The Risks Of An Uneven Recovery
Credit conditions will likely remain underpinned by an improving economic sentiment, vaccine progress, and strongly supportive financing conditions.
Credit trends are on diverging paths. The global corporate net negative outlook bias—measuring future downgrade risk—dropped to 26% in March from a peak of 40% last June. In the U.S., the rapid vaccine rollout and $1.9 trillion rescue plan have put the economy on a fast track, prompting us to revise downward the 12-month speculative-grade default forecast to 5.5% by December 2021 (from 7% previously).
The pandemic and an uneven “K-shaped” recovery has resulted in a near all-time high share of riskier credits. 40% of speculative-grade corporates in the U.S., and one-third in Europe, are rated ‘B-’ and below, with a high concentration in industries most exposed to social distancing such as media, leisure, and retail. Upgrades slightly outpaced downgrades in the past few weeks, but an increasingly diverging path across industries may curtail the favorable impact of recovery.
Financing conditions remain strongly supportive across the rating scale, on reiterated commitments from major central banks. Q1 saw record issuance on the high-yield bond and leveraged-loan markets in the U.S., including for issuers in the ‘CCC’ category, which have become a sweet spot for investors in search of yield.
Economic restart. The economic recovery from COVID-19 looks set to accelerate in mid-2021, particularly in the U.S., on the back of a massive fiscal stimulus plan. We have revised our 2021 global GDP growth forecast upward by 50 basis points, to 5.5%, reflecting brighter prospects for North America, China, and India. We also revised 2020 growth upward.
Inflation and repricing risks. In our view, the rise in long-term U.S. bond yields is an indicator of improving recovery prospects and is likely to be accompanied by controlled reflation rather than a dramatic reversal of a 40-year process of disinflation. The greater risks lie in the potential for market volatility and repricing given elevated asset prices, high debt levels, a desynchronized recovery and, ultimately, the withdrawal of extraordinary stimulus.
Other risks. Significant risks continue to weigh on the credit outlook, primarily linked to potential delays and uneven rollout of vaccines, and solvency pressure from the step-up in global leverage. The pandemic has also accelerated secular shifts on energy transition and digitalization, and heightened geopolitical tensions and risks to political and social stability, bearing credit implications over the medium term.
Overall: Credit conditions remain favorable for most borrowers, as government support underpins market liquidity, and coronavirus vaccine rollouts offer optimism that an end to the pandemic is in sight. U.S. GDP is set to grow 6.5% this year—the most since 1984.
Risks: With even low-quality borrowers able to tap credit markets at welcoming rates, we see signs that investors aren’t being adequately rewarded for the risks they’re taking and may soon demand better yields—all against the backdrop of record-high debt.
Credit: Spreads on U.S. corporate debt are tighter than they were at the start of last year; however, if inflation materializes, a selling-off of fixed-rate investments becomes more likely and would make it harder for weaker firms to tap the markets at favorable terms.
Overall: The two "arms" of the K-shaped recovery are widening. China and several developed AsiaPacific economies are seeing stronger recoveries than more pandemic-addled emerging markets. Sectors such as essential retail and telecoms should fully recover in 2021 but others, e.g. airlines, will take several more years. These disparities translate into widening ratings trends.
Risks: Sluggish rebounds in revenues, combined with rising debt, are the main threats. High risks are U.S.- China confrontation, slow vaccine rollouts or new infection waves, and policy response uncertainty. Elevated risks include market repricing, climate-change policies, and technology change. The latter, a longer-term risk, could hurt financing access as traditional business models face obsolescence.
Credit: Credit quality has steadied, but meaningful downgrade risk remains. Our negative rating actions have tapered over the past quarter indicating some stabilization in credit quality. That said, one-fifth of our ratings have a net negative rating bias. The likelihood of downgrades remains significant.
Overall: Credit conditions in emerging markets (EMs) look brighter than last year, given that developed economies' recovery accelerates and vaccination progresses. These factors are supporting EMs' external demand and industrial activity. Nevertheless, many sectors will continue struggling amid an uneven economic recovery and lackluster domestic demand.
Risks: Downside risks are relevant and recovery itself will bring new challenges for many EMs, especially if risks from U.S. economy overheating were to materialize and financing conditions worsen. Most EMs continue struggling to contain the pandemic, and with few exceptions, vaccine rollouts have been slow. Consequently, risks from case resurgence, partial lockdowns, and economic activity setbacks prevail. The risk of a slower economic recovery and worsening financing conditions could further pressure corporations' earnings and undermine governments' fiscal flexibility across EMs.
Credit: Negative rating actions have plateaued, but lower rating levels and negative outlooks reflect higher leverage and vulnerability to further shocks. Ratings' negative bias remains historically high in EM Asia and LatAm. A slower economic recovery or failure to deliver a vaccine within an expected time frame could lead to further downgrades.
Overall: While Europe faces another difficult few months with a resurgent virus, cautious optimism is warranted once vaccination programs finish in late summer (after a slow and fractious start) and the economy rebounds--but slower than in the U.S.
Risks: Vaccine supply, logistics, and vaccine hesitancy are key near-term concerns. Further out we see the threat of new variants and the potential for corporate insolvencies that so far have been artificially depressed. Renewed volatility and a repricing of risk spilling over from the U.S. to Europe is a new, elevated risk.
Credit: Fiscal and monetary support will continue through the year to ensure the pandemic is contained and recovery is well established. This has contributed to greater ratings stability in Europe, with few corporate rating actions and a gradual decline in negative outlooks in recent months. However, the proportion of corporate weakest links (rated ‘B-’ or below with negative outlooks or on CreditWatch negative) remains elevated at 14%.