Magnificent munis

Bottom line up top

Magnificent Seven becoming vulnerable? Last year, mega cap leaders Apple, Amazon, Alphabet, Meta Platforms, Microsoft, NVIDIA and Tesla — collectively known as the Magnificent Seven — saw strong performance (+107%) as a group, accounting for approximately two-thirds of the S&P 500’s 26.3% total return. They’ve also delivered outsized outperformance since the onset of the pandemic (Figure 1). This performance dispersion has led to a disproportionate increase in stock valuations of the Magnificent Seven relative to the rest of the market. As we move forward into 2024, investor expectations for continued strong earnings and profits from these juggernauts have raised the bar for further gains. The adoption speed of generative artificial intelligence (AI) will also help determine their path. Ultimately, we believe investors may have reached an inflection point. Not only is the dominance of the Magnificent Seven vulnerable to pullbacks, but the overall equity market is looking for a catalyst to move higher following the current earnings season.

Therefore, consider diversification. At the same time, although inflation has continued to moderate, the U.S. Federal Reserve has pushed back on cutting interest rates until it has “greater confidence that inflation is moving sustainably down to 2%,” namely, the central bank’s target. Against that uncertain backdrop, investors with significant exposure to the Magnificent Seven may want to consider diversifying toward asset classes that were left behind in last year’s broad rally, yet still offer attractive risk/reward profiles. In our view, that calls for taking advantage of the opportunities in fixed income — municipal bonds in particular.

Portfolio considerations

U.S. Treasury yields have risen across the curve in 2024, with the 10-year yield now more than 4%. Anticipating a slowdown in economic growth, we forecast the 10-year yield to end 2024 at around 3.50%. The expected decline in yields should reward investors who extend duration in fixed income, especially in the tax-exempt space. Municipal-to-Treasury yield ratios have risen year-to-date, meaning AAA rated municipals with maturities from 1-10 years yield roughly the same as similar U.S. Treasuries on a taxable-equivalent basis (Figure 2). High quality municipals present an attractive opportunity for those overallocated to cash. We expect Treasury yields to decline and for investors locking in yields now to be rewarded.

Additionally, we see compelling value in lower-quality investment grade (BBB) munis, which are yielding nearly 200 bps more than their AAA muni counterparts across short- and long-term maturities. For those willing to take on credit risk, up-in-quality high yield municipals could deserve an allocation in a portfolio.

This sector also offers longer duration than investment grade munis. Year-to-date, high yield mutual fund flows have turned positive and new issue deals are largely oversubscribed, with mutual fund demand exceeding supply. Supply is expected to stay constrained, and we expect credit spreads to remain stable, with default rates low and idiosyncratic. Both fundamental and technical catalysts support the high yield muni market.

With the start of tax season, municipal selling typically occurs mid-March through the second week of April. Investors should take advantage of any technical weakness that may occur over this relatively short window.