While global credit conditions are generally mixed around the world--broadly favorable in the U.S., Europe inching toward mild improvement, while Asia-Pacific and Latin America are less favorable--a multitude of risks have the potential to destabilize global conditions going into 2017.
Financial market volatility tops the risks, notably the markets relying too heavily on low or negative interest rates, relaxed lending standards, or increased investor risk-taking. Adding to that are the cumulative effects of dealer banks' reduced market-making activity, strained secondary-market liquidity for investors, and restricted access to debt financing for borrowers from a repricing of risk, and abrupt adjustment in global investment portfolios.
Brexit may have had a more muted reaction than initially predicted, but the U.K.'s referendum vote to exit the European Union might have energized broader, populist trends already pulsating through Europe. Along with a particularly contentious U.S. presidential race, the rise of populism and potential adoption of protectionist measures could raise barriers to international trade and disrupt investment. More broadly, there's the possibility that geopolitical risks from terrorism and Middle East turmoil (including Syria's and Europe's migration crisis) could threaten global security, increase risk aversion, and ultimately undermine global economic growth.
China also represents a continuing top risk. A disorderly deleveraging of its outsized and ever-growing corporate debt burden as its economy rebalances away from being overly investment-dependent would destabilize market confidence, loan performance, and asset and commodity prices. Such a scenario would increase volatility and liquidity stresses in financial markets, especially those in emerging markets.
The U.S. and Canada
Credit conditions in North America remain broadly favorable. The U.S.' long, slow recovery from the Great Recession continues as its labor market bounces back, household spending strengthens, and housing market continues to pick up steam. The wobble in net exports appears to have lessened. The solid jobs market and improving economic activity suggest the U.S. now needs less monetary stimulus to sustain its recovery.
Conditions are decidedly less rosy in Canada, which suffered a 1.6% quarter-over-quarter annualized contraction in real GDP in the second quarter. But encouraging signs--such as a 3.9% increase in energy-sector output in June--are appearing. Canada sells three-quarters of the crude oil it produces annually to other countries (mostly to the U.S.), so the production cuts led to weaker international trade. Crude oil and bitumen exports dropped 9.6% in the quarter, and sales of refined petroleum products tumbled 19.6%.
An abrupt increase in risk aversion could destabilize credit conditions and we are monitoring a number of potential triggers for a re-pricing of risk, including uncertainty in the European and U.S. political landscape, Brexit, a disorderly deleveraging of China's outsized and growing corporate debt burden, and the trajectory for policy rates set by the U.S. Federal Reserve and other major central banks.
Amid a backdrop of prolonged low Treasury yields, most measures remain neutral or difficult for funding conditions ahead. Commercial-paper yields have stayed exceptionally high since last fall and the yield curve in the U.S. fell quickly through most of 2016, but has increased noticeably during the last few weeks' increased volatility. Corporate credit spreads have fallen since mid-February and are back around levels seen before last summer's slowdown.
Europe, the Middle East and Africa
Economic activity in the eurozone has remained resilient in the three months after the Brexit vote, according to the latest batch of business surveys, not suggesting any marked slowdown in growth. Meanwhile, there were also positive developments in Europe's financial and credit markets. Equities rebounded after their initial Brexit plunge, mitigating negative equity price spillovers to the real economy from the start of the year and in the month of June. Plus, bank lending flows to the private sector continued to improve in July and August.
Brexit may have had a muted reaction so far, but it might have energized broader, populist trends already pulsating through Europe. Citizens of other EU member nations have expressed interest in holding referendums of their own to exit the group. Separately, Italy is holding a referendum in December, which--although unrelated to EU membership--could lead to heightened political uncertainty and invigorate even more anti-European parties. The refugee influx spawned new political parties in Germany, upending its traditional party system. And populist parties in France, while not likely to gain the presidency next year, are polarizing the political landscape and the electorate.
Credit conditions in EMEA, in general, continue on a path of mild improvement, but the continuing aggressive accommodative monetary policy by central banks masks the structural issues of most European countries' economies that still linger. While we don't believe Europe will sink into deflation-tinged lost decades like Japan, we do see a protracted period of feeble real economic growth, to which it is becoming increasingly more difficult to see an end. A number of factors contribute to this belief. They include zero or negative rates for years to come, high unemployment, an inability to aggressively mobilize fiscal policy, and lack of political will to find solutions. Moreover, banks in a few countries (namely on the periphery) are still saddled with a raft of nonperforming loans, which is slowing credit expansion. The dependence of the European real economy to the banking system is even higher than in U.S., where a mature capital market plays a big role in financial intermediation. Therefore, efforts to restructure the banking system (for example, by reducing the high stocks of nonperforming loans, strengthening capital ratios, and further consolidation and downsizing) is more critical, but, at the same time, more unpopular.
There is good news for funding and liquidity. Government bond spreads remain stable for Spain and Italy and other periphery countries, except for Portugal. As for the real economy, interest rates on new loans for small and midsize enterprises (SMEs) have narrowed considerably for Italy and Spain. Firms can pretty much now borrow at the same rate as Germany (+30 basis points [bps]) compared with +250 bps at the height of the crisis. And interestingly, interest rates on new household deposits are now lower in the periphery than in core countries. All this shows that reducing fragmentation, which has always been one of the intermediate steps for the ECB to reignite growth, seems to be working well.
Credit trends in Asia-Pacific continued to be generally less favorable as a result of the lag effect from the region's economic slowdown in terms of rating net negative bias in the third quarter of 2016. Having said that, we have observed financing and debt capital market conditions to have stabilized, and, in fact, swing back to life over previous quarters' volatile market conditions.
Regionally, our main concern is the current trajectory of the Chinese economy and credit growth, which we view as ultimately unsustainable. China's risks are more of a medium-term nature given the relative strength of the public balance sheet as well as the relatively closed and state-run nature of the economy. While we continue to have concerns about the trajectory of GDP, and particularly credit growth, we do not see much risk of any deviations from our baseline over the next few years unless there was a major political and economic miscalculation or inaction. We would underscore that this is an assessment of the authorities' policy reaction function and their desire to smooth the necessary adjustment rather than a vote of confidence in the macro story. To that end, the logical time to expect some action would be the Party Plenum later this year and the follow up Congress in early 2017.
After a volatile start to the first half of 2016, investors and lenders have seen financial market stability (or reduced market volatility) return during the third quarter across markets in the Asia Pacific region. This is also to varying degrees consistent with international funding conditions, which have improved after seven consecutive quarters of declines.
Credit conditions for Latin America are mixed going into next year. We expect a growth rebound in 2017 in Brazil and Argentina as both economies emerge from recession, which should improve credit quality for the corporate sector. However, political challenges and tightening fiscal policy will constrain the positive impact for corporates, while in other sectors, such as Brazilian local and regional governments, negative impact from this year's recession will continue to constrain credit quality. With the Mexican economy performing below our expectations, including weaker growth (and expected tightening of fiscal policy to compensate) and a weaker currency, domestic demand-sensitive sectors may be affected. For the financial sector, the largest banks have been resilient to the challenging environment in the region this year, despite growth in non-performing loans and lower profits; the gradual recovery expected for the region should be a positive. And for the region in general, besides continuing potential downside risk for Brazil, we continue to monitor other key risks, including global credit market volatility and the related impact on capital flows, and the persistence of low commodity prices from a historical perspective, despite a partial recovery from recent lows.
Financing conditions are subpar. Brazil's fiscal difficulties have been a drag on Latin American issuance, and Mexico has been facing headwinds as well, largely the result of falling oil prices earlier this year. Together with ongoing financial market volatility, these forces continue to present some of the weakest financing conditions for developing regions since the financial crisis. Still, some pockets of positivity exist, as Argentina demonstrated by returning to the debt markets in April, and are spreading to other areas in Latin America as well, though slowly.