Demand Destruction And Sharp Economic Contraction Adds Pressure To Already Pressured Credit Quality

S&P Global Ratings now forecasts a steeper global recession and expects global GDP to decline by 2.4% in 2020 but to rebound in 2021 with expected growth of 5.9% in 2021. We expect the U.S. to post a historic (annualized) contraction in the second quarter of 35% and full year 2020 GDP decline of 5.2%, though we expect a recovery in 2021 with 6.1% expected GDP growth (see "COVID-19 Deals A Larger, Longer Hit To Global GDP," published April 16, 2020). Although the capital goods sector serves a broad array of customers, we generally view it as cyclical and expect the economic contraction and reduced capital expenditures (capex) by key end markets to curtail demand for original equipment and, to a lesser extent, aftermarket parts. The collapse of oil prices will also hurt capital goods issuers with high exposure to the sector.

While we expect the service sector to be hit harder than the manufacturing sector, the Purchasing Managers Index (PMI) for the manufacturing sector returned to contraction territory, with March PMI decreasing to 49.1 from 50.1 in February and we expect the negative trajectory to continue.

Our outlook for the capital goods sector was already weak entering 2020 due to trade tensions and slowing economic growth. The rapid onset of COVID-19 added significant stress to a sector already facing headwinds. Given the challenging operating landscape, we have taken over 40 negative rating actions and the portion of ratings with negative outlooks has risen to about 31% from 19% at the end of 2019. By comparison, our negative bias stood at approximately 26% at the height of the 2016-2017 industrial downturn. While the 31% negative bias is high historically, this is still below corporate sectors that are more directly impacted. For example, over 65% of ratings in the oil & gas sector and 45% of rating in the auto sector have a negative bias as of March 31, 2020.

End-Market Strength Will Be A Decisive Credit Factor

While we expect all end markets to suffer under the economic recession, issuers with higher exposure to weaker end markets such as oil & gas, autos, aviation, construction, foodservice, material handling, auto, and to some extent metals/mining, will be more vulnerable given the dramatic decline in demand from these sectors.

Below are a few updates on these key end markets.

Oil & Gas

Oil prices have plunged, tied to oversupply and the standoff between Saudi Arabia and Russia. As a result, we expect capex related to the oil & gas sector to cut back substantially. We see the upstream segment facing the most pressure. Rig counts in North America declined by about 40% year over year and we do not expect a recovery in the near term. This will likely depress spending on oil & gas equipment. We expect significant capex declines, which could directly impact rated capital goods companies. For instance, ExxonMobil announced it was reducing capex by 30%.

We expect crude oil prices to remain weak this year due to a severe supply-demand imbalance, with West Texas Intermediate (WTI) averaging about $25 per barrel and Brent Crude about $30 per barrel this year.

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Aviation

Measures to contain the coronavirus pandemic have led many airlines to ground large portions of their fleets. The International Air Transport Association, IATA, projects that European air traffic could fall 46% in 2020 compared with 2019, assuming a very strict three-month lockdown, while we have assumed a drop in the range of 25%-35%.

Given the sudden drop in air traffic demand, this will likely result in a dramatic decline for services, particularly for the commercial aviation sector. We recently revised the outlook on General Electric Co. (BBB+/Negative/A-2) due to its exposure to aviation services. We also recently downgraded Parker-Hannifin Corp. (BBB+/Negative/A-2) and maintained a negative outlook, in part due to its aerospace exposure. Parker-Hannifin closed on the acquisition of Exotic Metals Forming, a designer and manufacturer of components for engine and airframe systems, in the second half of calendar 2019.

Autos

Our autos analysts expect a material decline of light vehicle demand globally and this decline will be particularly severe in the second quarter of the year, only gradually recovering thereafter. We expect global light vehicle sales will likely decline by almost 15% in 2020 to less than 80 million units (versus 90.3 million in 2019). Given the large majority of global auto manufacturers have announced production shutdowns at most of their plants in Europe and the U.S, this will likely result in a cutback in orders from their supply chains. We continue to see pressure in the heavy and medium duty truck segment, which was already bracing for a sharp decline even prior to COVID-19 headwinds.

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Metals/Mining

In late March, we lowered our assumptions for several metals for 2020-2022. Demand fundamentals for industrial metals have been weighed down since late 2019 by slowing economic growth in the U.S., China, and EU, particularly in the important construction and automotive sectors. On top of that, we believe the one-two punch of rapidly escalating coronavirus pandemic and the sharp drop in oil prices could cause demand to drop for some key metals in 2020. We expect producers to cut output and tighten inventory levels, resulting in reduction in capex.

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Supply Chain Disruption Is Restricting Capacity And Output

In addition to demand destruction, capital goods issuers are also facing supply chain disruptions. Government mandated closures of production facilities, slump in demand, as well as labor shortages are contributing to capacity reduction and restricting output. While operations in China have largely resumed as China has passed the first-wave COVID-19 peak and has gone some way to restarting its economy, disruptions have emerged in the U.S. and Europe, the Middle East, and Asia (EMEA). Industrial sector operating capacity is around 90% of normal levels in China as workers steadily return from their home provinces.

While supply chain disruptions could have some impact on operating performance, we expect these disruptions to be relatively short term and to have only a modest impact on most issuers. Issuers operating a diversified supply chain can better mitigate supply chain disruptions compared to those reliant on a limited number of facilities.

To mitigate the impact of the sudden revenue decline, issuers have implemented cost reduction measures such as workforce reduction or furloughing. Despite these measures, we still expect a significant erosion of profit margins given the relatively high operating leverage and capital intensity of capital goods businesses. Reduction in inventory, however, could result in some improvement in working capital that could support operating cash flow despite earnings decline.

Given the high level of uncertainty in the recovery, capital goods issuers could consider more permanent capacity reduction and more permanent labor cost reductions. In addition, although many capital goods issuers will curtail capex in the short-run, we think issuers will likely accelerate automation to their operations after the peak of the crisis subsides to enhance efficiencies in light of the disruption by COVID-19.

Lower Rated Issuers Will Face Greater Ratings Pressure

We have taken 43 rating actions in the capital goods sector in 2020, of which 41 were downgrades. The number of rating actions accelerated in March as we expect the impact from COVID-19 and the steep decline in economic activity to pressure operating results in 2020. The rating actions were mostly in the 'B' category and decidedly negative, with downgrades of mostly one notch and outlook revisions to negative. The high proportion of negative rating activity reflects our expectations of material deterioration in credit metrics as our revised forecast include sizable revenue declines in 2020 due to lower demand, margin compression, as well as lower cash flows and liquidity concerns such as refinancing risk or thinning financial covenant cushion.

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The Growing Number Of 'CCC' Ratings Highlights Increasing Default/Distressed Restructuring Risk In The Next Year

We expect defaults to rise in the next year as the number of issuers in the 'CCC' category has risen sharply to about 12% of the rated portfolio in the capital goods sector compared to 5% at the end of 2019. The expected higher defaults for capital goods is in line with our expectations for ratings performance in nonfinancial corporate borrowers. Given the extent of the economic contraction, oil collapse and capital markets volatility, this will likely mean a surge in defaults, potentially reaching a double-digit speculative-grade default rate for nonfinancial corporates in the U.S. over the next six to 12 months. Our expectations for increased defaults includes debt restructurings that we deem distressed. Generally, issuers rated 'B-' or lower are the most exposed to risks of distressed exchange or debt restructuring, which would qualify as a default under our ratings definitions.

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Large, Diversified Industrials Are Better Positioned To Withstand A Sharp Economic Downturn

We expect most investment-grade large, diversified industrials issuers to withstand near-term pressure and repair credit metrics in 2021. For example, Caterpillar Inc. (A/Stable/A-1) has a healthy cushion under its credit metrics to withstand a material slowdown in its construction, mining, and oil & gas end markets that will significantly reduce its revenue and earnings in 2020. Caterpillar's S&P Global Ratings-adjusted funds from operations (FFO)-to-debt ratio was 117% as of the end of 2019, which stands well above our 30% downside trigger.

Still, eight of the 24 investment-grade ratings have negative outlooks or are on CreditWatch negative to reflect the downside risk from an uncertain recovery in 2021. We also expect some cases of investment-grade ratings falling into speculative grade (fallen angels). For instance, we lowered the rating on Hillenbrand Inc. to 'BB+' from 'BBB-' because we believe the company's deleveraging following its recent acquisition of Milacron Holdings Corp. will now take longer than we previously expected due to a contraction in economic activity.

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Related Research

• An Already Historic U.S. Downturn Now Looks Even Worse, April 16, 2020
• Credit FAQ: Airlines And Airports Worldwide Confront An Unprecedented Plunge In Traffic And An Uncertain Recovery, April 6, 2020
• COVID-19 Will Batter Global Auto Sales And Credit Quality, March 23, 2020
• Metal Price Assumptions: Oil Prices And The Coronavirus Dulls Demand For Most Metals, March 16, 2020
• S&P Global Ratings Cuts WTI And Brent Crude Oil Price Assumptions Amid Continued Near-Term Pressure, March 19, 2020