni funds combined.

In 2018, unemployment fell to the lowest rate since 1969, the poverty rate reached a near historic low and household income increased. As of the third quarter, U.S. gross domestic product was nearly $8 trillion larger than the GDP of China. The Fed raised rates by 100 basis points over the course of four hikes but bonds nevertheless performed pretty well and remain in the range of historic lows. As expected, the 2-year Treasury felt the most pressure and yields rose the most, 60 basis points, from 1.88% to 2.48%. The 10- and 30-year yields increased by 28 basis points each from 2.40% to 2.68% and from 2.73% to 3.01%. Volatility as measured by the Chicago Board Options Exchange 10-year Treasury Note Volatility Index ranged from 3.16 to 6.07 with a daily average of 4.04. Munis outperformed governments on the short end, but underperformed on the intermediate and long ends of the yield curve. The 2-year muni yield gained 22 basis points, the 10-year rose 30 basis points and the 30-year yield climbed 48 basis points from the start of the year. Muni spreads widened in 2018; the difference between the 2- and 30-year yields increased from 98 basis points to 124 basis points. Treasury spreads, on the other hand, compressed from 85 basis points to 53 basis points. The ICE Bank of America Merrill Lynch US Treasury and Agency Index ended the year with a tax-equivalent total return of +0.82% while the U.S. Corporate Index finished at negative 2.25% and the U.S. Municipal Securities Index closed at +3.98%.

A new year has begun and investors feel buoyed by a tremendous holiday consumer spending spree and unexpectedly strong jobs report. Traders have seen partial government shutdowns before and are not rattled – yet. Markets await progress on trade talks and in the meantime are trading not only as if there are no more rate hikes on the horizon but as if a rate cut is possible. Amazon replaced Microsoft in as the most valuable publicly traded company in the U.S. There have been more changes in key White House and Administration roles and a rare Oval Office address. Democrats have regained control of the House of Representatives. More Brexit votes loom across the Pond. Data on U.S. inflation, new home sales, construction spending, and factory orders are expected this week but some may be postponed due to the shutdown. Seasonal and technical factors bode well for the tax-exempt sector this month. The municipal market springs back to life with an $8 billion primary calendar and investors are flush with January coupons and maturities. We welcome everyone back from the holidays and wish you a happy, healthy, and prosperous 2019.

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