1. Many state and local governments have been under pressure due to the pandemic. What’s your outlook for this sector in 2021?
The January 5 runoff election for Georgia’s two Senate seats has tipped the delicate balance of power in the federal government from divided to unified with the new administration. This outcome has considerably altered the landscape for state and local governments, and for the municipal bond market itself. Last week’s statement from then President-elect Biden confirmed that direct additional aid to state and local governments and an infrastructure package would form a critical part of his administration’s economic policy agenda. Market participants appear to have welcomed both developments and we will assess the prospects of this agenda as the legislative session unfolds.
Revenue and capital outlay pressures remain, despite several states announcing less-severe-than-expected revenue declines. We believe this is a second-order effect of earlier rounds of fiscal and monetary support that helped fuel strong equity market gains and anticipated capital gain receipts. As an example, California’s revenues are highly sensitive to personal income taxes, yet recently reported revenues through November were 23% ahead of the state’s fiscal year 2021 expectations (July 2020-June 2021). However, these announcements may not account for the reality that many states lowered revenue expectations substantially when formulating their budgets.
We expect fiscal pressure to remain significant over the medium term as the pandemic continues to weigh on large segments of the economy. Further, the revenue hit has varied widely, with some states facing substantial budget shortfalls. In our view, fiscal aid will likely be critical to limit deep cuts and additional layoffs. Of the 9.8 million nonfarm payroll jobs that have been lost during the recession, nearly 1.4 million have been in the state and local sector.[i]
2. What impact could the new administration have on the municipal sector?
In terms of direct market impact, much will depend on the details of the policy agenda and its prospects for passage in a closely balanced Congress. One key factor we’re awaiting is the size and scope of the infrastructure package, which the administration is expected to outline in coming days. Roughly 70% of core infrastructure finance takes place in the municipal market. But the type of program—whether it proposes direct federal grants or a taxable subsidy like the Build America Bond Program—will determine the market impact due to the mostly distinct investors that participate in the tax-exempt and taxable municipal markets.
Tangential to the pool of buyers is the prospect of an increase in the marginal corporate tax rate. The corporate tax cut instituted in the 2017 Tax Act largely dis-incentivized insurance company and bank purchases of tax-exempt municipals. Since the end of 2017, outstanding holdings of municipals declined by nearly 5% for insurance companies and more than 13% for banks.[ii] And the dis-investment in the exempt market was probably understated as issuance shifted to the taxable market, likely expanding the proportion of taxable municipal holdings.
Finally, it may be a long shot, but the prohibition of tax-exempt advance refunding in the 2017 Tax Act could come into play. If the new administration seeks a rollback of the prohibition, it could have a large impact on tax-exempt supply, which was reduced by 15% to 25% as a result of the 2017 Act. We expect that any additional supply, whether tax-exempt or taxable, will likely be met with strong investor demand.
3. What’s your view on municipal credit fundamentals? Do you see any prospects for improvement in credits that were hit hard by the pandemic?
We believe the prospects for municipal credit have been improving. Credit fundamentals for most municipal sectors typically change relatively slowly as tax and revenue generation tend to reflect longer-term economic trends. But the pandemic precipitated rapid changes in fundamentals that were largely the result of public health measures rather than economic factors; therefore, we anticipate relatively quick improvement in fundamentals once public health measures are lifted.
The pandemic is currently at severe levels, but the expectation of faster, wider-scale vaccinations could provide a rationale for anticipating improving economic activity as the year unfolds. Some sectors of the economy and the municipal market will likely take longer to recover. For example, the recoveries of mass transit and airports will likely be correlated to vaccination progress as well as difficult-to-anticipate behavioral changes. However, our medium-term outlook, particularly if accompanied by additional fiscal relief, is now less bleak than it was almost a year ago.
[i] Bureau of Labor Statistics, The Employment Situation – December 2020.
[ii] Securities Industry and Financial Markets Association, as of September 30, 2020.
Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted. Data and analysis does not represent the actual or expected future performance of any investment strategy, account or individual positions. Accuracy of data is not guaranteed but represents our best judgment and can be derived from a variety of sources.
Market conditions are extremely fluid and change frequently.
Loomis Sayles does not provide tax advice. Please consult with your financial advisor or tax professional.
This blog post is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. This information is subject to change at any time without notice.