Conning lowered its outlook Tuesday on municipal credit for U.S. states to stable from improving as state revenue growth began to show signs of strain amid rising expenditures.
In its "State of the States" credit report for the first quarter, the investment firm said states have started to ramp up spending after years of restrained expenditures in the wake of the Great Recession even as growth in revenue is slowing down.
Conning found that most states continue to show economic improvement because individual and state tax revenue is rising while expenditures and legacy costs are falling.
However, the report found at least nine states, most of them energy, oil and mining states, showed a sharp drop in individual and state tax revenue. The report said that less production will mean fewer jobs, less individual income and less state tax revenue in the states where these industries contribute almost 75% of overall revenue.
"Since our last report [in the fourth quarter of 2015], many of the lower-rated states have shown no improvement in credit quality despite the steady (albeit slow) recovery," Paul Mansour, Head of Municipal Credit Research at Conning, said in the release. "These states are seeing sluggish job gains, resulting in little to no tax revenue growth with slim cash reserves."
Overall, the report said that U.S. states' tax revenue growth had been relatively consistent since the end of the recession, but had softened in the past year.
"Income tax collection growth is expected to slow in FY 2016 to 3.3%, according to the National Association of State Budget Officers' Fall 2015 Fiscal Survey of the States. This is due to expected lower capital gains tax revenue for 2016 as a result of negative equity returns in 2015. Total state tax revenue grew by 3.8% in the third quarter of 2015 relative to a year ago. Twelve states reported declines in overall tax collections in the third quarter of 2015, according to the Nelson A. Rockefeller Institute of Government," the report said.
While revenue growth is slowly declining, spending is beginning to rise.
"[According to NASBO], actual state General Fund spending increased an estimated 5.9% for FY 2015. General Fund expenditures do not include federal monies that are designated for a specific purpose over which the state does not have discretion, such as Medicaid. Total state expenditures including federal grant revenue for Medicaid grew by an estimated 7.8% in FY 2015, which is the highest rate of growth since 1992. Growth in total expenditures is concerning as starting in 2017 the federal government will no longer be paying 100% of the cost of new Medicaid enrollees associated with the Affordable Care Act. The percentage paid by the federal government will be tapering down from 100% in 2016 to 90% in 2020," the report said.
The report also looked monetary reserves that states have on hand should unexpected developments occur.
"General Fund balances are an important measure of a state's fiscal health. They include a state's ending General Fund balance and its budget reserve or 'rainy day' balance, if it has one. Budget reserves provide revenue flexibility that states rely on during recessions. A healthy figure is 10% of annual state General Fund expenditures. For FY 2015, the aggregate state percentage was 9.6%. At the depth of the recession, aggregate reserves were just 4% of expenditures. The current results are skewed, with a handful of states such as Texas and Alaska having huge balances, while several states, including Pennsylvania, Illinois, and New Jersey, have virtually no fund balances. These states are at greater risk for credit stress if they are unable to rebuild their fund balances prior to the onset of the next recession."
Mansour said political divisiveness is hurting the prospects for sound state finances going forward.
"While measures such as tax increases, compensation reduction and other expenditure decreases could help to balance budgets, political disagreements are precluding necessary remedial steps. Investor caution for these credits is warranted," he warned.
The report also pointed out that fiscal health varies sharply among states.
The report's top five rated states, Utah, Idaho, North Carolina, Oregon and Florida, have some factors in common such as diverse economies, good business conditions, strong employment and home price growth, according to Mansour. This environment encourages net migration, which generates higher tax revenues and can reduce legacy costs.
The five lowest ranking states, New Mexico, West Virginia, Illinois, Connecticut and Kentucky, have been negatively impacted by problems such as ongoing legacy costs, the inability to reduce compensation-related state expenditures, and lower credit ratings.
On the bright side, the report said that U.S. economic growth continues to provide a solid foundation for state credit quality.
"By Conning's measurement, and despite an expected slowdown in state revenue growth, the credit outlook remains sound for most states," Mansour said, adding that "any uptick in the economy could produce a more upbeat assessment later in 2016."
The report takes various economic indicators to produce an overall state ranking, which can then be used to make investment decisions. Indicators include measures of economic activity as well as a state's overall business environment. Economic indicators account for 48% of the quantitative measures used to determine a state's rank, a state's economic competitiveness accounts for 12% and state specific general obligation credit indicators account for 40% of the score.
Conning is a global investment management firm with about $103 billion in assets under management as of March 31. It has offices in Hartford, New York, Boston, London, Cologne, Hong Kong and Tokyo.
