The outlook for U.S. local governments remains negative, as the sector continues to struggle with revenue constraints and expenditure demands amid a slow and uneven economic recovery, Moody’s Investors Service said in a report released Thursday.

“Our sector outlook speaks to the challenging environment in which most U.S. local governments will likely operate over the next year,” said Rachael Cortez, a vice president and senior analyst, and the main author of the report. “Overall, the economic recovery remains sluggish despite some bright spots, and looming federal spending cuts may exacerbate weak growth rates.”

In addition to the sluggish economic backdrop, continued constraints in key revenue sources, particularly state aid and property tax revenues, are another outlook driver. Most local governments rely on state aid and property taxes to fund ongoing operations — both of which continue to be pressured. Local governments face stagnant or reduced state aid, and while tax receipts are slowly rebounding, other state spending priorities, such as Medicaid, are competing with resources available for governments.

Moody’s noted that Michigan school districts have been particularly strained by state aid reductions as funding from the American Recovery and Reinvestment Act of 2009 dried up and the state cut per-pupil funding. New York is another example where most cities have seen stagnant or declining levels of state aid for several years and are further constrained by a state-imposed limit on property tax increases.

A good sign for local government property tax revenues is the recent rise in housing prices. However, municipal property tax revenues will remain under pressure in the near term, particularly because property tax receipts typically lag tax base assessments by several years.

A third factor driving the outlook is the mounting spending pressure following years of deferrals and delays. Since salaries and benefits comprise the bulk of local government operating budgets, issuers have looked to personnel services budgets for cost-cutting opportunities when revenues dipped over the last few years.

Many local governments have laid off employees, frozen or reduced salaries, and consolidated departments, and now they’re finding it harder to identify new areas of cost containment.

“Local governments throughout the nation will find it more and more challenging to prevent costs from rising, let alone identify additional expenditure cuts,” the report said. “Still, most local government management teams continue to make the difficult budget decisions.”

The report said that a handful of local governments may experience extreme credit deterioration brought on by a confluence of persistently weak economic and financial attributes. The ones that are most vulnerable include those with limited ability to mitigate the impact of federal spending cuts, rising pension costs or outsized exposure to enterprise risks.

Despite these pressures, the sector’s overall credit quality continues to be supported by its fundamental and unique strengths, analysts wrote. These include minimal competitive pressure, relatively broad capacity to increase revenues, considerable leeway to reduce discretionary spending without adversely affecting revenues, oversight and assistance from some state governments, and limited rollover risk due to the widespread use of self-amortizing debt.

“For most rated local governments, these stabilizing forces effectively counterbalance the credit strains posed by the current environment, as they did during previous economic downturns and other periods of operating stress,” the report said.

More than 99% of the general obligation ratings of cities, counties and school districts in each of the four U.S. census regions are investment grade, and Moody’s expects a similar rating distribution in the foreseeable future.

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.