The Top Five: Midterms and the Muni Market
Strategas’ Head of Fixed Income Research Tom Tzitzouris looked into his crystal ball to handicap the 2022 midterm elections and gauge their impact on the muni market. Here are our top five takeaways from our conversation with Tom.
Takeaway No. 1: With less than one month to go, we expect the Republicans to take control of the House of Representatives.
After Election Day, the current Congress has roughly eight weeks (known as a “lame duck” period) to pass any final legislation before the new Congress is sworn in. Were the Republicans to capture one or both houses of Congress, we’d expect the Democrats to try to take advantage of their existing congressional majorities and pass what they can during this lame duck session. That could include legislation on taxes, stimulus and other Build Back Better provisions that didn’t make their way into August’s Inflation Reduction Act.
What could this mean for the municipal market? Probably not a lot. Although sometimes lame duck sessions can create meaningful legislation, like when Congress passed the Bush tax cuts in 2010, it’s unlikely we’d see anything pass that could materially affect the muni market. Maybe some provisions on taxes, like the child tax credit.
It’s also worth remembering that there are still only 50 Democratic senators. Anything that would pass the House during the lame duck would still need every Democratic senate vote, including those from more conservative Democrats like Joe Manchin and Kyrsten Sinema.
Takeaway No. 2: If the Democrats maintain or expand their majorities, expect a quieter lame duck session but a more active two years ahead of the 2024 general elections.
This would be especially true if the Democrats pick up seats in the Senate, in which case their proposed legislation might not need to be so constrained to accommodate Senators Manchin and Sinema. This outcome could result in an expanded child tax credit, Medicare and Medicaid expansion and new provisions on affordable housing.
Were that to pass, you’d probably see these programs paid for with higher taxes, particularly on the wealthy, which would create some demand for municipal bonds. But there’s a catch: The markets would likely see this scenario as inflationary from the start. The Fed has committed to fight inflation by raising rates, and any economic benefit from increased demand and higher taxes could potentially be offset by the target Fed Funds rate ratcheting up to 4.75% or higher. That could result in a selloff of long-duration assets, which would be a buying opportunity for muni investors.
By comparison, if the Republicans take either the House or the Senate, or both, the market will likely view that as inflation-neutral or even somewhat deflationary.
Takeaway No. 3: Don’t count on a post-midterm market rally.
For decades, the pattern around midterms has been weakness in the market ahead of the elections resulting from policy uncertainty but something of a rebound after the election was over. This rebound was regardless of which party found themselves in power after the votes were counted – just attaining some semblance of certainty and direction was enough to give the markets a boost.
This year could be different because we don’t typically see the U.S. economy headed into a recession in year 3 of the presidential cycle. The ability of the Biden administration to use stimulus to bolster the market next year is already substantially diminished, plus the Fed still has more tightening to do. If anything, the likelier outcome is for additional market weakness between Election Day and the middle of next year. Were that to pass, I think you’d see credit spreads widening across both investment-grade corporates and municipal governments – munis probably less than corporates – but also further decline in the five- to 10-year part of the Treasury curve.
The best argument for a post-midterm rally is if the Republicans win one or both houses of Congress and the market views that as less inflationary. That could push yields down and provide a rally across risk assets and bonds.
Takeaway No. 4: Higher inflation still means higher borrowing costs for muni governments … but it’s complicated.
To understand why, it might be helpful to first look overseas. The Bank of England has been the first central bank to say they will keep tightening and raising rates to fight inflation, preserve sovereign borrowing costs and control the yield curve.
The entire U.S. investment community – equities, credits, munis – assumes the Fed will follow that same course. That includes curtailing balance sheet reduction: You might remember from our last conversation that we expected the Fed to stop tapering in the spring and even start reducing their $8.5 trillion balance sheet. They did, but balance sheet reduction has been drastically slow so far in 2022. If they keep to their current course, the Fed might put their balance sheet reduction agenda on hold before they start cutting rates – or even before they stop hiking rates.
As a result, the yield curve is going to be flatter than it otherwise should be. It’s already inverted, and it should continue to invert from here if the Fed continues on that path toward a 4.50% to 4.75% target Fed funds rate.
Takeaway No. 5: A recession is highly likely – but it’s unclear how deep it will be.
Short of perhaps Putin backing down in Europe, we think a recession is highly probable – but right now, we believe it will be a shallow recession. That could mean unemployment rising by only 1% to 1.5%, credit spreads in the investment-grade corporate space widening another 15 to 20 basis points and muni spreads widening 5 to 20 basis points. A shallow recession could also result in Treasury yields dropping another 30 to 50 basis points in the five- to 10-year part of the curve.
A lot will depend on how high the Fed Funds rate goes. If the Fed keeps it at 3.25% to 3.5%, which is close to where they are now, it will be a very shallow recession, almost negligible. If they bring the rate up to 4.50%, you're talking about a more painful recession. If the election results in policies that are seen as inflationary and the Fed responds by bringing the Fed Funds rate up to 5%, you’re almost certainly talking about a deep recession, which will be met with higher taxes on the wealthy and higher spending. That’s the exact playbook for stagflation.
But there is another risk I’m worried about. Let's assume that Republicans take at least one of the houses of Congress, creating a divided government. In that instance, there's little potential for municipal stimulus next year, at a time when you're looking at shrinking revenues across most state governments. With revenue growth not likely to meet expenditure growth, there will have to be some level of increased municipal government borrowing in late 2023 or 2024. This scenario would be similar to what we saw from the 1950s to the 1980s in smaller Northeastern and upper Midwest cities – cities that didn't have the debt levels they have today. The combination of increased municipal debt amid declining revenues was horrific: Cities like Detroit, Cleveland, Cincinnati and Pittsburgh lost half of their population, some more – and they didn’t recover until the late 1990s or early 2000s. I’m not predicting that’s going to happen again, but it’s worth acknowledging the economic preconditions are there. History doesn’t always repeat, but it often rhymes, and if it rhymes here, that could be devastating.
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