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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Sharp monetary tightening puts a brake on global growth: Central banks are reversing their relaxed policy stance in response to continuing cost pressures in global supply chains, amplified after Russia's military actions in Ukraine destabilized energy, food, and other key commodity markets. As economic growth slows and financing conditions become tighter, we see a risk that sharply higher interest rates, persistent inflation, and renewed consumer caution will push the U.S., and potentially Europe, into a recession, most likely in 2023.
Inflation, energy security, and geopolitical uncertainty are the chief risks. Persistent supply-side price pressures in the food and energy markets may fuel broad-based inflation, and the evolving repercussions of the Russia-Ukraine conflict could undermine global trade and economic growth. Other notable risks stem from governments prioritizing energy security and affordability over sustainability in the short term. .
So far resilient rating trends will be under pressure heading into 2023. The strong postCOVID recovery through Q1 has left many corporates with robust earnings and favorable refinancing profiles after two years of cheap money. Yet, falling real incomes and a higher cost of living could dampen consumer demand and make it more difficult to pass on rising input costs, eroding margins. Combined with tougher financing and operating conditions, businesses, especially the most vulnerable, are likely to start feeling some strain later this year. We expect U.S. and European default rates to double to 3% in Q1 2023, potentially reaching 5%-6% in a downside scenario.
Our new Credit Cycle Indicator (CCI) signals potential heightened credit stress globally in late 2022 or early 2023 with some variations in sensitivity between corporates and households.
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Overall: The run of remarkably favorable financing conditions has come to an apparent end, and there’s a growing risk that sharply higher interest rates and persistent inflation, combined with renewed consumer caution, will push the U.S. into a recession, raising the possibility credit conditions will deteriorate even further.
Risks: A further slowdown in economic activity could roil credit markets and result in the repricing of assets, higher debt-servicing costs, and even tighter financing conditions. If borrowers’ cost pressures don’t ease—or if inflation weighs heavily on confidence and demand—profit erosion could become more widespread and steeper than we expect.
Credit: For now, credit quality is proving resilient. But we see signs of demand deterioration in the most price-sensitive sectors, such as consumer products and retail. We now expect the U.S. trailing-12-month speculative-grade corporate default rate to reach 3% by March 2023, more than double the 1.4% in March of this year, with risk weighted to the downside.
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Double blow. Asia-Pacific issuers are suffering from increased costs and a sharperthan-expected economic slowdown in China. Sticker shock is coming not just via higher input prices (compounded by weaker currencies) but also higher borrowing costs.
Costs heighten. Commodity, energy, and food price inflation are pressing on revenues and profit margins. Households have a limited capacity to absorb even higher prices, curbing corporates' ability to pass on higher input costs. Asia-Pacific central banks, except for China and Japan's, are raising or poised to raise policy rates. Spreads are widening. Speculative-grade issuers are finding it more difficult to refinance.
China growth tightens. China's on-and-off lockdowns of cities have hit economic activity, in particular mobility dependent sectors. Pain in the Chinese real estate sector could persist as sales slow. We have cut China's GDP growth in 2022 to 3.3% from our previous 4.2%.
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Overall: Credit conditions in emerging markets (EMs) will likely worsen, given persistent inflationary pressures, tightening financing conditions, slower growth in China, and the potential for a recession in the U.S. Inflation is not abating and its effects on EM households, corporations, and banks are yet to surface. So far, households and corporations have been able to manage higher prices thanks to fiscal and monetary stimulus, as economic activity resumes amid the ebbing effects of the pandemic.
Risks: A protracted Russia-Ukraine conflict will likely keep pressuring prices, especially those of food and energy, through the year and potentially into next one. Price pressures for the next year are already accumulating. We expect that ongoing fertilizer shortages, harvest disruptions in Ukraine, export controls, and escalating fuel and transport costs will exert upward pressure on food prices next year. U.S. monetary tightening is already faster than expected. In our view, as high prices linger, the Federal Reserve will likely be aggressively increasing its rates in an effort to tame inflation. These conditions not only raise market volatility but also tighten overall financing conditions for issuers across EMs, as investors' risk aversion grows. Furthermore, at current speed, monetary tightening has the potential to lead the U.S. into a recession, which would hurt global growth and trade, leading to knock-on effects for EMs.
Credit: We expect our negative bias for rated issuers across EMs to increase over the coming quarters as rising interest rates, stubborn inflation, and weakening demand have the potential to erode corporate profits, households' purchasing power, and banks' asset quality. Few issuers will benefit from the complex panorama, mainly commodity exporters.
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Overall: A rapid deterioration in global macroeconomic conditions, combined with ongoing geopolitical uncertainty and lingering COVID-19 lockdowns in China are fueling persistently high inflation, market volatility, and rising yields, posing an increasingly murky outlook for credit quality that–for now at least–exhibits a degree of resilience built up during the bounce-back from the pandemic.
Risks: Key risks relate to: the outlook for energy and food as supply disruptions linked to Russia’s invasion of Ukraine intensify, a rapid adjustment of central bank policy rates to counter excessive inflationary pressures, stagnant growth weakening the operating environment and financial performance of corporates, tightening financing conditions reawakening fears over fragmentation within the eurozone, and the debt sustainability of more vulnerable entities.
Ratings: Credit ratings are likely to come under more pressure into 2023 as supply constraints keep food and energy prices elevated, households increasingly struggle with falling real incomes, and central banks prioritize inflation over growth. Tighter financing and operating conditions will refocus business and households on cash flow to protect against a highly uncertain outlook and ultimately solvency for the most vulnerable debtors. We expect default rates to increase to about 3% by year-end and into the first quarter of 2023.
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