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(Reuters) - Moody's Investors Service on Tuesday revised its outlook for U.S. states to stable from negative, marking a significant improvement in its assessment of state finances after cutting its outlook for the sector more than five years ago.
The rating agency said that the uncertainty surrounding federal budget cuts has diminished, revenue growth for many states has exceeded expectations, and budget reserves are continuing to grow.
Even as it marked better days for state budgets, Moody's warned the sector faces economic and fiscal risks.
Federal deficit reduction, especially cutbacks in government employment and procurement, could create an economic drag, while employment remains below its pre-recession peak, Moody's said. At the same time pension contributions will continue to squeeze budgets and "the regional divide in economic growth across the U.S. is delaying full fiscal recovery in some states," it said in a report.
The 2007-09 recession first hit state budgets in 2008, as revenue in almost all of the states plummeted to lows not seen for decades. States slashed spending, hiked taxes and tapped federal government aid. While the downturn was consistent, the recovery has been uneven. States rich in natural resources have bounded ahead of those hurt most by the bursting of the housing bubble.
This last winter, some states worried fights to shrink federal spending in Congress, which had resulted in across-the-board cuts known as sequestration, would put their improvements in jeopardy by slowing the economy and generating fiscal uncertainty.
"Certain indicators remain below pre-recession levels, but slow-but-steady economic recovery and more certainty regarding the impact of federal fiscal policy are improving the credit environment for states," Moody's said. "Widespread large federal budget cuts did not occur, which substantially eliminated the risk of a double-dip recession."
It added federal tax increases and restrained spending are likely to reduce 2013 gross domestic product growth "but have not measurably slowed job gains."
The stable national economy has translated into stronger state revenue, with tax collections growing for 13 straight quarters "largely driven by growth in the stock market and the resulting increase in income taxes," Moody's said.
That, in turn, is allowing states to replenish reserves, a key factor in determining their credit quality.
Moody's said sequestration, though, could have a delayed impact and states with a heavy federal presence such as Maryland and Virginia may see sales tax and employment declines.
Meanwhile, pension liabilities loom large. For years many states contributed less than actuaries suggested to their retirement systems, and during the recession they pulled back even more. At the same time, the financial crisis ravaged the primary source of pension revenue - investment returns, which have only recently improved.
"Despite better-than-expected revenue performance, pensions will continue to put outsized pressure on some states' budgets as contribution growth significantly outpaces revenue growth," Moody's found.
Moody's is also keeping an eye on regional disparities in economic recovery, saying "certain states in slow-growing regions are falling behind, which may create rating pressure."
Editing by Leslie Gevirtz