Global Credit Outlook
Escalating trade tensions – especially between the U.S. and China - ratchet up risks after a historic run of benign conditions, expanding leverage moves the credit cycle further into extra innings and capital outflow pressures squeeze emerging markets
Positive economic growth that continues in all regions—at differing speeds, of course—is extending the relatively benign credit environment that has benefited borrowers, but with a number of risks on the horizon.
Managing Director, Economics & Research
While global credit conditions remain broadly favorable, an escalating trade battle between the U.S. and its trading partners, notably China, in the form of billions of dollars in retaliatory tariffs are dragging down global investor confidence, threatening spending, and economic growth. It’s still unclear whether all involved parties will negotiate new trade terms or retaliate into an all-out trade war. Whatever the case, the actions thus far have infused broad uncertainty about the outlook for international trade and whether it will continue to be a lever that drives growth for the global economy.
North America: Tit-for-tat retaliatory tariffs that erode consumer and business sentiment could slow growth, while rising corporate debt is pushing a mature credit cycle nearer to a turning point.
Latin America: Exchange rate volatility is raising the cost of U.S. dollar denominated borrowing and a liquidity squeeze could tighten financing conditions.
Europe: A disruptive Brexit seems more likely. With no obvious resolution -- especially for the auto sector -- trade tensions with the U.S. could become a greater threat.
Asia-Pacific: As China runs out of room to impose retaliatory tariffs on its imports of U.S. goods, the U.S.-China trade battle could spread economic pain by spilling over into services trade.
Escalating trade tensions, a strong U.S. dollar and global portfolio rebalancing threaten stable credit conditions.
The growing list of products targeted in tit-for-tat retaliatory tariffs -- some produced by multinationals through integrated supply chains -- will expand the share of global GDP exposed to trade and investment disruptions.
Escalating tariff measures now hitting $250 billion of goods American buy from China and $110 billion of Chinese imports from the U.S. suggests options may be fading for forging a compromise between the world’s two largest economies. As the threat to producers’ supply chains undermines business sentiment and tariffs raise consumer prices, trade tensions could become a larger drag on growth than monetary policy normalization which continues in the U.S. and elsewhere.
The moderate upward adjustment in central bank policy rates haven’t been a threat to growth for developed economies. Expectations for continued rate hikes in the U.S. and a strong US dollar, however, are becoming a source of volatility and tighter financing conditions with international investors reducing their purchases of emerging market debt and equity instruments.
Policy makers around the world will be tested by a challenging mix of potential threats to stable credit conditions.
China’s retaliation against American tariffs will likely reduce U.S. GDP growth and as core inflation continues to rise a mature U.S. credit cycle could be nearer to a turning point, if access to credit sours and risker borrowers are squeezed by tighter financing conditions.
In addition to Brexit-related risks Europe is facing, upcoming European parliamentary elections could derail momentum towards an even closer union if support for nationalist parties slows progress, and immigration remains one highly divisive issue that could threaten the free movement of labor within the Schengen area.
China's deleveraging will likely take longer than the official three-year time line as the government manages the debt overhang that threatens stability, fine-tunes its risk reduction measures and accommodates slower earnings growth that is contributing to a pause in corporate deleveraging.
Although political risks have decreased, a number of new governments will be confronted with growth that is less synchronized across Latin America and the potential threat to borrowers facing greater volatility accessing USD-based financing.
In the latest salvo from Washington, the U.S. imposed tariffs on another $200 billion of Chinese imports—with tariffs of 10% rising to 25% in the New Year, unless the two countries come to a compromise. China’s retaliation and its decision to slap tariffs on a further $60 billion worth of U.S. goods suggests the world’s largest trade partners may not be ready to compromise. In fact, further escalation could see tariffs applied to all of the goods the U.S. and China import from each other. Attempts to help those hurt by globalization via higher tariffs or other forms of protectionism, even if well meaning, will raise prices and hurt all consumers, especially poor and middle-class families--not to mention damage the competitiveness of companies that import raw materials or components from other countries and threaten jobs for workers in export industries.
Although rate rises haven’t deterred North America’s borrowers and credit demand is holding up in many parts of Europe, financing conditions are tighter for emerging markets.
The U.S. speculative-grade default rate will likely continue to ebb. This could depend on how easily borrowers can adapt to further Fed tightening, tax code changes with debt-deterring elements and the waning positive effects on GDP of recent fiscal stimulus. Easing credit standards in the Eurozone are enabling a debt-funded increase in mergers and acquisitions. On the other hand, Brexit uncertainties continue to impact investment and funding decisions, and borrower appetite in the UK. Many emerging markets are feeling a financing squeeze as tighter bank lending conditions and exchange rate volatility threaten to raise domestic, as well as foreign currency borrowing costs.
Even as some risks warn of a turn in the credit cycle, many other leading indicators of near-term speculative grade defaults remain benign for the U.S.
The global economy’s move from recovery to expansion may pause as some regions face a new set of challenges.
U.S. economic momentum is likely to remain solid this year and next, supported by a strong labor market, still-bullish consumer confidence and favorable manufacturing sentiment. Eurozone GDP growth has peaked and is converging toward its trend rate, with exports for the region vulnerable to turmoil in emerging markets. China’s growth is slowing, but Asia-Pacific economic activity is still solid despite the worry lines of trade flattening, volatile currencies and rising borrowing costs for some borrowers. We are now expecting a recession in Argentina and lower growth in Latin America overall. Political uncertainty and the ability to pass crucial reforms are hanging over Brazil, the region’s largest economy and questions are surfacing about Mexico’s new government to deliver electoral promises while maintaining fiscal discipline.
Pockets of weakness emerge even as most sectors still benefit from relatively benign credit conditions.
Auto, commercial real estate, and credit-card lending are among the “at-risk” sectors we’re watching to gauge asset quality for U.S. banks. Pockets of weakness for U.S. corporate sectors include consumer products and retail, while the rapid expansion in speculative-grade bond issuance and leveraged lending, as well as covenant-lite deals are vulnerabilities that could amplify credit stresses if lender risk appetites sour. U.S. states are operating in a stronger revenue environment and yet their fiscal health is challenged by upward pressure on mandatory expenditures for Medicaid, pension contributions, and retiree health benefits costs.
Although European banks balance sheets remain sound, profitability is generally still sub-par. Business conditions are satisfactory for European corporates even as profitability margins in certain sectors appear to be softening due to rising input costs from the labor market. Companies, especially in the UK and Ireland, would also have to overcome supply-chain bottlenecks if faced with a disruptive Brexit scenario.
In Latin America, political risk continues to weigh on growth prospects for nonfinancial companies and they’re also challenged by depreciated currencies, subdued access to capital markets financing and worsening domestic conditions. The asset quality outlook for Indian banks remains weak, but this is an outlier amid a trend of relatively low non-performing loans for financial institutions in many Asia-Pacific jurisdictions, including Taiwan, Australia, New Zealand, Singapore, Hong Kong, and Japan.