As the new decade begins, U.S. state credit is generally strong. Possibly nearing the end of the longest economic expansion in modern history, states are delicately balancing service delivery costs, building reserves, and mitigating future risks like climate change. This balancing act is occurring during a time of growing fixed-cost obligations and a pace of economic growth likely to remain below that seen in past expansionary periods.

The shallow nature of this economic expansion has led to narrow fiscal margins for many states, but for fiscal 2019 state revenues came in higher than in fiscal 2018 and fiscal 2020 revenue projections remain positive. State officials are adjusting expenditure needs within the slower growing revenue-generating environment leading to this stability. Even though states are adjusting to the lower-for-longer economy and generating favorable results, some credit challenges remain and others are emerging. Management continues to play a critical role in maintaining balanced operations and credit stability.

S&P Global's economic forecast for 2020 expects a continuation of this slow growing environment. Gross domestic product (GDP) is projected to have grown 2.3% in 2019, but our forecast is for GDP to slow to a 1.9% growth rate in 2020. Although still positive, this could feel like more of a slowdown, further challenging the states' ability to match revenues to expenditures. Our current U.S. recession risk over the next 12 months is 25%-30%, higher than when 2019 began.

Ratings Distribution

For U.S. states, 2019 contained little change in the rating distribution as there was only one rating action--Nevada upgraded to 'AA+' from 'AA'. This static activity, though, still keeps the U.S. states as S&P Global Ratings' highest rated portfolio of ratings with 41 of the 50 states rated 'AA' or higher. As we begin 2020, every state has a stable outlook, except Connecticut, which had its outlook revised to positive from stable in March 2019.

Chart 1

What We Are Watching For In 2020

Economic growth challenges from disruptors aplenty

Our economic forecast calls for continued growth in 2020, but the slower pace of growth may cause some states to feel like they are in a recession. The challenges of an economy growing at less than 2% will present itself on both the revenue and expenditure sides of the budget. States' revenues are sensitive to the volatility of financial market performance, with income, sales, and capital gains receipts all driving a positive result for most in fiscal 2019 and the first half of fiscal 2020. Counter to those revenue streams though are those states reliant on oil, coal, or gas markets for revenue. Those states may continue to have revenue difficulty. On the expenditure side, the low growth encourages maintenance of lower interest rates and will have impacts on pension and other post-employment benefit (OPEB) funding requirements as funds are less likely to grow at target rates of return.

But, growth is still growth, and as the longest expansion in U.S. history continues, we have seen states making the hard choices needed to balance budgets, fund infrastructure, reform retirement benefits and bolster rainy day reserves, although OPEB funding is still mostly set aside for a later action. According to the National Association of State Budget Officers' (NASBO) "Fiscal Survey of the States," all states have at least one rainy day fund established to support the general fund during a downturn, 39 states have reserve levels above where they were in 2007 before the Great Recession, and 32 states are expected to have grown these funds as fiscal 2019 audits are finalized. Setting these monies aside demonstrates of the hard choices made by state managers keeping an eye on future budget stress situations. We see this trend as a sector positive.

In this lower-for-longer economy, states have been doing what is needed to deliver balanced budgets, while keeping an eye out for the next downturn. We expect 2020 to be more of the same operational focus. Slow growth is more on the edge of no or negative growth and this market dynamic provides less flexibility should market disruptors present themselves. Potential economic disruptors can arise from many areas of the national and global economy. Those we are monitoring affecting state credit include:

• An aging workforce, receiving negotiated long-term benefits, and yet in this full-employment economy the challenges of finding and retaining qualified workers could slow service delivery;
• Environmental, social, and governance (ESG) credit attributes, which warrant greater market scrutiny;
• Policy changes from Washington, D.C., and the continued political stagnation expected through the November presidential election;
• The ongoing trade and tariff disputes and geopolitical uncertainty, which can have broad market impacts with varied regional and economic effects; and
• The rising cost of housing, which leads to less disposable income in general and, at the extreme, more homelessness.

Pension and OPEB costs as the workforce ages and the economy lulls

The lower-for-longer economic forecast coupled with the living-for-longer demographic trend has made some state pension plans credit-drivers. Compounding this, many state pension plans prudently continue to lower their assumed asset return assumption in order to reduce market risk, and accept that this leads to higher costs. Pension and OPEB challenges though are not uniform across the states. Whereas some states have very large current and future cost obligations, others are at or close to being fully funded with limited risk of escalation, so the effect on credit from this obligation can vary greatly.

On Oct. 7. 2019, S&P Global Ratings published a "guidance" document, "Assessing U.S. Public Finance Pension And Other Postemployment Obligations For GO Debt, Local Government GO Ratings, And State Ratings." This document lays out our views of risk associated with various pension metrics, including assumptions in the measurement of liability and methods used to fund that liability over time. In the guidance, we introduce a couple of new measures we will be citing in our reports:

• Static funding, or a funding approach that does not reduce the funded ratio, but also does not improve it; and
• Minimum funding progress (MFP) metric, which looks to what needs to be contributed to achieve full funding over a reasonable time.

Despite improvements to overall funding and funding discipline seen in 2019, most states still fail to meet our MFP metric, indicating that pension and OPEB pressures could remain in place for state credits for the near future. In "U.S. States Are Slow To Reform OPEBs As Decline In Liabilities Masks Increased Risk", published Dec. 3, 2019, on RatingsDirect, we indicated that although the liability may have lessened over the past year in terms of what is unfunded, the challenges of providing these retiree health care and other post-employment benefits remain elevated.

As we saw at the turn of the century, well-funded pension and OPEB plans elicit the moral hazard of granting additional and sometimes costly new benefits when plan funding levels are high. Additional benefits granted can support of attracting candidates to government positions, but are often irreversible as the market sours. States with prudent management have used market high points to reduce pension and OPEB risks, increasing funded levels and adding future costly obligations. Recognizing the long-term cost impact is critical to ensuring credit stability and structural balance.

Some states are considering creative ways to help improve the funded status of their pension or OPEB systems through various types of asset transfers. In transferring ownership of a state asset to the retirement fund, the plan's funded ratio can be improved. There are different types of asset transfers, some of which might include uncertainty or tenuous growth assumptions that may be viewed negatively with regard to credit consideration. We will consider the valuation and potential monetization of the asset, along with the likelihood of the pension plan's ability to access those funds as needed to pay benefits. In other words, the asset being transferred needs to be readily converted to cash at the value assumed, because, in our view, you cannot pay a pension with a park.

Pensions and OPEB are just a couple of the fixed costs affecting state budget decisions. Medicaid is typically the largest fixed cost, with debt service a growing pressure for some. We aggregated 2018 Medicaid and debt service data from the NASBO 2019 State Expenditure Report with our data on pension and OPEB spending in 2018 and generated chart 2. From this information, the average amount of the total state spending taken up by these fixed costs was 34.6%, with Illinois at 47.8% and Wyoming at 18%.

Chart 2

Federal policy, the census, and infrastructure questions remain

Policy decisions in Washington, D.C., can have immediate credit implications for state ratings. One of the reasons we see 2020 as a stable credit environment for states is that we do not expect any meaningful policy changes coming from the nation's capital. With a stagnant Congress, what you see is what you get, and states can budget with some certainty. However, the presidential election in November could introduce some uncertainty, regardless of party victor. Once legislation again begins to move in Washington, we believe that further changes to the tax code, Medicaid program, trade policies, and infrastructure spending could be on the docket. Many of the presidential candidates are discussing significant changes to tax policy and service levels, and should those programs ever be enacted, how they are funded could have impact on the monies that flow from the federal government to states.

Historically a bipartisan issue, the federal funding of infrastructure projects of national importance could be another public policy topic decided in the coming months (before or after the election) that could affect state credit. We monitor which projects get approved and how federal monies are dispersed, but no federal program is factored into our stable outlook for the sector. State issuers have two opportunities in 2020 in terms of infrastructure funding. First, the lower-for-longer economy is projected to keep borrowing costs low, as the Federal Reserve aims to keep inflation around 2%. The second near-term opportunity is an increase in types of debt and types of investors currently in the market. Banks are continuing to offer attractive rates for direct bank loans and the market is attracting more foreign buyers allowing for a growth in taxable municipal bond issuance, and we expect both these trends to continue in 2020.

As a potential disruptor for state credit quality, we are watching the 2020 national census. Many funding programs, including Medicaid, student loans, and nutrition programs, have funding calculations with Census Bureau data as part of the formula. According to the Tax Policy Center, the census could affect nearly $1 trillion in "grants, direct payments, loans and loan guarantees that the federal government distributes to states and individuals." Any significant change in current disbursement patterns could have an impact on state programs and overall budget balances.

Will Medicaid continue to expand and be funded

The greatest influence on state credit from Washington is funding to the states for Medicaid. Medicaid provides health care to more than 75 million low-income individuals, and the states and the federal government share those costs. According to the NASBO "2019 Expenditure Report," Medicaid spending as a percent of total state general fund expenditures has stabilized at about 20%, but the federal share continues to grow. The same report says: "Medicaid benefits accounted for 58.2 percent of federal fund spending by states in fiscal 2019, compared to 43 percent in fiscal 2008." With this sustained growth in funds flowing from the federal government dedicated for Medicaid, other uses are getting squeezed, keeping Medicaid a credit focus.

Through Nov. 15, 2019, 36 states had adopted Medicaid expansion, as outlined in the Affordable Care Act (ACA), to increase program eligibility and provide health care to millions. After Jan. 1, 2020, the states that expanded under the ACA are responsible for 10 percent of the costs of the newly eligible individuals. The 10 percent is set from here on out after gradual increases from the ACA introduction in 2014. Additionally, the Kaiser Family Foundation reports that more states are expanding benefits than restricting them, adding such benefits as mental health, substance abuse and dental among others. With these continued expansions, S&P Global Ratings expects Medicaid to continue to consume a growing share of state expenditures.

Now that the U.S. 5th Circuit Court of Appeals has ruled in the Texas vs. Azar lawsuit that the individual mandate within the ACA, as it stands without a tax penalty, is unconstitutional, we are monitoring the subsequent actions as potential significant disruptors to state credit stability. Saying that the ACA represents a mandate to buy insurance, and that Congress does not have the power to adopt a freestanding mandate, the 5th Circuit has sent the case back to the lower court to decide if the remaining portions of the ACA can stand without the mandate. There is no court-defined timetable for a lower court decision or when, or if, this case may be heard by the U.S. Supreme Court. With this ruling and the return to the lower court, the long-term viability of the ACA is in question. The outcome of these coming court decisions could present substantial policy and funding challenges for the 36 states with Medicaid expansion, but also for health care in general, regardless of location.

Environmental, Social, And Governance Factors Coming More To The Forefront

ESG attributes are regular discussion topics as S&P Global Ratings public finance analysts talk with investors. On March 28, 2019, we published "When U.S. Public Finance Ratings Change, ESG Factors Are Often The Reason" and highlighted that 100% of the ESG-related state rating actions taken in the prior two years were driven by governance factors. Although ESG factors are not new to state management teams, the market focus is leading us to expand our credit discussions. We expect ESG discussions around climate change, income inequality, and cybersecurity to remain hot topics into 2020.

Environmental: climate change

Like many of the existing and potential credit risks, climate change is a risk that hits each state to varying degrees, but none are immune. The credit impacts are broadly two-fold. First the immediate impact of climate-related events and second, the public policy actions to mitigate the risk. Storms of greater frequency or ferocity, increased fire risk, and more severe droughts can disrupt economic activity, a key contributor to credit stability. Such events will take investment away from expansionary activity and divert it to replacement. Although this could be positive for sales taxes and property valuations, the long-term multiplier effect of economic investment is muted. Additionally, we have seen climate events change public policy. Whereas there is need to address infrastructure or housing deficiencies, storm hardening projects could divert funds from these more traditional state obligations.

Social: income inequality

S&P Global Ratings believes that social factors were a key contributor to the long-term financial decline and overall lower ratings on both Puerto Rico and Detroit where, among other issues, population trends and low incomes could no longer support the combination of operational and debt needs. These demographic changes exacerbated operational pressures by not only limiting revenue-raising capacity, but also by boosting demand for social services. Many states are looking to curtail this gap, through infrastructure spending focused on rural areas, with the belief the better transportation and internet connectivity in these areas will help raise standards of living. But, as mentioned above, infrastructure spending is facing resource and funding challenges beyond income inequality. As states are citing income inequality as a growing risk, we are monitoring how they are dealing with these economic and demographic shifts, with a credit focus on ways to avoid another severe credit deterioration fueled by a constituency's inability to pay and a change in needed governmental services. At its core the risk is that income inequality could lead to structural imbalances.

Governance: cybersecurity risks

States are increasingly focusing on cybersecurity at all levels of management. Calendar 2019 has been an active year for many types of cyberattacks, and the threat could get worse before it gets better. S&P Global Ratings analysts are incorporating how states are preventing attacks, training to respond, and planning for recovery, into our credit reports and are seeing varying levels of sophistication in responses to questions. At the local government level, the costs are significant in terms of budget or reserve levels and in some instances are beginning to affect credit quality. But, to date, most entities being attacked have had sufficient liquidity to cover the short-term losses. The long-term effects could be much worse. Everything in public finance relies on trust and constant attacks or repeated loss of public funds erodes that trust. This longer-term risk of continued erosion of public trust is significant, and could be ultimately more damaging than short-term liquidity hits. If voter trust erodes, driven by some sort of death-by-a-thousand-hacks, it could be more difficult to get taxpayers to provide needed revenues

Challenges to the economy of an aging workforce and full employment

It has been 50 years since the unemployment rate was as low as it is now--3.5% in November, according to the Bureau of Labor Statics. In that there have been more than 20 consecutive months with the rate below 4%, many consider the economy as operating at full employment. Full employment is generally positive for revenue collections and lower social service obligations; however, the average age of government workers could soon present a disruptive challenge. According to the most recent federal workforce data from the federal Office of Personnel Management (not updated in over a year), the federal government has nearly two times the number of over-60-year-old employees as those under 30. As that population retires in the next decade from these federal jobs, the dearth of candidates could lead to salary cost pressures. The federal government is not alone, as state and local governments are facing similar demographic challenges.

The cost of housing and the impact of homelessness

The growing unaffordability of housing in many parts of the country is a n additional potential disruptor to economic stability. Low unemployment coupled with a "back-to-the city" movement is driving some people out of once-accessible housing and into homelessness. As housing costs eat more of income, there is less spending that could generate sales tax receipts or other revenue streams for states. At S&P Global Ratings, we are monitoring the cost of housing and the effects on economic growth nationally, but have written on very visible trends in the West. Our latest, "Home Is Where The Funding Is: West Coast Housing Issuers And The Recent Capital Flow," published Oct. 10, 2019, highlights the unprecedented commitments of capital to address the housing affordability issue. We noted that, particularly in California, Oregon, and Washington, the cost of housing is increasing faster than incomes. Billions of dollars of housing investment are flowing into these states, but the issue is familiar in locations across the country, and how states address this issue could become a growing credit influence.

Who wins or loses with trade and tariff uncertainty

The continued uncertainty of trade talks across both oceans--U.S. and China, and U.S. and Europe--is driving market volatility. With rumors of the likelihood of a trade deal, markets have tended to jump, but then with eroding hope of a resolution they fall. Therefore, this market angst casts a pall over sustained growth, but the existing tariffs are already having some localized effects. We publish quarterly regional credit conditions reports. Our most recent, "In The Mist of Mixed Economic Signals, U.S. State and Local Credit Quality Remains Strong," Oct. 29, 2019, discusses how regional GDP growth rates are all expected to slow in 2020 (see chart 3).

Chart 3