Two updates from Fitch have underscored emerging risks in both the USA and Europe.
European credit investors have grown more bearish on emerging markets (EMs) and see them as the biggest risk to European credit markets, according to Fitch Ratings’ latest senior investor survey. But most investors see selective EM risk as acceptable in more stable countries and sectors.
Fifty-nine percent of respondents to the survey, which closed on 4 November, said the risk posed over the next 12 months by adverse developments in one or more emerging markets was high, up from 45% in our previous survey in July.
Investors again singled out EMs as most likely to experience deteriorating fundamental credit conditions in the coming year. Three-quarters of respondents think EM sovereign fundamentals will deteriorate, compared with two-thirds in July. For EM corporates the proportion increased nearly 20pp to 80%. Just 6% predict an improvement for either category.
A more pessimistic view among investors is consistent with the volatility in EM assets since mid-year. This has been driven by concerns about US monetary tightening, global growth, and commodity prices, as well as country-specific factors.
Survey responses reflect this range of related challenges, with no single risk factor notably outweighing others. 29% of respondents see low commodity prices as the main risk to EMs, followed by slower global growth (26%), a Fed rate rise (24%), and high debt levels (21%). The view that EM corporates face the greatest refinancing challenge has hardened, with 63% of respondents selecting this category, up from 46% in our previous survey.
Nevertheless, more than half of respondents described their view on EM debt as selective, looking to pick more stable countries and sectors to avoid high risk exposures. 14% think now is a good time to buy in an oversold market.
Concerns about EMs are not new, and Fitch’s European senior investor surveys have shown increasingly negative sentiment in recent years. US investors also saw EM contagion as the top risk to their market in our recent US survey. Our global growth forecast of 2.3% for 2015 factors in the impact of recessions in Brazil and Russia and a structural slowdown in China and other EMs.
Fed tightening can exacerbate credit pressures via its impact on EM rates, capital flows and currencies, but this will vary across regions and asset classes. Many sovereigns have large FX reserves and low public debt, while EM corporate debt has risen sharply in the last decade. Highly indebted corporates with large dollar exposure and unhedged FX risk profiles will face greater refinancing risk than those with good funding diversification. US rate rises may put pressure on some EM banking systems’ asset quality and increase refinancing challenges.
Fitch’s 4Q15 survey represents the views of managers of an estimated EUR7.5trn of fixed-income assets.
US banking regulators’ latest report on the Shared National Credits Program (SNC) noted an overall higher level of credit risk throughout the system in 2015, providing further evidence that overall asset quality is potentially trending weaker, says Fitch Ratings. This may lead to higher future loan-loss provisioning, which was already evidenced in third-quarter 2015 with energy-related loan-loss reserve builds.
SNC portfolio loan risk is not usually retained by US banks in its entirety. While US banks hold roughly 40% of the SNC’s outstanding commitments, the majority of the credit risk continues to reside in the nonbank sector. Of the $228.4 billion in loans classified as “weak” by regulators, nonbanks held $153.0 billion, while US-domiciled banks held just $40.7 billion, and foreign bank organizations held $34.8 billion. Compared with last year’s review, classified balances increased 19% while nonaccrual balances were 7% higher, with most of the deterioration attributed to the energy sector.
The credit issues highlighted in the report remain focused on leverage lending and, particularly this year, oil and energy exposures. The regulators noted that the banks are making progress in adhering to the leveraged lending guidance issued by regulators in 2013. However, there will still be weak structures cited by the regulators. While no specific grouping of US banks are identified, the sample of loans examined is skewed toward large syndicated loans originated by large banks.
The greatest impact on shared loan asset quality was oil price declines affecting exploration and production and oilfield services companies, which represent about 7% of the overall SNC portfolio. Classified oil and gas borrowers rose to $34.2 billion, representing 15.0% of total classified committed loans, up from $6.9 billion or 3.6% in 2014. The report noted that banks are taking “reasonable actions” during this stressed period.
Apart from the underlying credit picture, leveraged loan underwriting continues to reflect weaker capital structures and covenants that limit lenders’ abilities to manage risks. The SNC program continues to pay special attention to highly leveraged lending at US banks where debt/EBITDA exceeds 6x. Year-to-date 2015, 36% of leveraged transactions exhibited weak structures, up from 31% last year. Among the weaknesses cited are ineffective or no covenants, liberal repayment terms and allowances for incremental debt above leverage levels at the start of loans. The reported noted that 92.2% of leveraged loans originated after June 1, 2014 included incremental borrowing provisions, an area that was drawing attention.
Leverage lending has grown over the last few years and has contributed to US loan growth. Last year, leverage loans in the SNC review pool were up 31.8%, year over year, to $1.04 trillion. Healthcare, media and telecom, finance and insurance, and materials and commodities were the top four contributors to that growth. Banks have experienced a 13.7% CAGR in outstanding loan balances since year-end 2011, which compared to 8.5% since year-end 1989.
Beginning in 2016, the regulators will change the frequency of SNC exams. Previously, SNC exams were held once a year; but next year, the large banks will undergo two onsite SNC exams. The first review will begin in February, utilizing data as of Sept. 30, 2015. The target date for the SNC review results to be sent to the participating banks will be in March of the following year. The second review will begin in August, based on first-quarter 2016 data. Fitch does not expect the more frequent examinations to produce material changes in the exam findings.
