Supply chain constraints and rising labor costs have squeezed companies in the consumer products sector, driving many negative rating actions over the past year. Some companies have navigated the pressures by raising prices and cutting costs, but incremental risk is growing because of rising interest rates and the softening macroeconomic backdrop.

S&P Global Ratings economists believe the Fed will likely raise interest rates by 300 basis points (bps) by the end of 2022, having started from zero at the beginning of the year, and reach 3.50%–3.75% by mid-2023. Higher interest rates will add incremental cost pressure to a sector that has already been buffeted by rising costs in freight, transportation, and labor. Meanwhile, weaker macroeconomic conditions and a pullback in consumer spending could be a tipping point for issuers with limited financial flexibility.

We believe companies we rate 'B' and 'B-' will likely be challenged as many are already highly leveraged with moderate to minimal free operating cash flows (FOCF). In the consumer products portfolio, we rate 74% of issuers in the speculative-grade category, of which we rate around half 'B' or 'B-' (chart 1). We have net negative outlooks or CreditWatch with negative implications on more than 10% of issuers we rate 'B' and 'B-', indicating that we believe there is at least a one-in-three chance we could downgrade these companies (chart 2).

Chart 1

Chart 2

We analyzed the pool of issuers we rate 'B' and 'B-' to identify those that could be challenged to maintain credit quality in the current interest rate environment. We found that higher interest rates alone are unlikely to have a meaningful impact on credit quality. However, when we applied moderate stress to EBITDA beginning in 2022 and intensifying in 2023—similar to what could occur in a recession—we found credit characteristics could deteriorate which could spur negative rating actions for about half of the companies (table 1). We took into consideration nuances that may be present in subsectors or individual issuers. For instance, the operating environment in a recession for many food and beverage companies tends to be relatively benign as consumers shift to food-at-home from dining out. Similarly, issuers may have positive attributes that partly offset weak earnings, such as a high cash balance that bolsters liquidity.

Our ratings already our reflect our expectation of lingering inflation and supply chain bottlenecks in addition to a softening macroeconomic environment. S&P Global Ratings expects a low-growth recession next year with GDP of just 1.6% and higher unemployment. The odds of avoiding a recession in the next 12 months are slim. It will be difficult for the Fed to navigate a soft landing. A significantly weaker economic backdrop could materialize if the Fed pulls back on rate hikes too soon and inflation becomes more persistent. Conversely, continued rate hikes could spell recession in 2023.

In our weaker-than-expected earnings scenario, we found recurring challenges behind deteriorating credit quality. Not surprisingly, these align with themes that frequently drive credit quality in the sector. The essential nature of a company's product protects it from weaker consumer spending. The more discretionary a company's product or service is, especially higher-ticket durables, the more sensitive it will be to economic cycles. Brand power is critical to effectively passing on costs and maintaining margins. Without brand loyalty, consumers are quick to trade down to a less expensive substitute. Financial markets will likely be choppy amid rising interest rates combined with a weaker economy. Relatively weak issuers with near-term maturities or tight financial covenants could face liquidity crises or refinancing risk.

Exposure To Discretionary Spending Is A Key Risk

As inflationary pressures continue to tighten consumer wallets, the outlook for discretionary spending remains uncertain. Consumers are seeing the prices of their staple products, such as gas and grocery items, increase and this is leaving them with a lower capacity to spend on discretionary products, especially bigger-ticket items. For instance, the outdoor grill category has already been hit hard by supply chain challenges and cost inflation. Manufacturers like Weber Inc., which we downgraded to 'CCC+' in July, and Traeger Inc. (B/Negative/--) now face the double whammy of lower demand for relatively high-priced grills and very difficult comparisons to last year when they benefitted from pulled forward demand during pandemic lockdowns.

Discretionary categories that benefitted from spending patterns while consumers were homebound could also face a dramatic pullback in demand as consumers shift stretched discretionary spending to experiences or travel. Manufacturers such as Gibson Brands (B-/Stable/--), which sells guitars, and SWF Holdings I Corp. (B-/Stable/--), which sells window coverings and accessories, could see a decline in sales as consumers shift their discretionary spending to in-person activities or defer it altogether.

We also see a similar pattern for consumer service companies that are not essential, like WW International (B/Stable/--), a weight management service, and AMS Intermediate Holdings LLC (B-/Stable/--), a residential moving company. Offerings from companies such as these can be deferred or substituted by always cheaper do-it-yourself (DIY) options (for example, eliciting help from friends and family for home moving). We will continue monitoring the rising uncertainty around demand for discretionary products and services.

Presence In Competitive Markets With Slowing Growth

Companies in highly competitive markets are at risk of underperformance and margin degradation as new entrants take market share, leaving larger companies with too much inventory and the need to reduce production volumes. Lower volumes reduce the economies of scale that market leaders typically enjoy and use to offset cost inflation. In the alcoholic beverage sector, for instance, Blue Ribbon LLC (B-/Negative/--) and City Brewing Co. LLC (B/Stable/--) participate in the highly competitive beer and seltzer markets. Recently, these companies' toplines have underperformed and continue to face operational challenges as they navigate the relatively new hard seltzer market which has seen slowing category growth and many new entrants.

Liquidity And Refinancing Risks

Rising interest rates will continue to pressure companies, especially those with refinancing needs over the next 12 months. Higher rates (we believe the Fed will target 3.5% to 3.75% policy rate by mid-2023) could make refinancing more difficult for companies whose cash flows have weakened because of macroeconomic headwinds. In the consumer products sector, some companies face refinancing risk and may face negative rating actions if they cannot successfully refinance their debt in a timely fashion and at manageable rates. Oak Holdings LLC (B-/Stable/--), a sportswear company, uses its revolving credit facility to fund working capital investment in advance of critical selling seasons. The revolver will become current in October 2022, raising the risk that the company could face a liquidity crisis if it is not able to refinance or extend the maturity. Similarly, scholastic and graduation-related product seller Champ Acquisition Corp.'s (B/Stable/--) revolver will become current in December 2022. While these companies have exhibited stable performance recently as they have rebounded from the pandemic, the rising interest rate burdens increase near-term refinancing risk.

Our Scenario And Results

Our analysis includes our base-case assumption of a 150-bp interest rate increase in 2022 and an additional 175 bps in 2023. We then assume a 5% decline in EBITDA in 2022 and an additional 10% in 2023 to simulate earnings decline in a recession. We consider the resulting credit measures such as EBITDA interest coverage and free operating cash flow (FOCF), and implications of lower earnings and higher market interest rates to liquidity. Finally, we consider subsector and issuer-specific nuances that we believe could affect credit quality and the likelihood of a negative rating action.

Table 1