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U.S. State and Local Government Credit Conditions Forecast: Waiting - . - and Waiting To Exhale
U.S. State and Local Government Credit Conditions Forecast: Waiting - . - and Waiting To Exhale
U.S. State and Local Government Credit Conditions Forecast: Waiting - . - and Waiting To Exhale
Table Of Contents
Forecast Summary: Fundamentals Point To Ongoing Expansion Why Hasn't The Recovery Brought A Stronger Revenue Bounce For Local Governments? A Word Of Caution About An Otherwise Positive Forecast State And Local Government Employment Trends Diverge Second-Quarter Credit Conditions Favor Local Governments The Regions
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Many state and local governments have taken advantage of the recovering economy in recent years to shore up their finances. As Standard & Poor's Ratings Services has incorporated the improving financial positions across the sector into its analyses, an upward trajectory in rating trends has resulted. In our view, however, there is an emerging question about where things go from here, especially among the states. The slow motion economic recovery that began in 2009 has produced only gradual tax revenue growth for most state and local governments. Governmental credit quality has improved in this environment, but only because of sustained vigilance when it comes to budget management. After five or six years of restraint, however, we perceive that "austerity fatigue" has begun to set in for some states. But relaxing budgetary restraint now -- either by raising spending or cutting taxes -- could converge with a revenue plateau. Such actions could prove ill-timed from a credit perspective if revenues were to decline in response to a correction in the equity markets, for example. At the local government level, budget development tends to be less politicized than it is for states. When combined with their greater reliance on property tax revenues, local governments may be better positioned from a budgetary perspective at this stage. And recently released U.S. Census Bureau data confirm that the housing recovery is now materializing in the property tax collections, most of which flow to local governments. But the housing recovery, this time fueled in part by investor-buyers, has generated less accompanying economic activity than in most previous periods of home-price appreciation.
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Table 1
2014-2015 Industry Economic Outlook For U.S. State And Local Governments
Forecast* / Scenarios Downside (10%-15%) 2014 Macroeconomic indicators Real GDP (% change) Baseline growth in 2014 might be 3.0% but for cold winter weather and expiration of extended unemployment benefits. Reduced federal fiscal policy drag contributes to higher overall growth rate. Payroll growth, averaging 183,000 per month during the past 12 months has helped bring down the unemployment rate. Slight February uptick was due to labor market re-entrants. Retail activity took a hit during cold winter months, but recent indicators point to stronger trends into the summer. Rate of growth may be linked to sustainability of housing recovery. Price appreciation of 13.5% in 2013 and 22% since trough in January 2012 could begin to price out new buyers. Cash transactions--at 35% of existing home sales--could taper as bargains become less available. Very low--below Fed target; minimal formulaic cost driver implications Bull market has surpassed five-year mark. The index is hovering near record high valuation levels since December, about when makets began exibiting greater price volatility. 0.58 1.84 2.75 3.17 4.13 4.01 1.86 2015 Baseline (65%-75%) 2014 2015 Upside (15%-20%) 2014 2015 2013 Actual
Comment
(3.00) 7.59
0.10 7.68
(1.50) 6.37
(0.10) 5.80
0.90 6.05
(0.60) 5.00
(5.20) 7.35
1.30
1.25
2.70
3.05
3.34
4.01
1.95
0.82
1.08
1.12
1.48
1.40
1.68
0.93
0.80 1,589
1.84 1,659
1.81 1,870
2.08 1,960
2.13 1,988
1.61 2,102
1.76 1,643
*Baseline forecast is based on "U.S. Economic Forecast: Springing Into A Warmer Economy," March 24, 2014. Upside/downside forecast is based on "Two Economies Diverged In A Wood," Dec. 5, 2013.
Economic fundamentals continue to strengthen in our forecast and support our generally positive macro outlook. The underlying economic drivers we focus on for state and local governments should also continue in a favorable direction, albeit at a tempered pace, according to our forecast. We expect the unemployment rate, a key indicator, to continue its downward drift. As of March, the unemployment rate was 6.7%, and we forecast that it will fall to 6.4% for the annualized rate in 2014 from 7.4% in 2013. Assuming no changes in the labor participation rate (63.2%), the economy would need to create about 111,000 payroll jobs per month to keep up with population growth without a rise in the unemployment rate. For the 12 months through March, the economy added 183,000 payroll jobs per month, thus explaining the nearly full percentage point decline from March 2013, when the jobless rate was 7.5%. Most of the overall net payroll job gains have been from private sector hiring. After averaging a decline of 47,000 payroll jobs per month for the 48 months through 2012, the private sector added 194,000 per month for the 15 months through March 2014. Both measurements are a bit weaker when we look at total payroll jobs, including government workers. Although overall sales tax trends for state and local governments have been growing at a slower pace throughout the economic expansion compared with prior growth periods, they will likely accelerate somewhat through the second quarter. Retail spending took a hit during the cold winter months, but there are nascent signs of resurgence with the
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arrival of spring. Retail sales edged up 0.3% in February, with core retail sales, which exclude auto, gasoline, and building materials sales, also up by 0.3%. We like to keep an eye on this measure because it guides the real consumption component of GDP. We have dialed back slightly our forecast of housing starts in 2014, to 1.12 million from 1.14 million in December. While the change is modest, we track this closely because each start can translate to two to three jobs, not all in the construction sector. Additional supply would benefit a housing market that is already short on inventory. A relative dearth of supply has pushed up prices which, when coupled with higher interest rates, have begun to make first-time home buying a less-realistic proposition for many new entrants to the market. Inflation remains well-contained, if not too low for the Federal Reserve. And although the unemployment rate edged up to 6.7% in February, it was mostly because more people entered the labor force, signaling greater optimism among those without jobs. On the other hand, if we exclude those that have been unemployed for more than 27 weeks (considered long-term, reflecting some structural economic factors), then the unemployment rate is closer to what the Fed considers full employment at 4.3%. Given this, we expect the Fed to continue tapering its bond purchase program. In March, the central bank shaved another $10 billion off its buying, bringing monthly bond purchases down to $55 billion. Those purchases will likely end in October, and we don't expect the Fed to raise rates until sometime in second-quarter 2015 -- as long as the economy continues to strengthen.
Why Hasn't The Recovery Brought A Stronger Revenue Bounce For Local Governments?
Census Bureau data show that total general sales and gross receipts taxes tend to rebound following the end of recessions as pent up demand is released. For example, by 2003 and 2004, two and three years, respectively, after the 2001 recession had ended, sales taxes nationally began to bounce back, increasing 4.5% and 8.6%. But recovery from the Great Recession has been much more subdued. Collections increased just 3.6% each in 2011 and 2012, the second and third years after the end of this recession. Previously we have stated our view that consumers were focused on repairing their household balance sheets, which depressed retail spending. But now, with equity market and home prices having strengthened, sales taxes still haven't followed the historical pattern. Why not? In our view, it's partly explained by the nature of the housing recovery currently underway. Research by economists Atif Mian (Princeton University) and Amir Sufi (University of Chicago) highlights how the recent phase of home price appreciation differs from that of the mid-2000s. A higher portion of home purchases have been for cash suggesting that much of the buying has been by investors as opposed to owner-occupiers. Therefore, despite the recovering home prices, the greater-than-usual participation by investors has muted somewhat the economic multiplier that typically accompanies a housing recovery resulting in softer sales tax trends (see chart). However, this might be changing. Nevada has reported that traditional sales accounted for 70% of home purchases in February, up from 51% in the prior year. What we don't know is whether this is because owner-occupiers are entering the market or if investor-buyers are exiting. With still-slow wage growth and higher mortgage rates, the price increases might be bumping up against what home
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buyers can afford. We are more guarded in our view about some housing markets than others. According to the S&P/Case-Shiller Home Price 20-City Composite Index, after falling 34% from April 2006 through January 2012, home prices have since rebounded by 23%. The recovery in some markets, such as in the Las Vegas metropolitan area, which fell 66% from peak-to-trough, has been more pronounced, up 44% from the bottom. But if much of this appreciation reflects investor activity, it's not clear to us how much upside remains without it.
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recovery, we see some downside risk. For one, considering that valuations have hovered around record levels since December, we can't rule out the possibility of an equity market correction. In addition, we are aware that the Federal Reserve's accommodative monetary policy stance has been supportive of asset values throughout and subsequent to the Great Recession. To the extent that the Fed's withdrawal of monetary stimulus -- real or perceived -- triggers a sell-off in the equity markets, it could weaken states' revenue outlooks.
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The Regions
New England (Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont)
We expect credit conditions in New England to remain stable as economic growth, albeit still modest, should continue to strengthen through 2015. In our view, a stabilizing credit factor is New England's residential real estate market, which we forecast will remain relatively favorable. According to our forecast, housing starts in 2014 will stay positive, fueled by gains in both single-family and multifamily construction activity. Thus, communities should continue to benefit from higher building fees and other ancillary revenues relative to years past. In addition, recent data indicate that the region's median home prices will remain positive into 2015, which bodes well for a continued recovery in local assessed values. Because the primary revenue sources for local governments in New England are property taxes, a stable real estate environment is important in assessing a municipality's overall budgetary environment. Our base-case forecast shows that New England's economic growth will be 2.32% in 2014, down slightly from our December forecasts (2.38%). Rising home prices along with a strong stock market have restored confidence, which has translated to higher consumer spending and an uptick in construction activity compared with years past. We anticipate that federal spending will remain weak, although recent year-over-year cuts are beginning to moderate. Although the effects of sequestration and cuts to federal spending have hampered GDP growth in the past few quarters, the impact has varied from state to state. Looking ahead, while all states in the region are affected to some extent, we believe given the size of each state's respective economy, Connecticut, with its heavy reliance on defense manufacturing, and New Hampshire and Maine, home to the Portsmouth Naval Shipyard, are the most vulnerable. Massachusetts is the largest economy in New England, and we project that it will be the strongest, with GDP growth of 2.6% in 2014 and 3.0% in 2015. This is in contrast to Connecticut, the region's second-largest economy, which we forecast growth to be among the lowest in the country at 1.9% in 2014 and 2.4% in 2015. Maine continues to be the weakest state in the region, with forecast growth of 1.60%, a slight improvement from our December forecast. Leisure and hospitality, a traditional strength in Maine, has seen some growth, along with construction and professional and business services; however, we believe Maine's economy will continue to rely primarily on U.S. economic growth, as will regional growth to a certain extent, so it will continually lag behind its regional peers. New England continues to have the weakest employment growth prospects nationally, mainly due to demographic factors and lower labor force growth rates. Our data suggest that growth in total nonfarm employment will increase 1.19% in 2014 and 1.52% in 2015. Nominally, the largest gains in total nonfarm employment will be in Massachusetts. Employment gains will be heavily concentrated in the health care; professional, scientific, and technical services; and administrative support sectors, which are the state's most consistent drivers of economic growth. We expect the regional unemployment rate to decline only gradually, to 6.43% in 2014 from 7.0% in 2013.
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2.60% growth projected (as compared with 2.54% projected in December). Regional employment growth substantially lags behind the rest of the nation and may have suffered during the long winter, with growth projections weakening to a stagnant 0.98% in 2013, and we expect it will slow further to 0.90% in 2014 before picking up some speed in 2015 at 1.48%. The professional and business services sector showed the most consistent employment growth momentum in 2013 across the three states. While the leisure and hospitality sector showed growth in New York and Pennsylvania, it actually shrunk in New Jersey, which may be due to the Superstorm Sandy hangover and some of the struggles that the Atlantic City casinos have experienced. Unsurprisingly, employment continues to shrink in the government sector, with further contraction forecast in 2014 before slight growth (0.09%) in 2015. Housing starts continue to show momentum, with 20.4% growth in 2013 (though down from the 22.9% projected in December) and 14% projected for 2014 (also down--from 15%). New Jersey's housing market continues to experience the most softness, with high mortgage delinquency rates (second only to Florida, according to IHS Global Insight) and a large pipeline of foreclosure activity. Personal income grew slightly to 1.04% in 2013 from the December projection of 0.8% and we expect it will gain momentum in 2014 and 2015, at 2.18% and 3.42%, respectively. Retail sales growth projections have also slowed to 1.41% in 2014 --as compared with the 2.02% projected in December -- but we project improvement in 2015 at 2.19%. Regional 2014 agendas include significant road and bridge investment: Pennsylvania passed a long-awaited transportation bill in November providing up to $2.3 billion per year for roads, bridges, and mass transit with funding from the phase-out of the wholesale franchise tax cap, likely leading to increases in retail prices at the pump. The Port Authority of New York and New Jersey has plans to invest in improvements for three bridges providing connections to New Jersey: The Goethals Bridge, the Outerbridge Crossing, and the Bayonne Bridge. New York's $4 billion Tappan Zee bridge replacement is also underway.
South Atlantic (Delaware, District of Columbia, Florida, Georgia, Maryland, North Carolina, South Carolina, Virginia, West Virginia)
Based on ongoing consolidation and sequestration, federal employment continues to show weakness. We forecast a 2% reduction in federal jobs in the region in 2014 and a similar level in 2015. Meanwhile, nonfarm employment continues to show positive gains; we have revised our forecast for growth to 1.85% from 1.75% in 2014. This growth rate is higher than in New England, Mid-Atlantic, and East South Central; it is also close to the West South Central's growth rate, a region that has the highest nonfarm job growth. We have also revised the 2014 employment forecast in financial activities to 1.4% from December's 0.39%. The service sector growth is somewhat offsetting the government job loss. Across the region, we have seen job creation in manufacturing, financial, education, and professional services. Consistent with the national trend, we have revised South Atlantic region's GDP growth by almost 0.2% to 2.8% in 2014. While taxable values have not returned to pre-recession levels, the region's housing starts and home prices continue to rise. We project total private housing starts to rise 16% for 2014, with continuous improvement in 2015. Our forecast for existing median home prices remains similar to 2013's, at 8% for 2014 and slower growth in 2015. Meanwhile, there's been a slowdown in foreclosure activities across the region. However, foreclosure remains paramount in Florida, and rising mortgage rates could affect the pace of recovery. The overall housing improvements
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in the region have had a profound effect on consumer sentiment and spending expectations, as consumers appear to be more willing to spend and generally feel more optimistic about their finances. Forecast for retail sales remains positive at 2% growth for 2014, with projected improvements in 2015. Although the winter has kept consumers at home and deterred spending, many local governments have reported a slight increase in sales tax revenues when compared with the previous period two years ago. The incremental improvement in taxable values has also provided local governments some revenue-raising flexibility, and fueled their capital needs. As wages were stagnant during the Great Recession, during labor negotiations now governments are being pressured to raise them, given the improved economy. The net result from rising capital and personnel expenditures and tax revenues has been positive so far to the credit quality of local governments.
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is bleak, though improving. The state's lackluster employment opportunities are in part due to the shrinking government sector, which accounts for about 20% of Alabama's total payroll. Federal government spending and employment for the ESC region have continued to drop during the past several years and this is likely to continue. So, while the entire region will realize the impact of federal spending and employment declines, Alabama will feel the cuts most keenly. Despite lackluster public sector employment, the manufacturing sector in Alabama is expanding. Several manufacturers, both U.S. and international, have recently announced plans to open plants in Alabama. Mississippi's overall employment is stronger than second quarter last year, evidenced by employment growth in several of its key sectors, which we view as promising. However, the state is still lagging the nation in recovering from recessionary job losses. It has recovered about half of its pre-recessionary jobs. Much like Alabama, much of Mississippi's near-term job growth will be in the professional and business services sector's administrative and support functions. The relatively low level of completed postsecondary education make the state less able to compete for higher-paying professional jobs and expand in industries that tend to offer higher salaries. In aggregate, although there's been weakness in the region's employment trends, we don't believe it will be long-lasting. The region experienced a deeper recession than the country as a whole. We believe recovery for the ESC region will be slower than average, but we expect the region to recover. We anticipate that the lull in employment activity will end and that housing starts will increase. Furthermore, we also expect consumer spending to rise. Overall, we believe the region is positioned to bounce back; it just will take longer than most other regions.
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West North Central (Iowa, Kansas, Minnesota, Missouri, Nebraska, North Dakota, South Dakota)
The western Midwest's growth prospects are more positive than its eastern counterpart's and are moderate when compared with the other regions'. However, rapid growth in North Dakota's Bakken Shale area is inflating projections for the region as a whole. Although real regional GDP growth may be modest at 2.55% in 2014 and 3.11% in 2015 across the region, the region weathered the recession well, and therefore local governments are less dependent on significant growth to restore their balance sheets. The farming economy is likely to be relatively stable for the next two years. It boomed in 2011 and 2012 as crop prices soared during the drought but agriculture GSP dropped 29.02% in 2013 as crop prices fell. We expect agriculture GSP will grow a moderate 5.33% in 2014, followed by 4.14% in 2015. Passage of the Agricultural Act of 2014 has reduced uncertainty for farmers but eliminated direct federal payments. Slower net income and higher borrowing costs will likely limit agricultural equipment purchases, and we expect moderation in farmland values. Rising farmland market value has resulted in high single-to double-digit year-over-year assessment value growth across much of the western Midwest. While residential values have been declining or stable, rising farm values have offset these losses and have contributed to rising property tax revenues. As growth moderates, so will property tax revenues, but we expect that local governments in the region will have ample flexibility to balance their budgets. Supported by drilling across the Bakken Shale and a low cost of doing business, Fargo and Bismarck are among the fastest growing metropolitan statistical areas in the country. Soaring oil and gas tax revenues have contributed to North Dakota's recent and budgeted surpluses, and the state has also been sharing revenues with its local governments. The threshold of profitability for oil production in the Bakken Shale is high, and further expansion could diminish quickly, but we expect economic growth in the state to continue. Our forecast indicates 12.75% growth in the region's mining real GSP for 2014, rising to 13.14% in 2015. Balancing rising infrastructure and service costs while maintaining reasonable debt burdens will likely be among local governments' greatest challenges for the region as oil production continues.
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The energy sector continues to be a large contributor to the region's economic strength and rate of recovery. We project that the region's mining GSP will increase 1.6% for 2014 and 2% for 2015, which is down significantly from 15% annual growth in 2012. We feel that this slowdown is a reflection of the energy sector entering the mature phase of its business cycle. The region's unemployment rate remains well below the national level and our projections indicate that it will continue to decline to 5.1% in 2015 as many workers outside the labor force jump back into the labor pool as they see new jobs emerging. More specifically, we expect expansion in the professional and business services and construction sectors to contribute to employment growth through 2015. Texas, Louisiana, and Oklahoma have surpassed their pre-recession employment levels whereas Arkansas, the one state in the region that did not benefit from the high energy prices during 2011 and early 2012, has seen lackluster employment growth, well below the national average. The Arkansas labor force participation rate has declined but we project that the state will reach its pre-recession employment level by the end of 2014 due to anticipated growth in the professional and business services and education and health services sectors. Federal government employment projections for the region reflect a 2.6% decline for 2014 and a 0.8% decline for 2015; however, we forecast state and local government employment to continue to increase at a modest pace, with 0.7% growth in 2014 and 1% growth in 2015. Our projections for federal spending for the region reflect a nearly 1% decline in 2014 and a nearly 0.5% decline in federal spending in 2015. The 2015 U.S. Defense budget indicates that defense spending will be flat through fiscal 2015, which should provide some stability for defense contractors; however, we could see another pivotal decline in defense spending should the sequestration remain in effect in fiscal 2016. The federal defense budget will likely have an impact on local governments in Texas more than the other states in the West South Central region due to the significant presence of both military bases and defense contractors.
Mountain (Arizona, Colorado, Idaho, Montana, Nevada, New Mexico, Utah, Wyoming)
We expect Utah, Nevada, Arizona, and Colorado to be among the leading states in terms of payroll employment growth rates through 2018, setting the pace for regional job growth of 1.9% in 2014 and 2.9% in 2015. A robust population expansion, which will help fuel the cycle of growth, should accompany these gains. The region's aerospace, defense, and high-tech clusters will continue to attract a highly educated workforce and employers to the area, along with service sector jobs to support them. Meanwhile, its attractive climate and natural resources ensure that leisure and hospitality remain strong. We continue to forecast strong housing starts and home price appreciation in both the Mountain and Pacific regions. Median home prices in the Mountain states are forecast to grow 10.4% this year, with housing starts topping the list at 34% growth. However, it remains unclear how much future housing demand will be fueled, as it was in 2012 and 2013, by strong investor participation. If a slowdown in investor-led home purchases leaves a vacuum that consumer demand is unable to fill, it could put the brakes on the housing recovery (or at least ease up on the gas) until individual households are able to pick up the slack. In the Mountain region, that day may come sooner rather than later: With Colorado, Utah, Arizona, and Nevada forecast to lead the nation in both payroll and population growth over the next two years, there is a good chance that traditional homebuyers will be able to make up for softening investor demand. As the housing market continues to recover, we expect the Mountain states will see strong growth in retail sales this
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year and into 2015. In the longer run, however, the projected population expansion will increase the demand for local government services and place an additional burden on public infrastructure. State and local credit quality will depend on entities' ability to manage the tension between fiscal health on one hand and growth-related spending and debt pressure on the other.
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Table 2
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Table 2
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Table 2
*Forecasts are constructed using the Global Insight Model of regional U.S. economies. 1982 to 1984 equals 100. GDP--Gross domestic product. GSP--Gross state product. NAICS--North American Industry Classification System.
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