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The Dire State of the States

By Amey Stone For a couple of weeks late last year and early in 2003, investors were able to look past all the signs of economic weakness and see a light at the end of the tunnel. Sure, consumers were flagging and corporations retrenching. But once Iraq was over with (assuming a quick and not-too-dirty fight), the theory was that federal stimulus would kick in, chief executives would dust off their capital-spending plans, and Corporate America as well as individuals would suddenly feel better about investing in the future. That was the idea, anyway.

Since then, another drag on the economy has become increasingly apparent -- and passage of the Bush stimulus plan and winning a war in Iraq would do little to relieve it: the growing financial problems of state and local governments. For investors, this is yet another macroeconomic headwind to keep in mind before jumping back into the market.

After spending rainy-day funds in 2001 and 2002, and now plagued by tax receipts that continue to come in weaker than forecast, states have seen their finances deteriorate in a matter of months. In November, the two-thirds of states surveyed by the National Conference of State Legislatures (NCSL) projected budget shortfalls of $17.5 billion. By early February, their budget gaps had risen to $26 billion (see BW Online, 02/07/03, "State Taxes Need New Thinking"). Moody's now has a negative outlook on the credit of 17 states, which means they could be subject to downgrades in the next 12 months and face significantly higher borrowing costs.

WHAT STIMULUS? Saddled with requirements that they balance their budgets each year, states are likely to resort to raising taxes and cutting spending -- both major drags on local economies. Hikes in taxes eat into discretionary spending by consumers. Cuts in spending inevitably mean layoffs. According to the NCSL, at least 24 states are considering tax-increase proposals, 12 states have cut higher education, and 9 have laid off state employees.

"By increasing taxes at the state level, everything Bush offers as fiscal stimulus is going to be more than offset," says Robert Smith, economist and president of fixed-income investment firm Smith Affiliated Capital. Many of these financial problems will inevitably get handed down to municipal governments, which will do things like hike fees and raise property taxes, also eating into consumers' discretionary income.

Even more worrisome for the long-term health of state and local economies, governments are resorting to measures like cutting education and health care, even shortening prison terms as a way to save money. That can hurt a state's long-term economic performance, says William Gale, an expert in tax and fiscal policy at the Brookings Institution. He thinks the best thing Congress could do now to stimulate the economy is provide states with additional aid. But with the federal budget deficit already soaring beyond expectations, that kind of help probably isn't politically feasible in the near term.

AGE OF ANXIETY. Policy experts as well as professional investors have long anticipated local governments' financial problems would worsen in 2003. But the magnitude of the economic impact is just becoming clear, now that governors and legislators are unveiling budget proposals and proposing painful cuts and tax increases. "We've all known it's out there, but people are just coming to grips with it," says Stephen Carpenter, who manages tax-free bond portfolios for Cleveland-based National City Investment Management.

For investors, the coming months of budget wrangling will add to the general climate of anxiety and uncertainty, says Trip Jones, a senior vice-president at investment firm Fulcrum Global Partners. For example, as a commuter into New York City, he worries that he may be subject to the huge hike in commuter taxes proposed by New York City Mayor Michael Bloomberg. "I'm saying to myself, 'How much are my state taxes going to go up? Is Bloomberg going to get me?'" says Jones. "It's that uncertainty that freezes you and creates inaction."

Beyond the macroeconomic effects, investors in tax-free bonds will feel the pinch of the ongoing squeeze on state budgets. "Obviously there's going to be more municipal debt, which means more supply on the market, which drives down prices and raises yields," says National City's Carpenter. The end result: Muni bonds on average are getting riskier.

TIME TO BUY? While some of this has already been factored into muni-bond prices, the market seems to be waiting to see how specific states deal with their own budget issues before reacting, says Eric Kelley, who manages fixed-income portfolios for UMB Trust Investments in Kansas City, Mo. "I haven't seen yields get pushed up in a meaningful way in response to this yet," he says. And so far, he doesn't expect any states to have major credit problems. Says Kelley: "What we're worried about is that a lot of this could get pressed downstream to local cities and counties."

Perversely, Smith believes municipal bonds are actually the most attractive area of the market right now, partly because inflation is so low and also because yields are high on an aftertax basis. But he suggests avoiding general-obligation bonds, which are paid out of tax receipts, and instead considering revenue issues (bonds for things like water and sewer or electric projects), since they have their own revenue streams and are safer. Either way, diversification across states and issues makes more sense than ever, says Kelley.

The broader economic drag of looming state tax hikes and budget cuts are tougher to diversify against. There may still be a light at the end of the tunnel for the economy and the stock market if conflict with Iraq can be resolved and some sort of fiscal stimulus package makes it through Congress. But the states' mounting fiscal woes are one reason that light isn't burning very bright right now. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

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