Credit Research Outlook Ready for a Cyclical Downturn

A series of rolling recessions could hit the world in 2023 as a result of continued central bank tightening, but the absence of significant imbalances in the financial system and the sound condition of global bank credit profiles should help to lessen the negative effects of these recessions on the global cash investment universe.

Our credit team is preparing for most major economies to enter recession through 2023, but we anticipate that regional recessions will be more "normal" compared to the extreme downturns experienced during the 2007–2008 global financial crisis (GFC) and the 2020 COVID-19 pandemic. Since global central banks have yet to reduce inflation to the levels specified in their respective mandates, the tilt toward tighter monetary policy is likely continue, at least through the beginning of 2023.

Macro Outlook and Credit Cycle

The severe policy tightening that has already occurred has been successful in bursting the asset bubbles that grew during the pandemic (technology stocks, the cryptocurrency market, and housing) without seriously harming the credit cycle. Moreover, major economies around the world have slowed but not collapsed, and labor markets are still in very good shape.

Despite the partial "success" of monetary policy thus far, we would point out that most of the anticipated economic drag from monetary tightening still lies ahead due to lags in the transmission mechanism. There are indications that credit conditions may be beginning to considerably tighten. For instance, the most recent G4 bank lending surveys show that the demand for house loans is expected to decline sharply, but they also indicate that lending criteria for enterprises have become noticeably stricter.¹

As such, we are hesitant to rule out the possibility that the tightening of credit conditions or the restriction of access to funding over the coming quarters will be magnified through the continuing restrictive central bank policy, particularly for the riskier and more leveraged participants in the credit markets.

Risk Factors for Global Cash

We have previously outlined our belief that the absence of financial imbalance within major global economies may help to limit the depth of approaching recessions.² Deep and protracted recessions frequently accompany private sector deficits, which exacerbate the business cycle by having a more noticeable and detrimental effect on household wealth and through deleveraging channels.

As we enter this recessionary period, private sectors in the world’s largest economies are generally in surplus. Furthermore, the strength of the credit profiles of the banks on our Global Cash approval list gives us assurance that most of our investment counterparties' profiles will be resilient in the event of a recession.

Nonetheless, we would like to elaborate on three prominent risk factors that could have a greater detrimental effect on the credit cycle and the credit profiles of the banks in our coverage universe: central bank overtightening, European credit conditions, and highly leveraged economies.

1. Central Bank Overtightening

A deep/long downturn is not expected on a global basis, but downside risks related to the persistence of elevated inflation could prompt central banks to maintain restrictive policies for a prolonged period. While restrictive monetary policies and declining/negative growth rates should put downward pressure on inflation, there is the risk that strong credit creation, excess savings within developed economy households, and elevated corporate profitability can be sustained for a period, exerting upward pressure on inflation.

Such as scenario may compel central banks to adopt even more stringent regulations than those already planned. When terminal interest rates are at levels that are significantly higher than current expectations, imbalances in the credit markets that do not already exist could develop. These circumstances would put additional pressure on corporate earnings and growth and deplete excess savings in the consumer and corporate sectors of major economies.

The second order effects of business defaults could act as an accelerant for a deeper recessionary scenario, even though we still expect the impact to be concentrated in more leveraged segments of the credit market (private credit, leveraged loans, and high-yield rated companies), for which global banks in our investment universe have only limited exposure.

2. European Credit Conditions

The European Central Bank's (ECB) efforts to fight inflationary pressures are made more difficult by the way rate increases are asymmetrically implemented. This could lead to the ECB's monetary policy being more restrictive in countries that do not need it as much, and vice versa. The higher the Bund yields rise, the more the solvency dynamics of weaker countries may be called into question, potentially widening European sovereign and corporate credit spreads. In addition, larger fiscal deficits in the core may drive out issuance in the periphery, thereby reducing fiscal headroom there.

Undoubtedly, the original European debt crisis has abated, and the ECB now has a number of tools at its disposal to deal with acute peripheral country credit spreads, including the recently unveiled "Transmission Protection Instrument," the long-standing European Stability Mechanism, and outright monetary transactions. However, the asymmetry of ECB rate hikes and higher terminal rates in Europe could extend the European recession and eventually have a negative effect on the fundamental credit profiles of European banks.

3. Highly Leveraged Economies

We are closely watching countries in our investment universe, such as the UK, the Netherlands, Norway, Sweden, and Australia, that are most sensitive to increasing rates and have significant levels of leverage already. Given that Swedish households' consumer debt-to-income ratios are higher now than they were during the Global Financial Crisis (as opposed to, say, households in the UK, where debt levels are significantly lower compared to the 2008–2009 period), the Swedish mortgage market deserves close examination. Nearly half of all mortgage debt in Sweden has a variable rate, and the resets will put additional pressure on already-declining property prices.

Risks related to these circumstances can be mitigated by factors such as income growth, strong savings, and substantial house equity, which act as protective barriers against more serious disruptions in the Swedish housing market. Furthermore, given their exceptionally high capital ratios and the credibility of Swedish regulators through previous economic cycles, we continue to have a high level of confidence in the credit quality of the Swedish banks on our approved list. However, the elements for negative developments are obvious, particularly in the case of a severe or protracted recession.

Global Cash in a Good Spot

Despite the risks elaborated above, the debt issued by major international banks and financial institutions that makes up our Global Cash investment universe enters 2023 in solid fundamental credit condition. With rate increases resulting in robust net interest margins, strong loan growth enhancing net interest income, and asset quality maintaining at historically high levels, 2022 was something of a "goldilocks" period for most banks in our covered universe.

However, when chronic inflation and recessions start to affect consumers and companies, bank asset quality will start to decline across our coverage universe in the first half of 2023. Furthermore, it is uncertain if loan growth channels would stay robust as macroeconomic conditions worsen. Even so, given the strength of balance sheets (capital, liquidity), loan portfolios (limited exposure to higher risk/higher leveraged segments of the credit markets), and the advantages of revenue tailwinds brought on by rate hikes, we expect fundamental credit profiles to remain relatively stable in the first half of 2023.

We will select the most fundamentally weak sector, European Banks, as an example to demonstrate the relative resilience of our coverage universe.

The Case of European Banks

The structural of European banks weakness has been caused by a variety of issues, including excessive competition brought on by fragmentation and a lack of consolidation, a dearth of cross-border deposit insurance, underdeveloped debt capital markets, and the inherent problems with monetary unions. However, the atmosphere of permanently low or negative interest rates has been the most important factor.

The removal of this obstacle should significantly lessen the impact of declining credit profiles during recessions. Even if bad loans were to accumulate on their balance sheet during 2023 as a result of weakening economies, continued profitability could allow banks to accrete capital organically and preserve balance sheet strength and credit profile stability.

We believe that the effects of the upcoming rise in loan impairments will be less severe than during the most recent recessions. Our optimism is based on the observation that Europe has not created an excessive quantity of credit in the years leading up to the current recessionary scenario. Data from the Europe Systemic Risk Board and the Bank of America Global Research show that credit creation has generally lagged GDP growth in recent years (Figure 1).³

A statistically reliable gauge of the accumulation of credit risk has been the credit-to-GDP gap, which accounts for corporate and family borrowing – the bigger this percentage, the higher the risk. By this criterion, very few European countries seem to be in danger. The same data shows that over the period of negative interest rates, debt-to-income ratios in the euro area have decreased.

The practice of lending to risky borrowers has become less lucrative for European banks due to rigorous regulatory-driven stress testing and greater bank capital requirements. As a result, we think that compared to prior recessions, the risk of deterioration for European bank loan portfolios is lower.

In Closing

We are aware that every bank in our investment universe is about to experience a phase of weak economic growth, more difficult dynamics of asset quality, and hazy business chances in lending and capital markets. The issuers on our approved list, however, have the capital wherewithal to weather this cyclical downturn with the extra advantage of an increasing revenue cushion from rate hikes.

We think that rather than being systemic, the main risk factors in the investment universe will be idiosyncratic, with "problem spots" originating in banks with a history of poor risk management (for instance, Credit Suisse). Although we believe that investment counterparty selection has always been a key differentiator in short-term credit markets, as global recessionary pressures begin to take hold, it will become much more critical in 2023.