Make no mistake, trouble is in store

“Remarkable. It was like a bad dream that never happened,” reflected Paul Watters, senior director and head of corporate research at S&P Global Ratings, at a leveraged finance seminar delivered by S&P and Linklaters in London this week.

Watters was referring to the troubled sleep that may well have afflicted European leveraged finance professionals at the turn of the year, with Trump’s election, global political uncertainty, the threat of social instability and market jitters the fevered visions. A decade on from the global financial crisis, would 2017 plunge everyone once more into the abyss?

Nine months later and, as indicated by Watters, a big sigh of relief appears to be appropriate. You don’t have to scan too many news headlines to know that the world still has its issues but, in the markets, positives abound: equities have soared; commodity prices have risen; global economic growth has picked up; and, added Watters – to an audience no doubt basking in the warmth of good news – S&P’s rated portfolio is in almost unprecedented rude health.

“Dogs bark, but the caravan goes on,” concluded Watters, referring to an ancient proverb recently revived by Manchester United boss Jose Mourinho. Loose translation: North Korea, Trump, Brexit, populism, protectionism, blah blah, history marches forward regardless (or, in this case, financial markets).

But, just as those present were contemplating the prospect of leaving the gathering with a spring in their step, David Gillmor – S&P Global’s head of European leveraged finance – took to the stage. Though he sounded amiable enough, Gillmor may as well have been Dickens’ Ghost of Christmases Yet to Come. As with Scrooge, the audience may have complacently thought the demons had been dispatched – but here, finally, was the most haunting apparition of them all – pointing to the future.

“People today are making the mistakes which will show up in a few years’ time,” said Gillmor, to the accompanying sound of those present shifting uncomfortably in their seats. First lien/EBITDA ratios are at approximately the same level they were in 2007; deals with overall debt/EBITDA ratios of up to eight times are being seen; the average number of covenants in deals tracked by S&P is much lower than in 2007 (1.3 now versus 3.5 then); covenant-lite deals are now 72 percent of the total, having risen above 20 percent for the first time in 2014. There were other examples.

“Don’t think that any of this is normal,” said Gillmor, chillingly. Furthermore, he said, don’t take any comfort from low default rates. They can be cruel, it turns out, in their ability to lull people into a false sense of security – historical data show they tend to give no cause for alarm for years on end, before suddenly spiking sharply for a year or two and then rapidly falling again. Think of a snake lying coiled and motionless before taking a split second to rise up and strike its victim. When the next spike comes, Gillmor said, it will “probably be very severe”.

In 2017, Watters’ bad dream has not come to pass. Moreover, not many observers – including Gillmor – think it’s likely to in 2018 either. But the problems that will be suffered when the market eventually turns are being created now. The message was stark – but was it heard?