COVID paradigm shift a credit positive

HilltopSecurities’ Tom Kozlik updates his 2022 outlook for the public finance industry, raising his outlooks on the state and local governments and school district sectors to positive and sees an overall better environment for munis in 2022. Lynne Funk hosts. (32 minutes).

Transcription below:

Lynne Funk: (00:03)
Hello, and welcome to another bond buyer podcast. I’m Lynne Funk Innovation Editor at The Bond Buyer. And today I’m happy to welcome Tom Kozlik, head of municipal research and analytics at HilltopSecurities. Welcome, Tom.

Tom Kozlik: (00:15)
Hi Lynne. Thanks for having me. I appreciate it.

Lynne Funk: (00:17)
Great to have you. You recently revised your 2022 Outlook noting a COVID-19 paradigm shift. Why was it important enough for you to revise your 2020 outlook so shortly into February?

Tom Kozlik: (00:32)
That was a really big deal for me. I wouldn’t say that I was necessarily struggling with what was happening, but I was really trying to figure out in the month of January, how things were going to play out. And what I mean by that is at the beginning, the end of November, the beginning of December of when it is that we published our 2022 outlook, and that was also right around when the Omicron variant was evolving and developing. The medical community at the end of November and the beginning of December was saying that Omicron was going to be more contagious, but less lethal. And statistically, that was definitely true. And it’s proved to be true even now that we’re in the middle of February. But one of the things that I was watching in the end of December, the beginning of January, is that although the number of cases was rising substantially above where we saw in any of the other waves, including Delta, the number of death was also rising substantially.

Tom Kozlik: (01:45)
The number of deaths rose to a point over where Delta was. The number of deaths per day for Delta were at peaked out at about 2,000 a day. And the Omicron eventually peaked out about two weeks ago at 2,600 a day. When they were on that upward trend, what I was wondering is how policymakers, how that medical community was going to react. Was there going to be another wave of shutdowns that would then have a negative impact, on the economy and economic growth? Even though the number of deaths continued to rise, one of the things that we saw was that lawmakers, policymakers the medical and healthcare community, they were not doing things that were leading me to believe they were going to take steps that would have a negative economic impact.

Tom Kozlik: (02:49)
And so when I finally was comfortable enough to say, okay, now there’s a paradigm shift with COVID. There is now a situation where, how not just markets and investors, but policymakers and health experts, are viewing the COVID impact. And I came to the conclusion that society is being is gonna have to begin to chart a different course of what normal life is gonna look like. And I, I’m not saying that COVID is over, and these folks are not saying that COVID is over, cuz it’s not over, but there’s a new era of COVID that’s beginning, beginning. Now I think that, you know, even though the CDC guidance and the guidance from the federal government hasn’t necessarily changed all that much, what we were absolutely seeing is that the medical and science community was shifting and opinions from policy makers were starting to shift as well.

Lynne Funk: (03:47)
Right. We spoke since you published the report on Feb. 7 that several governors have already announced that they are or plan to scale mask mandates. Is that part of the new paradigm you wrote about and what is it that happened in your opinion that caused the medical and the health communities kind of to shift?

Tom Kozlik: (04:10)
Yeah, so throughout, not necessarily in December, but since the beginning of January, there was the acknowledgement, I guess I would say that there’s a different landscape. And what I mean by that is, where we are, where we were in January of 2022 compared to January 2021, it’s much different. January 2021, vaccines were just coming online. Almost no one was vaccinated. Now a year later, 50% of the world and 64% of the U.S. is considered fully vaccinated. There’s also a decent level of natural immunity that’s been building because of what’s happened during the different waves. And I think that I understand that people are just tired of COVID for sure. I don’t think that the medical community, I don’t think that policymakers are, are doing this just because of political reasons or just because society is tired.

Tom Kozlik: (05:15)
I think it’s because the landscape is different. There are those defenses that I just talked about, the vaccination levels are pretty high and the vaccination levels also for those who are most in danger of COVID are higher. For example, those over the age of 60 or 65, the vaccination levels are above 90%. And so the landscape is much different now. And I think that that’s why it is that folks in medical community and policymakers are able to even consider making such a significant shift.

Lynne Funk: (05:50)
I want to ask you about the golden age of public finance. That was something you wrote last year and in your previous version of 2022 outlook. December and January were quite a scare, but how has the golden age been impacted by all of this?

Tom Kozlik: (06:12)
I think in a lot of ways, and, or in most ways, I think the at the golden age is being strengthened by this paradigm shift. And the reason why is because I’m remembering about two weeks ago when New Jersey governor Phil Murphy was on Meet the Press, and he said, ‘we’re not gonna manage this to zero. We have to learn to live with this.’ And then a little over a week later, Gov. Murphy announced that he was going to be lifting the state’s mask mandate. Again, that doesn’t necessarily mean that mask mandates or the importance of masking might not come back, or that it won’t exist if there are changes in what happens with additional variants in the future. But that was an indication to me that policymakers are very well starting to learn about what it is that the reality going forward needs to look like.

Tom Kozlik: (07:02)
And that is not necessarily going to have a negative economic impact every couple of months. One of the things that was very telling to me was the January jobs number. Not only was it positive, but it surprised a lot of people to the upside. And that is also reinforcing to me, the fact that folks are learning to live with and trying to figure out what this new normal is going to look like. I think that the golden age of public finance — that’s a concept or a theme that I started talking about last year, mostly because of the significant amount of federal relief that started to flow to state local governments. And I say started to flow because it’s still flowing. There was $350 billion for state local governments, about $130 billion for school districts, all in, I counted about $650 billion of federal relief for the public finance sector.

Tom Kozlik: (08:05)
And so this is one of the big reasons of why it is that I said that there’s a golden age of public finance. I can’t necessarily put my finger on exactly how long it’s going to last, because I think it’s going to last for a shorter amount of time for the state local governments that were more structurally imbalanced before COVID, but even those structurally imbalanced entities have got a significant amount of federal relief that are going to help them at least over the next year or two. And there are a few sectors, I think, that are going to remain at risk even in this new paradigm, because those are going to be the sectors that are still going to be the most impacted by the ups and downs that we’re likely to see there.

Tom Kozlik: (08:54)
We don’t know what the next variant is going to be this summer. We don’t know what the variant is going to be next fall, but what we should have learned over the last two years is that this virus evolves and the variants evolve. And it is very likely that we’re going to see additional variants evolve into, into the summer, into the next year. And so I think that there are sectors, some local governments that are going to need to evolve. Remote work is here to stay. And I think that this is going to impact some center business districts and related economies.

As a result, healthcare is going to be on a different cycle and healthcare capacity could be at issue during these ups and downs. Areas of the transportation sector, such as mass transit, is still likely to take even longer to get back to some kind of pre-COVID levels. And there’s going to be a lot more up and down where mass transit’s concerned. So there are gonna be some sectors that are gonna remain at risk, but for the part, I think this golden age of public finance that I’ve been talking about is going to be strong going into 2022.

Lynne Funk: (10:02)
Do you think, perhaps that if you wanna take the comparison to the last real crisis and for state and whole governments, was 2008-2009, the Great Recession. Is it a testament to the federal government stepping in this time around that’s making state credit and all these different sectors that are at risk actually so much stronger than what they faced last time around?

Tom Kozlik: (10:26)
I’d say it’s a combination of the extraordinary fiscal relief coming from the federal government, but I would also say that it’s one of the reasons of why it is that state and local governments were hit so hard after the great recession is because of the impact to the housing market. Home values took a huge hit almost across the country. Some were hit harder than others, but home values were hit. Property taxes were hit significantly. I’m remembering, not just for a year or two, but for several years, state and local governments were dealing with difficult budget situations. And one of the big ways that they dealt with their budget situations is that they cut a lot of workers. The number of state and local government workers didn’t bottom out for several years until after the Great Recession.

Tom Kozlik: (11:25)
Some of the ways of how state local governments experienced the last crisis is different this time around revenues, they weren’t as negatively impacted this time around as they were last time. I think that is an important distinction. And then on top of that, we’ve got this extraordinary fiscal relief. And so that relationship is one of the big reasons of why it is that I think that this federal relief is one of, it’s not just one of the big stories of 2021 and 2022, but very well could be one of the big stories of the decade for public finance.

Lynne Funk: (12:05)
So you also raised your outlooks on state government, local government and school district sectors in your up your update. So tell us why and what you see for public’s finance rating agency activity in 2022 now.

Tom Kozlik: (12:18)
Yeah, we did. We raised our outlooks for state government, local government schools, school districts, to positive from stable, and those moves are directly related to what it is that we expect to see from the rating agencies in 2022. And, and kind of along the lines of what you just asked, it’s going to be a much different situation coming out of the COVID crisis, compared to what we saw coming out of the Great Recession. What I’m expecting to happen in 2022 is that public finance upgrades are likely to outpace downgrades, and in certain sectors and geographic areas, probably at a pretty significant pace. This is very different than what we saw in the wake of the Great Recession. That dynamic, downgrades outpaced up upgrades for years. It wasn’t until 2014 or 2015, if I remember correctly, that upgrades finally started to outpace downgrades. I mean, it was years. The fact that this year and most likely next year, upgrades outpacing downgrades is definitely part of this golden age of public finance, this strong recovery from the initial waves or the initial uncertainty of COVID. And I think that that is likely to be the case, definitely going to be the case this year, most likely next year, after that we’ll have to see.

Lynne Funk: (13:43)
I think I just read this morning that Moody’s sent out their 2021 report and they had 817 upgrades versus 307 downgrades in 2021, which was obviously a reversal from 2020, when downgrades topped upgrades, they said for the first time, since 2014. So sounds about, right. I want to ask though, with all of this federal aid with much better-than-expected tax revenues, really putting state and local governments, but state budgets in part are in a much better situation than probably anyone expected. Do you have any concerns that perhaps we’re overlooking some underlying concerns that maybe because everybody’s sort of just feeling this, this relief? We’ve hit a turnaround point and, and issuers are flush with cash. And I guess, for a very roundabout way, are there any concerns that after this aid runs out after, it’s gone, will they still be in a better position than they were post-great recession?

Tom Kozlik: (14:53)
So I think that one of the things we need to remember is that state governments, for example, after the Great Recession, for the almost 10-year period after the Great Recession until COVID began, there was, I describe an unprecedented level of credit deterioration of the state sector. Now the general state ratings were still pretty strong, but there were a handful, a small handful of meaningful states that were experiencing multi-year structural imbalances and their ratings were downgraded more than one through that decade. And one of the big reasons of why some of these states were experiencing those multi-year structural imbalances was pensions. The pension issue is still out there. The situation that we’ve experienced over the last two years has bought some time for not just the state, but the local governments, that were experiencing budget issues, as a result of rising pension liabilities.

Tom Kozlik: (15:59)
But without those entities addressing those multi-year structural imbalances, those situations will loo as bad, if not worse, once the dust settles on the federal relief. Now we’re still a year or two away from that situation. So they have time to get their fiscal houses in order, but that is one of the big things that I am thinking about. I’m trying to figure out what these budgets are going look like going forward, and are they going to take strides and use the situation that they have now to improve their fiscal standing and not go back to where they were prior to the COVID crisis.

Lynne Funk: (16:47)
That was a very good answer to my super long-winded question that should have just been, ‘are you worried about pensions still?’

Tom Kozlik: (16:55)
A lot of folks say pensions are a medium- to long-term issue for state and local governments. And for many, if not most, they are a medium- to long-term issue. But for a handful of meaningful and large state and local governments, it is a short- to medium-term issue.

Lynne Funk: (17:21)
We’re gonna take a short break, but we will be right back. And we’re back with Tom Kozlik of HilltopSecurities.

So then another question that I have is, we’re hearing now of quite a few states that are cutting taxes in various ways. Some of them are grocery taxes or actually income tax rates. What are your thoughts generally on that move right now? Is it something that they should be doing or should wait until there’s a clearer picture of the economic recovery, as it’s a little bit harder to reverse income tax rates in a couple years, as opposed to maybe a short-term fix of a cut and spending or per se.

Tom Kozlik: (18:06)
Yeah. I think that there’s a lot of nuance where budgets are concerned and revenues are concerned. I think that one of the things that states are going to be really concerned about going forward is their competitiveness. And I think that is partially going to be a result of this remote work evolution. People aren’t necessarily going to be as tied to a specific metropolitan area or a specific region, or they might not necessarily have to be as close to a world headquarters as they might have been pre-COVID. So I think that the idea of competitiveness is going to be something that a lot of state and local governments are going to be really continuing to look at, especially as we’ve seen states like Texas and Florida really take advantage of their tax structure; not only their tax structure, but the situation over the last year or two.

Tom Kozlik: (19:09)
And we’ve seen migration patterns favor states like that. Now from a credit perspective, if states are making decisions that are going to keep them competitive, I would think that they would also be making decisions to make it so their budgets are going to be remain fiscally balanced and structurally balanced, right? So as long as those tax policy decisions aren’t negatively impacting credit, then it’s a more of a policy and not necessarily a credit concern. It’s going to have a policy impact and if it makes so a particular state is more attractive, then maybe they end up having more residents move to that particular state of that particular region because of the policy. And for that reason, maybe it’s a credit positive. That being said, I am definitely on the lookout for situations where tax policy might have a credit negative impact.

Tom Kozlik: (20:14)
And if all it does is lower revenue, lower revenue is not just on the near term, but in the medium term. I agree with what it is that you just said in that oftentimes it’s difficult to raise those taxes after they’re cut and it’s not like it can’t happen. It can happen. We’re experiencing right now on the one hand state revenues for the most part look pretty strong. But they look pretty strong because there’s been some pretty significant stock market returns over the last couple of years. There’s been an increased amount of spending on goods that are taxable. And, you know, there, we might have seen an increase in those types of revenues. And so what I’d be concerned about is in, as we get a few years away from where we are now, if those revenues aren’t quite as strong and the projections that those lawmakers were looking at for their budgets don’t, they’re not quite in sync, then there could be a situation where the budgets are imbalanced. Even though that that’s not what they were expecting. So a fiscally or structurally balanced budget is really what it is what I’m looking for. And you need to, you can’t just say that cutting taxes is good or cutting taxes is bad. It’s one tool in the budget toolbox.

Lynne Funk: (21:44)
Of course, of course. So, you know, we we’ve talked about the direct federal aid. How about the Infrastructure and Jobs Act playing out at this point? It does appear that that Build Back Better is just really in the back, back, back burner. But what about the infrastructure act? What does it mean for the public finance industry?

Tom Kozlik: (22:04)
So the the bipartisan infrastructure plan became law in November of last year. And I agree with you in that it seems like the Build Back Better social package gets mentioned every once in a while. There are some articles about [Sen. Joe] Manchin saying one thing or another, but after the inflation number came out last week, Manchin put out a press release saying that the inflation tax is something to be watched. And it’s something that he’d been fighting for for months. And so I am not inclined to think that Build Back Better is going to resurface. And I am not inclined to think that Build Back Better is going to be able to get done in bits and pieces, because the only reason that Build Back Better was likely to materialize at all was because it was gonna be done through budget reconciliation.

Tom Kozlik: (23:01)
So I don’t think that that’s gonna go anywhere, but as far as the infrastructure package is concerned, you know, there are some who are talking about that infrastructure package — and just remind folks who are listening — there was a little over a trillion about $1.2 trillion that were included and about $550 billion of it was new spending. And the majority of that new spending, I should say about $110 billion of that new spending, was going to be on roads and bridges, and then some other bits and pieces in other areas like water. But the fact of the matter is that that $500 billion of new spending is really not all that much, especially when you’re talking about new spending, that’s going to be, it’s gonna be spent over a five-, if not 10-year, period of time. I saw a Moody’s Analytics table that was taking into account all of the money from that infrastructure bill.

Tom Kozlik: (23:54)
And there wasn’t any one particular year where spending top $100 billion dollars. And so it is going to add some to economic growth this year. And then the next couple of years, I’m not saying it’s not going to add to economic growth, but I don’t think that the bipartisan infrastructure plan was really all as much as transformative as what a lot of people are saying.

So I think there are going to be projects that are going to materialize as a result. When I put together my issuance projection for 2022, the money from the bipartisan infrastructure plan didn’t really factor into me increasing the overall issuance for 2022. But I also don’t think that as a result of the infrastructure money, or even the federal money that came, that’s coming to state law governments through the rescue plan act, I don’t necessarily think that those issuers are going to hold off on issuing bonds because of that federal money or because of the infrastructure money.

Tom Kozlik: (25:08)
And, and part of it is because I think there are certain things that bonds help to build. And I think that the more short-term type money that state and local governments are getting in that from the rescue plan relief, it’s gonna be different. It’s going to be used for different purposes than what those entities would be selling bonds to build. So that’s a long way of saying I think that the infrastructure plan is definitely going to add on the margin to economic growth, but I’m not expecting it to be a huge market in the public finance world.

Lynne Funk: (25:49)
And remind me, Tom, your projections for issuance in 2022 are $475

Tom Kozlik: (25:53)
$495 billion this year.

Tom Kozlik: (26:04)
I was to the high side. January issuance was below January issuance of last year and below the nine-year average. Starting right there, it’s going to be hard to beat what we saw in 21 or 20. That being said, one of the things that I really have seen over the years be something that helps to drive issuance is really where economic growth is. And if economic growth is above average, or if economic growth is pretty strong, then that usually bodes well for issuance.

Lynne Funk: (26:52)
So do you think given the market volatility to start this year. One of the things about taxables is why January was so low. Because refundings were so low, because of the rising interest rates, do rising interest rates have any real bearing on issuance. Do you think some issuers might hold back as the year progresses because of this?

Tom Kozlik: (27:16)
So I think that there are a couple of items to consider where refundings are concerned. I do think that for some time in the last half of 2021, there were some folks who were thinking that they might be able to get back the ability to use tax-exempts for advance fundings. I really do think that there were some folks who were optimistic. I wasn’t very optimistic that they were going to be coming back, even going back to July of last year. I think that now we’re now that we’re into 2022, and now that we’re in a situation where interest rates are likely to continue to rise and rise quickly, I would be surprised if issuers do not choose to execute refundings or advance refundings, if they make financial sense.

Tom Kozlik: (28:18)
And I think that just intuitively as rates rise, there’s going to be as situation where there are going to be less taxable refundings that are going to make economic sense. A lot of that depends on how fast rates rise and that’s one of the things that the market is trying to figure out as we speak. They’re trying to figure out what it is that the Fed is going to be doing. I think there was a decent, there was a higher than average amount of noise, in January, partially because of questions about what the Fed is likely to likely or not likely to do the market doesn’t necessarily have all of the answers now. But I think that we are going to be in a situation this year where we’re not going to see more refunding activity. It’s probably going to be around the same level, if not a little less than what we’ve seen in years past.

Lynne Funk: (29:20)
Right. It was definitely not a quiet start to the year. So I guess Tom, is there anything else I haven’t asked you? Do you want to chat a little bit more about the rest of 2022 and where you see this golden age headed?

Tom Kozlik: (29:38)
I think that the golden age is something that … well, let me talk through what it is that I was thinking during Omicron, because as Omicron in the middle to the end of December hit, one of the things that I was really considering is: what kind of threat that COVID, and the Omicron variant, was going to pose to this golden age that I’d been talking about since March of last year.

Because like I described, if there was a situation where we saw another wave of shutdowns and or if we saw policymakers or the health or medical community really start to clamp down, and then if there wouldn’t be, and I don’t think that there would likely to be a significant amount of federal relief on the other side of another wave of shutdowns, then the golden age would’ve been threatened in my mind. We didn’t see those types of shutdowns.

Tom Kozlik: (31:34)
But the fact of the matter is that something like that could happen this summer. Something like that could happen at the end of this year. And what I mean by something like that, maybe there’s a situation where a change is needed and vaccines are going to have to get rolled out. Maybe there is a situation where something close to the shutdowns that we’ve seen in the past occur again. But as of right now, it seems like, wow, that’s a slight possibility. It seems like this new paradigm is something that is evolving and people are learning to live with and in this new COVID era. As of right now, the way that I’m seeing the landscape evolve is that this is going to this going to be a situation where this golden and age of public finance, unless things change, it is likely to continue this year.

Lynne Funk: (32:31)
Tom, I hope you are correct

Tom Kozlik: (32:36)
As do I.

Lynne Funk: (32:37)
And I look forward to seeing you in person in Austin, Texas, in late March.

Tom Kozlik: (32:45)
That’s right. We’ll see you soon.

Lynne Funk: (32:46)
Yeah. See you. Tom Kozlik, thank you so much for all of your insights. Really appreciate your time. And thanks again.

Tom Kozlik: (32:58)
Thanks very much for having me, Lynne. I appreciate it.

Lynne Funk: (33:01)
Thank you for listening to this Bond Buyer podcast. I produced this episode with audio production by Kellie Malone. Special thanks this week to Tom Kozlik of HilltopSecurities. Rate us, review us and subscribe to our content at From The Bond Buyer I’m Lynne Funk. And thank you for listening.


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