While Global Conditions Vary By Region, Uncertainty Is The Common Thread

With regional economies moving at different speeds, and risks and imbalances often remaining specific to certain areas or countries, the divergence in global credit conditions that S&P Global Ratings observes contains a central theme: Uncertainty.

Given the right–or, perhaps, wrong–circumstances, we think current high valuations in equity markets, low risk aversion, and tight credit spreads could be a source of instability if investors’ appetite for risk sours.

As it stands, borrowers in the U.S. and Canada continue to enjoy broadly favorable conditions, even as pockets of pressure build–beyond the U.S. federal policy proposals and prospects for rising benchmark interest rates we’ve recently noted. Similarly, in Europe, financial markets remain relatively bullish on economic prospects and financing conditions, but Brexit clouds hint of a storm on the horizon.

In the Asia-Pacific region, credit conditions are likely to improve slightly in coming months, but tail risks remain as regional issuers have continued to borrow, particularly in foreign currencies, increasing their exposure to rate hikes by the U.S. Federal Reserve. And in Latin America, while financing conditions remain fairly positive and many borrowers have issued new debt or refinanced, we expect more market volatility in the second half of the year.

We summarize our views on the elements of risk and imbalances, macroeconomic outlook, financing conditions and sector trends for the four geographic regions in the table 1 below and elaborate on the first three elements in the following sections.

Risks And Imbalances
In North America, among the emergent risks we’re highlighting are retailers’ continued struggles to stay afloat, the resurgence in U.S. banks’ commercial real estate lending (to levels exceeding the run-up to the Great Recession), U.S. auto sales peaking and risks in auto leasing and subprime lending, and signs of a bubble in Canada’s housing market. These potential threats to what has been a prolonged period of favorable conditions for the region’s borrowers may compound pressures we’ve previously noted regarding uncertainties surrounding U.S. federal policy initiatives and prospects for continued normalization of monetary policy. Regardless of this uncertainty overhang, the ongoing investor search for yield continues to allow issuers across the rating spectrum to tap the capital markets under favorable terms and conditions, even with these pockets of pressure building. At some point though lenders could regain stronger footing–and when they do, funding liquidity will become scarcer, with lower-rated borrowers finding it harder to issue new debt.

Secular disruption has placed pressure on the U.S. retail sector–-in particular in the specialty apparel and department store segments. While slow income growth hasn’t helped, the industry’s difficulties stem more from structural shifts–including competition from e-commerce and more-nimble upstarts, and changing consumer preferences that aren’t apt to ease any time soon. As it stands, about one-third of borrowers in the sector have a negative rating outlook (see Chart 1).

In Europe, the Middle East, and Africa (EMEA)–as in many other places around the world–political and geopolitical risks have again taken center stage in S&P Global Ratings’ assessment of credit conditions. Terrorist attacks are fueling anxiety and feeding populist movements. Just one year after the U.K.’s vote to leave the E.U., Britons have once again surprised everyone with snap elections that were supposed to bring solidity and a strong mandate to the incumbent government. The opposite has in fact occurred, leading to a minority Conservative government, rendering Brexit negotiations more uncertain and difficult.

Given Brexit’s uniqueness, there aren’t really relevant precedents that market participants and negotiators (from both parties) can rely on. Judging by market commentators, there is a wide spectrum of possible scenarios that could play out between now and March 2019 (see table 2).

On the other hand, the highly anticipated French presidential election bringing Emmanuel Macron to power did not hold any surprises, and were followed by parliamentary elections that gave an absolute majority to the president’s newly established party.

For Asia-Pacific, we’ve placed the potential effects of higher interest rates as our top risk, with our No. 2 risk being market reaction to political events, including the possibility of increased tariffs (as U.S. President Donald Trump has threatened, for example), geopolitical confrontations (for example, conflicts involving North Korea), and rise of populist or extremist movements.

Uncertainty over the U.S. policy remains a key risk for Latin America. However, corruption allegations against Brazilian President Temer have become a main concern. Recent developments in Brazil point toward continued political uncertainty, which could hinder the country’s already fragile economic recovery. Such conditions not only could hurt domestic corporations and banks, but also their peers in neighboring countries such as Argentina. On the other hand, although it has become clear that it’s not going to be easy for the U.S. administration to fulfill campaign promises, we continue to watch for protectionist policies that could hurt the region’s economic prospects. In our view, while the possibility for such policies to materialize remains, institutions in the U.S. and stakeholders that benefit from free trade have helped change the tone and reduce investor anxiety towards the administration’s plans. Moreover, commodity prices remain fairly stable, which have helped ease market volatility.

Macroeconomic Outlook
Generally speaking, major economies across the globe continue to improve–or at least sustain the strength they’ve already gathered.

Despite a typical slow start to the year in the U.S., we anticipate real GDP growth in the world’s biggest economy of 2.2% this year–better than the post-crisis low of 1.6% we saw last year–as fairly strong consumer and business optimism outweighs policy uncertainty. Meanwhile, unemployment fell to a cycle low of 4.3% in May–but for the wrong reasons. A large number of people left the labor force (the labor participation rate is near a 39-year low), and fewer people were employed compared with the month before. In this light, the headline number ticked back up to 4.4% in June, and wage growth appears to be moderating rather than accelerating, with annual gains around 2.5%.

Inflation remains modest–below the Fed’s target of 2%. That said, we still expect the central bank to raise the fed funds rate once more this year, pushing the benchmark to 1.25%-1.50% by year-end. Policy makers have also started to talk about balance-sheet normalization, with most Federal Open Market Committee voting members leaning toward shrinking the Fed’s $4.5 trillion balance sheet this year, assuming the economy performs in line with their expectations.

In the eurozone, economic activity continues to strengthen, with GDP growing 0.6% in the first quarter. The expansion was broad-based geographically, with no national economy growing less than 0.4%. Germany (0.6%) and Spain (0.8%) led the way among the largest economies. And signs point to an equally upbeat picture for the second quarter. The eurozone composite purchasing managers’ index stayed at 56.8 in May, the highest in six years, and industrial production expanded by 0.5% month on month. Based on recent figures that are a bit stronger than we anticipated previously, we have revised our GDP growth forecast upward by a couple of decimal points to around 2% in 2017.

Along these lines, economic data in Asia-Pacific has turned positive over recent months, even as trade growth peaked across much of the region.

China’s official GDP growth target of 6.5% or higher for 2017 looks secure for now, and excess credit growth will likely continue for some time. Meanwhile, Japan’s GDP grew 2.2% in the first quarter (at a seasonally adjusted annual rate)–the fifth consecutive increase and the fastest pace since the first quarter of last year. Still, inflation remains stubbornly close to zero, with core inflation again negative, and the yen has been strengthening. Our 1.3% GDP growth forecast for 2017 looks safe, with some upside potential after the strong first quarter.

At any rate, China, Taiwan, South Korea, India, and Japan may be most sensitive economies from the perspective of net exports-to-GDP if the U.S. imposes tariffs or border taxes against exporting countries (see chart 3). While Singapore and Hong Kong are net importers from the U.S., their economies would also be affected, given their high reliance on the trade flow of exports and imports, particularly if non-U.S. countries engage in a tit-for-tat tariff war.

Elsewhere, while global economic conditions have remained favorable for emerging markets in recent months, idiosyncratic domestic factors have dimmed our expectations for growth in most major Latin American economies. Political uncertainties in Brazil, a lengthy labor strike at Chile’s largest mine, and severe flooding in Peru have created a scenario in which the region is falling behind the economic recovery in most of the rest of the world. The good news is that Latin American real GDP will still likely return to positive territory this year; the bad news is that growth will still be very sluggish in the best of scenarios, and the risks remain firmly tilted to the downside.

Financing Conditions
For the most part, borrowers up and down the ratings ladder continue to enjoy favorable financing conditions. In the U.S.–by far the world’s biggest corporate-bond market–credit spreads have continued to tighten modestly across rating categories, with lower-rated categories contracting more amid waning risk-aversion among investors. In fact, spec-grade spreads are back down to levels last seen prior to the prolonged drop in oil prices that began in the second-half of 2014, after rising to levels not seen since the financial crisis of 2008-2009.

Meanwhile, the recent pronouncement by the European Central Bank (ECB) suggests it is in no hurry to remove accommodative monetary policy. In its most recent downward revision, the central bank now expects inflation to average 1.5% in 2017 and 1.3% in 2018, well below its target of “below but close to 2%.” Only in 2019 does the ECB sees inflation approaching the target. We now expect the ECB to extend its quantitative easing program into next year. Also, the bank signaled that interest rates will remain at their present levels for an extended period of time–in line with our expectations that a hike in the main refinancing rate will not happen before 2019.

In Asia-Pacific, financing conditions have recently improved, with fairly low inflation across the region. According to Institute of International Finance’s (IIF) diffusion indices, Emerging Asia has generally improved across the board with credit standards for corporate loans, commercial real estate, consumer loans, domestic and international funding conditions, and trade finance seeing broad improvements (although there was some deterioration in residential real estate loans). In addition, our economists continue to see strong credit growth in China–and despite volatility in interbank funding and a subsequent liquidity squeeze, we believe this is a positive as a step toward more market-based outcomes. Nevertheless, financing conditions also have a sizable set of challenges ahead including China’s massive capital outflows.

In Latin America, while investor sentiment remains fragile, many issuers have benefited from favorable market conditions to cover their refinancing needs this year. Nevertheless, access to the market will be necessary beyond 2017, and coming volatility from the shifting political dynamics may weigh on conditions. Still, financing conditions appear to be somewhat more supportive than they were last year, with the IIF’s Lending Conditions Index showing that funding conditions and trade finance improved to above 50% (with 100% as most favorable and 0% as least favorable). And while overall lending conditions remained flat at 48%, this is an improvement from 45% at this time last year (see chart 4).

Risks that may deteriorate these conditions include a ramp-up of geopolitical instability, declining oil prices, or significant increase in protectionism among Latin America’s trading partners. On the positive side, a sizable absence of these factors would improve financing conditions as well as investor confidence, though we believe this may be some way off.

Lapo Guadagnuolo – Primary Credit Analyst – Standard & Poor’s