Navigating Washington's risks: Mar-a-Lago accord, tariffs and municipal tax exemption

Trade uncertainty has reached the highest level on record, advisors to the administration have reignited a 15-year-old debate on municipal bond tax exemption, and the White House could be looking for ways to weaken the dollar.

Here is our take on those three risks, listed in order of our assessment of most to least likely and impactful. 

This week President Trump offered a teaser to April 2nd by signing a proclamation to implement a 25% tariff on all auto imports, set to come into effect on April 3rd and expand to auto parts by May 3rd. The 25% tariff rate on vehicles covered by the US-Mexico-Canada trade agreement will only apply to the value of non-U.S. components.

There is little consensus over what the U.S. tariff regime may look like, raising the likelihood of market volatility and downside risks to U.S. and global growth. However, any sort of clarity on tariff policy may allow the market to move on to other risks.

A key observation for investors is that gold has outperformed the USD and S&P 500 by >6% across the 11 days dominated by tariff announcements this year. We continue to think gold has a valuable role to play in portfolios, alongside diversification across asset classes and geographies.

Outside of trade, taxes are garnering market attention this week. The federal government forgoes approximately $30bn annually by not taxing municipal bond interest. Stephen Moore, an informal Trump economic adviser, suggested modifying the tax exemption of municipal bond interest income to raise revenues.

We continue to think an elimination of the municipal bond tax exemption is unlikely, but some kind of modification to the tax-exemption is possible.

The decision to tax municipal bond interest has been debated by Congress many times over the last 15 years. So far, the tweaks have been marginal. In 2017, the Tax Cut & Jobs Act (TCJA) eliminated the ability for municipalities to issue tax-exempt advance refunding bonds on a tax-free basis. Prior to the TCJA, municipalities could issue bonds to refinance existing debt at lower interest rates before the call date of the original bonds, allowing them to take advantage of favorable market conditions. The interest on these advance refunding bonds was exempt from federal income tax, which made them an attractive option for municipalities looking to reduce their borrowing costs. This provision was estimated to save $17bn over ten years or $1.7bn per year— a small amount.

We see four potential scenarios regarding taxation of the municipal market:

1. Municipal market remains tax-exempt: Probability - High
2. Municipal Sector Modification (e.g., higher education, healthcare, or private activity bonds become taxable): Probability - Moderate
3. Municipal Bond Tax-Exemption Cap Initiated: Probability - Moderate
4. Municipal market becomes taxable: Probability - Low

Below we outline two potential scenarios that cover if municipal bonds are taxed. Keep in mind these cover the worst-case scenarios, are not our base case and result in just a ~10% maximum decline in price if not held to maturity.

Scenario 1: The first scenario illustrates taxing municipal bond interest at 28%, the rate that Stephen Moore and the 2011 American Jobs Act proposed. We estimate that a 28% tax on municipal bond income would cause an upward adjustment in interest rates by approximately 75 – 120 basis points (bps). This would cause a bond price erosion of approximately $1.40 - $9.60.

Scenario 2: The second scenario depicts tax-exempt rates rising to levels consistent with the AA/Aa rated corporate bond market. In this case, tax-exempt rates could widen by 118 – 170bps. In this instance, once the market normalizes, bondholders would generically see price erosion of approximately $3.00 - $13.60.

A paper by Stephen Miran, Chair of the White House Council of Economic Advisers, has raised some radical ideas as to how the administration could weaken the dollar.

The U.S. dollar is 6% above its 10-year average and 16% above its 20-year average valuation when measured against a basket of other major world currencies. A stronger dollar tends to lead to more imports (international goods are relatively cheaper for U.S. consumers) and less exports (U.S. goods are relatively more expensive for international buyers), which directly opposes the administrations goals of balancing trade and revitalizing domestic manufacturing. The administration has a stated goal to increase manufacturing domestically.

Miran’s paper focuses on two ideas:

• A “Mar-a-Lago Accord” where countries/central bank reserve managers agree to swap their holdings of short-term U.S. Treasury securities for century (100 year) bonds. If countries don’t agree to this, they would be subject to tariffs and have U.S. security guarantees removed.
• The U.S. could charge a “user fee” on reserve assets held by other countries – for example, a fee of 1% of coupons, which might increase to 2% if USD devaluation is insufficient. The paper also suggests differentiating between friends and foes: “Presumably, the Administration would want to withhold remittances to geopolitical adversaries like China more severely than to allies, or to countries that engage in currency manipulation more severely than to those that do not.”

The persistent overvaluation of the USD poses a challenge, but the “Mar-a-Lago Accord” and user fees on reserve assets carry substantial risks. Most notably, these measures could undermine the dollar’s reserve status and lead to much higher long-term interest rates, which are also contrary to the administration’s goals. Further, it seems unlikely that other economic policymakers would agree readily to a scheme to weaken the dollar like they did in the 1980s. Our view is that the accord is very unlikely.

We’ve highlighted several risks that are growing out of Washington. Investors should think about how they can position portfolios to help protect from those risks. We believe investors should stick to their strategic asset allocations, using equity exposure for long-term capital appreciation, and fixed income to hedge from growth scares. Additionally, we think tactically adding resilience (defined as income, diversification, and inflation protection) to portfolios through gold and real assets like infrastructure can help insulate portfolios from existing risks. Limiting the severity of drawdowns is critical to long-term investment success.

For questions as to how to best position your portfolio, reach out to your J.P. Morgan team.