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Munis and the midterms: A positive outcome

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Craig R. Brandon, CFA, Co-Director of Municipal Investments, Eaton Vance Management

      Boston - The final midterm election results are still coming in Wednesday morning, but it's probably safe to say that the Democrats taking the House of Representatives and the Republicans keeping control of the Senate is an overall positive outcome for the municipal-bond market.

      Investors were skeptical of the polls and predictions heading into these crucial midterm elections -- and certainly with good reason. However, from a very broad perspective, the results in Congress were about as predicted. This should settle the Treasury market, to which muni bonds are closely correlated.

      On the other hand, if there had been a surprise result and the Republicans kept the House, the likely result would have been higher Treasury yields and corresponding weakness in the muni market. This is because Republican majorities in both chambers of Congress may have ushered in another round of tax cuts.

      It's difficult to quantify the impact that recent reductions in the individual and corporate tax rates have had on the muni market. The conventional thinking is that lower individual tax rates should reduce demand for the tax-exempt advantages of muni bonds, all else being equal. While that's the perception, so far it hasn't been the case in reality. In fact, new legislation that limits the state and local tax (SALT) deduction has increased demand for munis from individuals and families in high-tax states.

      Conversely, corporate tax cuts have had a more noticeable impact by lessening demand from banks and insurance companies as lower tax rates make taxable bonds potentially more attractive.

      What to watch next

      The key takeaway here is that if the Republicans had kept control of the House, Treasury yields may have risen in anticipation of "Tax Cuts 2.0" and fiscal stimulus. Rates have been trending higher after spiking in the aftermath of the November 2016 presidential election, with U.S. 10-year Treasury notes climbing above 3%.

      Treasury yields have been rising, and bond prices falling, due to Federal Reserve tightening, a strengthening economy, rising inflation expectations and a higher deficit. Our view is that the muni market dodged a short-term bullet with the Congressional midterm results coming in roughly in line.

      One interesting takeaway, however, is a potential infrastructure package. Infrastructure spending is perhaps the only issue where Republicans and Democrats can find some common ground. With Democrats now in control of the House, infrastructure spending (a key issue for the Trump administration) could be back on the table. At least, it's something we will be watching.

      Another thing to watch is the pace of Fed rate hikes as the Fed kicks off its two-day meeting today, with the rate decision and policy statement expected Thursday afternoon.

      Bottom line: Republicans keeping control of the Senate, and the House flipping Democrat, was the expected result of the Congressional midterms. Overall, we believe this is a positive outcome for both the Treasury and muni markets because it should help keep a lid on more tax cuts, and on federal and state deficits.