This report does not constitute a rating action.
As the macroeconomic and credit outlook darkens with the risk of recession looming on the horizon, the changes are having secondary effects on the capital flows that interconnect the global economy.
The myriad shocks that have hit economies and markets--the Russia-Ukraine war and U.S.-China tensions; major central banks' aggressive battle against persistent inflationary pressures; the rising risk of recession; and intensifying climate risks--have prompted countries and investors to rethink and in some cases begin to reroute capital movements, trade flows, and supply chains.
Major central banks' shift from expansive quantitative easing implemented during the pandemic to intensifying quantitative tightening to combat nagging inflation has unnerved some market participants who are concerned that monetary tightening may go too far and cause a recession. This has prompted investors globally to adopt a defensive risk-off approach across asset classes--with speculative-grade primary markets becoming a clear casualty. As a result, the nebulous outlook has spurred widespread market volatility and diminished corporate bond issuance. At the same time, interest rate differentials, the performance of the U.S. economy, and safe-haven buying have spurred the U.S. dollar to 20-year highs against major currencies. These effects have raised questions about the implications of the interplay between aggressive interest rate hikes, financial market performance, and changes in capital flows.
Similarly, trade flows are profoundly transforming against the backdrop of weakening macroeconomic growth and escalating geopolitical risks. After enduring pressures across supply chains during the pandemic from pent-up demand, higher prices, labor shortages, and overwhelmed ports, companies around the world are confronting additional supply chain disruptions due to intensifying geopolitical tensions. Related input-cost pressures could erode margins and weigh on credit quality. This has created uncertainty about whether the drive toward energy independence, concerns about national security, and the rethinking of supply chains will slow, and maybe even reverse, decades of globalization.
Post-Pandemic Recovery Reversal Poses Significant Risks To Capital Flows
The risk of an economic hard landing for the U.S. economy endures as the Federal Reserve maintains its focus on taming inflation with what will be its most aggressive rate-hiking cycle in decades. S&P Global Economics qualitatively assesses the U.S. economy's risk of recession in the next 12 months at 45% (within a range of 40%-50%) and with risks closer to 50% heading into 2023 as cumulative rate hikes take hold. The potential for a recession in the U.S. poses risks to growth in emerging market economies, particularly Mexico from a trade perspective.
Meanwhile, the EU is grappling with the interrelated challenges of the ongoing Russia-Ukraine conflict and rising inflation, which have respectively triggered a critical energy crisis and propelled the European Central Bank (ECB) to raise interest rates by an unprecedented 75 basis points (bps) this month, with promises of more rate hikes to come. The accommodative monetary policies implemented by the ECB a decade ago at the height of the European sovereign debt crisis are exacerbating duration risk and leading to weak returns for investors as conditions tighten and rates rise.
Slower growth, recession fears, and the cause and consequences of persistent inflation have increased market volatility. Any perceived or real policy missteps could roil credit markets further and result in additional repricing of financial and real assets and tighter financing conditions. This is especially concerning against the backdrop of high debt levels, and it could hurt lower-rated borrowers in particular.
According to our proprietary Credit Cycle Indicator (CCI)--developed to track and consolidate leverage, asset prices, and market liquidity globally as a leading indicator for potential credit stress--heightened credit stress will likely develop in late 2022 or early 2023.
Concerns over central banks' ability to avoid recession while controlling inflation now include fears of stagflation. A severe scenario with a prolonged period of stagflation--including sharply contracted global GDP growth, additional producer price inflation of 300 bps, and higher interest spreads of 300 bps--could cause the number of corporate defaults to rise 2.4x to 17% by 2023--with China's loss-makers tripling to 22%. Those in corporate sectors that haven't fully recovered from the COVID-19 pandemic would rise by more than half, according to our latest stress test. We applied the stress test to a sample of 20,000 corporates (93% not rated) with debt totaling $37 trillion, representing 41% of total global corporate debt.
Receding Liquidity And Rising Refinancing Risks Are Compounding Financing Headwinds
Financing headwinds are resurfacing, primarily for speculative-grade issuers after two years of abundant liquidity unleashed by central banks' sweeping monetary stimulus, which drove yields lower and, in many cases, negative. This forced many investors to go lower down the rating scale or wait longer in search of acceptable returns. As quantitative tightening continues amid the slower growth and persistent inflation, liquidity is declining, financing conditions are constricting, and many credit investors have been suffering from poor returns. Higher credit risk premiums may return to the market, leading investors to increasingly demand higher returns--thus sending financing costs higher.
This year will likely surface a 16% contraction in global bond issuance year-over-year, following record issuance in 2021. We expect nonfinancial corporate issuance will fall about 30% in 2022, with deeper declines possible if conditions worsen. Issuance by financial entities will likely fare better, contracting about 10%.
While markets remain volatile and issuance remains low (particularly for speculative-grade markets), the level of refinancing risk coming due is the next focus. Of the $22.6 trillion in corporate debt (including bonds, loans, and revolving credit facilities from financial and nonfinancial corporate issuers) that S&P Global Ratings rates, 12% is scheduled to mature through year-end 2023, and 48% is set to come due over the next five years through June 30, 2027. From a distance, the overall near-term risk appears manageable, but the real risks lie in the pockets of sector-, regional-, and rating-level vulnerabilities that will increasingly complicate returns and investor appetite if conditions deteriorate.
Geopolitical Fractures Are Transforming Global Flows
The geopolitical shifts catalyzed by the Russia-Ukraine war reinforced how deep the global interdependencies actually are. Economies have increasingly used tariffs and trade flows as tools of geopolitical persuasion, as evidenced by the latest developments in the U.S.-China trade confrontation and Russia's weaponization of energy and food exports to Europe and other regions. These recent events, and others, have underlined the vulnerabilities stemming from global just-in-time production and risks to national security from over-reliance on foreign countries for critical materials, including energy, food commodities, metals, minerals, and more. However, undoing these global dependencies and developing alternatives takes time and isn't always doable or desirable.
The ongoing Russia-Ukraine war has hampered global commodity flows, including critical supplies of fossil fuels, food, and fertilizer. Germany, Italy, and other EU countries are embroiled in a major energy crisis that could prove both bleak and costly as households and business confront soaring prices and Russia cuts gas supplies to Europe indefinitely. Our recent analysis found that the if the EU accomplishes its plan to ration energy demand by 15% following Russia's shutdown of gas deliveries via Nord Stream 1, such circumstances would likely shave 1.4 percentage points from eurozone growth, cause inflation to surge and remain elevated, and force the ECB to raise its refinancing rate. We expect the global energy and food shocks spurred by the Russia-Ukraine war will last through at least 2024, weighing on GDP growth, fiscal performance, and social stability, and potentially leading to rating actions, depending on governments' and international organizations' responses.
While tensions between the U.S. and China persist, our base case is that mainland China's future military drills in and around the South China Sea will be less intense than recent exercises without any additional trade restrictions. An escalation of the geopolitical dispute would reverberate through global supply chains, particularly hurting the semiconductor sector. Nonetheless, China has long maintained its resilience in manufacturing and exports (despite pandemic disruptions and trade disputes). Manufacturers remain drawn to China, and firms already established there cannot easily disentangle themselves from the country, especially those engaged in auto and technology production.
Climate Stress Creates Near- And Long-Term Supply Chain Concerns
Extreme weather is solidifying as a preeminent risk for global trade flows, as prolonged and powerful heatwaves and droughts strain supply chains around the world.
Scorching temperatures and limited rainfall across China caused closures of key shipping routes, prompted authorities to instate power rationing and curb commercial-industrial activities, and threatened crop yields and agricultural development. As a result, the extreme weather has pressured China's corporate margins and supply chains, and it could fuel food inflation and dampen domestic consumption.
In the U.S., severe droughts have likewise pressured companies involved in food supply chains, and they've heightened water stress in states such as California and Nevada. Both supply and demand management will be critical to credit rating stability for Western U.S. public finance issuers as utilities face what we expect will be increasingly frequent and drawn-out drought conditions.
This report is part of S&P Global Ratings' "A World Redefined" 2022 research focus.
|Primary Contact:||Molly Mintz, New York;|
|Secondary Contacts:||Alexandra Dimitrijevic, London + 44 20 7176 3128;|
|Ruth Yang, New York (1) 212-438-2722;|
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