A global recession presages a spike in default rates.  In our view, it seems likely that the sudden stop to the global economy caused by COVID-19--and the drastic efforts to contain it--will lead to a global recession (see "COVID-19 Macroeconomic Update: The Global Recession Is Here And Now," published on March 17, 2020). Combined with the collapse in oil prices and extreme volatility in capital markets, this will inevitably have severe implications for credit markets. In S&P Global Ratings' view, this will likely mean a surge in defaults, potentially reaching a double-digit speculative-grade default rate for nonfinancial corporates in the U.S. and a material increase to high single digits in Europe over the next six to 12 months.

Collapsing demand threatens a cash flow slump.  Central banks will likely prevent systemic failures in the financial system by cutting rates to zero or lower, injecting liquidity into the system, and implementing measures similar to those after the global financial crisis to lessen risk.

Nevertheless, the collapse in many areas of global demand will stifle cash flow for many industries, placing intense pressure on working capital, cash balances, and the ability to sustain operations, with many (especially smaller) companies requiring temporary loan funding with government backing. Efforts to cut cash burn through reducing capital investment, dividends, M&A, and staffing are likely to follow, helping intensify the economic consequences of COVID-19. Volatile market conditions will hamper funding, and in some cases, industries could struggle to avoid insolvency absent government-led fiscal support.

Nevertheless, the credit impact won't be uniform.  Unsurprisingly, the industries most affected by cuts in discretionary spending and containment measures are airlines, transportation, leisure and gaming, hotels and restaurants, and retail. Disruption to cross-border supply chains is another critical pressure point weighing on the creditworthiness of industrial sectors such as auto manufacturing and capital goods. Somewhat more insulated from the epidemic and market dislocation are industries such as healthcare and telecommunications.

Oil adds another default dimension.  The drop in oil prices--prompted by a breakdown of supply agreements and an anticipated slump in demand--has created a second source of credit and default risk. On March 9, we revised our oil and gas price assumptions down, with our West Texas Intermediate oil price assumption lowered 36% to $35 per barrel for 2020. We are reviewing all investment- and speculative-grade exploration and production as well as oilfield-services companies. For the speculative-grade segment, in particular, issuers without hedges that face upcoming maturities and are somewhat squeezed on borrowing-base revolving credit facilities will most likely face multiple-notch downgrades (see "Unrestrained Supply Swamps Oil Outlook: S&P Global Ratings Revises Oil & Gas Assumptions," March 9, 2020).

Companies rated 'B-' and below will likely suffer most from financing needs and rapid rating transitions.  As flagged by S&P Global Ratings frequently over the past two years, the number of companies rated 'B-' and below has increased significantly, particularly in the U.S. and in Europe. These low ratings indicate a higher vulnerability to adverse business, financial or economic conditions. Companies with these ratings are most likely to lack the financial flexibility to weather a crisis hitting both their top-line revenue and financing costs. They are also the most exposed to risks of distressed exchange or debt restructuring, which would qualify as a default under our ratings definitions.

But the investment-grade segment is showing some resilience.  In contrast, we expect entities with investment-grade ratings to exhibit stronger resilience and have more flexibility to absorb the impact of a global recession. This is not to say that we shouldn't expect a certain number of rating actions on companies in this segment, particularly for sectors most exposed to a severe disruption, such as airlines or oil and gas companies. Moreover, companies at the lowest investment-grade rating, 'BBB', are likely to continue to attract market attention, and we could take rating actions on some companies in the more exposed industries.

Chinese corporates are under pressure.  China was the first country hit by the COVID-19 outbreak. With Chinese production disrupted, some companies (and individuals) will have difficulty with debt repayment. As the domestic banking system remains the predominant provider of financing to corporates, in the worst-case scenario, this could result in a near doubling of the questionable loan ratio in China's banking system. Moreover, as Chinese regulators relax their bad-loan benchmarks, we believe it could take years for domestic banks to revert to normal standards, with long-term repercussions for the creditworthiness of some institutions.

Beyond corporates, we expect varying degrees of downward pressure for these sectors:

• Banks' overall balance sheet strength are a key support of creditworthiness across many regions during periods of stress. The economic effects of the pandemic on countries, although likely uneven, will test asset quality and revenues. In the near term, tighter funding conditions are unlikely to cause widespread problems for the banks we rate, but some nonbank financial institutions could face a more difficult year (see "COVID-19 Countermeasures May Contain Damage To Europe's Financial Institutions For Now," "COVID-19 And Falling Rates Cloud The Outlook For U.S. Financial Institutions," and "China Banks And Coronavirus: Forbearance Today, Diminished Standards Tomorrow").
• For insurers, despite expected increases in claim costs from COVID-19, the effects from financial market volatility will be more acute, particularly for insurers with already limited capital buffers. The reduction in capital levels will come from the combination of the downturn in the equity markets, lower interest rates, and potentially elevated levels of corporate downgrades--especially from transitions of those currently in the 'BBB' category.
• In structured finance, collateralized loan obligations (CLOs) have some room to absorb downgrades--particularly given well-diversified holdings for many funds--but if the pace of negative corporate rating actions increases, we see downgrade risk for some subordinate tranche ratings and, potentially, some 'BBB' tranche ratings ("Coronavirus Will Put U.S. CLO Diversity And Managers To The Test," March 13, 2020). Beyond CLOs, securities linked to aircraft leasing may suffer from airline insolvencies. The reduction in consumer discretionary spending may hurt the credit quality of certain CMBS deals with high exposure to retail and lodging properties, corporate securitization, and small business loan and SME-related asset-backed securities. Also, different government-sponsored payment holiday programs for mortgage, consumer, and small and midsize enterprise (SME) debt could interrupt cash flow, but structural mechanisms should insulate investors from shortfalls unless the interruptions endure. In addition, speculative-grade tranches in structured finance generally may experience heightened downgrade risk given forecasts for recession.
• On the sovereign side, governments are stepping up with fiscal measures to manage the health situation and avoid a dramatic human toll from COVID-19, while supporting the population and companies through a period of quasi-suspended economic activity. Most sovereigns benefit from extensive monetary, fiscal, and regulatory measures to support countries during severe crises, but some might come under more pressure. The length of the crisis, the resilience of the country's economic and political base, and the speed and adequacy of policy response will be key for the trajectory of sovereign ratings.
• States and local and regional governments will likely be hit by higher costs to manage the health and economic situation of the population and a drop in tax revenues. Here again, the credit impact will vary widely depending on the exposure of the government to COVID-19 and the drop in oil prices as well as its fiscal flexibility to absorb the exceptional stress.
• The impact to emerging markets will vary. Countries with greater exposure to tourism, commodities, U.S. dollar financing or that have larger external financial requirements will most likely see downward rating pressure, while others might be less exposed and better able to withstand the crisis. Furthermore, some key emerging markets have some room for fiscal and/or monetary stimulus, which could soften the blows. On the other hand, the spread of COVID-19 to emerging markets has been gradual, so the impact has been mostly through above-mentioned transmission channels. A faster-spreading pandemic will force governments to adopt decisive measures; the latter will further undermine growth and business conditions.

The duration of the pandemic will have a critical effect on credit risk.  Ultimately, the length of the economic fallout from the crisis will determine the credit impact across regions and asset classes. A severe but relatively short-lived economic drop (our base case) will mostly affect weaker credits or those in the most directly exposed industries. But a prolonged recession, beyond our current revised base case, could have broader implications.

The situation remains fluid, and S&P Global Ratings will continue to update the market regularly with a daily update on the economic and credit view, as well as ratings impact, available on www.spglobal.com/ratings/en/research-insights/topics/coronavirus-special-report.