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North American Credit Conditions are Broadly Favorable but Could Change as Risks Remain

(Editor's note: Editor's Note: S&P Global Credit Conditions Committees meet quarterly to review macroeconomic conditions in each of four regions (Asia-Pacific, Latin America, North America, and Europe, the Middle East, and Africa). Discussions center on identifying credit risks and their potential ratings impact in various sectors, as well as borrowing and lending trends for businesses and consumers. This article reflects the view developed during the North American Credit Conditions Committee discussion on Sept. 26, 2016.)

While credit conditions in North America remain broadly favorable, with both the U.S. and Canada putting a sluggish first half economic performance in the rearview mirror, S&P Global Ratings sees risks that could threaten this stability. The persistence of low or negative interest rates in many economies around the world is helping growth recover, but the easy rate environment is also enabling increased risk-taking. U.S. and Canadian financial institutions are scaling back risk appetites by incrementally tightening lending standards for some borrowers. However, bank lending conditions remain broadly accommodative and investors are maintaining risky asset exposures to boost portfolio returns. Investors' greater tolerance for risk in the third quarter saw a notable increase in speculative-grade bond issuance and continued the gradual narrowing in credit spreads underway since February. The spread tightening reversed the short-lived widening that took place immediately after the United Kingdom's vote to leave the European Union. Early year jitters about the impact of China's slowing economy on global growth have eased and this is also boosting investor risk appetites.

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.

Overview

  • The U.S.' long, slow recovery from the Great Recession continues. 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.
  • Amid a backdrop of prolonged low Treasury yields, most measures remain neutral or difficult for funding conditions ahead.

Macroeconomic Conditions

The U.S. economy continues to expand slowly

The labor market is bouncing back from a slump in job creation through May. Household spending has strengthened, and the housing market continues to pick up steam. The wobble in net exports appears to have lessened. The long, slow recovery from the Great Recession continues, with the positive factors for the world's biggest economy being:

  • Surprising resilience in the private sector, which has helped to dramatically offset the drag from government spending cuts last year;
  • A welcome change that may see the government being a net (albeit small) positive for growth;
  • Business investment in equipment and nonresidential structures will be positive contributors to growth in the coming year (versus both were negative this year); and
  • Continued gains in hiring activity, which we expect to remain steady in the coming quarters, adding to wage gains.

Improving balance sheets, the continued recovery in housing, low gas prices, and the positive knock-on effects on consumer spending all will fuel economic growth. We expect real consumer spending to grow 2.7% this year, after it has increased by just a little over 2.3% on average during the recovery, which is now in its eighth year. But, given the lower-than-expected economic expansion in the first half, we now expect full-year U.S. real GDP growth of just 1.5%--down from our June forecast of 2%. Even if we assume the second half of the year came in line with our earlier expectations, full-year growth would be 1.7%. We now forecast 2.4% growth in 2017.

We continue to see the risk of the U.S. slipping back into recession at 20%-25%, as uncertain conditions overseas and a polarized government at home keep consumers and businesses cautious. While our downside scenario assumes very slow growth, we think the U.S. would likely avoid recession (typically defined as two consecutive quarters of contraction). The downside scenario could be brought about as exports take a hit and capital investment by businesses and residential developers never picks up, while consumer confidence reverses its recent gains.

As it stands, we expect the recovery to continue and forecast another rate hike by the Federal Reserve in December that would push the federal funds rate to 0.50%-0.75%, from 0.25%-0.50%. The solid jobs market and improving economic activity suggest the U.S. now needs less monetary stimulus to sustain its recovery. The Fed raised the benchmark rate by 25 basis points in December 2015--the first increase in a decade. But as central bank policy makers have stressed repeatedly, the level and pace of interest rate increases are data-dependent.

Conditions are decidedly less rosy further north.
Canada suffered its worst economic setback in seven years, with a 1.6% quarter-over-quarter annualized contraction in real GDP in the second quarter. Alberta's wildfires and shutdown in crude oil production reduced the energy sector's output by about 2.5% from a year earlier, while non-energy sectors continued to expand, albeit at a moderate 1.5% rate.

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, for instance, dropped 9.6% in the quarter, and sales of refined petroleum products tumbled 19.6%.

But the effects of Alberta's wildfires have already begun to fade. In June, a 0.6% increase in monthly GDP offset the cumulative 0.5% decline of the previous two months. Other encouraging news, besides a 3.9% increase in energy-sector output in June, included the rebound in durable and nondurable goods manufacturing (e.g., machinery, fabricated metals, autos, chemicals, wood products, and furniture).

We expect the recovery at the end of the second quarter to extend into the third, setting the stage for average real GDP growth of 2.0%-2.5% in the second half of the year. The improving terms-of-trade and rebound in gross domestic income is easing pressure on commodity producers to further cut capital spending or lay off workers. And fiscal stimulus--such as infrastructure spending and child-benefit payments--is now flowing through the economy.

Nevertheless, with real GDP growth averaging only 0.4% in the first half, we now expect the economy to expand at a slower 1.1% in the full year, down from our previous forecast of 1.4%.

The recent pick-up in equipment spending is encouraging, but businesses remain cautious amid an uncertain global outlook. Most of Canada's recent non-commodity export gains (e.g. autos, fabricated metals and forest products) are coming from improving American demand, so slower U.S. growth in the first half of 2016 could cause some Canadian companies to put their spending plans on hold while they wait for signs of recovery. Sluggish hiring is holding back wages for Canadian workers, annualized wage growth of 0.8% so far in 2016 is lagging core inflation of 2.0%, and large household debt burdens are also constraining consumers' purchasing power. More monetary stimulus probably won't be needed, but we see the Bank of Canada's policy rate remaining unchanged at 0.5% until late 2017. Although the recovery should continue to build, Canada real GDP growth is likely to remain modest, averaging just above 2% in 2017.

The U.S. will head to the polls, and credit markets will be watching
We will see a busy schedule of important elections in upcoming months, beginning with the U.S. vote in November, then next year in a number of European countries (notably France and Germany). Brexit may 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. Increasing populist sentiment ahead of the U.S. elections also points to a shifting political landscape in the world's largest economy. This rise in anti-globalization sentiment could further slow the already sluggish recovery in international trade if governments adopt protectionist trade or anti-immigration policies. A setback in international trade could put more pressure on policy makers to support growth through monetary or fiscal stimulus, as domestic spending by households and businesses around the world is not expanding rapidly.

Economic activity in the eurozone has remained resilient in the aftermath of the Brexit vote, and there have been positive developments in Europe's financial and credit markets since. After an initial plunge following Britons' vote in a referendum to leave the E.U., equity markets have rebounded, and bank lending to the private sector continues to improve. But we believe Brexit's negative impact will be greater in the medium to long term. British Prime Minister Theresa May recently confirmed her government's plans to begin formal Brexit negotiations with the rest of Europe by the end of March 2017, and uncertainty about the outcome of these negotiations could again spark financial market volatility.

Low or negative interest rates are contributing to easier financial conditions and the expansion in private sector credit is supporting economic recovery. However, growth remains uneven and the persistence of low rates has had a number of unintended consequences, including the squeeze on bank net interest margins, which is undercutting the profitability of lending. Savers are struggling to make adequate investment returns, and institutional investors (such as insurance companies or other asset managers) are increasing their risk appetite to boost returns. Low rates are also expanding the unfunded portion of pension liabilities for defined benefit plans. The search for yield could end badly if an abrupt increase in risk aversion causes a repricing of risk and disorderly adjustment in global investment portfolios. In such a scenario, reduced market-making activity by dealer banks could strain secondary-market liquidity for investors and restrict access to debt financing for borrowers.

The unintended consequences from low rates could linger as a quick exit from easy rate policies is unlikely. For instance, lower productivity growth is contributing to declines in the U.S. natural rate of interest (the equilibrium real rate consistent with stable inflation when the economy is at full employment) and this is reducing the amount the U.S. Federal Reserve will need to hike its policy rate. In other economies, such as Japan and the eurozone, where the recovery is not as advanced as it is in the U.S. and economic headwinds persist, a reversal of negative interest policies seems unlikely for the foreseeable future.

Canadian consumer debt burdens continue to climb
The 15% foreign buyers tax implemented by British Columbia in August could curb the rise in home prices in the province, while in Ontario prices are still appreciating at an unsustainable rate. The federal government is implementing new rules aimed at curbing risky borrowing. For instance, all insured mortgages will undergo a stress test to validate homebuyers' affordability at higher interest rates. Rising consumer debt burdens across the country are signaling elevated vulnerability to a housing correction, but low interest rates are enabling a faster pay-down of mortgage principal, so homeowner equity ratios are increasing. Among other debt sustainability measures, the ratio of debt to net worth has remained stable at about 20%, with the growth in consumer debt burdens offset by matching increases household asset holding (primarily increases in the value of real estate and securities holdings). Still, the significant weakening in Canada's terms of trade since mid-2014 and downward pressure on gross domestic income since then (notwithstanding recent improvements) is constraining nominal GDP growth, so household credit market debt has continued to rise as a share of GDP. Slower disposable income growth in the second quarter also saw the household debt-to-income ratio increase to a new high of 167.6%. There could be a further deterioration in these debt affordability metrics as we do not expect a significant pick-up in nominal GDP or household income growth in 2016 or 2017.