Sunday, December 18, 2016

Global Credit Market Outlook: The Conditions Are Set For Heightened Volatility In 2017

The following market forecast from Diane Vazza, Managing Director and Head of Global Fixed Income Research, S & P Global Ratings, should be of interest to anyone visiting the Leir Center website. Best, Bill Rapp, Director

Global Credit Market Outlook: The Conditions Are Set For Heightened Volatility In 2017

As 2016 comes to an end, a look back at the year shows a very different picture than what most market participants and commentators expected heading in. Defying what most polls were showing in the lead-up to the elections, the U.K. voted to leave the EU in June, and Donald Trump defeated Hillary Clinton for the U.S. presidency. These unexpected outcomes produced increased volatility in the financial markets immediately afterwards. In the case of Brexit, the effect has thus far mostly been short-lived outside of currency markets. Regarding U.S. monetary policy, our economists expected the Federal Reserve to raise interest rates three to four times in 2016, but the year is nearly over, and we have yet to see a single increase. 

One thing that we mostly expected was the increase in corporate defaults in the U.S. oil and gas sector, though the full extent of the increase was underestimated. We expect market volatility across most asset classes to continue into next year. Most of this will likely be a continuation of the increased uncertainty from this year, rather than any certain downturn. The potential for financial disruptions is higher than we previously expected, especially in light of the multiple, unexpected outcomes in 2016.

Still, we believe these factors are unlikely to have any major, negative impact on most of our core measures of credit markets--issuance trends, default rates, rating actions, and borrowing costs--for the coming year.
2017 Credit Market Outlook Summary
Along with our baseline expectations, we also have optimistic and pessimistic scenarios, all of which are based on qualitative and quantitative inputs. Our projections are founded on several assumptions and perceived risks. In our view, geopolitical factors will have the greatest impact on global credit markets in 2017, as the Trump Administration's currently unclear economic and trade policies, as well as the eventual implementation of Brexit, create uncertainties.

These issues have a direct effect on the two largest economies (the U.S. and the EU), with ripple effects expected to be felt globally. Because of the relatively unexpected results of Brexit and the Trump victory, the future courses of these events could present a wider range of both upside and downside risks to all of the credit market measures presented
here. These possibilities are made more uncertain with upcoming elections in several European countries.

Thus far, the reduced debt issuance that we expected as a result of the Brexit vote in June has largely not occurred. On the one hand, this could be a reflection of market resilience amid a backdrop of numerous stimulus measures from the European Central Bank (ECB) and the Bank of England (BOE). On the other hand, it may reflect issuers coming to market ahead of expected volatility and interest rate increases once the formal process begins in 2017.

Our expectations for issuance growth in the coming year are largely driven by increased issuance out of China, particularly among non-financial corporations, financial institutions, public finance entities, and domestically focused Chinese securitization. We do not expect the government to restrain corporate borrowing over the next 18-24 months. Within Europe, we expect the ECB to extend its current series of monetary stimulus measures beyond the March deadline in an effort to further boost inflation, and to act as a counterweight to real or perceived financial fallout from the implementation of the Brexit process.

We expect the speculative-grade corporate default rate in the U.S. to peak around the second quarter of 2017 and to decline in the second half of the year as stress in the energy and natural resources sector will eventually subside. However, currently our sector analysts are anticipating no noticeable increase in the price of oil over the next 12 months, so we expect the energy and natural resources sector to continue to dominate global corporate defaults and downgrades.

In Europe, we expect the speculative-grade default rate to remain around its currently low level of 2%, based on the expectation for a decline in downgrades and healthy lending conditions that should be favorable for refinancing.

Given the intentions of the incoming Trump Administration thus far, one area that could benefit is U.S. infrastructure in both the public and private sectors. However, most of the injection of funding and projects, should it occur, is expected to happen later in the year, and the proposed manner of financing the investment could have a mitigating impact on debt markets.

U.S. voters approved a large number of bond measures on election day, but municipal bond yields spiked following the Trump election victory. Should this persist, the higher yields could contribute to our prediction for lower volume from the municipal market in 2017. In structured finance, we expect the implementation of new risk-retention rules in the U.S. and ongoing regulatory uncertainty in Europe to hamper volumes in 2017, although growth may continue in Asia. 

We therefore expect anemic overall global volume growth of 1%-6% year over year. Rating movement in U.S. public finance should continue its upward trajectory, but U.S. states and higher education could experience more downgrades than upgrades.

We expect defaults in U.S. public finance to remain rare, but a significant number of ratings in the 'CCC' and 'CC' categories in Puerto Rico indicates that the number of defaults in 2017 could be similar to the 12 defaults so far in 2016.

Rating movement in non-U.S. local and regional governments (LRGs) will likely continue downward in 2017. The 295 LRG ratings have 43 negative outlooks and 19 positive outlooks. Nearly one-third of the ratings with negative outlooks are the same as and capped at the related sovereign. If we lower the sovereign ratings, we would also likely
lower these LRG ratings.

Based on the current proportions of corporate ratings with positive and negative rating outlooks and CreditWatch, we anticipate rating actions in 2017 to lean net negative, with a baseline estimate for a global corporate downgrade rate of 11.8% and an upgrade rate of 8.1%. We expect global structured finance credit performance to remain benign in 2017. The 12-month-trailing average change in credit quality looks set to remain close to zero, indicating aggregate ratings stability. The default rate will likely remain somewhat elevated compared with the pre-2008 timeframe, but below its long-term average.

Diane Vazza
Managing Director and Head of Global Fixed Income Research
S & P Global Ratings