Municipal and corporate bond markets in 2022 should stay on the solid course charted in 2021. However, keep an eye on potential disruptions and focus on a laddered approach.
The past year saw continued improvement in investment-grade (IG) corporate and municipal credit fundamentals. Economic growth was exceptionally strong and, despite COVID-related disruptions, the economy had exceeded its pre-pandemic size by the middle of year.
By year’s end, the surprising persistence and magnitude of inflation led the Federal Reserve to begin preparing markets for an early end to its quantitative easing (QE) program and for rate hikes, possibly as early as the first half of 2022. Against this backdrop, corporate and municipal valuations were well supported and 10-year yields rose modestly.
Mixed, but strong, performance year
Performance in the two asset classes was mixed. Municipals, as measured by the Bloomberg Municipal Bond Total Return Index, had a solid year, producing a 1.52% total return, while IG corporates, as measured by the ICE BofA/Merrill Lynch 1–10 Year US Corporate Index, returned -0.85%. While both markets were negatively impacted by rising interest rates, municipal bond yields ended the year only slightly higher as strong demand caused the municipal/Treasury yield ratio to decline substantially. In the case of corporates, the improving credit outlook and higher coupons helped the sector outperform Treasury notes with similar maturity by 1.06%—in line with their 25-year average excess return.
Despite shortages of labor and problems with the supply chain, economic growth remained strong. The New York Fed Weekly Economic Index is projecting a nearly 8% increase in gross domestic product (GDP) for 2021. Notably, non-farm payroll growth averaged 582,000 a month and the unemployment rate fell from 6.7% to 4.2%. While this is good news, many companies continue to struggle to find employees. The pandemic appears to have had a significant impact on the labor force, resulting in early retirements and a lower labor participation rate. Therefore, it’s reasonable to expect rising labor costs to be a factor for some time.
The supply chain remains challenging as well. In response to the pandemic, companies cut production and drew down existing inventories. Now, demand is surging—production and transportation companies are struggling to keep pace. Demand for goods has far outpaced existing capacity.
Not surprisingly, price pressures appear to be broadening and, while logistics and supply problems may be cresting, an uncomfortable level of inflation could be with us for some time. The Fed-preferred inflation metric, the Core Personal Consumption Expenditures Price Index, is rising at an annual rate of nearly 5%. While we think inflation will peak in the first half of the new year, we don’t think it will fall back below 2% anytime soon.
The Fed is clearly pivoting its focus from economic growth to fighting inflation. In his first congressional testimony since being renominated in early December, Chairman Powell suggested it was time to abandon the word “transitory” to describe inflation. At its December meeting, the Fed doubled the pace of the taper and modified projections to suggest the possibility of three rate increases in the coming year and three more in 2023.
The pandemic continues to disrupt activity. Late in the year, case counts began rising sharply, suggesting a potential new wave. However, due to rising vaccination rates, new drug therapies, and the growing aversion to lockdowns, we believe that each new wave will be far less disruptive than its predecessors. The Omicron variant may change that calculus, but further epidemiological analysis will be required before we know that with any certainty.