Key Takeaways
Improving, but still vulnerable credit markets. We enter 2022 with largely positive credit momentum, reflecting favorable financing conditions and a powerful economic recovery. This could be derailed if persistently high inflation pushes central banks to aggressively tighten monetary policy, triggering significant market volatility and repricing risks. New COVID-19 variants could also undermine confidence and recovery prospects.
The weakest areas of credit markets–often still highly sensitive to the ongoing impact of the pandemic– are most exposed, particularly highly leveraged corporates and some emerging markets. – Fewer downgrades and low default rates. Robust economic growth and largely favorable funding conditions point to a steady overall ratings performance in 2022 with fewer downgrades (6% global net negative bias) and low default rates (around 2.5%).
Yet persistent supply chain disruptions and high input costs could weigh on growth and ratchet up the pressure on so-far resilient corporate margins. Inflationary pressures are clouding the outlook for EMs still battling with the pandemic. Leverage continues to build up in the riskiest parts of the credit markets, leaving them exposed to shifts in market sentiment, as illustrated by the recent developments affecting the Chinese real estate developers.
Risk of aftershocks from inflation and high global debt
The aftershocks of the COVID-19 pandemic pose significant risks. Persistent inflation, tied to supply chain disruptions and soaring energy prices, could trigger wage inflation and push major central banks, the Fed in particular, to hike rates sooner and faster. This could generate market volatility, likely amplified by elevated global debt levels. New variants could weaken the global economic recovery, as could China’s policy and economic developments.
Beyond COVID-19, credit markets face significant longer-term uncertainties around energy transition, cyber risk, and evolving financial systems in an increasingly digital economy. The pandemic and its aftershocks will remain pivotal to credit prospects in 2022. Surging global demand, extraordinarily benign financing conditions, supply chain strains, and soaring energy prices are just some examples of the powerful forces triggered by the shock of COVID-19 and the emergency policy response it required.
In our view, credit momentum will remain positive, with financing conditions still heavily underwritten by supportive fiscal and monetary policy, and economic growth easing back to a more sustainable pace. Nevertheless, the recovery’s foundations are relatively fragile and vulnerable to setbacks. The pandemic itself remains very much active, with the omicron variant posing a new threat and vaccination rates worryingly low in many parts of the world.
Our base case is that default rates will remain low and credit prospects continue to show improvement, but uncertainties abound and risk premiums are uncomfortably low. We consider three sets of challenges and opportunities likely to shape the year ahead: Aftershocks assesses the immediate pressures largely brought about by the pandemic; Future Shocks focuses on more structural factors and emerging technologies shaping the future of finance; and Climate And Energy Transition discusses the credit implications of the behavioral and technical shifts stemming from efforts to avert the most severe consequences of climate change.
Aftershocks
COVID-19’s economic impact has waned but variants are a concern. As we enter the third year of the pandemic, it is difficult to say with certainty that this will be its last. Successful vaccination programs and the ramping up of their global vaccine supply offer the clearest route out and the transition from a pandemic to an endemic but manageable disease.
Yet, sharply escalating case counts in heavily vaccinated European nations and the threat that omicron or other variants might overcome existing vaccines are reminders of how far we remain from a post COVID-19 world. Encouragingly, economies are proving adaptable and, particularly when vaccination rates are high, capable of recovering strongly. We forecast global real GDP will grow by 4.2% in 2022 (from 5.7% in 2021), but the pace of recovery is uneven globally and highly correlated with vaccination rates and the magnitude of stimulus.
Even in countries where life has returned largely to normal, structural changes to consumer behavior, travel, commercial property, and even the desire to work remain apparent. Pandemic-related credit risk may have eased, but it has not been removed. We expect inflation pressures to moderate sufficiently to avoid aggressive monetary tightening. Headline inflation has exceeded most economists’ expectations in 2021, raising the specter of an abrupt transition in financing conditions should the most influential central banks need to move more quickly to raise interest rates.
Major central banks, including the U.S. Federal Reserve and the European Central Bank take the view that the surge in inflation primarily reflects pandemicrelated distortions that will fade and note that long-term inflation expectations remain well anchored.
Our base-case assumes an orderly exit path with the tapering of asset purchases, followed by a gradual increase in rates. Should inflation become more entrenched, particularly with respect to wages, an earlier and more rapid tightening of monetary policy would endanger the economic recovery and likely provoke significant market volatility. Monetary policy challenges are more immediate for emerging markets (EMs), with inflation pressures greater and longer-term expectations less stable. Inflation has a greater impact on households in EMs, since spending on food, gas, and transport represents a larger portion of their disposable income than for developed market peers.
The political and fiscal dynamics are consequently more challenging, with the need to avoid social discontent constraining the ability of some EM governments to put COVID-19-affected finances on a more sustainable footing. Many EM central banks have already lifted interest rates and might be forced to run a more restrictive monetary policy for longer if inflationary pressures prevail. These challenges could be exacerbated considerably should the U.S. Federal Reserve be forced to change tack on rates, given the heightened sensitivity of EMs to U.S. dollar exchange rates and financing costs.
Governments will seek to achieve a tricky balance between supporting growth and achieving fiscal rebalancing in 2022. As economies reopen, the recovery of tax revenue and the ending of temporary support measures should reduce government deficits in 2022. But they are still expected to remain above pre-pandemic levels in nearly all regions, as sovereigns will unlikely be able to implement serious revenue-increasing measures or reforms.
Governments face the delicate task of withdrawing fiscal stimulus without hurting growth, a challenge compounded by the more fragile and politically polarized social context after the damage caused by the pandemic. Sovereigns that cannot stabilize and improve their fiscal position will likely see negative pressures on their credit ratings over the next 12 to 18 months.
Global nonfinancial corporates appear to have weathered supply-chain disruptions and soaring cost inflation well so far. Companies in most sectors have been able to pass on costs or absorb them in a variety of ways (demand offsets, product mix adjustments, hedging, etc.), while keeping pay growth low.
Some industries have benefited particularly strongly from surging demand and shortages, notably shipping, semiconductors, and metals and mining. Consequently, nonfinancial corporates rated by S&P Global Ratings are likely to deliver strong results for 2021, with revenues and EBITDA soaring, and profit margins likely to hit a record level. However, 2022 is likely to prove more challenging as growth slows and profit margin pressure starts to ratchet up.
Our industry analysts expect supply disruption will persist until the end of 2022 for more than half of all sectors, and signs of upward pay pressure have emerged, particularly in North America. This is not helped by the so-called “big quit”.
At least 3 million people have exited the U.S. labor force since February 2020, highlighting a possible structural shift in the labor force, with almost two-thirds of the missing workers having left the workforce entirely. China’s policy shifts could bring long-term benefits but are likely to heighten credit stress and slow economic growth in the near term. In our view, the Chinese government will continue its reforms intended to promote “common prosperity”, which focus on reducing income inequality, maintaining financial discipline, and sectoral rebalancing.
If successful, these measures are likely to lead to a welcome improvement in credit metrics in the longer term. China’s current corporate debt-to-GDP ratio of 160% compares with a world average of 101%. In the near term, as seen with the volatility in the property sector, these changes are likely to heighten credit stress and cause more defaults. A transition away from carbon-intensive industries and property development, alongside the impact of zero-COVID measures, is likely to slow the pace of economic growth and we have trimmed our real GDP growth forecast to 4.9% for 2022 (see here).
China’s increasingly pivotal position in the global economy, particularly in relation to commodity and industrial demand, also means that any significant change brings risk of broader contagion and volatility. The knock-on effects on global gas prices of China’s attempts to improve the safety of domestic coal production and reduce carbon emissions, reducing coal supply and increasing demand for gas, is a powerful illustration of how Chinese policy decisions are increasingly felt worldwide.
Future shocks
The financial costs of the COVID-19 pandemic have led to a surge in global debt. We estimate that global debt outstanding will increase $37 trillion in 2021–the size of U.S. and China’s combined GDP–to $225 trillion, a total equivalent to 256% of global GDP. This raises the question of whether this has sown the seeds of a financial crisis. Higher debt alone is unlikely to trigger a crisis, particularly in the current low interest rate environment.
Moreover, near-term debt dynamics are likely to be favorable. Global debt to GDP should fall from 2022 onwards as incomes recover, particularly for the corporate sector. However, interplaying factors such as policy shifts or inflation could lead to a sudden tightening of financing conditions or markets demanding higher risk premiums, consequently putting pressure on the most highly levered parts of the global economy.
An example is China, where corporate debt accounts for 31% of the world total, with credit quality below the global average, and where the recent focus of policymakers on deleveraging and financial discipline is leading to higher defaults and soaring yields on the speculative-grade debt market. The digitalization of capital markets could bring radical change. The past 18 months have seen an abrupt intensification of the digitalization of capital markets.
We expect the adoption of cryptocurrencies and tokenization of assets to gather pace and increasingly disrupt financial markets as the technology evolves and gains wider acceptance and incorporation into the mainstream. Central bank digital currencies may act as a trusted bridge between the traditional and virtual worlds. Meanwhile, decentralized finance (DeFi) will continue to send shockwaves through traditional financial models, more as a complement than as competition with the incumbents for now.
But these technologies have the potential to revolutionize the financial markets over time. The digitalization of the economy heightens the risk of cyber attacks with the potential to hurt corporates, governments, financial markets, and economic growth. The number of creditrelevant cyber attacks keeps rising, and we believe 2022 will signal the start of more meaningful systemwide attacks.
Opportunities for hackers to gain access to IT infrastructure have increased over the past 12-18 months, owing to increased remote work and reliance on common third-party vendors. Cyber defenses need to at least keep pace with cyber risks. Otherwise, future cyberrelated systemic shocks could lead to widespread rating actions.
Climate and energy transition
Exposure to climate risks will increasingly affect credit quality. The past year has seen unprecedented rating actions driven by disruption and uncertainty over unexpected costs from severe climatic events, such as wildfires and droughts. This trend will likely escalate as global temperatures continue to rise, leading to erratic weather patterns affecting real assets and the infrastructure in particular.
Growing awareness of climate-change risks and policy plans, such as “Fit for 55” in Europe, could accelerate the energy transition to net zero. Following on from the COP26 Climate Change Summit in late 2021, governments are considering a wider range of policy tools, including market mechanisms, to support ambitious pledges aimed at achieving carbon neutrality by 2050. The transition to net zero will necessarily create winners and losers, and the risk of creating so-called stranded assets.
We expect an accelerated move away from fossil fuel investments by investors, financial institutions, and corporates following COP26 pledges around the “phase down” of coal and Global Credit Outlook 2022: Aftershocks, Future Shocks, And Transitions S&P Global Ratings December 1, 2021 6 commitments to align with a 1.5° Celsius trajectory within the next decade. Sectors for which achieving net zero is difficult or prohibitively costly, such as cement, steel, and refineries, are likely to be most at risk.
On the flip side, industries developing low-carbon solutions and carbon capture are likely to benefit. While the long-term destination may be positive, energy transition is unlikely to be straightforward or cost-free. The current surge in energy prices, exacerbated by geopolitical and weather issues, outlines the challenges on the road of the energy transition.
Courtesy Standard & Poors
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