A sunny muni outlook this Groundhog Day

Bottom line up top:

Macro environment: less shock, more calibration. Nearly 18 months into the U.S. Federal Reserve's easing cycle, investors are increasingly focused on the endgame for monetary policy rather than individual rate decisions. This shift is visible across public markets, where volatility has subsided, equity valuations have stabilized (albeit at above-average levels) and differentiation among interest rate-sensitive assets is based more on duration risk than economic growth expectations.

Futures markets no longer price in rapid Fed easing. Instead, they expect gradual easing, with the terminal fed funds rate drifting modestly lower (Figure 1). This "higher-for-longer, but not forever" narrative has supported a flattening of the yield curve, kept real yields elevated and reinforced the appeal of assets with visible cash flows and pricing power.

In equities, performance of the S&P 500 Index has become more earnings- than liquidity-driven, with 2026 forward earnings per share (EPS) growth estimates in the mid- to high-single-digits. In fixed income, the 10-year U.S. Treasury yield, while off recent highs, is still restrictive in real terms, anchoring equity valuations and capping multiple expansion even as earnings expectations hold up.

Labor: lament or lullaby? This week's U.S. labor market data will provide a critical sentiment check. ADP private employment, the latest JOLTS (Job Openings and Labor Turnover Survey) release and the January nonfarm payrolls report will help investors assess whether labor demand is cooling at a pace consistent with disinflation or recession. Above-trend job creation or reaccelerating wage growth could extend the higher-for-longer rate outlook, tightening financial conditions and pressuring risk assets. In contrast, a gradual decline in job openings and wage gains would likely reinforce confidence in a soft landing.

Markets appear to be trading not on the direction of policy per se, but on how long policy is expected to continue in that direction. For now, that nuance is rewarding resilience, balance-sheet strength and cash-flow visibility - traits that matter most when the cost of capital remains structurally higher, even as the cycle matures. In this environment, asset classes exhibiting both sound credit fundamentals and favorable technical dynamics may outperform. Municipal bonds meet these criteria.

Portfolio considerations

Municipal bonds endured a challenging 2025 in which they broadly underperformed other major fixed income categories. One reason was the significant headwind of record new supply ($580 billion in issuance, up 14% from 2024).

But munis are off to a strong start in 2026. Through January, admittedly a limited time period, investment grade and high yield munis have returned +0.94% and +0.98%, respectively, based on the Bloomberg Municipal Bond and Bloomberg Municipal High Yield Bond total return indexes. And while new-issue supply is likely to remain elevated, principal redemptions and coupon payments are expected to surge 50% (Figure 2), resulting in an estimated net supply of -$100 billion. Meanwhile, fund flows suggest investor demand may prove robust enough to absorb heavy new issuance, with munis recently experiencing back-to-back weeks of $1 billion+ inflows for the first time in over two years.

We believe continued municipal inflows will be sourced in part from the roughly $7.7 trillion currently sitting in low-yielding money market funds, as investors in those funds begin to see the value of rotating into more attractive income-generating assets. Across the municipal curve, longer-maturity bonds offer compelling tax-efficient yields. For those in the top federal income tax bracket, 20-year AAA municipals provide a taxable-equivalent yield of 6.68% - more than high yield corporates (6.58%). Along the AAA muni curve, the 20-year also represents a yield pickup of +1.72% and +1.33% over the 5- and 10-year maturities, respectively.

Credit fundamentals remain healthy as well: State and local government tax revenue collections and reserves hover near 40-year highs. In 2025, muni ratings upgrades exceeded downgrades for the fifth year in a row. Defaults are in line with long-term averages, while yields remain historically high. And spreads have stayed relatively stable, even during equity market selloffs. While a downturn in equities isn't our base case, stretched valuations and heightened geopolitical uncertainty are risks investors should not take lightly. Municipals, on the other hand, may remain largely insulated from geopolitical impacts.

In our view, these tailwinds, combined with disciplined credit analysis and active management, support the case for adding munis to portfolios for their tax-advantaged income and risk-adjusted return potential.

Nuveen's Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.

Regular meetings of the GIC lead to published outlooks that offer:

• macro and asset class views that gain consensus among our investors
• insights from thematic "deep dive" discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
• guidance on how to turn our insights into action via regular commentary and communications