MOORLACH UPDATE — Judicious Budget — December 18, 2018

One of the joys of having managed a $7 billion investment portfolio of cash equivalents is that you become very familiar with the yield curve. On rare occasions, you get to observe what is known as an inverted yield curve. When you Google this phenomenon, here’s what pops up:

An inverted yield curve is an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession.

Inverted Yield Curve – Investopedia

The key observation or takeaway is an inverted yield curve “is considered to be a predictor of economic recession.” It doesn’t help when the stock market has been going down and that housing sales have gone flat. All three are signs that government budget officers should be taking into account when they make their forecasts.

Here’s a recent chart that shows recessions occurring directly after an inverted yield curve. The recession of the early 1990s impacted my practice. It even gave me a little bit of time to run for Orange County Treasurer-Tax Collector in 1994, when the country was exiting the downturn and the economy was starting to heat up. Federal Reserve Board Chairman, Alan Greenspan, then started raising short-term interest rates to cool down the potential for inflation, which then caused the Orange County Investment Pool to implode (see MOORLACH UPDATE — The Tarnished State — December 17, 2018).

Here’s a similar graph, although not current to today, that may be easier to read:

A phrase we used often is “the trend is your friend.” Well, you can see where the trend line is going from these two charts. So you can see why the editorial board for the OC Register and The Sun chime in with their words of caution in the piece below.

The best place to be before a recession is having high cash balances and liquidity. This will allow you to acquire goods at a lower price as the economic downturn provides distress sales that you can take advantage of. It’s also a good time for governments to build infrastructure, when builders are looking for work for their companies, and are willing to do so with more competitive bids.

It’s not a good idea to be maxed out on your debts when a recession arrives. You just may become one of those distress sellers as you seek liquidity to make the high monthly interest and principal payments. Regretfully, this is where most of California’s school districts find themselves.

The Los Angeles Unified School District just released its Comprehensive Annual Financial Report (CAFR) for June 30, 2018. The LAUSD Unrestricted Net Deficit for 2016 and 2017 was $10.5 and $10.9 billion, respectively. For 2018, it’s $19.6 billion. That’s what adding unfunded retiree medical liabilities to the balance sheet will do (see MOORLACH UPDATE — Masking Fiscal Problems — December 10, 2018).

The LAUSD balance sheet has a new line in the Liabilities section: “Net other postemployment benefits liability,” with an amount of $14,968,510,000.

School districts cannot technically file for Chapter 9 bankruptcy, as they are agencies of the state. The state has to step in and assist. But, in Sacramento, the cupboard is currently bare in the schools’ Rainy Day Fund. Let’s hope a judicious budget can be assembled between now and June. Our new Governor will have to keep the cupboards stocked. We’ll see the first version of his Budget on January 10th.


Newsom must follow Brown’s lead in budget judiciousness


Incoming Gov. Gavin Newsom and the Legislature’s Democratic supermajorities certainly have a lot going for them. But they must take the state’s budget and full financial circumstances seriously.

While much has been made of California’s budget surplus and the state of the annual budget relative to past budgets, this is a time for vigilance and greater fiscal restraint.

Last month, the nonpartisan Legislative Analyst’s Office released a report entitled “The 2019-20 Budget: California’s Fiscal Outlook,” which lays out long-term analyses of state spending.

While noting that “the budget is in remarkably good shape,” and that the state’s “longer-term outlook is positive,” the LAO rightly warns that “the state’s budget condition can change quickly.”

Though the state is projected to have reserves of $14.5 billion by the end of fiscal year 2019-20, as well as $14.8 billion in additional resources to allocate in 2019-20, the reality is that even a smaller recession could easily wipe out this situation.

The LAO itself notes that in November 2000, they projected a surplus of $10.3 billion in 2001-02. However, this projection didn’t translate in the real world.

With the bursting of the dot-com bubble, instead of operating with a $10.3 billion surplus, the state ended up having to contend with a $12.3 billion deficit.

With the U.S. economy now in the midst of the second-longest period of economic expansion on record, it’s inevitable that an economic downturn is around the corner.

To his credit, Gov. Jerry Brown has long made a point of underscoring the idea that California must set itself up as best it can to handle the next recession.

Setting aside the merits of any particular program or spending commitment, it hardly seems reasonable for the state to ramp up spending in the name of helping people if there’s a serious risk such programs would have to be dramatically cut off as soon as a downturn happens.

For his part, Newsom has indicated a commitment to continuing the approach of Brown.

“All of this will be whittled down and we all will live within our means,” he told the Sacramento Bee of Democratic spending priorities. “We’re not going to deviate from being fiscally prudent.”

While that probably sounds to most Californians as a common-sense notion, common sense often appears to be in short supply in the Legislature.

One legislator who rightly sees what’s at stake, Sen. John Moorlach, R-Costa Mesa, has noted that while the Democrats won’t need a single Republican vote to ram through a spending spree, the state’s finances are already in precarious shape.

Moorlach has released financial reports on state and local governments revealing just how imbalanced government balance sheets are across California. California’s large and rising pension obligations alone are a cause for concern and will be for years to come. When one adds in medical benefits for retired government workers, the bleak picture only becomes worse. Add in any economic downturn in the next year or two and things can get bad enough even with currently spending obligations.

Accordingly, we urge Newsom to back up his talk of restraint and keep the Legislature in check.


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