The barrage of better than expected economic data witnessed in October continued through November and into the early days of December. With the improvement in growth, investor confidence has risen markedly from the doom and gloom days of the government shutdown. Reflecting the improved confidence, bond prices fell off and equity markets rallied. .
As we anticipated at summers end, investors have reversed their aversion to credit and have been buying the various sectors despite the downward price action of government debt. In addition to a heightened risk appetite, positive news on municipal finance also contributed to the improvement in credit. Specifically, the State of Illinois, after decades of fiscal mismanagement passed legislation designed to bolster their woefully underfunded state pension plan. While the governor has said he will sign the bill into law when it arrives at his desk, union officials representing future retirees said they intend to fight the agreement in court. They claim the action violates the Illinois constitution which states that the pension “shall not be diminished or impaired.” The unions may be fighting an uphill battle in proving diminishment or impairment. To improve the funding of the pension, the proposal would reduce the annual cost of living adjustment and increase the retirement age for workers hired on a go-forward basis; arguably, neither impairs the current value of the fund. Following the announcement, 30-year Illinois bonds rallied and have continue to improve in secondary trading. Given that positive outcome, we expect other municipalities to follow suit to bolster their pension obligation, thereby improving their credit profile. We continue to see the municipal bond market as the most undervalued sector of the bond market.
As mentioned in the first paragraph, economic activity continues to accelerate, with housing and job growth leading the way. Following strong job growth in October, economists were surprised with the continued strength witnessed in the November report. In addition to the second consecutive 200,000 job gain, labor force participation increased and the unemployment rate fell to 7.0% from 7.3%. The 7% unemployment rate is especially important since the Fed said at the June press conference that they expected to have concluded secondary market purchases when unemployment rate fell to that level. That puts the Federal Reserve and their maintenance of emergency easy-money policy in an awkward position. As we described last month, the Fed does not like to change policy in December due to diminished volume and the accompanying risk of outsized volatility. Just hours after the release of the employment report Wall Street economists were handicapping the odds of a taper announcement at the December 18th FOMC meeting at 50/50. With that date only a week away and coming with just eight trading days left in the year, Chairman Bernanke certainly must be regretting his decision to postpone the taper announcement back in September. Despite the challenge of the calendar, equity investors took the news of better than expected employment as good news for earnings and rallied the market sharply.
The favorable unemployment news came one day after Q3 GDP was revised from 2.8% to an “eye-popping” 3.6%. Much of the revision was attributable to an increase in inventories, which could potentially weigh on Q4 GDP if those goods are simply being restocked. However, if those goods were produced in anticipation of heightened sales, that could portend a strong economic outturn.