Supply Chain Strain, Inflation Pain
Broadly, credit quality is continuing to recover slowly from a lower base as the global economy rebounds from the pandemic shock.
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Globally, credit quality continues to recover slowly from a lower ratings base, as the world adapts to the dominant Delta variant and growth regains resilience. Rating upgrades are outpacing downgrades this year, although net upgrades so far represent only about 12% of the net COVID-induced downgrades in 2020. Credit outlooks in aggregate have stabilized and returned to pre-pandemic levels, while default rates have fallen sharply and are trending toward their long-term average.
However, a confluence of headwinds could challenge the credit environment as we reach an inflection point for monetary policy and central banks start their gradual path toward normalization at different paces around the world. This could put pressure on more vulnerable credits because the pandemic has left 20% of our non-financial corporate ratings globally rated 'B-' and below.
Key risk to our base case are: inflation pressures and supply chain frictions extending through 2022 could put pressure on corporate margins and force central banks to tighten monetary conditions sooner; elevated debt levels could heighten credit vulnerability for weaker corporates and emerging markets exposed to rapid shifts in market conditions, although this is mitigated where debt-service costs remain low; China's regulatory policy reset could create increased uncertainty over the credit and growth trajectories of the country with potential spillovers to the rest of the world, as illustrated by the Evergrande situation; and the increasing pace of the transition to a low carbon economy could cause significant disruption in energy markets, as already being seen in Europe.
The economic and credit sensitivities to COVID-19 and the Delta variant of the virus are becoming more manageable in most developed economies as vaccination programs and natural immunity provide a pathway to living with the virus and households and corporates adapt to new ways of consuming and doing business. Countries maintaining a zero-tolerance COVID policy (China, Hong Kong, Australia and New Zealand) and emerging markets (EMs) where vaccination rates remain low are still more exposed. A vaccine escape variant remains a tail risk.
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Overall: The U.S. economic recovery has hit a snag as supply disruptions slow activity andthe fourth wave of COVID acts as an additional drag. We now expect full-year GDP growth of5.7%. While ratings actions reflect improving outlooks for credit, and lending conditionsremain favorable, there’s a rising risk that investors may soon push up borrowing costs, especially if inflation persists or unexpected adverse events trigger market turbulence.
Risks: With corporate debt leverage near record levels, the recovery in demand remains uneven across industries. At the same time, borrowers in many sectors are dealing with rising input prices. All of this comes as the COVID health crisis lingers. We are also watching structural risks pertaining to the energy transition and ESG, cyber security, U.S.-China strategic confrontation, and commercial real estate.
Credit: The net negative bias among nonfinancial corporate borrowers has fallen to 8%, from a record 42% in May of last year. However, sectors including aerospace and defense, media and entertainment, and consumer products still reflect somewhat elevated downgrade risk.
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Read the North America Credit Markets Update – Q4 2021
Negative Rating Bias: Our net ratings bias has improved to negative 7% (previous quarter: negative 11%), its best level since the COVID-19 crisis broke. However, this momentum is unlikely to continue into the fourth quarter of 2021 given the slowing pace of economic recovery.
COVID-19 Recurrance: Despite higher vaccination coverage across Asia-Pacific, COVID outbreaks have resurged. Continuing or further lockdowns and social distancing restrictions would further drag on the rate of recovery. This could also disrupt supply chains, from upstream semiconductor chipsassembling in countries such as Malaysia, to downstream chip-users such as the auto, consumer product, retail, and tech sectors.
China's Policy Shifts: The country's toughening socioeconomic policy has heightened uncertainty over the trajectories of credit and GDP growth in China. This may have consequences for the business models of domestic sectors with spillover effects to issuers outside the country dependent on China for exports or supplies.
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Read the Asia-Pacific Credit Markets Update –Q4 2021
Overall: Improvement in credit conditions across key emerging markets (EMs) could be plateauing over the coming months, as pre-existing weaknesses and increasing postpandemic challenges slow economic recovery and hinder business conditions. On the bright side, many EM economies have returned to their pre-pandemic levels and negative rating bias has decreased. Vaccination has accelerated in most key EMs, while recent virus outbreaks haven't been as harmful to economic activity, given that consumption and investment patterns have been adapting to the pandemic.
Risks: Downside risks for EMs are significant. The effects of the pandemic will to be long lasting as governments maneuver to consolidate their finances and corporations to improve their fundamentals. Accelerating inflation in many key EMs could undermine economic recovery if it persists. China's policy shift could imply lower GDP growth with spillover effects regionally and globally. Meanwhile, any shock to financing conditions, driven for example by faster-than-expected U.S. monetary tightening, could result in defaults and bankruptcies, especially among lower rated entities.
Credit: Negative rating bias (the percentage of ratings with negative outlooks or placed on CreditWatch negative) followed a downward trend across most EMs, but remains high in EM Asia where pandemic effects linger and weigh on issuers' credit quality. While this is a sign that credit conditions have improved in many cases, negative outlooks led to lower ratings.
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Overall: Economic activity is rebounding in Europe as COVID-19 infection rates decline, vaccination rates continue to rise, and social mobility returns. The strength of the recovery, led by consumer demand, has added to supply chain disruptions that are likely to persist into 2022. Although the emergence of vaccine-resistant coronavirus strains remains an elevated risk, we see this as a risk to the pace of economic growth rather than a risk of contraction.
Risks: Economic growth has proven stronger than many expected, but pressures on earnings-- supply chain dislocations, inflation, and related cost pressures--are rising. If these elements persist longer than we currently expect, and major central banks take first steps to taper bond purchases, it could presage tighter financial conditions for borrowers, including a rise in interest rates sooner than we now forecast. Higher borrowing costs could hurt weaker borrowers, given the huge step-up in aggregate debt since the pandemic, even though debtservicing costs remain historically very low.
Credit: Financing conditions remain favorable, with yield-hungry investors increasingly turning toward lower-rated debt. What’s more, fiscal policy remains supportive, and is becoming more targeted toward sectors hardest hit by the pandemic. These factors continue to limit the extent of credit deterioration..
