War Outfall
Many are dismissive about the effects of this war on the economy to date. After the initial shock reaction, the equity market held up quite well. Defense contractors’ shares rallied as did the oil sector. In the meantime, the DHS budget languishes. The federal budget approval was moved down in the headlines. But the so called “off budget” expenses are about to balloon. The war is estimated to be costing somewhere around $1 billion per day. Despite the worthy goal of reducing threats, how will we be paying for all this additional unplanned spending?
The Treasury market has cheapened from the 4% range just days ago to 4.12% currently and has dragged other markets along. As expected, the dollar is stronger. Despite the debate about the justification for this war, the focus is now on the duration of the conflict. Even the Fed has said as much. The fever pitch over additional Fed easing moves has all but dissipated at least for the first half of this year.
Moving to the impacts on the municipal market, there are many. On the macro side, we all will be watching employment activity. Will hiring be slowed appreciably due to the uncertainty? We will know soon but do not expect much of any change early on.
What tends to react faster is retail sales. Energy costs more across the board. A spike in energy prices also leads to a diminution in retail spending. State and local governments use a fair amount of energy. There are the HVAC costs for the buildings that are mostly owned by the host governments. Rolling stock requires a steady flow of fuel. Some of the higher prices may be absorbed by the budgets. However, if we return to $100+ oil per barrel, budget assumptions will be exceeded by a significant margin.
Then there is the matter of public safety. The need to be more diligent on the watching front requires more manhours and spending. More patrolling of public assets and transportation modes adds up quickly. Overtime budgets will be overrun the longer the military action lasts. But the spending just does not end when the war is done. Potential terrorists are not on the same time trajectory.
Inflation has been hovering in the 3% range. But if the war drives up inflation, we could be experiencing an elevated level of inflation even if it is for an abbreviated time. The rate of inflation drives everything from labor contracts, benefit costs, labor & materials costs on building projects and many other factors.
Another aspect is what is the market effect. If rates continue to ascend, there is the matter of whether supply will be forthcoming. Some slowing of activity may be expected if bond transactions are at a minimum delayed. Supply has been steady over the last year and at the start of this year. Any diminution in supply would present changes to the market that have not been experienced for some time.
The effect on the demand side for municipals is mixed. The municipal market often benefits from a flight to safety. Flows have been positive for an extraordinarily long time. But if the war persists for a longer period, staying in cash may be an alternative for many. Over the long haul, municipals are often considered only second to Treasury obligations in terms of safety. Barring the infrequent spectacular default in municipal high-grade paper that garners headlines, the default rate is minimal. What will be more important going forward is how much pressure will be put on municipal budgets. Rating actions are not a foregone conclusion, but more may occur.
John Hallacy
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