Here's why California faces fiscal risks despite its largest budget surplus in more than a decade 

Key Points
  • California Gov. Jerry Brown signs his last budget, a $201 billion plan with a surplus of almost $9 billion compared with a large deficit he inherited back in 2011.
  • According to S&P Global Ratings, the Golden State has enjoyed "one of the strongest credit recoveries that we have seen among all the 50 states."
  • Yet experts say California faces possible headwinds, including a trade war and tariffs, that threaten tens of thousands of jobs in the state.

California Gov. Jerry Brown faced a state in dire financial straits when he took office in 2011, prompting him to push for a budget fix that included tax extensions and spending cuts to higher education and social programs.

Yet 7½ years later, California still faces risks, including a potential trade war between the U.S. and China that threatens tens of thousands of jobs in the state. Another fiscal risk for California is due in part to the state's tax system, which makes it especially vulnerable during times when the economy or stock market turn down.

Brown signed a record $201 billion state budget on Wednesday, his last while in office. It includes increased spending on public universities and programs such as child care and welfare. It also has new money for combating homelessness and restores some low-income health benefits that were eliminated during the recession.

Nearly $9 billion surplus

Overall, the budget includes nearly $140 billion from the state's general fund and more than $60 billion in bond and special funds. And it forecasts a nearly $9 billion surplus, which would make it the largest in more than decade.

"This budget is a milestone," Brown said. "When I took office way back in 2011, California was facing a real financial mess — a deficit of $27 billion."

California Gov. Jerry Brown signing his last state budget as governor at a ceremony in Los Angeles on June 27, 2018.
Source: KNBC

But the next governor will face the challenge of keeping the state's finances from going off the rails. Brown's 2018-19 budget document points out that California's "balanced budgets have been quickly followed by huge deficits."

"Brown has made it a consistent priority to stress structural alignment in the state budget between its recurring revenues and recurring expenditures," said Gabriel Petek, managing director and sector leader for U.S. states at S&P Global Ratings. "That may not be a priority of the next governor."

Preparing for the next recession

Brown, a Democrat, leaves office in January and was ineligible to run again because of term limits. He has made a point to warn lawmakers of the need to be prepared for the next recession.

“What’s out there is darkness, uncertainty, decline and recession," Brown said when he unveiled his final budget in January. "So good luck, baby."

The average length of an economic expansion since World War II is about 60 months, or five years, according to the state Department of Finance. The current economic expansion in California is about three years longer than the historical average.

The state's Legislative Analyst's Office earlier this year issued a report that said "a moderate recession, like the dot-com bust, could lead to a $40 billion budget problem. A more mild recession might result in a $20 billion budget problem."

To help weather the next recession, Brown pushed for a "rainy day" fund several years ago. The 2018-19 budget fills it up to the constitutional maximum allowed and leaves the state with reserves approaching $16 billion.

Strong credit recovery

"California is really one of the strongest credit recoveries that we have seen among all the 50 states," said Petek. "It went from being on the brink basically."

Still, S&P has California's credit rating today at double-A-minus, meaning it is a few notches behind the median for states, or "below average," according to Petek.

"California's rating is very much a reflection of our view that it's one pronounced revenue downdraft away from renewed budget stress," the analyst said.

Petek believes several potential developments could disrupt the state's "smooth sailing from a fiscal standpoint." He believes a sustained sell-off in the stock market, the change in governors next year and international trade impacts are all risk factors for California. Democratic Lt. Gov. Gavin Newsom, a former mayor of San Francisco, is being challenged by Republican businessman John Cox in November's gubernatorial election.

Large trade exposure

"California has the benefit of having a very diverse economy, the fifth-largest economy in the world," Petek said. "But no doubt, there's international linkages and trade linkages with trading partners from Canada to Mexico to Asia, including China."

Cargo ship at the Long Beach Container Terminal at the Port of Long Beach in Long Beach, California.
Tim Rue | Bloomberg | Getty Images

Indeed, the Los Angeles/Long Beach port complex is the busiest in the nation and in recent years has handled nearly 70 percent of the trade between the U.S. and China. There's also the Port of Oakland with slightly more than half of its marine trade tied to China.

Similarly, trade between numerous California businesses and Canada and Mexico could be harmed if the North American Free Trade Agreement is terminated by President Donald Trump.

"There's definitely a risk to both the state and national economies to the trade policies and the changes in the trade policies that have been pursued by the Trump administration," said Dan Hamilton, director of economics at the California Lutheran University's Center for Economic Research and Forecasting.

State's revenue volatility

At the same time, the state's reliance on personal income taxes from top earners, especially capital gains — treated in California like any other income — makes its "revenue very prone to high levels of volatility and sensitivity to fluctuations in financial markets," according to Petek.

Even small changes in the stock market can cause big swings in the state's collected revenues.

"Some of these risk factors are inter-related," he said. "We've already seen the market expressing some concern about the ratcheting up of rhetoric around trade."

Still, economists say they don't see a recession on the horizon in California but suggest the situation could change.

Forecast sees slowing

"The risk of a recession given where the economy in the U.S. is today is not so great," said Jerry Nickelsburg, director of the UCLA Anderson Forecast. "We're forecasting a good 2018, a little weaker 2019, and weaker again in 2020."

But Nickelsburg added that "there's risk of a near-term slowdown, if not a recession, because of the things that are happening in international trade."

"California is a big logistics industry because it has important Asia-facing ports, and that industry has been one of our growth industries," he said. "In a trade war-induced recession, that industry would be hit disproportionately hard."

During 2017, California exported more than $170 billion in goods and services, the top export markets being Mexico, Canada, China, Japan and Hong Kong. Foreign direct investment in California also is significant, bringing in nearly $65 billion in 2016, according to government data.

Two-fifths of import cargo

About 40 percent of the total U.S. containerized import cargo comes through the Los Angeles-Long Beach port complex, and California accounts for more than 11 percent of all exported products. Major exports of the state include agriculture, electronics, machinery and aerospace products.

"If rhetoric becomes reality, we could see a significant reduction in cargo, economic activity, and ultimately jobs," said Gene Seroka, executive director of the Port of Los Angeles. "After reviewing the information on tariffs — those being implemented or simply proposed, both by the United States and other countries — as much as 15 percent of cargo at the Port of Los Angeles could be subject to the tariffs."

According to Seroka, the tariffs and retaliatory actions by trade partners put at risk nearly 80,000 jobs within the Southern California region and more than 240,000 nationally.

"We support efforts to productively engage our trading partners to improve a rules-based international trade and investment system," he said. But he cautioned "a trade war, with a cycle of tariffs and retaliatory tariffs, could hurt the very businesses and workers we are seeking to support."