The global business environment has proved remarkably resilient in recent months, despite heightened political and geopolitical uncertainty following Donald Trump's election as U.S. President, the U.K. referendum vote to leave the EU, and the question of whether eurozone countries will experience similar political shocks.
The market calm may also reflect the absence of details on many of the new U.S. administration's policies, and the outcome of the U.K.'s negotiated exit from the EU. However, the calm also reflects favorable fundamental economic developments globally, including the continued stabilization of energy and other commodity prices, China's path to slower growth, and continued quantitative easing by the Bank of Japan and the European Central Bank.
In this uncertain environment, it is a good time to present S&P Global Ratings' Industry Top Trend (ITT) 2017 reports. These cover 17 major nonfinancial corporate sectors. Each report details our industry forecasts and key assumptions, and how they feed into our rating outlooks. In addition, the reports discuss the three most material risks or opportunities facing each industry.
Industry Top Trends 2017: Key Risks And Opportunities For Nonfinancial Corporates Globally
Drawing on our ITT 2017 reports, we have identified six credit factors that we believe will affect corporate credit quality in 2017-2018. These credit factors are either risks or opportunities, depending on the industry. Some factors represent material developments that we incorporate into our assumptions for rating purposes, while others may not be clear enough to factor into our current credit assessments. Potential developments relating to U.S. tax reform or foreign trade policy currently fall into the latter category. The six credit factors are:
1. U.S. administration policies
It is too early to determine the scope and timing of the planned reforms of the U.S. tax system, but the implications for U.S. corporate financial strategy could be significant.
A reduction in U.S. taxes on the cash repatriation of foreign earnings by U.S.-based multinationals (for example, technology and consumer products companies) would likely see some of this capital returned to shareholders, albeit with sensitivity to resulting leverage. In the case of technology companies, we might not see large share buyback programs if they would lead to materially higher leverage and lower ratings.
Similarly, depending on the tax reform passed, a lower statutory corporate tax rate, coupled with the elimination of interest expense deductibility, could increase free operating cash flow for many companies, with telecoms and cable operators being among the likely beneficiaries.
Several sectors--including capital goods, utilities, oil and gas, and transportation--stand to gain from accelerated capital depreciation, as this could encourage capital investment.
At the same time, capital-intensive sectors that rely heavily on debt financing to fund capital expenditure could incur a higher cost of capital if the benefits from a lower statutory corporate tax rate are overshadowed by interest expenses no longer being deductible. Such sectors might include oil and gas, metals and mining, telecoms, and autos.
Health care. Reforms to the way care is provided, where it's provided, the value patients receive, and how it's paid for and funded are major issues, with all elements of health care being redesigned in some way. This could lead to a material intensification of pricing pressure, including a shift to value-based reimbursement and initiatives to increase pricing transparency, and weaken the industry.
Trade protection. Any barriers to trade could have broad-reaching implications for many industrial sectors operating in the U.S.
These implications range from the disruption of cost-efficient, global supply chains for certain sophisticated industries (for example, aerospace, autos, consumer products, capital goods, and technology), as well as commodity-type industries (building materials and retail), to a rise in the domestic price of West Texas Intermediate crude oil.
Immigration restrictions could hamper technology services companies that rely heavily on H1-B nonimmigrant temporary visas for specialist workers, as well as limit the supply of construction workers in an already tight labor market.
2. Developments relating to China
Our main concern regarding China is high levels of corporate debt and weakening credit quality. However, the rate of economic growth and the pace of rebalancing the economy toward the consumer and service industries is particularly important for certain sectors.
We anticipate that auto sales growth in China--the largest light vehicle market in the world--will slow to 1%-5% per year in 2017, largely because of reduced tax incentives. Production capacity is scheduled to increase by a substantial 8% in 2017, exacerbating competitive pressures and eroding joint venture EBIT margins. Any possible trade war with the U.S. would risk undermining business and consumer confidence in China.
For the metals and mining sector, steady global demand and relatively stable supply has improved the market balance in most commodities. However, the level of Chinese demand remains our No. 1 risk factor, as China accounts for over half of global demand for most metals.
3. Financial policies
A growing risk to credit quality affecting many sectors is companies' adoption of more aggressive financial policies, particularly investment-grade companies engaging in debt-funded acquisitions encouraged by cheap debt.
There are several key drivers behind this growing trend. First, an objective to supplement stagnant organic growth by targeting companies operating in faster-growth markets (for example, specialty chemicals). Second, an acquisition strategy that relies on cutting operating costs, realizing cost synergies, and reducing competition to underpin or improve operating margins (for example, packaged goods). How companies fund acquisitions and how quickly they can reduce leverage largely determines the rating outcomes.
More positively, the rationale for greater mergers and acquisitions (M&A) activity in 2017 can also be to achieve diversity and scale (for example, telecoms and technology companies), as well as greater vertical integration combining content with distribution (for example, media companies).
We expect M&A to continue in the pharmaceuticals industry, with the aim of replenishing product pipelines and portfolios and countering competitive pricing. However, with a limited number of high-quality target companies, purchase multiples will be high.
Utilities companies are not immune to the M&A trend either. In North America, the focus is on debt-funded cross-industry or cross-border combinations, even at high purchase multiples. European utilities remain more disciplined about M&A, and are spinning off some of their more mature networks and using the proceeds to remunerate shareholders and reinvest in their remaining networks.
Structural overcapacity continues to weigh on some sectors' credit prospects. U.S. commodity petrochemicals is one sector likely to experience oversupply from late 2017, as substantial new capacity comes on stream. Another is cement, where low capacity utilization persists outside the U.S.
Shipping retains excess capacity and is vulnerable to a further slowdown in global trade. Similarly, oil drilling companies, especially offshore companies, remain oversupplied, with more drill rig deliveries due in 2017.
China still has substantial overcapacity in a number of industrial sectors. We believe that China's domestic auto industry is highly competitive due to structural overcapacity, placing pressure on industrywide profitability. In addition, steel production capacity in China remains excessive and is unlikely to shrink any time soon, given the government's medium-term horizon for eliminating inefficient capacity.
5. Technological change
Technological change presents serious risks and opportunities for many industries. The increasing digitalization of utility networks is an opportunity. This prevents problems, shortens response times, and reduces or optimizes the utilization of staff.
Meanwhile, many traditional retailers continue to struggle with the price transparency, surplus high street real estate, and the need for extensive delivery networks brought about by online shopping.
The introduction of new technologies can be disruptive, requires investment, and takes time. Online music sales and mobile advertising have reached an inflexion point, and now outpace traditional media.
For telecoms companies, however, we expect 5G capital investments will be limited over the next couple of years until a critical mass of applications for the "Internet of things" becomes available.
6. Regulatory environment
Regulation determines the operating and competitive environment for many sectors, including utilities and telecoms. We anticipate regulatory changes under the new U.S. administration that could, for instance, lead to some relaxation of data privacy rules. This would benefit telecoms, cable, and media companies seeking to provide more tailored services, as well as potentially monetizing their use of customer data.
Environmental regulation is also in flux. While autos and other cyclical transportation sectors are tasked with reducing emissions, the U.S. administration appears to be distancing itself from the 2016 Paris agreement on climate change. Nevertheless, the adoption of renewable energy sources is also driven by significant technological progress and falling costs, which continue to improve these sectors' economic viability.