Chart 1

What's Our Sector Overview?

S&P Global Ratings' economists are forecasting a recession for the first six months of 2023 (see "Economic Outlook U.S. Q1 2023: Tipping Toward Recession," published Nov. 28, 2022, on RatingsDirect); however, we believe states can manage through the year without credit disruption. As economic and financial storm clouds gather, state rainy day funds have reached an all-time high position--with no drawdowns planned--and many states continue to outpace fiscal 2023 revenue forecasts. At the close of fiscal 2022, using unaudited figures, we tabulated the 50 states having over $136.5 billion in rainy day reserves, significantly higher than the roughly $80 billion heading into the pandemic. According to the National Association of State Budget Officers, year-to-date, states expect reserves as well as other available general fund surpluses to grow and exceed $280 billion or nearly 25% of budgeted fiscal 2023 general fund expenditures. We will be monitoring revenue, expenditure and reserve levels as states begin presenting their fiscal 2024 budgets in the coming quarter.

The stable sector view reflects our belief that considering all the fiscal and operational pressures that states are facing, credit conditions are not going to be negative enough to out-weigh the management controls and fiscal options that states have to mitigate credit risks. Nearly every state has record reserves, but reserves are just one component of how we would expect states to address recessionary and inflationary challenges while preserving credit quality. In times of fiscal stress, management teams often mitigate issues with a multi-pronged approach of reserve usage, new revenue generation, and expenditure cuts.

According to the Urban Institute, fiscal year-to-date, revenues are up 1.8% in nominal terms for the median state, but down if inflation-adjusted; there are signs of weakness as corporate income tax collections are slowing in many states. Newer revenue streams of gaming and cannabis revenues continue to grow, although neither is a significant share of any state revenue mix so far. We view revenue diversity as a positive credit feature, as it can help diffuse collection weaknesses in any one stream. We expect to see these newer revenue streams continue to grow in 2023. Although revenues are continuing to meet or slightly outpace budgetary expectations, they are not necessarily keeping up with inflation. Should inflation remain elevated, this could add pressure on budgets even where revenues remain on target. We have not yet seen any expenditure cuts suggested to address a coming recession, but many states recognized the buoyant revenue position from fiscal 2022 and budgeted for flat or lower spending in their adopted fiscal 2023 budgets. States have an advantageous, although at times divisive, ability to share fiscal challenges with other related governments. In prior recessionary periods, we have seen states cut aid to local governments and other authorities, and believe this could happen again should the recession be longer and deeper than our economists forecast.

Along with revenues in fiscal 2023 holding mostly at or above forecast to date, another reason why states are in a good liquidity position is the significant federal stimulus aid still on hand. The federal government has allocated over $7 trillion in stimulus aid to fight the pandemic and support the economy over the past few years. The largest share of aid given directly to states was in the American Rescue Plan, with nearly $200 billion allocated to the states and territories. Of that amount roughly 21% has yet to be appropriated, and a few large states had yet to appropriate half the funds through August 2022, including Massachusetts, New York, Arizona, Ohio, and Nevada. The stimulus that has been allocated is primarily being used for COVID revenue replacement or pandemic-driven salary increases, unemployment trust replenishment, or capital funding, and not for large recurring programs. Much of the existing aid will be spent through fiscal 2026, providing both internal liquidity in the short-term and funds for capital requirements in the longer term. So, although the impact of a potential fiscal cliff caused by the depletion of federal aid is a current topic in the market, we view the coming change for states as more of a gradual slope than any type of precipice.

Outlooks and credit actions have all been positive in 2022; will 2023 bring changes?  We enter 2023 with six states on positive outlook and none on negative outlook. The six states on positive are Alaska, California, Kentucky, Massachusetts, New Hampshire, and New Jersey. Overall, credit ratings strengthened in 2022 with three rating upgrades: Connecticut to 'AA-', Illinois to 'BBB+', and New Jersey to 'A-' (see list of state actions in the Appendix). Although we see greater economic and demographic challenges in 2023, we expect credit worthiness to be maintained.

Chart 2

Sector Top Trends In 2023

How quickly will inflation abate?  As inflation remains high, we see it presenting challenges to states in elevated construction costs and wage pressures, but this could be offset somewhat by higher income and sales tax receipts. The employment picture has shown resilience with some surprises like strong manufacturing growth; however, leisure and hospitality continue to lag pre-pandemic levels. Even if recessionary and inflationary pressures outpace revenue strengths, we believe historically strong reserves coupled with active management to control costs will allow states to weather a short and shallow recession. The longer inflation remains elevated, the more it affects state budgets. Long-term wage agreements will have higher annual cost impacts. Construction cost forecasts could continue to exceed estimates with lingering high inflation. These costs, along with many others, would need to be reflected on the expenditure side of state budgets. (See S&P Global Economics forecast in the Appendix.)

What cost impacts will be felt from federal Medicaid changes?  State Medicaid agencies estimate that the state share of Medicaid spending (excluding federal funds) grew at a rate of nearly 10% in fiscal year 2022 and could reach a peak growth rate of 16.3% in fiscal 2023. The federal fiscal 2023 budget includes a transition schedule where over a year the additional 6.2% enhanced Federal Medical Assistance Percentage (eFMAP) reimbursement would would step down to zero (table 1).

Table 1

Most states budgeted this reimbursement to end in December 2022 (some even in September 2022), and the extra quarters of eFMAP reimbursements creates additional budget capacity.

Additionally, the federal budget sunsets the obligation of the states to not remove anyone from Medicaid rolls on March 31, 2023. Approximately 18.7 million individuals were added to the program through the pandemic; unwinding continuous enrollment requirements and redetermining ongoing eligibility could take up to a year. The proposed eFMAP step-down could help mitigate any state's additional costs. We'll be watching to see if this leads to budgetary pressures for states, particularly as reduced federal reimbursements could coincide with a recession--a period when Medicaid rolls often grow.

Will mineral royalty state revenues retain strength?  Geopolitical issues affected state credit in 2022, primarily as a driver of inflation and a disruptor of supply chains. States with severance taxes and mineral royalties, though, have seen revenue gains from the war in Ukraine, as oil and gas prices spiked, and U.S. production increased. Payments of mineral royalties to states have nearly doubled in fiscal 2022 from fiscal 2021, and recent sanctions on Russian oil could further provide beneficial revenue tailwinds. The Department of the Interior is forecasting payments in fiscal 2023 to remain strong, although down from the all-time high level in 2022. While oil prices have moderated from their peak earlier this year, price volatility continues to add uncertainty as budget writers look to incorporate oil and gas related revenues within the short term. Longer term, the multiyear outlook for severance tax-dependent states remains murkier, as the world transitions to renewable energy sources. For more on our energy state analysis, please see "Oil And Gas Prices Fuel U.S. Mineral-Producing States' Coffers As Economic Momentum Slows," Aug. 2, 2022.

Will the recession have impacts on capital programs?  States continue to have large capital programs, but through calendar 2022 have been funding these with increased pay-as-you-go current appropriations, prior bond issuances, or federal aid, so new-money debt issuance has lessened. As costs for these projects are coming in over original budgets, those sources may run out before previous forecasts would have indicated, and states will need to decide in 2023 whether to issue debt to make up the difference or to curtail the size or speed of projects. With states the leading sector of par issued in the municipal market, our economists forecast all public finance debt issuance in 2023 to grow 5% from 2022 issuance levels. (For more on state debt levels, see "Increase In U.S. State Debt Levels In 2021 Was Likely A Blip," July 6, 2022)

Will demographic changes that occurred during the pandemic be lasting?  States, like most sectors, are finding it challenging to hire. Across the county, one hears about open positions that once would have received a half dozen applicants are now lucky to draw one. In November, there were 4.7 million fewer job seekers nationally than there are jobs. To fight inflation and attract workers, employers have increased hourly wages 5.1% (December 2021 to December 2022), and yet that still equates to negative purchasing power due to inflation above 8%. If employees are hard to hire and wages continue to increase, economic growth could be stymied.

Fewer babies were born through the pandemic.  The worker shortage reflects a confluence of issues, including the pandemic causing an increase in early retirements, a reduction in international migration, and a decline in births. Population replacement is a challenge in many states. Prior to the recession, only four states experienced more deaths than births, but in 2021, half the states saw fewer births than deaths. Should this trend continue, it could have economic consequences.

International immigration continues to fall.  Historically, when natural replacement rates have been lagging, immigration has filled in the gaps, but not this time. The holdover effect of pandemic restrictions, coupled with the lack of a cogent federal immigration policy, is hurting the American economy with challenges at the southern border, as well as a significant dearth of skilled migrants. From an international net in-immigration peak of over one million people in 2016, each year since has experienced a decline, with just a net 245,000 migrants in 2021.

Chart 3

Chart 4

The population continues to age.  Despite people being stuck at home early in the pandemic, there was no resulting baby boom. Aging population has revenue and service level implications for states over the long term but there are also more immediate employment challenges. The government sector has long been experiencing a "silver tsunami" of long-tenured employees reaching retirement age, without a replacement cohort to fill the positions. COVID-era workplace policies drove many in the government space to early retirement. The pandemic-driven demographic trends do not look to be helping the employment challenges.

How Will Credit Quality Be Affected?

Why is our sector view not positive?  Overall, the credit position for states is looking positive, and we considered adjusting our sector view from stable. The macroeconomic uncertainties, though, give us enough pause to temper any positive expectations. Inflationary pressures are expected to remain, with core CPI expected to increase 4.7% in 2023 over 2022's already high levels. This growth will pressure wage expectations as well as construction costs; states will need to adjust to this higher cost environment. The war in Ukraine is creating food and energy uncertainty in Europe and Africa and should that conflict worsen, so could those global challenges. A U.S. response to food and energy shortages overseas will have varied effects on states, but regardless, the geopolitical uncertainties need to be considered when arriving at a sector view.

We will also be watching to see how a multitude of pressures combine to affect state program costs. The inflationary challenges and Medicaid changes coupled with the depletion of federal stimulus aid could have a multiplier effect on state cost pressures. There is an additional uncertainty surrounding capital gains tax collections. Many states benefit disproportionately from high income taxpayers, and in past recessions we have seen this stream become quite volatile. So, although there are more positive than negative outlooks assigned to our state ratings, while 86% of our outlooks are stable, these credit uncertainties have tempered our view.

All states can handle a simple fiscal 2023 stress test.  As discussed earlier, in times of fiscal stress, we think highly rated entities will address the challenge with multiple approaches, including tapping reserves, cutting expenditures, and raising new sources of revenue. We performed a stress test assuming only reserve usage. S&P Global economists expect the peak of the recession in our baseline economic forecast to cause a peak-to-trough decline in GDP of 0.8%. The GDP decline in the Great Recession was 3.8% (peak-to-trough) and so the expectation is that the coming recession will be roughly a fifth of what was experienced in 2007-2009. Applying a stress on state revenues equivalent roughly to one-fifth of the Great Recession and assuming the gap is filled by available reserves, we've determined that all states have a comfortable cushion to help mitigate potential declines in revenues.

The map (chart 5) map shows the strength of reserves across the country. We subtracted the theorized revenue declines from the forecast reserves and surpluses and every state would still have a positive reserve balance. In prior periods heading into a recession, it was not uncommon that some states would have nothing in reserves, so to be able to show that all could have a remaining balance after this forecasted shallow recession speaks to the sector's preparedness.

Chart 5

Pensions are generally looking good, though recent poor market performance will hurt funding metrics.   The aggregate funded ratios of the 50 states' pension plans exceeded 80% as reported at the end of 2021 reporting period. This aggregate contains high variance as many states report over 100% funded and a few states report below 50% and the high average funded position is expected to decline meaningfully as market conditions have deteriorated since the end of June 2021. Most systems have been unable to meet target rates of return in fiscal 2022. With recent performance, we would expect funded ratios to drop double digits in many instances as new results are published. (For more on state pensions, please see "Pension Brief: 2022’s Down Markets Reverse 2021’s Unprecedented Gains For U.S. Public Pension Plans," June 8, 2022, and "Market Swings Could Signal Contribution Volatility For U.S. State Pensions And OPEBs," Aug. 3, 2022.)

Poor cyber hygiene can affect credit quality.  Cybersecurity lapses continue to create disruption and drain liquidity throughout public finance. As cyber insurance becomes more expensive or even harder to attain, states have a leading role in modeling and supporting strong cyber hygiene practices. Many attacks in the sector are by criminals looking for cash, but geopolitical actors are likely to remain active in 2023. States need to be ready and prepare for an attack, plan on actions to take during a cyber event, and determine remedial actions post-attack. (For more on cybersecurity in ratings, see "Cyber Brief: Multifactor Authentication Remains Effective But Not Impenetrable," Oct. 18, 2022, and "Cyber Risk Management Is Credit Risk Management, Says Seminar," Nov. 1, 2022.)

Appendix

Table 2

Table 3

Related Research

• History Of U.S. State Ratings