Mid-March 2018 Municipal Market Matters

Mid-March 2018 Municipal Market Matters Natalie Cohen Head of Municipal Research natalie.cohen@wellsfargo.com 212-214-8014

Please see the disclosure appendix of this publication for certification and disclosure information. All estimates/forecasts are as of 3/26/2018 unless otherwise stated.

Municipal Market Effect of Tax Plan 

We originally estimated $305 billion of capital market debt in 2018, about 20% lower than in 2017 due mainly to the elimination of advanced refunding. Volume may well come in lower.

(This assumes no major federal infrastructure program.)



Outstanding “Pre-re” bonds should diminish and eventually disappear. (These are a product of advanced refunding and have been attractive investments as a Treasury alternative).



December had historically high issuance ahead of the Jan. 1 effective date – approximately $63 billion, more than twice the typical amount. The market absorbed the extra volume relatively easily and actually showed positive total return over the month. January, however, defied expectations of low volume and high redemptions by showing weakness rather than strength in total return.



Top individual rates remain high, which should help firm the relative value of tax-exempt pricing as the Federal Reserve begins to normalize rates.



States have a major task ahead as they review and revise their own tax codes. Given that 39 gubernatorial elections take place in November 2018, we expect a noisy 2018, especially through state budget processes in Q2 and Q3. States (and some local governments) need to adjust their tax codes to synchronize with the federal changes – and avoid major potential windfall. Thirtyone states use federal-adjusted gross income. Five use federal taxable income. Five do not use the federal code as a starting point (Alabama, Arkansas, Massachusetts, New Jersey and Pennsylvania).



“It ain’t over til….” Renewal of the National Flood Insurance Program has been pushed off to July 31st (in the middle of hurricane season). The debt ceiling is suspended until March 2019.

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A Few “Sleepers” That Affect Markets and Credit in2018 

The infrastructure plan that wasn’t: The president’s proposal has many merits such as expansion of private activity bonds and improving permitting of projects. He has supported a federal gas tax hike, but passage looks unlikely. Plus, Speaker Ryan indicates that infrastructure bills will come out individually over time. Projects are likely to continue at the state/local/authority level as they always have.



Was exuberance about November/December consumer activity short-lived?: Still parsing the effects of hurricanerelated purchases (repairs, auto replacement) and a potential “pull-forward” of major sales-taxed purchases to use the SALT deduction in 2017 (before it disappeared) from the macro figures. January/February retail sales have been more sluggish.



Repatriation does not mean major cash inflows, for clarification: HR1 has dubbed this tax on foreign earnings “deemed” repatriation. There is no requirement to bring cash back to the United States. Payment takes place over eight years and is back-loaded. There is also a back-loaded corporate AMT of sorts on foreign earnings: “base erosion and anti-abuse tax” (BEAT).



Elimination of SALT deduction affects more than coastal states : Most of the attention to the SALT issue is focused on coastal “high wealth,” “high tax” states. However, D.C. has an income tax, counties in Indiana and Maryland have income taxes, a large number of Ohio cities charge income tax, most municipalities in Pennsylvania have earned income tax and various other local governments levy income tax as well. These entities may have pressure from higher income residents who likely will pay more tax. Effects on fiscal conditions are worth watching in 2018.



HQLA resolved: Congress has voted to include municipal securities in the definition of “High Quality Liquid Assets” – category 2B. While this is positive, particularly for large banks that have increased holdings over the last decade, it is still a lower category than “sovereign” debt, such as Slovenia. 2B includes a 50% haircut on the value of these securities. Lower tax rates for banks and insurance companies may have greater impact on holders than HQLA. Wells Fargo Securities

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Credit Factors of Concern to the Market in 2018  Judge Swain’s opinions on Puerto Rico’s HTA affect viewpoints on special revenue bonds and statutory liens in bankruptcy. (Peaje Investments LLC vs.

PRHTA and Assured Guaranty vs. PRHTA)  The Supreme Court will hear oral arguments on April 17, 2018, on the internet sales tax case South Dakota vs. Wayfair, et al. This case revisits the 1993 Quill decision regarding sales tax on non-store sales.  Pension troubles continue to plague certain states and local governments; OPEB rolls into balance sheets, creating more visibility for underfunding. Janus vs.

AFSCME, Council 31 was argued Feb. 26, 2018 and a decision is also expected during this court’s session. This case involves the requirement to pay union dues if one does not want to be part of the union (in non-right-to-work states)  To what extent will states push down increased pension funding costs to their local governments and how much stress might that impose? (Illinois, California) Wells Fargo Securities

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Credit Factors in 2018, Continued Pension Underfunding and Budgetary Troubles Are Weighing More Heavily on State Ratings; Standard and Poor’s Expects State Ratings to Be More Volatile Going Forward State

State Ratings that Were Lowered (by at least one agency) From April 2016‐December 2017 * Moody’s S&P Fitch Kroll Reason

Alaska

Aa3

AA

AA

Connecticut

A1

A+

A+

Illinois Kansas* Kentucky* Louisiana Mississippi New Jersey

Baa3 Aa2 Aa3 Aa3 Aa2 A3

BBB‐ AA‐ A+ AA‐ AA A‐

BBB

New Mexico Oklahoma Pennsylvania

Aa1 Aa2 Aa3

AA AA A+

AA‐ AA‐ AA A

AA AA‐

"extraordinary" structural imbalance (Moody's), above average unfunded pension obligations and low oil prices AA‐

high unfunded pension and OPEB plus cyclical budget imbalances

A

Budget imbalance, extensive partisan gridlock on budget and significantly underfunded pensions Structural budget gap; underfunded pensions significantly underfunded pensions (no GO) weak revenue collection largely due to low oil and gas prices revenue shortfalls and reserve drawdowns, weak economy significant pension underfunding and budget imbalance substantial decline in oil and gas revenues (no notable pension problem) weak oil and gas prices and budgetary weakness heavy pension obligations; budgetary difficulties

structural budget imbalance and above average unfunded West Virginia Aa2 AA‐ AA‐ pension obligations *Kentucky has no GO rating *Kansas has no GO rating and outlook was upgraded Source: Moodys, Standard and Poor’s, Fitch, Kroll, Bloomberg and Wells Fargo As of December 31, 2017

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Relative Value, Municipal and Treasuries: Market Moves Pre- and Post- Election; Pre- and Post- Tax Reform  Before November 2016, investors believed income tax would remain high and municipal securities offered a safe, tax-free, fixed income investment.  Given that President Trump campaigned on significantly lowering corporate taxes, both municipal and treasury market yields moved heavily immediately after the election.  Treasury and municipal yields moved generally in lockstep until Q2 2017 when the 10-year municipal rallied relative to Treasuries, while long-dated 30 year municipals and Treasuries continued to move more or less in lockstep.  This is evident in the third chart, following, which shows 10-year municipals becoming rich relative to 10-year Treasuries.  We show these points graphically on the next three charts.

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Relative Value Municipal and Treasuries: Market Moves Pre- and Post- Election; Pre- and Post- tax reform—10 Yr. Yields Treasury and AAA GO Municipal Yields, 10 Year (August 2016-February 2018) Pre- and Post- Election Treasury 10 Year AAA GO 10 Year

3.00

Tax Reform Signed

Yield

2.50

2.00

Presidential Election

Vertical lines represent Federal Reserve rate hikes: --12.14.16 from .50%-.75% --3.15.17 from .75%-1.0% --6.14.17 from 1.0%-1.25% --12.15.17 from 1.25%-1.50% --3.21.18 from 1.50%-1.75%

1.50

1.00

Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 As of March 23, 2018 Source: Thomson Reuters and Wells Fargo Securities

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Date

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Relative Value Municipal and Treasuries: Market Moves Pre- and Post- Election; Pre- and Post Tax Reform—30-Yr Yields Treasury and AAA GO Municipal Yields, 30 Year (August 2016-December 2017) Pre- and Post- Election 3.40

Treasury 30 Year AAA GO 30 Year

Tax Reform Signed 3.20

Yield

3.00

2.80

2.60 Presidential Election

Vertical lines represent Federal Reserve rate hikes: --12.14.16 from .50%-.75% --3.15.17 from .75%-1.0% --6.14.17 from 1.0%-1.25% --12.15.17 from 1.25%-1.50% --3.21.18 from 1.50%-1.75%

2.40

2.20

2.00

Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 As of March 13, 2018 Source: Thomson Reuters and Wells Fargo Securities

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Relative Value Municipal and Treasuries: Market Moves Pre- and Post- Election; Pre- and Post Tax Reform—10 and 30-Yr Ratios AAA GO Municipal-Treasury Ratios 10 and 30 year; Pre- and Post-Election (August, 2016 - Present)

115%

Muni-Treasury Ratio, 30 Year Muni-Treasury Ratio, 10 Year

110%

105%

Cheap

Tax Reform Signed

Ratio

100%

95%

90%

85%

80%

Rich

November Election

75%

Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 As of March 23,2018 Source: Thomson Reuters and Wells Fargo Securities

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Shape of the Curve, Munis and Treasuries: A Volatile Relationship  Is there inflation? Or not?  Is the curve flattening or steepening?  Is market reaction stronger to political and policy changes or federal reserve rate changes?  On the next three charts we look at the 2/10, 10/30 and 2/30 relationships.  The 2/10 slope widened significantly right after the election and again when tax reform was signed but flattened between the two dates.  The 10/30 flattened considerably after the election and continued to do so.

However, municipals divorced Treasuries after the election.  In the 2/30 slope municipals tracked Treasuries until after the inauguration when there was a divorce. The two securities types got back together around the finalization of tax reform but this didn’t last long.  Given the volume of Treasuries that need to be issued to pay for tax cuts and increased budgetary spending, combined with tax payments on foreign-based US assets, as well as changing international dynamics we could envision price volatility over the next twelve months.

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AAA Municipal General Obligation and U.S. Treasury 2-10 Year Slope

140 Treasury Slope (2-10) AAA GO Slope (2-10)

120

Tax Reform Signed

Basis Points

100

Presidential Election

80

60 Vertical lines represent Federal Reserve rate hikes: --12.14.16 from .50%-.75% --3.15.17 from .75%-1.0% --6.14.17 from 1.0%-1.25% --12.15.17 from 1.25%-1.50% --3.21.18 from 1.50%-1.75%

40

20

0

Oct-16

Nov-16

Dec-16

Jan-17

Feb-17 Mar-17

Apr-17

May-17

Jun-17

Jul-17

Aug-17

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18

Feb-18 Mar-18

Date As of March 23, 2018 Source: Thomson Reuters and Wells Fargo Securities.

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AAA Municipal General Obligation and U.S. Treasury 10-30 Year Slope 100 Presidential Election

90

Tax Reform Signed

80

70

Basis Points

60

50

40 Vertical lines represent Federal Reserve rate hikes: --12.14.16 from .50%-.75% --3.15.17 from .75%-1.0% --6.14.17 from 1.0%-1.25% --12.15.17 from 1.25%-1.50% --3.21.18 from 1.50%-1.75%

30 Treasury Slope (10-30)

20

AAA GO Slope (10-30) 10

0

Oct-16

Nov-16

Dec-16

Jan-17

Feb-17

Mar-17

Apr-17

May-17

Jun-17

Jul-17

Aug-17

Sep-17

Oct-17

Nov-17

Dec-17

Jan-18

Feb-18 Mar-18

Date As of March 23, 2018 Source: Thomson Reuters and Wells Fargo Securities.

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AAA Municipal General Obligation and U.S. Treasury 2-30 Year Slope 300 Treasury Slope (2-30) AAA GO Slope (2-30) 250 Tax Reform Signed

Basis Points

200

150

Presidential Election 100

Vertical lines represent Federal Reserve rate hikes: --12.14.16 from .50%-.75% --3.15.17 from .75%-1.0% --6.14.17 from 1.0%-1.25% --12.15.17 from 1.25%-1.50% --3.21.18 from 1.50%-1.75%

50

0 Oct-16 Nov-16 Dec-16 Jan-17

Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17

As of March 23, 2018 Source: Thomson Reuters and Wells Fargo Securities.

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Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18

Date

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The 35-year Rally in Treasuries: When Will It Turn?

(Compared with Equity Market and Fed Funds)

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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Treasury and Equity Markets, Pre- and PostElection; Pre- and Post Tax Reform

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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Post Election Pivot (Q4 2016) Has Reversed in Many Cases 

Pivot: In Q4 2016, there was a reduction in Property & Casualty, Life Insurance, Money Market and Broker/Dealer holdings. Global investors not concerned with the U.S. Tax Code bought when municipals were cheap; individual households (plus residual categories like hedge funds and private equity) picked up the slack.



Cost of Capital: P&C and Insurance companies have returned to municipals since then. Insurance companies are subject to rating agency capital allocation models that are tax neutral but based on credit quality. Tax reform has led to changes in the calculation of “proration” or the haircut given to tax-exempt interest. Given the lower corporate rates, however, the end result is similar on the tax-exempt side. Plus, the cost of capital to switch from high-grade municipals to medium-grade corporate securities has friction, given rating agency models and to some extent the NAIC capital categories – these may offset the relatively lower value of tax-exempt securities.

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Yield Curve: The front end “lift” in rates could breathe new life into money market

Top Owners of Municipal Bonds, Selected Dates ($ billions) Q4 2014 % total Q3 2016 % total Q4 2016 % total Q3 2017 % total Q42017 % total Total Assets Outstanding $ 3,781.0 $ 3,838.3 $ 3,837.4 $ 3,808.7 $ 3,850.7 Household Sector* 1,693.9 44.8% 1,599.1 41.7% 1,675.6 43.7% 1,573.0 41.3% 1,568.5 40.7% U.S. Chartered repository institutions 451.5 11.9% 535.6 14.0% 549.2 14.3% 560.6 14.7% 570.2 14.8% Property-casualty insurance companies 339.6 9.0% 363.8 9.5% 338.5 8.8% 342.4 9.0% 350.8 9.1% Life Insurance companies 164.4 4.3% 189.0 4.9% 179.0 4.7% 187.9 4.9% 192.8 5.0% Money market mutual funds 282.0 7.5% 161.4 4.2% 162.2 4.2% 135.1 3.5% 142.3 3.7% Mutual Funds 586.6 15.5% 683.4 17.8% 632.2 16.5% 680.4 17.9% 687.0 17.8% Brokers and Dealers 18.9 0.5% 25.0 0.7% 21.0 0.5% 17.3 0.5% 17.2 0.4% Rest of World 80.6 2.1% 92.1 2.4% 94.7 2.5% 100.2 2.6% 104.6 2.7% *Note that the Federal Reserve uses the household sector as a "residual" to capture holdings that are not categorized elsewhere, importantly hedge funds Source: Federal Flow of Funds Z.1 report table L.212, March 8, 2018 release

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Foreign Investment in Municipals Continues to Grow 

Foreign investors have found the U.S. markets attractive and increased holdings in each category below. Investors reduced positions in Treasuries in Q4 2017 while increasing in all other category. Notice continued interest in U.S. municipals (although a small part of the total market).

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Although the flow of funds does not show a break-down of countries that hold U.S. securities, there is a significant investment in U.S. equities as well, providing a counterpoint. Based on Treasury statistics, mainland China and Japan are the top two holders of Treasury securities at $1.1 trillion and $1 trillion as of October, respectively.



Anecdotally, we have heard of secondary market trading by foreign holders of municipals, indicating some confidence in their liquidity.

Selected US Long Term Securities Held by Foreign Investors Billions of dollars

Date 2005 2007 2009 2011 2013 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 %∆ 2005-Q4 2017 %∆ 2009-Q4 2017 %∆ 2013-Q4 2017

$

Total Treasury* 6,941 $ 1,984 $ 9,729 2,376 10,021 3,670 12,040 5,001 14,691 5,794 15,733 6,146 15,953 6,287 16,197 6,281 16,484 6,158 16,399 6,116 16,823 6,079 17,311 6,171 17,864 6,323 18,407 6,307 165.18% 217.87% 83.69% 71.84% 25.29% 8.85%

Agency 1,006 $ 1,577 1,150 1,078 884 917 947 982 1,011 988 966 985 1,001 1,007 0.12% -12.41% 13.97%

Corporate Debt 1,804 $ 2,775 2,484 2,491 2,733 3,083 3,218 3,396 3,517 3,431 3,495 3,709 3,815 3,909 116.70% 57.39% 43.02%

Municipal Equity Debt 2,118 $ 29 2,956 45 2,658 59 3,397 72 5,204 76 5,501 87 5,413 88 5,449 89 5,707 92 5,770 94 6,188 96 6,347 99 6,625 100 7,080 105 234.20% 260.69% 166.31% 78.19% 36.03% 37.45%

As of March 8, 2017 release * Includes Treasury bills and other Treasury securities Source: Federal Reserve Flow of Funds, Table L.133 and Wells Fargo Securities

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Employment Continues to Grow, Stronger in Service Sectors Further to the inflation discussion, it is not a surprise that wage growth on a macro level is slow since nearly three-fourths of the job growth since peak pre-recession has been in lower paid professions such as education and health services, leisure and hospitality in contrast with higher paid manufacturing.

Employment by Selected Industry Sector December 2007‐February 2018 (000's) % 2007‐ Industry Feb‐18 Feb‐17 Dec‐07 2018 Total Nonfarm 148,177 145,896 138,413 7.05% Total Private 125,819 123,587 116,037 8.43% Goods‐producing 20,500 19,964 21,976 ‐6.72% Construction 7,173 6,919 7,490 ‐4.23% Heavy and Civil Engineering 1,007 987 1,006 0.11% Manufacturing 12,614 12,390 13,746 ‐8.24% Private, Service providing 105,319 103,623 94,061 11.97% Retail Trade 15,926 15,891 15,570 2.29% General Merchandise 3,141 3,143 3,062 2.59% Building Material and Garden Supply Stores 1,316 1,267 1,282 2.61% Clothing and Accessory Stores 1,374 1,395 1,517 ‐9.44% Furniture and Furnishings 481 476 567 ‐15.13% Nonstore Retailers 587 562 448 30.92% Education and health services 23,466 23,017 18,924 24.00% Total Health Care* 15,909 15,620 13,103 21.42% Leisure and hospitality 16,262 15,937 13,550 20.01% Accommodation and Food Services 11,891 11,640 11,306 5.18% Total Professional and business services 20,760 20,265 18,051 15.01% Total Government 22,358 22,309 22,376 ‐0.08% Source: Bureau of Labor Statistics, Establishment Data, seasonally adjusted and Wells Fargo Securities, LLC *Includes ambulatory health care services, hospitals, and nursing and residential care facilities.

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# jobs % YOY # jobs 2017‐ YOY 2017‐ 2007‐ 2018 2018 2018 9,764 1.56% 2,281 9,782 1.81% 2,232 ‐1,476 2.68% 536 ‐317 3.67% 254 1 2.02% 20 ‐1,132 1.81% 224 11,258 1.64% 1,696 356 0.22% 35 79 ‐0.05% ‐2 34 3.86% 49 ‐143 ‐1.55% ‐22 ‐86 1.05% 5 139 4.32% 24 4,542 1.95% 449 2,806 1.85% 290 2,712 2.04% 325 585 2.16% 251 495 2,709 2.44% ‐18 0.22% 49

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Finally, growth in private sector employment overall is good; government employment growth is modest by contrast.

As we have noted before, while we are delighted to see job growth in absolute numbers, the population has grown since peak pre-recession as well.

US Non-farm and Government Employees, in thousands

Period 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018* ∆2007-2018 ∆ post recession trough-present** Population 2007*** Population 2017*** Employment/Pop. 2007 Employment/Pop. 2017

February 2007 - February 2018, seasonally adjusted February Employment Total Nonfarm Private Total Govt. Total Federal 138,008 115,815 22,193 2,733 137,872 115,389 22,483 2,757 131,492 108,875 22,617 2,860 130,664 107,668 22,996 3,416 131,719 109,590 22,129 2,871 133,951 112,040 21,911 2,823 136,122 114,267 21,855 2,775 138,562 116,710 21,852 2,726 141,536 119,531 22,005 2,752 144,882 122,566 22,316 2,811 147,380 125,039 22,341 2,803 148,177 125,819 22,358 2,792 7.37%

8.64%

0.74%

13.40% 16.86% 2.32% 301,231 Working Age Population 2007 323,128 Working Age Population 2017

2.16%

State 5,121 5,162 5,187 5,135 5,083 5,052 5,047 5,056 5,072 5,101 5,066 5,134

Local 14,339 14,564 14,570 14,445 14,175 14,036 14,033 14,070 14,181 14,404 14,472 14,432

0.25%

0.65%

0.61% 1.72% 186,687 WA/TOT 200,241 WA/TOT

2.57% 61.97% 61.97%

45.81% Employment/WA Pop 2007

73.92%

45.61% Employment/WA Pop 2017

73.60%

* preliminary **trough-present differs in each category: for total and private sector: 2010-present; for federal and total government: 2014present; for local: 2013-present Source: US Department of Labor, Bureau of Labor Statistics and Wells Fargo Securities

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