No panic, but storms are brewing

While signs of stress in the US credit cycle are yet to migrate to Europe, there are fears that political developments may destabilise the region.

It’s a testament to the resilience of the benign credit cycle that, even now, no-one feels the end is nigh. A recent report on Europe’s corporate credit outlook from S&P Global summed up the mood perfectly with its title “The Sense of an Ending”. Nothing tangible, just a vague queasy feeling in the gut that things must turn sour eventually.

As we noted in last week’s Friday Letter, there are valid concerns around structuring and documentation – but these are creating problems that will only become apparent once a turning of the cycle has kicked in. And, as S&P points out, it is not obvious what the economic trigger will be for that turning point.

Indeed, the fundamentals continue to look surprisingly strong. Twelve-month trailing default rates are still around the 2 percent mark where they have hovered for some time now – and this is very low by historic standards. Although the only way is almost certainly up, S&P thinks they are unlikely to rise above 3 percent over the next year – which would represent nothing more dramatic than a move towards the long-term average.

Furthermore, a strong pick-up in global economic performance has fed into cashflows and financing conditions are supportive against a backdrop of modest inflationary pressure and central banks taking a “softly, softly” approach to policy normalisation. Emboldened by this, companies in Europe and around the world have been busily undertaking mergers and acquisitions.

It’s not that there are no causes for concern. As well as its “Sense of an Ending”, S&P also refers to the “calm before the storm”. Some would say the storm is on the horizon and moving closer with growth having passed its peak, asset purchases by the ECB’s quantitative programme set to end in December and interest rates having already risen in the UK (with rises expected in the eurozone next year).

But with lots of corporate cash to be spent, profit margins improving and debt levels easing as EBITDA improves, there is no sense of panic just yet.

The US, however, presents a somewhat different picture from Europe. Here, the credit cycle is more advanced and the rate tightening cycle well under way. Growth and cash generation are strong but, in the words of S&P, equity and credit valuations are “priced for perfection” (based on optimistic expectations of future earnings) and with high potential for repricing.

Although higher US interest rates and conflicts over world trade have the potential to spread problems well beyond the American mainland, the biggest challenge confronting European private debt appears to be politics within its borders.

With Brexit negotiations possibly heading towards a ‘no deal’, the Italian government increasing eurozone tension around immigration and fiscal policy disputes escalating towards a possible stand-off, politics rather than economics is most likely to be keeping private debt professionals awake at night.

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