(Editor's Note: Two defaults in the second quarter, from Petropavlovsk PLC and EuroChem Group AG, were captured as defaults from the U.K. and Switzerland, respectively, due to the locations of incorporation and corporate headquarters. The ratings on these issuers were subsequently withdrawn as of April 15 because these were considered to be entities with substantial presences in Russia. Note that we do not include Russia in our definition of Europe. If we were to remove these issuers from the count of defaults, the 12-month-trailing default rate ended June 2022 would have been 0.79%, down from the 1.05% reported throughout this report. Adjustments of similar magnitude would appear for default rates ended in April and May 2022, as well as for future rates.)
- We expect the European trailing-12-month speculative-grade corporate default rate to reach 3% by June 2023, from 1.1% in June 2022. In this baseline forecast, 24 speculative-grade companies would default amid slowing economic growth, rising rates, and falling profit margins.
- Recession odds are rising for Europe, but not as much as in the U.S., driven in no small part by Russia's ongoing invasion of Ukraine and associated inflation pressures largely relating to energy.
- Firms remain on relatively strong footing to weather a small downturn, but if a prolonged or deep recession occurs, we expect defaults to increase further, with our pessimistic scenario at a 5% default rate by June 2023.
- Interest rates remain low in Europe but are rising, while flagging consumer confidence and high energy prices remain risks, particularly as we head into winter.
Risks to our default forecast remain largely unchanged from the first quarter, with our base-case assumptions pointing to a slow-growth recession, rather than one marked by a contraction. Rising inflation and interest rates, along with the conflict between Russia and Ukraine, remain our headline risks. S&P Global Ratings economists put the odds of a recession in Europe in the next 12 months at roughly 35%--not high enough to call a definite recession. That said, growth is expected to be quite low, and consumers will face challenges later this year as heating and energy needs rise in an already stressed commodity market.
Much of the lower-rated debt ('B-' and below) in Europe is in the form of floating-rate loans, whose benchmark interest rates are rising in both Europe and the U.S. (see chart 2). EURIBOR remains well below LIBOR but has moved into positive territory for the first time in several years, and many loans have very low floors--sometimes zero. If this trajectory continues, higher rates will start cutting into profit margins for these issuers, giving them less room to maneuver, particularly in the event of slower economic growth.
Baseline: S&P Global Ratings Research expects the European trailing-12-month speculative-grade corporate default rate to rise to 3% by June 2023 from 1.05% as of June 2022 (see chart 1). This forecast represents an increase from the current historically low level but a return toward the long-term average of 3.2%. S&P Global Ratings economists now expect eurozone GDP growth to decline and inflation to expand faster this year relative to their prior forecasts. Markets priced in more risk through midyear but have taken a more optimistic stance since inflation readings in the U.S. moderated. The strength of European consumers will be crucial to issuers' continued ability to pass on higher costs, but both will face more challenges as the year progresses, particularly with elevated energy costs. This will likely squeeze profit margins as the European Central Bank (ECB) continues to raise rates.
Optimistic scenario: We forecast the default rate will hit 1.25%. Despite growing headwinds, firms have had relative success thus far in passing through higher costs to consumers, who themselves have a surplus of wealth to fall back on amid rising inflation. Given the strong relative positioning of both consumers and firms in the second half of 2022, an optimistic outcome is possible if the Russia-Ukraine conflict ends in the next few months, sanctions start to roll back, and inflation cools enough for a return of orderly reflation, which may help limit the extent of monetary policy tightening. These factors would help keep defaults low, but it may become critical for energy prices to retreat ahead of winter, and these prices depend largely on the conflict ending and economic relations between Russia and the eurozone improving, which is currently unlikely.
Pessimistic scenario: We forecast the default rate could rise to 5%. Defaults have remained very low (below 1%) in 2022 thus far. That said, the speculative-grade ('BB+' or lower) ratings distribution in Europe remains historically weak, with 29% at 'B-' and lower. Many issuers in the 'CCC' to 'C' categories have been at those ratings longer than the historical average and could be walking a tightrope given their dependence on current revenue trends. Additionally, they may require primary markets to open up with more favorable financing conditions than secondary markets currently reflect. If a deep or prolonged recession were to occur, many firms would become stressed to a point where defaults could rise more aggressively than in our base case.
Investors And Issuers Remain On The Sidelines
Market volatility this year has kept issuers and investors largely on the sidelines. Combined leveraged loan and high-yield bond issuance has fallen off markedly, posting a year-to-date total of only €71 billion through July (see chart 3). This is 68% below 2021's record pace and much lower than the roughly €125 billion average at this point in the year. Of the €71 billion thus far, more than one-third came from January, with the February-July average at only €10 billion.
While issuers may have slightly higher cash balances on hand than is typical, most debt is maturing well past 2023, and the ability to service existing debt is still fairly strong, a continued frigid primary market would pose a major obstacle to any issuers in need of new funding. We expect this to remain the case until interest rates (and inflation) start stabilizing.
Financing conditions for loans to enterprises (as measured by the ECB's euro area bank lending survey) also tightened in the second quarter and are expected to continue tightening even more than during the height of the pandemic in mid-2020 (see chart 4). The second quarter's tightening was in response to increased risks and decreased risk tolerance among senior loan officers. For the third quarter, loan officers expect further tightening in response to economic uncertainties as well as expected tighter monetary policy later in the year.
Loan officers expressed concerns over the impact of supply-chain disruptions, high energy prices, and corporate exposures to Russia, Ukraine, and Belarus. As to the latter, only a handful of rated European banks have meaningful direct financial exposures to the countries involved in the war. For these institutions, some financial losses are inevitable, but they will generally remain manageable given existing buffers and overall business diversification. All told, under our current base case, we believe European banks are resilient enough to manage the broader economic spillovers from the conflict.
Market Pricing Appears Largely Appropriate
Market pricing for lower-rated borrowers has continued to widen as risks mount (see chart 5). Spreads on speculative-grade bonds and leveraged loans have risen in recent months and could rise further as inflation remains elevated. The high inflation has forced central banks to tighten monetary policies earlier and more aggressively than previously communicated.
Through July 31, the speculative-grade bond spread reached 591 basis points (bps), up from 331 bps at the end of 2021. The spread has been exceptionally volatile since January, reaching a 2022 high on July 6 of 668 bps. That said, some positive news on U.S. inflation for July caused spreads to tighten on both sides of the Atlantic, pushing the European spread back down to 537 bps on Aug. 15.
Some anticipate--or hope--the Federal Reserve can pause its rate hike campaign and perhaps move to cuts in early 2023. It is still too early to call that a foregone conclusion as the labor market remains robust, but if the Fed were to become less aggressive in its monetary policy approach because of globally subsiding inflation, this could imply the ECB and Bank of England might follow suit.
The relative risk of holding corporate debt can be a major contributor to future defaults because companies face pressure if they are unable to refinance maturing debt. In broad terms, speculative-grade spreads have been good indicators of future defaults based on a roughly one-year lead time. That said, at current spreads, our baseline default rate forecast of 3% is roughly in line with or slightly above what the historical trend would suggest.
Using a framework based on broad measures of financial market sentiment, economic activity, and liquidity, we estimate that at the end of June, the speculative-grade bond spread in Europe was about 166 bps above our estimate of 415 bps (see chart 6).
The gap between the actual and estimated spread implies that despite numerous headwinds and current volatility, fixed-income investors in Europe are generally pricing in risk appropriately, if not conservatively, for now. Market volatility has lessened since early July, though economic sentiment has weakened as well (but still remains positive).
Some Rate Sensitivity Among The Lowest-Rated Debt
EURIBOR remains low compared with LIBOR, but it has moved into positive territory and is likely to further increase. For now, most of our speculative-grade borrowers with floating-rate debt still have more room to maneuver than U.S.-based issuers with outstanding loans priced in LIBOR, but this could change if rates continue their steep climb, particularly if economic growth should stall at the same time.
Meanwhile, overall speculative-grade debt maturing through 2023 is still relatively low at €111.7 billion. Through 2026, however, about €162 billion of debt rated 'B-' or lower will mature, with 62% of that in floating-rate loans (see chart 7). Moreover, many sectors that lead in floating-rate debt rated 'B-' or lower are the most consumer-reliant--led by media and entertainment, consumer products, and retail/restaurants.
Consumer Strength Remains Key And Will Be Tested
One key point we're watching is the ability of consumers to continue propping up demand amid high energy prices. Their ability to do so will undoubtedly be challenged later this year as temperatures fall and home heating requirements rise. Speculative-grade issuers could be particularly vulnerable to weakened demand, since the sectors with the highest numbers of speculative-grade issuers tend to be those that are consumer-reliant, such as media and entertainment, consumer products, and retail/restaurants--particularly at the 'CCC' to 'C' rating categories (see chart 8).
Prospects are not looking good on the consumer spending or inflationary front if sentiment indicators prove accurate (see chart 9). The Russia-Ukraine conflict is weighing on consumer sentiment, pushing some measures to their lowest levels since the financial crisis. Meanwhile, the ECB's survey of professional forecasters has inflation expectations at their highest level in the series' history in July (2.15%).
Positive Credit Momentum Holds, But Vulnerability Persists
In the 12 months ended June 2022, credit quality was relatively stable, with net rating actions (upgrades minus downgrades) still deep in positive territory, alongside a slightly negative net bias (positive bias minus negative bias) (see chart 10). This was little changed from the rating action trends over the prior 12 months. The speculative-grade net rating bias improved to -3.6%--an all-time high.
History shows that the rate of downgrades and net negative bias tend to lead the movement in the default rate by several quarters. Current downgrade rates and bias portend a fairly low default rate for the next couple of quarters, though this could give way to growing stressors in 2023.
Recent improvements in credit quality have not been enough to make up for the declines during 2020, leaving speculative-grade issuers still much more vulnerable than historically (see chart 11). And while our base-case assumption is that Europe will still avoid a recession, S&P Global Ratings economists' recession odds are at roughly 35%, within a range of 30%-43%. Even with a still-low likelihood of a full-fledged recession, we expect growth to slow meaningfully, which could still pose a challenge to many of the weakest borrowers
How We Determine Our European Default Rate Forecast
Our European default rate forecast is based on current observations and expectations of the likely path of the European economy and financial markets.
This report covers financial and nonfinancial speculative-grade corporate issuers. The scope and approach are consistent with those of our default and rating transition studies. In this report, our default rate projection incorporates inputs from S&P Global Ratings economists that also inform the analysis of our regional Credit Conditions Committees.
We determine our default rate forecast for speculative-grade European financial and nonfinancial companies based on a variety of quantitative and qualitative factors. The main components of the analysis are credit-related variables (for example, negative ratings bias and ratings distribution), the ECB bank lending survey, market-related variables (corporate credit spreads and the slope of the yield curve), economic variables (the unemployment rate), and financial variables (corporate profits). For example, increases in the negative ratings bias and the unemployment rate positively correlate with the speculative-grade default rate. As the proportion of issuers with negative outlooks or ratings on CreditWatch with negative implications increases, or the unemployment rate rises, the default rate usually increases.
This report covers issuers incorporated in the 31 countries of the European Economic Area, Switzerland, and certain other territories, such as the Channel Islands. The full list of included countries is: Austria, Belgium, the British Virgin Islands, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Gibraltar, Greece, Guernsey, Hungary, Iceland, Ireland, the Isle of Man, Italy, Jersey, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Monaco, Montenegro, the Netherlands, Norway, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, Switzerland, and the U.K.
- European Leveraged Finance Q2 2022: It's Not The Fall That Kills You, Aug. 8, 2022
- A Eurozone Slowdown Is For Sure; Recession Is Less Certain, July 19, 2022
- Credit Conditions Europe Q3 2022: Pain On The Horizon, June 28, 2022
- Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce, June 27, 2022
- Economic Outlook U.K. Q3 2022: The Great Inflation Squeeze, June 27, 2022
This report does not constitute a rating action.
|Ratings Performance Analytics:||Nick W Kraemer, FRM, New York + 1 (212) 438 1698;|
|Credit Research, EMEA:||Paul Watters, CFA, London + 44 20 7176 3542;|
|Credit Markets Research:||Brenden J Kugle, Centennial + 1 (303) 721 4619;|
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