Bangkok--9 Oct--Standard & Poor's
Amid a backdrop of consumer relief over falling gasoline prices but worry about the value of their homes, the Federal Reserve is trying to achieve the vaunted, but elusive, goal of a soft landing for the economy. "When we look at the numbers, it looks like the Fed will hit that soft landing successfully," observed David Wyss, chief economist at Standard & Poor's Ratings Services. But, he added, "soft landings turn into recessions pretty easily." Mr. Wyss and other Standard & Poor's representatives spoke at an economic presentation held in conjunction with the recent launch of ratings and research on Capital IQ, a Web-based platform that combines in-depth company information and fundamental and market analysis with financial modeling, screening, and workflow management tools.
Either a major disruption in the oil supply or a rising trade deficit caused by reduced foreign investment in the U.S. bond market could threaten the soft-landing scenario. The inverted yield curve, often a harbinger of a recession, has also raised concerns. Barring any shocks to the system, Mr. Wyss predicted solid but slightly slower growth for the near term, with GDP expansion moderating to a 2.1% rise in 2007 from a projected 3.5% for 2006.
"Oil still matters, but it doesn't matter as much as it used to," Mr. Wyss explained. The U.S. currently uses half as much oil as it did in 1971, before OPEC began flexing its muscles. Worldwide, consumption is down one-third over the same time period. The U.S. has posted better numbers, Mr. Wyss noted wryly, because it was originally more inefficient. Reliance on oil has also declined at the individual consumer level. It now accounts for only 5% of average U.S. household income, down from 8% in 1981, when the last price peak occurred.
Housing sales are moving downward after enjoying a multiyear run-up supported by low interest rates that made mortgages, and therefore home-ownership, affordable. Reflecting a global trend, U.S. home prices have climbed about 70% over eight years. Other countries have seen a steeper rise over the same period, with prices leaping 200% in Ireland and 150% in the U.K.
Mr. Wyss expects home prices in the U.S. to stabilize in most areas. In overheated markets, however, real estate values could drop, especially where exceptionally high prices, second homes, or investment properties are common, such as San Diego, New York, and Miami. The housing market will also suffer in areas dominated by beleaguered industries, such as automakers in Michigan.
While an economic soft landing may be in the cards over the short term, the future holds both change and challenge. Developing countries are making tremendous strides, with two-thirds of economic growth coming from outside the industrialized nations. China represented the powerhouse in 2005, at 31%, and India placed a healthy second, at 10%.
The U.S. remains a formidable player, accounting for 15% of global growth in 2005. But shifting demographics could undermine this strength, as pension and health care obligations for retiring baby boomers strain productivity. Mr. Wyss cited a sobering figure: If no changes are made to current tax rates or entitlement programs, U.S. debt will equal 350% of GDP by 2050 versus 49% now. Other industrialized countries face similar situations as the ratio of workers to retirees grows burdensome if not unsupportable. But Mr. Wyss expressed confidence that changes would occur, because they must.
For now, he predicted that American consumers would rein in their lavish habits as the economy cools down. Record household debt should moderate, and the savings rate should move back into positive territory, according to Mr. Wyss. "But it will take a long time to get back to the 7% and 8% savings rates of the early nineties," he cautioned.
Based on global expansion and tightening monetary policy, a turning point appears near, advised Diane Vazza, director and head of global fixed income research at Standard & Poor's. "We expect the current resiliency will buckle to the headwinds as more stresses emerge in 2007," she warned, specifying tighter credit and slower economic growth.
While ample liquidity and tight corporate bond spreads still predominate, signs of credit erosion have begun to appear. Ms. Vazza noted that for the first time in two years, global "fallen angels"—companies that move from investment grade ('BBB-' or higher) to speculative grade ('BB+' or lower)—have just exceeded "rising stars"—companies that move from speculative grade to investment grade. Fallen angels temporarily outpaced rising stars in March this year, but have regained and held the lead since June. In the U.S. high-yield bond market, downgrades have surpassed upgrades.
And then there are the "killer Bs"—hundreds of first-time speculative-grade U.S. issuers that represent "a breeding ground" for potential defaults, Ms. Vazza observed. In Europe, the growing number of mergers and acquisitions could undermine credit quality. In the emerging markets arena, ratings outlooks have shown a negative bias that could signal deterioration down the road. And at the global level, weakest links (issuers in the 'CCC' ratings range with a negative outlook or on CreditWatch with negative implications) are at their highest level in 20 months.
Right now, Ms. Vazza noted, "excessive liquidity is propping up a low default rate," which was down to a record 1% globally at the end of August, with a 1.4% rate in the U.S. and 0.5% in Europe. But while Standard & Poor's model indicates that defaults will inch up to 2% in 2007 and 3.5% by 2008, these figures are still below the long-term average of 4.7%.
"I'd characterize today's credit environment as one where the entities that we're rating are stretching the credit boundaries," warned John Bilardello, managing director in Corporate Ratings at Standard & Poor's. They're trying to expand their business, looking for the best financing, but with the weakest financials. He described it as the greatest pressure on credit quality within the past two to three years.
Mr. Bilardello enumerated three continuing trends. First, competitive forces and earnings goals are driving business strategy. Companies seeking additional revenue and market share have turned to growth tactics that put their capital and profit margins at risk. Mergers, acquisitions, and price wars are common examples of such tactics. Impaired credit quality often results because these tactics add operating risk and financial debt.
Second, shareholder-friendly activities—such as stock buybacks, special cash dividends, leveraged buyouts, and asset spin-offs—often prove unfriendly to creditors. While these actions may please private equity firms, dissident shareholders, and money managers, they have a negative impact on credit quality because they reduce cash and increase debt. Ultimately they can lead to credit downgrades and a higher rate of defaults, Mr. Bilardello noted.
Third, hyperliquidity has kept interest rates relatively low and spreads narrow. This situation has led lenders to reduce the number of covenants in their loans. One or two are common today, whereas three or four were the norm a few years ago. Second lien holders, in particular, may not be receiving yields commensurate with the risks assumed.
Nonfinancial corporates have seen their downgrade-to-upgrade ratio rise to more than two-to-one this year, compared to about one-to-one last year. Defaults will likely rise with any substantial weakening of the economy.
Robert Schulz, director in the auto sector at Standard & Poor's, described an essentially stable set of ratings for the global auto industry, with the glaring exceptions of Ford and General Motors. Ratings at these automakers have plummeted from the 'BBB' category to the 'B' range over the past year and a half. But even with these low ratings, Standard & Poor's doesn't see a near-term likelihood of bankruptcy for either company because of management's determination to turn around their respective North American operations and the availability of enough cash to meet their near-term needs.
Ironically, Mr. Schulz reported that Ford and GM are experiencing serious problems at the same time North American light-vehicle sales have been fairly robust. "Part of the challenge is a consumer perception problem, since domestic automakers have improved their quality," he said. In addition, legacy cost issues and a changing model mix away from profitable SUVs are pressuring the traditional U.S. automakers. And of course, they continue to lose market share as foreign competitors, such as Toyota and Honda, steadily gain ground.
While oil and gas have had two strong years, they haven't translated directly into higher credit ratings, reported John Thieroff, director in the energy sector at Standard & Poor's. Citing a volatile energy market, he said companies at the lower end of the credit spectrum could be vulnerable and prone to default.
"We see risk being demand driven," he explained, noting the growing energy needs of developing economies such as China. The limited excess capacity in the oil market (only 1 billion to 1.5 billion barrels a day) has reduced OPEC's power to influence markets. Coupled with geopolitical tensions, tight supply has contributed to rising prices. "We do believe there's a fear premium," Mr. Thieroff stated, suggesting it has added about $10, perhaps more, to the price of a barrel of oil.
A solution to capacity problems is unlikely to come in the form of new refineries in the U.S., he pointed out. Expansion of existing facilities is more probable in the U.S., while new refineries will be built in developing countries.
Both the economic and credit landscapes appear bound for change, with early signs already evident. U.S. GDP growth will likely slow, with the relationship between spending and saving becoming less lopsided. Global defaults will likely rise. Right now, though, the soft landing should still be on course.
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Media Contact:
John Piecuch, New York (1) 212-438-1102, [email protected]
Analyst Contacts:
David Wyss, New York (1) 212-438-4952
Diane Vazza, New York (1) 212-438-2760
John J Bilardello, New York (1) 212-438-7664
John Thieroff, New York (1) 212-438-7695
Robert Schulz, CFA, New York (1) 212-438-7808