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U.S. Public Finance Midyear Outlook: Will The Sizzle Fizzle?

U.S. Public Finance Midyear Outlook: Will The Sizzle Fizzle?

The current U.S. economic recovery is now the longest on record. It's also the slowest, which has been the bigger story for U.S. public finance credit quality (see chart 1). Last year's surge in growth--spurred largely by federal stimulus including tax reform--has contributed to strong revenue growth for many state and local governments and enterprise sectors this year. Equity markets are soaring, unemployment remains low, real estate markets are stable, and interest rates will remain low for longer. Unfortunately, the economic growth forecast portends a chill in the air. As well, summer ushers in the official start of hurricane and wildfire season. So far this year, intense flooding, earthquakes, and tornadoes have hit regions across the U.S.; and multiple cyberattacks have shut down computer systems across different sectors. Furthermore, pressures from pension and other postemployment benefit liabilities are accelerating. All of these issues across public finance are sure to temper some of the positive trends so far this year.

Chart 1


U.S. Economic Growth Will Likely Flatten In Second-Half 2019

S&P Global Ratings has revised its U.S. economic forecast for 2019 and expects moderating economic activity, which likely means slowing revenues (see "For The U.S. Expansion, Are Trade Troubles 'Just A Flesh Wound'?," published June 25, 2019, on RatingsDirect). Our baseline economic forecast doesn't include a recession for the remainder of the year, but slow growth has its own issues from a budgetary standpoint and we will be analyzing that across sectors. At the federal level, the much-anticipated infrastructure focus has lost its momentum and we don't expect any significant action on that in 2019. Ongoing low interest rates haven't significantly boosted infrastructure spending across most sectors, which is a missed opportunity, given the backlog of needs for many public finance issuers and the potential economic stimulus associated with infrastructure spending. (See "As U.S. State Debt Levels Moderate, Transportation Funding Takes Center Stage," published June 11, 2019).

Court Decision's Impact Is Broad, And Repercussions Are Still Unknown

Finally, the U.S. Court of Appeals for the First Circuit decision affirming a lower court's decision that payment of Puerto Rico Highways and Transportation Authority's special revenue secured debt is voluntary, and not required, during bankruptcy, has generated significant market attention this year. While the decision is technically only binding precedent for cases arising in the First Circuit, its impact is broad. The decision differs from a long-held view of many in the municipal debt market that Chapter 9 of the federal bankruptcy code compels a debtor to pay bonds secured by special revenues while in bankruptcy. Of particular importance, the appellate court decision might not be the final or only decision on this topic. The decision could be appealed, or the same issue could generate a different outcome in another circuit. We see the decision as consistent with our view that the credit quality of special revenue debt--including priority-lien debt, as we refer to it--is directly linked to the obligor's fundamental credit quality, whether in Puerto Rico or elsewhere in the U.S. In our view, the legal and judicial actions throughout the far-reaching Puerto Rico bankruptcy, as well as this decision, highlight the lack of predictability in distressed credit situations. (See "Has S&P Global Ratings' View On Special Revenue Debt Changed Following The First Circuit Decision?," May 1, 2019.)

Chart 2


Chart 3


Charter Schools: Changing Political And Policy Environment Is Front And Center

In its January 2019 sector outlook, S&P Global Ratings projected a stable outlook for U.S. not-for-profit charter schools, but noted that disruptions would affect some--especially after midterm election changes caused a loss of charter advocates in some states. (See "U.S. Charter Schools 2019 Sector Outlook: Despite A Stable Outlook, Disruptions Could Leave Their Mark," Jan. 16, 2019.) More recently, in "Fiscal 2018 U.S. Charter School Sector Medians: Overall, Enrollment And Financial Performance Improved," June 6, 2019, we highlighted financial stability in the rated sector.

For the remainder of 2019, key risks include:

  • The growing political divide and increasing support for less favorable charter laws and operating environments in many states, including proposals for charter school moratoriums and limitations on expansion, which could have material implications for charter schools.
  • The laws and funding for charter schools vary significantly from state to state, and we believe some regions are more at risk than others.
  • Demographic pressures and competition for students, increasing unionization and strikes, and rising pension costs still outweigh the opportunities in the sector (such as increasing parity funding or the proliferation of school networks).

Many 2019 state legislative sessions have concluded, and some states that are home to some of the strongest charter school enrollments passed legislation indicating a changing political and policy environment facing charter schools. The Governor of California commissioned a task force to investigate the impact charter schools have on public education in the state, and California also is considering legislation (AB 1505 and AB 1507) that would impose restrictions on new charter petitions, including giving local districts greater ability to deny charter applications. These bills passed the Senate Education Committee last week and will advance to the Senate floor. While these bills would likely limit the growth of new charter schools in the future, they could also an impact existing charter schools, as the bill includes criteria for when districts can deny renewal applications. In New York, the state legislature adjourned with caps blocking new charter schools in New York City firmly in place. On a more positive note, West Virginia became the 45th state to pass charter law; Idaho passed a new bond enhancement program, effective in July, modeled after Utah's program;; and Florida passed legislation requiring school districts to share funds from future referendums with charter schools. We expect national scrutiny will increase as charter schools versus local public schools is likely to be a key election topic.

In 2019, we have introduced Charter School Briefs that highlight state-specific issues we are following. (See briefs on California, Nevada, Pennsylvania, and Texas.) We anticipate our rated universe, which tends to be more mature than the sector as a whole, will remain stable.

Health Care: Stability For Now, But Adaptation To Risks Will Remain Key

Our near-term outlook for the U.S. not-for-profit health care sector is stable. We base this on continued balance-sheet strength, a long-term trend of improving business profiles mostly from mergers and acquisitions, and a growing array of diversifying joint ventures. In addition, recent evidence indicates that operating margins are stabilizing or improving across the rating spectrum, although there are numerous individual exceptions. These strengths are reflected in a slight uptick in positive rating actions: through June 26, we upgraded 19 issuers and downgraded 15.

Nevertheless, sector risks still loom. A potential recession, continued Medicaid changes, increased traction from nontraditional competitors, and heightened cost and revenue pressure in part due to an aging population mean stability isn't a sure thing. We also expect federal administrative changes, which are weakening the Affordable Care Act (ACA), will continue affecting the industry. The potential ramifications of a recent court ruling that the ACA is unconstitutional could be severe if upheld, although, in our view, this threat would likely be a factor in 2020 or later. The potential for stress in the sector is visible in our year-to-date outlook changes with 29 negative outlook changes versus only 22 positive changes. We expect management will be pivotal in future credit direction as the pace of change accelerates; for more details, see "Effective Management Continues To Enable Not-For-Profit Health Care To Adapt," published May 13, 2019.

As the 2020 presidential election approaches, there is robust debate among the Democratic Party candidates about "Medicare For All". We believe an expansion of the current Medicare program, with the existing rules and reimbursement levels, is highly unlikely, and would be negative for credit strength in the sector. We also believe the debate on expanding coverage reflects the current system's limitations on health care access and affordability challenges facing millions of Americans and the current health care delivery system.

Higher Education: Credit Pressures Still Proliferate

Since January, when our outlook for the not-for-profit higher education sector was negative, we have taken more negative rating actions than positive ones, as many of the smallest and financially weakest colleges and universities face sustained enrollment and operating pressures. In the area of governance, the "Varsity Blues" scandal relating to admissions also underscores our 2019 outlook focus on the importance of enterprise risk management. Heightened focus on affordability and the return on investment of a college degree is ongoing, as competition between higher education institutions persists for a shrinking pool of students. A declining high school-aged population of students in certain states and regions, coupled with a third consecutive year of falling international student enrollment, is straining demand for certain institutions. Based on our conversations with management about expectations for fall 2019 enrollment, projected results appear to be mixed, with stronger schools reporting enrollment in line with or exceeding budget, while many smaller or more regional institutions expect to fall short of budgeted enrollment.

Amid these pressures, institutional financial aid increases with no signs of stopping; early indicators for fall 2019 tuition discount rates are up from fall 2018 average rates. (See "U.S. Public College And University Fiscal 2018 Median Ratios: The Disparity Between Higher- And Lower-Rated Entities Persists," and "U.S. Not-For-Profit Private Universities Fiscal 2018 Median Ratios: Overall Stability Continues Despite Lingering Issues," both published June 25, 2019.) Even for schools with a significant endowment, financial aid increases are not sustainable, in our opinion. Also, given market performance for the year, we expect that endowment returns for fiscal 2019, although still positive, will be much weaker than those of the past two years. State funding has been flat to increasing for most institutions, and will likely continue so into fiscal 2020. Fundraising was strong in the first half of the year and we expect this to continue. Any significant economic slowdown would likely materially affect both state funding and fundraising. At the federal level, widespread discussions around higher education policies are ongoing. Candidates have made student debt and college affordability a key topic for the 2020 elections. Meanwhile, senators have been working on a bi-partisan proposal to reauthorize the Higher Education Act, but resolution is unlikely before the end of 2019. We predict that the private university sector will continue to face more stress than the public sector, with a particular burden falling on smaller colleges and universities. (See "Consolidation Or Closure: The Future Of U.S. Higher Education?," March 14, 2019.)

Chart 4


Housing: A Mixed Credit Picture Across The Diverse Subsectors

Our outlook for the U.S. public finance housing sector is stable, with the exception of the stand-alone affordable multifamily subsector, where we expect negative rating trends will continue. Housing affordability is generally a concern nationwide, creating both challenges and opportunities for the lenders, owners, and operators that we rate. Housing finance agencies (HFAs) have broadened their use of downpayment assistance to meet the needs of first-time buyers. HFAs have also increased their on-balance-sheet lending and improved their asset quality with continued shifts to mortgage-backed securities programs as well as declines in delinquencies and foreclosures overall. This has led to improved HFA financial ratios, and in turn led to three upgrades in the first half of the year. We expect issuer and resolution ratings will remain stable for the remainder of the year.

We continue to monitor community development financial institutions' (CDFIs') leverage and net assets ratios, which have deteriorated/weakened in the past several years primarily due to fast loan portfolio growth. If this trend continues at the same pace as in previous years, it could lead to negative rating actions. However, if CDFIs can stabilize net assets while maintaining relatively low leverage ratios, we would expect stable ratings throughout 2019. By contrast, in the stand-alone affordable multifamily subsector declining financial performance, caused by higher operating expenses, increased vacancies, and weak strategy and management, led to downgrades and negative outlooks in the first half of the year, and we expect this trend will continue. We are also keeping our eye on proposed legislation in the U.S. House and Senate that includes provisions that could negatively affect military properties.

Public Power: Risk Management And Financial Flexibility Are Key To Stability

S&P Global Ratings sees resilience in U.S. not-for-profit electric utilities. Strong risk management and financial flexibility enable public power and electric cooperative utilities to address disruptive forces and stave off weakening credit quality. Exposures include political, regulatory, and operational developments that could pressure financial performance. Some exposures have national influence and others are regional.

For the remainder of 2019, key exposures include:

  • State-level initiatives to impose more stringent regulatory controls on power plants' emissions and the byproducts of electricity production;
  • Elevated congressional attention to climate change following the midterm elections;
  • Personal and property damage claims asserted against California utilities due to wildfires; and
  • The financial burdens flowing from nuclear construction projects in South Carolina and Georgia.

We consider the benefits of ratemaking tools that provide electric utilities with a strong pathway for recovering operating and capital costs as tempering these exposures, irrespective of whether an electric utility has autonomous ratemaking authority or is subject to regulatory oversight.

Year to date, upgrades and downgrades have increased relative to those in previous years due, in part, to our revised retail electric criteria. (See "An Update On How The Revised U.S. Municipal Retail Electric And Gas Criteria's Implementation And Market Trends Have Affected Ratings," June 5, 2019.)

At the national level, there has been a push for relaxing federal regulations in the environmental arena and beyond. Nevertheless, we believe the focus on climate change and state regulatory initiatives will require active management and preparedness on the part of utilities. Compared with the national perspective of emissions issues, other key exposures we associate with electric utilities are regional.

In California, wildfire activity attributable to power lines threatens the financial viability of some of the state's electric utilities. Although not immune to wildfire claims, California's public power utilities are generally less exposed to such claims than their investor-owned counterparts, in our view. Autonomous ratemaking authority helps shield public power utilities from the potentially protracted and unpredictable prudence proceedings investor-owned utilities must pursue to recover liability costs from ratepayers. In addition, many of the state's public power utilities are strong stewards of their assets, have robust fire mitigation plans, and, as city departments, collaborate with local fire departments to reduce fire risk. (See "California Public Power Utilities Are Better Able To Temper Wildfire Related Liability Exposures Than IOU Counterparts," Feb. 28, 2019.)

Nevertheless, some California public power utilities are vulnerable to fire liability claims. We lowered the rating on Trinity Public Utility District to 'A-' from 'AA-' because of sizable liability claims that might exhaust its balance-sheet reserves and insurance capacity if the claimants prevail. We also revised the outlook to negative on Sacramento Municipal Utility District, the Transmission Agency of Northern California, and the City of Glendale's municipal electric utility, to reflect the significant portions of their service territories that are within regions designated by Cal Fire and the California Public Utilities Commission as posing elevated wildfire exposure. We are assessing the capacity of these utilities' existing and proposed fire mitigation activities to shield them from damage claims. These rating actions also reflect our view that prospects for public power utilities to achieve legislative relief from wildfire liability claims in California are remote.

Another significant region-specific rating action relates to the failed South Carolina nuclear construction projects and the delayed and bloated Georgia nuclear projects. We lowered ratings and revised outlooks to negative for the public power and electric cooperative utilities involved in the South Carolina projects to reflect the political and litigation backlash to their recovery of the $4.5 billion invested in the abandoned plants. Georgia's nuclear projects also weigh on ratings and outlooks because of cost escalations, project delays, and uncertain completion costs. S&P Global Ratings has lowered the ratings on five public power and electric cooperative utilities participating in the Georgia projects. The outlook is negative for each of these utilities.

We believe that, against a backdrop of significant disruptive pressures, public power and electric cooperative utilities with competitive retail electric rates can use ratemaking and rate design tools to respond to a dynamic landscape, facilitate cost recovery, maintain sound alignment among revenues, expenses, and debt service, and help maintain the mid-investment-grade ratings we generally see in the sector.

State And Local Governments: Looming Issues Could Pressure Stability

State and local governments remain largely in the same position they were in at the start of the year: slow but steady national economic growth continues to support credit stability. This doesn't mean, however, that there aren't pressures on the horizon that could alter the trajectory.

Chief among these is the ongoing potential for economic disruption from federal policy changes such as tariffs. States that rely heavily on international trade for GSP growth will be particularly vulnerable, especially if there is less diversity in the economy. And as states go, so go locals: any states that start to experience revenue pressures are more likely to share the pain with their constituent governments.

Because the real estate market is a critical component of financial stability for property-tax dependent local governments, housing trends remain important indicators of potential credit pressures. While the national picture includes some slowing in real estate investment (down 3.5% during second-quarter 2019), we project housing starts to increase in 2019 and 2020. Regionally, expectations include softening home price growth during the next few years but no dramatic shifts that would broadly affect credit quality.

Positive state revenue trends help drive stability for local governments, too

One bright spot since January has been strong state revenue performance. Although we think this is a temporary boost from stimulus from the Tax Cuts and Jobs Act, it has been a welcome development for all governments. Revenue trends are up, with 28 states projecting revenue growth of more than 3% in fiscal 2019-2020, helped along by strong numbers from the April income tax collection season. Fund balances are on the rise as well, with 38 states projecting fund balances to either grow or hold steady in fiscal 2019 (see chart 5); projections for 2020 indicate similar results. (See "Thanks To A Delayed SALT Effect, U.S. State April Income Tax Collections Bounce Back," May 14, 2019; and "U.S. States Take Advantage Of A Prolonged Economic Expansion," May 16, 2019.) Positive budget performance at the state level usually translates to funding stability for local governments and school districts and this has been the case for 2019 with some notable exceptions. However, for any governments not able to capitalize on positive variances in recent years and rebuild reserves, a downturn will come harder when economic trends change direction.

Chart 5


What we're watching for the rest of 2019

Given the recent cybersecurity breaches, flooding, earthquakes, and the start of hurricane and fire season, environmental, social and governance (ESG) issues remain front and center. ESG factors have always been important considerations for state and local governments, but attention has grown in recent years, particularly as the focus broadens beyond climate change. As discussed in "When U.S. Public Finance Ratings Change, ESG Factors Are Often The Reason," (March 28, 2019), about 34% of USPF rating actions in 2017 and 2018 were attributable to ESG factors. State and local government rating actions during that time were almost all governance-related, although not all were downgrades. When a government undertakes planning and preparation for these kinds of major disruptors, it supports the ability to provide core services to its constituents, as well as its long- and short-term credit quality.

Political changes are a perennial governance disruptor, and considering 20 new governors were elected in 2018, we continue to pay close attention to state-level policy shifts that could have implications for the state rating or local government ratings. Policies on Medicaid, pensions, state funding, education, natural disaster funding and programs, and infrastructure remain key from a budgetary standpoint. Illinois' proposed pension consolidation, Connecticut's proposed shift of pension funding to local governments, and California's legislative focus on wildfire recovery for local governments underscore these shifts. The first half of the year brought policy changes even to states without new administrations, such as Texas, which modified local and school funding mechanics--with divergent potential outcomes (see "Texas Funds Public Schools, Staving Off Expenditure Growth For Now," June 13, 2019, and "Texas Local Governments Could Face Budget Headwinds--And Credit Quality Strain--From Property Tax Reform," June 12, 2019).

Transportation Infrastructure: Still Full Speed Ahead

For U.S. transportation infrastructure subsectors, the risks and opportunities identified in January are on trend. Starting with our headline "Mostly Stable, Despite Expected Slower Growth And Unlikely Investment Package," Jan. 17, 2019, it's safe to say at the macro level we have yet to observe any actual declines in demand data we track. This include cargo and container trends, airline passengers, toll transaction and revenues, and vehicle miles traveled. Port operators are experiencing some impacts associated with the tariffs on Chinese imports, specifically in certain export commodities like soy beans. But as a whole, many of the large U.S. container port operators continue to see year-on-year increases in volume, caused in part by shippers trying to get ahead of future tariff increases It's difficult to tell where this story ends but it's clear that an evolving trade policy adds uncertainty to long-term planning, which trickles down to the maritime and port sectors, and that volume declines may be next.

Other macro factors contributing to continued positive demand trends across all sectors are continued stable-to-slightly lower oil prices compared with forecasts and solid 3.2% first-quarter GDP year-over-year growth (the fastest pace since the second quarter of 2015), though S&P Global Ratings economists are anticipating real GDP quarterly growth slowing to under 2% this year.

Our January Outlook headline also characterized the odds of a federal infrastructure package as "unlikely" and that still looks to be the case. Expiration of the current FAST Act law in October 2020 and the impending Highway Trust Fund (HTF) insolvency should provide some impetus for policy makers. However, given the current political climate and election cycle, we see the possibility of a new federal revenue source to plug the estimated $18 billion average annual shortfall to maintain current federal spending on highway and transit as remote. The HTF provides approximately 50% of annual highway and bridge capital improvements, or about $60 billion annually in formula and discretionary money allocated to states.

States, local, and regional transportation infrastructure owners continue to invest in infrastructure while leveraging existing and new revenue sources. Since 2013, over half of all states with both Republican and Democratic majorities have raised revenue to support expanded transportation improvements, with seven more governors mostly in the Midwest proposing gas tax increases. (See "As U.S. State Debt Levels Moderate, Transportation Funding Takes Center Stage," June 11, 2019.) New York made the boldest move toward developing new revenue sources, approving a variety of taxes to support mass transit including a first-of-its-kind congestion pricing initiative for New York City dedicated to the Metropolitan Transportation Authority capital investment program.

Finally, expanding capital programs are best exemplified by the airport sector, where we have identified over $92 billion in capital needs over the next five years at the top U.S. hubs (see "When The Cycle Turns: Airport Balance Sheets--And Exposures--Increase with Traffic," July 9, 2019). This report examines how U.S. airport hub ratings have fared as the airline industry has consolidated and the exposures associated with rising debt levels.

Water And Wastewater Utilities: Rate Affordability Remains A Key Focus

We still view affordability as one of the sector's main concerns and believe that it might create headwinds to credit quality this year and beyond. In April 2019, three leading utility professional organizations submitted a white paper to the U.S. Environmental Protection Agency (EPA) proposing that the long-used but unofficial metric of the annual utility bill as a percentage of household income was not enough. They argued that additional consideration ought to be made for the relative levels of poverty in the community. In fact, S&P Global Ratings has been using this exact approach in its criteria since January 2016. The potential for some relief came from the October 2018 enactment of America's Water Infrastructure Act (AWIA), which compels the EPA to consider integrated planning and affordability when enforcing violations of the federal Clean Water Act. This could potentially allow utilities to stretch out the use of debt--and the rate increases to support it--over a longer timeline while still implementing corrective action plans. AWIA also created a federal task force to study how communities can afford to pay for stormwater infrastructure so that the EPA can report back to Congress by early 2020 on how communities might better address drainage and flood control infrastructure. Given that climate change risks could exacerbate existing problems communities face during wet weather events, this could bode positively over the long term, especially if federal participation is meaningful. We also expect finality to proposed changes in the Lead and Copper Rule within the next six-12 months, and perhaps even legislation passed on per- and polyfluoroalkyl substances, based on the EPA's published action plan and the possibility Congress may direct it to develop a federal standard.

Overall, we haven't seen a deviation from the historical trend of upgrades slightly outpacing downgrades. We expect that rating action trends and overall ratings distribution to hold for the remainder of 2019. Utilities with large but underfunded obligations to retired employees could continue to see limited rating upside, but those liabilities by themselves are unlikely to pressure ratings lower. Generally, the allocable share of pension and postemployment benefit obligations to the utility tends to pale in comparison to the overall capital improvement plans. Still, we believe that the first observable place that credit stress would present itself would be in our all-in coverage: our adjusted debt service coverage metric that aims to incorporate the use of every dollar of operating revenues, regardless of lien or accounting treatment.

This report does not constitute a rating action.

Primary Credit Analysts:Robin L Prunty, New York (1) 212-438-2081;
Martin D Arrick, San Francisco (1) 415-371-5078;
David N Bodek, New York (1) 212-438-7969;
Geoffrey E Buswick, Boston (1) 617-530-8311;
Theodore A Chapman, Farmers Branch (1) 214-871-1401;
Kurt E Forsgren, Boston (1) 617-530-8308;
Jane H Ridley, Centennial (1) 303-721-4487;
Lisa R Schroeer, Charlottesville (434) 529-2862;
Jessica L Wood, Chicago (1) 312-233-7004;
Marian Zucker, New York (1) 212-438-2150;
Secondary Contact:Adriana Artola, Chicago + (312) 233-7201;

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