What Will Tariff Increases and Uncertainty Mean for the Municipal Bond Market?

Steel, aluminum, cars and car parts are being targeted. Tariffs on Mexico and Canada will remain at a high level except for certain products still subject to a free-trade agreement. Tariffs on pharmaceuticals continue to be on the table. There is also a minimum tariff of 10% across the board.

Notwithstanding the so-called 90-day pause, these tariff increases remain historically high and are probably almost as inflationary as the original tariffs. And who knows what will happen after the 90 days — another level of uncertainty.

In addition, severe cuts in federal programs, including possibly Medicaid, have and will likely occur. Assuming that tariff turmoil and federal cuts continue, what might they mean for the economy and the municipal market?

In terms of the economy, a likely outcome is stagflation — the occurrence of both lack of growth (recession) and inflation. The combination of large federal layoffs, federal spending cuts, and paralysis of companies’ investment plans due to uncertainty on account of tariff policy will likely result in stagnation. Companies may stop investing and put plans on hold due to uncertainty about costs. As costs increase due to tariffs, inflation may increase. An upward move in inflation will in turn result in more stagnation. This reinforcing dynamic results in stagflation, which could take root as soon as the third or fourth quarter of 2025.

Will the Federal Reserve Board come to the rescue? This is a virtual impossibility. Decreasing interest rates could feed inflation. Increasing rates could exacerbate stagnation. The likely outcome is for the Fed not to take any action.

Just as the economy could become topsy turvy, so could the municipal market with the following possible outcomes:

1. The health care sector is likely to face particular distress. Federal cuts combined with increased costs may create a double challenge that many hospitals/health care institutions could have trouble navigating.
2. The senior-living, multifamily housing, charter school, and higher education sectors will also likely struggle. These sectors are cost sensitive. Inflation will create cost pressures and there will be limits on the ability to increase revenue. This imbalance will result in added distress.
3. Any project in the midst of construction or in need of construction will face serious challenges due to price escalation and uncertainty.
4. Municipalities that are already facing the end of federal COVID-19 financial support will also face cuts in other federal support payments and lower revenue collections due to a recession. This combined with increased expenses due to inflation will create distress likely resulting in at least a few Chapter 9 bankruptcy filings.
5. Mutual funds could experience outflows due to inflation and could face liquidity issues at some point.

Defaults may likely occur in numerous sectors. Investors may face a very challenging environment requiring caution in investment decisions.

To mitigate risk in new investments, investors may consider the following:

1. Requiring equity cushions and seller take back soft subordinate debt where possible.
2. Obtaining completion guarantees from credit worthy parties and very high contingencies in new construction projects.
3. Insisting upon strong security packages.
4. Holding out for pricing that adequately rewards risk.     

The one thing that we can be certain of in the coming period is uncertainty and uncertainty calls for discipline, diligence, and prudence.