Most States Maintain Credit Stability by Working to Constrain Expenditures and Liabilities as Revenue Growth Moderates

The SNWAM Investment Team maintains a stable outlook on the State GO Sector and recommends a marketweight allocation to it. The State GO Sector was the focus of our April Muni Strategy Meeting, and our outlook is based on the fiscal flexibility of states and expectations for moderate growth of state tax revenues supported by continued economic growth. Our outlook is also tempered by those states that face challenges from having not been able to utilize a protracted period of economic growth to build reserves or mitigate liabilities.

Most states have taken advantage of the eight years of economic growth following the financial crises to build up their tax bases and reserves, and have restrained spending through the post-recession economic cycle. Based on our analysis and reviews of other reports, we expect that Fiscal Year 2017 tax revenues will see increases, but at growth rates that are lower than in prior years. In March, the Rockefeller Institute reported that the median forecast for state income taxes was reduced from 4.0% to 3.6%, and from 4.2% to 3.1% for state sales taxes. States also generally expect to see some improvement in FY 2018 tax revenues, with median forecasts for income taxes increasing to 4.1% and sales taxes increasing to 3.5%. Moody’s also expects that state tax revenues will resume moderate growth of 2-3% over the next 12-18 months, but that growth levels will still be below the five-year average of 4%.

While President Trump’s initiatives to stimulate U.S. economic growth may help boost state tax revenues, they could be offset by fewer federal dollars allocated to the states. The administration’s proposed federal budget, if enacted, could lead to a reduction in federal funds for state programs. Depending on the level of cuts, states may face a choice between cutting programs, increasing taxes, or tapping into reserves – which have grown, but are still below pre-recession levels.

While we expect to see overall credit stability in the sector, we have noted that some states are facing fiscal pressures, which have been reflected in ratings downgrades. Since our last review of the State GO sector in April, 2016, Standard and Poor’s has downgraded six states while only upgrading two. As energy dependent states have been downgraded due to the impact of lower oil prices, budget problems and growing liabilities have led to downgrades in Connecticut and New Jersey, as well as two downgrades in Illinois over the last year. Those downgrades confound logic given the long trend of positive economic growth. 

Growing pension liabilities in those downgraded states contribute to their overall credit pressures. While most states have taken steps to ensure that the funding levels of their public pensions remain solid, including the reduction of pension benefits in order to contain costs, some states with growing pension liabilities either have not been able to contain costs or have not adequately maintained contribution levels (or a combination of the two). Moreover, pensions are not the sole cause of their problems. Generally, states with the strong credit quality have also taken steps to maintain high pension funding levels, while those with low or declining funding levels have and/or continue to face credit pressures and weakening credit quality. 

The SNW Investment team has been able to find more value with mid-grade State GO credits and/or appropriation backed credits, or those associated the state tax revenues. We will continue to look for opportunities to invest in State GO credits that provide credit stability and increased value.

Source:  Moody’s, Rockefeller Institute of Government, Standard & Poor’s