Letter to the Shareholders: June 30, 2017

Dear Shareholder:

We’re halfway through the year and the municipal bond market turned in a very solid performance. That may come as a surprise to some folks. Not too long ago a number of pundits and market commentators had pretty much written off bonds based on speculation that a new Trump administration would lead to faster economic growth, lower tax rates, higher levels of inflation, and rising interest rat es. Events haven’t exactly unfolded the way some people were predicting back at the end of last year. Here’ s a quick overview of some of the key economic data that has affected the bond market during the first six months of this year.

Real gross domestic product {GDP) increased at an annual rate of 1.4 percent during the first quarter of 2017. That’ s well below the trend rate of growth and approaching what some economists would consider to be “stall speed”. Second quarter GDP growth is expecte d to be slightly bet ter, but still below desirable levels. The Fed’s own economic projections call for real GDP growth over the next three years to be in the range of 1.8 to 2.2 percent. It seems that economic growth is stuck in a 2 percent rut and it may be difficult to break out of it.

Inflation has continued to be subdued and prices for goods and services have actually declined in recent months. The Fed’s preferred inflation measure, the core personal consumption expenditures inde x {PCE), which strips out volatile food and energy prices, increased at an annual rate of 1.4 percent in May. Both the core and headline PCE readings rema in well below the Fed’ s 2 percent inflation target rate. Despite the fact that the economy is approaching full employment {the unemployment rate was 4.3 percent in May), there appears to be little or no wage price pressures that typically can lead to inflation . Generally, a slow growth, low inflation environment tends to support bond prices and that has certainly been the case during the first half of 2017.

Tax re form, both corporate and individual, continues to be discussed in Washington. So far, no real substantive details have emerged with respect to the anticipated overhaul of the tax code. The Trump administration has proposed to cut corporate and individual tax rates and simplify the tax code by eliminating many itemized deductions and/or exemptions. A couple of points are worth mentioning in connection with potential tax reform. Most importantly, the administration’s tax proposal preserves the tax exemption for municipal bonds. While it’s always possible things could change, we are very encouraged by the support that the current administration has shown for keeping the municipal bond tax exemption.

In theory, any reduct ion in marginal tax rates could potentially lead to a decrease in demand for municipal bonds since the exemption becomes less valuable. However, it is worth noting that the administration has proposed reducing the top federal marginal tax rate from 39.6 percent to 35 percent, an amount that is far less than previously thought likely. Most experts that follow the municipal bond market believe that the proposed cut in the top marginal rate is too small to significantly dampen demand for municipal bonds. We agree with that assessment. In the meantime, demand for high quality municipal bonds was very robust during the first half of this year.

On the supply side, net municipal issuance for the first quarter of 2017 declined substantially and came in at approximately -$14.1 billion below consensus estimates. The municipal bond desk at Citigroup estimates that the state and local government debt market will shrink by $39.5 billion over June, July and August as bonds mature faster than they are issued. This comes at the same time that investors will be receiving approximately $44 billion in interest payments. Favorable supply/demand trends helped support bond prices during the first half of this year. We think these positive technical factors will continue to support the municipal bond market during the second half of this year.

Federal Reserve Update:

The Federal Reserve Open Market Committee (“FOMC”) met on June 14 and raised the fed funds target rate an additional 25 basis points to  a range of  1.00-1.25%.  The FOMC statement noted that the FOMC had raised rates “in view of realized and expected labor market conditions and inflation. ” The FOMC acknowledged that inflation had declined recently and was somewhat below its 2 percent target, but suggested that it felt the drop was transitory in nature.  However, a number of Fed Governors  have noted in recent speeches that they believe the recent downturn in inflation and absence of inflation pressures gives the central bank additional scope for patience.

The Fed also released a formal balance sheet reduction plan. Prior to the recession, the Fed’s asset holdings were about $900 billion. The Fed started aggressively buying securities in the open market to support the economy and prop up the banking system in late 2008 and continued its purchases until October of 2014. To date, the Fed has amassed holdings of approximately $4.5 trillion on its balance sheet.

The start date for the balance sheet reduction plan was not specified, but most Fed watchers believe that it will commence later this year. Under the balance sheet reduction plan, the FOMC will gradually reduce its holdings by decreasing its reinvestment of the principal payments it receives from Treasury securities, agency debt, and mortgage-backed securities it currently holds. The goal is to reduce the size of the Fed’s balance sheet over an extended period of time without causing any market disruptions that might be caused if the Fed were to engage in outright sales of securities.

To sum up, despite widespread bearish calls at the beginning of the year, the municipal bond market performed very well during the first half of this year.  We think this is a timely reminder of just how important it is to take a long term approach to fixed-income investing.  More often than not, it pays off   to tune out all of the background noise, as it  may interfere with your ability to make sound investment  decisions.

As always, thank you for investing with Dupree Mutual Funds.


Allen E. Grimes, III
Executive Vice President