With the deficit in the United States now over $22 trillion, there may come a day when deficits and credit actually matter again. Until then, Europe and Japan are operating under the belief that negative interest rates are stimulative, and the U.S. Federal Reserve seems to be in the position in which it wants to cut interest rates much slower and by less than the financial markets are hoping for.

What if public sector finances become a serious issue that U.S. leaders actually have to deal with? An economic downturn will come one day, and the financial media was touting the use of “recession” in every headline and news flash they could work it into. When the real risks start to arise is when borrowing costs rise or if the deficit spirals during and economic downturn. Historically, governments cutting spending (think of European austerity measures in the recent past) is bad for the economy while it is happening.

Fitch Ratings has issued a report showing how elected officials could feel pressure to lower their spending during a downturn if it came with higher borrowing costs to correct higher deficits. This could pose a challenge to segments of the U.S. economy that are reliant on federal government spending and outlays. If that were to occur, Fitch believes that it could broadly influence credit quality in a number of sectors from U.S. public finance, down to financial institutions and even industrials.

Why this matters today is that federal debt projections have been continually increasing in recent years. That is also a time when there has been a record-breaking recovery and an expansion period of 10 years since the Great Recession.

Fitch pointed out that the U.S. general government debt is already the highest (nominally) among all AAA-rated sovereigns. The group’s debt sustainability analysis shows that the general government debt could exceed 120% of gross domestic product by 2028, citing gradual increases in borrowing costs, wider deficits and average growth running under the 2% potential growth rate for the United States. All this adds up to a challenging environment for federal spending under worsening fiscal dynamics.

The trickle-down effect could come down to states, counties and cities if things become too pinched. Fitch showed that federal transfers down to states and local governments were 18% of all federal outlays in 2018. This poses a risk for state credit profiles.

States are dependent on federal funds in health care for Medicaid as the largest portion of federal transfers to state and local government. Fitch’s report noted:

It also is a major factor contributing to the variation in states’ dependence on federal transfers as a source of revenue. Even though Medicaid is a mandatory congressional appropriation, meaningful changes to its funding structure cannot be ruled out over the long term, which could reduce overall federal Medicaid funding and raise fiscal burdens on states that choose to offset federal declines.

Fitch also showed that state operating budgets are structured to fund services provided by lower levels of government, rather than the state government offering those services directly. While this offers flexibility, it also is a key risk for local governments and related public enterprises.

Education also could suffer. Fitch warned that higher education has typically been targeted by states experiencing fiscal challenges. States were shown to have lowered support for public universities through the Great Recession and its aftermath, and local school districts usually rely on state funding as the majority of the state-to-local transfers.

Fitch has not downgraded state, county, city and local credit ratings based on the report, but it has been a while since there have been many reminders about state and local credit ratings would hold up under a federal squeeze. Fitch also warned that the recipe for state and local governments to maintain their existing ratings, those localities would need to “demonstrate their ability to manage through a federal deficit reduction in a manner that retains an appropriate level of financial flexibility.”

On a larger scale, Fitch believes that federal budget decisions would be less of a direct risk for government-sponsored enterprises. Fannie Mae and Freddie Mac were named, as were the Federal Home Loan Bank System and the Farm Credit System. The report said:

Federal loan programs channeled via private-sector U.S. financial institutions would be at risk to the extent that a downturn increases net subsidy costs to the government. While income from this activity is negligible for large and diversified lenders, it may be more significant for smaller institutions.

As far as the view of 24/7 Wall St., this probably feels too soon to expect a panic about the future of a runaway debt scenario and its trickle-down effects for states, counties, cities and other entities that rely on federal funding. That said, savvy investors have to be thinking in terms of many years ahead when they are making decisions based on most fixed-income investments and how to allocate their investments at any given time.

The media flaunted a “recession” watch as being imminent for long enough that many people might have assumed times were already tough. One thing that seems to be a common view today is that the next recession will be more of a “garden variety” type rather than a repeat of the Great Recession.

What if the next recession happens to arrive and the policy changes from Washington, D.C., come with a retooling and redirection of the entire economy and the entire tax system at the same time global growth slowing continues? If that were the case, the negative trickle-down effect of a federal outlays to the state and local level could arrive much sooner than most investors would have been braced for.

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