Top of the Morning: Muni Market Guide - A balancing act

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will spend some time diving into the latest Municipal Market Guide publication from the UBS Chief Investment Office.

I will point out that this publication is now available for you up on UBS.com slash CIO. Though, let me take a moment to introduce our guests before we get into the conversation. Both contributors to the publication, we do have joining us, Sadiq Murkherjee, a Senior Municipal Research Strategist, as well as Andrew Dubinsky, joining me here at the 1285 Podcast Studio.

Andrew is the Senior U.S. Economist from the UBS Chief Investment Office. So with that, Sadiq, Andrew, as always, thank you for dropping by, spending some time today with our listeners, our clients.

Sadiq, let me turn it over to you to lead today's conversation with Andrew. Thank you, Dan, and good morning UBS. We're talking about the Municipal Market Guide and the Mini-Market, the title of the report, as Dan said, a balancing act.

So let me just start talking about the broader fixed income markets. U.S. fixed income has come under some pressure in the last one month in the wake of elevated geopolitical risks, higher Treasury yields across the curve, and shortly higher oil prices. A macro environment really remains a top issue on investors' minds, and therefore the need to balance risk and return has never been greater.

And we will be talking about the macro environment in a little bit. That's really the focus of this call. But before that, let me give a rundown of the muni market.

Munis also sold off, along with most other U.S. fixed income assets over the past month, after a very strong start to the year. But despite the weakness, the good news is that munis are still outperforming Treasuries and corporates on a year-to-date basis. Historically, the muni market typically exhibits some weakness in March and in April, and this year, at least months to date, that is playing out as technicals weakened.

By technicals, I mean the balance of supply and demand weakened as supply continues to be elevated. Now, elevated supply, higher supply, higher issuance has been a defining trend of the muni market since 2024, actually, and that trend is continuing on, and we expect that trend to continue. So supply will remain elevated relative to historical levels.

It's coming in roughly at around the same pace as 2025, but that was a record year. So in those supply pressures, technically speaking, and that coincided with rate pressures on the Treasury side, and that's the reason for the weaker performance month to date. But again, on a relative basis, the muni market is outperforming Treasuries and corporates.

One of the things that has actually helped to partially offset the pressures of the market and weaker technicals is flows. Flows have continued to remain fairly strong. They've moderated a little bit over the last month, but they're still very robust and have helped to balance that weaker technicals and rate pressures.

One interesting thing about flows is that we are starting to see some interest, investor interest, on that longer end of the curve relative to what we saw in 2025. The curve remains very steep, has been steep for some time now, and so investors are starting to kind of get interested in duration as you are being compensated for duration given that steep slope, especially in the 1030 area. So if you look at longer investment horizons, multi-year investment horizons, that's the question investors often ask us, yeah, the 20-year area of the curve offers good total return potential.

And in addition to that, tax equivalent yields continue to be attractive relative to Treasuries and investment-grade corporates, especially for investors in the highest tax bracket. And lastly, supporting the market and Fed easing should help, and there is a lot of money on the sidelines. So all of those things provide for a constructive environment.

But having said that, in our view, near-term technicals and rate risks have to be factored in. So in the short term, we have been a bit defensive on curve positioning with the barbell in the 1 to 3 and 12 to 17 years in the curve, and that really affects our tactical balancing act, if you will, with a focus on risk-adjusted returns, not just total returns. So overall, a fairly constructive market.

The catch-up trade of MUNIs having underperformed last year is underway, and we expect 2026 to be a good year for MUNIs, but there are some issues to consider, especially on the rate side and the technical side in the very short run. Let me pivot to credit. MUNI credit remains strong.

A pointed metric is that 70% of the bonds in the index are rated in the AA category or better, and that's the highest in over 15 years. So a lot of credit ballast and fundamental credit strength in the index. That said, the strong rating upgrade momentum we have seen post-pandemic really has now moderated substantially, and year-to-date actually downgrades are outpacing upgrades, and perhaps we will see that trend continue in 2026.

But that said, overall credit quality remains very robust, and we've been asked this question. MUNIs are not directly impacted by concerns around AI disruption and private credit. They really finance essential long-dated public infrastructure that is removed from those concerns.

State fund reserves are very strong, and our overall constructive view on the economy, which Andrew will talk about a little later, is quite a factor. And while we expect credit quality fundamentals to remain strong, given the elevated uncertainties on the macro front, spread widening risks have increased. So in view of that, we prefer higher quality bonds of larger issuers.

So that, in a nutshell, was what we are seeing with the MUNI market. Now let me focus on really the main topic of this call, which is what is going on with the macro environment, what are our views. There's a lot of push and pull between macro factors, between labor market concerns and vision concerns, economic growth, and finally the Fed response.

So let me get Andrew into the call. Andrew, welcome. And if you could provide and share your thoughts on all those things and how you expect the macro environment to evolve, that would be great.

Yeah, that sounds like a great plan. So I'm going to start with the near-term growth outlook and pivot into other things like the labor market outlook, inflation, and wrap things up with the Fed. So starting with the growth trends, we entered 2026 with a lot of momentum from the private sector.

The shutdown did weigh on 4Q GDP, and that did obscure some of the strength. But if you look at core private demand consumption plus investment, you still had around 1.9% in the fourth quarter and a bit stronger in the third. And as we think about the first half, we have three tailwinds that should set things up to be quite strong, and things do probably taper out a bit in the second half.

But you have fiscal stimulus, still loose financial conditions even after some of the recent market volatility, and then you have fading tariff headwinds. And just diving into the fiscal stimulus a little bit, we're going to have quite large this refund season, around $50 billion to $100 billion larger than last year as part of the individual tax cuts. And then there's also some corporate tax cuts, and that should help the CapEx momentum broaden out from last year.

And last year was still quite good. We had business investment of growth of nearly 6%, and this year should be also quite strong with still continued AEI-related investment and some investment outside of AEI and other parts of equipment. Now, obviously, what's changing some of the tone of that positive growth outlook is the higher oil prices.

And the rule of thumb that we're using to think about what that drag could look like is around for every $10 increase in oil prices, we could see a 10 basis point or so drag and growth. And given the oil moves that we've had and to some extent that they stick through the year end, we could see a drag of 20 to 30 basis points, but that still leaves us with above-trend growth. Now, one thing that hasn't looked that impressive are the labor market trends.

And we obviously had some recent job market data, and it showed private job growth averaging around 30,000 over the past three months if you adjust for the effects of some recent strikes. And 30,000 doesn't sound great in the context of the past, say, 10 or 20 years, but we're just in a very different demographic environment. And we expect we'll stay in this low-hire, low-fire growth – sorry, hiring environment.

That's enough to keep the unemployment rate stable and even probably tick down a bit if that stronger growth outlook that I was talking about plays out. So 30,000 jobs from the private sector doesn't sound great, but it's probably enough to keep the unemployment rate stable. And it's also probably enough to keep job growth – I'm sorry, overall growth looking pretty good as long as we stay in this high-productivity growth environment that we've been in.

So that means we don't need necessarily a ton of jobs to generate the same amount of growth when productivity is pretty elevated. And we've been seeing productivity growth of over 2 percent in recent years, which is well above the average of, say, 2010 to 2019, about one point or so higher. So there is still some labor market downside risks and certainly one path that we'll talk about later for further Fed easing, but probably not the most likely path.

And what's really going to be a focus for the Fed is the inflation outlook. And starting with the core CPI index at 2.5 percent, it looks like it's on its way back to levels that the Fed would be pretty happy with. And you are seeing pretty steady disinflation in services, but still pretty elevated readings in core goods.

And if you look at core PC, which is the Fed's preferred index, you actually get a quite firmer read on things at a bit over 3 percent. And the tariffs are a big part of that. And we're expecting those effects to peak this quarter, early next quarter, and start to see some slower prints.

But those are a key headwind for a faster return to low 3 percent policy rates. And while oil is another, I think, near-term wrinkle, it's probably not going to be a big deal for core inflation. It's going to probably boost headline inflation by quite a bit.

And we could see that show up pretty clearly in the next release. But the effect on core inflation could be measured in one or two tenths, given the oil price move that we've seen. So definitely, we'll add some noise to that return to 2 percent that we're expecting over the next year or so.

But it doesn't derail it. So for the Fed, this week, we have a meeting. So depending on when you hear this, it's going to—we'll know the outcome of the meeting more clearly.

We're not expecting any changes to rate policy. But we're going to definitely hear about how they're thinking about this oil price shock. And our expectation is that, conditional that expectations remain pretty stable, they're going to be able to look through this supply shock.

So we're thinking that we're going to have return to low 3 percent rates by year-end, so two more cuts. And the timing of those cuts really depend mostly on when we get clear signs of disinflation in goods. And we're expecting that to play out in the first half.

And there's a chance that we get some more labor market downside risks play out. And that could be another path to further easing. That's not our base case.

But there's a strong preference to return to 3 percent, especially given where we are. And the Fed doesn't want to have policy rates being too tight as inflation comes down. But they definitely want to see some more evidence that these tariff effects are definitely a one-off.

So there's some uncertainty about when the easing restarts. But we think it's going to start this year, restart this year, and probably by the middle of the year. And I'll pass it back to you.

Thanks, Andrew. Those are really insightful comments. And that really helps frame the perspective of staying balanced, staying invested.

Yes, the macro conditions and macro uncertainties are higher. But overall, our view still remains overall constructive. As far as the muni market goes, the message to investors is fairly simple.

Stay invested, stay balanced. And opportunities could come up in March and April. Some dry powder is helpful.

But overall, for 2026, our view is unchanged. We have a constructive view of the muni market. With that, let me hand it back to you, Dan.

Well, Sadiq, Andrew, thank you both again for dropping by top of the morning today, spending some time with our listeners, our clients, for the update performance outlook for the municipal bond market. Andrew, very helpful macro recap as well. So thank you for that.

I will point out again to you, our listeners, the Municipal Market Guide for the month of March, that title Balancing Act, available for you up on UBS.com slash CIO. Of course, for clients of UBS, simply reach out to your UBS financial advisor if you would like to receive a copy of the Municipal Market Guide directly. Up from UBS studios, I'm Dan Cassidy.

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