Sector View: Negative
Our view of the sector remains negative given the level of pressures brought by COVID-19 and the recession. While we expect most credits will experience only slight, if any, deterioration in 2021 and beyond, in the current environment we still expect downgrades to outpace upgrades. Credits that maintain higher reserves are better positioned to withstand revenue and expenditure pressure, but for most, active management of any shortfalls will still be critical to maintaining credit quality. Local governments that have weaker financial reserves and less flexibility, and don't proactively manage their budgets in 2021, will be most at risk for credit deterioration.
In 2020 local governments across the country took the lead to innovate through the pandemic and recession. We expect this to continue in 2021 as they address challenges surrounding vaccine distribution. All of this must be done while addressing day-to-day government needs, sometimes in the face of revenue shortfalls. As we look to the year ahead, given the challenges presented, we know some downgrades are unavoidable, although not all issues placed on negative outlook in 2020 will go down (see Rating Actions And Distribution below). Local governments with flexibility borne by reserves, revenue, or expenditure flexibility have a head start for maintaining credit quality. But even proactive management teams with their hands on the wheel may find there is a limit to what they can do in the current environment.
Our view on 2021 highlights five questions that matter for the health and stability of local government credit quality. Some questions have specific factors that could affect the trajectory, but there are several potential disruptors that span broadly. These include delays in federal stimulus and/or an effective immunization campaign; a double-dip recession; and a markedly slower economic recovery than currently expected, either nationally or on a state level.
Questions That Matter
1. What are the federal fiscal and policy initiatives that will be meaningful for credit?
After months of waiting, the federal relief bill passed in December but did not include money for state and local governments. While that outcome was not a complete surprise, it is still a blow to local governments trying to make ends meet during revenue shortfalls brought on by COVID-19 and the recession. The National League of Cities' (NLC) annual survey of over 900 municipalities, taken before Congress's December action, put numbers to the pressure local governments have been seeing all year, with 71% of cities surveyed saying their government's condition will worsen unless Congress passes additional stimulus. A similar survey from the National Association of Counties with 1,800 respondents puts the number higher, at 91%.
How this will shape 2021
No new stimulus for locals will make a difficult budget year even harder. Locals know that without meaningful federal stimulus, balancing 2021 will be even more difficult and we're likely to see deeper budget cuts.
Low interest rates will continue to help with cost of capital, providing some budgetary flexibility. With the Federal Reserve pledging to keep rates low for the foreseeable future, locals will be able to take advantage of low borrowing costs. Lower interest rates also help offset the loss of tax-exempt advanced refundings, but a taxable refunding still won't save as much as a tax-exempt one.
A national infrastructure package would create jobs and rebuild assets. The greatest value would come from the inclusion of projects that benefit locals and schools, plus a broad-scale infrastructure program brings jobs directly to communities.
What we think and why
Absence of meaningful federal stimulus could lead to credit deterioration and rating changes. An early-on infusion of $150 billion in CARES Act Coronavirus Relief Fund money was a big help for locals but it wasn't enough to completely offset revenue decline due to the recession and additional pandemic-related costs. While the CRF dollars were shared broadly, the NLC estimates 29% of locals received no CARES Act funding.
Premature austerity pressures the economy. Given that state and local government makes up 10.4% of national GDP, continued budget cuts and employment reductions will slow down the national recovery and in turn slow local revenue recovery which adds to credit pressure.
What could change the trajectory
Continued gridlock in Congress. This could limit policy initiatives favorable to local governments from an economic or financial standpoint.
2. Will the uneven health recovery weigh on credit quality?
Throughout the pandemic we have seen the virus affect the U.S. unevenly, from illness spikes to tax revenue shortfalls brought on by state-mandated social distancing. As we move through the virus' winter surge, we expect the impact will be uneven. This puts harder-hit issuers at a different starting point than others as the world turns its sights to widespread use of a vaccine in 2021.
How this will shape 2021
State and regional recovery readiness varies. Some parts of the country may be ready to move forward post-virus more quickly, growing revenues and expanding the local economy, while others take longer. During 2020 we saw more differences between states than regions, as demonstrated by variations in unemployment rates as shown in chart 3.
Limited budgetary flexibility. As economies reopen, significant budget cuts will be necessary for some issuers to bring revenues in line with expenditures. This provides less flexibility in budgeting for 2021 and beyond.
What we think and why
Uneven health recovery will continue for some time. Since states are experiencing the virus differently, there will be different outcomes for revenues, expenditures, and credit quality. Economies that take longer to recover will continue to see more pressure on sales taxes and other revenues.
Property tax collections remain on track, providing stability for many. In areas where housing demand was high there could be a notable increase in the taxable valuation. Housing starts are very strong across the U.S., as is price appreciation in many areas. A slowdown in either won't necessarily signal weakness, but rather normalization.
In the event of another lockdown, sales taxes may not drop as much as feared. Sales and other user taxes were hit hard in general, but for many it was not as bad as original expectations. Should there be another virus spike, this should help provide stability.
Slow economic growth and vaccine-shy constituents could keep some areas from coming back quickly. This would be consistent with what we've seen where shutdowns happened earlier and/or lasted longer.
3. How does our negative view of the state sector relate to local governments?
While there is no direct correlation between the sector view on states and individual local government credits, the overall health of state finances can have a direct impact on locals. Some local governments—including school districts, where state revenues make up an average of 51% of funding—are dependent on the state for operating revenues. After a period of remarkable stability, in 2020 there were three state downgrades and 14 negative outlook revisions. Nearly all states are required to maintain a balanced budget, and when cuts are necessary to regain balance, one of the most common actions is to reduce aid to locals. Not all states head into 2021 with significant budgetary weakness, but where it exists we expect locals may feel it, too.
How this will shape 2021
Budgetary pressure at the state level can move quickly down to locals. If states need to make cuts to local governments and school districts to regain balance, these adjustments can result in mid-year budget cuts. Depending on the timing of the cuts, these are often offset by using reserves since making impactful spending adjustments can take longer.
Regardless of location, operations are tight for most. The uneven health recovery varies across states, and some are experiencing less revenue pressure than others. However, for those under strain, the pressure is likely to ramp up without additional federal stimulus.
Pain is likely to continue since 2022 doesn't look any better for many. Many states are talking about 2022 budgetary imbalances, another signal of an increased chance for revenue sharing cuts, potentially for more than one year.
What we think and why
Being prepared for potential cuts is important. When state budgetary imbalances occur, it may only be a matter of time until they hit locals. Early on in the pandemic school aid was cut in several states, but the December relief bill included $54 billion for public K-12 schools which will help, particularly since the bill didn't include stimulus money for states.
States with slower economic recoveries will exacerbate problems for locals. If the national economic recovery is slow and other revenues are similarly pressured, the situation will be exacerbated. Locals with their own revenue weakness will be hit even harder.
Some states may be waiting for the other shoe to drop. Local governments with a Jan. 1 budget year couldn't wait for possible federal stimulus to finalize their budgets. Any governments that were disappointed by a lack of stimulus for states and locals in the congressional bill may now have to make more sizable budget cuts.
Governments are on the front lines of the pandemic and their finances are showing it. Total revenues have been down across the country, with most states reporting year-over-year drops through September, and six states in excess of 10%.
4. Will ESG issues remain a front-and-center challenge that affects credit quality?
After many years of ESG conversations focused on 'E', in 2020 'S' and 'G' topics were also prevalent. This included civil unrest associated with George Floyd and subsequent calls for police reform. In the 'G' space, in addition to a myriad of pressures related to COVID-19 response, we saw ongoing cyberattacks on local governments. We expect all of this to continue at some level in 2021.
How this will shape 2021
ESG conversations will ramp up. Issuers, investors, and credit ratings firms will spend more time discussing ESG issues and determining how best to disclose the effect of these factors on credit quality
Social and Governance topics head to the fore. 'S' risks associated with civil unrest may start to gain prominence, as 'G' modifications are implemented to quell community concerns
Data, data, data. We expect additional information and data to be more readily available as extreme weather, chronic and increasing climate impacts, cyber security, and public safety conversations ramp up.
What we think and why
ESG will continue to move ratings. Addressing current 'E' and 'S' pressures through short and long-term planning initiatives is an important part of 'G'. In some cases, management's long-term view of these credit factors can mitigate a precipitous deterioration in credit quality.
Environment is back on the table at the White House. The change in administration will likely result in federal prioritization of transition and physical risks associated with climate change, prompting more conversations at the state and local level.
Data improvements and availability will be critical. Comparability of environmental data will continue to improve, prompting more meaningful conversations with many issuers around mitigation and long-term stability.
ESG-related rating changes--pandemic and non-pandemic
ESG-related rating changes in 2020 showed an uptick in 'S' factors, reflecting the influence of COVID-19 on local government credit quality, although not all the changes were pandemic-related.
5. Will COVID-19 have long-term implications for local governments?
Many governments will be unable to close COVID-created budget gaps using only structural measures, and we expect some one-time uses to be common. With 1.2 million jobs lost in the local government sector since March 2020, we expect more cuts to come, forcing harder choices and requiring locals to do more with less. With a winter COVID spike and a slower economy going into 2021, it will likely take local governments longer to recover to pre-recession revenue levels, especially as they grapple with any "new normal" shifts, such as changes in tax revenue trends or demographics.
How this will shape 2021
Given the trajectory of the recovery, we anticipate a slower start for the economy heading into 2021. A slower pace will translate into slower revenue recovery for many, resulting in more cuts to restore budgetary balance. This includes delaying capital projects which can result in growing deferred maintenance. For some, it will also mean pension contribution reductions.
Budget cuts continue and may ramp up. Some state and local governments waited to see what happened with federal stimulus before making significant budget cuts. With no stimulus for state and local governments forthcoming, we expect there could be significant adjustments, and in the interim, more use of reserves.
What we think and why
Proactive management remains critical for credit stability. Local governments that started out with more cushion will be better insulated from revenue shortfalls, but only if they manage things well. Avoiding budget balancing strategies that threaten longer-term stability--such as a marked increase in debt or a reduction in pension contributions—will be critical to success.
It will take time to see what the post-vaccine "new normal" looks like. Trends that started in 2020 may lead to longer term shifts in retail and demographics. For example, in a recent report, S&P Global Ratings said that "the U.S. commercial real estate market, already hammered by retail and lodging woes, may face more long-term damage if the pandemic-related population-shift away from larger cities, work-from-home arrangements, and corporate cost-cutting strategies stick."
Switching gears to recovery from pandemic management may be difficult. For issuers whose primary focus must remain on managing the pandemic, rebuilding may take the place of economic expansion.
Staying the course on pension and infrastructure funding is critical to long term credit quality. Even small changes to pension contributions in current budgets can have a significant impact on funding levels in the long term. For governments with already high fixed costs, the balancing act is even harder.
What could change the trajectory
"New normal" takes longer to shake out. S&P Global Economics projects growth will start to tick up in the second half of 2021, but we don't expect an automatic reset to pre-COVID times. Delays in a national economic recovery could jeopardize local growth.
We saw notable shifts in consumer habits in 2020 that had an effect on sales tax collections. Personal consumption expenditures dropped 18.6% between February and April, and as of October had not yet recovered completely. With the onset of social distancing, segments of the retail market show differing outcomes.
Rating Actions And Distribution
Most local governments started 2020 from a position of strength, and despite the pandemic and recession, rating distribution in the sector remained largely the same at year-end. We responded to the pandemic with more outlook changes than downgrades; overall, 88% of local government COVID-related actions were negative outlook revisions.
In 2020 local government downgrades outpaced upgrades by a factor of four, a sharp departure from 2019's rating actions. Approximately one-third of 2020's rating actions were directly attributable to COVID-19.
This report does not constitute a rating action.
|Primary Credit Analyst:||Jane H Ridley, Centennial + 1 (303) 721 4487;|
|Secondary Contacts:||Geoffrey E Buswick, Boston + 1 (617) 530 8311;|
|Lisa R Schroeer, Charlottesville + (434) 529-2862;|
|Contributors:||Adriana Artola, San Francisco + 415-371-5057;|
|Cora Bruemmer, Chicago + 1 (312) 233 7099;|
|Victor M Medeiros, Boston + 1 (617) 530 8305;|
|Joshua Travis, Farmers Branch + 1 (972) 367 3340;|
|Robert Tung, New York + 1 (212) 438 1189;|
|Blake E Yocom, Chicago + 1 (312) 233 7056;|
|Nora G Wittstruck, New York + (212) 438-8589;|
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