Fitch sees state and local governments well-positioned for 2025

Overall state and local government credit quality is well-positioned for 2025 and credit conditions will remain neutral as pre-pandemic fiscal conditions resume, according to Fitch Ratings.

A Fitch report, released Wednesday, noted that most state and local government rating outlooks are currently stable.

“The stability reflects the fundamental strengths of state and local governments, including broad and diverse revenue bases, control over revenues and spending, moderate long-term liabilities and sound financial cushions,” Fitch said.

Still, the report lists four scenarios to watch: an unexpected recession; weakening tax base fundamentals; a failure to adjust spending to align with normalized revenue growth; and deep revenue declines, especially for states that made tax policy changes in recent years and local governments that relied on one-time budget balancing measures.

Eric Kim, Fitch senior director and head of U.S. state ratings, told The Bond Buyer there are other factors Fitch is keeping an eye on, but “probably the most significant risk is the first one in terms of the potential for an unanticipated economic downturn.”

In a separate quarterly global economic outlook report published this month, Fitch warned of looming U.S. tariff hikes and said that if president-elect Trump keeps his campaign promises, his tariffs would drive a 3% rise in the consumer price index.

“If you took the president-elect at his word and he were to implement tariffs exactly as he proposed on the campaign trail, that would be a significant hit to the U.S. and global economies,” Kim said. “And that raises the potential for a downturn, which obviously has direct implications for state and local governments.” 

However, “social media posts are not actually policy,” he added.

Kim noted that regardless of who won the election, there was always going to be a downshift in federal aid: “The pandemic aid was already rolling off; it was clear that it was one-time money,” he said. “So there was already a significant decrease in federal support to state and local governments, regardless of who won.”

Another concern for the Midwest specifically is the extent to which many states in the region rely on sales taxes, especially the state sales tax, said Justin Marlowe, research professor at the University of Chicago’s Harris School of Public Policy and director of its Center for Municipal Finance.

“When you think about tariffs and the increased costs for everything, including and especially imported goods, suddenly a lot of durable goods become a lot more expensive,” he said. “It does create the potential that people see a slowdown in the types of spending that are so important to those sales tax bases.”

Infrastructure projects could also be impacted, he said. If barriers crop up to the import of key commodities — steel, aluminum and other key materials — and those commodities have to be sourced domestically, costs could skyrocket quickly: “If you have a project underway, or you’re about to launch a project, and suddenly the cost of that project increases 20 or 30 percent… that’s a very different project,” Marlowe said.

Worsening those cost concerns would be the realities of having to borrow into a steeper interest rate environment, he added. And with sales tax revenues required to support a lot of those projects, any decline in revenues would compound the problem.

The Fitch report also flagged weakening tax bases as a concern: increased home price uncertainty and climbing home insurance and mortgage costs on the one hand, and pressure on commercial real estate on the other.

Marlowe said on the commercial real estate front, “it’s going to take time, and it’s going to take creativity,” including different thinking about how to utilize downtown spaces. 

“It has been interesting in the last three months or so to see a little bit of a contrarian view emerge on the question of what’s going to happen to commercial real estate values,” he said, noting that Cook County, Illinois, Assessor Fritz Kaegi has taken a sunnier view of commercial real estate values, especially in downtown Chicago.

For local governments in the Midwest and elsewhere, though, a key question going forward will be how they used their pandemic relief funds and adjust to their absence.

Ashlee Gabrysch, Midwest region manager for local government ratings at Fitch, observed a “bifurcation in the style that local governments chose to adopt” around federal funds. Chicago Public Schools, for example, opted to delay a fiscal reckoning and spend one-time funds on the creation of new positions. Now, with those funds running out, the district is left without easy answers.

Marlowe said the pandemic did not create new trends, but it did accelerate existing trends and established habits among local governments.

“When I teach financial management and budgeting to my students, rule number one is never use one-time revenues to pay for ongoing expenses,” he said. “And the pandemic relief from the federal government was the ultimate test of that principle. For those that did follow it carefully, they built reserves, they were able to put it into capital projects.”

For governments that didn’t follow that rule, the threat of an economic downturn is exacerbated as the federal relief money runs out.

“Depending on how local governments used the federal stimulus funds, it also results in different fund balance levels,” Gabrysch said. “And if you were strategic with the federal stimulus monies and you used them for one-time things, you’re likely to be sitting on a pretty healthy fund balance.

“Those issuers that used pandemic funding for recurring operations, some of them have been drawing on fund balance to try to course correct or delay fiscal reckoning for a structurally balanced budget,” she added. “And in those cases, a recession is going to be an even greater risk because of the lack of robust reserves to draw on.”