If central banks overcome inflation in 2023, the next big challenge for borrowers will be weak demand and residual high costs. The stress will be worse for highly leveraged and emerging market issuers.

How this will shape 2023:

• Policy, the dollar, and China will be the main drivers from a macro perspective. Balancing monetary and fiscal policy to dampen inflation without impeding growth is the trillion-dollar conundrum for policymakers. For example, the European Central Bank's (ECB's) monetary policy normalization bears risks for the eurozone's financial stability. Higher U.S. rates and investors' risk aversion have led to a stronger dollar, which mostly affects emerging markets (EM). Meanwhile, China is struggling with weak domestic demand because of COVID-19 lockdowns and highly indebted property and local government sectors.
• For energy and the environment, transition risk is at the fore. The Russia-Ukraine war has highlighted the vulnerability of global energy supplies, with Europe having to cope without cheap energy. This crisis could alter the energy transition agenda and decarbonization pathway. Meanwhile, extreme weather events are the new normal, heightening economic, financial, and credit costs. Furthermore, climate change is already imposing short- and medium-term costs.
• Rising borrowing costs may be detrimental for governments, corporates, and infrastructure. With governments carrying more debt because of the pandemic, higher policy rates of central banks will hit governments' interest expenses hard. Meanwhile, after nearly a decade of "lower for longer" cost of goods and interest rates, less-resilient corporates could buckle under higher inflation and borrowing costs. Current adverse conditions could further delay infrastructure investment, which has been lacking in some countries, such as the U.S.
• Technology risks are on the rise. Heightened geopolitical tensions and adverse economic conditions have increased technology risks. The U.S.-China strategic confrontation, exemplified recently by U.S. restrictions on semiconductor technology exports to China, threatens a bifurcation of the complex and expensive semiconductor supply chain. Meanwhile, the number state- and nonstate-sponsored cyberattacks could rise further, the former because of geopolitical tensions, the latter as worsening economic conditions tend to trigger more desperate crimes.
• Private credit and digital currencies are expanding. The private credit market has grown substantially in recent years. The ability of companies in this market to navigate an environment of high inflation and rising interest rates remains to be seen. Within the decentralized finance (DeFi) ecosystem, we expect policy work around stablecoins and central bank digital currencies (CBDCs) to accelerate. On the crypto front, differences in crypto assets and DeFi platforms point to the need for investors to do case-by-case risk analyses.

What we think and why:

• There will be hard choices to make on the macroeconomic front. We expect inflation fighting by central banks to take precedence, given their mandates. However, the ECB looks set to normalize monetary policy only gradually over multiple years to maintain the eurozone's financial stability. Compared with developed markets, the head start by EM central banks will help with trade-offs. That said, EMs are exposed to the stronger U.S. dollar. About 81% of rated EM corporates' debt maturing through 2023 is denominated in U.S. dollars. Defaults will still rise in China, while the government is expected to inject short-term stimulus and undertake longer-term reforms.
• It will be a critical period for energy and the energy transition. We see Europe's gas and power markets remaining very tight for at least two to three years. The energy price shock makes a green economy transition even more urgent. However, global decarbonization plans have major execution risks and need massive investment. Because security of supply is now the priority, the energy transition will occur over decades. Meanwhile, the protection gap between physical climate risks and insurance coverage continues to widen. Risks will increase even if progress on decarbonization is made, due to historical emissions and the lagging effects on the climate.
• Broadly, refinancing will be harder. For sovereigns, slower global growth, inflation, and higher funding costs will likely outweigh governments' countermeasures. Debt refinancing is becoming harder, and in some cases inaccessible (that is, for sovereigns at the lower end of the ratings scale). For corporates, we expect revenue momentum to fade in 2023 and cash flow to come under sustained pressure. That said, earlier refinancing has bought time, with interest expenses likely to build up only slowly. For U.S. infrastructure, the highest construction-cost inflation in decades comes just as historic levels of federal investment are beginning to erode the benefits.
• The need to mitigate challenges to tech supply chains and cyber risks will persist. Diversification of technology supply chains is hard to execute. The world's complex tech-supply chains--with China at the center--took shape over decades. At the same time, government investment in cyber capabilities and defenses will rise. Although cyber insurance can mitigate the risk of cyberattacks, increasing premiums and the scope of coverage are problematic.
• What a macro downturn means for private debt and the future of money. In private credit, we could see a repeat of 2020, with more sponsor interventions, if the next recession remains a short and shallow one. Private borrowers, predominantly in the middle-market space, are more vulnerable to macro downturns given their scale and scope. On digital money, stablecoins and CBDCs won't become mainstream in 2023 due to their small market size and regulatory uncertainty. Rising interest rates will raise questions regarding the calibration of the yield they should offer.

What could go wrong:

• The wrong monetary policy mix could be a problem. Overly expansionary fiscal policy could prevent economies from necessary slowdowns and eventually lead to more-aggressive monetary policy responses to control inflation. This could cause a more painful downturn to wring inflation pressures out of the economy, at the cost of lost fiscal space. For EMs, there is the risk of capital-allocation shifts if regional and global growth slows too much. The risks facing China are a weak GDP rebound in 2023, re-centralization carried out too far, and worse China-U.S. decoupling trends.
• For energy and environmental risks, there's a need to balance trade-offs. For Europe, the negative shock of higher energy prices is now, while the positive effects of cheaper labor and a weaker currency will only show up later. Higher energy bills over a prolonged period could result in increased social discontent. Uncertainties about implementation of new decarbonization plans, such as the European RePowerEU plan or the U.S. Inflation Reduction Act, may result in different decarbonization pathways for each industry. Policymakers also face dilemmas between transition and physical risks, where investments in one might not always benefit the other.
• A wider war means slower growth. A key risk for all is a deeper-than-expected recession or downturn. This could be triggered, for example, by the Russia-Ukraine conflict spilling over to other countries, bringing NATO into the war. A capital flight to safe havens would add more pressure on EMs. The resulting supply disruptions would likely trigger higher inflation for longer, pushing the world into stagflation. Our corporate rating analysts' forecasts reflect assumptions of a mild downturn, with corporate EBITDA rising just 1% in 2023. In contrast, the five earnings recessions since 2000 saw global EBITDA fall by an average of 16%, from peak to trough.
• Geopolitical tensions may further affect tech and digital disruption. Escalating geopolitical tensions add uncertainty to the technology sector's transformation. Trade tensions, pandemic-related disruptions, and a drive by some economies to be less dependent on Chinese manufacturing are complicating the country's place in global supply chains. Meanwhile, the effects of cyberattacks could spread beyond intended targets, and across sectors and geographies. States' weaponization of cyber will also bring forth harsher repercussions that could further escalate conflicts.

The U.S. dollar's strength heightens refinancing risk, prolongs inflationary pressures, and complicates fiscal and monetary policy, adding to an already uncertain economic outlook.

How this will shape 2023:

• Refinancing corporate debt could become tougher. About 82% of emerging market (EM) corporate debt maturing in 2023, with a global scale rating from S&P Global Ratings, is denominated in U.S. dollars. What's more, we estimate that about 24% is rated 'BB+' or lower. This will exacerbate already rising financing costs for EM issuers with no dollar revenue or inadequate foreign exchange hedges. Refinancing could be especially difficult for lower-rated issuers already grappling with restricted or no access to primary debt markets.
• A strong dollar complicates central banks' attempts to tame mounting inflation. We expect core inflation to stay above central banks' targets across EMs (excluding China, Saudi Arabia, and Vietnam) as the strong dollar and higher energy and food prices push up the cost of goods and services. Central banks' ability to adjust policy rates further to bring core inflation in line with their targets depends on the current rate of core inflation, the amount of slack in the economy, and pressure from wage costs. In some countries, the reduction of energy subsidies will make efforts to control inflation more complex. In frontier sovereigns with dollarized debt, limited domestic savings, low household incomes, and pressured domestic currencies, high energy and food inflation continue to depress growth.

What we think and why:

• Refinancing risk linked to dollar-denominated debt will be concentrated in certain regions and sectors. Issuers incorporated in China with our global scale rating have by far the highest amount of dollar-denominated debt due in 2023, about 47% of the EM total. Despite a slowdown of economic growth, weaker renminbi, and continued property market stress, which all heighten refinancing risk, most of the exposures in China are investment grade (rated 'BBB-' or higher). Brazil shows the second largest exposure, followed by Mexico. By sector, financial institutions have the largest amount of debt in U.S. dollars, but higher interest rates should underpin banks' net interest margins and profitability if asset quality does not deteriorate sharply. In contrast, nonbank financial institutions are more vulnerable to a disruption of funding access in difficult operating conditions, given their reliance on wholesale funding since most cannot collect deposits.
• Pressure on some EM currencies will persist. The economies most vulnerable to this situation are net energy and food importers, such as Jordan and Lebanon, and those relying heavily on external financing, including Argentina and Turkey. EM currencies have depreciated not only due to rising U.S. rates but also because of worsening current account balances owing to the surge of commodity prices after the Russia-Ukraine conflict began. Energy importers' currencies have been hardest hit due to the spike in oil and gas prices and subsequent shock to their terms of trade. Among the few exceptions are commodity exporters Brazil and Peru, as well as Mexico, whose currency appreciated in the 10 months to Oct. 31, 2022.

What could go wrong:

• A prolonged global recession or more severe slowdown in the U.S. would put further pressure on EMs. Despite weathering the credit impact of the pandemic arguably better than expected, key EMs remain highly vulnerable to a severe economic downturn. A sharper slowdown in the U.S. than we currently expect would hamper economic conditions across many EMs, particularly those that have close trade links with the U.S. (such as Mexico) or receive substantial remittances from the U.S. (Honduras, El Salvador, and Guatemala). It could also trigger increasing capital outflows as investors turn toward safe-haven assets. This could exacerbate the impact of the dollar's strength, eroding the value of certain EM currencies and further increasing refinancing risk for all issuers, particularly speculative-grade entities with dollar-denominated debt.
• Stubbornly high inflation could bring medium-term refinancing peaks into view. There are signs that the Federal Reserve Bank's measures may be slowing the rate of inflation in the U.S., but it's early days yet, and inflation remains elevated in other regions, most notably Europe, and is beginning to increase in EM Asia. In China, a pickup in growth will likely fuel rather than temper global inflation. If persistent inflation prevents central banks from lowering policy rates or leads to further hikes, refinancing costs will remain elevated and access potentially restricted for longer. This would put the spotlight on refinancing risk after next year, where 2024 and 2025 would represent peak years for U.S.-denominated debt.  

Private credit kept deal flow moving in 2022, but with rising interest rates and higher inflation, its capacity to continue to be a source of liquidity is questionable--particularly for the large corporate market.

How this will shape 2023:

• Private credit anchored the debt markets in 2022, supporting not only the traditional direct lending market but also large corporate borrowers unable to tap the bond or broadly syndicated loan (BSL) markets. Lenders' ability to step in and support deal flow for large corporates as well as middle-market borrowers reflects the convergence between broadly syndicated and direct lending over the past decade. The result has been a private credit market with enough liquidity to fund larger and larger transactions, but also the flexibility to provide an array of financing structures--including unitranche and floating-rate notes--alongside traditional leveraged loans. However, this market is also far more opaque than the bond and BSL markets, and lacks certain infrastructure, such as standard credit agreements, a secondary market, or third-party mark-to-market pricing.
• A healthy private equity market is fundamental to maintaining private credit liquidity. Private credit can continue to support broader credit markets as long as private equity remains healthy. Today's robust private equity developed primarily in a low interest rate environment. The private equity model of generating returns by investing in companies comes into question as borrowing costs rise and corporate growth stalls. If private equity fundraising falters, lenders' ability to provide liquidity to the credit markets in 2023 comes into question--and without that funding, the private credit markets may also stall.
• Rising interest rates and unrelenting inflation put the traditional private credit borrowers at risk. Middle-market borrowers still represent the core of the private credit markets, and they potentially have less resilience for inflation and higher interest rates. As the global economy looks set to enter a recession of unknown duration and magnitude, the prospect of rising default rates in 2023 raises the question of how private credit will navigate that challenge.

What we think and why:

• Large corporate borrowers will still rely on liquidity from private credit. Although central banks are likely to ease off their aggressive rate hikes in 2023, it will take some time for public debt markets to normalize, and private credit will continue to support financing to large corporate borrowers. However, while the size of private credit transactions has risen steadily this year, the market's ability to support jumbo transactions is limited and, as a result, large corporate mergers and acquisitions may be scarce. For instance, jumbo buyouts such as Citrix ($16 billion), Tenneco ($7 billion), and Nielsen ($16 billion) got hung up in 2022, all of which were announced in the first quarter of 2022 but didn’t syndicate until the fourth quarter. In addition, private credit's ability to provide cross-border financing is in doubt, and both Citrix and Nielsen relied on fundraising in both the U.S. and European markets.
• Traditional private credit borrowers are at risk for a default cycle. Though they generally have tighter documentation and higher pricing, middle-market transactions are still highly leveraged. S&P Global Ratings' Credit Estimates provide some insights on leverage for private borrowers, and the data shows that in key consumer goods, industries (such as household products, textiles, apparel, and luxury goods) are highly leveraged and poorly positioned to pass on extra costs. We estimate their median leverage at slightly higher than 7.5x, and many of these companies already have thin interest coverage, with a median of about 2.0x. Even in non-cyclical sectors such as health care, where the median leverage is lower at 6.2x, there are significant cost and operational issues, including staff shortages, a surge pricing for contract workers, wage inflation, reimbursements, and supply disruptions. All these issues increase costs and erode companies' ability to service debt.

What could go wrong:

• If a global recession is long and/or deep, causing a swell of defaults and restructurings in private credit, the outcome is uncertain. The direct lending market was much smaller during the global financial crisis of 2007-2008, and it’s never been through a default cycle at its current size. Today’s private credit market involves a lot more borrowers than large corporates; S&P Global Ratings Credit Research & Insights' analysis indicates that there are more than 5,000 individual borrowers in the business development companies (BDCs) they track, compared to approximately 1,200 issuers in the Morningstar/LSTA Leveraged Loan Index. This large number of borrowers raises the question of where the post-petition funding will come from after any bankruptcy filings, and whether there are enough advisors and workout specialists. We know that time in bankruptcy is closely related to recovery levels--the longer a restructuring takes, the lower the recovery. Will the restructuring infrastructure be able to efficiently support a large number of small borrowers, allowing the best possible outcomes and recoveries for lenders?
• An alternative scenario is that we could see a repeat of 2020 with more out-of-court restructurings than bankruptcies. Squeezed borrowers are likely to make all efforts to preserve liquidity including the temporary conversion of cash interest to partial cash and payment in kind (PIK)--pushing back scheduled amortization payments to a final single bullet payment, extending near-term payment maturities, temporary deferral of interest payments, and the provision of covenant holidays--all in return for sponsor infusion and possible tightening of documentation. However, most of these liquidity-preserving transactions offer lenders less than the original promise on the securities without adequate offsetting compensation, and we would regard them as tantamount to a selective default. In both restructuring scenarios, both borrowers and lenders will take losses.
• The post-recession landscape is also challenging. On an individual credit level, traditional private credit borrowers may not be able to manage the normalization to higher interest rates. Deals are primarily floating rate, and the transition to a substantially higher base rate may weigh too heavily on borrowers' margins. In addition, while spreads in the private credit market have generally been wider than those in BSL, the rising risks to credit will likely cause those spreads to widen more, further complicating the economics of raising capital in this market.

Financial accidents could happen on the road to monetary policy normalization, but eurozone sovereigns and banks are more resilient to such events than 10 years ago. 

How this will shape 2023:

• The ECB will continue normalizing its monetary policy in 2023. After ending net asset purchases and quickly raising the main policy rates to a neutral level, the European Central Bank (ECB) will start reducing its balance sheet. A key milestone will be repayment of €2.1 trillion of outstanding TLTRO funding: cheap, long-term, and stigma-free funding that accounts for about 8% of eurozone bank liabilities, with variations across systems (see chart 1). Furthermore, the ECB will likely clarify the timing and pace for ending the reinvestment of maturing bonds held under quantitative easing, amounting to nearly €5 trillion. While reinvestments in the Pandemic Emergency Purchase Program (PEPP) should continue in full through 2024, reinvestments in the larger asset purchase programs (APP) may start to decline from mid-2023.
• This journey may pose multiple risks to financial stability. Withdrawing liquidity from the banking system and bond markets will increase yields (see chart 2). The sudden widening of spreads between eurozone government bonds in June 2022 was a reminder that financial fragmentation risks and the sovereign-bank nexus remain in Italy, Greece, and Spain (see chart 3). The ECB was quick to react, and the announcement of its transmission-protection instrument helped spreads tighten afterward. However, this antifragmentation tool has yet to be used and potential implementation might fall short of market expectations. Finally, the ECB's gradual shift toward quantitative tightening comes amid yet another external shock to eurozone economies: rising energy and food prices as a consequence of the Russia-Ukraine conflict. Fiscal space is more limited today than in the months before the pandemic, and monetary policy flexibility is also much more constrained than in early 2020.

What we think and why:

• We expect normalization of ECB policy to take place gradually, over many years. With the ECB encouraging banks to repay TLTROs, this position on its balance sheet will shrink first and end sometime in 2024. The reduction of bond holdings might be more gradual, even if reinvestments under the APP end in full from mid-2023. First, we believe that active quantitative tightening (selling bonds in the market) will remain an option for the ECB. Second, since the average maturity of the ECB's bond portfolio is around seven years, reducing bond holdings passively by not reinvesting their proceeds prevents any significant reduction of this balance-sheet position before 2025.
• We see eurozone sovereigns as better prepared to deal with financial fragmentation than 10 years ago. Europe has tools at hand to address this risk. On the monetary policy side, the flexibility given to reinvestment in the PEPP, the full allotment procedure, and Outright Monetary Transactions are all firewalls to the risk of fragmentation. On the fiscal policy side, although not a national budgetary measure, the NextGenerationEU plan is acting as a redistributive mechanism that benefits more fragile economies in the EU. Also, the suspension of EU budgetary rules has given member states room to absorb external shocks, albeit a revised version of these rules is set to be reactivated in 2024. In addition, economic fundamentals are better today than they were a decade ago. For instance, in Spain and France, structural reforms, which have targeted the labor market and price markups, have helped narrow the cost-competitiveness gap to Germany. Reforms attached to NextGenerationEU should benefit European countries' competitiveness by investing in human and physical infrastructure, and mandating reforms to improve the business environment and labor flexibility. For example, Italy, under its National Recovery and Resilience Plan, is moving ahead with pro-growth reforms aimed at reducing bureaucracy and improving the efficiency of its public administration and judicial system.
• Overall, higher rates will benefit eurozone banks, but some banks will struggle with more-expensive funding. A return of interest rates to neutral levels is a clear positive for eurozone banks, which will finally see net interest income grow. However, the end to TLTRO funding will be a challenge for several eurozone banks that will need to refinance with stable, long-term funding to meet regulatory requirements. Issuing long-term debt or collecting deposits will come at a high cost for eurozone banks with weaker funding franchises or perceived as exposed to weaker sovereigns, such as Greek or Italian banks. Access to inexpensive term funding will again become a key competitive advantage for eurozone banks, and potentially another source of financial and economic fragmentation in Europe.

What could go wrong:

• Financial markets could lose trust in the ECB's capacity to maintain a gradual approach. Normalizing monetary policies was never going to be easy for the ECB but is being made more complex by the geopolitical risks we see materializing in Europe and implications arising from energy prices across the region, as well as the risk of fiscal missteps along the way. The financial stress experienced in the U.K. government bond market lately was a reminder of the risks involved in any uncoordinated change in the policy mix. Another risk to financial stability could materialize if the ECB starts actively selling its bond portfolio, should inflation remain far above target for longer.
• There is a risk that fiscal policy tightens too quickly as a consequence of more turbulent market conditions, exacerbating risks of a more protracted economic recession. The cost of past fiscal interventions to shield households and companies from various shocks--including a global pandemic and surging energy prices in connection with the war in Ukraine--means that European governments are entering this period of rising interest rates with very limited fiscal space. As a consequence, fiscal policy, like monetary policy, will gradually tighten. Over the last year, liquidity in government bond markets has compressed, partly because nonresident participation in key markets has declined (see chart 4). Uncertainty about economic growth and inflation over the next few years will, in our view, increase the risk of volatility in government bond markets, such as we saw earlier this year for U.K. gilts. As the ECB tapers its net purchases, the market's absorption capacity will diminish further. Mindful of this, larger European sovereign issuers appear more focused on reducing net borrowing further in 2023 and 2024. But they still aim to withdraw fiscal stimulus only gradually. Worsening financing conditions would potentially force issuers to front-load procyclical cuts to public spending and potentially energy subsidies (Germany being the notable exception with its proposal of up to a €200 billion shield), leading to potentially self-defeating austerity at the national level.
• Tighter funding conditions could expose the financial system's most vulnerable corners but will unlikely pose a systemic threat to eurozone banking systems. Certain nonbank actors running structural liquidity mismatches could face funding squeezes, such as open-ended investment funds, highly leveraged real estate investment funds, and finance companies relying on market funding. Also, sharp price movements could expose nonfinancial corporates transacting in derivatives (often for good risk management purposes) but facing massive margin calls. As for eurozone banks, much has been done to enhance their resilience to shocks since the introduction of the Single Supervisory Mechanism. EU banks are now well capitalized (with CET1 ratios increasing by about 270 basis points to 15.2% since 2015), highly liquid, and better risk managed than 10 years ago. Financial instability could lead to some mark-to-market losses, as well as rising funding and credit costs, but also to increased client trading activity. This would dent overall profits, with winners and losers depending on the business mix and funding strength. However, a repeat of the financial crisis, with a negative feedback loop between financial instability, bank deleveraging, and economic contraction, remains a remote possibility.

As policymakers raise interest rates to fight inflation, higher prices and borrowing costs could limit much-needed infrastructure investment, with long-term economic and financial implications.

How this will shape 2023:

• U.S. state and local governments have shouldered an increasing share of infrastructure funding burdens. This spending decelerated in the decade following the Great Recession, due in part to slower-than-average revenue growth and increasing fixed-cost obligations, like pensions and health care (see chart). We estimate this led to underinvestment of $1.5 trillion for states alone. A comprehensive tally of unfunded infrastructure in the U.S. is elusive, but the American Society of Civil Engineers' (ASCE) most recent assessment is $2.6 trillion. Given persistent inflation, we expect this gap to widen.
• Recent federal legislation represents an important shift. The Inflation Reduction Act, the Infrastructure Investment and Jobs Act, and some portions of the American Rescue Plan promised much-needed federal support and relieved some pressure on state and local governments. Combined, well over $1.5 trillion is targeted for traditional infrastructure, including roads, bridges, airports, transit systems, water and wastewater utilities, power grids, and broadband networks. Additionally, the new laws expanded spending on resiliency preparedness against storms, droughts, and wildfires, with a broad range of provisions focused on reducing demand for fossil fuels. This is a historic shift in funding, with substantial short- and long-term economic benefits. The ability to deploy and leverage these resources will depend on macroeconomic conditions over the next several years, given the time limitation associated with most of these initiatives.
• The amount of state and local government debt has been stable for the past 10 years. This contrasts with rapid growth at the national level. While this might indicate debt capacity to leverage available federal resources, the reality is more complicated. The slow pace of economic growth and fixed cost pressures due to pensions and other health care obligations limit states' discretionary spending capacity and contribute to a cautious approach to debt issuance, given balanced-budget requirements. So, despite a prolonged period of low interest rates and favorable municipal market conditions, states and many local governments have deleveraged. State and local fiscal conditions are relatively strong now. However, prospects for a recession and rapid acceleration of construction costs and interest rates could be a disincentive for state and local governments to issue debt to fund large projects.

What we think and why:

• Higher construction costs could force tough choices. The highest construction-cost inflation in decades comes at an inopportune time. An unprecedented amount of federal investment in infrastructure is starting to flow, but rising material and labor costs are beginning to erode some of its benefits. One broad measure of construction inflation is the Producer Price Index for building material and supplies dealers, which in September was more than 30% higher than pre-pandemic levels, with oil-price volatility (a key input to roadway and building materials and construction equipment) adding to the increase. Even if supply pressures ease, massive federal spending will increase competition, boosting prices further. Beyond fluctuating commodity and equipment prices, a shortage of skilled labor and the corresponding growth in wages will likely be more enduring. It’s possible that some projects may be downsized, delayed, or canceled as the cost of materials and labor escalates.
• Rising interest rates will increase the cost of borrowing. Tax-exempt rates are up more than 250 basis points year over year, with credit spreads also widening considerably. The current MMD (Municipal Market Data) curve remains well above the 20-year average. Although macroeconomic fundamentals have influenced the curve, the main driver of spread widening is municipal bond fund outflows. With markets remaining volatile, as rates rise, the spreads on lower-rated issuers will likely follow, increasing financing risks. Higher rates imply limited refunding opportunities, already impaired following tax-law changes in 2017, and this has implications for many municipal market issuers' budgets. Furthermore, the availability of credit (both letters and lines) could shrink and subsequently push up the cost of credit if banks become more defensive ahead of an unpredictable recessionary environment and expected need to preserve capital. This dynamic will likely increase costs for issuers with variable-rate debt or those that use lines of credit for liquidity purposes.

What could go wrong:

• The recession could be more severe, or last longer, than we currently expect. Despite the economy's recent weakening and our expectation of a recession in 2023, credit conditions in U.S. public finance have been relatively stable, largely due to strong reserves and federal stimulus. A deeper or more prolonged recession than we assume in our base case may strain budgets and possibly translate into lower capital investment.
• Less investment means slower economic growth, diminished productivity, and deferred maintenance over the next 20 years. The ASCE estimates the economic opportunity cost of failing to close the infrastructure-investment gap would include the loss of $10 trillion in potential U.S. GDP growth, more than 3 million jobs, and $2.4 trillion in export value by 2039. Deferring critical maintenance will also increase costs in the future.

Monetary and fiscal policy should work in tandem for the best macro outcomes. But that's a dilemma amid low growth (calling for loose fiscal policy) and high inflation (needing a tight monetary stance).

How this will shape 2023:

• The current macro juncture is awkward for policymakers. Rising, above-target inflation and slowing, below-potential growth are not a good combination, since the two main macro policy arrows are pointing in opposite directions. High inflation calls for restrictive monetary policy to rein in demand while low growth calls for looser fiscal policy to stimulate demand.
• The more fiscal policy expands, the more tightening the central bank needs to do. This trade-off is inevitable at present, but the pain and inefficiencies rise when the tug of war worsens. Rising rates cause pain across the economy--to asset holders, borrowers, and workers--while government borrowing in the context of already high debt eats up precious fiscal space.
• Inflation signals remain noisy, clouding the picture. Even after a year of inflation rates not seen since the 1980s, prominent economists cannot agree on the seriousness of the challenge. Some think policymakers are raising rates too quickly, while others think that policymakers will need to do more than what is currently priced in markets. Needless to say, this lack of clarity complicates the policy response, as does the uncertain lag between policy action and economic outcomes.

What we think and why:

• Given a huge policy miss, inflation fighting will take precedence over preserving growth. Central banks' credibility has taken a sizable hit over the past year. This is particularly true in advanced economies, where the debate over transitory versus persistent inflation raged while inflation blew past policy targets, necessitating the strongest rate hike cycle in four decades.
• Fiscal policy will likely target protection of the most vulnerable. While governments are mindful of their debt sustainability, they will not completely sideline fiscal efforts in the pursuit of price stability. There is a clear economic--and moral--case for cushioning the shocks of higher inflation and slower growth to society's most vulnerable.
• Price controls should not be confused with actual inflation gains. There will be a temptation to apply policy band-aids. While capping the price tag of a particular good or service obviously lowers the price impact, it likely involves fiscal costs and does nothing to reduce underlying upward price pressures from a too loose policy stance.

What could go wrong:

• The wrong policy mix could make things worse. Overly expansionary fiscal policy could prevent the economy from a necessary slowdown and lead to a more aggressive monetary policy response to control inflation. This could lead to a more painful downturn to wring inflation pressures out of the economy, at the cost of lost fiscal space.
• Monetary policymakers could ease up too soon, wary of causing too much short-term pain. While largely technocratic, central bankers are not fully insulated from political pressures. In the case of a sharp slowdown with still rising inflation expectations, monetary authorities could lose their mettle, resulting in an eventually steeper path of rate rises to get inflation under control, causing a deeper recession and higher unemployment.
• Central banks' independence could come into question, portending fiscal dominance. The idea of a technocratic central bank operating independently within the government has generated decades of relative price stability. Moves to put the central bank under control of the legislature risks politicizing monetary policy. This would likely lead to an inflation bias that artificially pumps up growth, leading to inferior economic outcomes.

Three cracks are showing in China's economic wall: low productivity growth, excessive debt, and the strained relationship with the U.S. While the central government seeks to address these long-term issues, more bad news is likely to emerge in the next 12-18 months.

How this will shape 2023:

• Low productivity to slow China's growth trend. COVID-19 lockdowns and a property downturn have slowed China's growth momentum. The country's investment-led growth model is debt fueled and losing steam. According to the U.N., China's share of global exports stood at 15.2% in 2021, a five-fold increase since 1995. However, other emerging markets are eclipsing China's advantage of cheap labor. Furthermore, the country's aging demographic reduces labor participation (with the retirement age unchanged). Unless these challenges are addressed, China's long-term growth trajectory is likely to be subdued (see chart 1).
• Heavy debt is a burden. Some corporate sectors (e.g., property and construction) and local governments have excessive debt, while the central government has relatively low indebtedness (see chart 2). We believe Beijing is reluctant to deliver an all-encompassing bailout of overleveraged borrowers for fear of encouraging further moral hazard. Government stimulus packages are blunt instruments and funds don't always go where needed. Consequently, tighter oversight on infrastructure financing could come, to improve the viability of entities.
• The U.S. tech "war" rages on. China's strained relationship with the U.S. is bad for the economy. The most recent development is the U.S. government's restriction on the export of advanced semiconductor hardware and talent to China. China is one of the world's largest importers and exporters of semiconductor chips (see chart 3). Integrated circuits are among the country's top two imports by value (the other is oil). While China has stated its intention to be a global technology leader, its advanced chip-design capability is still developing. Consequently, the U.S. action will slow progress in this subsector in 2023 and possibly the next two to three years.

What we think and why:

• Controlled stimulus could boost 2023 growth. Although the government has reverted to infrastructure stimulus amid the tough economic situation this year, its push is unlikely to result in the kind of boom or rebound seen in the past. Authorities are cognizant of stresses on local governments and are setting reform goals to reduce off-budget financing or limit overleveraging to fund projects. Consequently, infrastructure projects face more scrutiny. The focus on more-productive investments will see greater differentiation of spending across subsectors.
• Reforms will improve longer-term growth. We believe policymakers remain focused on de-risking China's credit-dependent growth. However, the pace of reforms may slow if economic stability is threatened, underpinning the delicate balance between reform and economic development. For the property sector, the government's efforts to curb house-price speculation means the "three red lines" policy will persist. With structural reforms remaining a priority, constraints across important sectors (information technology, real estate, and education) will likely persist given their politically strategic and socially impactful characteristics.
• More defaults are likely. We expect defaults to rise in 2023 and after. One wave of defaults will be the fallout from mobility restrictions to contain COVID-19 outbreaks in 2022, which have also disrupted the traffic of goods. These have a direct hit on mobility-dependent sectors such as business and consumer services, media, entertainment and leisure, real estate, and transportation cyclicals. These sectors also happen to be the ones with the most negative outlook biases. Another wave ("creative destruction") is being driven by the above actions to reduce overleveraging and improve productivity in the economy.

What could go wrong:

• We could see a weak GDP rebound. If China delays easing COVID restrictions, the economy will take a bigger hit. We expect a more meaningful reopening after the Chinese Communist Party meetings in March. However, the overall process will likely be gradual. A prolonged strict COVID stance would exacerbate the impact on corporates' revenue and profitability. Concurrently, ongoing costs of COVID-19 containment will further drag on local and regional governments' fiscal strength.
• Too much re-centralization could hurt. Policymakers have to perform a balancing act, between centralization and decentralization, to achieve desired long-term growth. Decentralization helps encourage innovation (albeit not without risks of overexuberance). While restrictions have tightened on information technology, real estate, and education, some restrictions elsewhere have eased. The country's "little giants" initiatives point to efforts to promote economic growth.
• The China-U.S. decoupling worsens. Tensions between the U.S. and China raise the risk of some trade decoupling between the two. Full decoupling is unlikely over the next few years, given the complexity and interdependence of supply chains. We therefore expect China to retain its strong manufacturing position, given its well-established production and transportation infrastructure. However, an uncertain business environment and fears of sanctions could have longer-term ramifications for economic prospects, especially China's manufacturing role in the world.

Less growth, lower margins, and rising borrowing costs suggest a more difficult 2023, but cash and refinancing buffers will buy time.

How this will shape 2023:

• The era of ever cheaper borrowing costs appears over. After the global financial crisis, corporate leverage underwent a structural increase (see chart 1)--and credit quality a structural decline--as the cost of borrowing fell (see chart 2) and investors focused more on yield than risk. Efforts to quell resurgent inflation are reversing this trend, with rising rates and widening risk premiums bringing higher corporate funding costs and encouraging deleveraging. We estimate that the median effective interest rate paid by speculative-grade issuers on their debt is likely to rise from the 2021 low of 4.2% to 5.3% next year, taking interest costs back to where they were in 2014, and they're likely to trend higher as cheaper debt matures.
• Cost pass-throughs will become more difficult. Corporate credit quality--while never fully recovered from the pandemic--held up surprisingly well in 2022, bolstered by pandemic recovery momentum, surging profits for commodity companies, and a continuing ability to pass on soaring input costs to customers. This is unlikely to last, given higher borrowing costs and the cost-of-living crisis for consumers. Earnings momentum is fading, and the severity of the downturn will shape 2023 credit prospects.
• Corporates could amplify an economic slump. If economic downturns are deeper than our forecasts assume, companies are likely to respond rapidly to protect cash flows. This could mean hiring freezes, job losses, and cuts to capital expenditure, potentially amplifying the recession.

What we think and why:

• Cash flows face pressure. Profit margins for global rated nonfinancial corporates remain elevated: EBITDA margins for the last 12 months stand at 17.6%, the same as in 2021 and a period high between 2005 and now. This is unlikely to persist in 2023, with resistance to cost increases likely to grow. Revenue momentum will fade, working capital needs remain elevated, and interest costs continue to rise, meaning that cash flows will start to come under sustained pressure.
• Refinancing has bought time. Interest rate pressures are likely to build slowly. We estimate that the floating-rate share of rated debt is only 28% in the U.S., and only 9% of this is scheduled to mature in the next 18 months. Moreover, speculative-grade debt represents only 19% of this maturing debt. Pandemic-era refinancing will buffer rate pressures.
• Precarious capital structures will be tested. Even so, higher leverage, faltering growth, and fragile credit markets mean considerable pressure for entities with vulnerable capital structures. Defaults are consequently likely to rise, particularly in lowly rated consumer-facing sectors.

What could go wrong:

• A deeper recession could unravel credit quality. Our analysts' forecasts reflect economic assumptions of a relatively mild downturn and suggest EBITDA will increase just 1% in 2023. The five earnings recessions since 2000 saw global nonfinancial EBITDA fall by an average of 16% from peak to trough. Stressing our forecasts for higher-than-anticipated interest costs and weaker EBITDA to simulate a typically more severe downturn suggests a deep recession could take average speculative-grade leverage metrics back above pandemic highs (see chart 3) and mean that more than half of these entities would have negative free cash flow (see chart 4).
• Structural pressures persist. Beyond cyclical concerns, deglobalization could reverse many trends that have been favorable to corporate financial performance, particularly in relation to free trade, supply chains, and labor costs. Allied to rising borrowing costs, this could bring structurally lower profit margins and necessitate a more sustained period of deleveraging. 

Inflation and slowing economies will continue to challenge borrowers in 2023, but our analytical frameworks and expertise enable us to quickly assess and quantify emerging risks, such as cyber and DeFi.

How this will shape 2023:

• New risks are constantly emerging, and well-known risks will evolve. Our analytical frameworks enable us to consider the effects of such risks, even those that are unique or uncommon, across a sector or asset class and provide transparency. Our credit ratings are informed by an entity or structure's current and past performance, are forward-looking, include both qualitative and quantitative factors, and typically incorporate our quantitative financial forecasts. We may address key, well-known risks (such as supply-chain vulnerabilities or interest rate volatility) explicitly in our methodologies, while other emerging risks--related to decentralized finance (DeFi) or cyber risks, for example--may have unique features but can be assessed through a familiar lens, such as a review of a company's governance or liquidity. Together, our credit methodologies, analytical judgement, cross-practice credit conditions, economic research groups, and ongoing credit-risk surveillance are central to understanding current and emerging risks.

What we think and why:

• The crypto ecosystem is evolving rapidly, raising risks for the entities operating within it. This includes new companies whose primary business is crypto, or traditional ones dipping their toes in the water. Not all crypto assets or DeFi platforms are created equal. Therefore, a case-by-case analysis of their impact on credit risk is essential. Emerging risks include the convertibility of cryptocurrency into fiat currency, the interaction between a DeFi protocol's activities inside and outside a blockchain, or the uncertain and rapidly developing regulatory environment. To date, we have captured these risks by applying the flexibility built into our rating criteria through factors like capital, liquidity, or operational and competitive risks.
• ESG risks can be uncertain and long term. We factor them into our analysis through sector-specific criteria when they are, or may be, relevant and material to our credit ratings. Our long-term issuer credit ratings don't have a predetermined time horizon. Financial forecasts are for the period over which we believe we have a sufficiently clear view of an entity's potential financial performance, considering the asset class, capital structure, and potential impact of relevant credit factors, including ESG. Those forecasts exclude the potential cost of events that aren't sufficiently visible, such as extreme weather or a policy decision to levy carbon taxes. If risk factors are sufficiently visible but likely to crystallize outside the forecast horizon, we may factor them in qualitatively. Risks with significant uncertainty limit our ability to incorporate specific  

What we're watching:

• Supply disruptions are contributing to credit pressures. These disruptions range from production falling short of demand, supply disruptions due to legal and geopolitical events, and shipping and cargo logistics and availability, to workforce, raw materials, equipment, and inventory shortages. We seek to understand a supply chain’s dynamics to assess the key drivers of risks: for example, how a sector’s production cycle works, including any interconnectivity with other key supply chains; and how an entity’s inventory supply chain management addresses capacity. Other risks stem from the locations and alternate sources of supply, transportation and logistics dependencies, use of data and information systems, interconnectivity between supply chains, and the degree to which a specific production or supply chain model has built-in spare capacity and backup.
• Cyber risk is pervasive, and the materiality of its impact varies. We primarily view cyber risk by examining an entity's governance. We typically engage with the company's management to better understand how it prepares for, responds to, and recovers from cyberattacks. We assess preparedness based on principles like those in the National Institute of Standards & Technology's framework, among others. We then incorporate that into our view of an entity's overall risk management. Cyber risks are also considered in the context of a given sector and the entity's relative vulnerability within it, as well as in other parts of our analysis, such as the assessment of an entity's financial risk profile or a structured finance transaction's operational risk.
• Rising interest rates make it harder for issuers to refinance hybrid capital instruments. Hybrids are now more widespread in some sectors and regions and, in recent years, issuers have typically called hybrids on the first optional call date because it was cheap and easy. Issuers therefore face balancing the financial impact of refinancing, at higher costs, against investors' desire for hybrids to be redeemed on call dates. The optional nature of a call is a key feature underpinning our treatment of instruments as equity-like in our financial metrics, since a call provides issuers with the flexibility to manage capital and the timing of redemptions or refinancing. We expect more cases where issuers don't redeem hybrids on call dates or do so despite not being able to replace the hybrids. We see non-call cases as typically credit supportive, particularly when they stem from economically rational financing decisions and do not signal specific credit strains. While we typically expect corporate issuers to replace hybrids they redeem, our criteria give us the capacity to review cases where a hybrid has been redeemed without replacement to assess whether we see that as altering an issuer’s intentions to use other hybrids to absorb losses or conserve cash in times of stress. 

High energy prices are reducing the EU's trade competitiveness. Its industrial base could hollow out if markets are slow to rebalance.

How this will shape 2023:

• Soaring energy costs could accelerate the deindustrialization of Europe. They have already weakened Europe's cost competitiveness with the U.S. by as much as 4 percentage points of GDP growth. If energy markets are slow to rebalance and this competitiveness gap persists, European economies risk hollowing out their industrial base, which would involve the offshoring of energy-intensive activities, particularly in the manufacturing sector. This would continue the deindustrialization of Europe that began several decades ago, reflected in the decline in industrial employment, which however remains relatively high in Eastern Europe, Germany, and Italy.

• This competitiveness shock is unevenly affecting countries and sectors. Economies feeling the most pain have high energy intensity and bigger shares of fossil fuels in their energy mix. They are less oriented toward services and have a greater weight of energy-intensive sectors, such as the metals and chemicals industries. Through this prism, Nordic and big economies appear to be less exposed than small economies in the eastern part of the EU.
• Export competitiveness is already suffering. Sectors that manufacture tradeable goods and rely most on natural gas as a feedstock or for heat, as well as related downstream value chains, have already suffered big cuts to domestic production (see chart 4) and foreign trade. For instance, EU exports (outside the bloc) of petrochemical products most reliant on natural gas fell 6%-8% in recent months. Meanwhile, imports grew by double-digit rates in some segments, helped by the easing of global supply chains.
• Germany's industrial complex is front and center of the energy crisis. Five industries consume 76% of the country’s industrial energy (see chart 6), equivalent to almost 20% of its energy use, while producing 21% of industrial gross value added (GVA) and employing almost one million people. Of these, the chemicals sector has the largest weight in GVA and consumes almost 37% of the natural gas that German industry uses.

What we think and why:

• European gas and power markets are likely to remain tight for at least two to three years, reflecting the challenges of replacing Russian energy. This will alter business models and profitability for energy-intensive industries. The costs of regulation could exacerbate the situation if, for instance, the proposed carbon border adjustment mechanism doesn't adequately address carbon leakage, especially once the free allocation of emission permits phases out after 2026. That would further undermine the international competitive position of energy-intensive European industries.
• Currency valuation and labor costs also matter to cost competitiveness. Since European economies are export oriented, the sustained strength of the U.S. dollar relative to European currencies may offset some of the continent's lost cost competitiveness. Also, labor costs have risen more slowly in the European manufacturing sector than in the U.S. in the past decade. The millions of refugees from Ukraine and the conflict region may help contain wage pressures amid tight European labor markets and as the working population ages.
• The energy shock adds urgency to the energy transition. Under its policy (NextGenerationEU) to foster the green transition and decarbonize its economy, Europe is sending money to member states and public investment is on the rise--something not seen in the past decade in Europe. For instance, the EU is leading the way to decarbonize its cement industry. It has also drafted a plan--called REPowerEU--to save energy, produce clean energy, and diversify energy supplies. Some countries have national programs to shield their industrial fabric from soaring energy prices. But the reality is the global economy will remain heavily dependent on fossil fuels for many years, with demand increasing until at least 2030, in our view.

What could go wrong:

• Time is an important aspect to the risk of restructuring the industrial base. The negative shock of higher energy prices is here and now, while the positive effects of cheaper labor and a weaker currency will only show up later. The terms of trade for some European economies could take a long time to recover, and deindustrialization could be difficult to reverse.
• Europe's energy-intensive industries will have to make some tough choices. Facing a structural, geopolitically induced energy shock, low-growth environment, and regulation to accelerate the energy transition, industries might migrate even more to higher value-added products. Producers of more-commoditized products, such as base chemicals, with balance sheet strength are likely to expand investment in plants closer to expanding markets and in locations, such as the U.S., that can provide cheaper, more secure energy, as well as the necessary labor. Smaller, domestic, and less-diversified manufacturers unable to switch to cheaper energy sources are clearly most vulnerable to a deterioration of credit quality, especially in a slow growth environment.
• Deglobalization and slow global growth could wipe out the benefits of currency depreciation and cheap labor. Today's geopolitics aren't conducive to openness, and Europe is the largest economic region most reliant on international trade. What's more, the economic slowdown in the U.S. and China, Europe's two largest trading partners, isn't helping Europe gain significant export benefits from currency depreciation.

U.S. efforts to restrict China’s access to high-end semiconductor technology threaten to divide the global chip industry. But such a rift would cost trillions of dollars and take up to a decade.

How this will shape 2023:

• Semiconductor supply chains could be reconfigured. Tensions between the U.S. and China could result in a bifurcation of the global chip industry, which could be quite costly and slow, raising quality, reliability, and cost concerns all along the supply chain. Disruptions will mean less efficiency, with greater uncertainty and profit-margin compression weighing on companies' creditworthiness, given an increasingly fragmented supply chain with more embedded risks.
• The U.S. is pushing to become a global player in chip manufacturing. The U.S. took a big step toward this end with the CHIPS and Science Act. The legislation, and the $53 billion it provides for manufacturing incentives and R&D over the next 10 years, is critical to promoting semiconductor production in the U.S. Subsidies could spur investment, like Idaho-based Micron Technology's plan to invest $20 billion in a mega fabrication plant in New York, and more importantly keep domestic manufacturers from expanding elsewhere. This would help reverse years of decline in the U.S. share of global chip manufacturing capacity to about 12% from more than three times that (around 37%) in 1990. But to truly transform the industry, much more investment--public and private--is needed, given that a state-of-the-art foundry typically costs at least $10 billion and takes three to five years to build. Moreover, the Semiconductor Industry Association and Boston Consulting Group estimate that each region would need $1.2 trillion to localize supply chains to match 2019 production.
• China will likely accelerate its tech-innovation efforts. We anticipate that China will become more aggressive in encouraging the domestic sourcing of chips and tech products to satisfy its needs, rather than sourcing externally. Already a major manufacturer of lower-level, "trailing-edge" processors, China has a strong incentive to build up its leading-edge manufacturing to compete effectively (see chart). While China’s tech firms have a long road ahead to close the gap with their U.S. rivals, progress has come from the country’s “national champions,” including Semiconductor Manufacturing International Corp., a partly state-owned contract manufacturer; Yangtze Memory Technologies, a state-owned NAND flash memory chipmaker; and ChangXin Memory Technologies, a partly state-owned DRAM flash memory chipmaker. We think China will subsidize these state-backed companies to become dominant players in their respective areas.

What we think and why:

• Diversifying tech supply chains away from China is easier said than done. The world’s complex tech supply chains took shape over decades, and U.S. tech firms will have to tread carefully when shifting or adding a manufacturing presence outside China to avoid alienating an important customer base. Meanwhile, China’s share of global exports has surged in recent years and now exceeds 20%. S&P Global Ratings believes China’s record of maintaining and building on its central role in global production underscores the resilience of its export engine and the pull it continues to exert on manufacturing supply chains.
• For the U.S., a shift from design to fabrication would be a giant leap. For roughly 30 years, the U.S. semiconductor industry has focused on design and marketing, outsourcing manufacturing to foundries (also known as a “fabs” or fabrication plants) and back-end assembly and testing to other service providers, mostly based in Asia. Only a handful of U.S. semiconductor companies have a significant manufacturing presence in the U.S.: Intel, Micron Technology, Texas Instruments, Analog Devices, and GlobalFoundries.
• Changes are afoot in a fast-growing industry. Diversification efforts, which have been underway since the trade and tech dispute between the U.S. and China started in 2018, are important because the semiconductor market is huge and booming, expanding more than 20% to about $600 billion in sales in 2021, according to McKinsey. Driven by the automotive, data center, and wireless industries, the global chips market could expand by 6%-8% annually, on average, through 2030, when it would reach $1 trillion in sales globally. Taiwanese foundries account for most of the global market, the biggest being Taiwan Semiconductor Manufacturing Corp., which makes microchips for Apple, Advanced Micro Devices, and Qualcomm, among others.

What could go wrong:

• Escalating geopolitical tensions add uncertainty. Trade tensions, pandemic-related disruptions, and some economies' efforts to become less dependent on Chinese manufacturing are complicating China's place in global supply chains. The relationship between the U.S. and China remains strained. Tensions regarding Taiwan are casting a pall over the long-term business and economic prospects of the territory. The semiconductor sector would be the most vulnerable if cross-strait tensions worsen further.
• A global recession could weigh on demand. While the global IT market has proved resilient through (and in many ways benefited from) the pandemic, a global recession could play out differently. This is especially true given persistently high inflation and lingering supply chain concerns. And while it seems unlikely that the expansion in global IT spending would reverse course, growth could stumble enough that new investment in manufacturing plants could slow. 

The energy trilemma of decarbonization, supply security, and affordability is rebalancing as the energy crisis in Europe, global supply-chain bottlenecks, and emerging-market growth limit greenhouse-gas-emission reductions worldwide, despite countries implementing more decarbonization policies.

How this will shape 2023:

• As many countries have expanded their decarbonization ambitions, we expect energy transition investments to keep increasing during 2023. Economies, including major global players like China, the U.S. and EU, mainly aim to achieve their targets through the greater inclusion of renewables, hydrogen, and electrification into their energy mixes and through technological solutions, such as a faster roll-out of offshore wind and carbon capture.
• Access to energy and security of supply are crucial for maintaining healthy economies. The European energy crisis and related Russia-Ukraine conflict show that a rapid shift away from fossil fuels is far from easy. The resulting temporary delay in fossil-fuel phaseout will make it harder for Europe to curb carbon emissions in 2023, since Russian gas will mainly be replaced by more polluting coal, LNG, oil, and other combustibles. Developing markets’ growing economies, especially China and India, also require more energy, and the pace of renewables growth is in most cases insufficient to meet this incremental demand.
• Given these existing and shifting dynamics, the global economy will remain heavily reliant on fossil fuels. Global primary energy demand depends on fossil fuels for more than 75% of the total energy mix. Carbon emissions in 2022 should already exceed pre-COVID-19 levels. And under current policies and economic growth prospects, we expect global demand for fossil fuels will increase until at least 2030, eventually denting any substantial global carbon-emission reduction. Nonetheless, even as hydrocarbons are indispensable to the global economy, climate policies and incentives increasingly tip the investment balance toward new renewables and low-carbon applications.

What we think and why:

• Decarbonization plans face major execution risks. Colossal decarbonization ambitions translate into a huge rise in investment needs, notably for renewables. But the shift toward greener energies faces growing supply-chain bottlenecks for some components and materials, as well as local opposition to entire projects. This will likely continue to delay the rapid deployment initially envisaged, even if governments seek to reduce administrative hurdles for permitting. We see a risk that returns could be less attractive for power developers, due to higher upfront outlays.
• Security of supply has become the priority in the immediate term. Increasing the share of renewable power in the energy mix and overall production of electric vehicles certainly is a key pathway to reduce reliance on fossil-fuel imports, notably for Europe. But transition will evidently spread across decades. At the same time, the conflict has immediately made clear how important other domestic fuel sources, like coal, are to certain economies. This is notably the case for China, where coal demand may decrease to below 50% of primary energy by 2030 but still increase in absolute terms.
• A faster energy transition could further raise cost inflation in 2023. As global competition for new renewables increases, their construction costs are going up. For instance, the cost of solar activities will likely rise by about 4% in 2023, according to S&P Global Commodity Insights, after going up by about 8% this year. Yet energy from existing renewable sources remains much cheaper than fossil fuels in the current environment. Ensuring energy supply could add even more to the cost of inflation, with tight LNG supply conditions likely remaining prevalent until at least 2025 and likely resulting in volatile and historically high LNG gas prices globally.

What could go wrong:

• Higher energy bills for a long period may be hard to sustain and could heighten social discontent. This is especially a concern in Europe and several emerging markets. Managing the affordability and social inequalities of the energy transition were already high on the agenda at COP27 and elsewhere but may also play a greater role in the design of future transition policies.
• Uncertainties regarding implementation details of new decarbonization plans may result in significantly different outcomes for decarbonization pathways and costs for each industry. Market participants will be watching the detailed outcomes of Europe's RePowerEU plan and the U.S. Inflation Reduction Act. While both promise to inject billions in the energy transition, details are still missing on how these will be applied and under which conditions. The resulting changes could be accelerated or delayed as a result, while affordability, security of supply, as well as the potential for resulting stranded assets will be key considerations in the ongoing negotiations.
• Greater gas demand destruction in Europe and changes to consumer behavior would support decarbonization but could have some negative credit effects. The energy supply gap in Europe is forecast to require gas demand destruction of an estimated 15% in 2022-2023, notably for industries, which may lead to business disruption. However, the energy demand decline may be temporary, or mask shifts to other energy sources or substitution with imported goods. A successful energy transition will ultimately also require a change in consumer behavior or policy changes that influence the demand side (and could therefore weigh on credit quality). But signals are not clear, while material behavioral and adoption shifts are not occurring yet. For example, industry data point to a full recovery of U.S. and European air traffic by 2023 and 2024, respectively, to pre-COVID-19 levels. The area to watch here is how customer awareness may alter travel habits and whether future environmental taxes could significantly raise the cost of air travel. Energy companies will have to contend with market volatility in 2023, but these current events are shaping and speeding these industries' structural shifts for the long term.  

Most sectors face costs from climate transition, while preparing for, and adapting to, ever increasing exposure to physical risks.

How this will shape 2023:

• Climate risks continue to crystallize and are increasing. Aligned with recent trends, 2023 will likely see more instances of damaging and costly climate hazards (hotter and longer heatwaves, droughts, more severe floods, and damaging storms), solidifying how investments in adaptation and resilience are critical to help entities cope with the rising threats posed by physical risks. As global warming accelerates and the possibility of reaching net zero by 2050 becomes increasingly challenging, we expect the operational and financial implications associated with disruption and damage will increase as extreme weather becomes more common.
• Against the backdrop of more frequent and severe weather-related events, governments' focus on climate transition policies will continue to increase. Carbon pricing regulation will spread to additional jurisdictions and sectors. For example, the EU is set to cover the maritime, transportation, building, and road sectors with Emissions Trading Schemes (ETS), and China's ETS is set to cover industry in its next phase. Additionally, policymakers are likely to increase green public spending and/or regulatory measures to encourage a switch to lower-carbon-emission technologies, as seen in recent budgets. This will continue to increase the amount of economic activity affected by recent climate-related public investment packages.
• But the current energy crisis will reshape physical and transition climate-related risks, affecting efforts to limit emissions worldwide. Energy importers that are moving away from Russian energy supplies are likely to rely more on carbon-intensive energy in the short term. However, ongoing high energy prices and energy security concerns could fuel public- and private-sector investment in renewables and improvements in energy efficiency, which we believe will ultimately speed up the energy transition. Already, the current crisis has resulted in increased support for a faster roll-out of renewables and is likely to bring significant efficiency gains on the demand side. The EU, U.S., Japan, Korea, China, and India have all increased their clean energy ambitions as a response to the crisis according to the International Energy Agency (IEA). The IEA estimates that these new measures will lead to a 50% increase in clean energy investment, from today, to more than $2 trillion a year by 2030.

What we think and why:

• Transition risks are higher in the short to medium term as climate policies increase, potentially leading to some market repricing and divestment. Regulators and central banks are pushing financial actors to account for the financial impact of climate change, especially in developed markets. We believe greener policy agendas will move further into the mainstream and may have cross-border implications. The implementation of policies such as the U.S. Inflation Reduction Act, and further development in 2023 of the EU’s Fit For 55 roadmap (e.g. the carbon border adjustment mechanism), may begin to reshape markets by making green business models in certain regions relatively more attractive in terms of returns than their less environmentally friendly counterparts, thus driving new patterns of investment globally. In response, mitigation efforts may also include divesting high-emitting assets, but also increasing borrowing costs for issuers that fall behind on the transition.
• Importantly, physical risks will continue to intensify over time, even if significant progress on decarbonization is made. Due to historical emissions and the lag in the climate system, even if current pledges are implemented, we estimate that physical risks are set to increase by at least one-third by 2050, putting 4% of global GDP at risk, compared to 3.3% under the Paris Agreement. Even today, more vulnerable regions--in particular South Asia, Sub-Saharan Africa, and Central Asia--are experiencing sizeable and rising GDP losses from physical climate risks, but are also the least ready to adapt to those risks since they often comprise lower- and lower-middle-income countries (see chart). Finding solutions to manage loss is thus already contemporary and will remain a focus, with international cooperation being part of the debate.

What could go wrong:

• Current policies do not do enough to limit global warming to 1.5 degrees. According to the U.N., while progress has been made, current commitments are not on track to meet the well-below 2 degrees objective of the Paris Agreement, or the more ambitious net-zero pathways. Implementation challenges remain sizeable after setting targets. At a time of a complex economic and geopolitical environment, short-term focus might be given to other priorities, which could exacerbate decarbonization and adaptation costs in the medium term. Energy security concerns represent this complexity, highlighting that transition takes time and entails economic trade-offs and redistributive considerations.
• Decision-makers also face potential dilemmas between transition and physical risks, where investments in one might not always benefit the other. In many instances, we observe that countries more exposed to physical risks have tighter budget constraints than their less exposed developed peers, and often do not have the means to tackle physical and transition risks at the same time as ongoing domestic issues. Meanwhile, infrastructure initiatives that fund resilience might also lead to increased energy use and put more pressure on entities' transition strategies. Yet more people, homes, and companies will be left exposed to physical risks without sufficient investment. Wider co-benefits might be achievable but may need thinking at the system level, not just the asset scale.
• Global climate finance for adaptation remains scarce compared to mitigation. We observe that issuance of green, social, sustainability, and sustainability-linked bonds (GSSSB) has increased to 12% of total issuance (see "Global Sustainable Bond Issuance: Likely To Fall In 2022," published Sept. 20, 2022). To date, these have largely focused on and funded climate transition, with limited use of proceeds applied to address physical risks. Questions remain about who should pay for the interventions needed to adapt to physical risks. As this investment imbalance continues in 2023, it will further expose those most at risk from irreversible physical risks locked into the climate system.  

As global temperatures rise, the costs of extreme weather events are increasing. While insurance can help manage these costs, investment in adaptation and mitigation measures will not only reduce the impact of climate hazards but also assist in preserving their insurability.

How this will shape 2023:

• The frequency and severity of extreme weather events are increasing, a trend we expect will continue as global temperatures rise. Although seasonal variability can lead to fluctuations in the number of extreme events annually, the long-term trend is clear (see chart 1). Rising global temperatures are contributing to the increasing frequency and severity of extreme weather events, particularly so-called secondary perils, like wildfires, floods, and droughts. The proliferation of these secondary events exposes a wider swathe of the global economy and international society to climate hazards that may have not yet experienced primary perils, such as hurricanes or windstorms.
• The costs of these events will also continue to rise. The financial impact of extreme weather will remain on an upward trajectory (see chart 2). In addition to a greater number of areas that will be exposed to extreme events, other factors like urbanization; increasing economic interconnectivity, including through global supply chains; aging infrastructure; and fewer natural defenses will drive up the costs.

What we think and why:

• Physical risks can have negative implications for credit. We have identified physical risks as one of the environmental credit factors that can affect creditworthiness. Our "Environmental, Social, And Governance Principles In Credit Ratings," criteria, published Oct. 10, 2021, articulates the principles we apply to incorporate environmental, social, and governance (ESG) credit factors, including physical risk factors, into our credit ratings analysis. For example, costs associated with damage or lost revenue due to temporary shutdowns or supply chain disruptions can affect corporate issuers' cash flows. Rising exposure to extreme weather events can also adversely affect the cost of insurance and property valuations, which can reduce revenue collections for government entities or increase repayment risk for banks' mortgage books and mortgage-backed securities. To date, the impact of physical risk on credit quality varies by sector (see chart 3). For example, looking at the sectors where we've published ESG Credit Indicators, we observe that physical risk has had a negative influence on the credit rating analysis of 25% of U.S. states, but only 1% of telecommunications entities. For more information on our ESG Credit Indicators, please see "ESG Credit Indicator Definitions And Application," published Oct. 13, 2021.

• Insurance can play an important role in helping issuers manage physical climate risk. Insurance against physical risks is a key mitigant for many sectors, which explains why it is comparably more of a significant credit risk for the sector than others, influencing the credit analysis of 11% of insurance ratings. To manage that credit risk, we have observed insurers taking steps to improve underwriting standards and the understanding of physical risk. This is helping insurers to raise policyholders' awareness and advance mitigation efforts of physical risk, which may help reduce losses when events occur. In addition, timely claims payments can help stabilize cash flows and enable a faster response, recovery, and reconstruction, which can bolster economic activity following an event.
• Nevertheless, the protection gap will continue to widen. The amount of insured losses from extreme weather is increasing more slowly than economic losses, leading to a protection gap in the economy. We have observed that some insurers are increasingly managing their exposure to catastrophe risks by raising premiums, screening out hazards, and reducing coverage or exiting highly exposed regions, which could exacerbate this trend.
• Investments in adaptation and resilience can help the global economy manage the risk of uninsurability potentially closing the protection gap. We believe physical risks from climate change, and the associated financial and economic costs, will keep rising even if significant progress is made on decarbonization in the coming years, due to the impact of historical emissions that have already affected the atmosphere. In our view, at some stage, the cost of extreme weather and physical risk could lead to unaffordable, or unavailable, insurance coverage. We have observed significant insurance rate hikes in areas habitually experiencing weather-related losses, and some insurers have withdrawn from certain markets--for example, Florida or California, with respective losses from hurricanes and wildfires--where writing new business or renewing policies is unattractive. We believe investments in adaptation and resilience measures could help offset some of the rising economic costs, helping to mitigate losses associated with extreme weather events, encourage the ongoing availability and affordability of insurance coverage, and perhaps promote further insurance penetration.

What could go wrong:

• Affordability and availability of insurance could deteriorate. Although widespread insurer exits are unlikely in 2023, we believe insurers will demonstrate pricing discipline and monitor exposure growth by actively controlling risk accumulations, which will potentially limit how physical risks influence their credit fundamentals. However, higher premiums and policy non-renewals could lead to affordability and operational pressures in other segments of the economy, including corporations, banks, households, and local governments. This could also change the composition of communities if insurance protection gaps widen in areas most exposed to climate hazards.
• Continued lack of supply and demand for investment in adaptation and resilience could increase corporations, households, and governments' vulnerability to climate change. Investment in climate adaptation is lagging (see chart 4), accounting for less than 8% of climate finance globally. According to the Climate Policy Initiative, adaptation finance has expanded faster than mitigation finance over the last 10 years, but there is still a long way to go before investment in adaptation meets the $140 billion-$300 billion annual cost of adaptation that the United Nations Environment Program estimates the world will incur by 2030. A number of technical hurdles may constrain investment in adaptation, including the difficulty of predicting and measuring results and returns, uncertainty of the impact and efficacy of responses of adaptation projects, lack of data and standardization, and lack of consensus on how to consider positive externalities created by resilience investments. If investment in adaptation and resilience is insufficient to contain the risks posed by extreme weather within insurers' risk appetites, it could accelerate insurer exits or lead to steep price increases, widening the protection gap and pushing the risk back to corporations, households, and governments.

In an increasingly volatile geopolitical environment, cyber risk is a growing threat, and entities with weaker cyber governance and risk management will be more exposed to rating implications in 2023.

How this will shape 2023:

• Cyber is embedded in nation-state conflict. Amid the continuing Russia-Ukraine war and strategic confrontations between China and the U.S. and regional neighbors, we may see increased use of cyber capabilities accompanying military actions and foreign policy. The low deployment costs of cyberattacks relative to conventional military tactics, challenges in attributing them, and the potential scope for retaliation will help governments achieve foreign policy goals through espionage or sabotage of critical infrastructure.
• Cyberattacks with geopolitical motives will aim to create maximum economic and financial impact or disruption. Entities providing critical infrastructure, public services, and financial services are likely key targets for state or state-backed attackers. Other entities could easily become caught in the cyber crossfire. The more time attackers linger inside systems, the more ammunition they can muster for financial and reputational damage. Rating actions following cyberattacks tend to be in cases where it took time for entities to detect the breach or where the response was slow or insufficient.
• Cyber warfare will continue to evolve, necessitating more sophisticated insurance underwriting. There is a huge gap between the mounting economic and financial losses associated with cyberattacks and the size of the cyber insurance market, where coverage is less than 1% of economic losses. A growing number of (re)insurers are hesitating to underwrite larger risks, and some have decreased their risk appetite as the frequency and severity of cyberattacks increased and systemic vulnerabilities to geopolitical risk have grown.

What we think and why:

• Governments will increase their investment in cyber capabilities and defenses. As cyberattacks become increasingly sophisticated, governments will likely improve cyber preparedness through better risk and governance frameworks and detection and response strategies. Spending on cyber as part of defense and military priorities will increase in importance. For instance, the U.S. has budgeted an 11% increase in federal cyber security spending to $11 billion for 2023 and dedicated another $11 billion to the Department of Defense for cyber defense. We also expect growing cooperation between allied governments and international agencies to support states with weaker financial resources and cyber expertise. Significant international funding, technical assistance, and collaboration, including by the U.S. government and large American technology providers, such as Amazon and Microsoft, are thus far limiting the disruption caused by Russian cyberattacks on Ukraine.
• Cyber insurance can mitigate cyberattack risks, but rising premiums and the limited scope of coverage are dampening demand. Clear policies with precise wording are key to the sustainable development of the cyber insurance market, as highlighted by the contractual treatment of cyber warfare in the wake of the Russia-Ukraine war. We will continue to watch the evolving credit implications of cyberattacks due to any potential shortfalls in coverage for policyholders and for insurers' underwriting results, given many insurance policies’ still-ambiguous "act of war" exclusion clauses.
• Nevertheless, cyber insurance is still the fastest-growing subsector of the insurance market. We expect global cyber insurance premiums to increase by 25%, to over $14 billion, in 2023 (see chart). However, much of this recent growth stems from substantial price increases rather than underlying growth in the size or volume of contracts. The cyber insurance industry is in a period of portfolio optimization, leading to large rate increases, adjustments in coverage and conditions, and a greater focus on risk differentiation. Entities with more resilient cybersecurity strategies will receive more attractive insurance rates, which could encourage better cyber hygiene. Still, cyber insurance is only one element of cyber risk management. The risks will never be entirely avoidable or removable, and there is no replacement for good security practices.

What could go wrong:

• The impact of cyberattacks could spread beyond the intended targets, and across sectors and geographies. Given increased interconnectedness, digitalization, and concentration of third-party vendors, cyberattacks by states or state-sponsored actors could create knock-on credit implications for corporations, financial institutions, and other entities across the globe. In 2017, the NotPetya campaign--attributed to operatives allegedly working on behalf of the Russian military acting against assets in Ukraine--led to the spread of the attack worldwide.
• States’ weaponization of cyber will trigger retaliation that could further escalate conflicts. Explicit retribution for cyberattacks, thus far fairly limited, will likely evolve. Responses by targeted state entities and international organizations could include severing of diplomatic ties (as recently between Albania and Iran) or the imposition of sanctions that could affect the perpetrators’ access to international and financial markets.
• "Silent cyber" could pose credit risks both for insurance policyholders and insurers. Policies that do not explicitly address cyberattack coverage, or carry cyber warfare exclusions through force majeure clauses, can lead to insurers facing losses to settle unexpected cyber-related claims or expose policyholders to risks they thought were covered. Insurers may move to comprehensively exclude systemic and nation-state attacks from insured claims. But stricter underwriting may also mean more denials of cyber insurance to protect policyholders’ balance sheets, or more costly policies. This may potentially leave entities exposed to cyber threats without sufficient liquidity to deal with the aftermath of a cyberattack.

Although work on policy regarding stablecoins and central bank digital currencies (CBDCs) will speed up in 2023, their widespread adoption--and the attendant disruption--are still far off.

How this will shape 2023:

• A key question is when dedicated legislation for stablecoins will pass in the U.S. This will be critical to the future progress of stablecoins--cryptocurrencies whose market value is tied to an external indicator--since 95% of stablecoins globally are linked to the U.S. dollar. The causes of the recent failure of crypto exchange FTX and other protocols vary, and the timing of stablecoin regulations remains uncertain. But these events will sharpen the overall regulatory focus in 2023, which should ultimately lead to restrictions on algorithmic stablecoins (after the collapse of Terra and Luna in 2022) and on who can issue stablecoins. In Europe, the Markets in Crypto-Assets (MiCA) regulation proposed in 2022 should clarify the framework but wouldn’t take effect before 2024, even if the European Parliament passes it by the end of this year or early in 2023.
• While we expect another flurry of announced CBDC pilots, most initiatives will remain targeted in scope. In 2023, European authorities will likely discuss the possibility of launching a digital euro. But even if an agreement is reached, the launch is unlikely to occur until 2026 or later. That said, we expect further targeted wholesale use of CBDC (rather than retail experiments) in the region, typically involving mainly central banks and financial institutions (see chart). In the U.S., recognizing the potential risks and rewards, the White House has encouraged the Federal Reserve Bank to continue its ongoing research, experimentation, and evaluation of a U.S. CBDC, but there are no commitments to time frames or implementation at this stage. Examples outside Europe and the U.S. continue to thrive, with pilot programs--like the cross-border CBDC transactions between the Central Bank of the United Arab Emirates and the Hong Kong Monetary Authority, the Bank of Thailand, the Digital Currency Institute of the People’s Bank of China, and the Bank for International Settlements--likely to continue.
• More private-sector entities will trial novel payment mechanisms. In 2023, we foresee a number of payment firms announcing new initiatives, including stablecoin-supported transactions. As payment companies like Worldpay from FIS, Checkout.com, and Stripe have added payment options based on USDC (USD Coin), we expect the volumes of such payments to remain marginal in 2023 until stablecoins and/or CBDCs enjoy widespread adoption.

What we think and why:

• Stablecoins and CBDCs won't become mainstream in 2023 due to the small market for them and regulatory uncertainty. With the market capitalization of all stablecoins totaling less than $150 billion as of Nov. 18, 2022--the two largest being Tether (at $68 billion) and USDC (at $44 billion)--the total market is just a fraction of the $5.4 trillion U.S. monetary base. Much broader stablecoin adoption will be predicated on greater regulatory clarity, and the impetus behind stablecoins is also prompting authorities to accelerate work on CBDCs. But even though authorities in certain markets have declared CBDCs to be operational, their scope for now often remains specific to wholesale only, that is, between the central bank and financial institutions, and for certain market activities in particular. In certain countries, the launch of CBDCs has failed to curb the popularity of cryptocurrencies.
• Rising interest rates will raise questions about the calibration of yields on cryptocurrencies. Because central bank rate hikes will dampen some of their appeal, stablecoins and CBDCs will likely be designed as a payment tool rather than a store of value. As rates rise, currency issuers will get seigniorage, which will boost their revenue. Whether they offer those higher rates to currency holders is a different question. But this doesn’t change the premise that stablecoins should be safe and simple in their design, and that any offering returns above the risk-free interest rates should be viewed with caution.

What could go wrong:

• Stablecoin risks can be sensitive to external events and spread to the wider financial system. We expect the main stablecoins to be backed by low-risk liquid reserves (like cash and Treasuries). However, technical issues, market rumors, or other external events could still spark a run on stablecoin deposits, which would have material implications for the decentralized finance (DeFi) ecosystem, where stablecoins are a key component. Concentration across a small number of key stablecoins could magnify this impact and also lead to a sell-off of assets held as reserves. Conversely, limits to the volume of available safe assets that can be held as reserves may, to some degree, cap the size that certain crypto assets such as stablecoins may be able to reach.
• The assessment of risk, as well as many traditional financial institutions' business models, would need to adjust to a broader adoption of stablecoins. One consideration is understanding risks in stablecoin exposures. For example, stablecoins, which are minted by corporate entities, also embed the credit and operational risk of the minting entity, even if regulations will likely aim to reduce this risk. A material rise in the use of stablecoins and, by extension, DeFi applications could also have other credit implications through changes in the competitive dynamics underpinning various sectors.
• CBDCs will affect banks' business models. Our base-case scenario is that most authorities will go for an intermediated model, where commercial banks still have a key role to play. Even under that model, we expect some of the banks' revenue streams may come under pressure, for instance payment transactions. Equally, the underlying technology may offer some efficiencies. The calibration of the CBDC model will also be critical, since the amounts that can be deposited and their remuneration could also change banks' funding profiles.