Beyond Bulls & Bears

Fixed Income

US 2020 Election Investment Pulse: Neutral to Positive for Municipals

In coming years, US Congress and the Biden administration could implement spending programs and tax reforms at the national level that trickle down into state and local government policies too. Our Katie Klingensmith joined Muni Bond Team Research Director Jennifer Johnston to discuss the potential implications for the municipal bond market, against a backdrop of COVID-19.

Here are some highlights from their conversation:

  • “While increases in federal taxes don’t impact states directly unless their income tax code is tied to the federal code, it can have implications on a state or local government’s ability to adjust their own taxes. It can also have demographic impacts as well.” – Jennifer Johnston
  •  “We’re interested to see if the SALT [state and local tax] deduction comes back. This is going to be particularly helpful in high-tax states. In terms of spending priorities, Biden has already mentioned putting more money towards infrastructure as well as health care.“ – Jennifer Johnston
  • “The CARES Act was very helpful to states because it allowed for the reimbursement of some COVID-related spending that they were taking on. But there was never aid made available to replace the lost tax revenues that the shelter-in-place policies were creating.“ – Jennifer Johnston
  • “COVID is going to continue to be impacting state and local governments…. And in general, we’re not expecting there to be massive defaults or huge increases in bankruptcies. We don’t see that. We think there could be pockets of stress.”– Jennifer Johnston

Transcript

Katie Klingensmith: Jennifer, let’s jump right into the impact politics can have on the municipal bond space. While we don’t have final election results yet, it’s clear there was no blue wave. What does that mean for munis and, how do you view a Joe Biden presidency for the sector?

Jennifer Johnston: So we definitely closely watched the presidential election because so many of the policies that a president will ultimately decide can be impactful. One area, as an example, would be tax policy. While increases in federal taxes don’t impact states directly unless their income tax code is tied to the federal code, it can have implications on a state or local government’s ability to adjust their own taxes. It can also have demographic impacts as well. So we’re definitely watching this. Second, the spending priorities. Where are the priority areas for a president, whether it supports general economic growth or it’s targeted at certain sectors or municipal entities, that can certainly be a positive. Of course, the flip side is also true. If a president comes in and wants to curtail certain spending programs, that could be a negative. Unique to this election would be the concept of stimulus. It’s something we’ve been hearing about for six months now. And it’s very important to the states and important as an outcome of this election. And then, as you mentioned, while not really financially focused, we didn’t get the blue wave that a lot of people were projecting. And so we always watch to see how Congress and Senate majorities move. And in this case, it’s going to be impactful on how much the president can actually get implemented with essentially a divided government. So clearly campaigned on increasing tax rates. And I already mentioned that this could impact a state or local government’s ability to raise their own taxes and impact demographics. But another impact is that it can also increase the attractiveness of munis as an asset class for investors. So that can be another outcome.

Jennifer Johnston: We’re interested to see if the SALT [state and local tax] deduction comes back. This is going to be particularly helpful in high-tax states. In terms of spending priorities, Biden has already mentioned putting more money towards infrastructure as well as health care. So regardless of whether public option becomes a reality, we would expect to see more money in those segments. And then regarding stimulus, Biden has been supportive of a package and we would expect the package to be larger, and come right after inauguration, as compared to if Trump had been elected.

Jennifer Johnston A lot there, but, again, no blue wave, although Democrats could take control of the Senate pending the two Senate seats in Georgia. So regardless of how the two Georgia Senate runoffs are decided, we really don’t expect Democrats to have the majority in the Senate that they really need to help Biden carry his policies through at the level he wanted. So we do expect there to be some gridlock and that could hamper some of his policies.

And just as I noted, so many of those topics are ones we’re going to want to explore today. I just level set for everybody who is listening today, what is it that federal taxes matter to you in this full bond investing?

Katie Klingensmith:
Can you talk more about the importance of federal taxes and how they can impact municipal bond investing?

Jennifer Johnston: Sure. So federal taxes do matter, but they also can have other to actually approve tax increases. This isn’t the case in every state. It would depend on state law, but if taxpayers feel like they have less money because they’re sending more of it to the federal government, they might have less of an appetite for approving tax increases at the local level. And as states and locals are grappling with COVID-related budget cuts, that could mean there are less options and using taxes to close those gaps. So, we definitely think there could be an outsized risk in jurisdictions where voters are required to approve tax increases. Second, it could also impact the ability for issuers to get voter approval for bonds. In most areas, general obligation bonds require voter approval. Especially at the local level, this is essentially a tax increase because voters are allowing in many cases property taxes to be levied to pay for the bonds. So voters certainly could be less likely to increase tax and approve voter-approved bonds if federal taxes go up. And third, there’s the potential that tax rates could result in businesses or individuals moving to lower-tax states. Even though federal tax rates would essentially impact everybody similarly, people can move to impact their state and local tax bills. And this has always been a concern, especially in high-tax states like New York, New Jersey, California. But we actually think there’s an interesting twist on this now, and that is the whole working-from-home model that most people are using right now. And what we’re hearing is that it’s successful. So we’re interested to watch what this means after a vaccine is available and we can go back to whatever the new normal is. Are people going to return to the office? Are they going to be able to work from home? And will their companies allow them to work anywhere? Because if what’s kept you in your jurisdiction, was your job. if you can now do that from anywhere, will you take advantage of this opportunity and actually make the move? So we want to be watching that to understand how demographics could change that.

Katie Klingensmith: Certainly there are many big impacts, if people living in high cost of living areas will relocate to more affordable places. Let’s take a step back to the federal level and what the chances are of progress on infrastructure spending and expanding the Affordable Care Act, as a Biden administration would like.

Jennifer Johnston: Sure. We agree we’ve heard the same talk out of the campaign. And again, as a result of a likely divided government, we’re not quite sure he’ll actually be able to achieve everything. House Democrats had passed an infrastructure bill that didn’t go anywhere because of the Senate. So we remain concerned that that may continue to stymie the ability to get that implemented. But regardless we would expect to see the federal government support additional spending, both in the health care realm, as well as through infrastructure. And that is likely to be good for local governments. One way, all of the things being equal would be oftentimes, especially around infrastructure. It creates jobs and anything to improve the economy will improve tax revenues to both state and local governments. And then in general, even in the health care industry, if we don’t get a public option, it doesn’t necessarily mean there’s not going to be any positive impact, additional health care spending, and support can actually help, not just the health care industry, but also states who are also involved in funding, some of the health care costs. So we expect to see that as generally being positive.

Katie Klingensmith: That also is related to a comment you made in your opening remarks, Jennifer, that stimulus is likely to happen regardless, but there’s some real questions right now about the size of a stimulus package and the timing what’s your outlook.

Jennifer Johnston: A big, ongoing topic is stimulus. I think many view that it will happen, but there remains a question of the size and timing of it. States have been lobbying for more state aid since the CARES [Coronavirus Aid, Relief, and Economic Stability] Act was passed earlier this year. And the CARES Act was very helpful to states because it allowed for the reimbursement of some COVID-related spending that they were taking on. But there was never aid made available to replace the lost tax revenues that the shelter-in-place policies were creating. In addition, many states assumed federal stimulus receipts in their fiscal year ‘21 budgets, which is the fiscal year we’re in right now. So if that aid doesn’t materialize or doesn’t hit their internal assumptions, they’re going to have to come up with another way to close their budget gaps. So both size and timing is important. We know Biden supports a large package and would expect it to be larger than what would’ve happened if Trump won, but with a divided government, he’s unlikely to get all of that. So we expect that some states could have to implement additional budget measures to close gaps mid-year. By the time Biden is inaugurated, we’ll be more than halfway through most states’ fiscal years, so it’s going to be hard to close those budget gaps mid-year. So this is certainly something we’re going to watch closely and timing here is actually really interesting. So we actually think that Trump will push to pass some sort of stimulus by calendar year-end, or at least by the end of his term. He has stated he supports additional stimulus. We just expect it to be smaller than what Biden would have wanted. And then what the question really becomes is that Biden would probably push for another package after inauguration. But in addition to just being difficult because he doesn’t have the Senate majority, could it be hard just because Trump had already done something. So definitely something we’ll be watching closely, not just implications for the current fiscal year, but as this fiscal stress kind of continues. This is going to still be a problem in FY ‘22.

Katie Klingensmith: Can you talk more about the dynamic of budgets at the state and municipal level, and how they were looking pre-pandemic?

Jennifer Johnston: That’s a great question because all levels of government are very integrated. It’s the fiscal federalism that the country is built on. And I think it’s important to point out that going into the pandemic, we were at the end of a decade-long expansion. And for most states and local governments, they had rebuilt reserves; governments were seeing budget surpluses. And even as recent as January 2020, which is when governors start to release their budget proposals for the next fiscal year, they were introducing new spending programs. I mean, things were good. So, at least most entities went into this pandemic from a position of strength. So we’re very fortunate that that was the situation. But as it relates to COVID, it’s the shelter-in-place policies that are really what’s impacting revenues. This has led to large employment losses and sharp declines in retail spending. So for many governments that rely on income taxes and sales taxes, they’ve been hit hardest. And for most (not all) states, income and sales taxes are actually the largest tax revenues. So the decline hit fast and was very sharp. Normally when we enter into a recession, it’s a little bit more gradual. So you have a chance to plan appropriately for it. That wasn’t the case with COVID. Now as economies have reopened, and for those entities that tax unemployment benefits, revenues have been coming back. So we’re starting to get some good news, but it certainly varies regionally. And for a lot of other reasons, so something we’re watching for cities, a few do collect income taxes, most rely on sales taxes, user fees, and property taxes. So, to the level they get sales taxes, they’ve been hit hard as well. Now, for those with property taxes, property taxes can actually soften the blow of it. They tend to be stickier. And because of the process of assessing and levying the tax, usually any declines happen a little bit longer down the road. So it can be a stabilizer for a lot of local governments.

Katie Klingensmith: What about schools and the impact on them?

Jennifer Johnston: They don’t actually often rely on direct receipt of sales taxes, or income taxes but they’re largely funded by state aid. So when state revenues decline aid from states to school districts an also decline. So the long and the short of it is that the further down you go from your parent or state government, it shows that you have less flexibility. And oftentimes, they’re just dealing with whatever the state does. So we tend to see the pain more quickly at the local level than at the state level. But I think it’s really important to point out a few things, which is it’s hard to generalize. As we’re looking at which credits can be most impacted, we’re looking for a variety of things. First of all, what does the employment mix? Is a city, state, whatever are they dependent on tourism, trade, transportation? These are the industries that we expected and we are seeing being really hard hit. So an entity that is highly reliant on tourism is probably going to underperform a community that’s reliant on something else. Any entity that’s, again, reliant on sales or income taxes, not all entities are reliant on sales or income taxes. So those that aren’t could be better performers. Again, also, as I mentioned, we went into in a really strong position. So many people have reserves that they can tap for a rainy day, and this is a rainy day, but there are plenty of entities out there that were stressed going into the pandemic and they don’t have those reserve levels. So, it gives them less fiscal flexibility.

Again, as I mentioned, some entities have to go to voters or actually ask the state to increase their taxes, whereas other people can just make those legislative bodies can make those decisions on their own. So some people just have more fiscal flexibility. They have more tools in their tool belt. And finally, the idea of what areas are seeing the biggest cases of COVID. Some communities had very few cases and they were able to reopen more quickly than others that have seen very high incidents. And so they are having to keep many of their shelter-in-place policies in line. So we’re clearly seeing that as an impact. But again, pointing out that there can be so many differences, many bonds, particularly general obligation bonds, are backed by property taxes. And as I mentioned, early property taxes tend to lag economic indicators. So in many cases we can be seeing a general decline in credit, but if the bonds are backed by property taxes, they’re still going to perform well. Even if the entity itself might be having difficulty closing budget gaps. So I think what’s really unique about the muni market is we have so many issuers, laws differ from state to state, different types of governments have different types of challenges on their economic mix. And you really need a strong research team to be able to wade through all of this. And, at Franklin we’ve tapped into our years of experience and our modeling capabilities to really understand which credits within a sector are better positioned than others. And we can do this quickly and effectively, and it allows us to take advantage of opportunities in the market, especially as we see spreads widen.

Katie Klingensmith: So you mentioned that surpluses and rainy-day funds had a lot of states and municipalities were in a good position going into the pandemic, but they’re often facing spending pressures from pensions. What are you seeing in that area?

Jennifer Johnston: Yeah, it was something we were watching closely prior to the pandemic and usually the situation where you have economic growth and everybody’s doing really good. You don’t usually see a lot of spending pressures, but during the expansion we saw a lot of pension funds try to right-size themselves, meaning they wanted to take advantage of the time to put in better policies and better assumptions around, what their pension base looked like. They might have changed discount rates to be more in line with returns on their investments. And this is great from a pension perspective, this is a good thing, but it often leads to higher requirements from the employers, which would be state and local governments from a contribution perspective.

So, we actually saw a lot of governments have to actually increase taxes to deal with this accelerating cost around pensions and also retiree health care. We actually saw tax increases happening towards the end of the expansion, which is sort of a unique timing. And the reason we’re focused on that is that two things. One, if you increase taxes during the expansion, if that’s the situation, are taxpayers going to be as likely to approve them again during a recession? And the second aspect of it is that we started to see a few of them fail. This is again pre-COVID, but we saw a school district do a parcel tax. The teachers had gone on strike. There were a lot of concerns over rising costs, and so they tried to get a parcel tax passed and it actually failed. And we also saw some bond referendums fail. So again, this is an interesting trend during an expansion period, and we’re definitely watching it and trying to see how indicative it could be as we look to how local governments are going to deal with the COVID-related recession.

Katie Klingensmith: Any ballot measures from the election across the country get your attention?

Jennifer Johnston: In the state of Illinois, their constitution requires a flat income tax. And prior to the pandemic, they had put a measure on the ballot to change from a flat income tax to a graduated tax, which is far more common nationwide. And the ballot measure is just about changing from flat to graduated. It had nothing to do with the rates themselves because the legislature can actually control that. An example of a legislature or state having a lot of control over their taxes. And, based on the state’s projections and the tax rates that the legislature had adopted, it would end up netting more money to the state. Higher rates on the wealthiest, but lower rates for most taxpayers. And again, this was done prior to the pandemic and most felt it would succeed, but it actually ended up failing. So that is certainly interesting to watch both as a trend, as well as where Illinois is going to have to come up with some other ways to close its gaps. And so we’ll be continuing to watch how the state reacts to that. On the bond authorization side, I had mentioned that district earlier, that parcel tax that failed. Well, interestingly, they put a $7 billion bond measure on the ballot a few weeks ago and it passed. So really interesting to watch and try to understand the uniqueness of various voter bases and how they approach things like taxes and bond infrastructure, and support for facilities in a school district as an example.

Katie Klingensmith: So as we wrap up, what is your view going forward in the muni space as a result of the elections and the ongoing pandemic?

Jennifer Johnston: COVID is going to continue to be impacting state and local governments. Most policies are carried out at the state and local level, including likely a vaccine distribution. So, this is going to continue to be something on the minds of elected leadership throughout the country. And in general, we’re not expecting there to be massive defaults or huge increases in bankruptcies. We don’t see that. We think there could be pockets of stress. But ultimately as it, as it comes to a Biden presidency with a likely divided government, we’re expecting to see higher taxes, which could make munis more attractive of course. We’re expecting additional stimulus, which should help stabilize some of the issues at the state and local levels. And then we did see a lot of bond measures pass in the November ballot. And so we expect there to be more bonds. So generally we’re neutral to positive on what the future holds, and we’ll be watching closely.

Katie Klingensmith: Jennifer Johnston, director of research for the Franklin Templeton Municipal Bond Department, thank you for joining us.

Host: And thank you for listening to this episode of Talking Markets with Franklin Templeton. We hope you’ll join us tomorrow, as our special series related to the US elections continues. And, if you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other major podcast provider.

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