October 26, 2016
Conning Releases Q4 2016 State of the States Update
- Conning’s municipal credit report downgrades overall U.S. state credit quality from stable to declining
- U.S. State expenditures have grown, and aggregate state reserves have fallen
- Declines in oil prices, underfunded pensions, and lower capital gains tax revenues have entangled mores states in recent months
- Political gridlock is blocking legislatures from addressing structural deficits
HARTFORD, CT – October 26, 2016 – Leading global investment management firm Conning today released its semi-annual"State of the States municipal credit research report, which reveals growing concerns for state credit quality. State tax revenues have turned negative, while states’ expenditures are growing, leading to lower reserves. In several states political infighting is hampering legislatures’ ability to reform structural deficits, while high tax states have experienced diminished capital gains tax revenues. Persistently low oil prices continue to put pressure on state revenues in the oil patch states. Additionally, a low yield investment environment is compelling states to contribute more to underfunded public pensions, placing further strain on limited budgets.
“Key measures of overall state credit quality have worsened since Conning’s last report in April 2016,” said Paul Mansour, a Managing Director, Head of Municipal Research at Conning, and lead author of Conning’s State of the States report. “Tax revenues are slowing while state expenditures are picking up, resulting in a drop in aggregate state reserves. General Fund balances, an important measure of a state’s fiscal health, have also declined: a healthy figure is 10% of annual state General Fund expenditures. Yet, as of this report, combined state reserves were estimated to be equal to only 8.9% of state expenditures.”
Conning’s State of the States report uses key economic factors to rank states in order of credit health. Conning’s proprietary model found that Colorado, New Hampshire, Tennessee, and Utah were among highest in credit quality, while Michigan and New Hampshire have experienced the most improvement over the last six months. Common factors among top ranked states include strong economic growth, diversified economies, and modest legacy costs. States with lower rankings tended to face larger legacy costs and have slower-growing economies that have hindered credit improvement. The research also showed that all states are facing several common challenges:
Falling Revenues U.S. state revenues declined 2.5% in the second quarter of 2016. On a rolling six-month basis, they were off a more modest 0.7% over the same period last year as per data from the U.S. Census Bureau. Depressed oil prices, weak equity markets, and lower corporate profits are underlying drivers for the drop in state revenues. This marks the first time since the end of the Great Recession that state tax revenues have been this low for any six-month period. Lower capital gains taxes have affected states such as Connecticut and New York, while oil and gas prices and drilling activity remain depressed, impairing finances in oil-patch states like Alaska and Oklahoma.
Rising Expenditures U.S. state expenditures have increased for six consecutive years. Actual state General Fund spending increased an estimated 5.5% for FY 2016, according to figures released from the National Association of State Budget Officers (NASBO) — the highest rate since the Great Recession. Expenditure growth is primarily being driven by Medicaid, pension contributions, and personnel.
Uneven Job Growth Employment growth is a key credit indicator on its own, and it also drives state tax revenue, housing prices, and personal income. Over the past 12 months, the U.S. economy added almost 2 million new jobs. California, Texas, and Florida led the way, adding 354,000, 198,000, and 116,800 jobs respectively. In contrast, New York and Oklahoma lost 106,700 and 36,500 jobs, respectively.
Underfunded State Pensions Investment returns of state pension funds for FY 2016 were well below the assumed return levels of between 7% and 8%.
According to recent industry reports, public pension plans had a median return of 1.07% in fiscal year 2016, down from 3.43% in fiscal year 2015, both well below assumed returns that many plans employ. The two largest U.S. pension systems – CalPERS and CalSTRS (with $295bn and $189bn of assets) – had returns of 0.6% and 1.4%, respectively, in fiscal 2016. These lower returns will require an increase in pension contributions, especially affecting states with low funded ratios, including Illinois, Connecticut, Pennsylvania, Kentucky, and New Jersey. According to this State of the States report, over the past few years weak investment returns together with forecasts of continued low investment returns have increased pressure on states to reduce their discount rate assumptions. Lower investment returns have offset savings created by plan benefit changes enacted by many states, leaving the aggregate funded ratio stalled at around 75%. Lower discount rates translate into higher required contributions, amplifying strains on already stressed budgets. While a handful of states have large pension costs relative to their state budgets, the overall state pension contribution is a modest 4.3% of expenditures.
Political Gridlock The report finds that legislative failure to address structural deficits continues in states such as Pennsylvania, Kansas, Louisiana, and Illinois. Political inaction joins declines in oil and gas prices, underfunded pensions, and lower capital gains tax revenues as issues that have entangled more states in recent months.
About Conning’s Municipal Credit Research
Conning’s State of the States Report helps the firm’s investment professionals make better-informed credit decisions and improve relative value for client portfolios. State of the States indicators include measures of economic activity, such as income levels, housing prices, foreclosure rates, as well as a state’s overall business environment (i.e., ability to attract new business).
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Conning (www.conning.com) is a leading global investment management firm with approximately $120 billion in global assets under management as of September 30, 2016.* With a long history of serving the insurance industry, Conning supports institutional investors, including pension plans, with investment solutions and asset management offerings, award-winning risk modeling software, and industry research. Founded in 1912, Conning has offices in Boston, Cologne, Hartford, Hong Kong, London, New York, and Tokyo.
*As of September 30, 2016, represents the combined global assets under management for the affiliated firms under Conning Holdings Limited, and Cathay Securities Investment Trust Co., Ltd. ("SITE"). SITE reports internally into Conning Holdings Limited but is a separate legal entity under Cathay Financial Holdings, Ltd. which is the ultimate controlling parent of all Conning entities. Ctech:5081937