Credit Research Update Some Gloom, But No Expectation of Doom

The global economy is in a synchronous downturn, but the absence of material imbalances and the private sector’s financial surpluses should help mitigate the ill-effects of a recession on the global cash investment universe

Despite pockets of strength, the global economy is in a synchronous downturn. The growth headwinds provided by aggressive monetary policy tightening, a brewing energy crisis in Europe and continued COVID-19 related disruptions in China are enough to materially enhance the risk of recession over the short and medium terms for developed market economies.

While this should help to lower inflation, uncertainty about the global inflationary path remains high, which should mean central banks will continue with their hiking cycles in the foreseeable future. It is also not clear whether central banks will need to “force recessions” to bring inflation down to acceptable levels. But we continue to believe that the current lack of financial imbalance within major global economies will help to limit the depth of recessions.

Global Private Sector Financial Balance Strong

Deep and protracted recessions typically coincide with private sector deficits, which amplify the business cycle through wealth and deleveraging channels. Certainly, the Global Financial Crisis (GFC) was the most pronounced example in recent history. However, we enter the current period of recessionary concerns with private sectors in the world’s largest economies sitting in a position of strength – the sectors’ financial surpluses should reduce its vulnerability to tightening financial conditions and falling real incomes (Figure 1).

To put things into perspective, right before the GFC, the median private sector financial balance averaged only 1.8% of GDP across major economies, with the US running a deficit 5% of GDP, versus a surplus of nearly 10% of GDP at present. In general, factors that undermined growth in the 2010s – such as austerity, deleveraging in the household sector and systemically weak banking systems – are not present today, and should serve as cushions to the global economy as central banks work to weaken aggregate demand in order to fight inflation.

Global Cash Investment Universe

With regard to our global cash investment universe, there is a growing list of reasons for us to focus on the European banking sector as we navigate through economic and market volatility. For one, the energy crisis in Europe means that its economy is at risk of experiencing a material recession. Further, as we have noted before, the European banking sector is structurally weaker than other banking systems that are in our investment universe.

However, we have reasons to be optimistic that credit quality degradation within the sector will not be material in the short-to-medium term. Our relative optimism stems from our expectation of government support to households and businesses to mitigate any potential impact from the energy crisis. Governments in the United Kingdom, Germany, France, Sweden, among others, are putting together fiscal support packages to help mitigate economic crisis in their respective countries. Although these measures may not prevent recessions over the upcoming quarters, they could limit the depth of downturn in these economies. As a result, we believe that large-scale loan defaults in bank portfolios are unlikely at this time.

The situation is not dissimilar from the pandemic period, which suggests that largescale asset-quality degradation is unlikely in the European banking sector. For sure, some stress will inevitably develop in the form of higher loan-loss provisions and more challenged business lines (such as commercial real estate lending) and some banks will perform better than others. However, we believe that the credit performance to date is a good lead indicator of structurally lower exposure to high-risk credit in the banking system now versus the past. Further systemic support is provided by the fact that Europe’s large banks have strong liquidity and capital metrics, which held up well during the pandemic. At present, European bank management teams expect that the positive profitability impact from higher interest rates will largely offset the expected increase in loan loss reserves from economic headwinds.ⁱ

Across our investment universe, global banks continue to tread a thin line between: 1) rate hikes providing net interest income strength and 2) deteriorating economic growth and inflation. Low unemployment in developed economies is the major mitigating factor for banks against the worsening economic data at present. Risks are certainly skewed to the downside as far as credit quality trends in our investment universe are concerned, and we continue to adjust our credit approval list to account for such developments. However, the foundation of credit profiles for banks on our approval list gives us confidence that the credit profiles of most of our investment counterparties will remain resilient in the short-to-medium term. This means, despite the sense of gloom, we do not expect any doom in our cash credit universe.

Financial Institutions

Non-Financial Corporates

Despite a string of adverse shocks through the first half of the year, global non-financial corporate profits continued to expand at a healthy pace through the second quarter of 2022. Bolstered by higher profitability, the global business sector has been a key source of this resilience as hiring continued and investment spending on equipment and inventories strengthened.

Although the sustained recovery in profits is encouraging, the momentum was clearly waning at the conclusion of Q2. While earnings growth over 2021 and the beginning of 2022 was broad-based across countries and sectors, the more recent gains have been concentrated in energy with signs of a sharper deceleration across other sectors. Considerable profit gains have been realized in the materials and industrial sectors as well, albeit far less than in energy.

Beyond these three sectors, however, profit growth momentum has reversed. Moreover, corporate margin pressures are building, as tight labor markets will likely keep wage inflation sticky and rising interest rates lift the cost of credit and add to the margin squeeze.

With regard to credit fundamentals for investment grade (IG) non-financial issuers, it is quite clear that from a leverage and profitability standpoint, peak credit quality is well behind us. For firms in the US, net leverage metrics were higher for the median IG-rated firm over the past year, while in high yield (HY) there has been little recent directional momentum, a trend that has persisted since early 2021. US HY firms are managing their balance sheet strength more conservatively than their IG peers. For both IG and HY firms in the US, cash balances have declined materially with median cash to total assets now only marginally above pre-pandemic norms.

The profit and margin performance for European IG firms has been weaker than US peers, with sequential profitability flatlining, in aggregate. While energy aid packages may mitigate the impact of rising electricity costs on corporate fundamentals in the very near term, this is only a short-term solution. Net leverage for European IG firms remains elevated in historical terms, which poses “fallen angel risk” for BBB-rated companies next year.