Despite the possibility of a variety of potential disruptors, overall we expect stability to continue for local governments in 2020. With a long history of effective responses to unexpected circumstances as well as the recent trend of revenue growth, the sector is well poised to meet the challenges of the new decade. However, to maintain credit quality over the longer term, management teams will also need to be prepared when and if the credit cycle turns.
At the start of a new decade, S&P Global Ratings' local government rating portfolio remains strong and stable, supported by a long period of consistent revenues and economic growth. This trend led to another year of more upgrades than downgrades in 2019.
Our view of local government credit quality for 2020 is stable. We believe that the U.S. economic forecast, coupled with the sector's flexibility to adjust to changing economic trends and federal and state policy shifts, will translate to steady credit performance for most issuers. Further, the long recovery has provided an opportunity to improve fiscal conditions across the sector. Those governments that took advantage of this long recovery period will be best positioned for any future economic and revenue shocks. As always, active and timely budget management is key to credit stability.
What We're Watching For
If the state sector's stability waivers
Given the economic and revenue sharing relationship between states and locals, stability in the state sector generally bodes well for locals. So the ongoing stability we've seen in states--even with slower growth in revenues--is a positive for local governments. As detailed in our 2020 state sector outlook (see "U.S. States 2020 Sector Outlook: Finding Balance In Today's Lower-For-Longer Economy," published Jan. 6, 2019, on RatingsDirect), U.S. state credit quality is generally strong as the new decade begins. The shallow nature of the post-Great Recession economic expansion has led to narrow fiscal margins for many states, but state officials have adjusted expenditure needs within the slower revenue growth environment, providing a foundation of stability.
However, given that close relationship, pressure at the state level can quickly spread to local credits, particularly those with a significant reliance on the state for revenue sharing, such as school districts. State revenue sharing always depends on the overall health of the state's own revenue flows. Slow revenue growth, a correction in equity markets, or shifting federal funding or policies (particularly Medicaid) can cause states to rebalance expenditures. When state budgetary stress occurs, the solution is frequently passed down to locals through local revenue sharing cuts or delays in payments. Any locals without sufficient reserves to weather the changes will be faced with the need to make budget cuts quickly or resort to cash flow borrowing.
Signs that reserves are sufficient to withstand a downturn
At the start of 2020, the economic environment remains hospitable for local governments, with most able to consistently achieve break-even or better results. A look across the sector indicates that reserves are in a stronger position now than before the Great Recession, which supports our view of a generally stable outlook. The reserve improvement was most pronounced for cities and counties, reflecting greater flexibility and revenue diversity as well as autonomy to adjust spending. This is in contrast to the years following the Great Recession, where many municipal governments saw a deterioration in general fund performance and lower reserve levels as a result. This is typical for issuers as they make cuts to regain balance, supporting operations with fund balance in the meantime. The net general fund results for school districts doesn't fall as far after the Great Recession as cities and counties do, but it also doesn't rebound as much during the ensuing recovery.
Even in a lower-for-longer economic growth environment it is critical for local governments to build up a cushion to help soften the blow of the next economic downturn, or any other kind of unexpected event. A review of our rated universe of local governments and school districts shows that operating surpluses grew over the past several years and many management teams have been building reserves (see chart 4). We view this positively from a credit standpoint and believe it will be key to managing any future downturn. We also note the much higher average reserve level for cities and counties compared to school districts. With most school districts getting the majority of their funding from states, the overall financial strength of a district's home state becomes even more important for credit quality.
As shown in chart 3, average net general fund results for school districts have remained positive during the course of the recovery. Looking more closely at the trend in funding for schools in chart 5, there is evidence of an uptick in reserves as revenues grow, demonstrating that districts are building up a cushion, but that notable additional reserve accumulation is likely more difficult to generate without help from higher funding levels.
Changes at the federal level that bubble over to local governments
We expect policy uncertainty at the federal level to be as pervasive in 2020 as it was in 2019. Ahead of the 2020 presidential election this may be even more pronounced, pulling lawmakers' focus from critical local funding initiatives like an infrastructure package. Other policy shifts, such as trade tensions and Tax Cuts and Jobs Act (TCJA) have affected local governments around the country in different ways. Although there haven't been any rating changes attributable to either yet, we see both having potential negative credit implications for some governments over time.
Trade: S&P Global Ratings' chief U.S. economist estimates that in its current state the trade and tariff situation will shave 30-40 basis points off U.S. GDP in 2020, pushing projected U.S. growth down to 1.9% in 2020 from a projected 2.3% in 2019. With a variety of industries included in the numerous sets of tariffs enacted, the impact can be seen across the U.S. Chart 6 shows the percentage of China tariff-affected employment by county, giving a sense of the economies that could be most vulnerable to fallout from the tariffs, particularly if the local economy lacks diversity. Given the day-to-day changes on trade and tariffs, we will continue to watch for any larger implications, particularly if tariffs on consumer goods are imposed and result in a slowdown in sales and therefore sales tax collections.
Tax reform: Two years after the passage of the TCJA the positive economic impacts have started to wane, and we are starting to see some pressures created from the $10,000 state and local (SALT) tax deduction cap. Taxpayers from areas with high state and local taxes lost the ability to deduct the full SALT bill from their federal taxes, and some are feeling it in their net taxes paid. While this has not translated into an exodus from states with high property tax, there are other implications for local governments, including potential hesitation to approve additional bond referendums that would raise taxes. There could also be an impact on the housing market, slowing down housing sales or price appreciation in particularly high tax areas since the net cost of owning some homes will increase without full federal tax deductibility. Chart 7 highlights where the SALT cap pinch may be felt the most.
Improvements in the economy that bode well for local governments
Despite economic uncertainty stemming from trade tensions, U.S. economic growth continues, and S&P Global Ratings' chief U.S. economist recently revised the chance of recession over the next 12 months downward to 25%-30% from 30%-35% (see "Fewer Signs Of Scrooge-ing Up Growth In the New Year," Dec. 4, 2019). However, the chance of recession still remains higher than the 15%-20% estimate a year ago.
There were several factors that contributed to the improvement in the estimated chance of recession, but for local governments the most important factor was an uptick in single family building permits. Strong housing indicators are good for local economic stability, and the market for home sales is further boosted by good wage growth (projected year-over-year average gain of 3.1% in 2020), and low unemployment. The lower-for-longer interest rate environment also helps home buying remain more affordable. Projections for home price growth in 2020 are again strongest in parts of the West, but with most growth projected to be in the 3% to 4.5% range, the signs of a bubble are limited.
A shift back to weak pension funding discipline that translates to credit pressure
With an overall increase in recession risk over the past year (see chart 8) and the expectation of continued low interest rates, there are notable risks ahead for pension and OPEB plans, particularly those that continue to struggle toward funding discipline and stability.
In 2020 we expect to see a continuation of the trend of many local governments limiting payment deferrals by adopting more conservative amortization methodologies. Unrealistic assumptions cost much more in the long run, particularly if aggressive assumptions result in systematic underfunding that is allowed to compound over many years, generating a much larger problem down the road. We expect local governments will continue to address the funding needs of pensions despite increasing near-term costs for sponsors. The median assumed asset return has been steadily decreasing for years, ending 2019 at 7.25% after hitting 7.45% in 2018.
In light of lower investment returns, the need for local governments to use market-appropriate amortization and demographic assumptions becomes even more important. The confluence of assumed rate of investment return, amortization period and consideration of the demographic makeup of plan participants and retirees are also critical to the overall health of the pension fund, and to the budgetary demands on the governments supporting it. Trends in funding status can be a useful indicator of year-over-year funding progress; however, it can be equally important to look at the plan's actuarial assumptions, methods, and funding practices in conjunction with the economic and demographic picture in order to form the most reasonable expectation of what the future holds.
Beware of high fixed costs. From a credit quality perspective, high fixed costs tend to crowd out other parts of the budget. This can limit service delivery as well as the ability to address other long-term capital needs. As detailed in "Fifteen Largest U.S. City Pensions See Modest Gains In 2018, But Recession Risk And Rising OPEB Cost Challenges Persist," published Sept. 23, 2019, there is a wide gap between Philadelphia's 14% and Chicago's 45%, creating a much different budgetary picture for two large cities with a myriad of challenges. For local governments burdened with fixed costs that make up a significant portion of their budget, the precarious balance of paying for legacy costs while still providing appropriate service delivery will continue indefinitely.
ESG issues that are credit disruptors
Environmental, social and governance (ESG) issues comprise the core function of government, and so the concepts are nothing new to local governments. However, the constantly evolving nature of the pressures mean municipalities must keep up a constant vigilance or risk falling behind. In our view it's not a case of if ESG issues could emerge for a credit, but rather when they will, particularly for any local governments that haven't kept pace.
Governance and service delivery are the core mission of all local governments, and the skills and adaptability that management teams possess are usually what keeps operations in balance when times are tough. As described in our article "When U.S. Public Finance Ratings Change, ESG Factors Are Often The Reason," March 28, 2019, the majority of the ESG-related rating changes during the two years of the study were attributable to governance issues. This highlights the importance of proactive management in addressing challenges, particularly those that would affect long-term credit quality.
E: Environmental issues require planning to address acute issues like hurricanes, as well as longer term issues like extreme heat and sea level rise. We evaluate a government's approach to environmental issues based on their individual challenges, and focus heavily on what planning is being done. In 2020 we will be asking about that planning, and also following up with local governments who experience a weather event that threatens either long- or short-term structural balance, particularly if a major portion of the tax base requires rebuilding.
S: Social issues including demographic changes or evolving service delivery demands are also unique to each community. Demographic shifts like an aging populace can lead to more service demands for local governments, and a city or county with an aging population will need to look further out to be prepared. As pressures from pensions, infrastructure and other long term costs continue unabated, some governments are turning to artificial intelligence in order to do more with less, targeting a narrow spectrum of the population to pinpoint service delivery more effectively.
G: As governments have worked to streamline and automate operations, management teams have increasingly turned to technological solutions which have had the unexpected consequence of leaving their systems and operations more vulnerable to cyberattack. We have seen an uptick in ransomware and other cybercriminal activity, and governments must stay one step ahead in order to protect themselves, which is proving to be unfeasible for some. In 2020 we expect the frequency and demands of the attacks to continue to grow; in cases where they interrupt core functionality or significantly affect financial position, we expect there could be downward rating pressure. Given a constantly changing playing field, we will continue to discuss cyber insurance and other precautionary measures with issuers.
Growth in some regions projected to outpace others, resulting in uneven credit impacts
Although there have been many bright spots in the national economy—such as wage growth, low unemployment, and housing starts—growth across the regions has been uneven. As shown in chart 8, S&P Global Ratings recently lowered its projection for a recession over the next 12 months to 25% to 30% from 30% to 35%, but the figure remains notably higher than it was in 2018.
For regions experiencing slower growth—particularly if there are additional vulnerabilities like tariff-affected jobs (see chart 6)--a national or regional economic slowdown could create a more pronounced effect. Demographic changes can have a similarly dampening effect on local economies, and can also shift the priorities and funding sources of local governments. We will also be watching the outcomes of the 2020 census closely over the next few years to see if the political climate affects the count, particularly in areas such as sanctuary cities.
We regularly review the country by region, frequently comparing the regions using three key data points: unemployment, regional GDP growth, and housing starts. In chart 11, a history of GDP growth since the Great Recession shows clear post-recession dominance by the West region, which is projected to continue in 2020 (see chart 12).
The most notable regional difference in the year-over-year projections shown in Chart 12 indicates a divergence in the trend of housing starts, specifically a reduction in the West. The West region has seen some of the strongest growth in housing starts and home price appreciation in recent years, and less supply will squeeze buyers in this region even tighter. While home price appreciation can be good for the size of the tax base, increasing unaffordability could create unintended consequences over time.
In addition to these key statistics, there are themes from each region that differentiate them from the others and in our view have the greatest chance to affect credit quality.
Risks and opportunities created by a low interest rate, slower growth economy
A lower-for-longer environment for both interest rates and economic growth can be a double-edged sword for local governments in a variety of ways. A prolonged period of low interest rates allows for more advantageous borrowing rates, but it also means pension funds looking for higher yields move to more risky investments, creating more potential for volatility. And while a slower economic expansion means less chance of a bubble, it has also taken longer for some local governments to regain pre-recession payroll levels as compared to private payrolls. As shown in Chart 14, public sector payrolls fell more slowly and gradually following the Great Recession, but afterwards didn't have the same kind of growth demonstrated in the private sector.
S&P Global sees 2020 as a continuation of the lower-for-longer environment. Given that, we anticipate the lower interest rate environment will continue to benefit local government refunding opportunities, particularly in a post-TCJA world without tax-exempt advanced refundings. We will be watching to see if the lower borrowing costs translate into more revenues for infrastructure projects, which would also help in a slower economic growth climate.
The healthy U.S. economy with low unemployment and strong ongoing wage growth has also provided a good backdrop for the passage of bond referendums. Bond elections in November 2019 showed passage of the largest issues concentrated in Texas, the Rust Belt, and the Pacific Northwest.
In order to maintain credit quality over the long term, it also means that the municipalities will have to find a way to close budget gaps without deferring costs, which can often mean issuing additional debt. Projections for 2020 new issuance volume top $400 billion,indicating many critical projects will likely be funded with debt.
This report does not constitute a rating action.
|Primary Credit Analysts:||Jane H Ridley, Centennial (1) 303-721-4487;|
|Geoffrey E Buswick, Boston (1) 617-530-8311;|
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