October 25, 2017
Conning Releases Q4 2017 State of the States Report
- Tax Revenue Growth - But Not Enough To Cover Expenditure Pressures
- Personal Income And Employment Growth - Concentrated In The West
- Political Uncertainty On Tax Reform
- No Improvement In State Pension Funding
HARTFORD, CT – October 24, 2017 – Leading global investment management firm Conning today released the Q4 edition of the company’s semi-annual State of the States municipal credit research report. This update for the second half of the year retains Conning’s declining outlook on aggregate state credit quality. State revenue growth has improved, but not enough to meet state expenditure growth, placing aggregate state reserves under immense pressure. However, Conning has improving outlooks on many revenue bond sectors as these credits benefit from more people driving, flying, attending college and spending money.
Many states – including Illinois, Maine, New Jersey, New York, Rhode Island, Pennsylvania, Wisconsin and Connecticut – were unable to pass budgets on time because legislators were reluctant to raise taxes, a necessity in states where revenues this year were less than expected. While both Connecticut and Pennsylvania have yet to agree on a budget, Illinois was able pass a budget shortly after its deadline, a pre-requisite to improving the state’s poor credit quality.
The U.S. economic recovery remains bifurcated: the Pacific Northwest, Mountain and Southeastern regions are experiencing GDP growth around 5% while many Northeastern and Midwestern states show very slow growth (if any). Though credit quality has an overall declining outlook, many states in the Pacific Northwest and Southeast have also experienced strong growth in employment, personal income and home prices. Additionally, some oil and gas states have seen economic improvement due to the steady, albeit slow, rise in natural gas prices during the last quarter.
“The most common thread for all higher-ranking states is a favorable business climate as measured by regulations, state tax policies and state leadership,” said Paul Mansour, a Managing Director, Head of Municipal Research at Conning and lead author of Conning’s State of the States report. “We expect that the above-average economic activity in these states will prompt credit upgrades and better price performance going forward.” Adds Mansour, “As long-term investors, Conning is looking to add state and local credit exposure in faster-growing regions and states, while being more selective in slower-growing and lower-ranked states.”
Conning’s semi-annual State of the States report ranks each of the 50 states by credit quality. Taking key economic factors into account, Conning found that Utah, Idaho, Florida, Nevada, and Colorado had the highest credit quality while Illinois, New Mexico, Mississippi, Connecticut and West Virginia were ranked lowest.
Conning’s research concluded that many states continue to face challenges in reversing the declining outlook on their credit quality, including:
Pension Contributions Remain a Major Problem
Conning sees no improvement in state pension plan funding since the Q2 2017 State of the States report. On average, the funding ratio for state pension plans has declined to 71.1% in 2016 from 74.5% in 2015. States unable to agree on raising taxes cannot fully fund their pensions as planned. New Jersey has neglected to fund its entire annual contribution all together in hopes that investment returns in the next fiscal year will make up for the missed payment.
Federal Policy Changes Create Uncertainty
Looming tax changes on the federal level threaten states already in poor fiscal shape, specifically those with high personal-income tax rates. Proposed tax reform limiting itemized deductions could result in little to no tax relief. Potential changes in state Medicaid reimbursement formulas – moving to block grants – equates to a risk transfer from the federal government to states.
General Fund Balances Expected to Decline
Overall state expenditures are growing faster than revenues and, along with legislative fatigue on raising taxes, has caused General Fund reserve balances to decline. General Fund reserve balances (General Fund balances + “rainy day” fund balances) are a key measure of a state’s fiscal health and credit quality. While a healthy state reserve balance should be 10% of its General Fund expenditures, the average aggregate state General Fund reserve is 8.5%, with many states less than 3%. The failure of states to build reserves during this period of extended economic growth is worrisome: many states appear ill-equipped to deal with a recession.
Economic Debt Adds Up, Crowds Out Other State Expenditures
While there has been no notable growth in stated debt during the last four years, economic debt keeps adding up. Economic debt measures each state’s total fixed-cost obligations – not just its direct or stated debt issued – and is an important determinant of state credit quality. Annual expenses to service fixed costs of obligations in states with high levels of economic debt can account for 20% or more of General Fund expenditures.
“Although pension reforms help, the best way states can reduce their high economic debt is to drive tax revenue with growth,” said Mansour. California has built its reserves and reduced outstanding debt through strong economic growth, especially in the technology sector. The incentives states and cities are offering to attract Amazon’s second headquarters reflects the positive economic impact a core of technology companies can have on a state’s credit quality.
Puerto Rico* – Hurricane Maria Complicates Debt Adjustment
Federal legislation passed in 2016 created a framework for Puerto Rico to pay its large municipal bond debt over many years, and the current plan only calls for 24% of scheduled principal and interest to be paid. Hurricane Maria likely reduced the amount Puerto Rico can pay during the next 10 years. However, as the island now needs market access to finance its recovery efforts, the debt-adjustment process may be accelerated and there may be a greater likelihood of some form of federal assistance.
*Puerto Rico is not included in Conning’s State of the States ranking.
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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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