Confluence Of Risks Halts Positive Credit Momentum
The effects of the Russia-Ukraine conflict on global economic and credit conditions are becoming more pronounced, with the first few months of 2022 making a turn in positive credit momentum.
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The confluence of the Russia-Ukraine military conflict, nagging inflation and the prospects for higher interest rates, and the lingering pandemic mark a turn in the positive credit momentum of the past 14 months. But while downgrades are now outpacing upgrades, ratings remain resilient overall, and pressure is mounting unevenly
The effects of the Russia-Ukraine conflict on global economic and credit conditions are becoming more pronounced; widening spreads in major markets suggest investors are growing somewhat more risk-averse. Defaults look set to rise from historically low levels and could exceed our baseline forecasts (for 3% in the U.S. and 2.5% in Europe) by December.
Main risks include an escalation of the conflict or expansion of sanctions to gas and oil exports to Europe, or broader geopolitical tensions; central banks’ struggle to control inflation without choking economic growth, leading to higher borrowing costs (especially for lower-rated credits); persistent supply disruptions and high commodities prices squeezing profit margins; and new COVID variants.
Ratings have been resilient outside of countries directly affected by the conflict and the sanctions, and entities highly exposed to the surge in commodities prices. Many corporates started the year with stronger balance sheets, having taken advantage of two years of cheap funding to extend maturities, with the result that speculative-grade corporate debt coming due through 2023 has fallen roughly 40% since Jan. 1, 2021. Banks, including those in Europe, are also proving resilient, having significantly reduced their exposure to Russia following its annexation of Crimea in 2014.
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Overall: Borrowers in North America may soon see the run of remarkably favorable financing conditions come to an end as intersecting credit headwinds could result in pronounced downside effects. While the region is comparatively insulated to the effects of the Russia-Ukraine conflict, it is not immune to the fallout.
Risks: On top of heightened geopolitical risks and worsening cost pressures and supply bottlenecks, we see a high risk that investors could soon demand significantly higher returns. This could result in the repricing of financial and real assets, higher debt-servicing costs, and tighter financing conditions.
Credit: Credit markets have begun an about-face—kicked off by the aggressive tone of Fed policymakers and followed up by Russia’s invasion of Ukraine. Nominal yields on U.S. corporate debt have risen quickly, returning to pre-pandemic levels in less than three months, which has kept many issuers on the sidelines.
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Higher interest Rates: The interest rate outlook of Asia-Pacific is divided. China, because of its economic slowdown and limited inflationary pressures, has been able to lower interest rates. In contrast, most Asia-Pacific central banks have had or are poised to raise policy rates. Meanwhile, investors look set to seek higher spreads to compensate for higher risks. There has already been some investor risk aversion at the lower end of the rating spectrum.
Higher inflation: Higher energy and commodity prices, exacerbated by the Russia-Ukraine conflict, are increasing regional inflation pressures. The hit would be most keenly felt by the largest net energy importers (relative to GDP) of India, the Philippines, Korea, Taiwan, and Thailand; but it is a plus for the net energy exporters of Australia, Indonesia, and Malaysia.
Higher expenses: Corporates unable to pass through the higher input costs to consumers will see margin compression. Coupled with tighter financing conditions and risk repricing, the pain will be especially pronounced for highly leveraged industries and borrowers. These include small and midsized enterprises (SMEs) and households, which have yet to fully recover from the COVID-related economic shock of the past few years.
Confluence of headwinds: A combination of higher geopolitical uncertainty, cost inflation and accelerating monetary tightening by major central banks, together with China's property sector problems, is pressing down on regional and global economic growth. In more extreme scenarios, economic recession or stagflation could eventuate.
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Overall: The Russia-Ukraine military conflict is hampering already feeble credit conditions in emerging markets (EMs). Inflationary pressures were already denting corporations' margins and households' purchasing power prior to the conflict. Now the rising energy and food prices have intensified challenges, at least over the short term, because the potential for a severe confidence shock could weaken global demand and cool off prices.
Risks: Downside risks for EMs are significant. Additional inflationary pressures and persistently high energy prices could result from an extended conflict between Russia and Ukraine, especially if sanctions on Russia hit its hydrocarbon exports. EM sovereigns are struggling to deal with the pandemic costs, managing inflation, and meeting protracted social demands, a balance between fiscal consolidation and social strife. At the same time, financing conditions could weaken rapidly following the hasty U.S. monetary tightening or continued escalation of the military conflict.
Credit: Financing conditions have tightened amid rising volatility. Spreads have surged for EM corporates, particularly those in the EEMEA region. Investors are becoming more selective, while some low-rated entities may struggle to refinance their debt or raise capital if current market conditions persist.
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Overall: The invasion of Ukraine represents a seismic systemic shock to Europe and the world. The humanitarian crisis as well as border and energy security are critical short-term priorities. The political and economic repercussions will take longer to play out. They carry significant downside risks given the highly uncertain and volatile situation, even though the European economy and financial markets have held up well so far.
Risks: Energy security, further supply chain disruption, and amplification of existing inflation pressures are the dominant risks in light of the ongoing Russian invasion of Ukraine. Frontloading a monetary policy response to high inflation could lead to an excessive tightening in financing conditions. Barring a more severe variant, COVID-19 is now increasingly viewed as endemic in Europe.
Credit: Financing conditions are expected to tighten as European central banks focus on inflation even as the growth outlook slows. The 14-month improving trend in credit quality is likely to reverse, with cost input pressures to increasingly weigh on corporate margins through the year. We expect default rates to move higher toward 2.5% by year end.
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