Munis may mitigate tariffs’ unlucky charms

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U.S. equities could use a Saint Patrick to banish tariffs from the landscape. Increasingly harsh global trade talk has prompted an economic growth scare, with uncertainty around an escalating global trade war (Figure 1) driving down stock prices. The S&P 500 Index entered correction territory (down more than 10% from its most recent peak) last week and has seen its post-election gains erased. As the focus of tariff concerns shifts away from inflation and toward a possible recession, the index has become hypersensitive to any downside surprises in economic data (retail sales, manufacturing, consumer and business confidence), as well as to headlines about significant reductions in the federal workforce, a potential government shutdown and other high-profile disruptions

More rate cuts after all? Equity markets are currently pricing in three Federal Reserve rate cuts of 25 basis points (bps) each in 2025 given the anticipated negative impact of tariffs on economic growth, but investors will need to digest the risks of the growth scare before finding relief in the potential upside from rate cuts. Furthermore, there’s no guarantee those cuts will materialize, as tariffs remain a possible source of upward pressure on prices. In our view, tariffs could add +0.3% to the core Personal Consumption Expenditures (PCE) Price Index on an annualized basis. That would result in core PCE coming in at 2.8% instead of a forecast 2.5% for 2025 — well above the Fed’s 2% target. Barring any additional unexpected tariffs, however, we don’t foresee further inflationary impact from tariffs beyond 2025.

No asset class is a four-leaf clover, but investors have options. As growth and inflation worries continue to weigh on market sentiment, investors can seek buffers against volatility by focusing on more defensive areas of the equity market (with less exposure to beleaguered mega cap technology stocks) and by considering allocations to other asset classes currently offering good value and attractive income potential.

Portfolio considerations

While heightened market volatility and uncertainty have created challenges for investors, particularly in equity markets, one asset class in which we remain confident is high yield municipal bonds. Credit spreads for this segment of the market have historically remained stable during prior equity market selloffs, especially compared to taxable high yield corporates. Additionally, municipal default rates are only a fraction of those for their taxable counterparts across both investment and high yield munis. Figure 2 shows a 10-year cumulative default rate for high yield municipals of just 7.1%, versus 29.7% for their taxable high yield counterparts. Lastly, in 2024, municipal credit ratings upgrades outpaced downgrades by a ratio of nearly 3:1 through the third quarter.

At the index level, high yield munis have longer duration than investment grade munis. But actively managed municipal strategies can offer shorter duration and take advantage of attractive interest rates in the short-to-intermediate part of the yield curve. The municipal curve is positively sloped, rewarding investors for taking on duration exposure. Given the volatility of interest rates at the longer end of the curve, however, we believe a portfolio allocation to intermediate-term municipal credit is worth considering.

Within municipal credit, the land-secured (“special tax”) sector is among our favorites. Bonds in this sector finance the horizontal infrastructure (buildings and systems built close to the ground) of communities in states experiencing robust population growth and housing demand. Allocating to this sector provides exposure to long-term household formation and not necessarily to home prices, which fluctuate. This sector has long been a reliable source of supply issuance, and also comes with strong collateral, as the bondholder has first lien on the underlying land and all assessments attached to that land.

Year-to-date per Lipper, more than two-thirds of all investments in active municipal bond funds have gone into high yield municipals, reflecting investors’ conviction in this segment. That said, we have also observed a growing number of large but fundamentally weaker deals being teased into the market, which makes vigilant credit selection increasingly important.

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Endnotes

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