Market Outlook

This morning’s stronger-than-expected payrolls number for November (203,000 versus the Street consensus of 185,000, with the jobless rate dipping to 7.0%) capped a week of generally positive economic data. The average work week rose to 34.5 hours and the average hourly earnings for private employees edged up to $24.15. Coming on the heels of a blowout GDP growth of 3.6% for Q3, today’s jobs report all but confirmed the resiliency of the U.S. recovery, in the face of all the fiscal headwinds coming out of Washington D.C.

Even the dreaded fiscal drag could be fading soon. As reported by the Wall Street Journal, “Congressional budget negotiators are working to wrap up a two-year fiscal agreement that would put to rest the threat of a government shutdown in mid-January and bring order to a tumultuous budgeting process until after the 2014 elections.”

Municipals have not, of course, been immune to the downward pressure in Treasuries.

One sobering note among all the economic optimism: much of the Q3 GDP growth came from inventory accumulation, potentially at the expense of the current quarter.

Over the last few trading days, the financial markets have been operating in that rather perverse “good news is bad news” mode, where the strong economic data are viewed negatively just because they might accelerate the timing of the Fed’s tapering efforts. Equities have been selling off while 10-year Treasury yields once again tested the 2.90-3.00% range. With everyone already set up for a worst-case scenario, this morning’s news allowed equities to recoup much of their losses from earlier in the week. After an initial knee-jerk spike to 2.93%, Treasury yields have also stabilized around the 2.87% level.

Overall, the market’s initial reaction may indicate that investors are starting to get comfortable with the threat of tapering. Having said that, we still assign a low probability to any kind of Fed action before year end. The central bank may wish to see at least one more month of firm economic data before making any kind of a move.

Municipals have not, of course, been immune to the downward pressure in Treasuries. As of Thursday night, the Bond Buyer’s 20-Bond GO Index has increased by 9 basis points this week, to 4.70%. The Revenue Bond Index has also risen by 7 basis points this week, to 5.30%. Both indices are at their highest since mid-September.

Absent a turnaround in Treasuries, an expected surge in new issue supply next week, to over $10 billion, should keep the tax-exempt market on the defensive. Interestingly, almost half of next week’s calendar will be coming from New York State.

A Watershed Week in Munis

This week turned out to be one of those watershed weeks when many of the common wisdoms in muniland were challenged.

For one, Jefferson County’s relatively smooth exit from bankruptcy proved that, in spite of doomsday threats from market traditionalists, the muni market really does not have a very long memory. As my friend Phil Fisher from Bank of America said recently, “there is no bad bond, only bad prices.” To put it differently, there is a price for everything, even for bankrupt credits. Going forward, it’s hard to conceive of any issuer being locked out of the market due to the stigma of bankruptcy. The rising participation of opportunistic crossover investors in our market will ensure there’ll always be a bid side out there. (Officials from Puerto Rico should take note, but then again, they probably already know this).

As we intimated in our last column, Judge Rhodes’ ruling in Detroit was a shot heard all around the country, and as far west as California, where two key municipal bankruptcy cases are being decided: Stockton and San Bernardino. In both cases, the treatment of pension obligations due to the California Public Employee Retirement System (CalPERS) in Chapter 9 has been a critical issue. So far, the City of San Bernardino has taken a hard line and stopped making payments to CalPERS. Its position should be bolstered by the Detroit ruling. The City of Stockton, in contrast, has chosen not to cut pension obligations in bankruptcy, a decision which is being hotly contested as unfair by one of its creditors, the Franklin Funds. The latter’s argument may also be strengthened by the Detroit ruling.

By sheer coincidence, on the same day Detroit retirees saw their unsecured creditor status confirmed, the Illinois legislature also overcame years of political paralysis and passed a landmark pension reform package …

Not that we should expect CalPERS to give in without a fight. In response to the news out of Detroit, the retirement system gave an interesting preview of its legal strategy:

“The Detroit court failed to recognize the difference between a two party contract and the unique nature of a state public employee retirement system, which creates a three-way relationship among a public agency, its employees and the retirement system. In California, our members’ vested rights to their pensions are protected by the California constitution, statutes and case law.

Unlike Detroit, CalPERS is not a city pension plan. CalPERS is an arm of the state and was formed to carry out the state’s policy regarding public employees. The Bankruptcy Code is clear that a federal bankruptcy court may not interfere in the relationship between a state and its municipalities. The ruling in Detroit is not applicable to state public employee pension systems like CalPERS.”

By sheer coincidence, on the same day Detroit retirees saw their unsecured creditor status confirmed, the Illinois legislature also overcame years of political paralysis and passed a landmark pension reform package, which Governor Pat Quinn signed into law yesterday.

Although the new pension rules are expected to be challenged in court by the municipal unions, they have apparently been carefully crafted to withstand any potential legal attack. For instance, even though pension obligations are constitutionally protected in Illinois as a “contractual relationship,” Democratic and Republican legislative leaders contend the phrase “contractual relationship” allows them to impose retirement benefit reductions if they offer something in exchange to employees – a legal concept known as “consideration.” As a result, retirees now have the right to sue the State to enforce funding of pension liabilities, among other things.

Thus far, the market has rewarded Illinois paper with significant spread tightening: the taxable pension obligation bonds in particular have tightened by almost 45 basis points. We’ll be able to observe the impact on G.O. bonds when the State comes to market next week.

Does this mean Illinois is out of the woods? Of course not. It will be several years before the pension changes will have a significant impact on cash flows. Until the Prairie State’s huge backlog of unpaid bills and ongoing structural deficit are addressed, Illinois paper should continue to trade as the cheapest State credit in the country. Nonetheless, pension reform, if upheld, should give the State a little breathing room to put its fiscal house in order.

Will the Detroit ruling incite other local governments around the country to consider bankruptcy as a way to restructure their crushing pension obligations? We think that’s possible, but highly unlikely. Clearly, any municipality in financial distress with its back against the wall will need to consider all of its options. However, the unions may now find it preferable to work out a compromise outside of bankruptcy, rather than take the risk of going through a messy Chapter 9 process, where literally anything can happen.

History was made in munis this week and much of it bodes well for the market going forward.

Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.

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