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Given the nature of recent global events, like the Russia-Ukraine conflict or coronavirus re-emergence, it is evident that national, state, and regional economies aren’t as financially insulated as originally thought.
The inflationary pressures—combined with the rising cost of capital, employee retention, and continued supply chain issues—are all contributing to the assessment of local governments’ fiscal health. However, with the federal government’s COVID-19 response and the recent infrastructure push, many public finance government sectors are experiencing a sense of stability, including airports, transportation infrastructure, utilities, higher education, and more. But recession fears are looming for the U.S. and world economy in general, which will likely have adverse impacts on local and state government finances.
In this article, we will take a closer look at some economic indicators and how they are shaping the economic outlook for public finance sectors of the economy.
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As many investors know, federal government stimulus funds for local governments have certainly helped with recouping certain revenue losses, as well as kickstarting projects that may have stalled due to funding issues or access to capital markets. However, the increased spending or overstimulation in the economy has created inflationary pressure, which many think will or has adversely impacted the ultimate intended outcome. In addition, the rising interest rate environment is also adding strain to local governments trying to access the capital market for their respective project funding needs.
Let’s take a quick look at a few of the sectors and their economic outlook:
Local and state governments: According to S&P’s recent assessment, local and state governments have a stable financial outlook, primarily due to federal stimulus funding and the recent downturn having very little impact on the main revenue sources, i.e. property tax and sales tax. With the recent economic shutdown, the economy was propped up by federal interventions and main revenue sources saw little to no impact for these two sectors. However, it’s prudent to watch the ongoing impacts of historic inflation, the softening housing market throughout the U.S., the re-emergence of COVID-19 variants, and, more importantly, how these governments use or commit the federal funds.
Many economists are predicting a recession in the short term and some are raising alarm bells that the softening of the housing market is an indication of this assessment. However, not all recessions are created the same and may impact different asset classes each time. Many local and state governments are also voicing continued concerns about their IT infrastructure and how it may not be able to ward off a cyberattack.
Water and wastewater utilities: This is another essential service may be more recession proof, but it isn’t insulated from environmental/natural events like droughts. Many local governments are prioritizing the revamping or overhauling of their old utilities’ infrastructure and replacing it with more modern options.
As mentioned, in an economic downturn, users are likely to continue paying their water and wastewater bills before paying for other services. However, you may see a local, regional or statewide mandate that requires citizens to reduce water use due to natural events like droughts,which will likely impact revenues from services provided to citizens.
There are often contentious discussions with citizens and elected officials about the affordability of these services and whether the demographic base can afford utility rate hikes in a normal economic environment and/or in a recessionary phase of the economy. The S&P ratings assess this sector with a stable outlook for the near future with a few words of caution: “Robust financial performance cushions the sector from near- and longer-term pressures. Rate-setting flexibility has long underpinned the strong financial performance that is the cornerstone of the sector; however, we believe affordability concerns could limit this strength for some. Asset resilience will be critical in meeting climate-related challenges.”
Higher education sector: The higher education sector has come a long way after the first wave of COVID-19, when in-person classes were almost non-existent at the majority of the higher education institutions. This likely led to low enrollment numbers in the student population, impacting bottom-line financials.
However, post-COVID-19, the higher education sector bounced back relatively quickly and enrollments ramped up. However, with recessionary pressures and inflation concerns, this sector may need to be watched closely to observe how the economic indicators unfold. After having a negative economic outlook for years, this sector seems to have a stable outlook for the near future.
Transportation infrastructure sector: This sector was severely impacted by the pandemic, followed by a shift in employers not requiring in-person presence from employees and a geographic population shift away from major metropolitan areas primarily served by light rail, bus, and other operations. It’s important to note how transit agencies are primarily funded. The straightforward answer is daily ridership, which dictates the fiscal future of transportation agencies. With things going back to some state of normalcy, we are seeing ridership returning and riders feeling safer with public transportation.
In addition, infrastructure funding and the COVID-19 federal stimulus have helped with accelerating some large capital projects for many transit agencies. During the pandemic, many transit agencies also pushed for local sales tax measures to help support their operations and take their dependency from a single revenue source—ridership revenues—to more sustainable revenues.
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In current times, many investors may find themselves in a peculiar position due to events that happened over the past two years: emergence of COVID-19, global economic shutdown, major local government revenues sustained, federal government interventions, followed by inflation and now anticipation of another possible recession. In addition, even with the rising interest rate environment, we are seeing strong municipal debt issuances to finance local government projects.
All these variables boil down to a bottom line: understanding credit quality. Investors must carefully understand the revenues backing their municipal debt investments and how an adverse economic event can impact the marketability of their holdings.
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Disclaimer: The opinions and statements expressed in this article are for informational purposes only and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgement of the author(s) at the time of publication and are subject to change without notice. Information has been derived from sources deemed to be reliable, the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professionals and advisers prior to making any investment decisions.