Conclusion: Careful analysis of State & Local Government fiscal headwinds suggests that a Republican takeover of Congress may lead to decisive spending cuts, which could negatively impact U.S. economic growth in the intermediate term. Furthermore, State and Local Government’s FY11 revenue projections are very out of line with economic reality, which suggests further cuts are on the way.
Position: We remain bearish on Muni bonds for the intermediate term TREND.
It’s certainly no secret that State & Local Governments are facing tremendous pressure to balance their budgets and their cuts have been a drag on the economy over the past couple of years. What is not at all baked into consensus GDP forecasts, however, is the likelihood that these measures accelerate meaningfully over the next 2-6 quarters.
In FY110 States faced a $191 billion budget shortfall that is estimated to decline to a $160B shortfall in FY11 (which began July 1st and ends June 30, 2011 for all but four states) according to the latest reports from the Center on Budget and Policy Priorities and the National Conference of State Legislatures. The marginal improvement is based on projections of an aggregated +4% YoY increase in tax receipts. All told, of the 47 States surveyed, 40 States expect total tax collections to have positive YoY growth in FY11 and another 6 expect flat growth in the same period. Only one State budget has forecasted a YoY decline in tax collections in FY11 (Alaska b/c of declining crude oil-related revenues).
On a more granular level, we see that 35 of the applicable 43 States are baking in YoY growth in Personal Income Taxes (~34% of State tax collections) ranging from +1% to >10% in FY11. This forecast likely does not consider the damaging effects of the lingering stagnation in the job market. Since the start of the current fiscal year, unemployment has hovered 9.6% and adjusting for the 20-year average labor force participation rate, unemployment nationally is somewhere closer to 11.5%. Total Nonfarm payrolls have declined by a net 218k in the three months since the start of FY11. That compares with a total loss of 221k payrolls in all of FY10! Furthermore, we contend the transfer to real income growth from government-sponsored income growth will be challenging.
Of an applicable 45 States, 34 States expect YoY growth in Sales Tax Receipts (~32% of State tax collections) ranging from 1 to >10% in FY11. Another 5 states expect flat Sales Tax receipts YoY, with only 4 forecasting declines in their budgets. Notably, West Virginia anticipates a (-5.3%) decline in Sales Tax Receipts in FY11 due to pulling forward $228 million of FY11 tax collections into FY10. Robbing Peter to pay Paul as they say…
We can all but guarantee you that no State budget has the Hedgeye Macro Team’s 4Q10 Theme Consumption Cannonball embedded in their revenue forecasts. Simply put, we expect discretionary spending to go negative to the tune of down 5-6% for each of the next 2-3 quarters starting in 4Q10. Layer on the deteriorating consumer confidence, rising taxes, and Housing Headwinds contributing to a rising savings rate as a result of net worth erosion and it’s almost a certainty that State Sales Tax Receipts will lag in FY11 and potentially into FY12 as well. 34-39 States will be painfully surprised to the downside in this category.
Regarding Corporate Income Taxes (less than 6% of State tax collections) 34 of an applicable 46 States are forecasting YoY growth in that category in FY11. Twenty-five States project the increase to be greater than 5% and 18 are projecting double-digit growth. At 39.2%, the United States has the second highest combined corporate income tax rate in the developed world behind none other than Japan. The key takeaway here is that there is little room for tax hikes to meet these robust projections. Corporate earnings have to be extraordinary for States to even sniff the area code of FY11 budget forecasts. It is all but a foregone conclusion that earnings in the XLY, XLP, and XLF will suffer over the next 2-3 quarters because of the Consumption Cannonball, accelerating commodity inflation, and yield curve compression. Where will the tax receipt growth come from?
Our bearish forecast for State Tax Receipts in FY11 does assume that States no longer have the headroom they once did to raise tax rates based on two consecutive years of hikes and the likelihood that a portion of the Bush Tax Cuts will expire on the Federal level. In 2009, roughly half of the States raised taxes to tune of a $28.6 billion increase in tax collections. In 2010, the net increase from tax hikes was only $3 billion. All told, 30 States have already raised tax rates to some degree in the previous two years. Consumers are severely cash strapped and living on Uncle Sam’s dime, so further tax hikes from here have the potential to negatively impact U.S. GDP growth going forward.
All told, State’s FY11 budget revenue forecasts are very out of line with the current macroeconomic setup. Of course, the economy could always surprise to the upside, but hope is not an investment process we subscribe to at Hedgeye. As the math suggests in the table below, State tax receipts are extremely pro-cyclical so, as the economy goes, so goes State budgets.
Currently, only six States are reporting mid-year budget shortfalls for FY11. We expect that number to increase substantially over the next 3-6 months, which suggest incremental budget cuts are on the way. Last month’s (-83k) decline in State & Local Government payrolls was far and away the largest monthly decline since the start of The Great Recession. Based on our projection for State & Local Government revenue collections to come in substantially lower than initially forecasted in FY11, we see September’s layoffs as a sign of things to come, rather than the “blip on the radar” status assigned to it by many market participants.
Unfortunately for the U.S. economy, reprieve for State budgets is quickly eroding. According to NASBO, State’s rainy day funds are a mere $36.6 billion down 47% from the 2006 high of $69 billion. As a percentage of expenditures, State’s year-end balances are a mere 2.2% when factoring out Texas and Alaska (66% of the total). In FY10, the remaining 48 States combined to have the lowest balance ratio since 1992!
The prospects for further federal government aid seem even bleaker given the increasing likelihood of a Republican majority in Congress. According to the Center of Budget and Policy Priorities, States have only a remaining $6 billion in American Recovery and Reinvestment Act funds left to patch the FY12 budget gap of an estimated $140 billion. Incremental funding from H.R. 1586, the August 2010 Jobs Bill, buoys State spending on Medicaid only through June 2011 and adds only $10 billion to the State Fiscal Stabilization Fund.
If State & Local government revenues come in in-line with our bearish estimates, where will the much needed additional funding come from as States are forced into mid-year budget rebalancing and as they prepare FY12 budgets? Likely not from the federal government, given the Republican Party’s momentum in the latest polls.
In short, House Minority Leader John Boehner’s words yesterday tell the story much quicker than I have:
“[If the Republicans win a majority] you’ll see us every single week move bills that will cut spending.”
Look out below.
While remain bearish on the long term trajectory of the U.S.’s debt and deficit ratios, we do understand the near term impact of pulling away government funding, which has been propping up the economy over the last several quarters. The chart below says it all.