Special Briefing on the Outlook for 2026: How States & Cities Will Adapt to Wrenching Change

As a year marked by fiscal uncertainty and shifting federal priorities comes to a close, state and local governments are grappling with structural changes. For a discussion of how federal retrenchment, artificial intelligence(AI)-driven growth, and sharply rising municipal market borrowing market will shape state and local finances in the year ahead, Penn IUR and the Volcker Alliance convened a panel of experts for “Special Briefing on the Outlook for 2026: How States & Cities Will Adapt to Wrenching Change” on December 16, 2025.

William Glasgall, Penn IUR Fellow and Public Finance Adviser at the Volcker Alliance, and Susan Wachter, Co‑Director of Penn IUR, co‑hosted the Special Briefing. The panel included Torsten Slok, Partner and Chief Economist at Apollo Global Management; Matt Fabian, Partner at Municipal Market Analytics; and Eric Kim, Senior Director for U.S. Public Finance Ratings at Fitch Ratings.

Slok opened the discussion with a retrospective look at expectations versus reality in 2025: “We come from a year where the trade war was dominating all conversations. The fear was, in the spring and the summer, that the trade war would have dragged the economy down much more than it ended up doing.” Instead, he said, “we had the AI boom, we had strong spending on data centers, and strong spending also associated with the energy build-out.”

Looking ahead, Slok struck an optimistic tone: “The outlook for 2026 is actually beginning to look better and better. GDP growth will begin to accelerate over the coming quarters, and perhaps most importantly for this conversation and for muni bonds, the level of yields and the level of inflation are likely going to stay higher for longer, simply because we still have an inflation level that is at around 3%, not quite back to the Fed's 2% target.”

Wachter asked why consensus forecasts missed the mark: “The consensus was that trade was going to pull down the economy in 2025 and add to inflation in ways that it didn't actually.” Slok pointed to two factors: “Number one is that the tariffs that were announced on April 2nd were not the level of tariffs that ultimately were implemented. In other words, the magnitude of the shock that was hitting the economy actually ended up being a lot milder. Second, there were also significant tailwinds coming through AI. In summary, “the trade war was dragging things down, but at the same time, AI and data center build-out was pushing things in the opposite direction,” he said.

“We expect GDP over the next several quarters to begin to gradually increase from roughly 1.5% in the first quarter and then go up towards 2% in the middle of the year and 2.5% in the second half of the year,” Slok continued. Wachter asked how much of this growth could be attributed to AI versus the "One Big Beautiful Bill Act." “The Congressional Budget Office has estimated that the One Big Beautiful Bill will lift GDP growth by 0.9% in 2026,” said Slok, most of which he noted can be attributed to provisions on accelerated depreciation. “GDP normally grows around 2%, so if roughly 1% of that comes from the One Big Beautiful Bill, that's a very, very meaningful boost.”

Despite the overall positive forecast, Slok warned that “the biggest risk to this outlook is that it comes with a likelihood that the Federal Reserve will have to come back and raise interest rates again.” 

Fabian echoed Slok’s optimism about the economy and spoke about the implications of borrowing in the $4 trillion US municipal bond market: “I am optimistic that issuance will continue to grow. We think that there's going to be another record year ahead of us in 2026, as far as dollars of bonds sold. We think that the market will internally remain well lubricated, with nice flows of investor cash into the sector.” He pointed to strong credit performance: “Twenty twenty-five is still in the running to have the lowest number of municipal bond defaults since 2009 …  One of the reasons that's true is because inflation has elevated state and local tax revenues and helped paper over other potential challenges that have emerged.” 

Fabian summarized his outlook as “bullish on issuance, bullish on distribution, less bullish on prices.”
Fabian further highlighted structural changes in investor behavior, marked by a “transition to an almost entirely retail-oriented lender base of separately managed accounts and ETFs [exchange-traded funds], to a lesser extent. That kind of investor is buying bonds for income, for safety, much less about total return.” When Wachter asked how this new retail market emerged, Fabian credited technology: “They have scaled up tremendously fast. And they continue to colonize new sections of the market, new parts of the yield curve, new credit distinctions.” 

He also noted “ETFs in the second half of this year have also accelerated. We're at north of $40 billion of ETF inflows. That's double, at least, what ETFs have ever had before. It's roughly triple what active traditional mutual funds have brought in this year, and ETFs alone have taken down 7-8% of total issuance.” Asked by Wachter whether these trends will continue, Fabian replied, “There's plenty of room to run. There's enormous potential if bonds are cheap enough, if these programs continue to flourish and grow and are well marketed, and we don't have some sort of catastrophic blow-up.”

Kim offered a credit perspective shaped by both resilience and risk: “Our sector outlook for U.S. state and local governments in 2026 is neutral. We expect credit conditions to be generally in line with the environment we saw in 2025. That doesn't mean it's entirely benign, and it doesn't necessarily mean things will be easy.” He cited rising economic uncertainty. This “really ratcheted up with the Trump administration's sort of back-and-forth approach on tariffs, and the labor market has been thrown for its own loop. Part of that has been the federal government's pretty aggressive immigration policies.” 

Kim added, “The average monthly gain in jobs so far this year is the worst we've seen since the depths of the COVID-19 pandemic. One of our key credit risks is whether the effects of either tariffs or immigration policies escalate more than we anticipate and end up cutting much more deeply into economic growth. Another is the potential boom in AI-related investment, whether that slows down unexpectedly.”

Despite these challenges, “GDP growth has actually been surprisingly strong this year,” said Kim. “We had 3.8% growth in the second quarter of the year, and if you look at the Atlanta Fed's GDPNow model, they're estimating 3.6% growth for the third quarter of the year. Fitch's estimates are that the surge in IT capital spending accounted for nearly 90% of U.S. GDP growth,” he added.

Kim also flagged a major structural shift: “Another credit trend we've seen this year that we expect to continue [is] a shift in states' relationships with the federal government. It's a shift that pushes more responsibility and cost down to states.” The most visible example is the "One Big Beautiful Bill Act," also known as H.R. 1: “The bill included a number of new federal tax cuts and extensions of the 2017 tax cuts. It also included a significant amount of federal spending cuts. The biggest of those cuts were in two social welfare programs that are jointly managed by the states and the federal government, Medicaid and SNAP. The Congressional Budget Office estimates this will end up costing states about $14 billion annually. The other area of the federal-state relationship that we think is especially worth watching over the next year is around disaster and emergency response,” Kim said.

Even so, Kim stressed strong fundamentals as a positive indicator: “Our average rating for state governments is between AAA and AA+, or our two highest rating levels. State governments are coming into the year with dedicated operating reserves at historically high levels. The median rainy day fund balance was about 13% of general spending at the end of fiscal year ‘25, according to the National Association of State Budget Officers… We definitely see some choppy waters ahead for state governments, but we also think they're well positioned to weather the challenges with strong reserves.”

Kim added that “our house view is still for economic growth. We don't anticipate a recession…but there’s definitely risk there. We're anticipating 1.9% economic growth for 2026, picking up a little bit in 2027 at 2.1%.”

During the question-and-answer period, Glasgall questioned whether constituents will absorb the costs of federal retrenchment, citing a proposed Los Angeles County ballot measure to raise the local sales tax to compensate for losses in federal health care funding. Fabian replied, “State and local governments will have the option of backfilling federal spending withdrawals, and that is likely to happen in many cases. State and local taxes rising in order to help pay for this is a given.” Kim added, “There are going to be more challenges in having state governments really fill all the holes that are potentially going to be left.” Fabian called the process “long-term and messy…very inconsistent state-to-state, area-to-area. What the feds are doing is changing rapidly. What the states do in response will change more slowly.”

“Part of the problem is that states have gotten too small,” Fabian added. “States should probably be bigger so that massive federal changes in policy don't affect [states] to the same degree.” He pointed to “the resizing or right-sizing of states” as an important catalyst for municipal bond issuance. Wachter asked whether in practice this will differ across red and blue states; Fabian noted that both will grow regardless of political leanings.

Wachter then raised the topic of debt competition: “We're talking about the downsizing of the federal government, the upsizing of states. At the same time, the federal government debt expenditure is going up, and private debt is going up as well. Does this not have some impact on the cost of debt for munis?” Fabian agreed: “It's incumbent on states to think about this now, and locals to think about this now. This is the prospect. There's an emergent cost curve that we should be borrowing.” Kim added, “From a credit perspective, the other thing we think about is the fiscal constraints on the U.S. government itself. It's going to be less likely and less able to step in and provide the kind of backstop we saw in the prior recession during COVID, during the GFC.”

Glasgall closed on a note of cautious optimism: “To paraphrase [Supreme Court] Justice Louis Brandeis in the 1930s, states are the laboratories of democracy. We're going to see different solutions emerge. AI is going to be part of this in delivering services. We're going to see different ways to deliver services at a lower cost… There are going to be a lot of opportunities for experimentation and creativity.”

This Special Briefing was the latest in a series of 60-minute online discussions featuring distinguished guests from Penn IUR and Volcker Alliance’s national research networks, along with other leading academics, economists, and federal, state, and local leaders. These convenings are made possible by funding from The Travelers Institute, members of the Penn IUR Advisory Board, and the Volcker Alliance.
 

Moderated by William Glasgall, Volcker Alliance Public Finance Adviser and Penn IUR Fellow, and Susan Wachter, Co-Director of the Penn Institute for Urban Research and Wharton Professor of Real Estate and Professor of Finance, this briefing is the sixty-fourth in a series of sixty-minute online conversations featuring experts from the national research networks of the Volcker Alliance and Penn IUR, along with other leading academics, economists, and federal, state, and local leaders. 

Special Briefings are made possible by funding from The Travelers Institute, the Volcker Alliance, and members of the Penn IUR Advisory Board. Recordings of the entire Special Briefings series are available on the Volcker Alliance or Penn IUR websites. 

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Related Materials

• Fitch summaries of Eric Kim’s papers: 

  U.S. States, Locals Face Shifting Headwinds with Strong Resilience

  Federal Spending Cuts Push More Fiscal Risk to State, Local Governments

• State outlook paper from Geoff Buswick at S&P Global (free with registration): 
  U.S. States 2026 Outlook: As States Face Widening Challenges, Their Actions Likely Will Uphold Credit Stability

• Torsten Slok's Daily Spark