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2023 looks brighter for munis

Municipal bonds struggled along with most asset classes in 2022, but we are moderately optimistic as the year begins. While we note that above-normal inflation and a hawkish Federal Reserve are keeping risk elevated, munis stand to benefit from higher yields and solid credit fundamentals.

State finances have been strong

As 2023 begins, municipal bond credit fundamentals appear sound.

  • Throughout 2022, most state and local governments were in solid financial shape as unprecedented federal support during the Covid-19 pandemic and strong U.S. economic growth provided a tailwind to muni credit.
  • U.S. employment and economic activity has held up well despite the Fed’s aggressive tightening efforts over the past year. The muni sector is better positioned for a potential recession than it had been in previous economic cycles due to unprecedented levels of state reserves.
  • Municipal defaults remained below long-term averages throughout 2022, and they continue to be a very small percentage of the market.

We are watching inflation, growth, and the Fed

Although it appears inflation has peaked in this cycle, U.S. economic data remains relatively strong, in our view. The unemployment rate is low and consumer spending has been resilient. This will likely keep the Fed on track to continue ratcheting up interest rates to loosen the tight jobs market in early 2023. However, we believe the bulk of the tightening is likely behind us. The Fed’s eventual shift to a less hawkish stance can become a tailwind for municipal bonds, as we continue to believe the stabilization of U.S. Treasury rates and reduced muni outflows will improve market returns.

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