1Q 2024 Municipal Bond Market Insights
Mar 21, 2024
PGIM Fixed Income’s Head of Municipal Bonds, Jason Appleson, shares his views on the economy, interest rates, and the increasing appeal of municipal bonds.
MODERATE GROWTH WITH “WEAKFLATION” AHEAD
Despite elevated volatility and continued uncertainty in 2023, the U.S. economy remained resilient throughout the Federal Reserve’s (Fed) hiking cycle. The Fed hiked by an additional 100 basis points in an environment marked by falling but still relatively high inflation. Against this backdrop, municipal (muni) bonds delivered solid 2023 performance.
We continue to believe that “weakflation” is the most likely economic theme in the U.S. Under this scenario, U.S. GDP growth is expected to slow but remain positive, with declining-but-sticky inflation above the Fed’s 2% target. Our current forecast is for below-trend growth in 2024.
The demand for labor has been coming down over the past year. At the same time, labor supply has actually increased, buoyed by immigration to a certain extent, among other factors. As the gap between labor demand and labor supply continues to close, we believe the labor market will show signs of weakness and contribute to a slowing economy.
RATE CUTS MAY BE COMING LATER IN THE YEAR
Markets and the Fed are looking ahead to when policy easing may be necessary. Although the Fed signaled that cuts were coming, there’s no guarantee they will commence in the first half of the year. Chairman Powell has stated that he wants to see “more good data” to support the belief that inflation is moving sustainably toward the Fed’s 2% target. We continue to expect a modest series of rate cuts from the Fed, with easing to begin in the second half with a total of three rate cuts in 2024. These reductions in policy rates, while easing, are likely to leave policy in restrictive territory.
MUNIS ARE A LATE-CYCLE HAVEN
Over the last two decades, there has been a shift in dynamics in broker-dealer inventories, which have declined by 75% since 2007. Meanwhile, traditional retail vehicles, like ETFs and open-end mutual funds, have been growing significantly and play a key role in the overall liquidity of the muni market. Muni bond yields have been elevated over the past 10 years, making taxable equivalent yields relatively attractive versus Treasury market where rates are at around 4%. The tax shield has improved materially with higher rates as more dollars are exempt from taxation.
Default rates in muni bonds and the probability of getting downgraded are lower versus corporate bonds. As states benefited significantly from COVID stimulus, the balances in state rainy day funds, which allow states to set aside surplus revenue for use during unexpected deficits, remained at record highs. While this surplus may start to decrease as the economy slows, they are coming from the highest levels recorded since before the Great Financial Crisis.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
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