LOS ANGELES — Standard & Poor's analysts sounded a cautionary note about California's future financial situation as the state begins the budget process amid stock market volatility.
The state's reliance on capital gains as a major revenue source ties the state's fortunes to the highs and lows of the stock market.
"The stock market has been volatile lately, and history suggests that in a market correction, state revenues will follow stock prices lower," said Gabriel Petek, an S&P credit analyst, in a report released Monday that he co-authored with analyst David Hitchcock.
The future direction of California's credit quality is linked to its ability to maintain balanced fiscal operations, Petek said.
"Similar to the equity markets, the broader economic recovery, now in its seventh year, has already outlasted most expansions," Petek said. "Although Standard & Poor's forecasts another year of economic growth and modest stock market appreciation, we cannot rule out the possibility that financial markets and the economy have peaked."
California's success in achieving budgetary balance resulted from stock market gains in an improved economy, but also from the state's efforts to get spending under control.
But lawmakers are beginning budget negotiations with more open-ended discretion over general fund spending than they have had in years.
"This gives rise to the potential that the state could ramp up its recurring spending commitments just as its revenue trends reach a plateau—or worse, begin to falter, thereby putting the state's fiscal alignment in jeopardy," Petek said.
For the past several years, California has allocated the majority of revenue growth to education through a maintenance factor in order to close a funding gap in its state constitutional requirements for K-12 funding that peaked at $10.6 billion in 2012.
Lawmakers appropriated most of the funds for one-time purposes, insisting that they count toward the retirement of $10.4 billion in deferred school aid payments, Petek said.
Since 2011, they also limited most revenue gains to one-time outlays for debt repayment and to capitalize the state's budget reserves, according to the report.
Managing the state's multiple-year revenue rebound in this manner has contributed to improvements in California's bond ratings.
Standard & Poor's rates California general obligation bonds AA-minus.
The stronger revenue performance and much-improved budgetary position of recent years belie somewhat how fragile California's fiscal balance remains, Petek said.
"Even without a recession, the escalating schedule for pension contributions and rapidly growing unfunded liability for retiree health care already account for an increasing share of future budget capacity," Petek said.
The analysts said they determined based on developments described in the report that no rating actions are currently warranted.
Only a rating committee may determine a rating action and, as these developments were not viewed as material to the ratings, neither they nor the report were reviewed by a rating committee.
The developments were not considered material to a ratings change, because the analysts are highlighting a risk on the horizon that they have highlighted for several years, Petek said.
"There is nothing that has changed at this point," Petek said.
"Most of the revenues in April are tied to stock market performance from 2015," he said. "So, what is happening now is something to be aware of, but we don't know if the stock market will stay down, or recover, and not impact the state's revenues."
