Standard & Poor’s Ratings Services has just published the European Corporate Credit Outlook 2016, “Recovery, Divergence And Disruption” which offers a detailed view of credit conditions for the upcoming year. Although the region’s economic recovery is gaining momentum supported by ECB’s accommodative approach and the credit cycle appears to be in a “sweet spot”, the road ahead is likely to be slightly uneven, as the corporate sector could be impacted by a swathe of disruptive risk factors from technology, regulation, politics, slowing growth in emerging economies, and falling commodity prices.
This disconnect in the broader economic outlook and prospects of European corporates stems from three broad groups of operating trends and risks seen in the region.
- Industries reliant on the domestic environment are likely to be unscathed by external shocks; but with rising global economic convergence, there are very few European corporates fitting in this segment.
- Firms that have undertaken significant capex in the past, have now been pushed to cut costs owing to recalibrating demand due to slowing emerging market growth and a persistent supply glut in their respective sectors.
- New technological innovations are gradually beginning to alter the dynamics of a few sectors. Although this trend has had a very little influence on the overall credit conditions until now, these implications could be far-reaching in the long-run.
The corporate conditions are likely to become more difficult, as a number of firms operating in sectors associated with higher operating risks far outweigh those poised to reap rewards from the improving domestic climate.
Despite the downbeat credit outlook, default rates in Europe are unlikely to see a large increase and will continue to hover well below the long-term average. This is largely a result of the region being perched in an early- to mid-cycle credit phase with corporate debt multiples still at reasonable levels.
On the corporate financing front, debt issuance via bond and loan markets has dropped, visibly due to the contagion fears arising due to Greece’s financial troubles and other external macro-economic threats. We expect European borrowers will continue to capitalize on lower rates next year, while U.S. borrowers could be swayed to tap funds from the other side of the Atlantic, with the Fed poised to hike rates.
That said, the speculative-grade bond market is still not out of the woods, as it has been choppy following the consistent bouts of selling in the secondary market, largely due to easing risk appetite globally. Sub-investment grade corporates have addressed this shortfall by deftly tapping the leveraged loan market and CLOs.
Continuing volatility in the high-yield bond market could keep this trend going. Low interest rates have been a key driver for M&A activity in Europe in 2015, with activity by value reaching the highest level in 7 years. This trends is unlikely to abate, especially in the current environment where growing organically has been difficult.
Taking cognizance of the overall picture, the European corporate credit outlook remains fairly healthy, however, in our view there are two broad groups of companies facing a more difficult environment, those exposed to areas of global oversupply – closely linked to the commodity downturn and its broader impact on emerging markets – and those at risk from a swathe of technological, regulatory and political disruptions. The risks facing these sectors suggest a continuing modest deterioration in the European credit outlook and an upturn in default rates.