A blue wave may be best outcome for state budgets and the muni bond market

Published Wed, Oct 14 20202:49 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Key Points

State and local governments have been looking to Washington for more funding to make up for revenue shortfalls, but stimulus spending has become mired in politics and is unlikely before the election.
States and cities, and the public finance market, could get the most help if Democrats win the White House and majority control in Congress.

The best hope for state and local governments looking for another dose of federal aid would be for a 'blue wave,' where Democrats win the White House and both houses of Congress in November. So far, a plea by governors and mayors for more assistance has been lost in the battle between House Democrats and Senate Republicans. The House proposes more than $2 trillion on a major stimulus bill, including local government aid, and senate Republicans plan to bring up a $500 billion package next week that includes no state assistance. States and local governments saw an abrupt drop off in tax revenues when they shut down in March, and many are nowhere near a return to normal. Moody's Analytics forecasts that state and local governments will see a "fiscal shock" of $450 billion, including revenue shortfalls over fiscal year 2021 and 2022. "They've been holding off cutting, thinking the federal government will come through," said Mark Zandi, chief economist at Moody's Analytics. "My sense is they're going to start cutting again. We're going to see at least another 1.1 million in job losses." State and local government job losses totaled about 1.2 million since March, with more than 200,000 education-related jobs cut in September alone. At this point, chances are low for a stimulus package before the election. Treasury Secretary Steven Mnuchin Wednesday said getting something done before the election would be very difficult. For the municipal bond market, no help could mean more downgrades to state and local government credit. Downgrades can result in higher borrowing costs and could make bonds less attractive to investors looking for higher quality securities. "In a nutshell, we view a Democratic sweep as the most positive outcome for the muni market given VP Biden's proposals to increase personal and corporate income tax rates, which would increase the value of tax-exempt munis, larger aid relative to other election outcomes for market issuers, and a greater chance for a large-scale infrastructure package," note Bank of America muni strategists. Ed Mills, Raymond James Washington policy strategist, said an election outcome where the Democrats gain the White House and Congress would provide the biggest boost dollar wise for state and local governments. "The quickest way is Trump's re-election. The largest is a Democratic sweep," he said. He said President Donald Trump could have Senate Republicans sign onto a smaller state and local aid package post-election. The most uncertain outcome would be if Biden wins and the Senate remains Republican. Senate Majority Leader Mitch McConnell has said he doesn't want to bail out state pension shortfalls or states that have not been managed well. Yet, the funding market for these governments has been functioning well, since the Federal Reserve said it would backstop the municipal market. While the Fed's facility has been rarely used, issuance in the market has been strong and demand has been good. In the June through September period, municipal bond issuance was about $60 billion above normal, and for October it looks set to come in about $10 billion above average. "There's been a lot of refunding issuance, and issuers have been taking advantage of extremely low rates," said Tom Kozlik, Hilltop Securities head of municipal strategy and credit. "Issuers are rushing to get things done before the election because of volatility...One of the concerns going forward is the heavy issuance could be an issue." But still, there is a potential wave of credit downgrades coming, even if they do get more aid, and there have already been some. For example, Moody's Investors Service lowered the ratings on both New York state and New York City earlier this month, the first cut to either's ratings by Moody's in nearly three decades. The ratings were cut to Aa2, the third highest investment grade rating. Moody's Investors Services warned it would be a long time before a return to normal for the region, which had been the epicenter of the pandemic during the winter and spring. "Those are both directly Covid-related downgrades," said Kozlik. "There haven't been as many downgrades as people expected to see at this point. but these things happen slower in the municipal world than in the corporate world." Kozlik expects to see a lot more downgrades, and he notes that general revenue shortfalls vary by state, with many of them in double digit declines. Goldman Sachs economists, in a note Tuesday, said economic activity is much more depressed in denser parts of the U.S. and particularly in New York. "New York underperforms the rest of the country across a number of economic metrics: its unemployment rate is 7.6pp above the national average, consumer spending is 6.3% below the pre-virus level vs. 2.3% nationally, and small business revenue has also recovered by much less," the economists wrote. "This is likely to remain the case because structural challenges, especially reluctance to take public transportation, will weigh on activity until a vaccine is widely available." New York's Metropolitan Transportation Authority, which runs buses and subways, was one of the few issuers to tap the Fed's facility, selling $450 million revenue anticipation notes to the Fed. So far, permanent business closures in New York appear to be less severe than expected, and commercial bankruptcy filings in September were lower than pre-pandemic filings, according to Goldman. "Nevertheless, New York and other major US cities operating at persistently lower levels of economic activity likely face greater risk of long-term damage," the Goldman economists noted. New York state's general tax revenues are expected to decline by 15% in fiscal 2021, according to the Center on Budget and Policy Priorities. California, also hit hard by the pandemic, should see general revenues decline between 17% to 21%. New Jersey is out 18% of its pre-pandemic revenues, and Florida is expected to be down 10%. Illinois, Indiana and Minnesota are all seen down 12%. States dependent on tourism are faring worse, like Nevada, down 26% in general tax revenues and Hawaii, down 23%. But revenues for Maryland and Pennsylvania are expected to be down just 3%, and Idaho and Nebraska should be off by just 1%, according to Center on Budget and Public Policies. "The credit quality of local governments in the U.S. public finance sector has largely been declining and while we have not yet seen massive downgrades in the sector, we do expect downgrades to continue, and we expect downgrades will outpace upgrades for years," Kozlik said. Kozlik said municipal and state officials will look to slash budgets at the end of 2021, as they review their budgets half way through their fiscal year. That means they could cut jobs of public employees including first responders and educators. There could be another round of cuts in June, when fiscal year 2021 ends. Sylvia Yeh, co-head of municipal fixed income at Goldman Sachs Asset Management, said the muni market is bifurcated, and it's the high-yield part of the market that is being disrupted. That would include long term healthcare facilities and student housing. State and local governments will have to reduce costs to keep their budget balanced. "They are probably one of the more responsible. They do have the tools of budgetary discipline," Yeh said. Cooper Howard, director of fixed income strategy at Schwab said without a stimulus deal, he expects to see states and local governments make cuts to employment, but also use of the Fed's muni facility would likely increase. He said he is growing cautious on lower rated issuers and recommends investors focus on issues rated AA/Aa and above.

A man wearing a protective mask reads his cell phone at an entrance to the subway in New York City, September 22, 2020.

John Lamparski | Getty Images

The best hope for state and local governments looking for another dose of federal aid would be for a 'blue wave,' where Democrats win the White House and both houses of Congress in November.

So far, a plea by governors and mayors for more assistance has been lost in the battle between House Democrats and Senate Republicans. The House proposes more than $2 trillion on a major stimulus bill, including local government aid, and senate Republicans plan to bring up a $500 billion package next week that includes no state assistance.

States and local governments saw an abrupt drop off in tax revenues when they shut down in March, and many are nowhere near a return to normal. Moody's Analytics forecasts that state and local governments will see a "fiscal shock" of $450 b