U.S. President Barack Obama
President Barack Obama said that Iran can have a civilian nuclear program if it promises never to have a military one, the Washington Post reported. Reuters

Fitch Ratings says challenging times will continue for U.S. states, but fundamental strength remains. Among the 43 states Fitch rates, 38 carry a stable outlook. The stable outlook for the entire sector reflects the recurring budget measures that most states took this year and the expectation of their continued commitment to budget balance amid slow economic and revenue recovery.

This is an improvement from the negative outlook Fitch assigned in 2011, when there was tremendous uncertainty as federal stimulus funding was expiring, new governors had been elected in more than half the states, and the political composition of many state legislatures had changed.

While state budget gaps will be smaller in 2012, Medicaid -- the second largest expenditure item for state governments after education -- will become a key issue.

"Medicaid will present the biggest budget challenge for states in the coming years, in addition to other spending pressures such as pensions," Fitch analyst led by Laura Porter wrote in a report Wednesday. "The rate of growth of these programs has been well above that of the states' revenue streams."

Although states have been focusing on controlling Medicaid cost, options are limited by federal mandates. The status of the Obama healthcare bill also remains an additional point of uncertainty.

Medicaid funding is protected from the automatic cuts that are to start in January 2013 following November's failure of the congressional super committee.

"In the current anti-tax environment, budget balancing has been weighted towards spending control rather than revenue increases," analysts wrote. Fitch expects this to continue to be the case in 2012, which means that service providers, such as school districts and healthcare providers, are unlikely to see much growth in funding even after significant cuts this year as the federal stimulus funding expired in June.

Spending from these emergency funds totaled $61.1 billion in fiscal 2010, dropping to $50.3 billion in fiscal 2011, and is expected to fall to a minimal $3 billion in fiscal 2012 with the phase-out of the program, according to a survey jointly produced by the National Governors Association and National Association of State Budget Officers.

California and Illinois have the lowest ratings among the states Fitch covers -- both two notches below the top investment grade -- which indicates they are much more sensitive to changes in the economic conditions.

Overall, Fitch believes most states will be able to stay within their budgeted fiscal 2012 spending levels.