• It's Here!

    Etf Pro

    Get the big financial market moves right, bullish or bearish with Hedgeye’s ETF Pro.

  • It's Coming...

    MARKET EDGES

    Identify global risks and opportunities with essential macro intel using Hedgeye’s Market Edges.

Conclusion: Recent developments in the FY12 State & municipal government budget season reveal to us several trends that are incrementally bearish for US GDP growth and the US Dollar over the intermediate-term.

STRATEGY UPDATE – THE FOUR C’s OF BUDGET SEASON: CONSTERNATION, CONSTIPATION, CAPITULATION, & COMPROMISES:

Given recent unrest in the Middle East, State and municipal finances have been placed on consensus’ back burner even as protestors continue to flock to the streets of Wisconsin, Indiana, and Ohio while minority legislators of these States camp out across State lines to avoid voting on controversial bills.

With States facing a collective $125-$140B budget gap in FY12 (starting on July 1 for all but four States), we expect investors to pay increasing attention to this topic as we advance further into a historic budget season, which is being delayed on the margin by the world’s largest game of “kick the can down the road” (referring specifically to the federal government’s resolve to fund itself for two weeks at a time).

One could make a compelling argument that the public employee protests currently impacting the Midwest region will spread throughout the country like wildfire, especially considering the relative health of Wisconsin, which just recently issued arrest warrants for its fugitive legislators. The chart below speaks volumes to the potential for growing civil unrest throughout the nation, given that the fiscal adjustment needed in WI, IN, and OH are fairly benign relative to States like NV, IL, NJ, TX, and CA:

State & Local Government Finances Not Just a Problem for Muni Bonds - 1

At the bare minimum, the key takeaways here are:

I: Widespread protests and delays in passing State & municipal budgets are, on the margin, bearish for GDP growth in the near term due since the outcome is likely layoffs of public employees and a delay in implementing true fiscal reform. Accordingly, the US dollar is reacting negatively to these budget battles, which are not being resolved expeditiously (refer to our Q1 theme of American Sacrifice for more details):

State & Local Government Finances Not Just a Problem for Muni Bonds - 2

II: As we outlined in our deep dive munis presentation a few weeks ago, many of the cuts, tax hikes, and union-shrinking proposals are not politically palatable. The result of widespread public backlash and legislative uproar to governors’ budget proposals is more than likely to result in some combination of declining public payrolls, accelerating retirements by public employees afraid of losing pension benefits/eligibility, and an acceleration of muni bond issuance, which, on the margin, is incrementally supportive of our case for higher interest rates throughout the US economy. (refer to our Q1 theme of Trashing Treasuries for more details):

State & Local Government Finances Not Just a Problem for Muni Bonds - 3

State & Local Government Finances Not Just a Problem for Muni Bonds - 4

State & Local Government Finances Not Just a Problem for Muni Bonds - 5

Neither of these outcomes is supportive of consensus’ current US GDP growth estimates.

As mentioned before, threats to union rights and their collective bargaining power are fueling the current demonstrations in WI, OH, and IN. Regarding State & local government employment specifically, various studies have concluded that public sector employees earn more in aggregate compensation relative to private sector employees.

Per a December report out of the BLS, wages and salaries for State & local government employees averaged $26.25 per hour vs. $19.68 per hour for private sector workers. In addition, State & local government employee benefits outpace those received by private sector employees by $5.65 per hour worked ($13.85 vs. $8.20). A recent study by USA Today found this to be true in 41 States (including D.C.).

Given the relatively healthy compensation of heavily-unionized public sector workers (36% vs. 15% in the private sector), an accelerated deterioration in labor trends in this sector will be an incremental headwind to aggregate US consumption growth over the next 3-4 quarters (in addition to consumer price inflation and housing deflation).

In aggregate, a potential reduction of over $100B from GDP by cutting State & local spending, in addition to a contraction in household consumption associated with a decline in the commensurate savings from soon-to-be-cut services provided by the government, is not bullish for growth. Moreover, tax hikes like those proposed in CA, CT, and IL (to name a few) won’t help either…  

 

SUMMARIES OF KEY ISSUES CURRENTLY FACING STATE & MUNICIPAL GOV’TS:

 

Federal Budget Cuts: House bill 302(b) has proposed to cut non-defense discretionary spending by $63B below the original FY11 budget and 15-16% below the current continuing legislation. Aside from Medicaid, this is the category where the bulk of federal funding for States and municipalities is derived from. These cuts are on top of the well-known collapse in federal stimulus funding beginning in FY12: 


State & Local Government Finances Not Just a Problem for Muni Bonds - 6

 

State & Local Government Finances Not Just a Problem for Muni Bonds - 7

 

Inability to Adequately Pare Rising Medicaid Costs: Republican governors have met with Obama this week to ask for more flexibility in managing Medicaid implementation. Many of them, including New Jersey’s Chris Christie and Kansas’ Sam Brownback left the talks uninspired and incrementally worried about upcoming budget deadlines. Current federal mandates severely limit the amount of cost cutting States can do with regard to Medicaid (21% of total expenditures), so the focus of budget cuts will be forced to shift elsewhere.

State & Local Government Finances Not Just a Problem for Muni Bonds - 8

 

Changes to Federal Tax Code: Federal legislation enacted in December allows corporations to immediately deduct the entire cost of capital investments on purchases made from 9/8/10 - 12/31/11, rather than the typical depreciation schedule. Absent changes to current State tax code, 19 States stand to lose roughly $5-$6B in corporate tax revenues in the upcoming fiscal biennium.

 

Rising Unemployment Insurance Costs: Starting this fall, 30 States will be responsible for paying $1.3B in interest payments on $42B in loans taken out from the federal government to support depleted unemployment insurance funds. Currently, President Obama is attempting to push through legislation that will delay these interest payments for an additional two years, though Republican Congressmen refuse to support the proposal because it effectively doubles the portion of worker incomes subject to unemployment insurance taxation. Many States plan to issue bonds to fund the interest payments should the bill fail to pass the legislative process.

 

All told, the tea leaves provided by the standoffs in Wisconsin, Ohio, and Indiana, paint a cautious mosaic for this sector’s contribution to US GDP in 2011 and beyond. At 12.2% in 2010, State & Local government consumption was a close third in US GDP weightings; our call is for that “close” third to shift to a “distant” third and weigh on growth over the intermediate-term TREND. From a long-term prospective, however, a much-needed dose of austerity is exactly what this country needs to salvage its prosperity.

Will the professional politicians of America have the political spine to make the tough choices they’ve been called upon to make? Wisconsin Governor Scott Walker (R.) best summarizes the urgency of addressing this question with his recent comments:


 “We’re broke in this State because time and time again, politicians of both political parties ran away from the tough decisions and punted them down the road for another day. We can no longer do that.”

New Jersey Republican Governor Chris Christie’s recent comments confirm this growing sense of urgency due to States running out of “outs” themselves:

“We can’t print money. We can’t run trillion-dollar deficits.”

To his point, 46 States have to balance their budgets by July 1 or risk delays in payments to vendors and creditors alike. If the US Dollar and the protests in Wisconsin et al are indicating anything, it is that this catalyst is closer on the horizon than a resolution of the budgetary debates. Stay tuned…

Darius Dale

Analyst