States Will Be Tested In Unprecedented Ways

States have a long history of managing through volatile economic periods, but this does not guarantee rating stability. We have observed many improvements to budget structures, reserve policies and debt management over time that, in our view, significantly improve the state sector's ability to manage through cycles. Even with extreme COVID-19 related stress, many state ratings will likely remain stable. However, S&P Global Ratings changed all U.S. public finance sector outlooks (macro, forward-looking view on where we see credit trends in the year ahead), including for states, to negative on April 1, 2020, reflecting our expectation of a swift and sharp decline in the economy and uncertainty regarding the timing of recovery (see "All U.S. Public Finance Sector Outlooks Are Now Negative," published April 1, 2020, on RatingsDirect). This update did not change individual state rating outlooks, but since March we have placed seven states on negative outlook, and currently no states have positive outlooks. We have also downgraded Alaska and Wyoming one notch. Further credit deterioration, including downgrades, is still likely.

Chart 1

Chart 2

We expect the unique nature of the current economic and political environment will continue to test states in unprecedented ways. The sudden-stop recession and magnitude of revenue declines will test liquidity. States that previously did not exhibit a high degree of cyclicality may experience this downturn more severely. Uncertainty around the duration of the pandemic, social distancing policies, and enduring shifts in behavior will elevate the importance of revenue forecast updates and agility to adjust budgets. Lack of consensus around the size, timing, and need for additional federal aid also complicates state budgets. Changing attitudes regarding the role of state governments could influence tax or austerity decisions. Also, budget tools that were on the table in past recessions, such as cuts to education, corrections, or Medicaid providers, may be less palatable during a pandemic. With these nuances in mind, further credit deterioration within the states portfolio is likely.

All states have now reopened their economies, but we are seeing wide differences in their economic and revenue recovery. This uneven pace is likely to continue, driven by the health and safety of residents and the comfort people feel in returning to pre-COVID-19 practices. Recent state forecast revisions have provided a window into the magnitude of projected revenue shortfalls. Compared with pre-COVID-19 projections, states have revised fiscal 2020 projections downward ranging 3%-18%, and over half have lowered fiscal year 2021 estimates anywhere from 5% to 30%. Following the Great Recession, which ended in June 2009, states experienced an aggregate peak revenue shortfall of $230 billion in 2010. The unique sudden-stop nature of this recession, and prolonged health and safety risks, are likely to result in overall state budget gaps that will significantly exceed this threshold in fiscal 2021.

State Budget Decisions Hinge On Summer Federal Legislative Session

We expect to see cuts to state programs and local aid to help states balance their budgets. How much or to what extent will likely be greatly influenced by what form and amount of additional federal aid may come out of Washington. Despite a record amount of federal stimulus year to date, there has been no action on additional federal government that could offset state revenue shortfalls. Aid so far has been to reimburse states for direct COVID-19 expenditures (see "What the CARES Act Means for Credit in U.S. Public Finance," April 20, 2020). We still believe that another stimulus bill is likely, but cannot rule out premature austerity similar to what occurred in the Great Recession, when the federal government stopped aid after the American Recovery and Reinvestment Act of 2009, leaving states to make hard decisions to close budget gaps.

Medicaid enrollment trends are countercyclical, and the significant job and income losses associated with the weakening economy have caused a larger pool of individuals to be eligible for the program. Due to public health emergency restrictions which halted non-urgent services, Medicaid utilization has decreased to date, but increased enrollment will likely lead to higher costs. During recessions, the federal government has a history of increasing the Federal Medicaid Assistance Percentage (FMAP) rate to provide fiscal relief to states. The CARES Act authorized a 6.2% increase in Medicaid matching funds through Dec. 31, 2020, to help stabilize state budgets. However, if enrollment remains elevated after increased matching funds expire, states could face additional cost pressures. Medicaid is the second largest state general fund expenditure, and elevated costs could constrain options to regain budgetary stability.

To address elevated unemployment costs, states will use unemployment insurance claims funds and then have the ability to raise corporate taxes to replenish the depleted funds. But this takes time and in the interim, states can borrow from the federal government to keep the unemployment checks flowing. Some states are lobbying to have this federal borrowing to pay for the unemployment claims forgiven, but this debt forgiveness has not been done in the past.

Market Volatility And Event Risk Could Elevate Credit Pressure

Weak stock market returns through June 30, 2020, and potential market volatility heading into fiscal 2021 may exacerbate fixed cost pressures. Stronger second quarter results pushed pension fund results into positive territory, but we expect most plans will fall short of assumed rates of return. Subsequent increases in actuarially recommended contributions will likely be modest over the next fiscal year but still add to budget pressures. The bigger credit risk may arise if legislatures cut pension contributions to close budget gaps, as many states did during the Great Recession.

As we cited in our sector view in January, natural disaster and cybersecurity event risks can drain liquidity and divert management from other priorities. As the Atlantic hurricane season is off to the fastest start ever in terms of named storms to date, the season could be active through the fall. Responding to a hurricane during a pandemic could present its own unique challenges and extra costs, further straining budgets. Large wildfires are already burning in Arizona, and the western U.S. wildfire season typically runs through early summer. Hacktivists have been active during the social protests in many states, with state and city servers being locked with denial of service attacks, and working from home exposes many to home router deficiencies that are not as secure as commercial grade servers. All these event risks are likely to continue at elevated levels throughout 2020.

We view the national social protests as a potential credit issue. The New York Times says that with an estimated 15 to 26 million people already participating in various Black Lives Matter protests over the past two months, this is one of the largest civil rights actions in the history of the country. These events, and others supporting income and housing equality, are likely to continue. Current protests could drive state policy changes, and if protracted affect economic and financial recovery.

Economic Concentration And Revenue Volatility Will Be Key Credit Drivers

While we expect all states will suffer from a revenue downturn, the magnitude of credit stress will vary. States with concentrations in tourism, manufacturing, and energy sectors will face the slowest economic recoveries; however, their ability to weather a prolonged downturn will also depend on fiscal structures. We have assessed all 50 states' likely vulnerability to credit stress brought on by the COVID-19 recession based on economic projections and propensity for revenue volatility combined with financial flexibility to address shortfalls.

We recognize, however, that it remains particularly difficult to project economic recovery in this unparalleled recession. Likewise, historical revenue volatility does not necessarily indicate shortfalls in this downturn. Credit direction will depend on the ability and willingness of a state to make fiscal adjustments. Therefore, while our survey assesses the likely magnitude of state stress, it does not necessarily correspond with the likelihood of rating or outlook changes.

Summary Of Stress Susceptibility Results

To approximate bands of state fiscal susceptibility to credit stress in the COVID-19 recession, we averaged our assessments of IHS Markit employment, personal income, and gross state product (GSP) 2020 forecasts with a weighted average of budgetary structure factors. In order to assess budgetary stress in a recession, we took into account state propensity for revenue volatility, rainy day reserves, and fixed costs. As a proxy for management response to the downturn, we considered revenue adjustment history and service level evaluations based on our U.S. State Ratings Methodology.

We see broad-based risk across the sector due to weak economic conditions. Based on our survey, we expect that the COVID-19 recession will likely cause half of states to experience high susceptibility to credit stress, with the other half experiencing moderate susceptibility. A state's economic outlook largely drives whether our survey indicates a high degree of stress, followed by whether the state has taken measures to insulate its budget in a downturn. Our results capture states that may have strong rainy day reserves but also experience high revenue volatility, such as Alaska or California. In other cases, the states may have low revenue volatility, such as Kentucky, but high fixed costs and weaker rainy day reserves.

Our survey provides an assessment of a state's resilience to the current recession, but our budgetary assessment largely relies on historical data and assessments. As S&P Global Ratings continues to monitor the state portfolio, we will take rating actions, as necessary, to incorporate not only our forward-looking view of states' economies, but also how state management teams make adjustments in response to budget gaps.

Chart 3

Concentrated Economies Face A More Severe, Prolonged Downturn

S&P Global Economics expects that U.S. economic recovery will continue to face headwinds despite gradual reopening as lingering fears of another wave of COVID-19 will likely keep Americans maintaining some form of social distancing. Our June baseline forecast indicates that U.S. GDP will likely contract 5.0% in 2020. We expect that the current recession has likely already reduced economic activity by 11.0%, which is nearly three times the decline seen during the Great Recession in one-third the time. And, this updated forecast sees a slower recovery, lopping off a full point in the growth expected in calendar 2021 to just 5.2% from 6.2% (see "The U.S. Faces A Longer And Slower Climb From The Bottom," published June 25, 2020).

From the onset of the recession, stark differences across states were apparent. Variations in social distancing requirements and outsized concentrations in hospitality or energy industries led to different experiences of economic stress and deviations from past recessions (see "Tourism-Dependent U.S. States Could Face Credit Pressure From COVID-19's Outsized Effects On The Industry," April 27, 2020, and "U.S. Oil-Producing States Dealt Double Blow From Price Collapse And COVID-19," June 8, 2020). While the unemployment rate was elevated across all states, as of the most recent state-level data available (May), it was highest in states with concentrations in manufacturing or hospitality industries.

Chart 4

Although the May U.S. jobs report revealed a rebound as businesses started to reopen, 19.6 million jobs remain lost, twice the jobs lost during the financial crisis of 2007-2009. S&P Global Economics continues to expect larger increases in employment in June, but we still forecast unemployment will remain elevated at8.9% in the fourth quarter (see "U.S. Biweekly Economic Roundup: Employment Surprises, Rising Sooner Than Expected," June 5, 2020).

Notably, states that experienced the sharpest rise in unemployment following COVID-19 lockdowns are not necessarily those facing the slowest path to recovery. States with more-concentrated economies, rather than those with the strictest social distancing measures, are more likely to experience the slowest economic growth.

Chart 5

Rainy Day Reserves May Not Be Adequate To Offset Revenue Volatility And Fixed Costs

U.S. states weathered the last recession well from a credit perspective--none fell below the 'A' category. However, going into this recession, the state ratings distribution is somewhat lower and extends down further. This largely stems from a confluence of rising costs and stagnant revenue growth following the last recession. In our opinion, state propensity for revenue volatility, weaker rainy day reserves, and elevated fixed costs are leading factors that indicate state budgetary stress in a downturn. Although many states rebuilt rainy day reserves and adjusted revenue structures over the past decade in anticipation of a future downturn, greater fixed costs, whether from a legal or practical standpoint, may mean less flexibility to respond to this recession (see "When the Credit Cycle Turns, U.S. States May Be Tested in Unprecedented Ways," Sept. 17, 2018).

Prior to the current recession, most states prioritized building up reserves for a potential downturn. Based on National Association of State Budget Officers (NASBO) data, average state reserves grew by 170% to about 13% of budgeted expenditures between 2009 and 2019. We expect that these reserves will be critical to immediate and long-term response by states to revenue swings in the budget until recovery takes hold.

Liquidity comes to the forefront in a recession, and rainy day reserves are just one measure. Most states have liquidity available within internal funds to address near-term declines in revenues. For those requiring external liquidity, such as lines of credit, we have seen evidence of strong market access. Even at the lower end of the ratings distribution, Illinois was able to take advantage of the Federal Reserve's Municipal Liquidity Facility (MLF) in June (see "States Demonstrate Resilience As Cash Falls Short," June 30, 2020).

There is no one-size-fits-all assessment of state rainy day reserves; adequacy depends in large part on individual state revenue cyclicality. States with greater revenue volatility require greater reserve balances or other counteracting measures to respond to revenue shortfalls. We have utilized the Pew Charitable Trusts state revenue volatility assessment as a starting point, which incorporates tax revenue volatility over fiscal years 1998-2017, then adjusted for states forecasting outsized volatility stemming from declines in tourism unique to this recession.

Chart 6

In addition to tapping rainy day funds, states may employ a mix of tax increases and expenditure cuts to address budget gaps. While general fund tax increases were significant ($39.7 billion) during the Great Recession, the majority of adjustments were on the spending side ($64 billion), according to a 2013 analysis prepared by NASBO. Thus far, in response to COVID-19, we have seen states express a greater willingness to cut services levels in combination with drawing on reserves rather than raising revenues.

Fixed costs, including pensions and Medicaid, take up a more significant share of state budgets, leaving less room for discretionary budget cuts. As stated in our January 2020 state sector outlook publication, in fiscal 2018, five states had fixed costs of about 40% of expenditures.

States have already faced unprecedented challenges in 2020, and more are likely to come. Although many states entered into this recession in a strong fiscal position, the severity of the sudden-stop economic impacts will last for years. Where we see the state budget actions as maintaining or driving toward near-term structural balance, we expect limited rating movement. Nevertheless, these challenges can be long-lasting and so where budget actions are short-term or interim in nature, credit stability will be pressured and ratings would change.

Related Research

• States Demonstrate Resilience As Cash Falls Short, June 30, 2020
• The U.S. Faces A Longer And Slower Climb From The Bottom, June 25, 2020
• U.S. Oil-Producing States Dealt Double Blow From Price Collapse And COVID-19, June 8, 2020
• COVID-19 Induced Recession Throws Curveball To U.S. State Budgets, May 21, 2020
• Tourism-Dependent U.S. States Could Face Credit Pressure From COVID-19's Outsized Effects On The Industry, April 27, 2020
• What the CARES Act Means for Credit in U.S. Public Finance, April 20, 2020
• The COVID-19 Outbreak Weakens U.S. State And Local Government Credit Conditions, April 2, 2020
• All U.S. Public Finance Sector Outlooks Are Now Negative, April 1, 2010
• U.S. States 2020 Sector Outlook: Finding Balance In Today’s Lower-For-Longer Economy, Jan. 6, 2020
• When The Credit Cycle Turns, U.S. States May Be Tested In Unprecedented Ways, Sept. 17, 2018