Sarasota financial advisor: Don’t panic over trade tariffs!

Sarasota financial advisor: Don’t panic over trade tariffs!

By Ray Collins | May 15, 2019

John Mousseau says it is important not to get caught up in concerns about a trade tariff war with China.

“If you’re sitting there and you read just the headlines, it looks like a cannon ball shot across the bow of the ship. In essence what it is, is just a shot in a longer term negotiation. I think it was long overdue to negotiate with some trading partners. The U.S. — in terms of being a world partner — has given up more than it has gotten in the last few years,” Mousseau said.

Mousseau said neither the U.S. or China wants a full-scale trade war.

Read and see more stories by Ray Collins here:  https://www.mysuncoast.com/authors/raycollins/

 




1Q2019 Review: Tax Free Municipal Bond – A Shining First Quarter for Munis

The first quarter of 2019 was a good one for the tax-free bond market, with yields falling during the quarter.

There are two main reasons that munis have had a good run so far this year.

Cumberland Advisors Market Commentary

Muni supply is down. The drop last year has carried over to this year. Remember, 2018 supply was down almost 25% compared to 2017 supply, in part due to the glut that was issued at year-end 2017 to beat the tax bill. The market has struggled with lower supply since. A great deal of the drop in supply can be traced to the 2017 tax reform act, which prohibited advance refundings of older, higher-coupon municipal bonds. Refundings were an important source of supply in past years, particularly in 2014 and 2016.

Demand is also higher, particularly in the high-tax states like New York, New Jersey, and California. Because of the SALT provisions of the tax bill, the cost (in terms of foregone yield) of owning out-of-state bonds in these states is much higher. We don’t see this demand factor changing. (See our February piece regarding the SALT conundrum: http://www.cumber.com/the-salt-state-and-local-taxes-conundrum/.)

In the past few weeks, longer-maturity munis have also declined in yield as investors have moved further out on the yield curve to secure incremental yield. Also, the more dovish stance by the Federal Reserve since year end, reinforced in the March Federal Reserve meeting, has seemed to ease retail investors’ normal reluctance to invest in longer maturities. The tax-free muni yield curve is also much steeper than the Treasury yield curve is, with the difference between 10- and 30-year AAA munis at approximately 80 basis points while the difference between 10- and 30-year Treasuries is only 44 basis points.

What does all this positive movement in the muni market mean?

Clearly there has been a reversal in bond market sentiment since last October, when the 10-year Treasury reached nearly 3.25%. The 10-year is back to a 2.45 yield, but the drop of 80 basis points has been accompanied by almost no drop in the rate of core inflation (nor any rise). And even though headline inflation has fallen (mainly due to oil), the drop in REAL yields has caused us to reassess bond markets in general and tax-free bonds in particular.

We think the SALT provisions are resulting in people – particularly in high-tax states – paying MORE this year in income taxes. In a market that has seen a resumption of bond fund inflows, we are concerned that the approaching tax deadline may see some bond selling, either directly or in bond fund form, to pay for the taxes.

We are also concerned that state and local governments – again, particularly those in high-tax states – will be under pressure from their citizens to cut taxes to make up for the extra taxes being borne because of the SALT provisions. If high-tax states oblige but don’t cut expenses, debt-service coverage could suffer.

Last fall, we thought REAL rates were high, bond selling was overdone, and the muni yield of 4%-plus was a giveaway. That yield bogey is VERY hard to find in a bond market that has done an about-face in the past four months. Thus, we are getting more defensive at the margin to make sure we are positioned to take advantage of any volatility accompanying April 15th. When it gets crowded at our end of the boat, we generally start moving to the other end.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio

____________________________________________________________________

Cumberland Advisors invites you to our third annual Financial Literacy Day, to be held April 11, 2019, from 8:30 AM to 4 PM at the Selby Auditorium of the University of South Florida Sarasota-Manatee.

Our focus is “Financial Markets and the Economy,” featuring:

Panels –
• The Stock Market
• Health Hunger and Philanthropy
• How the World Looks to Me – A Global Economic Outlook
Special Presentations –
• A Conversation with Susan Harper, Canada’s Consul Gen in Fla, on Trade/World Affairs
• Keynote by Gretchen Morgenson, Senior Special Writer in the Investigations Unit at The Wall Street Journal and Former Business and Financial Editor for the New York Times.
We welcome and encourage the participation of our friends, colleagues, and clients. The cost is only $50 to register, and includes coffee, pastries, catered lunch, and a light reception with Gretchen Morgenson. Please reserve your spot soon – we expect a full auditorium. Learn more: https://www.cumber.com/financial-literacy-day/

 




4Q2018 Review: Munis Turn It Around

Muni yields rose in the first six weeks of this quarter – mostly in sympathy with US Treasuries (UST). We saw the 10-year and 30-year Treasury bonds rise 20 and 25 basis points respectively. Since early November, AAA muni yields (AAA) have dropped across the board, and the 10-year Treasury yield has fallen a whopping 45 basis points in a matter of seven weeks.

 

The consternation and volatility in the stock market are the main reasons for yields doing a U-turn.

Some of the other themes affecting muni yields we discussed earlier this month:

(*) The housing market slowdown. Price gains have continued to slow for seven months in a row; and a number of Northeastern states and other previously “hot” markets have seen declines, especially at the higher end of the price range. This falloff is due to a combination of higher mortgage rates earlier this fall plus the specter of higher real estate taxes because of the lack of deductibility in the new tax bill.

(*) Concern about the rising level of debt and rising government debt service costs (see our piece “November Bond Market Bounce” from December 4thhttp://www.cumber.com/the-november-bond-market-bounce/).

(*) A general slowdown reflected by the price of oil. See graph below:

West Texas Crude per Barrel

(Source: Bloomberg)

 

The freefall in oil suggests that other prices may also be falling, so the combination of HIGHER yields earlier in November and stable-to-falling core CPI certainly made REAL yields seem much more attractive this fall.Now that yields have fallen, let’s survey the landscape.

37% Taxable Equivalent
(Source: Bloomberg)

The above graph shows the current muni AA curve and the Treasury yield curve. The curves demonstrate why we have used a barbell strategy, particularly on the tax-free side, where longer muni yields are CHEAPER than Treasuries yields. We believe those high yield ratios on the longer-maturity spectrum eventually go back to 100% or under – this outcome would be consistent with other Federal Reserve hiking cycles. For spread purposes we have also included a AA corporate bond yield curve and created a taxable-equivalent muni yield curve using the current top tax rate of 37%. This comparison demonstrates the advantage of munis over Treasuries for any level of taxpayer and the additional advantage of tax-free munis over corporates for high-tax payers, in the five-year tenor and beyond. The much lower default experience of munis versus corporates simply stretches this advantage.

The Federal Reserve last week raised the fed funds target yield range ¼% to 2.25%–2.5%.

The Fed also made mention of two possible increases next year and did so with less flexibility in the language, which helped to spook the equity market after the announcement last Wednesday. Our thoughts are that if core inflation remains where it has been, at 2.0–2.25%, and if there are more Fed hikes next year, the Fed will finally have gotten Fed funds to a positive spread over core inflation – where it has not been for 10 years. That would appear to be a good place for the Fed to pause. And as we get to that pause, we will begin to pick up the pace of moving very-low-duration assets out somewhat further on the yield curve to lock in rates, as shorter to intermediate rates most likely slowly work their way down.

Happy New Year to all our readers!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s (source: Wikipedia), posited that when a team from the “old” NFL (the current NFC plus the Colts, Browns, and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the Super Bowl.

 

If a team from the AFC won the Super Bowl, the Dow would decline. Amazingly, this theory has worked out almost 80% of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017). The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

But we decided to have a little fun; and since it’s World Series time, we wanted to see whether there was any tie-in to how the BOND MARKET did in the calendar year following a World Series win by either the American League or National League. The easiest data to use was the 10-year US Treasury bond and its return in a calendar year. We measured TOTAL return (coupon and price) and then took away headline inflation (CPI). (By the way, we have this data in our bond models, so it was easy to deploy for a “fun” topic.) We went back to 1966 to have a similar time period to the Super Bowl.

Our results are below:

How the BOND MARKET did in the calendar year following a World Series win by either the American League or National League

What do the results tell us?Frankly, not as much as we hoped.

Some notes: We used the full calendar year AFTER the World Series. And we ignored 1995, which followed a year when there was not a World Series due to the players’ strike. In the bond market, 1995 was a big year because the market rebounded after the carnage of 1994.

In the 51 years that we measured, the American League won the World Series 27 times and the National League triumphed 23 times. The bond years following an American League winner had a positive return 15 years and a negative return 12 years. The AVERAGE bond market return following an American League winner was 2.39%. The average UP year for an American League winner was 9.12%, and the average DOWN year following an American League winner was -6.03%.

The National League numbers look a bit more promising. In the 23 years that the senior circuit won the World Series, the AVERAGE return was 3.06%, 67 basis points higher than the average American League return (remember, these are total returns, inflation-adjusted). The average POSITIVE return for the National League was 9.18%, fairly comparable to the American League’s 9.12%. But the average DOWN year for the National League was -4.88%, considerable less than the American League’s -6.03%.

At some point we may go back another fifty years to add to the study, since we have a much longer record for the World Series than we do for the Super Bowl (which started after the 1966 season).

But the results would suggest that the bond market on average does better after a National League win in the Series, with a slightly better upside number and a considerably better downside number. What does 2018 hold? Well the American League Houston Astros won the World Series last year over the Los Angeles Dodgers. But wait – the Astros were a National League team until 2013! So with this mixed history, the 10-year Treasury to date has a total return of approximately -3% through the end of the third quarter, with inflation of approximately 1.4% through the first nine months. That’s a total return through nine months (after inflation) of roughly -4.4%. If we have a flat quarter, that should suggest that a down year this year would be more like a National League return (and Houston was an National League team for all but six years of its 56-year existence). Of course the returns will change between now and the end of the year. The volatility in the equity markets, slowing housing markets in a number areas of the country, and possible worries about SALT provisions in the tax bill may start to push more assets into a bond market that has been oversold in general – particularly given that trailing headline inflation has dropped from 2.9% to 2.3% in the past three months.

As for next year, we know we fare somewhat better with the National League, but GO RED SOX!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Tax Free Munis Continue to Perform

The tax-free bond market has continued to benefit from the drop in supply so far in 2018. To recap, the end of 2017 saw a bulge in supply as issuers tried to beat the tax-cut bill that Congress was still massaging through joint Senate/House committee work.

Cumberland Advisors - Tax Free Munis Continue to Perform

The final results of the bill were an elimination of advance refunding bonds but a continuation of private activity bonds. With the lack of clarity about aspects of the final bill, the supply of both advance refundings as well as private activity bonds mushroomed in early December, leading to a record amount – $63 billion[1] of municipal bond issuance – in the last month of the year.

The offset to the huge uptick in supply in December 2017 has been a drop in supply this year. Through the first five months of the year, new-issue supply has dropped from $161 billion at this time last year, to $126 billion. We have also seen demand pick up, particularly in high-tax states. Many states are seeing an increase in demand because, under the new tax bill, state income taxes as well as local property taxes are no longer deductible on federal taxes; thus the taxable equivalent yield for high-tax state bonds from California, New York, Minnesota, and other high-tax states has risen.

The relative improvement in the tax-free bond market can be seen in the table below.

Cumberland-Advisors-Tax-Free-Munis-Continue-to-Perform-Table01

As the Federal Reserve has continued to hike short-term interest rates, we have seen improvement in the tax-free muni/US Treasury yield ratios. The second quarter so far has continued a trend we saw in the first quarter, with yield ratios in the short end of the curve moving lower. Longer-term yield ratios have also moved lower, but the effect has been a little less dramatic than in the short end.All of this makes a lot of sense in an environment where shorter-term interest rates are moving up because the Federal Reserve is raising rates in the face of an ever-improving economy. If the average tax rate in this country is close to 25%, then only a 75% move in a muni tax-free rate is needed to equal whatever the equivalent rise in Treasury yields is. We believe the longer-maturity muni/Treasury yield ratios will trend lower as the Fed’s hike cycle continues into next year.

In addition, most tax-free yields are NOT on the AAA curve but usually decently above it, with most AA and A-rated bonds trading 40–80 basis points or more above the AAA curve. Thus the longer end of the tax-free bond market still offers superior value in our view. This is why we continue to employ a “barbell” approach to our fixed-income management, particularly on the tax-free side.

Below is a graph showing the US Treasury yield curve and the Bloomberg AA tax-free yield curve:

We can see that the muni yield curve is fairly well behaved from a ratio standpoint out to 7 years, then it cheapens and crosses the Treasury curve and yields continue to rise, even though the Treasury curve is lower – and flatter. One factor here is that longer Treasury yields have stayed lower ever since President Trump was elected. One of the reasons is that inflation has continued to be stubbornly low, and low inflation has been reflected in long Treasury yields, which have also stayed low. Another factor is that US government yields continue to be much higher that sovereign debt yields in other developed countries. In our view, the longer tax-free yields with yield ratios well over 100% provide a safe haven for bond assets if this ratio moves LOWER over time (as it did during the 2004–2006 period – the last time the Fed raised short-term interest rates). Thus we have the two parts of the barbell – on the one hand, owning shorter-term assets that can roll over quickly and be reinvested in higher-yielding short-term bonds as the Fed raises short-term rates. And, on the other hand, owning long-term munis, which provide much higher incremental yield than longer Treasuries do as well as short-term taxfree bonds. In addition, the cheap muni/Treasury yield ratios provide a life jacket to the duration risk of longer bonds. In other words, even if long Treasury yields rise, a return to a more normalized 100%-or-below yield ratio will buffer price erosion of longer tax-free munis.

Finally, a quick word about the Internet Sales Tax Decision announced late last week by the Supreme Court. The Supreme Court found that businesses did not need a physical presence in order for states to levy a sales tax in their respective states. Thus, sales of goods on the internet will now be able to be taxed, generally by the states in which they are purchased. The fact that we have Justices such as Justice Ginsburg and Justice Thomas on the same side of an opinion suggests that common sense prevailed here. Certainly, states that are more highly dependent on sales tax revenues will benefit from this ruling. The fact that the Supreme Court superseded its earlier ruling on this (Quill case) is also refreshing in that the Justices now recognize that technology has changed the original premise of the Court’s thinking. At Cumberland, we think this decision means greater debt service coverage for various sales-tax-backed bonds, and we would expect to see an improvement in their trading values.

And lastly, as we go to press, the US Supreme Court has ruled that government workers who choose not to join unions may not be required to help pay for collective bargaining.  Though this case was decided on First Amendment issues, it has broad positive implications for state and local governments to craft solutions to the pension issues facing them.  We will write more on this important decision in the next few days.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


[1] Figures pulled from Decade of Muni Finance, published by Bond Buyer.

 


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.