Tougher financing and operating conditions in Europe will restrict corporate credit in 2019, as lenders begin demanding a higher risk premium, according to a research report by S&P Global Ratings.
"In our view, even without a political trigger, the preternatural calm of European credit markets is unlikely to be sustained in 2019, as concerns around the impact of a turn in the credit cycle grow and the comforting balm of ECB QE is removed," S&P wrote in its report, referring to the years of post-financial crisis easy credit enabled by the European Central Bank's low interest rate policy and quantitative easing. Yields on corporate debt are already rising, and S&P warns credit markets will be more turbulent in 2019.
The rating agency noted that on their own, rising interest rates and plateauing economic growth — eurozone GDP growth slowed to 0.2% in the third quarter, prompting S&P to revise down its forecast for 2018 to 1.9% — are unlikely to cause a jump in default rates among companies that have taken advantage of cheap funding, but combined with other factors, "bouts of market volatility are possible."
"This is a transition; it's going to become a more challenging environment for businesses and financing conditions," Paul Watters, S&P's head of corporate ratings, said in an interview. "Liquidity will become a little bit more restrained for some of the weaker sectors or weaker credits."
The mounting pile of corporate debt is a pressing concern in the U.S. as interest rates rise and the prospect of high default rates rise, where interest rates are rising and, while Europe is behind the U.S. in the credit cycle, Watters said investors will similarly be keeping an eye on highly levered European businesses.
"Clearly at this stage, given the growth outlook in Europe, interest rates remain incredibly low by any measure, the outlook for defaults remains somewhat benign. The U.K. is maybe a little bit different because [Brexit] uncertainties are quite high, and there is a specific issue around the retail sector," Watters said.
Deteriorating credit quality
Credit spreads in Europe and elsewhere have moved higher in recent months, and although they remain in a "contained range," a further widening in spreads is possible despite the firm economic fundamentals, according to S&P.
"We are starting to see a deterioration in credit quality with the net outlook bias — the percentage of ratings with positive outlooks less the percentage with negative outlooks — deteriorating again globally in the fourth quarter of 2018, and bringing an end to eight consecutive quarters of improvement," S&P wrote.
Some $63.5 billion of speculative-grade debt is due in 2019, according to S&P Global Market Intelligence data, with the largest nominal repayments expected for telecommunications, technology, retail, automotive and healthcare.
M&A activity has been bolstered by cheap credit. So far in 2018, 71% of new leveraged loan issuance and 33% of speculative-grade bond issuance have been channeled into M&A. But S&P expects M&A to moderate in 2019.
Sector such as aerospace and defense have been highlighting M&A activity in their 2019 expectations, while other sectors that have already undergone a spate of M&A dealmaking, including communications and healthcare, are likely to shift focus to bedding down recent acquisitions, the report noted.
End of QE
The end of QE is a significant concern for many investors who expect the artificial demand for debt created by the ECB's asset procurement program will not be replaced.
S&P shares this concern, noting that while a return to normal financial policy should be a cause for celebration, "markets are likely to struggle with the removal of a source of regular demand for assets."
While the majority of the ECB's €2.6 trillion program has been focused on sovereign debt, the ECB acquired €177 billion of corporate bonds by end-November 2018 through its Corporate Sector Purchase Program.
But Watters said the ECB's forward guidance earlier in 2018 about the end of its asset purchasing program has given the market time to adjust. "Clearly at the margin, you would expect the cost of debt to rise, credit spreads to rise, risk premiums to rise, but we're not saying it would create a liquidity problem," he said.