Sector View: Stable
The stable sector view reflects local governments' proactive management; economic growth; and strong federal fiscal and policy response throughout the pandemic. Multiple rounds of federal stimulus for pandemic-induced revenue and expenditure fluctuations continue to provide a solid foundation for addressing potential pressure caused by new virus variants. When coupled with economic growth around the U.S., we expect local government credit quality to remain stable in 2022; however, borrowers will have to remain flexible to adjust to changing conditions.
Local Governments Are Well-Positioned For 2022
With $5.2 billion in cumulative federal aid for U.S. public finance (USPF) issuers during the pandemic plus $550 billion in new funding from the long-awaited Infrastructure Investment and Jobs Act (IIJA), state and local governments (LGs) have had significant support to weather COVID-19. We expect the stimulus will help LGs make up for revenue or expenditure dislocation experienced over the past 18 months. However, to retain financial stability when stimulus ends, LGs must actively manage pandemic-related pressures, such as the new challenges related to inflation and labor costs.
S&P Global Economics' recent forecast, "Economic Outlook: U.S. Q1 2022: Cruising At A Lower Altitude," published Nov. 29 on RatingsDirect, calls for GDP growth of 3.9% in 2022, lower than 2021's growth, but still better than we've seen in the last decade. Supply chain issues along with inflation and labor market pressure are expected to continue to weigh on the U.S. economy, some of which will flow through to LGs. However, we expect LGs to be up to the challenge of these hurdles given that management teams have responded well to the shifting shape of the pandemic thus far.
Given the response we've seen to date and the support to be provided by stimulus over the next two years, we expect the sector to remain stable for the foreseeable future. Should the life cycle of the pandemic continue to create unforeseen side effects, active management of changing circumstances will be critical to maintain balanced operations and credit quality.
Chart 1
Stimulus Spending Choices Are important
In our view, how stimulus dollars are used could play a significant role in long-term credit strength. Accelerating projects that provide economic growth will lead to a different outcome over time than using them to plug a hole created by the pandemic. With flexibility in how the money can be used, we anticipate there will be a wide range of projects funded; many of those could be transformational for the local governments using them to accelerate growth, or at the very least, provide ballast for troubled economies.
At roughly $1 trillion in total, the IIJA is an important shift in funding U.S. infrastructure, and it will relieve some pressure on state and local governments that have had the growing responsibility of funding infrastructure for decades. Improved transportation and water infrastructure impact local economies broadly, and the IIJA's reach beyond 'traditional' infrastructure such as cybersecurity and broadband expansion support the digital necessities that are equally critical for modern growth. S&P Global expects that the infrastructure spending will have a positive multiplier effect on the broader economy and as such benefits are expected to accrue to LGs as well. Similarly, if passed, the Build Back Better Act would support local governments through additional funding for issues related to families, climate change, and health care, among others.
Questions That Matter
1. Will all the federal support improve LG credit quality?
Local governments received broad federal support over the past two years from multiple rounds of stimulus. The effect on future credit quality from stimulus funds may hinge on how the funds are used: accelerating growth and development, or shoring up struggling finances.
How this will shape 2022
Stimulus funds provide short-term breathing room. With flexible ARPA dollars, LGs are in a good position to respond to lingering pressures related to the pandemic. Additional support for infrastructure from IIJA will help address some deferred capital needs, freeing up budget space for many.
General fund financial results will look better for a time, but for some it could be short lived. Significant amounts of federal money coming onto LG balance sheets should make the bottom line look better for some but may mask underlying financial pressures for others. If acute pandemic-related shortfalls persist in 2022 (or worsen during the federal spending time frame through 2024), higher reserve levels may not last.
Prioritization of capital projects. The combination of federal stimulus and the IIJA will allow many LGs to accelerate project plans into 2022. We will be focused on what this may mean for overall debt issuance for the sector. However, given inflation and labor availability these projects may have a longer time horizon.
What we think and why
Stimulus provides a critical bridge to post-pandemic. While most LGs have managed through the pandemic without significant financial deterioration, some have not. Stimulus dollars provide the ability to rebalance and help support credit quality in the short term, particularly through budget relief.
Federal support also enhances stability over the long term. With significant underfunding of infrastructure needs historically and a growing backlog of deferred maintenance, stimulus and IIJA funds will help stabilize the infrastructure investment. However, it will not be enough to meet all needs over the long term so LGs need to determine how to maximize this funding as part of their capital funding strategy.
Not all stimulus money will be used for one-time expenditures. Some LGs may use the money for ongoing costs. We expect there will be some use of stimulus to support new projects in anticipation of growth. We will be watching to see if that new growth materializes, and if it doesn't, if a structural imbalance is on the horizon.
What could go wrong
A tight labor market and higher materials costs could make projects hard to complete on time and on budget. Lower labor force participation rates are pushing up wages and the struggle to retain talent is leading to some multi-year union contracts with hefty raises. With more projects rolling out, labor availability could become an issue if it causes delays in projects, not to mention the ability to fill regular staffing needs.
Two-year stimulus clock could limit meaningful change. Transformative projects take time to develop and implement. With a date-certain spending deadline, LGs will either have to create bigger project plans that layer in other funding sources or choose easier-to-complete projects.
Chart 2
2. How do ongoing COVID challenges compete with other needs that pressure LG stability?
The arrival of "post-pandemic" grows increasingly uncertain. New virus variants and outbreaks will require local governments to deploy resources differently to address changing public health needs.
How this will shape 2022
Uneven health recovery is not creating different outcomes in regions to date. Despite broad differences in vaccination rates and virus spikes, there have not been markedly different impacts to credit quality around the U.S. However, new variants always pose the possibility of shifting that course and the ability to respond quickly when required remains critical.
Hospitality tax and convention center revenue softness persists. With fluctuations in business travel continuing, hospitality taxes and convention centers still face some direct pandemic-related challenges, although many have bounced back well. While lower debt service coverage levels have not resulted in widespread downgrades in the sector, ongoing revenue softness could create more credit deterioration.
Shifting return-to-office timelines create uncertainties. Ongoing pandemic surges are likely to continue, affecting commuting patterns, tax collections, and the commercial and office segment of the tax base. While some temporary changes may be able to be absorbed, permanent, notable shifts will take more adjustment.
What we think and why
Issuers have managed pandemic response well to date. We expect the proactive nature of LG management to continue, which in turn provides significant support for credit quality. During the pandemic we saw quick action by LG teams to cut expenditures and adjust revenue expectations, allowing for added stability even before ARPA money was available.
Acute pandemic-related pressures have eased and regaining structural balance is critical. Plenty of government stimulus has helped local governments weather the storm, but it is imperative that adjustments be made to remain balanced once federal money runs out. If not, credit stability will be affected.
Despite uncertainties, federal support will allow the LG sector to remain stable for some time. The flexibility and timing of federal stimulus will help local governments manage pandemic-related pressures that arise going forward. This will help maintain credit stability and provide needed flexibility to support a shifting landscape.
What could go wrong
National political divisions affect politics locally. A push from some LGs to require vaccines or masks continues to polarize communities. In the extreme, sharply divided electorates and disgruntled citizens may be less likely to approve ballot measures, particularly when management and elected officials disagree on the health and safety strategy.
Inability for some LGs to regain balanced operations before federal support ends, particularly if new virus spikes hit harder. For some, long term credit health is dependent on the ability to regain structural balance before one-time federal dollars run out.
Post-COVID economic landscape within cities could vary widely. Uneven health outcomes have led to uneven recoveries, and while that has not caused credit deterioration to date, differences created by the pandemic could become more pronounced over time. Federal stimulus dollars will provide some help but may not be able to bridge all the gaps.
Chart 3
3. How much will E, S, or G change ratings?
The necessity of addressing E, S, and G simultaneously will be a refrain for the foreseeable future. Preparedness for future weather and climate disruptions is critical for issuer credit stability over the long term; focus on the S and G of ESG may not be as visible as environmental issues but is important to long term credit stability.
How this will shape 2022
Resources to address a wide variety of ESG-related pressures are essential. Support for operations from federal stimulus and the IIJA will provide some resources; this is particularly important given that initiatives need to be underway now to prevent deterioration in the future. S & G needs can be harder to see on the surface and can be more difficult to mitigate, but prioritizing funding for them is also critical to long term credit strength.
Shifting weather patterns and persistent drought continue to create ESG demands. Unprecedented drought conditions in the West raise larger questions regarding economic development and availability of natural capital resources over the long term. While it is not expected to be an imminent threat in 2022, development limitations related to ESG pressure will continue to build over time.
Ongoing focus from municipal market participants will keep topic top of mind. ESG issues have long been part of issuer's day-to-day conversations. As interest grows in assessing, quantifying and managing these risks from a credit perspective, conversations regarding disclosure and transparency will be at the fore.
What we think and why
Being prepared to address unexpected ESG events is critical for credit quality. Those that haven't started planning are more likely to experience credit deterioration from an acute ESG event like a hurricane or physical climate risk, or a cyberattack. Advanced planning and remaining vigilant regarding potential threats is paramount to credit stability
IIJA and federal stimulus dollars will help but won't be enough. The myriad resources needed for ESG preparation--from climate to cyber security to affordable housing--cannot all be funded with one-time federal money. Maintaining credit quality in the face of competing ESG demands will require local support and resource prioritization.
What could go wrong
Lack of preparedness will be detrimental for some. For some, cyberattacks and wildfires aren't a matter of if, but when. Where these events will occur remains a critical unknown that could impact credit stability for those unlucky enough to be in the path.
"S" events happen before they are ready to be addressed. As we saw during 2020, social issues can create unique challenges for LGs as they are typically the first in line to respond and manage protests, demonstrations, and other events. There can be short- and long-term implications associated with these issues and LGs without a playbook for handling will be at a disadvantage.
Delayed projects due to COVID and labor/material shortages put local governments further behind. A wide variety of infrastructure and other projects were put on hold during the pandemic. While some governments will have time to complete projects before disaster strikes, not all will be so lucky.
Chart 4
4. Could implications from learning loss be significant enough to affect credit quality?
With several rounds of federal stimulus and strong state finances, school districts and charter schools are well poised financially. However, whether these stimulus funds will be sufficient to get any lagging learners back on track--and allow classroom operations to get back to normal--remains to be seen. New virus variants create additional uncertainty for in-person learning.
How this will shape 2022
How things settle down for school operations has yet to be seen. While there is plenty of federal money to get things back on track, it's a different track. Balancing short-term federal support with longer-term needs will ensure districts are well situated for stability beyond pandemic funding support.
IIJA didn't directly address capital for schools and infrastructure needs abound. Schools have short-term operating support from federal dollars, but capital needs and deferred maintenance are still pressures for some. Increasingly contentious school board politics during the pandemic may make passing ballot measures more difficult.
Federal funds will help make up lost ground. In total, school districts across the country received $190 billion in Elementary and Secondary School Emergency Relief (ESSERs) funding. When combined with strong finances at the state level and good tax base growth, school district revenues should be stable for most.
Chart 5
What we think and why
As with municipalities, it is essential for schools to adjust to ongoing virus-related changes. Making up for learning loss is critical to keeping students on pace. How long that takes, and if growing achievement differences arise between districts, could have an impact on communities.
Federal money won't cure all ills. Structural imbalances and downgrades are still happening even with lots of federal dollars to support operations. For districts that started the pandemic imbalanced or on a downward trend, stimulus will help keep them afloat, but not forever.
Growing educational disparities, an "S" factor, can't be solved easily. State funding formulas and historic inequities prior to stimulus do not have easy solutions. ESSERS funding will help but may not narrow the gap appreciably, and even a few months of unaddressed learning loss can have an impact on future earnings, according to a study by McKinsey & Company.
What could go wrong
Current challenges filling vacant positions could derail operational balance over the longer term. Some union contract negotiations with big multi-year raises settling now, during a time of high inflation and high teacher demand, will create more pressure in the years to come. Even when inflation and labor markets normalize, any generous multi-year contracts districts settled to keep teachers in the classroom could affect structural balance.
Enrollment shifts caused by the pandemic don't go back to normal. Many districts attributed falling enrollment over the past two years to pandemic shifts, and while some have seen enrollment rebound many have not. Early indications of lower kindergarten enrollment would exacerbate the situation if the trend continues, particularly In states with per-pupil based funding.
Will playing catch up delay moving forward? For districts with more learning loss or other pandemic-related aftereffects, addressing those needs could outweigh new program creation. This could have an impact in both the short- and long-run.
Chart 6
5. Does the economic recovery look different among the regions?
Strong U.S. economic growth has been beneficial for local governments broadly and promotes rating stability. Despite the regional ebb and flow of virus outbreaks, no area of the country appears to be faring better—or worse—than others.
How this will shape 2022
Despite uneven health recovery regions don't look markedly different. There were more fluctuations for retail sales among regions during 2020, but 2022 projections cluster around a drop of around 1% from 2021 levels. Similarly, 2020 unemployment spikes across all nine regions all fall to projections of 3% to 4% in 2022 (see charts 8 and 9).
Growth may be slowing but remains higher than pre-pandemic levels. GSP growth projections for 2022 are lower than 2021 but all regions remain at 3.6% or higher. On the downside, as the economic recovery marches into 2022 some economic readings are weaker than they have been during the recovery, particularly for the labor market and inflation (see chart 7).
Chart 7
Housing market is hot-hot-hot. A strong housing market supports property value growth (and thus property taxes), and home price appreciation has been off the charts in some cities. However, it is also pricing home buyers out of some markets. If this persists, it would present social issues relating to housing affordability. Recent higher costs to build new homes exacerbates the problem.
What we think and why
Lower labor force participation could have both short- and long-term implications. As local governments work toward post-pandemic, progress could be stymied by labor market participation. If the tight jobs picture persists it will start to have more of an impact on LG operations, particularly for any generous long-term union contracts settled now without a reopener.
Inflation has not had a credit impact to date, but persistent elevated levels pose risks. Higher inflation rates could result in more reluctance to support capital or operating levies over time, increasing the possibility of an impact on LG operations.
Pandemic relocations may be here to stay. Many people moved during the pandemic, either temporarily or permanently. Some of these relocations were from higher-cost to lower-cost regions, but many were from the city to the suburbs. How these demographic shifts play out over time will be important for the pace of economic growth.
What could go wrong
Economy slows down or inflation heats up faster than anticipated. With a 10%-15% risk of recession over the next 12 months, the forecast for a major economic shift is considered low. However, should policy missteps or other unforeseen events arise it would cause disruption.
Hospitality tax revenues and convention center activity takes even longer to return and threatens coverage levels. Some taxes in these sectors are taking longer to reach 2019 collection levels than other LG revenues. If revenues aren't showing signs of marked recovery after two years, the chance of credit deterioration in the face of another virus surge is more likely.
Supply chain disruption persists, limiting ability to make meaningful capital-funded changes with stimulus. Similar to labor market pressure, an inability to complete stimulus-funded projects within the federal spending timeline would set local governments back unnecessarily.
Chart 8
Chart 9
Rating Actions And Distribution
The local government sector began 2021 with a negative sector view on the heels of a year where LG downgrades outpaced upgrades by four to one. However, once it was clear more federal aid was coming via ARPA, the LG sector view was revised to stable and rating transitions reverted to a more normal trend of upgrades outpacing downgrades.
Chart 10
Chart 11
Chart 12
This report does not constitute a rating action.
| Primary Credit Analyst: | Jane H Ridley, Centennial + 1 (303) 721 4487; jane.ridley@spglobal.com |
| Secondary Contacts: | Cora Bruemmer, Chicago + 1 (312) 233 7099; cora.bruemmer@spglobal.com |
| Geoffrey E Buswick, Boston + 1 (617) 530 8311; geoffrey.buswick@spglobal.com | |
| Kristin Button, Dallas + 1 (214) 765 5862; kristin.button@spglobal.com | |
| Victor M Medeiros, Boston + 1 (617) 530 8305; victor.medeiros@spglobal.com | |
| Robin L Prunty, New York + 1 (212) 438 2081; robin.prunty@spglobal.com | |
| Helen Samuelson, Chicago + 1 (312) 233 7011; helen.samuelson@spglobal.com | |
| Nora G Wittstruck, New York + (212) 438-8589; nora.wittstruck@spglobal.com |
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