Global Credit Conditions are Generally Stable Amid Lingering U.S. Policy Uncertainties

S&P Global Ratings
Written By: Terry Chan, Lapo Guadagnuolo, Robert Palombi, Jose Perez-Gorozpe and David Tesher
S&P Global Ratings
Written By: Terry Chan, Lapo Guadagnuolo, Robert Palombi, Jose Perez-Gorozpe and David Tesher

Global credit conditions have brightened somewhat in recent months as the world comes to grips with the historic political upheavals from Brexit, and Donald Trump's transition from candidate to presidency--and a glimpse into whether his campaign rhetoric will solidify into actual U.S. policy.

The U.S. continues to enjoy broadly favorable economic conditions. Europe, despite a sluggish economy, has been surprisingly resilient as deflation fears subside--though a slew of upcoming elections, notably in France, have the potential to spread volatility in the region. Latin America and Asia-Pacific, while generally stable, have exhibited lingering anxiety over the U.S.'s potential protectionist trade policies on their exports, business activity, and issuer revenues. The flip side of that equation, however, is that U.S. policy initiatives, such as lowering taxes and unwinding financial industry regulations, could be a boon to economic growth.

Further clarity will arrive in coming quarters as the U.S. Congress debates these issues and determines how and if these policies will move onto the implementation phase. Though minimized in relation to U.S. policy risk, other top global risks remain on our radar. These include the potential repricing of risk in the currency, equity, or debt markets--and a corresponding adjustment in global investment portfolios--if the U.S. shifts toward increased deficit spending and less monetary stimulus; and anti-globalization sentiment, as well as the potential adoption of protectionist measures, that raise barriers to international trade, unwind cost efficiencies from global supply chains, or disrupt investment.

Other top risks include excess credit growth in China, where borrower credit quality is weakening; a disorderly deleveraging of China's outsized and growing debt burden (particularly corporate), would undermine market confidence, loan performance, and asset and commodity prices. Such a scenario would increase volatility and liquidity stresses in financial markets, particularly those in emerging markets. The still-high growth rate of debt could lead to potential losses over the next year or two; however, we believe China's banks have sufficient financial strength to absorb the potential losses that could arise.

Our credit condition expectations by region are as follows:

The U.S. and Canada

North American credit conditions are broadly favorable. The U.S.'s economic expansion continues unabated, thanks to consistently optimistic jobs data and long-awaited wage inflation, and a strengthening housing market. But notable pressures are building--with some on the upside--related to federal policy initiatives and further increases in benchmark borrowing costs. We see little chance that the world's biggest economy will slip back into recession any time soon, and we forecast GDP growth of 2.3% this year and 2.4% in 2018.

Our base case could be thrown off, in either direction, by policies being put forth by legislators and the new administration. On the upside, pro-growth policies (including deregulation and certain aspects of tax reform) could help accelerate the economy's recovery from the Great Recession. On the other hand, isolationist trade policy would likely weigh on growth, in our view. While financial markets have been bullish--pricing in a higher federal budget deficit, accelerating inflation, rising interest rates, and appreciation of the dollar--we see the weight of these opposing forces, along with other risks around the globe, as having the potential to chip away at what has been a prolonged period of favorable credit conditions in the region.

Against this backdrop, we think the Fed will raise its benchmark federal funds rate two more times in 2017, after March's quarter-point increase to a range of 0.75% to 1% (the third such increase since the crisis). We assume four more quarter-point hikes next year, with the Fed funds rate reaching a so-called neutral rate of around 3% by the end of 2019. (It's important to note that this would represent a level that neither stimulates nor restrains economic growth, and that is at least a full percentage point below where it once was). Though we believe U.S. corporates will be able to manage their maturities in the near term, should lenders regain the upper hand in credit market dynamics, funding liquidity will become scarcer and lower-rated borrowers will almost certainly find it harder to issue new debt.

In Canada, the stabilization in commodity prices has been welcome news, and the country's economy is returning to growth after almost slipping back into recession in 2015. Average real GDP growth of 3.2% in the second half of 2016 was the best Canadians have seen in three years. However, we are monitoring elevated and still-growing household debt, which continues to outpace growth in personal income, as it is eroding consumers' debt servicing capacity. At the same time, an unsustainable pace in home price appreciation is increasing Canada's vulnerability to a housing correction.

Europe, the Middle East and Africa (EMEA)

European credit conditions, in line with a surprisingly resilient economy, are encouraging. GDP growth in the final quarter of 2016 was stronger than many had expected, and soft data suggests that 2017 started with favorable tailwinds. Moreover, with accelerating inflation, the specter of deflation seems to be finally gone. But uncertainties still abound, stemming mainly from the political sphere, which highlights the fundamental structural issues of the eurozone's economic architecture.

Purchasing managers' indices and consumer confidence readings almost everywhere across Europe are encouraging. The availability of credit is not a concern, because bank lending has generally been outpacing nominal GDP growth. However, broadly speaking, we believe 2017 is going to be another year of struggle for banks trying to improve their business models to counter lower profits. Meanwhile, nonfinancial corporates will keep financially sound with relatively easy access to cheap funding. However, due to the low-growth environment, we see a continuation of the cost cutting and underinvestment that these corporates have been experiencing for few years now.

In the emerging markets of the EMEA region, we believe external financing conditions will remain volatile, as foreign investors repeatedly reassess the attractiveness of assets in these countries in light of ever-changing expectations about the path for the interest rates in the U.S. and other developed markets.

In the political sphere, all eyes are on France, where presidential elections will begin in less than a month.

Market indicators, including opinion polls, suggest a Le Pen presidency is unlikely. On this basis, our base case is that a National Front win is unlikely. Consequently, it is also our base case that France is unlikely to leave the eurozone and therefore we have not incorporated such an opinion in our ratings.

However, if Ms. Le Pen were to win, it would probably cause a shock in the financial markets, which would most likely bring about high volatility, a heightened sense of uncertainty, and a possible exodus in fund flows away from France and perhaps other European countries. We think it could put the future of the EU and the euro into question again.

This could, in turn, very quickly and possibly more severely, hurt weaker economies in the eurozone, leading to cash outflows and increases in their government bond spreads. Speculative bets on the survival of the euro could ensue, testing the markets and the ability of the European Central Bank (ECB) to do "whatever it takes" to calm them.

Asia-Pacific

Credit condition risks have increased for Asia-Pacific issuers going into the second quarter of 2017. We consider the top risk the uncertain impact of the new U.S. administration's potential protectionist trade policies on Asia-Pacific exports, business activity, and issuer revenues. Financing conditions, however, are showing less sign of stress and have recently stabilized, although a liquidity squeeze occurred for China's smaller financial institutions in mid-March 2017.

On the macroeconomic front, the baseline has improved somewhat but risks have widened and become skewed to the downside. In respect of rating outlooks, we still have a relatively high net negative bias for the metals and mining; oil and gas; real estate development; and capital goods sectors.

The primary driver of increased risk in Asia-Pacific credit conditions is the uncertainty caused by the new U.S. administration's protectionist trade position ("America First"). Such a trade stance could dampen regional export and business activity. Other continuing risks are China's debt overhang, potentially higher interest expenses, and volatile foreign exchange rates.

Meanwhile, property prices in some markets (such as China and Australia) are still on an upward trend. Given the region's build-up of corporate debt in recent years, refinancing may pose a future challenge. We have removed "commodity price decline" from our list because the risk has eased, in line with the "declining" risk trend we highlighted in previous reports.

Markets are showing fewer signs of stress after the global bond sell-off in the weeks following the U.S. presidential election in November 2016. While still volatile, government bond yields have largely moved within the range occurring in mid-November to mid-December 2016.

A lending survey of emerging Asia banks by the Institute of International Finance indicated that the tightening of lending conditions by banks had slowed in the fourth quarter of 2016. Anecdotal evidence indicates that while banks are slightly more cautious, borrowers recently have been able to tap cross-border capital markets fairly easily and at favorable yields.

Latin America

Credit conditions in Latin America have improved slightly in the past few months, though lingering uncertainties could mean any recent progress is just the calm before the storm. The commodity price shock ended in 2016, and slowly increasing prices have restored some confidence among global investors, pushing yields down for investment- and speculative-grade issuers. Consequently, pressure has eased on the region's currencies, and therefore, inflation. And with Mexico as an exception, most countries' monetary policies' easing cycle is gaining momentum. Nevertheless, a handful of challenges remain for the region. We believe the attendant risks shouldn't be underestimated.

U.S. policies continue to pose high uncertainty for the region's growth prospects, especially for Mexico. On one side, we expect the U.S. to raise interest rates two more times this year, which could bring pressure back to exchange rates and change the trajectory of capital flows. Second, the U.S. is considering tax reform, including a Border Adjustment Tax, which could strengthen the dollar and alter international commerce terms. If passed, we believe these conditions could manifest in higher inflation throughout the region, while also suppressing commodity prices.

The political landscape continues to be complicated in Brazil. In addition, the Congressional elections in Argentina in late 2017, and general elections in Mexico and Brazil in 2018, will probably bring some volatility in the markets later in the year. Prolonged low economic growth, combined with rising public dissatisfaction about political corruption in many countries, could weaken governments' ability to pursue moderate fiscal policies, resulting in a growing debt burden. The potential erosion of the sovereigns' financial profile could result in downgrades.