The Next Stimulus Bill Will Need to Bail Out State and Local Governments

Editor's note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Under the most optimistic scenario, the United States lifts restrictions on businesses later this year as we get control of the coronavirus pandemic, gradually reviving the economy. However, even if we manage to contain the virus as well as possible, there is a major economic challenge on the horizon: State and local government budgets are getting pummeled and will need to reduce spending in the third and fourth quarters, leading to a contractionary fiscal policy right as we try to get the economy moving again. Not only will this retrenchment impede our recovery, investors need to be aware that stretched local budgets will also put pressure on the municipal-bond market.

The federal government will need to step in and provide a backstop to lower levels of government in the U.S. While Congress has already appropriated $150 billion in aid to states, that is not going to be enough to address this crisis. A federal rescue of the rest of the public sector is likely, but the path to this stimulus will have more twists and turns than the first three coronavirus bills Congress was able to pass in a matter of weeks.

Right now, state and local governments are coping with three huge financial challenges. First, tax revenue is collapsing. Sales tax receipts are in free-fall as people stay home, while income taxes decline as people lose jobs. Property taxes, which are typically used to fund towns, cities, and counties, are more stable as long as people still have cash to pay them, but with record new unemployment claims, those collections will fall as well.

Second, the cost to contain coronavirus is largely falling on state and local governments through increased Medicaid costs, costs to source badly needed medical equipment, and overtime pay for emergency medical services and first responders.

Third, most units of government are vulnerable to market swings because they invested in risky assets to pay for future pension benefits for their police, firefighters, teachers, and other workers. As pension plan trustees have shifted fixed income to equity and even alternative investments such as private equity, they have been able to achieve better returns than they otherwise would have, reducing their actuarially required contributions to fund these benefits.

But during market downturns, falling pension asset values will increase the pension contributions that governments must make. These increased contributions generally need to come from new taxes or reduced spending elsewhere, although some governments have issued pension-obligation bonds in recent years--a questionable approach. Some plans have been underfunded for years, even during the recent bull market. The government sponsors of these plans will be under even more stress and may struggle as they need to find fairly valued liquid assets to sell in order to pay promised benefits this year.

As municipal-bond investors watch things unfold, particularly Congress debating a rescue package, municipal-bond values will probably continue to be intermittently volatile. Investors sometimes expect more comity from members of Congress than is reasonable or even desirable. If members of Congress weren't arguing about adding massive debts to the federal government's ledger, and ultimately to future taxpayers, they would not be doing their jobs. So, expect continued volatility in bond prices as investors assimilate news reports and other hints about the likelihood, shape, and size of a state and local government rescue package.

Of course, this volatility will also depend on the issuer. Some local governments have been much more responsible than others and thus have larger rainy-day funds and better-funded pension plans. Additionally, the Federal Reserve is now buying municipal bonds, adding additional liquidity and stability to the markets.

Ultimately, Congress will rescue state and local governments because the COVID-19 pandemic has affected almost every single elected representative's constituents. Members will argue--appropriately, in my view--about the way to equitably provide relief, avoid rewarding bad behavior, and target the hardest hit areas, and how to share the economic pain that social distancing measures and the virus itself have created. However, despite the three huge challenges state and local governments face, they will be at least partially alleviated by Congress' next response to the virus, and probably subsequent legislation as policymakers try to maintain as much economic stability as they can.