“Connecticut would not be Connecticut if we cut $3.5 billion out of the budget. We are a strong, generous, hopeful people.”
-CT Governor Dannel Malloy
Remember Greece? That bankrupt troika puppet state who, not too long ago, would have sold you your own personal island for some cheap flattery and a loosey.
We’re now a few weeks away from the 6Y anniversary of the coining of “Grexit” and a few months shy from Greece (finally) exiting its post-crises bailout program.
It’s hard to overstate the lost opportunity and impacts to employment, wealth and living standards to the local people and economy over the last decade.
But, for the geographically and economically detached, it did birth an entertain-assance in sovereign neologism…
We got Grexit, Frexit (France), Brexit (Britain), Quitaly (Italy), Czech-out (Czech Republic), Leavia (Latvia), Departugal (Portugal), Swedone (Sweden), Noland (Poland) and Noatia (Croatia) … among others.
It was a good run. It’s not quite over.
Enter …. #Cexit (Connecticut Exit).
Back to the Domestic Macro Grind…
Last week we hosted our 1Q18 Housing Themes call. A major section of the deck detailed state-level migration trends and the associated implications for state budgets, home prices and new construction activity.
As mini-case studies, we profiled Connecticut and New York, specifically. Here are a selection of highlights (email if you are interested in the full deck):
- Taxes vs Net Migration: The relationship between effective tax rates and state level net migration is strong. The R-squared isn’t super tight but the distribution plots largely as you’d expect with the highest tax states (Illinois, New York, Connective, New Jersey) seeing the largest net outmigration. The converse holds as well.
- Demographics: Negative demographics (Northeast = older) serve to amplify the underlying trend as retirees attempt to lower costs and optimize income.
- Population: New York and Connecticut have seen an accelerating exodus with net migration negative and falling over the last 7 years. Population outmigration has compounded at approximately -0.80% over the past 3 years in Connecticut and at roughly -1% in New York.
- But It’s Worse Than That … The amount of income leaving CT and NY is roughly double the amount of people leaving the state. For example, while net migration in 2016 was negative to the tune of -0.80% in CT, the % of AGI (adjusted gross income) leaving the state was -1.8%. This is up from -0.9% in 2015. In other words, the tax base is leaving the state at an accelerating rate. The biggest losers and beneficiaries of AGI flows can be seen in the Chart of the Day below.
- Negative Mix-Shift: In addition to net negative (population) migration, CT is experiencing negative mix-shift dynamic with those entering the state earning ~25% less than those exiting the state.
The implications of the above reality should be largely self-evident. The solution, (much) less so.
Connecticut has had an intractable budget deficit in recent years and the pension/other obligation burden is only going to worsen for the foreseeable future.
An accelerating loss in revenue(i.e. the AGI/Tax base leaving the state) alongside an accelerating rise in costs propagates a doom loop for fiscal finances.
Absent largescale restructuring in benefit obligations in combination with public service reductions and lower investment, the primary channel for state and local governments (state level support to local governments will be under pressure) to plug the gap is via higher taxes …. Which likely only serves to accelerate outmigration and propagate a negative, self-reinforcing cycle.
Illinois is currently in the worst position and may be our next case study in slowly-then-all-at-once, nonlinear economics.
Importantly, perhaps most importantly, the dynamics described above are before Tax Reform.
Upper-middle income earners in high-tax, higher income, higher home value states like CT, NY and NJ represent a principal revenue source for Tax Reform via the cap in SALT (State and Local (& property) Tax) deductions.
As we’ve highlighted, SALT deductions for CA, NY, and NJ alone totaled $220B in the latest data and the Treasury estimates the costs (i.e. lost revenue) for the deduction of Property Taxes and other State and Local Taxes will total $485B and $1T, respectively, over the next decade.
And the income demographic this impacts represents a disproportionate share of the tax base in the affected states - and is largely the same demographic that has led the outmigration from Northeast states over the last half-decade.
In short, tax reform is likely to accelerate and exacerbate existing net migration patterns with net population and net income flowing from Northeast SALT states to cheaper, low tax southern states like Florida and Texas.
It shouldn’t be lost on anyone that Connecticut’s budget quandary is occurring at the peak of the expansion when things are supposed to be as good as it gets. That is profoundly discouraging.
Conceptually, proactive risk management is easy to agree on. In practice, actual crisis tends to be the lone catalyst of sufficient force to overcome political inertia to wholesale change, unfortunately.
Sorry, Dannel – hope remains neither a risk management nor fiscal sustainability process.
As it relates to Housing, Builders have understood the demographic and population flow dynamics and are positioned/overweight accordingly. Indeed, over 36% of current Builder exposure is to Florida and Texas.
Many of the builders with favorable demographic, migration and tax reform exposure (and against the backdrop of domestic #GrowthAccelerating) were up ~100% in 2017 and have started 2018 similarly.
“Move to where the puck is going” is not just a hockey axiom.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.47-2.63% (bullish)
SPX 2 (bullish)
NASDAQ 7 (bullish)
VIX 8.69-12.62 (bearish)
USD 89.50-91.90 (bearish)
EUR/USD 1.19-1.23 (bullish)
Oil (WTI) 61.40-65.20 (bullish)
Gold 1 (bullish)
Copper 3.18-3.26 (bullish)
Have a great weekend,
Christian B. Drake
U.S. Macro analyst
