Europe, Middle East, and Africa
Markets Outlook 2010
January 2010
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Europe, Middle East, and Africa Markets Outlook 2010
Contents
Introduction
3
by Tony Angel, Executive Managing Director and Head of S&P in Europe, Middle East, and Africa
Executive Summary
4
European Corporate Credit Outlook 2010: Companies Brace For Another Challenging Year
6
by Blaise Ganguin, Chief Credit Officer, and Paul Watters, Director, S&P Ratings Services
European Equity Market Outlook 2010: Equities, The Asset Class Of Choice
17
by Robert Quinn, S&P Equity Research
Europe’s Homeowners Begin To Miss Fewer Mortgage Payments 24
by Andrew South, Senior Director, S&P Ratings Services
European Economic Outlook: The Bad News Is The Good News Isn’t Good Enough
27
by Jean-Michel Six, Chief European Economist, S&P
Emerging Market Sovereign Credit: The House Shook, But It’s Still Standing
32
by John Chambers, Managing Director, S&P Ratings Services
EMEA Sovereign Report Card
36
Does Recent Issuance Signal The Revival Of European Securitisation?
44
by Andrew South, Senior Director, S&P Ratings Services
What Are The Implications Of The New EU Emissions Trading Scheme For European Companies?
48
by Michael Wilkins, Global Head of Carbon Markets, S&P
Achieving Market Returns With Carbon Efficiency In A Cap-And-Trade World
54
by Alka Banerjee, Vice President, S&P Indices
Annual Review of UK Equity Income Funds 58
by Peter Brunt, Associate, S&P Fund Services
Structured Finance Investors Expect Default Rates To Climb On U.S. Prime And U.K. Mortgage Collateral 68
by Peter Jones, Global Head of Valuation Scenario Services, S&P
The Sukuk Market Has Continued To Progress In 2009 Despite Some Roadblocks
72
by Mohamed Damak, Associate, S&P Ratings Services
African Sovereign Ratings, Global Shocks and Multilateral Support
76
by Remy Salters, Associate, S&P Ratings Services
Contacts
82
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
1
2
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Introduction
Welcome to Standard & Poor’s Europe, Middle East
ratings, market indices, equity and fund research,
and Africa (EMEA) Markets Outlook for 2010.
securities evaluations, and a range of data and risk
management services.
The report covers our latest views and forecasts for
EMEA’s financial markets in the year ahead. Drawing
S&P celebrated its 25th year in EMEA in 2009.
on insight and comment from S&P’s macro, credit,
Through our network of offices in London, Paris,
equity, fund and valuation analysts, we examine
Frankfurt, Madrid, Milan, Stockholm, Moscow,
prospects for credit quality, equity markets and the
Dubai, Johannesburg and Tel Aviv, we bring both
wider economy in the region in 2010.
local and global perspectives to the key issues facing
investors in the region. Our analyses and opinions
We also explore a number of issues likely to impinge
are informed by local knowledge and insights, while
on EMEA investors in the coming year, including a
drawing on our assessment of global trends and
review of European mortgage markets, a look at the
applying internationally consistent methodologies.
future of securitisation in the region, fiscal trends
and sovereign risk in EMEA’s emerging markets, the
We continue to work closely with investors in the
European Union’s carbon emissions trading scheme,
region, to listen to their views and to further develop
and the outlook for the Islamic finance (sukuk) market.
and improve our offerings to meet their changing
needs. In that spirit, we would be interested to hear
Contributions to this report have been drawn from the
your feedback on this report and look forward to
wide range of financial research carried out by local
continuing our dialogue with you in the months ahead.
S&P analysts in Europe. They reflect S&P’s position
as one of the region’s leading providers of financial
market intelligence, spanning credit research and
Thank you.
Tony Angel
Head of Europe, Middle East and Africa
Standard & Poor’s
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
3
Executive Summary
Executive Summary
EUROPEAN CREDIT MARKETS
n The speculative-grade default rate on publicly rated
companies likely peaked at 13.1% in the third quarter of
2009 but is likely to remain substantially above trend in
2010 before returning to a more subdued environment
in 2011.
n Companies with highly leveraged capital structures are
having a difficult time coping with the dislocation in
credit markets. Issuers in the ‘BB+’ category or below
have been hit particularly hard, with many having to
approach their lenders to restructure their debt or waive
financial covenants.
EUROPEAN EQUITY MARKETS
is starting to be reflected in official forecasts from the
OECD and the ECB.
n The strong bounce back is likely to be short-lived
however. In 2010, growth in the Eurozone and the U.K.
will be below potential and we do not anticipate a return
to trend before the middle of 2011. The persistence of
the credit crunch as financial institutions repair their
balance sheets; rising unemployment weighing on
consumer demand; and deteriorating profit margins in
the nonfinancial corporate sector, are all likely to weigh
on the European economy.
EMERGING MARKET SOVEREIGNS
n We remain positive on European equities as the preferred
asset class for 2010. Real estate remains unattractive,
savers are priced out of cash with bond markets likely
to face elevated yields from the crowding out effects of
record sovereign issuance through 2010.
n We have initiated our 2010 year-end forecast for the
S&P Europe 350 at 1,140, equivalent to 15% upside
from current levels. This recovery requires a sustainable
pick-up in final demand, which will fill the gap when
government-sponsored growth wears off. We see final
demand improving across all countries – but not at the
pace that equity markets are suggesting.
n The pace of deterioration in emerging market sovereigns
slowed nearly to a halt during the final months of 2009,
according to this report card covering 42 low- and
middle-income countries. No rating on an emerging
market sovereign has fallen out of investment grade
and the rate of downgrades is expected to remain in the
historical range that prevailed before the downturn.
n Only 14 emerging market countries are expected to
have positive real per capita income growth in 2009
and eight will continue to contract in 2010. The fiscal
position of almost every government will be worse than
that of the preceding five years as automatic stabilisers
operate.
EUROPEAN RMBS TRANSACTION OUTLOOK
EUROPEAN STRUCTURED FINANCE MARKET
n Central banks in the U.K. and Europe undertook sharp
cuts in interest rates in late 2008 and these have now
worked through to reach mortgage borrowers. As a
result, arrears have moderated across various sectors,
and borrowers in markets where floating-rate loans are
common are benefiting from lower mortgage payments.
n The scale and sharpness of the economic downturn,
and the consequent effect on arrears and loan losses
in securitisations—as well as the fall in house prices—
has pushed the rate of downgrades in European RMBS
transactions to its highest level in the sector’s 20-year
history.
n Some of the factors that contributed to the neartotal depletion of investor-placed issuance in the
European securitisation market are beginning to
abate. Rationalisation of the investor base, changes
in accounting treatment and government support for
financial institutions have lessened the threat of forced
sales and mark-to-market volatility.
n The rebound in the securitisation market may yet prove
short-lived. While secondary spreads have tightened
recently, higher volumes of primary issuance could put
that trend under pressure. Other funding sources may
continue to hold more appeal to originators, and the
effect of evolving regulatory requirements on originators
and investors remains uncertain.
EUROPEAN ECONOMY
n Economic indicators released throughout the summer
of 2009 consistently reinforced the view that Europe’s
economy may be on the turn, and the improved outlook
4
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
EMISSIONS TRADING
VALUING STRUCTURED FINANCE ASSETS
n Europe has recently revised its greenhouse gas cap-andtrade system, the European Union Emissions Trading
Scheme (ETS). Phase III of the ETS, which takes effect
in 2013, will introduce new, tighter caps and more
stringent rules for the allocation and auctioning of
carbon allowances.
n Companies with operations in Europe could be at a
competitive disadvantage compared to those based in
developing countries, where the carbon compliance
regime is less rigorous. The post-Kyoto protocol will have
to deliver an efficient mix of financial instruments and
economic support for both developed and developing
countries to get them on board.
n House prices are expected to trough in the U.K. within
the next year, while default rates on U.K. and Spanish
mortgages will increase, according to the latest quarterly
survey of 64 institutions active in the European and U.S.
structured finance markets.
n There is a clear disparity between buyers and sellers in
the European market when judging the timing of defaults
on the mortgage collateral backing RMBS transactions.
Some 90% of the buy side consider defaults take place
at repossession, while only 10% regard delinquency as
the point of default.
LOW CARBON INVESTING
n For many investors and investment managers, directing
their investments toward companies with lower carbon
emissions is a strategy they believe could strengthen their
portfolios under any cap-and-trade scenario. However,
analysts are increasingly seeing cases where firms with
similar products in the same country are emitting
significantly different amounts of greenhouse gases.
n To enable investors to determine a company’s carbon
efficiency and track the performance of carbon-efficient
market indices with broader benchmarks, S&P launched
the S&P U.S. Carbon Efficient Index, which tracks the
S&P 500 performance but with one-half the emissions
of an S&P 500 portfolio.
UK EQUITY INCOME FUNDS
n “Clustering”, a measure of which companies and sectors
fund managers have invested in the underlying market,
is a rising concern among UK equity income funds. The
absence of banks from investors’ dividend radar now
means that over 66% of the UK market dividend is
provided by just 15 companies, according to a survey by
S&P Fund Services.
n Many funds in the sector show a high level of overlap
among their top 10 holdings. For example, 22 of the 23
S&P Fund Services-rated UK equity income funds had
mobile telecoms provider Vodafone as a top-10 holding.
Other common holdings included BP, GlaxoSmithKline,
Royal Dutch Shell, AstraZeneca, HSBC Holdings and
BAT.
ISLAMIC FINANCE
n The medium-term outlook for the global sukuk market
is positive, thanks to a strong pipeline of about $50
billion of sukuk either announced or being considered.
Although Islamic financial institutions have been more
resilient than their conventional peers the shift in the
environment has negatively affected some.
n While the default of several sukuk was possibly partly
responsible for the slowdown in issuance during 2009,
these should provide the market with useful information
on how sukuk behave following default. Major hurdles
remain on the path to development, including difficult
market conditions, a lack of standardisation, and low
liquidity.
AFRICAN SOVEREIGNS
n Falling commodity prices, remittances, foreign direct
investment, and the freezing of global capital markets
combined to stifle the African boom. Sovereigns in Sub
Saharan Africa continue to face pressures on the fiscal
and external sides, and a deterioration in terms of trade
due to higher oil prices could lead to further economic
adjustments.
n While greater support from multilateral lending
institutions has been a new element in recent months,
creditworthiness is ultimately most affected by the
cogency of policy reactions to the less favorable external
environment.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
5
European Corporate Credit Outlook Commentary
European Companies Brace For Another Challenging Year
Contact:
Paul Watters, Head Of Corporate Research, S&P
Ratings Services, London (44) 20 7176 3542
[email protected]
W
hile the worst of the recession may be behind
us, thanks to the positive impact of fiscal and
monetary stimulus packages, stabilisation in global trade
and much improved funding conditions given a newfound
risk appetite from investors, Standard & Poor’s Ratings
Services nevertheless expects the recovery to be extremely
shallow. Weak capital spending prospects by European
companies, coupled with expectations for a further
rise in unemployment, continued weakness in regional
housing markets, ongoing tight lending conditions by
banks, the threat of rising interest rates and taxes, and a
strengthening euro, paints in our opinion, a challenging
picture for corporate credit quality in 2010.
While we believe that defaults may have reached a
cyclical peak at 13.1% in the third quarter of this year,
they are likely to remain substantially above trend line
of 4.5% in 2010, before returning to a more subdued
environment in 2011. We estimate that between 55 and 75
Western European firms with speculative–grade corporate
credit ratings and credit estimates could default in 2010,
representing a default rate of 8.7% to 11.1% for Western
issuers, which would still make next year the third worst
year on record if it were to materialise. Unsurprisingly,
sectors most at risk include, in our view, the auto industry
and its supply chain, and consumer-related sectors, such
as retailing, home furnishing, and the hospitality segment.
Given the predominantly recessionary conditions of
the past year, the ratio of downgrades to upgrades for
European corporate rated entities increased to 5.7 to1 in
the first 10 months of 2009, from 3.6 to 1 in 2008. We
downgraded about 41% of our portfolio of publicly rated
companies in 2009, compared with 32% in 2008, while
the share of upgraded companies is down to 7% from
9%. Importantly, we see this negative trend continuing
in 2010, even as the economic environment appears to
be improving. This is because many rated companies
are assigned a negative outlook due to the expectation
of an ongoing challenging environment in most if not
all sectors and limited headroom at their existing rating
6
level. Performance in line with or above our base-case
assumptions, coupled with less uncertainty regarding
the strength of the economic recovery and financing
opportunities, could result in a reduced share of negative
outlooks. However, we anticipate that possible positive
outlook revisions or upgrades would only likely occur
towards the end of 2010.
Ahead of such an uptick, we believe that companies
are likely to remain cautious on acquisitions over the near
term. M&A activity is likely to be sporadic, in our view,
driven by weakness in the currency markets or companies
seeing an opportunity to reinforce their supply chain where
that may be beneficial. Overall, we don’t see M&A activity
as a major ratings driver in the near term. Similarly, we
think that companies will generally remain conservative
with regard to dividends and share buybacks until the
recovery is more firmly established.
Private equity firms are likely in our opinion to remain
constrained by the limited availability of debt finance
and will more likely focus on nursing many of their
overleveraged and underperforming portfolio companies
back to a stronger financial position. We believe a receptive
IPO market for (LBOs) in 2010 would be a positive credit
development for those companies with stronger underlying
business risk profiles and there may be opportunities for
strategic trade buyers to acquire some distressed LBOs.
This would be welcomed by the lenders involved.
The Credit Crunch Continues To Bite
At the macroeconomic level, there are signs that the
economies of Europe are looking up and this improved
outlook is starting to be reflected in official forecasts from
the European Central Bank (ECB) and the Organisation
for Economic Cooperation and Development. At the
foundation of this upswing, in our view, are the vigorous
policy responses from across the industrialised world. The
fiscal and monetary stimuli injected into most economies
over the past 12 months are a major difference when
comparing the current downturn with the Great Depression
of 1929.
We believe the prospect of a sustained recovery is still
some way off, and the improvement in economic conditions
remains unevenly distributed across the Eurozone. In 2010,
we believe growth in the Eurozone and in the U.K. will be
below potential and we do not anticipate a return to trend
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Table 1: Main European Economic Indicators
Real GDP (% change)
Germany
France
Italy
Spain
U.K.
Ireland
Eurozone
1.3
0.3
-0.9
1.1
0.7
-2.3
0.7
2009e
-5
-2.3
-5
-3.6
-4
-8.1
-4
2010f
1.1
1
0.5
-0.6
0.9
-2
1
2008
2.8
2.8
3.3
4.1
3.4
3.1
3.3
2009e
0.3
0.1
0.7
-0.2
1.8
-2.5
0.3
2010f
0.9
0.9
1.3
0.8
2
0
0.9
2008
7.8
7.4
6.8
11.3
5.7
6.5
7.6
2009e
8.5
9.5
8.4
19
9
13
9.6
2010f
9.5
10.3
9.2
21
9.5
14
10.7
2008
CPI inflation (%)
Unemployment rate (%)
f--Forecast. e--Estimate.
before the middle of 2011. The main factors constraining
such a return, in our opinion, are the persistence of the
credit crunch as financial institutions repair their balance
sheets and adapt to a new regulatory environment; rising
unemployment through the middle of 2010, weighing on
consumer demand; and deteriorating profit margins in
the nonfinancial corporate sector, placing a lid on capital
spending. The worst of the recession may now be behind
us, but in our view, a full recovery is still some way off.
The first reason behind our belief that the second-half
recovery will slide toward more subdued growth next year
is that the credit crunch is still with us and is not likely to
go away anytime soon. The most recent statistical releases
from the ECB show that loans to nonfinancial companies
have all but stalled during the summer, while household
lending remains very weak.
Banks, meanwhile, continue to use the liquidity provided
to them by the central banks to repair and strengthen
their balance sheets. As an illustration, in the latest ECB
refinancing operation of June 24, 2009, €442 billion was
lent to financial institutions in the Eurozone. A month later,
about €192 billion had been redeposited by the banks at
the central bank, while a good proportion of the remaining
funds were used in balance sheet repair operations via the
purchase of government bonds.
Tight credit conditions have two important implications.
First, they generally indicate no near-term recovery in
asset prices, which is negative news for companies and for
consumers. Housing markets, for instance, may stabilise
in 2010, as is already occurring in the U.K., but we do
not expect they will get the funding to grow again to any
significant extent. We believe this funding constraint will
likely slow overall debt restructuring and contribute to a
slow recovery in growth.
Second, limited availability of bank loan funding
implies a greater reliance on the bond markets. Corporate
bond issuance has already surged during 2009, while
the number of companies raising funds by selling stock,
including rights offers, is significantly lower than in 2008.
Companies are willing to pay higher spread premiums on
the bond markets to raise their liquidity buffers and replace
bank loans. However, we observe that to date only a few
mid-cap companies have accessed the Eurobond market.
As long as this remains the case, tight credit conditions will
penalize small and midsize companies and weigh on their
ability to increase capital spending, limiting the scope for a
strong and long-lasting economic recovery.
A further risk factor relates to the substantial increase in
sovereign issuance as a result of higher public deficits. This
presents the risk of a crowding-out effect, where spreads on
private sector debt start to increase substantially, causing
bond prices to fall and yields to spike, and discouraging
new corporate bond issuance. While we still believe
the probability of such a scenario is low, it cannot be
completely ruled out.
The transition toward greater reliance on bond market
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
7
European Corporate Credit Outlook Commentary
European Companies Brace For Another Challenging Year Continued
funding by European companies, while secular, will in our
opinion take time--especially for midsize firms. Until such
a move is complete, we expect overall funding will remain
tighter and more expensive than in 2004-2007, which is
bound to weigh on capital spending.
The Pace Of Corporate Defaults Will Remain
Elevated
We believe negative ratings pressure and the increase
in default rates in 2009 could have been far worse
considering the extent of the dislocation in financial
markets. Policy measures to support liquidity in the capital
markets; reduced funding costs across the credit spectrum,
lenders forbearance, and companies, focus on cash flow
preservation and debt reduction, have in our opinion all
played their part in shoring up companies financial position
in the face of a severe economic downturn.
Nevertheless, we still believe that credit quality among
rated corporates will continue to deteriorate (albeit
at a slower pace) in 2010. The business and operating
environment remains difficult, but the drivers are expected
to be different to those in 2009. In summary, negative
ratings pressure is likely to be derived from:
n Output that in our view will continue at well below
capacity, which will weigh on margins and cash flow
metrics.
n Upward pressure on working capital, which will build
as restocking begins and modest growth returns.
n Rising input cost pressures (particularly commodities,
electricity, and gas), which is a widespread concern
across many sectors because competition and excess
capacity is limiting pricing power. This would impact
margins and cash flow generation.
n The long-term business implications of companies,
cost-cutting programmes and cutbacks on capital
expenditure. Protecting cash flow in the short term may
potentially damage longer term business prospects.
n Visibility over medium term business conditions and
Table 2: European Defaults, Year-To-Date 2009
Date
Parent company
Country
Sector/Subsector
To
From
Reason
Jan. 30, 2009
Scottish Annuity & Life Insurance Co.
(Cayman) Ltd.
Cayman Islands
Insurance
D
CC
Distressed exchange
Feb. 10, 2009
Akerys Holdings S.A.
France
Homebuilders and
real estate companies
SD
CCC
Missed interest payment
Feb. 17, 2009
Castle HoldCo 4
Cayman Islands
Homebuilders and
real estate companies
SD
CCC
Missed interest payment
March 19, 2009
Bite Finance International, B.V.
Lithuania
Telecommunications
SD
CC
Distressed exchange
March 31, 2009
Sensata Technologies B.V.
Netherlands
Capital goods
SD
CC
Distressed exchange
April 2, 2009
NXP B.V.
Netherlands
High technology
SD
CC
Distressed exchange
May 7, 2009
Thomson S.A.
France
High technology
SD
CC
Missed principal payment
July 3, 2009
Safilo SpA
Italy
Consumer products
SD
CC
Distressed exchange
July 13, 2009
NXP B.V.
Netherlands
High technology
SD
CC
Distressed exchange
July 20, 2009
CEVA Group PLC
Netherlands
Transportation
SD
CC
Distressed exchange
July 29, 2009
Treofan Holdings GmbH
Germany
Forest products and
building materials
SD
CC
Deferred interest
payment
Aug. 14, 2009
Head N.V.
Netherlands
Media and
entertainment
SD
CC
Distressed exchange
Aug. 14, 2009
ESCADA AG
Germany
Consumer products
D
CC
Foreign bankruptcy
Oct. 12, 2009
VAC Holding GmbH
Germany
Capital goods
SD
CC
Distressed exchange
Nov. 4, 2009
Invitel Holdings A/S
Hungary
Telecommunications
SD
CC
Distressed exchange
N.A.--Not available. Data as of Nov. 5, 2009. Source: Standard & Poor’s Global Fixed Income Research.
8
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Table 3: Weakest Links
Entities Rated ‘B-’ Or Lower With Either A Negative Outlook Or Ratings On CreditWatch Negative
Rating combination and subsector
Issuer
Debt amount (mil. $)
Country
TUI AG
3,858
Germany
B-/CreditWatch Negative
Media and entertainment
B-/Outlook Negative
Consumer products
Fage Dairy Industry S.A.
Chemicals, packaging, and environmental services
Cognis GmbH (Cognis Holding GmbH)
Chemicals, packaging, and environmental services
Kleopatra Lux 1 S.a.r.l
Chemicals, packaging, and environmental services
Yioula Glassworks S.A.
Oil and gas exploration and production
Turbo Alpha Ltd.
191
2,741
0
206
1,400
Greece
Germany
Luxembourg
Greece
U.K.
CCC+/Outlook Negative
Capital goods
Sensata Technologies B.V.
2,547
Chemicals, packaging, and environmental services
Ineos Group Holdings PLC
10,722
Forest products and building materials
M-real Corp.
Forest products and building materials
Pipe Holdings PLC (Pipe Holdings 2 Ltd.)
1,326
Media and entertainment
Carlson Wagonlit B.V.
Telecommunications
Cableuropa S.A.U.
298
1,070
663
Netherlands
U.K.
Finland
U.K.
Netherlands
Spain
CCC/Outlook Negative
High technology
NXP B.V.
11,284
Netherlands
CCC-/Outlook Negative
Media and entertainment
Head N.V.
106
Netherlands
Metals, mining, and steel
Zlomrex S.A.
250
Poland
Telecommunications
Bite Finance International B.V.
442
Lithuania
CC/Outlook Negative
Automotive
Delance Ltd.
250
Cyprus
Capital goods
Baxi Holdings Ltd.
158
U.K.
Insurance
Syncora Guarantee U.K. Ltd. (Syncora Holdings Ltd.)
Telecommunications
Hellas Telecommunications I SARL
Telecommunications
Invitel Holdings A/S
0
4,164
688
U.K.
Luxembourg
Hungary
*Issuer added to the list since the September 2009 commentary. ¶Indicates an issuer moving to a negative outlook from CreditWatch negative or to CreditWatch negative from a
negative outlook since the September 2009 commentary. Data as of Oct. 13, 2009. Source: Standard & Poor’s Global Fixed Income Research.
the sustainability of the recovery is poor, with the
consequent risk of material setbacks that can fuel
downgrade pressure and trigger defaults.
Speculative Grade Defaults to Decline Gradually in
2010
Our speculative-grade default rate (by number) for Western
European companies (combining our public ratings with
our private credit estimate dataset) increased further in the
third quarter of 2009, to a preliminary rate of 13.1% for
the 12 months to end-September 2009.
The current default rate is higher than our 11.7%
base case but lower than the 14.7% downside scenario
that we projected for the end of 2009 (see “Leveraged
Buyouts Are Fueling Surging Defaults In Western Europe,”
published April 8, 2009, on RatingsDirect). The 13.1%
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
9
European Corporate Credit Outlook Commentary
European Companies Brace For Another Challenging Year Continued
default rate is derived from 96 companies in our dataset,
with total outstanding funded debt of €68.9 billion that
have defaulted over the past 12 months. These defaults
comprise 15 publicly rated companies (see table 2), with
total outstanding debt of €36.4 billion, and 81 private
companies with credit estimates, whose outstanding debt
amounted to €32.5 billion. The data set underpinning our
default analysis covers 733 speculative-grade corporate
credit ratings and credit estimates relating to companies
based in Western Europe. (Western Europe: EU-27 plus
Norway, Switzerland, and Iceland).
We believe it is likely that the default rate for this
economic cycle peaked in the third quarter, and will start
to unwind in the fourth quarter of 2009, a trend that we
believe will continue throughout 2010. We anticipate that
the default rate will fall back to 11%-12% by year end
2009.
We base this view on the economic stabilisation that’s
evident in Europe and the beneficial effect this is starting
to have on external sources of corporate liquidity and
lender behaviour. We expect ongoing efforts to strengthen
banks’ balance sheets and government pressure to support
businesses is likely to gradually improve the funding
options for lower-rated companies.
Moreover, where companies are in financial difficulty
and covenants are threatened, we observe that lenders
currently appear to be much more inclined to consent
to amendments rather than impose the more radical
balance-sheet surgery evident in the second quarter. This
has the effect of reducing the number of defaults likely to
materialise in the near term. It doesn’t solve the longer term
questions for many overleveraged LBOs however– namely
how they will be able to refinance their outstanding debt
before maturity in three to five years time.
Weakest Links
In our view, default risk is highest among the European
companies that we consider to be “weakest links,” defined
as companies rated ‘B-’ or lower with a negative outlook
or on CreditWatch with negative implications. There are
currently 21 of these companies in the region (see table
3), slightly higher than our mid-December 2008 tally of
18. This provides a visible demonstration of our view of
the ongoing decline in credit quality and the likelihood of
Table 4: European Fallen Angels
Date
Issuer
To
From
Sector
Country
Debt amount
(mil. US$)
6/8/2009
Peugeot S.A.
BB+
BBB-
Automotive
France
9/7/2009
Brussels Airport Holding S.A./N.V.
BB+
BBB
Transportation
Belgium
7/7/2009
Acquedotto Pugliese SpA
BB+
BBB-
Utility
Italy
6/30/2009
Landsvirkjun
BB
BBB-
Utility
Iceland
1,384
6/19/2009
Renault S.A.
BB
BBB-
Automotive
France
12,728
6/16/2009
Wienerberger AG
BB+
BBB-
Forest products and building materials
Austria
1,300
5/15/2009
Drax Power Ltd.
BB+
BBB-
Utility
U.K.
4/23/2009
Daily Mail & General Trust PLC
BB+
BBB-
Media and entertainment
U.K.
1/4/2009
UPM-Kymmene Corp.
BB+
BBB-
Forest products and building materials
Finland
3/31/2009
Gruppo Editoriale L’Espresso SpA
BB+
BBB-
Media and entertainment
Italy
395
3/31/2009
Fiat SpA
BB+
BBB-
Automotive
Italy
7,628
3/13/2009
GKN Holdings PLC
BB+
BBB-
Capital goods
U.K.
932
6/3/2009
British Airways PLC
BB+
BBB-
Transportation
U.K.
729
12,762
2
267
909
964
2,723
2/24/2009
Republic of Latvia
BB+
BBB-
Sovereign
Latvia
2/13/2009
Fortis SA/NV (Fortis Group)
BB
BBB-
Bank
Belgium
23,237
1/27/2009
Continental AG
BB
BBB-
Automotive
Germany
525
Data as of Nov. 6, 2009. Source: Standard & Poor’s Global Fixed Income Research.
10
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
1,705
Table 5: European Potential Fallen Angels
European Issuers Rated ‘BBB-’ With A Negative Outlook Or On CreditWatch with Negative Implications
Subsector
Issuer
Country
Debt amount
(mil. US$)
Bank
F&C Asset
U.K.
Management PLC
Consumer
products
Rentokil Initial
PLC
U.K.
1,448
The outlook revision reflects our concerns about the weakening performance in
major parts of Rentokil Initial’s business in 2008, the fragmented and competitive
nature of the service industry, and the company’s weak credit measures, which
are making it increasingly difficult for Rentokil Initial to improve its operating
performance.
Consumer
products
Tate & Lyle PLC
U.K.
1,382
The negative outlook primarily reflects our concerns relating to Tate Lyle’s ability
to restore its credit metrics and to maintain covenant headroom at levels that are
in line with the investment-grade category.
Chemicals,
Clariant AG
packaging, and
environmental
services
Switzerland
1,431
The negative outlook reflects our expectation that Clariant likely will suffer severe
volume declines, which will heavily affect profitability and will put pressure on the
current rating. Also, it shows the weak prospects for the chemicals industry and
deterioration in volumes sold by Clariant in fourth-quarter 2008.
Financial
institutions
Franz Haniel &
Cie GmbH
Germany
1,485
The negative outlook reflects FHC’s excessive market-value leverage for the
current ratings.
Metals,
mining, and
steel
SSAB AB
Sweden
1,500
The negative outlook reflects the possibility that we could downgrade SSAB
further during the coming year because we believe that the weak steel market
conditions are very challenging and that the company could report ongoing losses
during the rest of 2009, depending on market conditions, and negative free
operating cash flow.
Retail/
restaurants
Kingfisher PLC
U.K.
2,223
The negative outlook reflects Standard & Poor’s view that Kingfisher’s financial
ratios are below the levels commensurate with the ‘BBB-’ rating, as reflected in
the company’s aggressive financial risk profile, specifically its high leverage.
Sovereign
Republic of
Iceland
Iceland
6,795
The outlook reflects execution risks on the IMF program, which fall into three
areas. Apart from the amount of the program and the amount allocated to
recapitalise the financial system, it also reflects the risk that the government
coalition could come under strain because it will have to undertake a sharp fiscal
adjustment in 2011. All programs might not be enough to restore stability and
liquidity in the foreign exchange markets.
Transportation
Autoroutes ParisRhin-Rhone S.A.
France
1,485
The negative outlook reflects the company’s higher-than-expected volatility in
heavy-vehicle traffic, its ensuing weaker-than-expected EBITDA and cash flow
generation, and the tight headroom under its covenants at the Eiffarie level.
Transportation
Deutsche
Lufthansa AG
Germany
3,118
The outlook reflects our view that the group’s financial profile might be affected by
slowing passenger volume and a weakening yield trend as fare competition has
intensified. Also, the company is under pressure from increasingly high capitalexpenditure commitments in the near term, as well as recent acquisitions.
Utility
Western Power
U.K.
Distribution
Holdings Ltd. (PPL
Corp.)
1,812
The negative outlook on WPD reflects that on PPL Corp. and does not result from
any change in WPD’s stand-alone credit profile. The ratings could also come under
pressure if WPD’s financial profile deteriorates.
Capital goods
ThyssenKrupp AG Germany
6,829
The CreditWatch indicates that we could downgrade ThyssenKrupp if we do not
see a meaningful plan of debt reduction. The CreditWatch also reflects the severe
downturn underway in the steel sector and its effects on ThyssenKrupp’s credit
metrics.
423
Rationale
The outlook reflects F&C’s relatively weak leverage and debt-service metrics
compared with similarly rated peers’.
Data as of Nov. 6, 2009. Source: Standard & Poor’s Global Fixed Income Research.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
11
European Corporate Credit Outlook Commentary
European Companies Brace For Another Challenging Year Continued
more rated European companies defaulting in the months
to come.
Fallen Angels
Our tally of potential fallen angels, defined as those
companies rated ‘BBB-’ with either a negative outlook
or ratings on CreditWatch with negative implications,
currently stands at 72 issuers globally, including 12
European companies. Over the long term, fallen angel
activity generally mirrors the broader movement in
credit quality (as measured by the ratio of downgrades to
total rating actions). It also compares well with general
economic trends worldwide, increasing during periods
of weak real GDP growth and declining when GDP is
strong. This inverse correlation is not surprising because
companies’ aggressive leverage at the peak of the economic
cycle tends to make them vulnerable to downgrades when
economic conditions deteriorate, resulting in an increase in
fallen angels in and around troughs in the economic cycle.
Specific Industry Rating Trends
Business conditions should improve somewhat in most
sectors on the back of a modest economic recovery.
While we believe business conditions should improve
somewhat in most sectors on the back of a modest
economic recovery, negative ratings headwinds still weigh
heavily on many sectors for various reasons. In summary,
the rating outlook and key drivers at the sector level are in
our opinion:
n Negative rating trends are expected to persist in retail
as rising unemployment encourages ongoing consumer
downtrading that is likely to keep margins under
pressure.
n Media industry earnings should begin to rebound in
2010 as cost adjustment efforts take full effect and
the top line stabilises. Nonetheless, there remains a
material risk of a (limited) number of downgrades if the
advertising markets do not improve as expected in the
second half of 2010.
n In chemicals, negative rating trends should improve
relative to 2008/09 although underutilisation of assets
and increasing working capital requirements as demand
picks up will keep pressure on cash flow metrics.
n Ratings prospects in the European oil and gas refining
(downstream) segment are negative as the sector is
12
vulnerable to the modest increase in demand that
we expect as well as the need to close or restructure
poorly performing refining installations. Conversely,
ratings trend appear positive for upstream oil and gas
companies following the faster than expected recovery
in oil prices and to a lesser extent gas prices.
n Ratings prospects for capital goods producers are
likely to remain negative overall through most of 2010
reflecting relatively low demand and excess capacity. In
most capital goods segments, we think it will take time
before demand recovers significantly in Europe, even
if investment activity is now picking up in emerging
markets and, according to our expectations, in the US in
2010. While most companies in the sector are generally
performing in line with or close to levels consistent
with our ratings, the headroom to accommodate
further weakening and downside risks has decreased
considerably.
n Forest product companies rating outlooks continue to be
driven by a combination of weak economic conditions,
poor demand, and pricing pressure although economic
conditions are slowly improving. Prospects appear better
for packaging companies than for forest producers.
n Challenges will continue in the automotive, and auto
components sectors, as European car sales are expected
to fall in 2010 following the phase out of various
government sponsored sales incentive schemes. Longer
term structural challenges build as companies migrate
manufacturing, logistics, and vehicle models to new
environmental standards. Business prospects for light
and heavy commercial vehicle production appear worse
in our view compared to auto manufacturers.
n Weak business conditions expected in 2010 for the
utility sector mixed in with the execution risk of
planned corporate disposals, continuing cost cutting
programmes, and an ongoing commitment to longer
term capital investment on balance leaves the overall
rating outlook for the sector negative in our estimation.
n The stable rating outlook for the European
pharmaceutical industry reflects stable business
fundamentals, although there is a heightened risk
of more aggressive financial policies resulting from
research and development costs stepping up as patents
expire and marketing costs on new drugs.
n Greater ratings stability is anticipated in the building
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Table 6: Stand-Alone Credit Profile of European Bank Ratings Rise With Government Support
Counterparty credit rating
Barclays PLC
Credit Suisse Group AG
Holding company
Operating company
Notching uplift from
government support
A+/Negative/A-1
AA-/Negative/A-1+
0
A/Stable/A-1
A+/Stable A-1
0
Deutsche Bank AG
N.A.
A+/Stable/A-1
0
HSBC Holdings PLC
AA-/Negative/A-1+
AA/Negative /A-1+
0
A/Stable/A-1
A+/Stable/A-1
4
N.A.
A+/Stable/A-1
2
The Royal Bank of Scotland Group PLC
UBS AG
N.A.--Not available. Data as of Nov. 11, 2009. Source: Standard & Poor’s.
material sector following the spate of downgrades in
2009 as low construction volumes (particularly for
commercial property) is mitigated by the full year impact
of the recent swingeing restructuring programmes.
n Other stable sectors - reflecting the combination of
more resilient business conditions, low cyclicality, and/
or generally significant headroom for key financial ratio
targets: aerospace & defence, investment grade telecom,
consumer goods, transportation, infrastructure, mining
and food retailers.
For sub-investment grade companies, we believe:
n The sectors that have the greatest vulnerability to default
(with rating scores at B- or below) are, in descending
rank order, telecom services, chemicals, hotels and
gaming, energy, transportation and consumer products.
n In the telecom service sector, mobile operators,
particularly those with highly levered balance sheets, are
experiencing intense competition as consumers retrench
at the same time as capex requirements remain elevated
in response to significant growth in demand for network
capacity to carry wireless data.
n Chemicals companies (mainly commodity producers)
and transportation companies are at risk of being
squeezed between rising commodity input costs and soft
end user markets.
n The listing of the hotel and gaming sector reflects our
expectations of ongoing difficulties for the business
travel and tourism industry and the prolonged impact
that is having on cash generation.
n In the high yield consumer products sector, although the
operating outlook has improved in our opinion, short-
term refinancing risks continue to drive a number of
negative rating outlooks in the sector.
Credit Quality Of Europe’s Banks Should
Stabilise By The End Of 2010
In 2009, European banks are continuing to navigate a deep
regional recession that comes on the heels of unprecedented
losses at several of the sector’s largest banking groups. The
huge losses and vanishing prospects for a quick rebound
have triggered multiple emergency support actions from
national governments and the ECB. While fiscal stimulus
has calmed traumatised financial markets, most European
banks remain, in our opinion, vulnerable to the depressed
environment. In addition, we see ongoing and higher credit
losses characterising the second phase of the downturn in
the European banking industry.
Extraordinary Government Support Has Helped
Large Banks
Some European governments have offered the region’s
largest banks extraordinary support through the direct
injection of capital, plus other measures. We believe,
however, that this support is temporary and that banks
will have to relinquish it at some point and stand on their
own (if they have not done so already). The extent to
which government support enhances ratings (see table 6)
is important, and we continue to observe how banks are
using this period of support to reconfigure and strengthen
their businesses.
In our opinion, the future health of the European banking
industry and of individual financial groups largely depends
on the pace, sequencing and ability of governments to
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
13
European Corporate Credit Outlook Commentary
European Companies Brace For Another Challenging Year Continued
extricate themselves from the extensive support programs
currently in place. Governments will be keen to reduce
their stakes in banking groups, but only if such groups’
capital and overall financial condition is improving. We
believe they will be slow to remove funding guarantees,
as these have the least budgetary impact. Indeed, budget
consolidation will likely be a drag on growth and may put
more pressure on borrowers.
In our opinion, creditworthiness among European
banks should stabilise in the second half of 2010, after a
two-year decline. True, there will be anticipated significant
factors weighing on the industry in 2010, namely
continued high credit losses, slow growth or reduction
of risk assets, capital strengthening, increased regulation,
and the removal of government support programs put in
place during the crisis. Nevertheless, the cost of wholesale
borrowing, as reflected in bank credit spreads and in
the borrowing rates, is expected to continue to stay low
through the first half of 2010, prolonging the improvement
since June 2009. Furthermore, a relatively favorable
interest rate environment, with low refinancing costs and
an upward sloping yield curve, should in our opinion help
banks’ margins and partly offset the still-high rate of loan
provisioning. We believe that there should be minimal
additional write downs of U.S. mortgage-backed securities,
but see a potential for write-backs. We also anticipate
that investment banking and asset management lines will
be positive contributors, the extent of their contribution
depending as always on the development of capital markets.
On the downside, we see the high rate of loan losses
in 2009, as reflected in net new loan loss provisions,
continuing in 2010, weighing significantly on banks’
bottom line results. Specifically, this means losses in their
leveraged loan portfolios, as well as in loans to commercial
real estate, and shipping; and a higher-than-average rate of
loan losses in consumer loans, due in part to high and rising
unemployment. While we believe loss rates on mortgage
loans will generally be low in continental Europe, this is
unlikely to be the case with such loans in the U.K. and
Ireland. This is due in our opinion to legacy of riskier
lending practices in the U.K. and more severe collapse in
house prices in Ireland.
With European regulators taking an increasing interest
in the banking sector, capital adequacy requirements are
likely to increase, in our view. We believe the banks will
14
improve their capital adequacy by reducing risk assets and/
or increasing capital through retained earnings and new
issues of common and hybrid equity securities.
Banks Will Build Capital
The financial turmoil of the past 24 months has highlighted
the limitations of the existing regulatory framework, and
banking regulators around the world have been under
heavy pressure from politicians and the market to reshape
regulatory capital measures. One thing is clear in our
view: Banks’ regulatory capital requirements are likely to
increase significantly in the next few years.
Financial institutions around the world have been
rebuilding capital in light of the deterioration in their
operating environment as well as potentially tougher
regulatory requirements. New hybrid instruments are being
developed with innovative features to qualify as regulatory
capital. Some of these are referred to as “contingent
capital” because they contain language that converts the
instrument to equity upon the occurrence of some event,
ordinarily breaching a specified solvency trigger.
Regulators and banks typically see contingent capital
securities as relatively attractive because they will perform
a specific role in a time of stress by converting to equity (or
potentially a hybrid capital instrument such as preferred
stock). In this way, they are designed to help the bank’s
capital position at a time when the bank would likely have
limited access to alternative forms of capital. We have few
examples to date of contingent capital securities, and those
that exist may or may not be representative of how the
market will ultimately develop.
We view contingent capital securities as another
potential tool to manage the capital base in times of stress.
However, in our view, banks are generally not designing
them to address the need to repair existing weak balance
sheets. They are one potential answer to one capital
management question, but many banks will still need to
address their capital positions through traditional forms of
tangible equity. (For more detailed information on these
securities see “Standard & Poor’s Ratings Services Criteria
Regarding Contingent Capital Securities,” published Oct.
26, 2009, and “Contingent Capital Is Not A Panacea For
Banks,” published Nov. 10, 2009, on RatingsDirect.)
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
A New Banking System Is Likely To Emerge
So, while positive recent news from equity and credit
markets and trading results of some banking groups
provide encouragement, we believe that the costly multiyear
process of cleaning damaged loan books will continue to
dominate bank results over the medium term. Weakened
revenue flow from other business lines in the recessionary
environment will make the cleanup task harder still. This
is reflected in the negative outlooks on many of the largest
banking groups in Europe. Key reasons for negative rating
actions on individual European banks during 2009 and
negative biases for 2010 include our view of either one
or more often any combination of the following: outsized
investments in structured credit products, exposure to
corporate and investment banking, domestic credit risk,
exposure to Central and Eastern European markets,
weakness in risk management, weak earnings prospects, or
concerns over business models.
Because this recession and financial industry crisis has
had such a profound effect on banks and other financial
institutions, we believe that the industry will undergo
significant changes in regulation, supervision, and overall
competitive structure over the medium term. Ultimately,
the changes in regulation should have a stabilising effect on
the creditworthiness of the sector, in our opinion.
In our view, banks may also have to reconsider a basic
part of their business model--the degree to which they
can use securitisation to offload assets from their balance
sheets--as well as how to cope with greater marketplace
volatility and higher losses during this recession.
We will continue to pay special attention to the
following factors which we have identified as likely to
have a significant ratings impact: the continuation of
extraordinary government support, risk and capital
management, how actual losses compare with those our
stress tests imply, and any systemic threats that arise.
Insurers’ Resilience Will Likely Be Tested
Through 2012
The insurance sector has fared well relative to banks
over the past two years. For example, no rated insurer
based in Europe has failed, neither has any insurer been
rescued by the state. However, while insurers were not
the cause of financial turmoil, they still suffer some of its
consequences. Over the period, impairments on invested
assets have substantially eroded insurers’ capitalization
and profitability; in some cases leading to downgrades.
This is compounded by weak economies. Among 160 rated
insurance groups in Europe, downgrades number 24 and
upgrades total nine in 2009 so far. Most of the downgrades
relate to life insurers. Despite positive trends in equity
markets, lower credit spreads over recent months, and signs
of recovery in economies around the world, we remain of
the opinion that economic and financial market conditions
will continue to put pressure on Europe’s insurers. This is
reflected in our outlooks--, 33 of which are negative and
only six are positive.
Investment returns will likely be poor in 2009 and
2010
Looking ahead, we anticipate that impairments on certain
classes of investments will eat into insurers’ earnings
in 2009 and potentially in 2010. Overall investment
returns, in our view, will likely remain subdued over at
least the next two years, reflecting a combination of lower
investment yields and significantly lower realisations of
capital gains from equity investments. We are also cautious
on certain investment risk exposures such as financial
institutions’ hybrid securities and, for those insurers with
large U.S. subsidiaries, the following asset classes pose
the greatest risks, in our opinion: commercial mortgagebacked securities, collaterised debt obligations (CDOs),
commercial mortgages, commercial real estate, and
residential mortgage-backed securities. Low investment
margins have a direct bearing on the returns that life
insurers can offer their life insurance policyholders, which
will adversely affect new business.
Stagnant economies are hurting insurers’ earnings
Standard & Poor’s economists observe that the risk of a
double-dip recession remains, and the scale and likely
pace of a potential global upswing is still unclear. In
addition, we believe it is too early to consider the current
financial market rebound as evidence of a lasting recovery.
This impacts insurers in a number of ways, but it hurts
life insurers most. Life insurers’ new business levels are
depressed in most European countries this year and we do
not anticipate a rapid recovery. This can be attributed to
low investment yields (see above), lower investor confidence
(savings and investment products), lower housing market
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
15
European Corporate Credit Outlook Commentary
European Companies Brace For Another Challenging Year Continued
activity (affecting mortgage-related products), and lower
disposable incomes. Furthermore, life insurance policy
lapse rates are elevated as policyholder’s surrender their
policies or discontinue premium payments in order to
realise or conserve cash. These top-line issues have a
direct bearing on insurers’ profitability, as do the weaker
returns on investments backing non-linked policies and
the charges that insurers levy on unit-linked policies and
asset management products (which are largely based on the
market value of the managed investments). On the non-life
side, typical of recessionary conditions, the frequency of
claims is on the increase.
The non-life insurance cycle presents a mixed
picture for future earnings
In our opinion, Europe’s reinsurers are better placed to
weather the economic conditions than primary insurers.
Premium pricing is sound for most lines of reinsurance
business, which augers well for profitability this year and
next. Reinsurers have been posting impressive underwriting
results so far this year, and the crucial North Atlantic
hurricane season is nearing its end. Their response to the
impact of the financial turmoil on their marked-to-market
balance sheets in the fourth quarter of 2008 was to quickly
reverse the downward pricing trend. With their balance
sheets looking much healthier today, upward pricing
pressure has abated. Primary insurers typically did not
respond in the same way, leaving a mixed picture around
Europe in terms of the adequacy of rates. Rates in the U.K.
and Italy are showing signs of significant progress in the
key motor insurance line of business, whereas in Germany,
downward pressure still prevails, as it does in much of
continental Europe.
Capital adequacy is much improved on its firstquarter low point
Insurers’ capital adequacy hit its low point at the end of
the first quarter of 2009, when the capital adequacy of
many insurers was inconsistent with their rating levels.
This remains the case for several insurers, although the
gap is currently considerably narrower for virtually all
of them. Much of the improvement is down to equity
value appreciation and narrowing credit spreads for the
unrealised losses that existed at the end of the first quarter.
Such gains are in addition to still-reasonable levels of
16
underlying profitability. There are even isolated examples
of reinsurers resurrecting their share buyback programs.
We believe other insurers may close the gap by retaining
earnings in 2010, or by raising new capital since equity
and debt markets are open to them again at increasingly
attractive cost.
Solvency II creates uncertainty about longer term
capital needs
Many insurers and their industry associations are voicing
concerns about the future capital needs of the European
insurance industry under the EU Solvency II Directive.
Solvency II is intended to completely overhaul and
harmonise the supervision of insurers across Europe and is
scheduled to take effect from October 2012.
The Committee of European Insurance and Occupational
Pensions Supervisors (CEIOPS) is responsible for advising
the European Commission on the capital requirements for
the industry under Solvency II. CEIOPS’ most recent advice
increases the capital requirements for many of the key risks
that insurers face well beyond the requirements tested in
the most recent Quantitative Impact Study (QIS 4). The
perceived view of insurers is that these requirements
represent a knee-jerk response to the financial turmoil of
the past two years. For the past two years, our research
publications note that the new capital requirements could
lead to a strategic response from at least 25% of Europe’s
insurers. If CEIOPS recent advice is accepted by the
Commission, Solvency II would have a far more significant
impact on many more insurers than we had previously
envisaged.
We understand that Solvency II is not the only concern
to insurers’: They sense that the policy responses targeted
at banks (living wills, dynamic provisioning, and systemic
risk capital add-ons, for example) may also be applied
to them. If they are applied, we believe this would have
significant adverse implications for insurers’ capital
management practices.
ADDITIONAL CONTACTS:
Blaise Ganguin, Chief Credit Officer, Paris
Jean-Michel Six, Chief European Economist, Paris
Scott Bugie, Managing Director, Paris
Andreas Zsiga, Director, Stockholm
Rob Jones, Managing Director, London
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
European Equity Market Outlook Commentary
European Equity Market Outlook 2010:
Equities, The Asset Class Of Choice
Contact:
Robert Quinn, European Strategist, S&P Equity
Research, London (44) 20 7176 7843
[email protected]
W
e open with our conclusions: equities are our clear
preferred asset class and are more attractive than
credit, cash or real estate. Differences within market
opinion or lack of consensus agreement be it on the inflation
cycle or the eventual shape of the economic recovery,
usually offer alpha capture to those with clearly defined
strategies and we believe we are in one of those moments.
In addition, we assert that equities capital appreciation
and economic growth are synchronous in the longer term
but not necessarily in the short term. Hence, we expect
European equities to perform well in 2010 versus historical
averages and expect a 13% total return from current levels.
Main themes discussed:
n The roots of confusion: Which parts are moving ahead
of sync and why?
n Asset class perspectives and expectations; concomitant
with individual inflation forecasts (we think
unproblematic beyond 2011). Equities remain asset
class of our choice.
n Emerging economies to secularly outperform developed
markets but Europe is well positioned to benefit from
this trend, particularly ahead of the US.
n Banks profile: Trading profits continue to overpower
loan losses.
n Unemployment risen far faster than prior recessions,
supports FY10 EPS.
Clearing the confusion
Let us recap what has happened over the past four to
eight quarters: headline inflation ranged from 4-6% in the
western regions, and higher still in the majority of emerging
economies in mid-2008; deflation fears reverberated around
the financial markets in the subsequent quarters; trade
credit evaporated and guaranteed the most synchronised
recession of all time; banks that were centuries old no
longer exist; funding conditions were removed from
smaller nation growth states; and finally, the combination
of the Federal Reserve’s stress tests on US banks’ balance
sheets, the utilisation of every single central bank policy
tool plus newly invented ones and the G20 emergency
meetings secured a bottom in asset prices and the recovery
rally of all risky assets took hold with abandonment.
The exceptional policy response by the leading western
central banks, in both speed and magnitude, have clearly
blurred the lines of analysis between forecasting a relatively
strong recovery following the Great Recession.
In terms of inducing further levels of price appreciation
in risky assets, one would have to conclude that the
perceived improved liquidity conditions, as measured by
fund manager surveys (bid-offer spreads, depth of markets,
ease of execution), would contribute to greater levels of
risk aversion – in the knowledge that if you buy something
you can equally sell out of it. The counter-intuitive nature
of a liquidity-driven market, easy money reflecting an
uncertain economic landscape, makes it inherently difficult
to time when the process ends. Valuations in Europe are
not particularly expensive if taken in tandem with ratherpositive consensus earnings.
For this recovery to grow roots it requires a sustainable
pick-up in final demand, across all geographies, to fill the
gap when government-sponsored growth wears off and the
private sector takes over. We believe the key question, then,
Chart 1
Chart 1
Monetary response has been unprecedented
Chart 3
Eurozone
Previous financial crises
Current
New Au
ppt change
5
Indl Ord
4
110
3
105
2
100
1
95
0
90
-1
85
-2
80
forecast
75
-3
70
-4
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
65
Nov-07
x-axis:quarters before/after
Source: FactSet, S
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poo
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart 2
US final demand
Retail Sales ex Autos
New Home Sales
Feb-0
17
Chart 5
2000-2009
UK asset
UK Broa
European Equity Market Outlook Commentary
European Equity Market Outlook 2010: Equities, The Asset Class Of Choice Continued
is what the residual level of demand will be thereafter?
The conclusion we come to is that end-demand is
improving, gradually, as we and most other economic
forecasters expected. The US has moved ahead of the
Eurozone, based on growth rates, due to greater policy
measures
Chart 1 as final demand is modestly picking up across
more
than one
economic
while the latter region
Monetary
response
has sector
been unprecedented
exhibits smaller levels of spare capacity. In the Eurozone,
Previous financial crises
Current
itpptischange
clear that new auto sales provided the ballast for
consumer
spending in the past two quarters but we believe
5
the
4 inevitable pulling-forward of demand will result in
reduced
volumes in the next years, by which time other
3
indicators
will hopefully do more off the heavy lifting. We
2
have
seen industrial orders in manufacturing pick up in late
1
Q2
0 but they stalled of more recently; construction markets
remain
very weak in Europe and activity is now over 13%
-1
lower
than Q4 07 levels. Similarly, retail sales
are down
-2
forecast
8.4%.
-3
-4 Additionally, China, prompted by an aggressive
-8 -7 -6 fiscal
-5 -4 programme
-3 -2 -1 0 and
1 2so 3 often
4 5 touted
6 7 as
8 the
government
world’s economic saviour, may only have limited ability to
x-axis:quarters before/after
support other global economies. We also believe that the
Source: FactSet, Standard & Poor's Equity Research
actual
positive economic impact on European economies
Standard
& Poor’s
2009.
is©too
often
misinterpreted.
For example, Chinese imports
rocketed more than fivefold between the fourth quarter of
75
Asset class perspectives concomitant with
inflation expectations
70
65
Nov-07
The
Feb-08 May-08
Aug-08 Nov-08
May-09much
Aug-09 debate
Nov-09
inflation
argument
has Feb-09
stirred
in
the FactSet,
markets
deflation
Source:
Standard while
& Poor's Equity
Research was heavily priced into
many
financial
assets
at
the beginning of the year. The
© Standard & Poor’s 2009.
elevated gold price indicates some investors’ readiness
for uncomfortable inflation ahead. In our view, both are
Chart 5
Chart
Chart 33 Rebased performance of
2000-2009:
UKEurozone
asset classes
final demand
Chart 1
Chart
22
Chart
Monetary
response has been unprecedented
US finalCurrent
demand
Previous financial crises
New Home Sales
ppt change
Retail Sales ex Autos
5
2001 through to the third quarter of 2008. However, over
the period, Asia was the biggest beneficiary, contributing
57% of the rise, while Europe, or Germany moreover,
captured only 11%. In fact, China only accounted for 4.2%
of total Eurozone exports in 2008 according to Eurostat.
The benefit that China does undoubtedly bring is that of
positive
Chart
3 business sentiment. If we look deeper into the
domestic
demand
profile within China, new automobile
Eurozone final
demand
salesNew
have
rocketed
on par
Retail with
Sales that of Germany but
Auto Sales
consumer
good sales do not
signify a required rebalancing
Indl Orders-Mf
Construction
110of the economy any time soon.
105 In our view, the recovery impulse equity markets are
100currently riding has been driven by both fiscal spend and
95the inventory cycle adjustments. We have attempted to
90apply a timeline to when this impulse will start to wane
85and believe that Q2 10 will see the last of the support in
80most western economies.
Nondefense Cap Orders ex Air
UK Govt
TR
Indl Orders-Mf
New Auto Sales
110 4
400 110
100 3
350
90
80
70
60
Cash
Construction
105
100
2
300
1
95
0
250 90
-1
200 85
80
150
75
-2
forecast
50 -3
100 70
40 -4
-8
-7
-6
-5
-4
-3
-2
30
Nov-07 Feb-08 May-08 Aug-08
x-axis:quarters before/after
-1
0
Nov-08
1
2
Feb-09
3
4
May-09
5
6
7
Aug-09
Source: FactSet, Standard & Poor's Equity Research
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poor’s 2009.
© Standard & Poor’s 2009.
18
FTSERetail
TR Sales
UK Broad
Market
TR
New Auto
Sales
8
50 65
Nov-07
Jan-00
May-08
Jan-03
Aug-08
Nov-08
Jan-06Feb-09
May-09 Jan-09
Aug-09
Source:
FactSet,
Standard
& Poor's
Equity
Research
Source:
FactSet,
Standard
& Poor's
Equity
Research
© Standard
& Poor’s
© Standard
& Poor’s
2009.2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOKChart
2010 5
Chart
Chart
4 2
USRebased
final demand
2009:
performance of UK asset classes
Feb-08
Chart
6
2000-2009:
Rebased performance of
Quarterly
writedowns
UK asset classes
Nov-09
possible but neither very likely. The most frequent and
volatile inflation scares are associated with commodity
prices spiking, particularly the oil price. Unless these spikes
are accompanied by associated rises in income levels than
they are entirely self-limiting. More importantly, core
inflation has been impressively detached from the greater
fluctuations in headline rate due to the strong commodity
cycle last time out. A benign inflationary environment is
core to our positive expectations for the equity markets.
One does not have to look too hard to find news flow
on rising fears of inflation. The most commonly produced
evidence used centres on the following points:
n Central bank monetary bases have expanded
exponentially.
n Commodity prices have been strong and their y-o-y base
effect will make larger contributions.
n A weak USD will cause rising import prices to ripple
through pegged-currency nations.
n Inflation expectations have been stable but are starting
to trend upwards.
We have already determined that commodity price
spikes are self-limiting in absence of income growth so let
us turn to the balance sheets of central banks. In truth,
these have already ‘peaked’ and have begun to shrink. If we
were to see the CB’s monetising the fiscal debt, effectively
printing money to buy further sovereign issuance, then
we would agree with those fearful of the early steps of
hyperinflation but we are clearly not in that predicament.
Instead, many monetary policy programmes have
different schedules to expiry and therefore will prove
less likely to spook the bond markets and the exercise of
mopping up excess liquidity will be cleaner in our opinion
than many believe. Excess money supply is inflationary
in a trend-growth environment but the margin of spare
capacity is far too large to inflation to take hold. Finally, a
weak USD environment will of course see the US economy
import inflation via domestic currency devaluation and the
same can be applied to the multitude of countries that have
their currencies pegged to USD. What is worth reminding
investors here is that this would concern us only if the
dollar depreciated 15-20% every year but this is highly
improbable. Inflation will always be a rolling 12-month
indicator therefore the further weakening in USD that we
expect in 2010 will not have the same impact as this year
unless the currency remains in freefall.
In contra to these ‘inflationistas’ there is a growing body
of consensus forecasting a deflationary landscape for next
year and beyond. Evidence quoted by the ‘deflationistas’
revolve around:
n Output gaps are yawningly wide.
n Measures of spare capacity are multiples of historical
averages.
n Labour market, and hence wages, expected to be weak
for years.
We believe the deflation argument is more plausible
than the one made for ‘problem inflation’. According to
OECD forecasts, the majority of the developed world
is operating with an average output gap, the difference
between current and potential growth, of 6%. This figure
requires some perspective: the 2001-3 recession witnessed
an estimated output gap of 2% on average, similar to the
1991-3 episode and a little lower than the 3% of the mid1970s. The US suffered an even deeper shortfall of 7% in
late 1982 but this was way adrift of the 4% of most other
OECD members. While the science behind output gaps is
inherently inexact and untimely, in our view, the evidence
of the previous four recessions in the US point to a typical
duration of three years to close and positive equity returns
throughout.
The key determinant of demand-pull inflation is spare
capacity, particularly in manufactured goods and labour
markets. The current readings of these industries imply
further disinflation. On this note it is again worth noting
that mostly disinflation occurs after a recession ends.
Hence, this argument will remain for some time and cannot
be easily disproved. Similarly, key drivers for cost-push
inflation are labour costs and, synonymous with the earlier
point, wage inflation has fallen considerably on both sides
of the Atlantic. Finally, we expect unemployment to stay
high for some time and note again how rapid the jobcutting was in this downturn compared to prior periods.
Therefore the employee compensation cycle will be muted
in our investment horizon and beyond.
So if the deflation argument is harder to disprove
than the inflation one, what makes us believe that it
won’t happen? Quite simply, the rapid stabilisation of
asset prices as well as stable inflation expectations. The
deflation episodes of both the 1930s in the US and 1990s
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
19
Chart 3
Eurozone final demand
Monetary response has been unprecedented
Previous financial crises
Current
Retail Sales
New Auto Sales
ppt change
5
European
Equity Market Outlook Commentary
Indl Orders-Mf
4
110
3
105
2
100
1
95
0
90
-1
85
-2
Construction
80
forecast
75
-3
70
-4
65
European Equity Market Outlook 2010: Equities,
The Asset Class Of Choice Continued
Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
x-axis:quarters before/after
Source: FactSet, Standard & Poor's Equity Research
Source: FactSet, Standard & Poor's Equity Research
in Japan were highlighted by incorrect central bank policy
© Standard & Poor’s 2009.
manoeuvres
which in our opinion cannot be levelled this
time. In addition, by performing the above exercise of
detailing the issues of both arguments it becomes clear that
a high degree of offsetting takes place. Were the nascent
Chart 2to falter and ‘double-dip’, then we would be far
recovery
Chart 1
US final
demand
more
inclined
to agree with the deflation camp.
Monetary response has been unprecedented
New Home Sales
Retail Sales ex Autos
crises
Current Cap Orders ex Air Previous financial
Auto
Sales
CreditNondefense
was
the winner of 2009,New
2010
is the turn
ppt change
110
of equities
5
100
Equities
have been the biggest absolute gainer in 2009
4
following
the wooden spoon performance of 2008 but
90 3
on80a2 risk-return basis corporate credits, which exhibits
3-470 1times less volatility, is the clear winner. Due to the
variable
investment duration of the classes (investors are
60 0
less -1likely to cash out of a HY bond as easily or quickly as
50
equities)
we extend the time horizon of analysis. Based on
-2
forecast
the40-3chart below, the gold medal it seems should be taken
30 corporate credits and handed to sovereign bonds
from
-4
Nov-07
Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09
(equities
themselves
-8 tried
-7 -6 to-5 disqualify
-4 -3 -2 -1
0 1 2 twice!).
3 4 5 To
6 negate
7 8
Source:
FactSet, Standardof
& Poor's
the
introduction
the Equity
euroResearch
and the convergence of rates
x-axis:quarters before/after
we© Standard
have
focused
on the post-2000 period and in addition
& Poor’s 2009.
& Poor's Equity Research
usedSource:
the FactSet,
UK asStandard
a focus.
But
what& Poor’s
does2009.
the reading of the tea leaves suggest for
© Standard
Chart
Chart 44
2009:
Rebased
performance of UK asset classes
Chart
2
USUKfinal
FTSE TR
Broaddemand
Market TR
Sales ex AutosCash
UK Retail
Govt TR
130
New Home Sales
Nondefense Cap Orders ex Air
New Auto Sales
110
120
100
110
90
300
250
400
FTSE TR
UK Broad Market TR
UK Govt TR
Cash
100250
70
50200
150
0
50
70 40
30Dec-08
100 Prior
Mar-09
Jun-09
Nov-07 Feb-08 May-08 Aug-08 Nov-08
Source: FactSet, Standard & Poor's Equity Research
Source: FactSet,
© Standard
& Poor’s Standard
2009. & Poor's Equity Research
© Standard & Poor’s 2009.
20
Chart
65
Chart
Chart
5 writedowns
Quarterly
2000-2009: Rebased performance of
Europe
US
UK asset classes
150300
60
80
each of the asset classes in turn then
conclude with equities.
For fixed income investors, 2009 delivered ‘equity-like
returns with credit-like risks’. Clearly this on the back
Chart
5
of a disastrous prior year but nonetheless on an annual,
2000-2009:
performance
risk-return Rebased
basis credit
has been the of
asset class of the year
UK
asset
classes
inChart
our opinion.
However,
the
majority
of total return for
3
FTSE TR
Broad Market is
TR from spreads,
bondUKinvestors
which have tightened
Eurozone final demand
UK Govt TR since the
Cashmarket trough. In addition, S&P
considerably
Retail Sales
New Auto Sales
400
Credit Research estimates that the default rate in Europe
Indl Orders-Mf
Construction
is110likely to be above the long-term average of 3% for some
350
time. What is interesting when making the comparisons
300105
between
equity credit rally, is that the latter has been driven
100
250
by95 high-quality companies while the former has been
200
predominantly
led by lower-quality ones. While we do not
90
dispute that some value exists in credit, we recognise that
150 85
the
best conditions of wide-spread levels, decent economic
80
100
growth,
low default rates and improving credit quality will
75
50
not
be
evident
in 2010.
70
Jan-00
Jan-03
Jan-06
Jan-09
Cash
requires
less analysis and both Europe and the US
65
Source:
FactSet,
Standard
& Poor'sreal
Equity
Research
have
hadFeb-08
negative
throughout
downturn.
Nov-07
May-08
Aug-08rates
Nov-08
Feb-09 May-09this
Aug-09
Nov-09
European
©Our
Standard
& Poor’s 2009. Economics team expects the ECB to raise
Source: FactSet, Standard & Poor's Equity Research
the main refi rate modestly in H2 10 and the BoE to follow.
© Standard & Poor’s 2009.
The Federal Reserve’s statement on November 4 that they
200
350
100 80
90
analyse
©2010?
Standard &Let
Poor’sus
2009.
Sep-09
Feb-09
Dec-09
May-09
Aug-09
50 FactSet, Standard & Poor's Equity Research
Source:
Jan-00
Jan-03
© Standard & Poor’s 2009.
Jan-06
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart 4
Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09
Chart 6
Quarterly writedowns
Jan-09
es
UK Govt TR
Cash
400
350
300
250
200
150
100
Aug-09
50
Jan-00
Jan-03
Jan-06
Jan-09
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poor’s 2009.
highlighted, economic trends are likely to diverge next year,
with stronger growth and policy tightening in emerging
markets versus low growth and loose policy in developed
peers. We have already seen the central banks of Australia
and Israel raise rates and these monetary tightening cycles
will be far stronger than those enacted by the Bank of
England, ECB, or the Federal Reserve.
Chart
6
Chart 6
classes
Quarterly writedowns
Europe
US
300
250
200
Banks: loose monetary policy supports strong
trading and asset quality
150
100
50
0
Prior
Dec-09
Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poor’s 2009.
are “likely to warrant exceptionally low levels of the federal
funds rate for an extended period” makes a point that we
want to emphasise. Interest rate futures are showing little
sign of volatility on the December 2010 contracts as well
as further out. It will take much longer than our investment
horizon before real rates turn positive in our view and even
then we do not expect nominal rates to return to their precrisis range between 4-5%.
Residential real estate has stabilised in both the US and
UK, where most stress has been suffered, as well as pockets
across the Eurozone. In fact, the UK market is on a sevenmonth bounce. Despite the near-20% decline in national
prices, valuation metrics are still above long-term averages
and rental yields only match the cost of financing at best.
This of course is great news for the banking sector as loan
losses will likely be revised up. In terms of further price
appreciation, we deem it unlikely to be higher than singledigit given the obvious headwinds.
Equities are not without downside risk but the events
that will spur adverse effects on them will also apply to
two of the three classes above too. We explore equities in
further detail a little later in Equity Market Expectations
below.
One final asset class that we find attractive would be
to take long positions in commodity currencies. As we
We had repeatedly flagged that the broader equity market
rally would depend on the banks price performance but it is
only right to admit that we underestimated the strength of
their earnings power. On reflection, the ZIRP environment
has been incredibly conducive despite lending activity
focusing on refinancing rather than new net lending, while
the commissions earned from phenomenal levels of capital
market issuance, due to still-impaired credit channels,
have been a boon. In our view, the key determinants for a
continued price appreciation are for strong trading profits
to conquer asset quality movements.
At the onset of this financial crisis, IMF has estimated
writedowns and credit losses to total USD4 trn globally.
In its October 2009 Global Financial Stability Report this
estimate had been revised up to USD2.81 trn. According to
Bloomberg data, USD1.66 trn has already been recognised
leaving the remaining shortfall at around USD1.15 trn.
Unfortunately for Europe, 66% of those losses have been
borne by US financial institutions despite the IMF’s initial
assertion that European losses would be of a similar size to
their US peers. Implied cumulative loss rates in the US are
far higher than those forecast for the Eurozone, particularly
for residential mortgage and consumer loans.
The credit loss cycle, as opposed to the writedowns on
securities still has some way to go but we believe that it will
peak in 2009. We forecast total credit impairments for our
European banks coverage to hit EUR585bn for the 200911 period with EUR212bn to be digested in the current
fiscal year. Banks earnings are likely to suffer in the coming
quarters from high provisioning levels and weak revenue
growth. Rising unemployment and excess capacity are
likely to keep credit demand low in our view, while credit
availability will also be constrained by banks being more
risk-conscious, as capital remains scarce. As asset quality
remains pivotal to earnings growth, evidence that asset
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
21
European Equity Market Outlook Commentary
European Equity Market Outlook 2010: Equities, The Asset Class Of Choice Continued
financials in our opinion. On a cost-to-income basis,
European banks have shed seven percentage points from
their cost base versus the start of the prior cycle. This ratio
had been falling in the period 2003-7 but distorted by
increased revenues unlike the permanent reduction in the
cost base we forecast for the 2009-11 period.
Finally, we anticipate high levels of non-core asset sales
throughout the year in response to the EC’s competition
regulations for the banks that have received state aid, as
well as a possible source of capital/balance sheet reduction
for others.
Chart
Chart 77
Trading profits supportive in near term
Trading Profit
Pretax profit ex trading
EUR, bn
15,000
Chart 7
Chart
10,000 7
Trading profits supportive in near term
Trading
profits supportive in near term
5,000
Trading Profit
Trading
Profit
0
Pretax profit ex trading
Pretax profit ex trading
EUR, bn
EUR,15,000
bn
-5,000
15,000
10,000
-10,000
10,000
5,000
-15,000
5,000
-20,000 0
0 Q1 08
Q2 08
Q3 08
Q4 08
-5,000
-5,000
Source:
FactSet, Standard & Poor's Equity Research
-10,000
Profit cycle surprises on the upside…
Q1 09
Q2 09
Q3 09
-10,000
© Standard & Poor’s 2009.
-15,000
-15,000
-20,000
Q1 08 real
Q2 08
Q3 08
Q4 08
Q1 09at current
Q2 09
Q3 09
-20,000 including
prices,
estate,
are sustainable
levels
Q1 08
Q2 08
Q3 08
Q4 08
Q1 09
Q2 09
Q3 09
have
been
positively
received. A pick-up in global demand
Chart
8 FactSet,
Source:
Standard & Poor's Equity Research
isUnemployment
also FactSet,
likelyStandard
to contain
corporate
loan losses. Cost-cutting
Source:
&has
Poor's risen
Equity
Research
far quicker...
© Standard & Poor’s 2009.
measures
have
given
a
buffer
for
credit impairments and
© Standard & Poor’s 2009.
2003
2008
1991
the extent of which has received less attention than non-
Unemployment may be a lagging indicator for economic
activity but it has a far stronger relationship regarding
the corporate margin cycle. If we use the two outturns of
1990-93 in the UK and 2000-02 in the US as a yardstick,
then a rule of thumb appears that for every 1% increase in
the unemployment rate, non-financial corporates lose 1%
in their operating margins. This has largely been the case
since the 2007 peak in profitability but underneath these
numbers, the prior two recessions did not witness the sheer
Chart
9 in sales that we are currently working through.
decline
…but
thansales
expected
Onmay
our peak
2009 sooner
estimates,
have fallen 13.5% for
the Unemployment
non-financial
within our S&P Europe 350
rate companies
% SA (Ihs)
0.5
Next 12-month Unemployment expectations (rhs)
0.0Chart 8
Chart
8
Chart 8
-0.5Unemployment has risen far quicker...
Unemployment has risen far quicker...
-1.0
1991
1991
2003
2003
12
11
Chart
9
…but
may peak sooner than expected
…but
may
peak sooner than expected
10
2008
2008
-1.5 0.5
0.5
-2.0 0.0
0.0
-2.5 -0.5
-0.5
-3.0 -1.0
-1.0 1M 4M 7M 10M 13M 16M 19M
-1.5
-1.5
Source:
-2.0 FactSet, Standard & Poor's Equity Research
Unemployment rate % SA (Ihs)
Unemployment
rate Unemployment
% SA (Ihs)
Next 12-month
expectations (rhs)
9
Next
12-month
Unemployment
expectations (rhs)
12
12
8
11
7
22M
25M
28M
-2.0
© Standard & Poor’s 2009.
-2.5
-2.5
-3.0
1M 4M 7M 10M 13M 16M 19M 22M 25M 28M
-3.0
1M 4M 7M 10M 13M 16M 19M 22M 25M 28M
Source: FactSet, Standard & Poor's Equity Research
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poor’s 2009.
© Standard & Poor’s 2009.
22
80
Chart
Chart 99
11
10
10
6
9
Jan-95
9
Jan-98
Jan-01
Jan-04
Jan-07
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
60
50
40
30
80
20
70
10
60
0
50
-10
Jan-1040
30
8 FactSet, Standard & Poor's Equity Research
Source:
8
© Standard & Poor’s 2009.
7
7
6
Jan-98
Jan-01
Jan-04
6 Jan-95
Jan-95
Jan-98
Jan-01
Jan-04
Source: FactSet, Standard & Poor's Equity Research
Source: FactSet, Standard & Poor's Equity Research
© Standard & Poor’s 2009.
© Standard & Poor’s 2009.
70
20
10
0
Jan-07
Jan-07
80
70
60
50
40
30
20
10
0
-10
-10
Jan-10
Jan-10
benchmark. Operating margins declined 1.5pp from its
peak of 13.2% in 2007 while net profit margins lost 3.3pp
over the two-year period. This goes some way in explaining
why NFCs surprised so broadly in both Q1, Q2 and to
a lesser extent in Q3. The downside risks for the margin
cycle will rise significantly if private sector growth is still
to take hold in H2 10 but for the forthcoming quarters we
see fewer risks.
…as unemployment surprised on the down
The sheer rapidity of headcount reductions enacted by
European, and US, corporates as well as the increased
labour market flexibility versus prior recessions has been a
standout feature of this downturn. In the US, unemployment
has risen 5.3 percentage points since GDP contraction
troughed in Q4 07. Similarly, the UK and eurozone have
witnessed 2.6pp and 2.5pp moves. It is this permanent
reduction to the cost base that has buttressed the surprising
margin resilience by the non-financial sector and is one the
key drivers of our positive outlook for equities.
One positive to take from this for the real economy
is that evidence is growing that unemployment may
peak sooner rather than later and at levels lower than
originally forecast, similar to the IMF loan loss revisions.
The EC survey on unemployment expectations peaked
in Q1 09 and, although the series is barely more than a
decade old, it has exhibited strong relationship over the
past business cycle and proffers an eight-month lead time.
This would imply that the current pace of increase for the
unemployment rate for the eurozone, currently at 9.7%,
should slow in the coming months.
2010 EPS estimates, the equity market is neither cheap nor
expensive but is worth entering. There is a healthy level of
pessimism among investors that suggest to us that, if and
when the ‘animal spirits’ do return, equities will capture
significant capital gains.
About S&P Equity Research
As the world’s largest producer of independent
equity research, over 1,000 institutions license
Standard & Poor’s research for their investors and
advisors, including 19 of the top 20 securities firms,
13 of the top 20 banks, and 11 of the top 20 life
insurance companies. Standard & Poor’s team of
100 experienced U.S., European and Asian equity
analysts use a fundamental, bottom-up approach
to assess a global universe of approximately 2,000
equities across more than 120 industries worldwide.
The equity research reports and recommendations
provided by Standard & Poor’s Equity Research
Services are performed separately from any other
analytic activity of Standard & Poor’s. Standard
& Poor’s Equity Research Services has no access
to non-public information received by other units
of Standard & Poor’s. Standard & Poor’s does
not trade for its own account. The analytical and
ethical conduct of Standard & Poor’s equity analysts
is governed by the firm’s Research Objectivity
Policy. Further details are available at http://www.
equityresearch.standardandpoors.com/
Equity market expectations
We reiterate our opening conclusion that equity market
performance is not entirely congruous with economic
growth and that other factors need to be taken into account.
There is a significant body of institutional investors,
according to the MLFM survey, who feel they have missed
the free ride in equities over the past two quarters and
hence are wary of the attractiveness at this point. We have
clearly ascertained the attractiveness on an asset class basis,
and detailed the strict cost controls exhibited in both the
financial and non-financial sectors. This leads us to forecast
FY 10 real EPS growth of around 25% for European
equities, the strongest year for many decades. At 12.5x
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
23
Europe’s Homeowners Begin To Miss Fewer Mortgage Payments Commentary
Europe’s Homeowners Begin To
Miss Fewer Mortgage Payments
Contact:
Andrew South, Senior Director, S&P Ratings
Chart London
2
Services,
(44) 20-7176-3712;
[email protected]
Residential Mortgage Debt Per Capita
Chart
Chart 11
Average Total Delinquencies By Country/Sector
U.K. nonconforming
Italian
(€’000)
Index
350
300
250
200
150
100
50
Apr-09
Jun-09
Feb-09
Dec-08
Oct-08
Aug-08
Jun-08
Apr-08
Feb-08
Oct-07
Dec-07
(Indexed, June 2007=100)
© Standard & Poor’s 2009.
Mortgage Arrears Trends Differ By Country
Mortgage arrears rose in most European countries
throughout 2008 and early 2009, according to data we
have from loans backing securitisations that we rate (see
chart 1). Arrears growth has been markedly more severe
in countries where unemployment has risen most strongly,
such as Spain and Ireland, where the housing bubble
was more pronounced, and where economic activity and
employment depend more on the real estate sector.
The latest data indicate that—for now at least—arrears
may be peaking. This is likely due to the sharp fall in policy
and benchmark market interest rates since late 2008.
Spanish unemployment growth a key force behind
rising mortgage arrears
Arrears growth in Spain has far outpaced that in other
European mortgage markets (see chart 1), although it started
from a relatively low base. Spanish borrowers typically
have floating-rate loans linked to a benchmark index, and
therefore suffered directly from higher interbank rates during
much of 2008. Moreover, Spain’s unemployment growth,
which has been far higher than the Eurozone average, has
tempered any improvement in arrears from more recent
rate cuts and been a significant force behind arrears growth.
(20)
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Oct-05
Dec-05
Feb-06
Apr-06
Jun-06
Aug-06
Oct-06
Dec-06
Feb-07
Apr-07
Jun-07
Aug-07
Oct-07
Dec-07
Feb-08
Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
Aug-07
0
Italy
France
Germany
Spain
U.K.
Ireland
Denmark
400
(10)
24
U.K. prime
U.K. BTL
450
ince
40 the onset of the financial market disruption in late
2007,
European residential mortgage borrowers have
35
increasingly
found themselves in financial distress, although
30
the degree
varies by country and type of borrower. The
25
reported
20 arrears—or missed payments—on loans backing
European
residential mortgage-backed securities (RMBS)
15
that Standard
& Poor’s Ratings Services rates have risen
10
sharply5 as a result. But more recently, the situation may be
improving.
0
In early 2008, higher interest rates across Europe meant
mortgage payments rose, squeezing many homeowners’
finances. In our opinion, this was initially a major factor
Source: European Mortgage Federation, as of 2007.
spurring
higher arrears and, ultimately, defaults on
© Standard Furthermore,
& Poor’s 2009.
mortgages.
the disruption in capital markets
raised banks’ funding costs and led to significantly
restricted access to credit for many borrowers, especially
those in financial difficulty looking to refinance.
However, both the Bank of England (BoE) and the
European Central Bank (ECB) adopted sharp cuts in policy
rates in late 2008, and these have now worked through
to reach mortgage borrowers. As a result, arrears have
moderated across various sectors, as borrowers in markets
where floating-rate loans are common have benefited from
lower scheduled mortgage payments. This has enabled
some borrowers already in arrears to make good on their
previously missed payments, and has also slowed the rate
of new arrears cases. This improves the prospects for credit
Chart
ratings
on3 outstanding RMBS transactions in Europe,
12-Month
Growth
In Outstanding
Balance
though
there is one
important
caveat: Even
though interest
ratesOf
areLoans
currently
low, unemployment
generally continues
For House
Purchase (%)
to rise in most
countries.
Arrears could
Ireland therefore
Italy
GermanyEuropean
Spain
France
start to climb again if employment deteriorates significantly.
40
So far in 2009, we have taken a number of rating actions
on European
RMBS: According to our analysis, ongoing
30
deterioration in the credit quality of the underlying
20
mortgage loans led to a corresponding decline in the
creditworthiness
of the notes issued in these transactions.
10
The future trend in arrears will help determine whether the
0
rate of downgrades now slows.
Jun-07
S
45
Spanish
Irish
10
5
Source: European Mortgage Federation, as of 2007.
© Standard & Poor’s 2009.
Italy
France
Germany
Spain
U.K.
Ireland
Denmark
0
Jun-09
15
Apr-09
20
Feb-09
25
Dec-08
30
Oct-08
35
Aug-08
40
Apr-08
45
Jun-08
(€’000)
Feb-08
Residential Mortgage Debt Per Capita
Aside from arrears, prepayment rates are another key
indicator of the health of European mortgage borrowers.
Higher prepayment rates generally signify more lending
activity and greater flexibility for borrowers to manage
their debt.
In the U.S., where long-term fixed-rate mortgages are
common—and where borrowers may generally redeem
their mortgage loans at any time without penalty—spikes
in prepayment rates tend to occur when interest rates fall
to low levels. In the U.K., on the other hand, borrowers
have tended to refinance regularly, leading to consistently
high prepayment rates. This is because product terms and
conditions usually encourage borrowers to refinance their
mortgage loans every two or three years.
In other European countries this is less the case, and
prepayment rates are more a function of lending conditions
at any given time. Continental European prepayment rates
Chart
have 1generally been significantly lower than those in the
U.K.
Average
Total Delinquencies By Country/Sector
InU.K.general,
however,Spanish
prepayment U.K.
rates
nonconforming
primehave fallen
significantly
across
since 2007, as
Italian
Irish the European
U.K. BTL marketsIndex
lenders’ funding conditions have tightened and refinancing
450
has become more difficult or more costly for many
400
borrowers. At the same time, governments and regulators
350
have encouraged lenders to shrink their balance sheets and/
300
or raise additional capital, while borrower demand for new
250
credit has also fallen.
200
This withdrawal of both lending supply and demand
150
is noticeable when observing data on net lending. In the
100
Eurozone, net lending to borrowers for house purchases
50
has fallen significantly, and in some extreme cases—such as
0
Ireland—has even turned negative on an annualised basis
(see chart 3).
Despite this, however, in most of the European countries
(Indexed,
2007=100)securitise some of their loans, the debt on
whereJune
lenders
©household
Standard & Poor’s
2009.
balance
sheets that is related to house purchases
continues to rise, albeit slower than before. Households
Dec-07
Chart
Chart 22
Net Lending Continues To Fall Across The
Board
Oct-07
Of Europe’s borrowers, German and Dutch homeowners
have remained financially the healthiest to date. The
popularity of longer-term fixed-rate mortgage products
may be part of the reason for this, because it means that
short-term rates do not immediately affect the affordability
of existing mortgages. Our German RMBS index shows
a relatively small increase in arrears, due mainly to a few
transactions that securitise nonstandard German loans.
Other aspects of the mortgage market’s structure
are also important to consider in looking at the relative
performance of borrowers in different countries. For
example, in Italy, despite relatively significant house price
declines and rising unemployment, the growth in mortgage
arrears has been relatively modest. We believe that the
overall low indebtedness of Italian households has acted
to partially offset any difficulties these borrowers have. For
example, the average mortgage debt in Italy is among the
lowest in the EU27 region at only about €5,000 per capita,
Jun-07
Fixed-rate loans insulate German and Dutch
borrowers
according to data from the European Mortgage Federation
(see chart 2). Similarly, aggregate residential mortgage debt
outstanding is a relatively low proportion of annual GDP.
Thus, even when times are hard, many consumers still find
it easy to make their payments.
Aug-07
The sharp rise in unemployment was probably associated
with the disproportionate importance of the real estate and
construction sectors to the Spanish economy. Activity has
declined significantly in those sectors since 2007.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
25
Ju
Ap
Fe
De
Oc
Au
Ju
Ap
Fe
Oc
De
Au
Ju
Ger
Ir
Den
Fr
(Indexed, June 2007=100)
Source: European Mortgage Federation, as of 2007.
© Standard & Poor’s 2009.
© Standard & Poor’s 2009.
Europe’s
Homeowners Begin To Miss Fewer Mortgage Payments Commentary
Europe’s Homeowners Begin To Miss Fewer Mortgage Payments Continued
Chart 3
Chart 3
12-Month Growth In Outstanding Balance
Of Loans For House Purchase (%)
Germany
Spain
France
Ireland
Italy
40
30
20
10
0
(10)
Oct-05
Dec-05
Feb-06
Apr-06
Jun-06
Aug-06
Oct-06
Dec-06
Feb-07
Apr-07
Jun-07
Aug-07
Oct-07
Dec-07
Feb-08
Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
(20)
Source: ECB.
© Standard & Poor’s 2009.
have therefore yet to begin reducing their debt burden in
earnest.
In studying the forces behind prepayment rates in the
U.K., we have found that current low prepayment rates stem
from a combination of tighter lending standards and falling
house prices. Of course, many borrowers do not qualify
for loan refinancing in the current environment. However,
even if they do qualify, many borrowers currently have an
incentive to stay with their existing mortgage loan and pay
their so-called standard variable rate, which usually kicks
in two or three years after a lower introductory mortgage
rate. We expect the potential for prepayments to slowly
rise over time, as interest rates on new mortgage products
normalise over the next one to two years, and also as
house prices potentially stop falling and recover. This will
once again increase the number of borrowers eligible for
refinancing in a typical securitised mortgage pool.
More RMBS Downgrades In 2009, But Most At
Lower Rating Levels
Unsurprisingly, given the scale and sharpness of the
economic downturn, and the consequent effect on arrears
and loan losses in securitisations—as well as the fall in
house prices in many European countries—our rate of
26
downgrades in European RMBS has recently been higher
than at any time in the sector’s 20-year history. Since the
onset of the crisis in mid-2007, our overall downgrade rate
for European RMBS has been 10.5%, while our upgrade
rate has been only 6.6%. However, we believe our rating
downgrades have appropriately reflected the deteriorating
creditworthiness of the associated RMBS.
Unemployment tends to lag economic indicators
such as GDP growth, so loan losses might continue to
accumulate, leading to further RMBS downgrades in some
countries. However, most rating actions so far have been
in transactions securitising nonconforming loans in the
U.K., and in Spain, some backed by nonstandard loans to
first-time homebuyers. In more mainstream sectors, such
as U.K. prime RMBS, we have taken fewer rating actions.
Also, our downgrade activity has been far more
prevalent among lower-rated notes, which have suffered
the most as rising mortgage losses ate away at excess
spread. This leftover “profit” from the mortgage pool—
after the transaction has paid all administrative and debt
service costs—forms a disproportionately significant part
of the junior notes’ credit support compared with more
senior notes. Spanish transactions in particular also have
interest-deferral features, which divert cash flows to benefit
senior noteholders at the expense of the junior notes if loan
performance deteriorates too much. This effect has caused
some of the sharper downgrades to junior notes in Spanish
RMBS transactions.
Beyond these specific areas of concern, however, we
haven’t taken widespread negative rating actions.
In German RMBS, most of the arrears growth we have
observed during the crisis has been confined to transactions
involving nonstandard mortgage products aimed at
higher-risk borrowers. For more traditional transactions,
performance has been flat.
So what of the future financial health of Europe’s
mortgage borrowers? We believe that unemployment will
continue to be one of the key determinants of their future
payment behavior—and, therefore, of the creditworthiness
of European RMBS. Additionally, how and when the
availability of mortgage credit recovers will be vital to
Europe’s consumers, giving borrowers greater flexibility to
manage their debt.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
European Economic Outlook Commentary
European Economic Forecast: The Bad
News Is The Good News Isn’t Good Enough
Contact:
Jean-Michel Six, European Economist, Paris
(33) 1 44 20 67 05
[email protected]
W
hile there are signs that the economies of Europe are
looking up, Standard & Poor’s believes the prospect
of a sustained recovery is still some way off.
The second quarter GDP results for the major Eurozone
economies and the U.K. contain encouraging signals, in our
view, that the worst of the recession may now be behind us.
High frequency indicators published since then reinforce
that view. The most notable surprise is that both Germany
and France started to expand again in the second quarter,
each posting 0.3% growth. In the previous 12 months,
those two economies had contracted by 5.9% and 2.6%,
respectively. Overall, Eurozone GDP fell in the second
quarter by a very modest 0.1%.
Consumers And World Trade Buoy Demand
A breakdown of GDP components shows that the
rebound in Germany and in France was driven by private
consumption, while the stabilisation in world trade had a
positive effect on exports. Private consumption in Germany
was underpinned by the government’s scrapping bonus for
new car purchases. Introduced in January 2009, the scheme
offered bonuses of up to €2,500 in a form equivalent to
the “cash for clunkers” program that now operates in the
U.S. In total, the German government earmarked €5 billion
to back its scheme, which proved highly successful: In the
seven months to July, new car sales totaled 2.4 million, a
27% increase over the same period a year earlier. However,
with the €5 billion already spent as a result, the government
announced at the end of August that the scheme would
not be repeated. A similar program in France (albeit with
a smaller bonus) pushed up new car sales by 2% between
January and July, providing a significant boost to overall
consumption.
In Germany, a moderate rise in unemployment also
helped consumer demand. Between October 2008 and
August 2009, the unemployment count rose by 298,000,
leading to an increase in the unemployment ratio to
8.3% from 7.6%. This looks modest in light of the sharp
contraction in economic activity that took place between
the third quarter of last year and the second quarter of 2009.
For an explanation, we need to consider the parallel decline
in working hours: In contrast with the modest increase in
unemployment and the 0.3% fall in employment, the 3.9%
fall in working hours over the period was large. In fact,
the contraction in working hours on an annual basis is the
sharpest since Reunification in 1990.
This divergence between employment and working
hours is mainly due to the government subsidies for shortshift working that allow companies to reduce labor input
without laying off employees. Companies are able to
use these subsidies until the end of 2010. Data from the
German statistical office show that between December
2008 and June 2009, the number of workers on short shifts
increased by around 1.3 million. On average, employees on
short shifts work around two-thirds the hours of regular
employees.
Elsewhere in Europe, the improvement in economic
conditions remains unevenly distributed. Spain’s GDP, for
example, declined by 0.4% in Q3 according to the Bank
of Spain on the back of falling private consumption and
investment. In Italy, GDP dropped 0.5% (6% year on
year) after contracting 2.7% in the first quarter. The U.K.
economy experienced its sixth consecutive contraction,
with GDP falling 0.4% in the third quarter. Over the past
year, the contraction in the U.K. economy totals 5.5%--the
biggest fall since the launch of quarterly GDP figures in
1955. Meanwhile, unemployment reached a 10-year high
of 7.6%.
Consensus Grows For An Upswing In Europe
Yet, high frequency indicators released through the summer
consistently reinforce the view that Europe’s economy is on
the turn. The latest Purchasing Managers Indices (PMIs) for
September show a marked improvement across the region,
in line with that of the rest of the world. In Germany,
the seventh consecutive increase in the Ifo Institute for
Economic Research’s survey of business sentiment, to
91.9 in October from 90.3 a month earlier, on the back
of a renewed rise in future expectations, is impressive,
and further supports the view of an ongoing, broad-based
recovery in the Eurozone’s largest economy. Here, business
sentiment improved in all sectors, manufacturing as well
as services. In the U.K., the PMIs show a more gradual
improvement. But the impressive turn in the housing market
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
27
European Economic Outlook Commentary
The Bad News Is The Good News Isn’t Good Enough Continued
28
2010? We note that while global equity markets were
rallying through the summer on the back of improving
economic data flows, the strength in government bond
markets, in other words the fall in bond yields, revealed
more perplexed investors. Typically, yields rise during the
transition from a recession to a new cycle of economic
growth. Recent developments, however, indicate that bond
investors expect a very shallow recovery in 2010, and
consequently do not anticipate that central banks will start
raising interest rates before late in 2010. In our opinion, the
bond markets have a point: Several persistently negative
factors could soon cause that “V”-shaped recovery to
morph into subtrend growth.
The Credit Crunch Continues To Bite
The first reason behind our belief that the second-half
recovery will slide toward more subdued growth next year
is that the credit crunch is still with us and is not likely to
go away anytime soon. The most recent statistical releases
from the ECB show that loans to nonfinancial companies
have all but stalled during the summer, while household
lending remains very weak (see chart 1). The picture is
similar in the U.K., where loans to businesses fell by a huge
Chart
1
Chart 1
Chart 2
GDP And
M3 Money Supply And Loans To Companies,
Households In The Eurozone
Loans to companies
M3 money supply
U.S. GD
Eurozon
Loans to households
1.01
16
0.95
2
0.94
0
0.93
Jul-09
4
May-09
0.96
Mar-09
6
Jan-09
0.97
Nov-08
0.98
8
Sep-08
10
Jul-08
0.99
May-08
1
12
Mar-08
14
Jan-08
(% change year on year)
strongly suggests that households’ confidence is improving:
House prices rose 1.25% in October after a 1.5% gain a
month earlier, according to the Halifax Building Society.
This is the fourth month in a row that U.K. house prices
have risen month to month.
The improved outlook is starting to be reflected in
official forecasts: In June, projections from the Organisation
for Economic Cooperation and Development (OECD)
anticipated that the G7 industrialised nations’ GDP would
be broadly flat in the second half of 2009. Now, the OECD
projects output growth at a seasonally adjusted annual
rate averaging about 1.25%. The European Central Bank
(ECB) has lifted its GDP growth forecast for the Eurozone
by about 0.5% in 2009, to negative 4.1% from negative
4.6%.And the European Commission also lifted its forecast
for the European Union in its latest release published in
October. In short, there is now a growing consensus that
the European economies will experience a solid upswing
through the second half of the year, vindicating the view
of those observers, including Standard & Poor’s, that have
been anticipating a “V”-shaped recovery.
At the foundation of this upswing, in our view, are the
vigorous policy responses from across the industrialised
world. The fiscal and monetary stimuli injected into most
economies over the past 12 months are a major difference
when comparing the current downturn with the Great
Depression of 1929. During the Depression, money supply
collapsed, while the weighted average fiscal deficits for the
24 largest economies remained below 4% of GDP. Lessons
have been learned since then: On the monetary side, the
ECB’s balance sheet jumped to 23% of GDP in March
2009, from 16% in June 2008, ensuring that the financial
sector remained fully liquid. On the fiscal side, reflationary
measures such as the highly successful schemes to subsidise
car sales discussed above have also helped to limit the
retrenchment in domestic demand. In addition, the sharp
drop in oil and commodity prices since the second half of
2008 triggered a fall in retail price inflation--another factor
of support for consumers. In turn, the resilience of consumer
demand in the first half of 2009 has led companies to end
their inventory adjustment. Stock normalisation (that is, a
restocking boom) is in our view a key factor behind the
current economic rebound.
Does this mean that the crisis is over? Should we
anticipate that above-trend growth will continue through
Q1 2008
Sources: Eurostat
Source: European Central Bank
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
© Standard & Po
£8.4 billion in July according to U.K. money data from the
Bank of England.
Banks, meanwhile, continue to use the liquidities made
available to them by the central banks to repair and
strengthen their balance sheets. As an illustration, in the
latest ECB refinancing operation of June 24, 2009, €442
billion was lent to financial institutions in the Eurozone.
A month later, about €192 billion had been redeposited
by the banks at the central bank, while a good proportion
of the remaining funds were used in balance sheet repair
operations via the purchase of government bonds.
Tight credit conditions have two important implications.
First, they indicate no near-term recovery in asset prices,
which in our view is negative news for companies and for
consumers. Housing markets, for instance, may stabilise in
2010, as is already occurring in the U.K., but they won’t
get the funding to grow again to any significant extent. We
believe this funding constraint will likely slow overall debt
restructuring and contribute to a slow recovery in growth.
Second, limited availability of bank loan funding implies
a greater reliance on the bond markets. Corporate bond
issuance has already surged to a record $446.3 billion
in the year to date, a 55% increase over 2008 taken as a
whole, according to Dealogic, a data provider. By contrast,
companies have raised $109.6 billion in Europe this year
by selling stock, including rights offers, a figure 25% lower
than that raised in the same period in 2008 according to
data compiled by Bloomberg. At the same time, syndicated
loan volumes fell to $188.4 billion, from $713.3 billion
in the same period in 2008. Companies are willing to pay
higher spread premiums on the bond markets to raise their
liquidity buffers and replace bank loans.
This trend is likely to result in important long-term
changes in terms of disintermediation in Europe. In the
U.S., the overall proportion of bank loans is slightly below
40% of companies’ overall debt. In the Eurozone, the
corresponding figures at the end of 2008 amounted to €0.7
trillion in corporate bonds and €8.2 trillion in corporate
loans; in other words, a loan proportion of more than 90%.
Such a loan-to-bond conversion rate raises several
issues. For instance, European bond markets traditionally
attract only large-cap companies, mostly at the investmentgrade level (that is, firms with long-term corporate credit
ratings of ‘BBB-’ or above). We observe that only a few
mid-cap companies have access to the Eurobond market.
As long as this remains the case, tight credit conditions
will penalize small and midsize companies and weigh on
their ability to increase capital spending, therefore limiting
the scope for a strong and long-lasting economic recovery.
A further risk factor relates to the substantial increase in
sovereign issuance as a result of higher public deficits. This
presents the risk of a crowding-out effect, where spreads on
private sector debt start to increase substantially, causing
bond prices to fall and yields to spike, and discouraging
new corporate bond issuance. While we still believe
the probability of such a scenario is low, it cannot be
completely ruled out.
The transition toward greater reliance on bond market
funding by European companies, while secular, will in our
opinion take time--especially for midsize firms. Until such
a move is complete, overall funding will remain tighter
and more expensive than in 2004-2007, which is bound to
weigh on capital spending.
Worrisome Trends In The Labor Markets
Another reason to question the sustainability of the current
upswing beyond 2009, in our view, relates to recent trends
in European labor markets. On a cumulative basis between
the first quarter of 2008 and the second quarter of 2009,
real GDP fell less in the U.S. than in the Eurozone (negative
3.6% versus negative 4.3%). Yet employment contracted
more in the U.S. than in the Eurozone (negative 4.0%
versus negative 2.1%, see chart 2).
There are several explanations for this striking
difference. One is that because labor markets in Europe
are generally considered to be less flexible than in the
U.S., unemployment takes longer to reflect any change in
economic conditions. Consequently, the deterioration in
Europe’s labor markets will likely extend well into 2010
and weigh on consumer demand. In the early 1980s, for
example, the unemployment rate did not peak until a year
and a half after GDP had stopped contracting. A second
explanation is that this slow deterioration reflects the
redefinition of unemployment counts and the German
government subsidies for short-time working as discussed
above.
But regardless of which explanation is in favor--higher
rigidities or short-term government initiatives--we believe
there is another conclusion to draw. In the U.S., the very
quick adjustment in employment levels has allowed
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
29
European Economic Outlook Commentary
The Bad News Is The Good News Isn’t Good Enough Continued
Chart 2
Chart 2
GDP And Employment In The U.S. And Europe
nies,
Mixed Export Prospects In Central Europe
U.S. GDP
U.S. employment
Eurozone GDP
Eurozone employment
1.01
1
0.99
0.98
0.97
0.96
0.95
0.94
Jul-09
May-09
0.93
Q1 2008
Q2 2008
Q3 2008
Q4 2008
Q1 2009
Q2 2009
Sources: Eurostat, U.S. Labor Office, S&P
© Standard & Poor’s 2009.
companies in the private sector to somewhat dampen
the income shock implied by the decline in GDP. Indeed,
the latest costs data show nonfarm productivity rising by
6.6% in annualised terms during the second quarter. Unit
labor costs over the same period fell by 5.9% (annualised),
which suggests there was a considerable improvement in
profit margins. The opposite seems to be happening in
Europe. We do not yet have second quarter data, but in
the first quarter, productivity in the Eurozone declined by
1.5% (3.7% year on year) while unit labor costs rose by a
substantial 5.6% year on year. Those figures suggest that
European private sector firms, confronted with a bigger
shock in terms of GDP decline than their U.S. counterparts,
also had to absorb a much larger proportion of that shock.
As they try to restore their profitability, they will be limited
in their ability to increase capital spending.
In other words, the relatively mild deterioration of labor
markets in Europe compared with the U.S. is misleading
in two ways: First, while slow growth in unemployment
has so far protected consumer demand, further anticipated
increases will delay any significant upswing in household
spending. Meanwhile, the income shock to European
private sector firms, which is bigger than in the U.S. if
judged from a productivity and labor costs standpoint,
30
will weigh more heavily on capital spending and business
investment.
Another factor that will dampen the strength of the
recovery in the Western Europe is the outlook for Central
and Eastern European (CEE) economies. Among emerging
markets, CEE economies have been experiencing the
steepest rollercoaster ride in terms of growth. After
exceeding global growth averages for the past decade, CEE
regional growth has plummeted since 2008 and in our view
will underperform both emerging Asia and Latin America.
A dangerous combination of falling exports and slowing
capital inflows lies behind this bleak picture.
The abundant foreign financing that was available
through the large contingent of foreign banks in the
region, coupled with the prospects of further convergence
with the more mature economies of the EU, made the CEE
economies look particularly attractive places to invest until
the beginning of the global financial crisis in mid-2007.
Since then, however, countries with the largest current
account deficits--especially Estonia, Lithuania, Romania,
and Bulgaria--have been the most exposed to sharp
corrections. Estonia and Latvia are already in the midst
of sharp recessions; Hungary and Latvia turned to the
International Monetary Fund at the end of 2008 to avert
a currency crisis. Moreover, the strong foreign banking
presence, previously a major spur to economic growth,
is now turning into a real weakness. This is because the
parent companies of those foreign banks are feeling the
pressure from the ongoing credit crunch and have to
reprioritise their lending choices, a development that could
negatively affect their subsidiaries in Eastern Europe.
Meanwhile, the high level of foreign debt to GDP in most
countries--103% in Bulgaria, 115% in Estonia, and 93%
in Hungary—puts additional pressure on each country’s
exchange rate, effectively limiting the local central bank’s
margin for maneuver in terms of interest rate cuts.
Not all CEE economies are in the same boat. The Czech
Republic, which has a low foreign debt to GDP ratio (40% in
the fourth quarter of 2008) and resilient consumer demand,
has been weathering the downturn better than most of its
neighbors. Poland also bucks the CEE trend. As Eastern
Europe’s biggest economy, Poland has a larger domestic
market, making it relatively less dependent on exports to
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
ailing Western Europe. Furthermore, the country’s flexible
exchange rate and record-low interest rates have helped
cushion the slowdown. Poland proactively distinguished
itself from others in the CEE region and boosted investor
confidence in May of this year by securing a $20.5 billion
flexible credit line from the IMF--a special facility reserved
for emerging markets with strong fundamentals. But while
Poland’s economy is weathering the global turmoil better
than most of its regional peers, we feel that a rapid recovery
is unlikely and that the outlook is not without risks. In
particular, Poland’s fiscal situation is deteriorating, which
will likely push back the country’s planned adoption of the
euro in 2012.
Overall, we believe the recovery in most CEE economies
will be long to materialise--another negative for longer
term growth prospects in Western Europe.
factors constraining such a return are the persistence of the
credit crunch as financial institutions repair their balance
sheets and adapt to a new regulatory environment; rising
unemployment through the middle of 2010, weighing on
consumer demand; and deteriorating profit margins in
the nonfinancial corporate sector, placing a lid on capital
spending. The worst of the recession may now be behind
us, but a full recovery is still some way off.
Sustained Recovery May Take A While
A solid upswing is taking shape in most European economies,
in sync with similar developments in North America and
in Asia. The foundations of this “V”-shaped recovery lie
in the fiscal and interest rate stimuli implemented in the
past 12 months, and in the surge in foreign trade. But this
strong bounce back is in our view likely to be short-lived.
In 2010, we believe growth in the Eurozone and in the U.K.
will be below potential and we do not anticipate a return
to trend before the middle of 2011. In our view, the main
Table 1: Main European Economic Indicators
Real GDP (% change)
Germany
France
Italy
Spain
U.K.
Ireland
Eurozone
2008
1.3
0.3
-0.9
1.1
0.7
-2.3
0.7
2009e
-5
-2.3
-5
-3.6
-4
-8.1
-4
2010f
1.1
1
0.5
-0.6
0.9
-2
1
2008
2.8
2.8
3.3
4.1
3.4
3.1
3.3
2009e
0.3
0.1
0.7
-0.2
1.8
-2.5
0.3
2010f
0.9
0.9
1.3
0.8
2
0
0.9
2008
7.8
7.4
6.8
11.3
5.7
6.5
7.6
2009e
8.5
9.5
8.4
19
9
13
9.6
2010f
9.5
10.3
9.2
21
9.5
14
10.7
CPI inflation (%)
Unemployment rate (%)
f--Forecast. e--Estimate.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
31
Emerging Market Sovereigns Commentary
Emerging Market Sovereign Credit: The House Shook, But It’s Still Standing
Contact:
John Chambers, Managing Director,
S&P Ratings Services, New York (1) 212 438 7344
[email protected]
emerging market sovereigns in Europe, Middle East and
Africa (EMEA), including their official names. All ratings
in this article are long-term foreign currency sovereign
ratings as at September 25, 2009; outlooks also refer to
foreign currency ratings.)
T
Rating Action Recap
The number of sovereign downgrades has fallen markedly
since March 31, 2009, the data closure date of our last
emerging market sovereign report card. In the latest sixmonth period, we lowered three ratings, versus 14 in the
previous period. We lowered a high percentage of the
emerging market sovereign ratings during the period from
October 2008 to March 2009 (see chart 1). In the last six
months, the percentage of downgrades returned to the
range of 2% to 5% per quarter that was more common in
the past decade.
The downgrades themselves pertained to El Salvador in
the second quarter (see “Republic of El Salvador Long-Term
Ratings Lowered To ‘BB’ From ‘BB+’; Outlook Stable,”
published May 12, 2009), and, in the third quarter, Jamaica
(see “Jamaica Long-Term Ratings Lowered To ‘CCC+’;
Outlook Is Negative,” published Aug. 5, 2009) and Nigeria
(see “Nigeria Sovereign Ratings Lowered To ‘B+’ On
Chart
Chart 11
Chart 2
Distributio
Foreign C
Emerging Market Sovereign Foreign Currency
Rating Actions (%)
Upgrades
Downgrades
A
(%)
(%)
25
120
B
100
20
80
15
60
10
40
5
20
0
© Standard & Poor’s 2009.
1995
1994
1993
2009 Q3
2009 Q1
2008 Q3
2008 Q1
2007 Q3
2007 Q1
2006 Q3
2006 Q1
2005 Q3
2005 Q1
2004 Q3
2004 Q1
2003 Q3
2003 Q1
2002 Q3
2002 Q1
2001 Q3
2001 Q1
2000 Q3
0
2000 Q1
he pace of credit deterioration slowed nearly to a halt in
the emerging market sovereign asset class by our metrics
since our last report card was published in April 2009.
Over the six months to September 25, 2009, we lowered
the ratings on three emerging market sovereigns and
raised the ratings on two. No emerging market sovereign
defaulted, and one emerged from default. Currently, 12 of
42 emerging market sovereigns have a negative outlook, as
opposed to 16 of 43 six months before.
As we argued in the last report card, this asset class
is resilient: it withstood a severe external shock--an
earthquake that knocked over a cabinet or two but
didn’t collapse the house. No rating on an emerging
market sovereign has fallen out of investment grade
(although ratings on two other sovereigns have) since the
global recession began. The distribution of our ratings
by category is virtually unchanged during the period
under review, and our default statistics are broadly in
line with or below the reference rates proposed by the
Basel II Committee On Banking Supervision. Although
risks remain to the downside, as our rating outlooks
and economic forecasts indicate, we believe our ratings
capture these risks. In the near term, we expect the rate
of downgrades to remain in the historical range that
prevailed before the global recession.
In the medium term, we also expect to upgrade selected
emerging market sovereigns as their fundamentals improve.
This report card covers 42 central governments of lowand middle-income countries that are significant issuers of
foreign currency bonds or that have a material nonresident
investor base for their local currency government debt.
The selected set began with 14 sovereigns on Jan. 1, 1994,
and now includes 42 sovereigns as of Sept. 25, 2009. (In
this last period, we graduated the Slovak Republic, and
removed its rating data from this set. With an ‘A+’ rating
and having joined the European Monetary Union, the
Slovak Republic has more in common with high income
nations.) These 42 include more than a third of the 124
sovereigns we now rate. (See table 2 for a list of rated
Note: All dates as
Ratings are as of
emerging market
© Standard & Po
32
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart
Chart 22
Distribution Of Emerging Market Sovereign
Foreign Currency Ratings (%)
A
BBB
BB
B
CCC/CC
SD
(%)
120
100
80
60
40
20
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
0
1993
2009 Q3
2009 Q1
2008 Q3
2008 Q1
2007 Q3
2007 Q1
2006 Q3
2006 Q1
2005 Q3
2005 Q1
2004 Q3
2004 Q1
2003 Q3
2003 Q1
2002 Q3
2002 Q1
2001 Q3
2001 Q1
2000 Q3
2000 Q1
Banking System Distress And Deepening Fiscal Problems;
Chart 1
Outlook Stable,” published Aug. 21, 2009). We lowered the
Emerging
Marketbecause
Sovereign
Foreign
Currency
rating
on El Salvador
its debt
dynamics
no longer
Actions
wereRating
compatible
with(%)
a ‘BB+’ rating, which is at the top
of speculative
Jamaica because we
Upgrades grade. We downgraded
Downgrades
believe
(%) the chances of a distressed debt exchange have risen.
We 25
cut Nigeria’s rating because the troubles in its banking
system were deeper than we had previously thought and
20
because
of the falloff of government oil revenues. All the
downgrades were a single notch, although the ratings of
15
Jamaica
and Nigeria fell into a lower rating category.
During the last six months, we raised two emerging
10
market sovereign ratings. Ecuador emerged from default
after5curing its default through an exchange (see “Republic
of Ecuador Ratings Raised To ‘CCC+’ From ‘SD’; Outlook
Stable,”
published June 15, 2009) and we raised Pakistan’s
0
rating one notch, given its improved external liquidity
position and the progress it has made under its IMF
program
(see “Rating On Pakistan Raised To ‘B-’; Outlook
© Standard & Poor’s 2009.
Stable,” published Aug. 24, 2009).
These rating actions left the proportion of emerging
market sovereigns in investment grade (‘BBB-’ or above)
unchanged at 40% (see chart 2). The proportion of ratings
in the ‘CCC’ category rose to 7% as of Sept. 25, 2009, with
the upgrade of Ecuador from ‘SD’ and the downgrade of
Jamaica. The asset class is well spread out among rating
categories between ‘A’ and ‘CCC’.
As of Sept. 25, 2009, 12 emerging market sovereigns
had a negative outlook, 29 had a stable outlook, and
Ukraine alone had a positive outlook. Although outlooks
are not announcements of a fate foretold, they have high
predictive value (see “Use Of CreditWatch And Outlooks,”
published Sept. 14, 2009, and “Outlooks: The Sovereign
Credit Weathervane, 2008/2009 Update,” published March
13, 2009). Thus, we believe that emerging market sovereign
ratings will remain under pressure. However, this pressure
is abating somewhat. Since our last emerging market
scorecard, apart from the governments whose ratings we
raised or lowered, the ratings outlooks for three sovereigns
improved (Kazakhstan, Turkey, and Ukraine) and worsened
for one (Mexico).
The rating trends for emerging market sovereigns are
comparable to rating trends for all rated sovereigns. We
upgraded less than 1% of our entire sovereign set either in
the second or third quarter of 2009 and downgrades ran
Note: All dates as of Dec. 31, except for Sept. 25, 2009.
Ratings are as of first rating by Standard & Poor's and not necessarily by first inclusion in
emerging market subset.
© Standard & Poor’s 2009.
4% to 5% each quarter, rates comparable to those during
the 2001 recession.
Forecasts Remain Glum
Our forecasts also point to persistent ratings pressure.
Economic conditions remain difficult. We project that only
14 of the 42 emerging market countries will have positive
real per capita income growth in 2009 and eight will
continue to contract in 2010. The fiscal position of almost
every government will be worse than that of the preceding
five years as automatic stabilisers operate. Comparing 2007
with 2011, we expect government debt levels to increase by
5% or more of GDP in 14 sovereigns. Although the global
recession will help slow domestic credit growth and help
narrow current account positions in many deficit countries,
half of them will have gross external financing requirements
exceeding current account receipts plus usable reserves this
year and next. The stock of external debt, however, should
remain at manageable levels for most of them.
Default Rates Will Rise
No emerging market sovereign has defaulted since Ecuador
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
33
Emerging Market Sovereigns Commentary
The House Shook, But It’s Still Standing Continued
in December 2008. As our rating levels and rating actions
indicate, we expect sovereign default rates to rise. Since the
2002 to 2004 cohort, our three-year cumulative default
rates for emerging market sovereigns have been below
the monitoring and trigger level the Basel Committee On
Banking Supervision proposed for all rating categories (see
Table 1 and “Basel II Update Of Global Ratings,” published
March 3, 2008). Except for the ‘BBB’ level, our 10-year
average three-year cumulative default rate for emerging
market sovereigns is also below the Basel II committee
reference rate.
By definition, we believe that commercial creditors to
governments with ratings at the bottom of our scale (such
as Jamaica or Ecuador) are particularly vulnerable either to
nonpayment or distressed exchanges. Often, the question
of what constitutes a distress exchange is a judgment call.
For example, this year, we reviewed three exchanges by
Argentina and determined that they did not meet our criteria
for distressed exchanges (see “Republic of Argentina ‘B- /C’
Ratings Affirmed On CER Debt Swap; Outlook Remains
Stable,” published Aug. 25, 2009, for an example). The
sovereign defaults from the ‘BBB’ level both came from the
emerging market set: Indonesia and Uruguay. Default rates
in the ‘B’ category may be lower for our sovereign rating
universe than for the emerging market subset because the
former includes many governments that received large debt
relief before obtaining a rating and thus may not be fully
seasoned in the default statistics. (For a complete record
of sovereign defaults since see “Sovereign Defaults And
Rating Transition Data, 2008 Update,” published Feb. 12,
2009, and “Sovereign Defaults At 26-Year Low, To Show
Little Change In 2007,” published Sept. 18, 2006.)
Why Emerging Market Sovereigns Survived
As we argued in earlier emerging market scorecards and
in the rationales discussing the upgrades of individual
governments earlier in this decade, many emerging market
sovereigns had improved their external positions, which
helped them maintain investor confidence through the
2009 global recession. They did this by deepening their
domestic financial markets (see “The Impact Of Sovereign
Creditworthiness On Local Capital Market Development,”
published Feb. 1, 2008, and “The Credit Implications
Of Local Currency Financing,” published Oct. 5, 2005)
and by building their international reserves. They did it
by adopting more flexible exchange rate policies and by
diversifying their sources of international finance. Many of
them improved their fiscal positions by raising revenues and
paying down debt. Some in investment grade even reached
the point of being able to conduct countercyclical fiscal
policy (see “Latin America: Golden Or Leaden Casket?”
published May 20, 2008). Thus, their credit standing was
robust in the face of an external shock. Since August 2007,
when market dislocations began, we’ve lowered the rating
on only one emerging market sovereign, Ukraine, by more
than two notches. The ratings and outlook of more than
half have stayed the same or improved.
Why Emerging Market Sovereign Ratings
Haven’t Converged With Those Of The G7
Ironically, the resilience of the asset class has led some
commentators in the developing world to ask why the
Table 1: Three-Year Cumulative Default Rate For Emerging Market Sovereigns
AA-AAA
A
Monitoring
level
Trigger level
2003
2004
2005
2006
2007
2008
2009
0.8
1.2
N/A
N/A
N/A
N/A
N/A
N/A
N/A
1
1.3
0
0
0
0
0
0
0
BBB
2.4
3
11.11
11.11
0
0
0
0
0
BB
11
12.4
9.09
0
7.69
0
0
0
0
28.6
35
9.09
11.11
12.5
18.18
20
0
0
B
Note: Transition rates to default on foreign currency debt for sovereigns rated at the beginning of the period. All dates as of Dec. 31, except for Sept. 25, 2009. These three-year
cumulative default rates (CDR) are calculated to meet the definition of CDR put forward by the Basel Committee on Banking Supervision in the Basel II proposals. The “monitoring
level” is the first threshold prompting financial institutions to pay additional attention to the changing credit environment. The “trigger level” is the second threshold that if breached
two years in row implies cumulative default rates are considerably above historical default experience prompting financial institutions to review risk weights for investments. N/A--Not
applicable (no observations).
34
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
ratings on their governments aren’t equal to or better than
those of the Group of Seven (G7) industrial countries. The
two sets, in fact, intersect at the ‘A+’ rating: Italy is the
lowest rated of the G7 and China and Chile are the highest
rated of our emerging market set. In general, however, the
G7 have stronger institutions that produce policies that
have increased national wealth, engendered flexible labor
and product markets, promoted a diversified economy, and
deepened domestic financial markets. These institutions, in
our view, provide checks and balances that help prevent
policy formation from going off course, particularly during
difficult economic times. As a rule, they borrow mostly in
their own currency or in a currency of a monetary union
they belong to. As a result, they enjoy the confidence of
investors and then can run countercyclical fiscal policy for
an extended period of time.
As with any earthquake there are aftershocks. They may
deepen the cracks in the ceiling. But we hold to our opinion
that the majority of these governments in investment grade
and the higher levels of speculative grade will keep their
credit standing intact, thanks to previous policy measures.
For the lower rated sovereigns in the ‘B’ and ‘CCC’
categories, we expect more defaults. There the supporting
beams may need to be reinforced quickly.
Notes on a selection of rated EMEA emerging market
sovereigns follow. Table 2 summarises our view on the
creditworthiness of each sovereign with particular emphasis
on near-term factors that may have credit implications.
This report and the ratings contained within it are based on published
information as of September 25, 2009 unless otherwise specified.
Table 2: Selected EMEA Emerging Markets Sovereign Ratings
Sovereign
Sovereign credit rating
Analyst
Bulgaria (Republic of)
BBB/Negative/A-3
Marko Mrsnik
Czech Republic
A/Stable/A-1
Frank Gill
Egypt (Arab Republic of)
BB+/Stable/B
Farouk Soussa
Gabonese Republic
BB-/Stable/B
Sarah N'Sondé
Georgia (Government of)
B/Stable/B
Trevor Cullinan
Ghana (Republic of)
B+/Negative/B
Remy Salters
Hungary (Republic of)
BBB-/Negative/A-3
Kai Stukenbrock
Kazakhstan (Republic of)
BBB-/Stable/A-3
Frank Gill
Lebanon (Republic of)
B-/Stable/C
Farouk Soussa
Morocco (Kingdom of)
BB+/Stable/B
Véronique Paillat-Chayriguès
Nigeria (Federal Republic of)
B+/Stable/B
Moritz Kraemer
Poland (Republic of)
A-/Stable/A-2
Kai Stukenbrock
Russian Federation
BBB/Negative/A-3
Frank Gill
Serbia (Republic of)
BB-/Negative/B
Marko Mrsnik
South Africa (Republic of)
BBB+/Negative/A-2
Remy Salters
Tunisia (Republic of)
BBB/Stable/A-3
Véronique Paillat-Chayriguès
Turkey (Republic of)
BB-/Stable/B
Farouk Soussa
Ukraine
CCC+/Positive/C
Frank Gill
*Ratings are as of Sept. 25, 2009. All ratings are foreign currency ratings. CPI--Consumer price index. EMU--European Monetary Union. FDI--Foreign direct investment. IMF--International
Monetary Fund. SBA--Standby Agreement. SDR--Special drawing rights. WPI--Wholesale price index.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
35
EMEA Sovereigns Report Card
EMEA Sovereign Report Card
Standard & Poor’s Ratings Services EMEA Sovereign
Report Card provides an overview of the factors that
have shaped sovereign credit quality during 2009. We also
examine the factors that will likely influence the region's
sovereign credit quality in the near term.
All of the sovereign ratings referenced below are long-term
foreign currency ratings.
Bulgaria (Republic of)
After a period of high growth fueled by a credit boom,
Bulgaria’s economy is sharply contracting due to the
slowdown in external financing flows. Bulgaria’s financial
system is dominated by Western European banks, and given
the continuing adverse market conditions in their home
markets, these banks have severely reduced lending to the
nongovernment sector in Bulgaria, which has stalled credit
growth. This slowdown is likely to continue next year both
engendering and responding to falling investment and
private consumption, and exacerbated by weak external
demand. Therefore, what had been an unsustainably
high current account deficit (24.6% of GDP in 2008) and
inflation (down from 15.3% year-on-year in June 2008
to 1.3% in August 2009) are correcting markedly and
FDI is falling in concert. Bank asset quality will continue
to deteriorate--hurting capitalisation, liquidity, and
profitability of the sector--and test the resolve of Western
banks to support their Bulgarian subsidiaries. After a
period of solid budgetary performance, which allowed
Bulgaria in 2008 to reduce its gross debt level down to
about 14% of GDP and to accumulate fiscal reserves
of about 13% of GDP, the country’s public finances are
under pressure as the revenues decline due to the economic
downturn, while pressures on social outlays will increase.
The newly elected government is committed to support the
Currency Board Arrangement fully and to pursue balanced
budgets in 2009 and 2010 by increased tax compliance
and spending cuts, thus further reinforcing the previous
constraints on spending, while worse-than-expected
fiscal outcomes would likely be financed by drawing on
fiscal reserves. Fiscal underperformance, coupled with the
difficult external financing environment may, nevertheless,
require support by the international financial institutions.
36
Czech Republic
The sovereign credit ratings on the Czech Republic are
supported by the country’s diversified and competitive
economy as well as its capacity to finance itself
predominantly in local currency. Ratings are constrained,
however, by challenges to fiscal stability posed by the
economic downturn and the country’s aging population.
The Czech economy, which enjoyed average real GDP per
capita growth of 5.3% from 2004 to 2008, is expected
to contract by 2.5% during 2009, largely as a result of
a sizable inventory adjustment, and an accompanying
contraction in fixed investment. Despite the difficult
external environment, taken together the capital and
financial accounts have remained in surplus during 2009,
over-financing the Czech Republic’s current account
deficit, which is projected to average 2% of GDP over the
medium term. Overall levels of leverage in the economy
are relatively mild, with total gross external debt of less
than 40% of GDP. We expect the 2009 general government
deficit to exceed 5% of GDP, due to declining direct tax
revenues and rising expenditures associated with the
budget’s automatic fiscal stabilisers. The uncertain timing
of general elections makes it more difficult to project the
fiscal outcome in 2010, but at current trends the budget
deficit could exceed 7% of GDP if the government does not
take corrective measures. Despite moderate progress, the
government has not yet implemented second pillar pension
reform, which is critical for the Czech Republic to ensure
the sustainability of long-term public finances. Given the
fragility of the current governing coalition and upcoming
elections in 2010, significant pension reform is not likely in
the near term. General government debt is set to increase
from 30% of GDP at end 2008 toward 40% of GDP in
2011. The average maturity of the debt stock is six-plus
years implying that the government rolls over roughly 6%
of GDP of debt per year. Although this average maturity
is likely to decrease slightly in 2009-2010, we expect the
rollover percentage to remain at a comfortable figure.
Between 2009 and 2011, interest expenditure should
remain below 5% of government revenues.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
France Germany
July 30, 2009: S&P affirmed the AAA credit rating with a
Stable Outlook.
January 13, 2009: S&P affirmed the AAA credit rating on
Germany with a Stable Outlook.
Strengths:
n Wealthy, highly diversified, and open economy, with a
skilled and productive labour force
n Stable political environment, underpinning prudent
macroeconomic policies
Strengths:
n A wealthy, modern, highly diversified, and competitive
economy
n A stable political environment
n Resilience to large-scale economic shocks
Weaknesses:
n High tax burden and upward pressure on structural
expenditures
n Continuous delays to budgetary consolidation and
relatively high indebtedness
n Labour market rigidities
Weaknesses:
n General government debt remains among the highest in
the ‘AAA’ category
n Weak growth potential due to structural weaknesses,
high labour costs, and an adverse demographic profile
n Political system not conducive to swift and decisive
policy reform
The stable outlook reflects our expectations that the French
economy will return to positive growth once the global
economy recovers, and that this will be accompanied by
a clearly discernible trend in budgetary consolidation
and debt reduction. Despite the recession, we expect
the government will continue to implement its planned
structural reforms, which we believe would improve the
economy’s competitiveness and contribute to the economic
recovery. Should the large budgetary imbalances and
relatively high gross debt remain unaddressed following
the resumption of economic growth, the ratings on the
Republic of France would come under downward pressure.
The stable outlook reflects our view of Germany’s capacity
to weather the adverse financial and economic shocks
posed by the ongoing international economic turmoil. Its
flexible and competitive economy should be able to recover
relatively quickly once external demand returns, while
fiscal consolidation efforts during previous years have, in
our view, provided some fiscal space for countercyclical
fiscal policy.
Nevertheless, a more protracted economic slump,
significantly higher fiscal deficits, and a worse government
debt trajectory than currently expected could place
downward pressure on the ratings, particularly given that
the German government's debt levels are among the highest
of ‘AAA’ rated sovereigns. Much remains, in our view, to
be done in matters of economic and fiscal policy, even
once the crisis has been mastered. Numerous structural
challenges to Germany's economy remain, and spent fiscal
buffers will, we believe, have to be regained.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
37
EMEA Sovereigns Report Card
EMEA Sovereign Report Card Continued
Hungary (Republic of)
Israel
We expect the Hungarian economy to contract by 7% in
2009 and by another 1% in 2010, as the economy not
only is hurt by the international economic and financial
crisis, but also by the procyclical tightening of fiscal policy
under a €20 billion IMF/EU program. We expect the
technocratic government of Prime Minister Gordon Bajnai
to broadly achieve the general government deficit target
of 3.9% of GDP agreed to with the IMF for 2009, and
we also expect the government to pass a budget for 2010
in line with the IMF target of 3.8% of GDP. We expect
gross general government debt to rise to 84% of GDP in
2010, from 66% in 2007. IMF and EU funds continue
to provide significant relief for government funding.
Calming markets and availability as well as adherence to
the IMF/EU program eventually allowed the government
to gradually return to capital markets for funding, first in
forint, and in July with its first foreign currency issuance
in more than a year. Improved market access is expected
to make the government rely less on IMF/EU funds in
the future. Instead, the government agreed in September
to extend the duration (but not the size) of the current
SBA with the IMF by six months to October 2010. We
expect general elections in April 2010 to bring a change
in government, with center-right Fidesz likely to head the
next government. While the party is currently campaigning
on a populist platform, we do not expect a significant
departure from prudent fiscal policies. Despite the gradual
improvements in Hungary’s fiscal and economic situation,
the new government will be faced with a sizable reform
challenge. Further consolidation of public finances and
the reduction in Hungary’s large government debt burden
will be key elements. Key structural challenges, such as the
large size of the public sector and a still relatively generous
social system, which stifle private-sector performance and
Hungary’s growth potential, also remain to be addressed.
The deteriorating economy will continue to put pressure
on Hungary’s financial sector, increasing the risk of
contingent liabilities materialising despite relatively strong
solvency positions at the outset of the downturn. We expect
nonperforming loans to rise, driven by the weakening
economy.
July 16, 2009: S&P affirmed the A credit rating on Israel
with a Stable Outlook.
38
Strengths:
n Prosperous and resilient economy
n Short but impressive track record of fiscal consolidation
n Solid external finances
Weaknesses:
n Heavy public debt burden
n Significant geopolitical risks, somewhat mitigated by
U.S. support
The stable outlook balances the resilience of the Israeli
economy, the strength of its political institutions, and its
external creditor position with a high government debt
burden and the geopolitical risks that the nation faces.
Several assumptions underpin the stable outlook on our
ratings on Israel's debt. We forecast that the government
will meet its fiscal targets, or exceed them if growth surprises
on the upside. We believe that the government will proceed
with reforms to strengthen institutions and improve
economic efficiency. The long-pending central bank law and
a new banking law to expedite bank restructurings work in
this direction while measures to limit capital market loses
for participants or increase the tax wedge in wages work
oppositely. We expect that Israel and the world community
will confront Iran over its nuclear program solely in the
diplomatic realm. If these assumptions do not hold, then
the ratings would come under pressure. On the other hand,
if the government materially outperforms on the fiscal side
or if Israel's geopolitical risks improve, pressure would
build on the upside.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Italy
Nigeria (Federal Republic of)
January 13, 2009: S&P affirmed the A+ credit rating on
Italy with a Stable Outlook.
The ratings on Nigeria, which we lowered on Aug. 21,
reflect the reduced fiscal flexibility due to costs associated
with the government’s recent bailout of five large domestic
banks, and also the falloff in government oil revenue.
Although all-important oil production reportedly reached
1.7 million barrels per day (mbpd), a slight improvement
from first-quarter 2009, it still falls well below the
budgeted amount of 2.2 mbpd and is unlikely to recover
unless initiatives attempting to contain militant activities
in the Niger delta progress, which we consider unlikely in
the short-term, limiting upside potential on the rating. So
far, neither negotiations, an attempted military clampdown
in early 2009, nor an amnesty offer during the summer
have led to a breakthrough. In August, the central bank
intervened in five major banks, replacing their management
and undertaking recapitalisations. An extraordinary audit
of these banks revealed that aggregate nonperforming
loans exceeded 40% of total loans. In our opinion, this
action has begun a welcome restructuring of Nigeria’s
banking system, but it also reveals the extent of problem
loans beyond our previous estimates. We expect bank
credit to contract in the coming months, slowing economic
growth. We believe that the one-off cost of the bank
recapitalisations, combined with low oil production and
prices, will result in a 7% of GDP swing in the general
government balance to a projected 2009 deficit of 4.5% of
GDP. The estimated 2009 general government deficit will
likely result in Nigeria’s Excess Crude Account (its main
fiscal reserve) falling to $7 billion (4% of GDP) from $20
billion at the beginning of the year, and an increase of the
general government debt ratio to 13% of GDP. Although
we forecast that international reserves will fall by about
one-third from the 2008 peak to $43 billion at year-end
2009, we expect the ratio of gross external financing
requirements to current account receipts plus international
reserves to remain unchanged in 2009 from the year
before at a comfortable 60%. If the government’s and the
country’s strong external balance sheet erode more quickly
than we expect, it could lead to renewed pressure on the
rating.
Strengths:
n A prosperous, highly diversified, and globally integrated
economy
n Economic and Monetary Union (EMU) membership
Weaknesses:
n Very high general government debt and interest burdens
n Weak structural budget position, exacerbated by low
economic growth potential
n An electoral system susceptible to fragile parliamentary
majorities
The stable outlook on Italy reflects our perception of the
balance between the constraints imposed by the heavy
government debt burden against the country's more modest
external imbalances and the resources of its diversified
economy. Stronger-than-anticipated consolidation of the
fiscal position, placing the government debt ratio on a
sustainable downward trend, could lead to upward pressure
on the long-term rating, as could a more vigorous pursuit
of competitiveness-enhancing reforms. Conversely, if the
debt ratio were to rise markedly from current levels, due to
weakening economic growth or fiscal slippage beyond our
expectations, the long- and short-term ratings could come
under renewed downward pressure.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
39
EMEA Sovereigns Report Card
EMEA Sovereign Report Card Continued
Poland (Republic of)
Russian Federation
Poland’s economy is weathering the international economic
and financial crisis comparatively well, and is expected
to be the only economy in the Central and Eastern
European region not to contract, but to stagnate, instead,
after average annual growth of 5.9% in 2006-2008.
The relative resilience of consumption, the international
competitiveness of Poland’s economy, supplemented by
the zloty’s flexible exchange, and an accommodative fiscal
policy support Poland’s economic resilience compared to
that of its regional peers. We expect growth to recover only
gradually in 2010, at 1%, before growing at an average
3.8% in 2011-2012. The economic contraction, a fall in
investment, and depreciation of the zloty since mid-2008
are supporting an adjustment in the current account. We
expect the current account deficit to fall from its multiyear
peak of 5.5% of GDP in 2008 to a forecast 2.6% in 2009,
and then to remain at broadly that level during 20102011. We expect the headline deficit to be fully financed by
net FDI inflows and EU transfers recorded on the capital
account. This does not include sizable errors and omissions,
however, which amounted to 4% of GDP in 2008. Poland’s
external liquidity is further bolstered by access to the $20
billion flexible credit line concluded with the IMF in May
2009. Poland’s public finances continue to deteriorate
markedly, driven by cyclical factors as well as by fiscal
loosening. The 2008 general government deficit, at 3.9%
of GDP, came in considerably higher than we expected
as a result of one-offs, weaker tax revenue, and a weaker
performance of local governments. We expect the deficit to
widen further to 5.7% of GDP in 2009 and 6.5% in 2010.
As a result, we forecast the government’s gross debt burden
will peak at just below 55% of GDP by 2011, down from
47% in 2008. We expect the debt containment rules in
place to be effective in controlling the development of
government debt levels. Should, for example, 2010 general
government debt exceed 55% of GDP, the public finance
law would require the government to draft a 2012 budget
that ensures the 2012 debt-to-GDP ratio will be lower than
in 2010. Above 60% of GDP there is even a constitutional
requirement for a balanced budget.
September 3, 2009: S&P affirmed the BBB credit rating on
Russia with a Negative Outlook.
40
Strengths:
n Substantial fiscal reserves
n Low general government debt
n Vast natural resources
Weaknesses:
n Weak political, legal, and economic institutions
n Significant contingent liabilities, including those linked
to negative demographic trends
n Unreformed banking system
n Narrow economic base
n Commodity dependency
The negative outlook reflects the possibility of a downgrade
if authorities fail to consolidate the primary general
government deficit over the next several years from current
levels of near 8% of GDP or should the government be
forced to provide large additional capital injections into
the distressed financial system.
On the contrary, rapid consolidation of public finances,
most probably accompanied by improving terms of trade,
would restore strength to Russia’s balance sheet, and would
be supportive of a stable outlook.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
South Africa (Republic of)
Spain
President Jacob Zuma’s appointments to key relevant
positions, especially at the National Treasury and Reserve
Bank, have supported our baseline scenario that the new
administration will not put in place a major macroeconomic
policy shift. The balance and modus operandi between the
new National Planning Commission and the economic
ministries will take some time to emerge. We expect,
however, that the Treasury will retain the main role in
government macroeconomic policy. We expect real GDP
to contract by close to 2% in 2009, recovering to growth
of about 2% in 2010. Although leading indicators suggest
the worst of the recession may have passed, the budget for
fiscal 2009 (ending March 31, 2010) assumed GDP growth
of 1.2%, and the difference has been felt in significant
monthly revenue shortfalls. The Medium-Term Budget
Policy Statement due to be presented in October will be
new Finance Minister Pravin Gordhan’s first opportunity
to take stock and adjust the fiscal policy outlook. In the
short term, some effort to increase expenditure efficiency
is ongoing, but we believe the government will continue
letting automatic stabilisers take effect. Therefore, we
expect a general government deficit of about 6% of
GDP in fiscal 2009. There is further downside risk to
that forecast due to revenue uncertainties and a trend of
higher-than-budgeted wage settlements. The government
debt and interest burdens are moderate in themselves,
but stepped-up rand bond issuance, combined with large
public enterprise borrowing plans, could eventually raise
questions about domestic market capacity and/or crowding
out effects. The $2 billion in global notes issued this year
highlighted international appetite for South African paper,
but we believe currency risk considerations will continue
to cap external issuance. We forecast a tangible reduction
in the current account deficit in 2009 despite the public
investment push, to 5.3% of GDP from 7.6% in 2008. On
the financing side, net portfolio inflows have recovered
with emerging market appetite in the year to date, driving
sustained rand appreciation. If inflows once again come
under pressure, however, the risks remain tilted toward
an additional domestic demand adjustment as the route to
balance-of-payments easing, given the still poor external
demand environment.
January 19, 2009: S&P lowered the credit rating on Spain
to AA+ from AAA with a Stable Outlook.
Strengths:
n Modern and relatively diversified economy with stable
political system
n Fiscal flexibility, underpinned by moderate but rising
general government debt
n Membership of the European Economic and Monetary
Union (EMU)
Weaknesses:
n Unbalanced, labor-intensive growth
productivity increases
n High level of private sector indebtedness
with
low
The stable outlook reflects the significant challenge Spain
faces to rebalance the economy, the flexibility provided by
the fiscal surpluses and reserves built up during the boom
years, and our expectation of fiscal consolidation once
near-term economic pressures moderate.
If Spain is able to make significant progress in liberalizing
labour and product markets in order to increase
productivity growth, improve competitiveness, and bring
unemployment in line with the rest of the Eurozone, and put
general government debt levels onto a declining trend, this
would support the ratings in the long term. Conversely, the
ratings would come under pressure should the correction
in economic imbalances proceed even more slowly than we
expect, or should large fiscal imbalances extend beyond
what is necessary for countercyclical measures, resulting
in a further deterioration in the public finances over and
above our current projections.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
41
EMEA Sovereigns Report Card
EMEA Sovereign Report Card Continued
Sweden
Turkey (Republic of)
January 13, 2009: S&P affirmed the AAA credit rating on
Sweden with a Stable Outlook.
The ratings on the Republic of Turkey are constrained
by medium-term macroeconomic challenges relating
mainly to the fall in external demand and financing, and
the negative impact this has had on fiscal outturns. Real
annual GDP growth registered a weak 1.1% in 2008, and
we expect the economy to contract by about 6.5% in 2009,
as exports fall and external financing continues to be tight.
Unemployment is on the rise, with nonseasonally adjusted
figures showing a 4.4% year-on-year increase in the rate of
unemployment in May 2009. We expect the fiscal impact
of the slowdown to be marked in 2009. Pressures on the
budget deficit have increased as the government seeks to
provide fiscal stimulus to the economy. While the majority
of stimulus measures so far have been temporary and
reversible, the era of fiscal consolidation that followed
the 2001 crisis has almost certainly come to a halt in the
medium term, and uncertainties persist regarding the future
path of fiscal policy. On the other hand, Turkey’s external
balances will continue to improve, mainly due to an easing
in the global price of oil and a fall in imports related to
domestic investment and consumption. However, in our
view, the inverse relationship between domestic economic
activity and external imbalances remains a structural
feature of the Turkish economy, and this dependence on
external financing remains a constraint on the ratings
despite the nominal improvement in the current account
deficit. The ratings on Turkey will remain supported by the
government’s track record of sound economic and fiscal
management, and the significant structural improvements
these have yielded to Turkey’s public finances since 2001.
Improvements in the banking sector have also helped it to
weather the global financial crisis better than most peers,
although scope for deterioration in asset quality in the
coming months exists as the economic slowdown persists.
Finally, Turkey’s relatively high level of wealth underpins
its standing within the ‘BB’ rating category.
Strengths:
n A steady decline in the general government debt burden
in past years, although a small rise is expected
n A prosperous, competitive, resilient, and diversified
economy
n Large and sustained current account surpluses, which
have strengthened the sovereign's external position
Weaknesses:
n A very large general government sector that constrains
fiscal flexibility
The stable outlook reflects our assessment that Sweden is
well placed to weather the current crisis. We believe that
Sweden's strong commitment to fiscal discipline and the
longstanding record of sound macroeconomic policy will
continue to support its creditworthiness. These strengths
should allow Sweden to deal with slower growth prospects
and the weakening in public finances in the coming
years without any permanent and significant shifts in the
economy.
42
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Ukraine
United Kingdom
The positive outlook on Ukraine’s long-term foreign
currency sovereign credit rating reflects exceptional
international financial backing for Ukraine, which has
helped to offset significant medium-term pressures on the
sovereign’s debt servicing capacity. With more than 60% of
the IMF loan already disbursed, the Ukraine government has
been able to fund capital injections into the financial system
worth more than 5% of GDP, while increasing its 2009
general government deficit target (which excludes 2.6% of
GDP in transfers to Naftogaz, as well as the restructuring
costs for the banking system) from 0% to 6% of GDP. As
of the end of August, foreign exchange reserves of $29
billion cover more than 2x short-term debt. Meanwhile,
sovereign foreign debt servicing payments for 2009 and
2010 total a fairly moderate $2.7 billion. Ukraine’s ‘CCC+’
rating continues to signal intense economic, fiscal, and
external pressures, as well as weak political institutions,
which will be tested ahead of the January 2010 presidential
elections. The preelection period may usher in a marked
slowdown in the implementation of measures attached to
the IMF program, such as the reduction in state subsidies
for residential gas consumption, amid a deterioration of
the fiscal stance. Failure to meet budgetary targets for 2009
and 2010 could lead to increased monetisation of fiscal
deficits, though for 2009, most of the Central Bank’s local
currency government securities purchases (equivalent to
3% of GDP) were made to bolster the capital adequacy
ratios of nationalised banks rather than to finance current
expenditures. Uncertainty on future policy direction has
generated another round of exchange rate depreciation,
which, should it continue, will further increase the cost
to the government of recapitalising the financial system.
While the current account deficit is narrowing, it is doing so
primarily because of a sharp fall in real incomes. The timing
and extent of any economic recovery will mainly depend
on the external environment, Ukraine’s terms of trade, and
the commitment of the government to implementing the
remainder of the IMF program.
May 21, 2009: S&P lowered the Outlook on the United
Kingdom’s AAA credit rating to Negative from Stable.
Strengths:
n A wealthy, open, and diversified economy
n A well-established political system and macroeconomic
policy framework
n Large liquid market for government debt issuance, with
100% of funding in domestic currency at maturities
considerably longer versus peers
Weaknesses:
n Structural deterioration in fiscal position, alongside
uncertainty regarding the future costs of government
financial system support
n High household indebtedness to weigh on medium-term
growth prospects
The negative outlook reflects Standard & Poor’s view that,
in light of the challenges to strengthen the tax base and
contain public expenditures, the U.K. government debt
burden could approach 100% of GDP by 2013 and remain
near that level thereafter. The rating could be lowered if we
conclude that, following the forthcoming general election,
the next government’s fiscal consolidation plans are
unlikely to put the U.K. debt burden on a secure downward
trajectory over the medium term. Conversely, the outlook
could be revised back to stable if comprehensive measures
are implemented to place the public finances on a
sustainable footing, or if fiscal outturns are more benign
than we currently anticipate.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
43
Structured Finance Commentary
Does Recent Issuance Signal The
Revival Of European Securitisation?
Contact:
Andrew South, Senior Director, S&P Ratings
Services, London, (44) 20 7176 3712
[email protected]
N
ew signs appear to indicate that investors are
tentatively returning to the European securitisation
market. But is it too soon to conclude that traditional
issuance—placed with investors rather than retained by
originators—is making a comeback?
Over the first half of this decade, securitisation grew
to become a significant funding source for European
lending institutions. However, the onset of global financial
instability in 2007 caused a widespread investor retreat
from the sector. Originators’ ability to tap traditional
securitisation investors fell dramatically, and instead, they
retained most issuance for potential use in central bank
“repo” schemes, which acted effectively as investors of
last resort. The credit crunch in the real economy, and
borrowers’ heightened difficulties in servicing their debts,
has likely further limited the appeal of structured finance
transactions to investors.
In our opinion, however, some of the contributing factors
to the near-total depletion of investor-placed issuance in
Europe are gradually beginning to abate. Rationalisation
of the investor base, changes in accounting treatment for
some structured finance holdings, and government support
for financial institutions have lessened the threat of forced
sales and mark-to-market volatility among structured
finance securities. Positive economic indications suggest
that—in some sectors at least—the threat of significant
further deterioration in credit quality is easing.
The recent secondary market rally—demonstrated by
significant tightening of securitisation spreads—suggests
some renewed investor appetite. As a result, the cost of
securitisation as a funding tool may be decreasing to a
point where originators might once more find it economical
or strategically desirable. Indeed, some originators have
recently placed a handful of transactions with investors,
rather than retaining them, as was more common since late
2007.
However, these signs of a rebound in the securitisation
market may yet prove short-lived. In our opinion, the
European economic recovery is likely to slow during 2010,
44
and while secondary spreads have tightened recently,
higher volumes of primary issuance could put that trend
under pressure. We also believe that other funding sources
may continue to hold more appeal to originators for now.
Finally, the effect of evolving regulatory requirements on
originators and investors remains uncertain.
Securitisation Issuance Placed With Investors
Has Fallen Dramatically Since 2007
In the early years of this decade, securitisation grew to
become a significant source of funding for European lending
institutions. Originators successfully used it to fund assets
as diverse as Italian nonperforming loans, Portuguese tax
claims, and U.K. football stadiums. Residential mortgages
have been the most dominant asset type, however (see
chart 1).
Then, after 2007, global financial disruption caused
a plunge in the volume of issuance placed with private
investors.
Technical pressures sparked initial investor retreat
When the first symptoms of financial disorder emerged,
the biggest problem seemed to be unexpectedly weak
borrower performance in a niche sector of U.S. mortgage
lending. In Europe, though, credit performance was not a
Chart 1
Chart 1
European Securitisation Issuance By Asset Class
Excluding issuance retained by originators
RMBS
CDO
ABS
Chart 2
European
Placed
CMBS
(€ Bil.)
(€ Bil.)
1000
600
900
800
500
700
600
400
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300
400
300
200
200
100
100
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2001
0
2001
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2003
2004
2005
2006
2007
2008
2009
YTD
© Standard & Po
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart 3
Total Deli
Chart
2
Placed
Retained
Chart 2
(€
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European
Securitisation Issuance
1000
Placed
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900
(€ Bil.)
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700
900
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700
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500
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400
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2003
2004
2005
2006
2007
2008
100
© Standard & Poor’s 2009.
0
2001
2002
2003
2001
2002
2009
YTD
2004
2005
2006
2007
2008
2009
YTD
© Standard & Poor’s 2009.
Chart 3
Chart 3
Total Delinquencies By Sector
Spanish mortgages
ChartU.K.
3 nonconforming mortgages
U.K. prime mortgages
Italian mortgages
Total Delinquencies By Sector
500
450
400
500
350
Auto loans/leases
U.K. nonconforming mortgages
Credit cards
Spanish mortgages
U.K. prime mortgages
Italian mortgages
Auto loans/leases
Credit cards
450
300
400
250
350
200
300
150
250
100
200
50
150
0
100
50
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09
demonstrable
source retained
of concern
for most structured finance
Excluding issuance
by originators
1 at that time.
assetChart
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theSecuritisation
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600
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Notably, some
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600
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refinance the short-term debt they used to fund longer-term
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structured
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300
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market value, even though economic and credit
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community,
triggering a vicious circle of write-downs,
©
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2009.
fund 0redemptions, and forced asset sales that in turn
2001 mark-to-market
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2005 further.
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YTD
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© Standard & Poor’s 2009.
proved to have significant market risk, given a deep crisis
of confidence and low liquidity.
With the securitisation asset class tainted by technical
concerns, and investors apparently staying away, the market
for new issuance in Europe effectively closed to originators.
Instead, eligible originators turned to central bank facilities,
such as the Bank of England’s Special Liquidity Scheme
(SLS) and the European Central Bank’s repo scheme. Central
banks have effectively become securitisation’s investors of
last resort, and, as a consequence, most originators have
retained any issuance since 2007 for potential use in these
schemes (see chart 2).
As liquidity problems evolved into a credit crunch, the
effects broadened to touch the real economy. We believe
that rising unemployment and lower credit availability have
since contributed to the deteriorating credit performance
of many financial assets that back European securitisations
(see chart 3).
Tougher funding conditions for lenders restricted the
credit they could supply to borrowers, but we believe
borrower demand for credit weakened as well. Prospective
first-time homebuyers, for example, have an incentive to
remain on the sidelines until house prices reach a trough.
Changes in corporate and household risk appetite may
also mean borrowers have sought to reduce their debt as a
matter of principle. As a result of both constrained supply
and demand, the volume of new lending to households and
Chart 2
European Securitisation Issuance
0
© Standard & Poor’s 2009.
(Indexed, J
© Standard & Poor’s 2009.
(Indexed, J
Jun-07
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09
Chart 1
European Securitisation Issuance By Asset Class
corporations has dwindled significantly over the past two
years, further undermining potential securitisation volumes.
In our opinion, many of the causes of the near-total
depletion of investor-placed securitisation issuance in
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
45
Structured Finance Commentary
Does Recent Issuance Signal The Revival Of European Securitisation? Continued
Europe are now gradually beginning to abate, although
hurdles remain in many areas.
Signs Of Improvement In The European
Economy
Improving economic conditions may be necessary for
the return of a vibrant European securitisation market.
Protracted declines in house prices, for example, may have
made residential mortgage risk less attractive to investors
as long as significant uncertainty surrounding the ultimate
scale and scope of the recession remained.
There are now signs that the worst of the recession could
be behind us in the major European economies, although
we believe the prospect of a sustained recovery is still some
way off. For example, Germany and France each posted
0.3% real GDP growth in the second quarter. Forwardlooking consensus indicators, such as purchasing manager
indices, reinforce the view that the Eurozone economy is
on the mend. In the U.K., this is further supported by the
housing market’s recent improvement, with prices rising
more than 6% over the past five months, according to the
widely-watched Nationwide index.
We believe the fiscal and monetary stimuli governments
and central banks have implemented over the past 12
months, as well as a surge in foreign trade, are causing this
apparent “V”-shaped recovery.
While we expect this strong bounce-back to be shortlived, with a likely slowdown in both Eurozone and U.K.
growth in 2010, the potential for further substantial shocks
seems to be slowly declining.
Efforts To Place The Industry On Structurally
Sounder Footing
As is common following asset bubbles, the potential
investor base for structured finance in Europe is likely to
have consolidated significantly. In particular, certain types
of investment vehicles have generally left the market,
thereby possibly mitigating the potential for a repeat of
many of the aspects of the crisis. Also, practical changes
among some remaining investors—such as a switch away
from mark-to-market accounting for assets they intend to
hold to maturity—should reduce concerns about future
forced asset sales and write-downs, which, in our view, will
also likely support the market.
The previous “sellers’ market” may have perpetuated
46
information asymmetries between originators and
investors. Initiatives by industry bodies such as the
European Securitisation Forum have, though, sought to
bring greater transparency through standardized data
reporting recommendations. While these issues may not
have been central to the problems that have plagued the
market, efforts to enhance transparency are clearly a step
in the right direction.
We too are committed to rebuilding confidence in the
ratings on structured finance securities, and since early 2008
we have taken numerous actions to enhance governance,
strengthen our analytics, increase transparency, and help
further educate market participants. The simple fact that
European structured finance ratings are now being tested
in a downturn should also help achieve this goal.
While we believe there are likely further collateral losses
to come in outstanding structured finance transactions, the
effect of weaker fundamentals on their ratings has been
relatively mild in many European sectors. In fact, so far,
most ratings have performed largely as intended, given
the current economic environment. For example, of the
4,478 European asset-backed securities (ABS), commercial
mortgage-backed securities (CMBS), and residential
mortgage-backed securities (RMBS) ratings outstanding in
mid-2007, only 10 (0.22%) had defaulted by mid-2009.
And only 0.05% of bonds rated investment-grade in mid2007 defaulted over the period, compared with 1.90% of
speculative-grade bonds, demonstrating that these ratings
have acted as a relative measure of creditworthiness.
We lowered a larger number of ratings over the period,
but, again, the rate of downgrades has been relatively
modest at the higher rating levels. For example, 96.8% of
bonds that were rated ‘AAA’ in mid-2007 were still rated
‘AAA’ (or had been redeemed in full) by mid-2009. We
note, though, that many ratings remain on CreditWatch
negative.
Originator Economics Are Improving, Though
Regulatory Uncertainty Remains
Ultimately, the future appeal of securitisation as a funding
source for European originators will depend on its cost—
determined largely by investor demand—versus the cost
of other funding sources. As such, central bank liquidity
schemes that accept structured finance assets, as well
as other government-backed funding support for many
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
lending institutions, may continue to dampen the issuance
of securitisation paper to private investors.
All the same, secondary spreads for securitisation
tranches have tightened considerably since early 2009. For
‘AAA’ U.K. prime RMBS, for example, spreads have now
returned to where they were in mid-2008. In September,
these spread levels helped encourage originators to sell
the first new transactions to European private investors
that we’ve seen in more than a year. These transactions
reportedly met with significant investor demand from
a variety of institutions and jurisdictions. This may not
necessarily mean a recovery of the market any time soon,
though. It remains to be seen whether other originators are
willing or able to follow suit, and how quickly any new
issuance exhausts investor demand.
While the recent spread rally may have occurred in
sympathy with the better tone in the wider financial markets,
secondary trading volumes for European structured finance
remain thin. This may be partly due to ongoing redemption
of prerecession issuance leaving relatively little structured
finance paper outstanding with investors other than central
banks. Much other outstanding paper may well now have
found a permanent home until maturity. If low secondary
supply is the main driver behind recent spread tightening,
the spread trend could be sensitive to any further new
issuance.
A final remaining risk we view as potentially constraining
the revival of the European securitisation market is the
ongoing uncertainty over future regulation. For example,
the mooted requirement for originators to retain a greater
economic interest in pools of assets that they securitise,
as well as bank regulatory capital requirements, which
also continue to be reviewed, could alter the appeal of
securitisation to both originators and bank investors.
The current position in the European structured
finance market therefore remains complex and uncertain.
However, we believe that many of the contributing factors
that caused investors to retreat from the market in the past
two years may be showing signs of recovery. The detailed
characteristics of future transactions may differ from those
of the past, but we believe the fundamental techniques of
securitisation, when used appropriately, continue to have
the potential to benefit both originators and investors—
and, by extension—household and corporate borrowers.
This report and the ratings contained within it are based on
published information as of October 13, 2009 unless otherwise
specified.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
47
Emissions Trading Commentary
What Are The Implications Of The New
EU Emissions Trading Scheme For
European Companies?
Contact:
Michael Wilkins, Global Head Of Carbon Markets,
London (44) 20 7176 3528
[email protected]
C
arbon trading regulatory and environmental
requirements are tightening in Europe and globally.
Exactly how these changes will affect credit quality
among rated companies in industry sectors that generate
significant greenhouse gas (GHG) emissions is as yet
unclear. Nevertheless, Standard & Poor’s Ratings Services
believes that emission levels and carbon pricing will become
increasingly important when assessing the creditworthiness
of such companies in the future.
Europe has recently revised its GHG cap-and-trade
system, the European Union Emissions Trading Scheme (EU
ETS). Phase III of the scheme, which takes effect in 2013
and extends until 2020, will introduce a new, tighter cap
and more stringent rules for the allocation and auctioning
of carbon allowances.
At an international level, within the context of the U.N.
Framework Convention on Climate Change (UNFCCC), a
new global regime is currently under discussion for when
the main provisions of the Kyoto Protocol expire after
2012. (The Kyoto Protocol, originated in December 1997,
specifies emission obligations for industrialised countries
and defines emissions trading and flexible mechanisms. It
took effect on Feb. 16, 2005.) Furthermore, there appears
to be significant momentum for concluding a new deal
during the U.N. Climate Change Conference that will take
place in Copenhagen on Dec. 7-18. The successor protocol
may introduce binding commitments on climate change
among industrialised nations and may eventually herald a
multilateral system for the international trading of carbon.
Although several essential regulatory provisions are yet
to be defined, raising uncertainties as to the final framework
provisions, in our view it is clear that these developments
could have a significant effect on how companies decide
to operate on the increasingly global carbon markets. This
is because carbon prices are directly influenced by the
regulatory market framework.
In order to provide investors with an overview of the
main changes related to the next phase of the EU ETS and
their potential impact on the creditworthiness of rated
48
European corporate entities, we have provided answers to
some frequently asked questions. In doing so, we employ
certain terms associated with the global carbon market,
namely:
n Allowance: An emissions trading right under a cap-andtrade scheme such as the EU ETS.
n Offset, or carbon credit: A certificate of carbon emission
reduction that can be used in place of an allowance for
compliance requirements.
n Carbon offset project: A carbon reduction project
that is awarded carbon credits under the U.N.’s Clean
Development Mechanism (CDM) or equivalent scheme.
Frequently Asked Questions
What are the main changes that the revised EU ETS
introduce?
The EU launched its ETS on Jan. 1, 2005, to help Europe
meet Kyoto Protocol GHG emission-reduction targets at
the lowest possible cost. It achieved this by setting up an
internal market for the exchange of carbon allowances and
credits. The first trading period ran for three years to the
end of 2007; the second period, which began on Jan. 1,
2008, runs for five years until the end of 2012.
The EU Council adopted the revisions–-part of the EU
Climate Change Package–-on April 6, 2009, following its
approval by the European Parliament on Dec. 17, 2008.
The package is central to the EU’s drive to lower GHG
emissions by at least 21% by 2020, from 2005 levels.
Under the new rules, industry sectors the ETS covers must
start purchasing at least 20% of their emission permits at
auction starting in 2013. That percentage will rise gradually
to 70% in 2020, with a view to reaching 100% by 2027.
In Phases I and II of the ETS, allowances have largely cost
nothing as most have been allocated for free.
Revisions to the scheme proposed in 2008 introduce a
number of changes that will be implemented from the start
of Phase III in 2013. According to EU announcements these
cover:
n A longer trading period (eight years instead of five years,
between 2013 and 2020);
n An annually declining emissions cap that achieves a
21% reduction by 2020, compared with 2005 levels (see
chart 1);
n A single, EU-wide cap with member states no longer
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Versus Actual And Forecast Emissions 2008-2020
EU-20 allocation*
The Pow
Baseline emissions
Cement
(Mil. tonnes
of CO2)
Pulp and
3,000
(Mil. tonnes
of CO2)
2,500
300
2,000
250
1,500
200
1,000
150
500
100
0
50
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
0
Chart
Chart 11
© Standard & Poor’s 2009.
EU Emissions Trading Scheme Allocations
Versus Actual And Forecast Emissions 2008-2020
EU-20 allocation*
Chart
3 Sour
f--Forecast.
Breakdow
© Standard & P
The Powe
Baseline emissions
Cement,
(Mil. tonnes
of CO2)
Pulp and
Chart
4
3,000
2,500
Platts Ov
(End Of Y
300
2,000
250
1,500
30
200
1,000
25
150
500
20
100
0
15
50
(Mil. tonnes
of CO2)
2009 CE
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
*Assumes 20% reduction target for emissions, relative to 1990 levels.
Source: Point Carbon.
10
0
5
2008 2009
© Standard & Po
Chart
Chart22
CERs--Certified e
Verified Emissions By Industry Sector In 2008
Under EU Emissions Trading Scheme
Other or not
applicable
1%
Metal
ore
1%
Pulp and Refining
7%
paper
Pig iron 1%
and steel
6%
Chart
4 &P
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(End Of Ye
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and lime Ceramic
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products
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2009Refin
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25
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20
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10
0
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7/11/2008
© Standard & Poor’s 2009.
Chart 2
Coke
Cera
CERs--Certified
em
Verified Emissions By Industry Sector In 2008
Under EU Emissions Trading Scheme
Cement
Other or not
Pulp and Refining
and lime Ceramic
applicable
7%
paper
Pig
iron 1%
products
1%
STANDARD & POOR’S EUROPE,
MIDDLE
EAST, AND AFRICA: 9%
MARKETS
OUTLOOK 2010
and steel
1%
6%
Metal
Coke
ore
1%
1%
Glas
30/5/2008
Source: Platts.
Combustion
installations
72%
5
20/6/2008
Which industry sectors will Phase III changes most
affect?
In terms of scope, the ETS has so far covered the highest
emitting industrial sectors in Europe: power and heat,
cement and lime, oil refineries, chemicals, iron and steel,
pulp and paper, and building materials (glass, bricks, and
ceramics). Together, these sectors accounted for around
46% of the EU’s total GHG emissions during the first
7/11/2008
f--Forecast.
Sourc
0
© Standard & Poor’s 2009.
30/5/2008
There is no change in the penalty for noncompliance
with these rules, which remains at €100 per metric ton
of CO2 equivalent (t/CO2e), relative to current prices of
around €14 t/CO2e. However, allowances and carbon
credits obtained during Phase II can be carried forward
(“banked”) into Phase III.
There are still a number of largely technical decisions
relating to the implementation of the revised EU ETS, which
the European Commission (the Commission) will take
through a committee procedure called “comitology” before
the third trading period begins in 2013. For instance, as a
priority, the Commission’s stated aim is to determine the
sectors and subsectors that will benefit from free allowances
under “carbon leakage.” This occurs when the production
of goods is moved to countries with less strict climate
change policies than those in the original producer country.
The Commission anticipates that European Communitywide benchmarks for free allowance allocations will be
adopted by December 2010. Furthermore, the Commission
is planning to adopt a regulation on auctioning under the
post-2012 ETS by June 2010.
2008 200
20/6/2008
setting emission allowances but instead allocating them
on the basis of harmonised rules;
n A substantial increase in the amount of auctioning of
allowances. Free allowances should decline each year by
equal amounts, resulting in only 30% free allocation in
2020, with a view to eliminating free allocation in 2027;
n A directive for power producers to acquire all of their
emissions allowances at auctions. Exceptions will be
made for countries with a high dependence on fossil fuels
or insufficient cross-border grid connections, whereby
10 member states can apply for reduced auctioning rates
in power production; and
n A redistribution mechanism that entitles certain countries
from Eastern Europe to auction more allowances.
*Assumes 20% reduction target for emissions, relative to 1990 levels.
Source: Point Carbon.
© Standard & Po
Cem
49
Refini
Pulp a
ns
008-2020
Emissions Trading Commentary
What Are The Implications Of The New Emissions Trading Scheme On European
Companies? Continued
two phases of the scheme. The power and heat sector
(represented by combustion installations) produced 72% of
all verified emissions between 2005 and 2008 (see chart 2).
From 2013, however, we understand that the scope of
the ETS will broaden to include new industrial sectors
(see chart 3). These cover petrochemicals; ammonia and
aluminum; other gases such as N2O emissions from the
production of nitric, adipic, and glyocalic acid production;
and perfluorocarbons from the aluminum sector. Although
the capture, transport, and geological storage of all GHG
emissions will also be covered, these sectors will receive
allowances free of charge according to EU-wide rules.
Meanwhile, the aviation sector will also be included
from 2012. In our view, this will likely lead to further
financial strain on airlines (see below), in light of the
competitive and economic pressures already weighing on
that industry.
the first two phases, the credit impact of ETS Phase III
compliance is far less certain. In our view, the new rules
mean that emission levels--along with the price of carbon-will become significantly more important in determining
business and financial risk for carbon-intensive sectors
such as power generation, oil and gas, steel, cement, and
chemicals. We believe key factors affecting creditworthiness
are likely to be:
n The extent to which sectors the scheme covers will be
able pass on additional costs to consumers;
n The competitive disadvantage of having operations
and suppliers in Europe versus companies based in
developing countries where the carbon compliance
regime is less rigorous; and
n The additional costs of a general broadening of the
sectors the scheme covers, revised allocations, and
stricter caps from 2013 to 2020.
How is the revised EU ETS likely to affect corporate
credit quality?
The effects of the revised allocations and caps are
already evident among rated European companies. Our
rating on power generator Drax Power Ltd. (BB+/Stable/--)
reflects higher carbon prices post-2012--when the sector
will move into a net short position (see chart 1). On May
15, 2009, we lowered the long-term corporate credit
rating on Drax to ‘BB+’ from ‘BBB-’. The downgrade
reflects our view of a material weakening in the company’s
earnings during 2009 due to the U.K. recession, which is
resulting in weak power demand and significantly lower
wholesale power prices and dark green spreads (the market
measure of power prices after coal and carbon costs). The
downgrade also reflects what we perceive as Drax’s rising
business risk because of its focus on coal-based generation,
which is subject to increasingly stringent regulatory and
environmental requirements.
Drax’s earnings have been under pressure since 2008,
when Phase II of the EU ETS came into effect. The increased
cost of carbon allowances and higher coal prices led to a
10% decline in EBITDA in 2008, despite relatively high
power prices and dark green spreads. Moreover, Phase
III of the ETS will bring in another structural increase in
carbon costs.
In our view, Drax continues to generate positive, albeit
unpredictable, free cash flows and its credit protection
measures are robust. However, we believe the company’s
ability to absorb lower prices is diminishing.
Notwithstanding the short-term benefits arising from
Chart
Chart 33
Breakdown By Industry Of Emissions Outside
The Power Sector In The EU 2008-2020f
Cement, lime, and glass
Pulp and paper
Aviation
Metals
Oil and gas
New industry
Other
(Mil. tonnes
of CO2)
300
250
200
150
100
50
018 2019 2020
0
2008 2009f 2010f 2011f 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 2020f
f--Forecast. Source: Point Carbon.
© Standard & Poor’s 2009.
50
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart
4
Platts Over-The-Counter CERs Futures 2008-2009
Which other industry sectors are likely to come
under pressure in Phase III?
While the power sector is by far the most exposed to the
new ETS rules, other sectors are by no means immune
in our view. Even those sectors that are relatively small
contributors to overall emissions such as aviation (3% of
the EU total) are likely to feel the strain. Point Carbon,
a carbon markets news and data provider, estimates that
airlines–-including U.S. and non-European carriers--may
have to purchase up to €1.1 billion in allowances by 2012
in order to comply with the scheme. The eventual cost may
be even higher, since the estimate is based on the current
price of carbon of around €14.4 t/CO2e. Since the sector
as a whole suffered a $10.4 billion loss in 2008 due to
the economic downturn, according to the International
Air Transport Association, this additional liability will
likely increase financial stress on the sector, depending on
how much of the extra costs airlines can pass through to
passengers. U.S. carriers Delta Air Lines Inc. (B/Negative/--)
and United Air Lines Inc. (B-/Watch Neg/--) will reportedly
face the largest shortfall of allowances in 2012 when they
will have to buy carbon allowances of 3.5 and 3.3 million
metric tons, respectively. We understand American Airlines
Inc. (B-/Watch Neg/--) is also likely to face a large bill. The
biggest buyer in the EU, meanwhile, is likely to be British
Airways PLC (BB/Negative/--) with an estimated shortfall
of three million metric tons of CO2.
What has been the impact of the EU ETS so far on
European corporate credit quality?
To date, the effects of Phase II of the ETS (2008-2012) on
European corporate credit quality are broadly in line with
our expectations. Given the adequacy of the allocations
relative to emission caps, there has been no material
negative impact on credit quality overall. In some cases,
because of overallocation and reduced industrial output
arising from the economic downturn, the effect has been
positive according to our analysis. The rating on French
chemicals company Rhodia S.A. (BB-/Stable/B), for
example, has benefited from carbon credits. This is because
of the company’s involvement in generating and trading
certified emission reductions (CERs) from its own carbon
emission-reduction projects. All rating actions on Rhodia
since the beginning of 2007 factor in the material CERs
the company was able to receive. Our rating on Rhodia
also takes account of the very high margin available from
these activities (an EBITDA margin of more than 90%) and
their material free cash flows. We expect carbon credits to
remain the group’s main source of cash flow in 2009 and
2010, as they were in 2008 and 2007. In the latter two
years, we believe free operating cash flow (FOCF) would
have been negative had it not been for the sale of carbon
credits.
Similarly, by selling carbon credits in the first quarter of
2009, Belgian-based lime producer Carmeuse Holding S.A.
(B+/Watch Neg/--) was able to comply with its financial
covenants. Carmeuse, with multiregional and global
operations, monetises the credits it receives, translating
them into a source of financing that in our view has been
favorable relative to the group’s other debts. However,
given the lack of further credits that the group can sell
and our concerns regarding covenants and refinancing,
we placed the rating on Carmeuse on CreditWatch with
negative implications on July 9.
What about firms that so far have benefited from
carbon markets?
In our view, the effect of ETS Phase III compliance on
firms that have benefitted from the carbon markets, such
as Rhodia, is uncertain. Up to the start of Phase III in
2013, we anticipate that carbon prices will continue to
fluctuate, as they have in the past. Currently, CER prices
are approximately €12-€13 t/CO2e, about one-half of their
2008 level (see chart 4).
Over the next two to three years we believe carbon prices
are likely to remain volatile and potentially depressed,
at least until the start of ETS Phase III when the market
moves from a net long position to a net short position.
This will occur when demand for carbon credits from
companies will exceed current supply. Rhodia’s registered
carbon emission-reduction projects mature in the second
half of 2013. Thereafter, it’s possible that registration of
such projects will not be renewed by UNFCCC, or will
be renewed on less favorable terms. However, in our
view price support should remain strong over the longer
term given the more stringent caps imposed on industrial
companies post-2012, and there remains an incentive for
projects to continue generating CERs in this period. That
said, the proposed reform of the CDM–-the mechanism
that provides the framework for the vast bulk of carbon
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
51
of CO2)
300
250
Emissions
Trading Commentary
200
150
100
50
018 2019 2020
0
2008 2009f 2010f 2011f 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 2020f
f--Forecast. Source: Point Carbon.
What
Are The Implications Of The New Emissions Trading Scheme On European
© Standard & Poor’s 2009.
Companies? Continued
Chart
Chart 44
The Clean Development Mechanism:
A Low Cost Alternative to Emission
Reductions?
Platts Over-The-Counter CERs Futures 2008-2009
(End Of Year Delivery)
2009 CER
2010 CER
2011 CER
2012 CER
30
25
20
15
10
5
ke
%
15/7/2009
6/3/2009
24/6/2009
20/4/2009
5/12/2009
3/5/2009
26/3/2009
22/1/2009
2/12/2009
12/8/2008
31/12/2008
27/10/2008
17/11/2008
15/9/2008
10/6/2008
8/1/2008
22/8/2008
7/11/2008
30/5/2008
2008
20/6/2008
0
CERs--Certified emission reductions. Source: Platts.
© Standard & Poor’s 2009.
credit generation–-may temper this positive effect (see box
below). Refining
paper impact of the revised EU ETS on
What isPulp
theandlikely
the Clean Development Mechanism?
Pig iron and steel
The revised ETS directive extends a company’s right to use
carbon credits
resulting from emission-reduction or offset
Other or not applicable
projects undertaken in developing countries to cover part
of the emissions
Metal ore for the third trading period (see box right).
These credits are termed Emission Reduction Units (ERUs)
Glassimplementation
and glass fiber
from joint
(JI) projects, and CERs from
CDM projects.
Combustion installations
In a statement given to the Credit Markets Insights
conference
in Copenhagen on March 17, 2008, Jos
Coke
Delbeke, Deputy Director General of Environment at the
Commission,
that the EU wishes to move away from a
Ceramic said
products
project-based CDM to a sectoral approach. It believes such
andincrease
lime
a move Cement
would
the quantity of credits available,
as well as provide a transition for developing countries
to establish overall caps on their emissions. While reform
of the CDM will be negotiated at the UN conference in
Copenhagen later this year, the EU has already put forward
the basis for establishing more stringent provisions
52
The Clean Development Mechanism (CDM) is
a flexible mechanism established under the Koto
Protocol to help developed countries with binding
greenhouse gas (GHG) reduction targets meet their
compliance obligations to lower cost.
Under the CDM, developed countries and
companies based in those countries can finance
carbon reduction projects in developing countries.
Once a project is completed, developed countries
can generate Certified Emissions Reduction (CER)
Credits that they can use to offset their emissions.
There is a strong link between Kyoto’s flexible
mechanisms and the EU ETS. Under the ETS,
companies can use CER’s from CDM projects to
achieve compliance with their emissions-reduction
obligations. It is often far cheaper both to lower
GHG’s and to generate carbon units in material
quantities in developing countries than it is in
Europe.
Some have criticised the CDM mechanism, mainly
on the grounds of the transparency and quality
of emission-reductions projects, but also on its
implications for competitiveness. That’s because most
CDM projects have been in China, India and Brazil.
For this reason, reform of the CDM is one of the key
features of the U.N. climate change negotiations in
Copenhagen in December.
The EU argues that for advanced development
countries and highly competitive economic sectors
(oil and gas, cement and metals and mining, for
example), project-based CDM should be phased
out in favor of a sectorial carbon market crediting
mechanism. Also, it stresses that CDM should credit
only those projects that deliver real additional
reductions and go beyond low-cost options such as
hydofluorocarbon (HFC) reduction programs.
for the use of CDM credits in Phase III of the EU ETS.
According to the EU, the revisions would include setting
out quantitative levels, the examination of eligible project
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
types, and possibly a restriction on the number of credits
earned by such projects. Equally, credits could be excluded
altogether.
Quantitative levels.
The overall use of credits is limited to 50% of the EU-wide
reductions between 2008 and 2020. New sectors and new
entrants in the third trading period will have a guaranteed
minimum quota allocation of 4.5% of their verified
emissions during 2013-2020. For the aviation sector, the
minimum quota allocation will be 1.5%. The decision to
set the exact quantitative level on the use of JI/CDM credits
should occur by Dec. 31, 2010.
Quality criteria.
Only credits from project types eligible for use in the EU
trading scheme during 2008-2012 will be accepted in 20132020. Furthermore, the EU also anticipates the setting up of
quality criteria. For instance, from Jan. 1, 2013, measures
may be applied to restrict the use of specific credits from
projects with a huge environmental impact such as large
hydroelectric schemes. The outcome of the Copenhagen
conference in December will also determine the status of
quality criteria.
Where do cap-and-trade programs outside of
Europe stand?
At present, the EU ETS is the only large-scale cap-andtrade scheme in operation, although this is likely to change
within the next two to three years. On June 26, the U.S.
House of Representatives passed the Clean Energy and
Security Act, the so-called “Waxman-Markey” bill, which
aims to introduce a Federal cap-and-trade scheme similar
to the EU ETS but on a much larger scale. WaxmanMarkey pledges a 17% reduction in GHG emissions by
2020 and 83% by 2050, from 2005 levels. A slim majority
in the House of Representatives approved the bill and the
Senate is now debating it, with enactment likely by end of
2009 or early 2010.
Other regions are introducing similar programs: We
understand that Australia’s Carbon Pollution Reduction
Scheme (CPRS) and New Zealand’s ETS will likely
become operational in 2011–-a year later than originally
envisaged–-and will follow similar rules to the EU ETS.
Carbon trading schemes are also under development in
Korea, Japan, Mexico, and Canada.
This report and the ratings contained within it are based on published
information as of September 10, 2009 unless otherwise specified.
Pricing.
The demand for CERs among EU compliance buyers will
determine the price of carbon credits, as will the supply
originating from CDM projects in developing countries.
The Copenhagen negotiations and the proposed EU
reforms are likely to affect both. We believe that demand
should in theory be strong in Phase III due to the overall
allocation shortage relative to forecast emissions that we
anticipate (see chart 1). In practice, supply may struggle to
match demand, since we understand from carbon market
participants that obtaining UN approval for CDM projects
has become increasingly difficult. Another key variable
is what happens in the U.S., where proposed legislation
allows the import of up to 1.5 billion metric tons per
year of international offsets. Compared with the 234
million metric tons of CERs imported into the EU in 2008,
satisfying the demand for carbon credits in the U.S. is in
our view going to have a major impact on future prices.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
53
Low Carbon Investing Case Study
Achieving Market Returns With Carbon
Efficiency In A Cap-And-Trade World
Contact:
Alka Banerjee, Vice President, S&P Indices,
New York (1) 212 438-3536
[email protected]
W
ith carbon cap-and-trade legislation already in place
in Europe and a real possibility in the U.S. and
around the world, many investors are now focusing on
the issue of climate change from carbon dioxide emissions,
and making their investments with these issues in mind.
While some carbon dioxide or other greenhouse gases
(GHG) may be natural by-products of many industry
processes and economic activities, companies are starting
to recognise that they can reduce some of their emissions.
Increasingly, analysts are seeing cases where two or more
firms with similar products or services in the same country
are emitting significantly different amounts of GHG
(in both absolute amounts and relative to output when
measured as tons of carbon dioxide emissions per unit of
revenues). For many investors and investment managers,
directing their investments toward companies with lower
carbon emissions is a strategy they believe could strengthen
their portfolios under any cap-and-trade scenario. To do
that, though, they must be able to determine a company’s
carbon efficiency, and track carbon-efficient market indices
with broader ones. To address this need, Standard & Poor’s
has introduced its U.S. Carbon Efficient Index, which tracks
the S&P 500 performance but with one-half the emissions
of an S&P 500 portfolio.
In the near future, Standard & Poor’s plans to launch
an Emerging Markets Carbon Efficient Index to measure
the performance of large and mid cap emerging market
companies with relatively low carbon emissions, while
seeking to closely track the return of the S&P/IFCI Large
mid index. By leveraging the S&P/IFCI Largemid Index,
the leading emerging market index, S&P will provide the
market with the first broad emerging market index that
can be used to provide investment vehicles with a reduced
carbon exposure and a performance similar to that of the
original index.
Analysing Carbon Efficiency
Carbon efficiency simply measures a company’s emissions
per U.S. dollar revenue it earns. Trucost, a global research
54
company, has partnered with Standard & Poor’s Index
Services to provide the carbon emissions data.
Trucost uses a methodology that calculates the
company’s total GHG emissions. The methodology
breaks down the company’s financial results into small
subcategories of various business activities. It looks at
each activity’s revenues and costs, and then a predefined
model produces each company’s profile with quantities of
resources and emissions. Trucost also scrutinises company
disclosures and public registries, and incorporates them if
appropriate.
Some sectors pollute more than others. Energy or
material sector companies should always have more
GHG emissions than financial or technology companies.
However, who pollutes more isn’t always so obvious.
Banks may have a significant carbon footprint by virtue
of the companies they finance or hold stakes in. Industrial
companies could be getting materials from companies that
are far less efficient than their peers. Therefore, analysing
the supply chain will give a more complete picture. An
analyst will take into account direct operational emissions,
purchased energy, and supplier emissions when calculating
emissions.
Trucost analyses the company’s resource usage and
emissions and its supply chain, and then applies external
prices to resources and emissions to allow for comparisons.
The company gets a brief summary of the conclusions, is
allowed to provide its own explanations or corrections, and,
finally, Trucost reviews and incorporates them if applicable.
Public domains also can yield any company disclosures of
emissions information. To reach a normalised total GHG
score, Trucost divides it by total revenues in U.S. dollars
to produce a number-labeled “carbon footprint per dollar
revenue earned,”a footprint that determines a company’s
carbon efficiency. A large multinational company may have
large total GHG emissions, but by dint of using up-to-date
and relevant technology, it may be far more efficient than a
smaller company with smaller emissions but with far worse
industry practices. Therefore, this footprint is our most
valuable barometer of true carbon efficiency.
Using Market Indices In Carbon Investing
Investors traditionally look at equity indices to help inform
their investment decisions. When it comes to matters
“green,” benchmarks that track environmentally friendly
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
The U.S. Carbon Efficient Index
A close tracking error with the S&P 500
Since its inception in 2004, the Carbon Efficient Index has
followed the S&P 500 closely (see chart 1).
As expected, the tracking error between the two indices
is quite tight in the years 2004-2007, falling below 1% and
going up to 1.67% in the very volatile 2008 and a more
Chart 3
Historical
The Wors
Chart
Chart 11
Index Historical Performance (At June 30, 2009)
S&P 500
S&P U.S. Carbon Efficient (Total Return)
S&P 500
Excl. wo
160
Jun-09
© Standard & Poor’s 2009.
Jan-05
0
Sep-04
Dec-08
Mar-09
Jun-08
Sep-08
Dec-07
Mar-08
Jun-07
20
Sep-07
40
0
Dec-06
20
Mar-07
60
Jun-06
80
40
Sep-06
100
60
Dec-05
120
80
Mar-06
140
100
Jun-05
120
Sep-05
160
Mar-05
140
Sep-04
The traditional approach to environmentally friendly
indices, namely clean industry indices and environmental
indices, has no proven history of outperforming
conventional broad market indices. This is due to the relative
short time the investment option has been around, and the
varied and confusing legislation on environmental issues
that may contain loopholes. The fiduciary responsibilities
of company boards and pension funds do not permit them
to investment heavily in an environmental strategy that
cannot guarantee a market-accepted return.
The importance of globally accepted benchmarks and
their relationship to a carbon-efficient strategy comes
in here. Using the S&P 500, the globally recognised
bellwether for the U.S. markets, S&P Index Services
devised an approach that could guarantee an investor U.S.
market returns by keeping the tracking error between the
S&P 500 and the new S&P U.S. Carbon Efficient Index
low--in the range of 1% to 1.5%. Another advantage is
that stocks drawn from the S&P 500 were either dropped
due to their high carbon footprint levels and the remaining
stocks’ weights were altered to bring about an almost
50% reduction in carbon exposure. The advantage of this
approach is that the investor is assured of market returns
while being able to invest in a “greener” portfolio.
Trucost provides us with each stock’s total GHG and
carbon footprint each quarter. All stocks in the S&P 500
are then put in Northfield Information Services Inc.’s
Portfolio Optimizer, which models risk. The aim is to
remove a minimum of 100 stocks and a maximum of 150
stocks with sector weights being kept to 50% (a 5% buffer
if provided for the first stock that breaches the limit) of the
original portfolio. Within these constraints, the approach
is to target 40% to 55% carbon footprint reduction with
a tracking error of 1%. This process repeats each quarter
to match the quarterly rebalancing of the S&P 500, and
invariably the results vary each quarter, but still the results
are quite consistent. The index maintenance itself tracks
the S&P 500 as closely as possible with share changes and
corporate actions being handled on the same dates and in
the same manner as the parent index.
Dec-04
or socially responsible companies include:
n Clean industry indices follow companies that directly
create clean technology or benefit from environmental
trends. These are relatively narrow in scope and don’t
reflect the market.
n Environmental indices use environmental screens to
create lists of companies with desired characteristics.
They may deviate significantly from the broader market
due to sector or individual security allocations.
n Carbon emissions trading indices consist of carbon
credits and derivatives (European Union Allowance
[EUA], Certified Emission Reductions [CER]). These
indices also have exposure to nonequity investment.
n Broad market index tracking indices specifically track
a broad market index, balancing tracking error and
carbon reduction. The S&P U.S. Carbon Efficient Index
fits precisely into this category, where the investor is
provided an opportunity to get access to the broad
market returns of an established index, in this case the
S&P 500 for the U.S. market, with an ability to have a
reduced carbon exposure.
© Standard & Po
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart 2
Annual Carbon Footprint Comparison
55
Low Carbon Investing Case Study
Achieving Market Returns With Carbon Efficiency In A Cap-And-Trade World
Continued
Historical Index Performance Excluding
The Worst Polluters
400
350
Chart
2
Chart
300 2
S&P U.S. Carbon Efficient (Total Return)
160
Chart
3
140
Historical Index Performance Excluding
120
The
Worst Polluters
100
80
60
40
20
Jan-09
Sep-08
May-08
Jan-08
Sep-07
Jan-07
May-07
Sep-06
May-06
Sep-04
80
Jan-06
0
100
Sep-05
120
Excl. worst polluters
May-05
140
S&P U.S. Carbon Efficient (Total Return)
Jan-05
160
S&P 500
60© Standard & Poor’s 2009.
40
20
Summing
Up
Jan-09
Sep-08
May-08
Jan-08
Sep-07
May-07
Jan-07
Jan-06
Sep-05
May-05
Jan-05
In0 conclusion, as cap and trade becomes more of a reality
with a direct punitive financial impact on companies, we
can no longer afford to be complacent about the emission
behavior
of our
©
Standard & Poor’s
2009. corporate entities. Yet it remains essential
to marry market performance with the green approach to
investing. The S&P US Carbon Efficient Index provides an
alternative that could be palatable to most.
Sep-04
Jun-09
Dec-08
Mar-09
Jun-09
Mar-09
Sep-08
Jun-08
Sep-08
Dec-08
Dec-07
Mar-08
Jun-08
Mar-08
Jun-07
Sep-07
Sep-07
Dec-07
Dec-06
Mar-07
Jun-07
Mar-07
Sep-06
Jun-06
Sep-06
Dec-06
Dec-05
Jun-05
Mar-06
Jun-06
Mar-06
Dec-05
Jun-05
Sep-05
Mar-05
Sep-04
Dec-04
Sep-05
Excl. worst polluters
Mar-05
The 160average carbon footprint of a typical S&P 500
portfolio ranges from 280 to 400, while that of a portfolio
140
linked to the S&P U.S. Carbon Efficient index ranges from
120
Chart
1 Reductions range from 40% to 55% for the
170
to 200.
100
portfolio
over the five-year
history (see
chart 30,
2). 2009)
Index Historical
Performance
(At June
80 greenhouse gas emissions, a simple aggregation of
Total
S&P 500
S&P U.S. Carbon Efficient (Total Return)
60
all emissions
regardless of normalisation via revenue, are
160
also
reduced drastically. For an S&P 500 index, the total
40
140 ranges from 15 million tons of carbon emissions to
GHG
20
120 to 23 million tons. This number is brought down to
close
0
less
100than 8 million tons, a reduction of more than 60%.
What if we did not go through a process of optimisation
80
and60 simply removed the worst polluters? We ran a placebo
© Standard & Poor’s 2009.
exercise where we removed the same stocks as in the
40
carbon-efficient version (which ensured some consistency
20
in sector balance) and plotted the performance against
the 0S&P 500 and the Carbon Efficient Index. The results
Chart
as we
see 2them are considerably less satisfactory in terms
of performance
(see Footprint
chart 3). Hence
the lauded objective
Annual Carbon
Comparison
Standard &to
Poor’s
2009. invest in the cleanest companies can
of©trying
simply
S&P U.S. Carbon Efficient
S&P 500
frequently
lead to unexpected results.
450
Sep-04
S&P 500
Dec-04
S&P 500
U.S. Carbon Efficient (Total Return)
A reduction
in carbonS&P
emission
Sep-06
Index Historical Performance (At June 30, 2009)
Chart
Chart 33
May-06
reasonable 1.39% in 2009, when the first half of the year
saw some volatility. The average for the entire period is
Chart 1
1.12%.
250
Annual
Carbon Footprint Comparison
200
S&P U.S. Carbon Efficient
150
450
100
400
50
350
0
300
250
2004
2005
About Standard & Poor’s Indices
S&P 500
2006
2007
2008
2009
200© Standard & Poor’s 2009.
150
100
50
0
2004
2005
© Standard & Poor’s 2009.
56
2006
2007
2008
2009
Standard & Poor’s Indices maintains a wide variety
of investable and benchmark indices to meet an
array of investor needs. Over $1 trillion is directly
indexed to Standard & Poor’s family of indices,
which includes the S&P 500, the world’s most
followed stock market index, the S&P Global 1200,
a composite index comprised of seven regional and
country headline indices, the S&P Global BMI, an
index with approximately 11,000 constituents, and
the S&P GSCI, the industry’s most closely watched
commodities index. For more information, please visit
www.standardandpoors.com/indices.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Table 1: Top 10 Weights*
Name
Sector
Weight (%)
ExxonMobil Corp.
Energy
4.35
Microsoft Corp.
Information technology
2.16
Johnson & Johnson
Health care
1.86
Procter & Gamble
Consumer staples
1.85
AT&T Inc.
Telecommunication services
1.78
Chevron Corp.
Energy
1.76
General Electric Co.
Industrials
1.73
International Business Machines Corp.
Information technology
1.73
JP Morgan Chase & Co.
Financials
1.65
Apple Inc.
Information technology
1.48
Chevron Corp.
Energy
2.38
Microsoft Corp.
Information technology
2.33
Johnson & Johnson
Health care
2.16
Procter & Gamble Co.
Consumer staples
2.13
AT&T Inc.
Telecommunication services
2.06
General Electric Co.
Industrials
1.79
JPMorgan Chase & Co.
Financials
1.72
Apple Inc.
Information technology
1.55
Wal-Mart Stores Inc.
Consumer staples
1.54
Verizon Communications Inc.
Telecommunication services
S&P 500
U.S. Carbon Efficient
1.5
Largest companies excluded after optimisation
Name
Sector
Weight in the S&P
U.S. Carbon Efficient
ExxonMobil Corp.
Energy
4.35
International Business Machines Corp.
Information technology
1.73
Coca-Cola Co.
Consumer Staples
1.18
Philip Morris International Inc.
Consumer Staples
1.03
PepsiCo Inc.
Consumer Staples
1.01
Goldman Sachs Group Inc.
Financials
0.89
Abbott Laboratories
Health Care
0.85
ConocoPhillips
Energy
0.79
Occidental Petroleum Corp.
Energy
0.67
United Parcel Service Inc.
Industrials
0.61
*Data as of June 12, 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
57
UK Equity Income Funds Annual Review
UK Equity Income Funds
Contact:
Peter Brunt, Fund Analyst, S&P Fund Services,
London (44) 20-7176-8412
[email protected]
KEY FACTS
Sector name: UK Equity Income
Review period: 1 September 2008 - 30 August 2009
O
ur 2009 annual review of UK equity income and its
associated sectors has produced 23 S&P rated funds:
14 in the mainstream UK equity income sector, plus four
equity income & growth funds and five equity & bond
funds.
Changed ratings
Reassuringly, in a year in which the UK suffered its worst
meltdown in living memory, followed by one of the fastest
rebounds, we found only three cases in which the existing
S&P rating required amendment. Each arose from a change
in fund manager. These three funds were F&C Stewardship
Income and F&C UK Growth & Income, both until recently
managed by Ted Scott and now with Catherine Stanley and
Hilary Aldridge respectively; and Aviva UK Equity Income
Fund, which has landed in the safe hands of Chris Murphy
following Daniel Roberts’ move to Gartmore.
Changes to sector
Splitting the UKEI sector caused only four S&P rated funds
to be reclassified, none of which required a ratings change.
There are two extremes of equity income investing. The
first treats income as mandatory and aims to provide its
investors with a steadily rising stream of income in the
form of regular distribution payments. These managers
may on occasion need to raise exposure to higher yielding,
potentially lower quality stocks, but therein rests the skill
of the manager. Managers in this group include Richard
Hughes of M&G and Tineke Frikkee of Mellon.
The contrasting view treats equity income investing as
a discipline that keeps the manager focused on company
fundamentals in order to produce an above average total
return. Potential income is rolled up with the fund. Between
the extremes are the vast majority of managers who look
to provide a growing income without endangering capital
and will therefore reduce their distribution payments when
required.
In recent years, the Investment Management Association
(IMA) has introduced two initiatives to help differentiate
58
Number of rated funds: 23
Dispersion of ratings:
AAA – 5
AA – 9
A–8
NR – 1
Index Performance:
• FTSE All Share: calendar 200 -29.9%; 2009 to 31
August 17.8%.
Peer groups:
• UK equity income mainstream
• Median fund performance: calendar 2008 -27.9%;
2009 to 31 August 13.7%.
• UK equity income & growth
• Median fund performance: calendar 2008 -27.4%;
2009 to 31 August 11.0%.
• UK equity & bond
• Median fund performance: calendar 2008 20.5%;
2009 to 31 August 10.6%
between these funds. By placing yield calculations on
a uniform footing it has been able to use them to create
three equity income fund sub-sectors. While entry to the
mainstream UK equity income sector still requires a yield
premium of at least 10% over that of the FTSE All Share
index, a new sector, UK equity income & growth, has been
formed to house those funds on a yield of between 80%
and 110% that of the index. Strange days, indeed, when
income funds have official approval to run on a sub-market
yield. The third category, UK equity & bond funds, remains
unchanged.
Following this new categorisation in March 2009,
17 funds were reassigned to the UK equity & growth
sector, including three S&P rated funds from Invesco
Perpetual - Income, High Income and Strategic Income
- which were moved on yield considerations, along with
Henderson Global Care UK Income Fund, which moved
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
voluntarily despite meeting the 110% yield target to stay
in the mainstream sector. None of these moves were cause
for a ratings change. The appearance of Neil Woodford,
manager of the Invesco Perpetual Income and Higher
Income funds, was no surprise given his views on capital
preservation, while Henderson’s George Latham was
simply gaining an extra degree of freedom in an uncertain
market environment, having raised his annual distributions
in each of the last six years.
Despite last year’s fuss over Neil Woodford’s two funds
operating on sub-market yields, both are now on yields
comfortably above the 110% premium required for them
to stay in the mainstream UK Equity Income sector, but
that can change. No changes occurred in the UK equity &
bond sector.
Fund performance
Table 1 shows the annual and cumulative returns in sterling
of funds to 1 September 2009, in the UK equity income,
UK income & growth and UK equity & bond sectors.
The defensive qualities of equity income investing shone
in 2008, but fared less well in the low quality cyclical rally
encountered in 2009.
Our review period covered the 12 months to 1
September 2009 and so included the 2008 collapse and
the 2009 rebound in UK equities. To highlight this we
considered performance over two periods: September 2008
to March 2009, followed by March to September 2009. In
general, large-cap defensive stocks - and thus UK equity
income portfolios - performed well in 2008, but have faced
a strong headwind in 2009 during the rally in low quality,
low yielding cyclicals.
Over the first six months of our review period, UK equity
income funds in general fell by around 27.5%, compared
to fall of 30% fall in the FTSE All Share index and 31%
for the median UK growth fund. From March to September
2009, however, fortunes flipped, with the median equity
income fund up by 14% against rises of 17% and 18%,
respectively, from its UK growth counterpart and the FTSE
All Share index. In addition, while there was little difference
in returns in the UKEI sub-sectors over the initial sixmonths of our review period, when markets were falling,
clear differences appeared in the following six months. In
this rising market, mainstream UKEI funds rose by almost
14% in six months, equity income & growth funds gained
only 11% and equity & bond funds, just 10.5%.
Relative returns from the three sub-sectors - equity
income, income & growth and equity & bonds - reflects the
shift in the underlying market from defensive to aggressive.
In the bear climate of 2008, equity & bond funds came
out ahead by being the most defensive. The year-end results
show the sub-sector average fund to be down roughly
22% compared to 27% for income & growth funds and
29% for mainstream equity income funds. This is further
underscored by the best and worst performances in the
mainstream UKEI sector being more extreme in 2008 than
in the other two sectors.
Over 2009 to date, the opposite has been true, with
mainstream equity income funds up on average by around
15.5%, compared to 12.3% in the income & growth and
10.5% in the equity & bond sectors.
For equity & bond funds the credit quality of the bond
exposure was a key factor in performance.
Although funds with a higher allocation to bonds
outperformed in 2008, the type of bond was key. Fund
managers holding corporate bonds underperformed in
2008. As the credit markets collapsed, the lower the
investment grade, the worse the performance. Managers in
AAA rated credits achieved relative outperformance.
As on the equity side, very few managers were successful
in gauging either the extent of the market falls in 2008,
or the change in market sentiment in 2009. Tony Nutt
(Jupiter) under performed in 2008 due to his colleague,
Ariel Bezalel’s, decision to overweight corporates. To
Bezalel’s credit however, he stuck with this stance and has
outperformed in 2009.
Tim Rees (Insight Monthly Income Fund) outperformed
in 2008 by keeping his bond exposure in gilts, along with
high levels of cash and a bias towards FTSE 100 names on
the equity side. But this proved too defensive in 2009.
Distributions
Despite the increasing number of rights issues and dividend
cuts over the past 12 months, all S&P-rated UK equity
income funds grew their annual dividend payment in 2008.
The prospects for 2009, however, are less promising.
The historic dividend yield on the FTSE All Share index
has changed markedly over the last 18 months reflecting
the market crash and subsequent rebound. Having held at
around 3% since 2004, it shot up to 4.5% in 2008 and
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
59
UK Equity Income Funds Annual Review
UK Equity Income Funds Continued
Table 1: Sector Performance For Selected Percentiles
UK equity income sector
Cumulative
to 01/09/2009 (%)
Calendar year (%)
2005
2006
2007
2008
2009 YTD
5Yrs
3Yrs
FTSE All Share GBP
22.1
16.7
5.3
-29.9
17.8
35.8
-6.3
Top fund
38.6
25.7
9
-18.5
45
60.7
14.3
Top Decile
24.3
21.8
4.7
-21.9
27.2
45.9
1.2
Upper quartile
22.8
20.3
2.2
-24.6
18.7
37
-4.9
Median
20.9
18.5
-0.5
-27.9
13.7
26.6
-10.3
Bottom quartile
19.4
17
-4.2
-32.3
10.6
18.3
-17
Bottom decile
17.1
14.8
-7.3
-36.7
7.3
10.9
-20.5
5
-17.1
-16.9
-53.6
-24.2
-12.5
-37.4
UK 20.8
equity income
18.2 & growth
-1.1 sector -29
15.5
27.2
-10.5
Bottom fund
Average
UK equity income & growth sector
FTSE All Share GBP
Cumulative
to 01/09/2009 (%)
Calendar year (%)
2005
2006
2007
2008
2009 YTD
5Yrs
3Yrs
22.1
16.7
5.3
-29.9
17.8
35.8
-6.3
Top fund
27.5
27.7
7.5
-11.7
33.2
61.3
6.5
Top Decile
26.5
27.5
7.3
-18.9
24.5
60.6
1.2
Upper quartile
23.6
23.8
6
-19.6
15.5
54.6
-2.6
Median
20.1
18.4
2.6
-27.4
11
32.7
-11.3
Bottom quartile
17.7
17.2
-1.5
-31.6
5.4
25.6
-14.3
Bottom decile
12
15.2
-3.2
-34.1
2.7
16.3
-16.6
Bottom fund
11
14.1
-5.5
-44.6
1.7
7.9
-18.3
-26.8
12.3
37.5
-8.5
Average
UK equity 20
& bond sector
20.2
2.1
UK equity & bond sector
Cumulative
to 01/09/2009 (%)
Calendar year (%)
2005
2006
2007
2008
2009 YTD
5Yrs
FTSE All Share GBPP
22.1
16.7
5.3
-29.9
17.8
35.8
-6.3
Top fund
29.2
23.4
8.9
-11
27.4
56.7
19.8
Top Decile
20.7
17.2
5.3
-14.4
15.2
42.2
0.8
19
16.1
2.3
-19
12.8
34.8
-1.7
Median
17.2
12.3
-0.7
-20.4
10.6
28.2
-7.7
Bottom quartile
16.1
10.4
-2.1
-23.3
7.2
19.6
-12.4
8.6
6.4
-3.8
-27.2
4.3
4.3
-14.1
7.5
5.4
-11.7
-41.9
3
-13.2
-37.2
16.7
12.7
0.3
-21.6
10.5
26.6
-7
Upper quartile
Bottom decile
Bottom fund
Average
60
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
3Yrs
now rests at around 3.5% and falling.
Historically, banks have contributed a significant part
of the market’s yield, so any reduction on this front was
going to be noticeable. However, when this occurred in
late 2008 the negative impact was delayed by the overall
equity market collapse. Falling share prices meant that the
FTSE All Share index closed 2009 on a dividend yield of
4.49%, its highest level in over four years. As a result, every
S&P-rated equity income fund manager increased their
distribution rate for calendar year 2008.
Since then, however, the missing bank dividends and
steep share price rises have seen the market yield fall back
to around 3.5%, with 3.25% as the year-end consensus.
Extending annual income growth into 2009 has been a
far more difficult task and most managers are expecting
to have to cut their distribution payments. Threadneedle’s
Leigh Harrison, for example, stated that although the
distribution on his two S&P AA-rated Threadneedle funds
- UK Equity Income Fund and UK Equity Alpha Income had grown consistently over the past few years, he expected
a cut of around 10% over 2009. This 10% figure was
typical across all of our fund manager interviews. Taking a
cautious view on how long it will take before we see good
dividend growth again, Harrison was also careful not to set
the bar too high for 2010.
Clive Beagles (JOHCM UK Equity Income Fund),
commented that he believed that most dividend cuts had
taken place in the UK market and he was thus expecting
a slightly smaller reduction in his distribution of around
7.5% relative to 2008. He also predicted no growth of
the annual income in 2010, citing a headwind from a
weakening US dollar when around 40% of UK dividend
flows are paid in US dollars.
In contrast, Nick McLeod-Clarke (BlackRock Income
Fund) was more confident stating that not only had his
fund never cut its dividend, but that it was also on target to
grow the annual distribution in 2009.
A pragmatic approach to yield has benefited
performance
The more successful managers over the last 12 months have
been those prepared to adopt a flexible approach to income
investing and hold low-yielding stocks alongside high
yielding names, varying the balance in favour of the latter
in 2008 and the former in 2009. Notable beneficiaries of
this strategy included Nick McLeod-Clarke (BlackRock),
Clive Beagles (JOHCM), Michael Gifford (Old Mutual)
and Karen Robertson (Standard Life).
Clive Beagles showed an interesting variation on this
approach by shifting the balance of his portfolio in late
2008 via opportunistic holdings in “distressed assets”.
These short-term positions within a generally defensive
portfolio included various mid-/small-cap names, along
with Rio Tinto and Kazakhmys, which, for a short time,
qualified on yield grounds due to their depressed share
prices and were sold when their yields reached market
levels. In doing so, Beagles’ was one of very few funds that
outperformed in 2008 and 2009.
Some funds, however, are mandated to invest only in
stocks that offer a yield premium to the market. One such
example, is BNY Mellon Newton Higher Income Fund,
where fund manager Tineke Frikkee, produced very strong
outperformance in 2008 by staying underweight banks and
miners - and overweight tobacco, utilities and healthcare
- but lost ground in 2009 when she stayed true to her
approach with high-quality defensive names at a time
when low-quality cyclicals outperformed.
The search for success has seen increased turnover in the
portfolios as managers have tried to deal with the increased
sector rotation. Managers with a clear top-down view have
been the more successful.
The extreme market conditions over the past 12
months have seen rapid rotation between sectors, driven
primarily by macroeconomic factors including corporate
nationalisation, inflation/deflation and commodity price
inflation. Managers with a clear top-down element in their
approach should have had a clear advantage over their
pure stockpicking counterparts, although getting the topdown view right proved highly challenging for even the
most experienced managers.
Brian Gallagher, for example, (UBS UK Equity Income)
is an experienced fund manager with a successful track
record in using top-down themes to set weights for the
individual elements of his seven-segment portfolio mega-caps, mid-/small-caps, high yielders, growth stocks,
recovery, tactical opportunities and Europe. Yet even
he underestimated the extent of the market collapse in
2008 and was caught holding a number of banks, miners
and small-cap growth stocks. To his credit he shifted the
portfolio quickly to a highly defensive position, limited
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
61
UK Equity Income Funds Annual Review
UK Equity Income Funds Continued
losses and ended the year only marginally behind the sector
median. Since then he has added more “recovery” stocks
to take advantage of the cyclical rally. This worked well
although his relative returns against the peer group were
held back by his cautious holding of high levels of cash.
Top-down input helped Nick McLeod-Clarke’s
BlackRock UK Income Fund to be one of the few funds that
has outperformed in both 2008 and 2009 to date. Having
positioned the fund defensively during the fourth quarter
of 2008, he followed the group’s house view and made
a timely and decisive move into cyclical stocks in March
2009. Raising exposure to banks and miners, including a
6% position in BHP Billiton, kept the fund firmly on an
upward trend.
Given the various style differences within the equity
income sectors, the safest way to create a reliable stream of
income is to combine a mix of funds.
Fund manager changes
There have been relatively few fund manager changes over
the past 12 months.
When Ted Scott changed roles from portfolio manager
to strategist in May 2009, he passed responsibility for
the F&C Stewardship Income Fund to Catherine Stanley,
and for the group’s UK Growth & Income fund to Hilary
Aldridge.
Catherine Stanley is an experienced fund manager,
having focused successfully on UK mid-/small-cap
portfolios since 1991. While her tenure on the Stewardship
Income Fund represents her first lead manager role on an
all-cap mandate, she is closely supported by the rest of
the UK team. This includes three experienced large-cap
managers, who she will draw on for stock selection further
up the cap scale. The fund therefore achieved an S&P A
(New) rating.
Although Hilary Aldridge had worked closely with Scott
on the UK Growth & Income fund since 2005, she has
more limited experience as a lead portfolio manager. She
has managed the F&C Special Situations Fund with limited
success, albeit in difficult markets, since December 2007.
We welcome the integration of Aldridge into the wider
UK team and the creation of an income focused sub-team,
both of which will help in the management of this fund.
We also recognise the analytical experience of the manager,
but we are cautious over her lack of lead portfolio manager
62
experience and the fund was therefore Not Rated by S&P
at the time of review.
Chris Murphy took over the management of the Aviva
UK Equity Income Fund in April 2009 following Dan
Roberts’ departure. Murphy is an experienced investor
with a strong track record on UK equities. Commonality
with the investment process used on his successful UK
growth mandates is very high, albeit with a greater focus
on dividend yield, but sufficient to allow the fund to achieve
an S&P A (New) rating.
Risk factors
Risk is a complex and emotive subject. It can be seen as
an inherently negative factor in the sense of increasing
danger, but can also be considered positively in offering
opportunity and reward. We have set out to identify
some of the characteristics that a fund displays that may,
according to the individual circumstances, help advisers to
identify the potential for exposure to excessive risk.
We have constructed two sets of characteristics.
One comprises factors that are related principally to
portfolio construction, and the other is related to historic
performance. Neither category is all-inclusive and we will
build on both as more clean data becomes available. Inputs
based on historic performance offer a statistical insight
into how each fund has performed over the last 36 months,
but past performance cannot predict future returns.
The initial sets of characteristics are given below (see
Tables 3). Each factor is considered useful in understanding
a portfolio and the potential risks involved, but none should
be considered in isolation. Similarly, we would caution
against making cross-sector comparisons, as what may be
significant in a US equity context may be less helpful in
considering, for example, a European equity fund, and vice
versa.
The definitions and comments on risk factors are
designed to provoke thought and should not be considered
as our definitive views. Importantly, while above-average,
average and below-average positions in the tables have
been identified, these are presented as facts and not
interpretations of risk.
Sector Positioning
As a starting point for future reference, we have included
Table 2, showing the sector positioning of S&P-rated UK
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Table 2: Sector Breakdowns - September 2009
Style
Yield
(1)
FTSE All Share benchmark weights
Cons
Goods
Cons
Services
Oil &
Gas
Financials
Health
care
Industrials
IT
Materials
Telecoms
Utilities
Other
Cash
Bonds
%
%
%
%
%
%
%
%
%
%
%
%
%
12
10
18
24
8
7
1
10
6
3
1
0
UK Equity Income funds
Aviva Investment Funds - UK Equity Income
Value
5.5 %
14
13
9
21
9
14
2
3
9
6
0
0
BNY Mellon IF - Newton Higher Income
Value
7.6 %
13
11
18
13
12
11
0
0
8
13
0
1
F&C Stewardship - Income Fund
Value
4.9 %
3
16
8
29
0
12
0
0
8
16
0
8
JOHCM UK Equity Income Fund
Value
4.8 %
5
12
17
31
6
14
0
1
7
6
0
1
M&G Charifund
Value
7.2 %
4
6
14
21
8
12
1
1
12
11
10
0
Old Mutual Equity Income Fund
Value
5.9%
7
14
13
33
2
9
1
9
4
3
4
1
BlackRock UK Income Fund
Blend
4.7 %
6
5
21
31
8
3
3
6
10
4
2
1
F&C IF II - UK Growth & Income Fund
Blend
5.7 %
0
13
14
23
10
5
0
0
8
12
Invesco Perpetual - Income & Growth
Blend
4.5 %
10
17
10
19
10
13
0
1
7
12
0
1
Jupiter Income Trust
Blend
4.8 %
9
5
19
21
11
10
0
0
13
7
1
4
Standard Life - UK Equity High Income Fund
Blend
4.6%
12
7
17
20
10
10
1
8
7
6
0
2
Threadneedle UK Equity Income Fund
Blend
5.3%
9
12
12
22
9
16
0
4
5
6
0
5
Threadneedle SIF - UK Equity Alpha Income
Blend
6.4%
7
16
11
26
10
18
0
0
3
8
0
1
UBS UK Equity Income Fund
Blend
6.8 %
12
13
16
29
8
6
1
5
6
4
0
0
8
11
14
24
8
11
1
3
8
8
1
3
Sector averages for UKEI rated funds
15
UKEI Income & Growth funds
Invesco Perpetual - Income Fund
Value
4.1 %
22
6
6
7
18
10
2
0
10
18
1
0
Invesco Perpetual - High Income
Value
4.3 %
23
6
6
7
17
10
1
1
10
18
1
0
Invesco Perpetual - Income Fund
Value
4.1 %
22
6
6
7
18
10
2
0
10
18
1
0
Invesco Perpetual - UK Strategic Income
Value
3.8 %
19
7
9
10
15
11
1
1
10
15
0
2
Henderson Global Care UK Income Fund
Blend
4.9 %
2
12
4
30
12
14
2
2
10
12
0
0
17
8
6
13
16
11
2
1
10
16
0
0
Sector averages Inc & Gth rated funds
UK Equity & Bond funds
M&G Extra Income Fund
Value
5.7 %
7
5
12
14
6
6
1
2
8
10
5*
0
Old Mutual Extra Income Fund
Value
6.4 %
6
10
11
27
2
7
0
7
4
2
0
1
24
23
CF CanLife Income Unit Trust
Blend
5.8 %
12
2
15
8
13
5
0
3
7
11
1
0
23
Insight Investment Monthly Income Fund
Blend
4.4 %
4
12
12
18
9
6
1
4
8
3
2
1
20
Jupiter High Income Fund
Blend
5.4 %
10
1
15
20
10
6
1
0
8
4
0
2
23
Sector averages E&B rated funds
8
4
14
16
8
8
2
3
6
7
1
1
23
FTSE All Share benchmark weights
12
10
18
24
8
7
1
10
6
3
1
0
(1): gross historic yield
(*): “Other” 5% is preference shares
equity income, UK growth & income and UK equity &
bond funds as at 1 September 2009.
Considering the UK equity income (UKEI) funds first, six
of the managers covered would claim to be value-oriented
in their approach to portfolio construction. Yet as the
table shows, their portfolio positioning shows significant
differences. Chris Murphy, for example, had positioned
Aviva UK Equity Income fund with around 14% exposure
to consumer goods alongside 21% in financials including
very little in banks. In contrast, Clive Beagles (JOHCM
UK Equity Income Fund) had only 5% exposure to the
consumer goods sector, but 31% in financials, again mainly
through property and non-life insurance. As a result,
Beagles had pulled ahead of Murphy by around 7% over
the previous three months having captured more of the
rebound in lower quality cyclicals.
In the UK equity income & growth sector - the new
addition for lower yield equity income funds - Invesco
Perpetual’s positive house view on consumer goods can
be clearly seen with exposures in a tight range from 19%
to 23% reflecting individual mandates and manager
preferences.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
63
UK Equity Income Funds Annual Review
UK Equity Income Funds Continued
Table 3: Portfolio Characteristics
Portfolio as at 1 September 2009
Size £m
No of
holdings
% in
Top 10
Performance characteristics based on 3yr data to 1 September 2009
No. of holdings Monthly
representing Volatility
90% of assets
Beta
RSquared
Sharpe
Ratio
Maximum
Drawdown
Positive
months
(%)
Negative
months
(%)
UK Equity Income
Aviva Investment Funds - UK Equity Income
495
63
43
41
5.0
0.9
0.9
-0.1
-33.1
61
39
BlackRock UK Income Fund
290
45
53
31
5.3
1.0
0.9
-0.1
-35.5
58
42
BNY Mellon IF - Newton Higher Income
2540
72
53
34
4.6
0.8
0.9
-0.1
-34.0
56
44
52
42
56
29
5.2
0.9
0.9
-0.1
-44.5
58
42
F&C Stewardship - Income Fund
242
163
39
109
5.3
0.9
0.8
-0.2
-48.3
56
44
INVESCO PERP UK IS - Income & Growth
452
65
41
48
5.5
1.0
0.9
-0.1
-43.3
58
42
F&C IF II - UK Growth & Income Fund
JOHCM UK Equity Income Fund
243
56
47
41
6.1
1.1
0.8
-0.1
-41.9
56
44
Jupiter Income Trust
2813
65
50
38
5.1
0.9
0.9
-0.2
-41.0
58
42
M&G Charifund
1015
102
47
54
5.3
0.9
0.9
-0.2
-46.3
52
48
Old Mutual Equity Income Fund
37
84
35
59
5.5
1.0
0.9
-0.1
-40.7
56
44
Standard Life - UK Equity High Income Fund
812
63
47
45
5.3
0.9
0.9
-0.1
-37.9
58
39
Threadneedle UK Equity Income Fund
588
62
37
48
4.8
0.9
0.9
-0.1
-31.3
61
39
Threadneedle SIF - UK Equity Alpha Income
181
35
50
50
4.8
0.8
0.9
-0.1
-31.4
56
44
UBS UK Equity Income Fund
43
Average
57
44
41
n/a
n/a
n/a
n/a
n/a
n/a
n/a
70
46
46
5.1
0.9
0.9
-0.1
-37.4
51
43
UK Equity Income & Growth
78
74
44
44
4.3
0.8
0.9
-0.1
-29.6
56
44
INVESCO PERPETUAL UK IS - High Income
INVESCO PERPETUAL - UK Strategic Income
8634
93
56
32
4.5
0.8
0.8
-0.1
-30.5
56
44
INVESCO PERPETUAL UK IS - Income Fund
6432
99
55
38
4.5
0.8
0.8
-0.1
-31.3
58
42
59
71
44
34
6.5
1.1
0.8
-0.1
-49.6
53
47
84
50
50
4.9
0.9
0.8
-0.1
-35.2
56
45
Henderson Global Care UK Income Fund
Average
UK Equity & Bond
CF CanLife Income Unit Trust
208
67
43
46
4.0
0.7
0.9
-0.2
-31.2
56
44
Insight Investment Monthly Income Fund
44
66
58
48
4.3
0.8
0.9
-0.1
-29.8
64
36
Jupiter High Income Fund
591
120
74
43
4.4
0.8
0.9
-0.1
-34.4
61
39
M&G Extra Income Fund
350
143
90
38
4.0
0.7
0.9
-0.2
-34.2
47
53
Old Mutual Extra Income Fund
25
Average
107
80
29
4.8
0.9
0.9
-0.2
-40.5
53
47
100
69
41
4.30
0.80
0.90
-0.1
-34.0
56
44
S&P rated UK equity & bond funds all had broadly the
same 23% exposure to bonds with Richard Hughes (M&G
Extra Income Fund) gaining additional yield by having
around 5% in preference shares. The main differentiating
factor in this sector was in the equity exposure to
financials, which ranged from just 8% for Craig Rippe’s
CF CanLife Income unit trust, to 27% on Old Mutual
64
Extra Income Fund managed by Michael Gifford, who
coincidentally used to run the CanLife fund. Year-to-date,
Old Mutual is comfortably ahead, although we note that
when Gifford took over the Old Mutual fund in January
2009 he inherited a portfolio from Leonard Klahr that was
already overweight financials and running a high cyclical
bias, which boosted early relative returns. Gifford has
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
since continued on an upward trend by raising consumer
exposure and holding a balance of high and lower yielding
stocks.
Portfolio characteristics
Table 3 provides a selection of portfolio characteristics
including size, number of holdings, the percentage of
each portfolio taken up by its 10 largest positions and
the number of stocks making up 90% of each fund’s total
assets.
The number of holdings is provided to give an indication
of the specific risk within a portfolio. The fewer the holdings,
the higher the stock-specific risk. Modern portfolio theory
suggests that 20 holdings is adequate to reduce specific risk
to acceptable levels, but while academics may believe this,
most fund managers are uncomfortable with such a small
number of holdings.
In the combined UKEI and UK equity income & growth
sectors, our survey shows most funds had between 55 and
65 holdings - much the same as last year - with a few outliers
on the upside who have added additional diversification in
what has been a difficult market to assess. By far the most
punchy portfolio was the 35-stock Threadneedle SIF UK
Equity Alpha Income fund, but this reflects the mandate,
which is designed to be a slightly higher risk version of the
more mainstream Threadneedle UK Equity Income Fund,
which had 62 holdings at the time of our survey.
The sharply increased number of holdings for UK equity
& bond funds reflects the fixed income content. As credit
spreads have narrowed so credit exposures have been raised
and duration extended. This was witnessed to good effect
on the Jupiter High Income Fund where the bond exposure
is delegated by Anthony Nutt to bond specialist Ariel
Bezalel, who this year has stayed overweight corporates
and focused on financials and BBB credits.
We calculated the top-10 concentration of each rated
portfolio to give an idea of how much specific risk each
manager is willing to take on in individual stocks. Our
figures show a tight range, with most top-10 concentrations
lying between 40% to 50%.
The percentage of holdings making up 90% of the
portfolio is included to provide a view of the tail of a
fund. A high percentage figure suggests that there is a short
tail, while a low percentage figure indicates a relatively
high number of holdings make up the bottom 10% of the
portfolio. Some managers use this area of the portfolio as
a “kindergarten” to monitor ideas or companies that, price
willing, could become holdings. Most managers do not
and a large number of tiny holdings may suggest a lack
of discipline, or indecisiveness, as the aggregate amount
of these “coming and going” positions could be used to
fund better ideas. A short tail suggests the weightings in the
portfolio are fairly evenly distributed.
Our sample for the two equity sectors shows the number
of holdings constituting 90% of total portfolio assets
ranging from 35% on the Old Mutual Equity Income fund
to 56% on the F&C IF II - UK Growth & Income and
Invesco Perpetual UK IS - High Income funds. The sample
average was 46%. However, in the UK equity & bond
sector the average decreased to 41%.
Our last measure of risk is one that holds particular
importance for equity funds in search of income. Clustering
is a measure of where funds are invested in the underlying
market. For example, the absence of banks from investors’
dividend radar now means that over 66% of the UK market
dividend is provided by just 15 companies.
Using all S&P-rated funds as a sample, one can easily
see high levels of overlap of names among each fund’s
top 10 holdings. For example, 22 of the 23 funds had
Vodafone as a top-10 holding. Other holdings in common
included Royal Dutch Shell, which is a top 10 holding in
78% of the funds, ahead of BP (88%), GlaxoSmithKline
(87%), AstraZeneca (75%), HSBC Holdings (61%) and
BAT (53%). Obviously these are very large capitalisation
companies and we have not taken either the size of each
fund or of each individual position into account, but it does
highlight the potential crowding of certain stocks within
the sector.
Several managers noted this as a real concern. Brian
Gallagher (UBS) combines his uniquely structured portfolio
- with its balance between capitalisations, growth stocks and
European names - with covered calls to allow to sufficient
yield while maintaining diversification. Jupiter’s Tony Nutt
was also concerned by this high level of concentration and
had included a small number of European names into the
Jupiter Income Trust.
Yet not all managers are overly concerned with
clustering, noting that there are an increasing number of
good companies offering sufficient yields ideas outside
the highlighted pick of mega-caps. Threadneedle’s Leigh
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
65
UK Equity Income Funds Annual Review
UK Equity Income Funds Continued
Harrison, for example, found the majority of new ideas
for his two income funds outside the FTSE 100, including
industrial stocks Melrose and Ashtead.
And for at least one investor, concentration and scale
of investment has little effect on his investment approach.
Invesco Perpetual’s Neil Woodford has over £18bn in
assets under management run primarily off the same
strategy and is consequently one of the largest shareholders
in several FTSE 100 names. When, for example, he sold
out of BP and Royal Dutch Shell in June 2009, he used
the profits to add to his existing positions in Astrazeneca
and GlaxoSmithKline taking each to over 8% in both his
Income and High Income funds. Since these funds together
account for £14bn, he was holding over £1bn in each
company.
Return characteristics
Volatility is a measure of the historic performance of a
portfolio calculated from the standard deviation of a
fund’s monthly total returns (income reinvested) over the
most recent 36-month period. The higher a fund’s volatility
value, the more variable its absolute monthly performance
around the sector average return. The figure is effectively a
measure of absolute consistency in contrast to the discrete
year bar charts attached to each report that provide a
visual appreciation of a fund’s relative consistency. The
figure is solely a measure of a fund’s absolute volatility, ie,
the deviation around its own mean performance. It does
not represent deviation from an index or sector average.
A high volatility figure could mean either consistent
outperformance or consistent underperformance against
competitor funds and therefore needs to be used in
conjunction with other factors.
Beta is included as a measure of a fund’s sensitivity to an
appropriate benchmark, in this case the S&P mainstream
UK equity income, UK equity income & growth and UK
equity & bond sectors. A beta above 1.0 therefore indicates
that the volatility of a particular fund is higher than the
average for the sector, and vice versa for betas below 1.0. In
broad terms, a beta of 1.2 implies that a fund will perform
20% better than the sector on the upside, but 20% worse
on the downside.
From our survey, portfolio betas were found to vary only
between 0.8 for Threadneedle UK Equity Alpha Income
(suggesting that although a focused higher performance
66
portfolio, it is currently in a highly defensive mode) to 1.1
for JOHCM UK Equity Income.
We have included R-squared as an indicator of the
correlation of a fund’s performance with an appropriate
index, in this case the FTSE All Share index. The higher
the figure, the higher the correlation. Very high levels of
correlation suggest an index or quasi index fund. All S&Prated funds recorded a score of either 0.8 or 0.9 suggesting
a relatively high level of correlation to the underlying index
in the current market environment.
Sharpe ratios have been included as a measure of
how well a fund has performed relative to the risk it has
experienced. It is calculated by reference to the annualised
average return of the fund minus the risk-free rate of
return divided by the standard deviation. A low figure
indicates disappointing performance relative to the risks
undertaken, while a negative ratio indicates that the fund
has underperformed the risk-free return.
The maximum drawdown is defined for our purposes
as the value of the largest loss in any monthly return
experienced by the fund in question over the last three
years. This current survey shows that in every case the
maximum drawdown came in 2008 with figures ranging
from 49.6% from Henderson Global Care - UK Income
fund to 29.8% from Insight Investment Monthly Income
Fund.
Our final two columns are probably one of two easiest
to understand and perhaps the most significant in that
they express in percentage terms the success rate of S&P
rated funds. As would be expected of a rated fund, all have
recorded more positive than negative months.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
About Standard & Poor’s Fund Services
Standard & Poor’s Fund Services is one of the world’s leading
providers of qualitative, forward-looking fund management research
reports. Our fund research reports are based on in-depth analysis of
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and quantitative (historic performance, portfolio construction and
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We rate funds into the following three categories of AAA (highest)
or AA (very high) or A (high) to indicate three different standards of
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on a report, you act or fail to act in a particular way.
We are paid for our fund management reports normally by the
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Our fund management reports are continuously monitored and
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STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
67
RMBS Valuations Survey
Structured Finance Investors Expect
Default Rates To Climb On U.S. Prime
And U.K. Mortgage Collateral
Contact:
Peter Jones, Global Head of Valuation Scenario
Services, S&P Fixed Income Risk Management
Services, London (44) 207 176 7441
[email protected]
D
efault rates on the collateral behind U.S. prime and
U.K. residential mortgage-backed securities (RMBS)
may only peak in 12 to 24 months time, while the default
rates for U.S. Alt-A and subprime mortgages may even be
over the worst. That’s the prediction of the third quarter
Valuation Inputs Consensus survey of 64 institutions active
in the European and U.S. structured finance markets.
Broadly speaking, investors now expect better
performance from U.S. mortgage collateral and forecast
the bottom of the U.S. real estate market within 12 months.
They also expect house prices to trough in the U.K. within
the next year, but predict default rates on U.K. mortgages—
which are far lower than those in the U.S.—will increase.
The survey indicates that respondents see U.K. and U.S.
mortgage assets in two very distinct ways.
The Fixed Income Risk Management Services group
at Standard & Poor’s is conducting a series of quarterly
consensus surveys to monitor the input assumptions and
methodologies investors use to value structured finance
bonds. The G20, the financial industry, regulators, and
auditors have all emphasized over the course of the past 12
months that recovery in the securitisation industry requires
improved investor confidence—and this in turn requires
pricing transparency and consistency around all the input
assumptions, models, and processes involved in a valuation.
We believe that when investors are aware of the dispersion
of these input assumptions they can work toward lessening
the market’s information asymmetries, and justify input
assumptions for their own various valuation requirements
in an independent and transparent way.
Over the course of this year, investors have made greater
use of loan-level data and cash-flow projections based on
detailed analysis of the underlying collateral behind all
classes of illiquid and complex structured finance assets.
There is also more in-depth discussion in the market
around valuation. Indeed, one of the major developments
taking place today is the creation of a set of standards
around valuation.
68
More than 60 institutions active in the structured finance
markets took part in the Valuation Inputs Consensus survey
for Q3 2009, split evenly between the buy side and sell side
in the U.S. and Europe. Respondents were primarily risk
managers and credit analysts, plus portfolio managers on
the buy side and front office staff on the sell side. We polled
participants on a variety of prepayment, credit, and house
price metrics in the U.S., U.K., Spanish, Italian, and Dutch
RMBS markets.
The Q3 results provide a number of useful insights. When
comparing the results with the Q1 and Q2 surveys, we can
see investors’ changing expectations for the performance of
RMBS collateral and we can begin to quantify the trends
(converging or diverging) in buy and sell side valuation
methodologies.
Lower Default Rate Forecasts For U.S. Alt-A
And Subprime Mortgage Collateral Suggest
Worst May Be Over
Indeed, default rate forecasts on U.S. Alt-A and subprime
mortgages—which generally carry greater credit risk
than, say, prime mortgage collateral—have improved.
The 12-month expectations for default rates on almost
all vintages of each subcategory of Alt-A and subprime
mortgages are improving. For example, the default
expectations on 2007-vintage Alt-A pay option ARMs
mortgages are down to just under 13% (from 30%
surveyed in Q2) and down to 21% (also down from
30%) on subprime adjustable-rate mortgages (see chart
1). Although these default rate forecasts remain high, it
appears that investors believe that most poorly performing
securitised U.S. mortgage loans have already defaulted or
paid down.
These improving expectations, however, do not apply
to U.S. prime fixed- and adjustable-rate mortgages. For
example, 12-month default rate projections have increased
on 2007-vintage U.S. prime fixed-rate mortgages to
just under 4% in the Q3 survey from 2% in Q2. And
respondents also forecast default rates on U.S. prime
adjustable rate mortgages will increase, with expectations
for the next six months of 3.8% (on an average of vintages,
see chart 2) rising to 4.8% within 12 months, and not
returning to today’s historically high levels for at least
another two and a half years (the furthest into the future
that the survey looks).
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Investors project U.S. real estate market will trough
Chart
1 12 months
in the
next
U.S. Alt-A
Adjustable-Rate
Investor
forecasts
for U.S. homeMortgage
prices for the next 12
Collateral
Default
Rate Predictions
months
are trending
upward,
with average home prices in
loan-origination
vintage
LosBy
Angeles
projected in
the Q3 survey to fall by 13%, an
improvement
22% decline
2004 on the2005
2006forecast in
2007Q2. Similarly,
the latest2008
investor projections
for
Miami
have
improved to
Average
a 16%
decline
from
a
23%
fall
and
in
Dallas
to minus
(%)*
5% 25
from minus 9%. On the whole, the survey indicates
that investors expect the U.S. real estate market to reach a
bottom
20 in the next 12 months.
Additionally, in accordance with the current aggregate
15
optimistic
tone, the findings of this survey indicate a higher
degree of real estate appreciation when a rebound occurs, in
10 contrast with the previous survey, where participants
sharp
expected the rate of appreciation to be minimal at the onset
5
of recovery.
0
Investors
assign higher
default
0-6
7-12
13-18 assumptions
19-24 to worse
25-30
Period (months)
performing benchmark transactions
*Annualized.
The©survey
also polled participants for the assumptions they
Standard & Poor’s 2009.
use to evaluate certain benchmark transactions. We found
that participants assigned higher default assumptions to
transactions with higher delinquency and foreclosure rates
and a higher degree of concentration in the Sun Belt states
Chart 3
(Arizona, Florida, Nevada, and California). An interesting
U.S. Prime Adjustable-Rate Mortgage
corollary of this analysis is that survey respondents
Collateral Default Rate Predictions
focused on the underlying collateral and the associated
By loan-origination
underwriting,
and the vintage
mortgage loans’ originator and/or
2005did not influence
2006
2007assumptions.
the issuer2004
of the RMBS
their
2008
Average
Expectations
For Declining U.K. House Prices
(%)*
Improve,
But The Timing Of The Rebound Isn’t
8
Clear
7
Investors are similarly more positive about U.K. house
6
prices. On average, market participants believe U.K.
5
house prices will decline a further 7% within the next
4
12 months.
This is an improvement from the 10% fall
3
that participants forecast in the Q2 survey. However, the
2
dispersion
of opinions on house price performance is wide,
with1 responses ranging from as low as a further 30%
decline
over 12 months to a 2% increase. And—further
0
0-6 this inconsistent
7-12
13-18of the real19-24
25-30
reflecting
view
estate market—
Period (months)
there is no consensus among
participants when the trough
*Annualized.
in U.K.
house
prices
© Standard
& Poor’s
2009. will take place. Asked to forecast in
Chart 1
Chart 2
U.S. Subp
Collateral
By loan-ori
Chart
12
Chart
U.S. Alt-A
Adjustable-Rate Mortgage
U.S.
Subprime
Adjustable-Rate
Mortgage
Collateral
Default
Rate Predictions
Collateral
Defaultvintage
Rate Predictions
By loan-origination
By loan-origination
vintage 2006
2004
2005
2007
2004
2008
2005
Average
(%)* 2008
Average
2006
2004
2007
2008
(%)*
(%)*
25
35
35
30
20
30
25
25
15
20
20
10
15
15
10
105
5
5
0
0
0 0-6
0-6
*Annualized.
7-12
7-12
© Standard & Poor’s 2009.
*Annualized.
13-18
Period
(months)
13-18
19-24
25-30
19-24
25-30
Period (months)
0-6
*Annualized.
© Standard & Po
© Standard & Poor’s 2009.
Chart
2
Chart 3
Chart 4
U.K. NCL M
Prediction
By loan-ori
Chart
4
U.S. Prime
Adjustable-Rate Mortgage
U.K.
NCL
Mortgage
Collateral
Default Rate
Collateral Default Rate
Predictions
Predictions
By loan-origination vintage
By loan-origination
vintage 2006
2004
2005
2007
2004
2008
2005
Average
(%)* 2008
Average
2006
2004
2007
2008
(%)*
(%)*
8
13
13
7
12
12
6
11
5
11
10
4
10
3
9
2
8
1
7
0
60-6
0-6
*Annualized.
9
8
7
6
7-12
7-12
© Standard & Poor’s 2009.
*Annualized.
13-18
Period13-18
(months)
19-24
19-24
25-30
25-30
Period (months)
*Annualized.
© Standard & Po
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
0-6
69
RMBS Valuations Survey
Structured Finance Investors Expect Default Rates To Climb On U.S.
Prime And U.K. Mortgage Collateral Continued
Chartquarter
2
which
prices will bottom out, the most popular
U.S. Subprime
Adjustable-Rate
response—Q1
2010—garnered
less Mortgage
than one-fifth of the
Collateral
Rate
Predictions
vote.
Indeed, Default
there is an
even
dispersion of forecasts over
By loan-origination
vintage from Q4 2009 to Q4 2010.
each
of the next five quarters,
2004
2005
2006
2007
Default
on U.K. mortgages rise in
2008rate predictions
Average
the
medium
term
(%)*
25-30
While respondents broadly expect U.K. house price
35
declines to stabilise some time over the next 12 months,
30
they
are not confident about default rates on the mortgages
25
behind
U.K. nonconforming loan (NCL) and prime RMBS
transactions.
In the short term, market forecasts for default
20
rates have stabilised—average expectations for ongoing
15
default rates from the Q3 survey are very similar to
10
expectations
respondents provided in the Q2 survey (now
9%5 for NCL and 2% for prime). However, default rate
forecasts for NCLs across all the U.K. vintages we surveyed
0
climb
12 to 18 months’
time from
the
0-6 to 9.8% in7-12
13-18
19-24 8.2% for
25-30
period covering the nextPeriod
six (months)
months, and to 2.2% from
*Annualized.
1.8% in the same time periods for all vintages of U.K.
© Standard & Poor’s 2009.
prime mortgages (see charts 3 and 4).
Chart
Chart 34
U.K. NCL Mortgage Collateral Default Rate
Predictions
By loan-origination vintage
2004
2005
2008
Average
2006
2007
(%)*
13
12
11
10
9
8
7
6
0-6
25-30
7-12
*Annualized.
© Standard & Poor’s 2009.
70
13-18
Period (months)
19-24
25-30
U.K. loss severity expectations climb
Despite improved house price expectations, over the next
12 months forecasts for loss severities (the severity of any
actual losses occurring on the collateral in default) on
U.K. NCLs have risen to 36% from expectations of 31%
revealed in our Q2 survey. This may well be influenced by
banks’ inclination to step up repossessions—crystallising
any losses on the corresponding loans—on account of the
apparent stabilisation in house price declines.
U.S. And European Investors Continue To Use
Differing Valuation Methods
On both sides of the Atlantic investors’ operational
approaches to valuing RMBS vary considerably. Our survey
reveals a number of discrepancies between the buy side and
sell approaches, although even within these categories we
found no overwhelming consistency.
Respondents continue to regard prepayment rates,
default rates, and loss severities as the main influences on
the performance of underlying loans in U.S. RMBS and
their corresponding bond valuations. But methodological
discrepancies appear between buyers and sellers when
measuring these valuation input assumptions. For
example, in the U.S., 64% of the buy side seems to favor
using “voluntary” prepayments as their key prepayment
assumption, compared with 86% of the sell side who use
“conditional” prepayments. Similarly, when calculating
default rate projections, 83% of the buy side favors the
use of macroeconomic cycles while 80% of sell side
respondents time their default projections to coincide with
specific macroeconomic triggers.
Likewise, results from the U.S. survey show that when
calculating the precise point of default on the underlying
mortgages, 83% of the sell side considers default to fall at
delinquency while 50% of the buy side considers foreclosure
(or “repossession” in the U.K.) the point of default.
In Europe, our survey continues to reveal a similar
disparity between the buy side and sell side investors in
terms of their valuation methodologies. For instance,
when calculating future default rate assumptions, 70%
of the buy side participants surveyed use inputs that are
vectored—rather than flat—compared with 46% of the
sell side. This disparity also applies to the calculation of
future loss severity assumptions, with 50% of the buy side
using vectored assumptions versus only 18% of the sell
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Chart
Chart 45
U.K. Prime Mortgage Collateral
Default Rate Predictions
By loan-origination vintage
2004
2005
2008
Average
2006
2007
(%)*
3.5
3.0
2.5
2.0
1.5
1.0
0-6
7-12
13-18
19-24
25-30
Period (months)
*Annualized.
© Standard & Poor’s 2009.
side. Indeed, there are a number of inconsistencies between
the approaches of RMBS buyers and sellers that might
suggest the buy side is currently capable of undertaking
more sophisticated analysis around structured finance
assets. This may be a result of the sell side “de-tooling”
its securitisation capabilities in the wake Lehman Brothers’
collapse and because buyers can generally concentrate their
analysis on their own portfolio.
When modeling future cash flows, for instance, as much
as 79% of buy side participants in Europe use loan-level
data when it is available. On the sell side, however, only
half use the available loan-level data to model cash flows
(52%). Indeed, well over half of the buy side consider
loan-level data to be “very important” when undertaking
valuations versus less than a quarter of the sell side.
Furthermore, nearly half the buy side (46%) claims to have
in-house capabilities for cash flow modeling, whereas 81%
of sell-side respondents rely on third-party models.
There is also a clear disparity between buyers and sellers
in the European market when judging the timing of defaults
on the mortgage collateral backing RMBS transactions.
Some 90% of the buy side consider defaults take place at
repossession while only 10% regard delinquency as the
point of default; whereas on the sell side 57% consider that
default takes place at repossession and 43% at delinquency.
These figures clearly quantify the disparity between the
valuation approaches of both sides of the market, and
provide little comfort to would-be investors looking for
consistency in valuation methodologies.
For the global structured finance market, trying to
validate internal assumptions used for the valuation of
structured finance assets is certainly one of the central
challenges for investors and money managers today.
Nearly every investor we have spoken with over the past
year agrees there is a need for change in the discipline of
credit and risk valuation as it relates specifically to price
and price risk.
At the same time, however, it has been difficult to combine
all the elements necessary to deliver truly comprehensive
methods for security and portfolio valuation. Addressing
this difficulty is the next step the market needs to take.
As we invite more market participants to take part in the
survey—with the next one to be conducted in January
2010—it is hoped the increasing volume of data received
will help create a benchmark of input assumptions for the
benefit of investors, portfolio managers, and other market
participants.
This report and the ratings contained within it are based on published
information as of October 30, 2009 unless otherwise specified.
About S&P Fixed Income Risk
Management Services
Standard & Poor’s Fixed Income Risk Management
Services delivers a portfolio of products and services
to investors that serve the global financial markets by
providing market intelligence and analytic insight for
risk driven investment analysis, including for the debt,
structured finance, derivative, and credit markets.
Standard & Poor’s Fixed Income Risk Management
Services are performed separately from any other
analytic activity of Standard & Poor’s. The unit has
no access to non- public information received by
other units of Standard & Poor’s. Standard & Poor’s
does not trade on its own account.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
71
Global Sukuk Market Outlook Commentary
The Sukuk Market Has Continued To
Progress In 2009 Despite Some Roadblocks
Contact:
Mohamed Damak, Credit Analyst,
S&P Ratings Services, Paris (33) 1 4420 7322
[email protected]
T
he sukuk market continued to progress in the first nine
months of 2009, despite difficult market conditions
and certain longstanding roadblocks. New issuance topped
$15.3 billion in the first nine months of 2009 compared
with $14.8 billion during the same period in 2008. While
this represents a slight increase, this is a significantly lower
figure than for 2007. This smaller amount of issuance was
due not only to the still-challenging market conditions
and drying up of liquidity, but also to the less-supportive
economic environment in the Gulf Cooperation Council
(GCC) countries, particularly in the United Arab Emirates
(UAE, not rated). Malaysia (foreign currency A- /Stable/A-2,
local currency A+/Stable/A-1) has taken the lead as the
major country of issuance for sukuk, accounting for about
45% of sukuk issuances in the first seven months of 2009.
Issuers in the Kingdom of Saudi Arabia (AA- /Stable/A-1+)
have contributed another 22% of sukuk issued during the
same period.
The default of a couple of sukuk was possibly partly
responsible for the slowdown in issuance. The silver lining
was that these defaults should provide the market with
useful information on how sukuk will behave following
default.
Major hurdles remain on the path to sukuk market
development, however, including:
n Difficult market conditions, which are slowing the
planned issuance of numerous sukuk;
n The lack of standardisation, notably when it comes to
Sharia interpretation; and
n The low liquidity of the sukuk market, which constrains
investors trying to exit the market in times of turbulence
or access the market looking for distressed sellers.
Standard & Poor’s provides market participants
with independent and objective opinions about the
creditworthiness of issuers and issues--including Sharia
compliant ones. We don’t comment on the Sharia
compliance of a particular issue or issuer. Our ratings
don’t constitute a recommendation to sell, buy, or hold
a particular security, regardless of whether it is Sharia
compliant. Instead, our ratings may assist investors to
make decisions and issuers to benchmark our view of their
creditworthiness against their peers’.
The Global Sukuk Market Continues To Grow,
But At A Slower Pace Than Last Year
The sukuk market continued to expand in the first nine
months of 2009 with total issuance topping $15.3 billion
(see chart 1). The pace of issuance increased by about
3.4% compared with the same period in 2008. However,
this represents a sharp reduction compared with the record
year of 2007. In our view, the two main reasons for this
slowdown were the deteriorated global market conditions
and drying up of liquidity due to the generalised global
economic turbulence and the economic slowdown in the
GCC in general and the UAE in particular, which resulted
in lower financing needs and reduced access to the market
Chart
Chart 11
Total Sukuk Issuance 2001–2009
Total sukuk issued
Sukuk cumulative Total
(Bil. $)
100
90
80
70
60
50
40
30
20
Standard & Poor’s Ratings Services still believes that
the medium-term outlook for the sukuk market is positive,
given the strong pipeline--with sukuk announced or being
talked about in the market estimated at about $50 billion-and efforts to resolve the major difficulties impeding sukuk
market development.
72
10
0
2001
2002
2003
*First seven months of 2009
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
2004
2005
2006
2007
2008
2009*
YTD
in one of the main areas driving sukuk market growth.
Standard & Poor’s expects economic growth in the UAE
to be flat or slightly negative in 2009 down from more than
7% in 2008, mainly because of the economic slowdown in
the Emirate of Dubai and the steep fall in oil prices.
Nevertheless, the pipeline for sukuk issuance remains
healthy in our view and the market continues to attract
interest from an increasing number of issuers in both
Muslim and non-Muslim countries. In addition, several
stakeholders are trying to lower some of the hurdles that
still impede the market development of sukuk.
In Standard & Poor’s view, the lack of uniform standards
for Sharia interpretation has meant that an integrated
sukuk market has yet to emerge. In particular, we note
various commentators’ view that the comments made by
the Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) on the Sharia compliance
of certain sukuk may have contributed to the decline of
the market--though we further note that the extent of that
effect is difficult to assess. We observe that the AAOIFI and
the Central Bank of Malaysia have attempted to provide
more uniformity. The AAOIFI has announced that it will
screen products and services for Sharia compliance. The
Malaysian Parliament has recently approved a law that
gives the National Sharia Advisory Council of Bank Negara
Malaysia (the central bank of Malaysia) legal status as the
final arbiter in matters related to Sharia compliance of
Islamic products in Malaysia.
These steps could, in our view, increase investors’
confidence in the Sharia compliant aspect of the products
and services labeled as Sharia compliant by AAOIFI and
the National Sharia Advisory Council.
Another positive development for the market in our
opinion was the creation of the Saudi sukuk and bond
market under the Tadawul (the Saudi stock exchange).
Indeed, market observers have pointed out that the lack
of sukuk liquidity is a primary weakness compared with
conventional bonds. Lack of liquidity became a particularly
important factor amid the financial turbulence in the GCC.
It was difficult for sukuk investors to close their positions
and free up liquidity. On a positive note, we understand
that some central banks in the Gulf accept sukuk for
repurchase transactions, which allows banks to use them
as a source of liquidity.
Chart 2
Chart 2
Total Sukuk Issuance by Country in 2009 (%)
United Arab
Emirates
4.26%
Bahrain
9.79%
Brunei
Darussalam
0.71%
Gambia
0.08%
Saudi Arabia
22.03%
Indonesia
16.05%
Pakistan
2.04%
*First seven months of 2009
Malaysia
45.03%
© Standard & Poor’s 2009.
Asia Is Taking The Lead
Issuance in 2009 shows that Asia has taken the lead in
driving the expansion of the sukuk market, with more than
60% of issuance made in Asian countries, and Malaysia
as the main domicile country for issuers (see chart 2). The
Gulf region also continued to play a significant role in the
development of the market, contributing 36.1% of total
new issuance. However, unlike in 2008, when the UAE was
among the main drivers of the market, in 2009, the UAE
represented only a limited portion of new sukuk issuance
mainly because of the significant slowdown in Dubai’s
economy and the correction of its real estate sector. In the
Chart
3 months of 2009, the government of the Emirate
first
seven
ofTotal
Ras Al
Khaimah
(A/Stable/A-1)
issued the only sukuk
Sukuk
Issuance
by Currency
inJan
the To
UAE,
for
a
total
of
$400
million.
During the same
Aug 2009 (%)
period, Gambia continued to be the sole African country
Bruneian Bahrain
in which sukuk were
its central bank issuing a
Gambianissued,
dollar with
dinar
dalasi
0.71%
Indonesian
series of sukuk for a total of $7.8
1.81%million. Going forward
0.08%
rupiah
dollar
and once
market conditions improve, weU.S.believe
that the
9.13%
19.16%
market will continue globalising and additional issuers
from non-Muslim and Muslim countries will join the club
of sukuk issuers.
The first seven months of 2009 have seen more or
less the same number of sukuk coming to the market as
Saudi
Malaysian
Arabian riyal
ringgit
22.03%
STANDARD & POOR’S EUROPE,
MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK
2010
45.03%
Pakistan
73
Global Sukuk Market Outlook Commentary
Chart 2
Total Sukuk Issuance by Country in 2009 (%)
Bahrain
United Arab
Brunei
The Sukuk Market Has Continued To Progress In 2009 Despite
Some
9.79% Roadblocks
Emirates
Darussalam
4.26%
Continued
0.71%
Gambia
0.08%
Saudi Arabia
22.03%
during the same period in 2008, with about 70 issuances.
However, concentration has increased significantly, with
the 10 largest sukuk issued during this period making up
78.7% of total issuance compared with 58.8% during the
same period in 2008. Saudi Arabia took the lead as the
country host to the largest sukuk issuance. Saudi Electric
Co. (AA-/Stable/--) issued that sukuk, for a total amount of
Saudi Arabian riyal (SAR) 7.0 billion ($1.8 billion). Saudi
Electric Co. will reportedly use the proceeds of issuance
for general corporate purposes. The issuance is governed
by Saudi law.
The sovereign wealth fund of the oil-rich Malaysian
state of Terengganu--the Terengganu Investment Authority
(TIA, not rated)--issued the second-largest sukuk, for
Malaysian ringgit (MYR) 5 billion ($1.4 billion). The
Malaysian government guaranteed the sukuk. TIA will
reportedly use the proceeds for its general investments,
working capital requirements, and other purposes. This
sukuk has a maturity of 30 years, one of the longest sukuk
maturities.
In August 2009, Malaysia-based Petroliam Nasional
Bhd. (Petronas, foreign currency A-/Stable/--, local currency
A+/Stable/--) also issued a large sukuk, for a total amount of
$1.5 billion. Our ‘A-’ rating reflects the creditworthiness of
Petronas, which is the sole primary obligor on the periodic
distributions under the trust certificates and also the sole
primary obligor on the redemption amount at maturity of
the trust certificates under the purchase undertaking.
U.S. Dollar Is Slowly Coming Back
The U.S. dollar lost its leadership position in sukuk
issuance in 2008, with only about 10% of issuance made
in this currency for the year. In the first seven months
of 2009, about 20% of total sukuk were issued in U.S.
dollars (see chart 3), signaling the progressive return of the
dollar as one of the main currencies for sukuk issuance.
However, we expect the dollar to regain its position only
slowly because liquidity is still tight on international
markets. Issuers have therefore concentrated on local
markets where liquidity has been more abundant and
the appetite for Sharia-compliant instruments stronger.
Standard & Poor’s expects the sukuk market to continue
being skewed toward issuance in local currencies in
the foreseeable future, with a relatively limited portion
being issued in dollars. Once market conditions return
74
to normal, dollar-denominated sukuk shouldIndonesia
regain a
16.05%
stronger position.
Pakistan
Sovereign-Related
Entities Are Propelling
2.04%
Market Growth
In the first seven months of 2009, governments and their
related entities have taken the lead in sukuk issuance
(see chart 4). These entities accounted for about threeMalaysia
quarters of the sukuk issued during that
period. Even if we
45.03%
*First seven months of 2009
exclude the entities that act as corporations, such as Saudi
© Standard & Poor’s 2009.
Electric Co., or the supranational entities, like the Islamic
Development Bank (AAA/Stable/A-1+), governments and
their related entities still accounted for more than one-half
of sukuk issued. Sovereign issuance is important for the
sukuk market because it can help construct a yield curve
that investors can use in benchmarking the yield on private
corporate sukuk domiciled in these different countries.
We believe that sovereign issuance will continue to drive
market growth for the remaining months of the year,
because investors are shying away from corporate issuance
during these turbulent times. This establishes a foundation
for stronger growth once market conditions improve,
however.
Chart 3
Chart 3
Total Sukuk Issuance by Currency
Jan To Aug 2009 (%)
Indonesian
rupiah
9.13%
Gambian
dalasi
0.08%
Bruneian
dollar
0.71%
Bahrain
dinar
1.81%
U.S. dollar
19.16%
Saudi
Arabian riyal
22.03%
Malaysian
ringgit
45.03%
*First seven months of 2009
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Pakistan
rupee
2.04%
concerned about the $3.5 billion sukuk issued by Dubaibased real estate developer Nakheel PJSC (not rated),
which will mature in December 2009.
These episodes reminded investors that default can
and does happen in the sukuk market, as in any other
Financial institutions
part of the financial sector. However, sukuk default
is a
new phenomenon, as the market is still in its infancy. This
Corporations
represents an interesting development as it should
help
investors to understand what could happen in the case
Governments and related entities
of default and what the legal and financial repercussions
could be.
Chart
Chart44
Total Sukuk Issuance By Type In 2009* (%)
Financial
institutions
2.8%
Corporations
22.6%
ADDITIONAL CONTACTS:
Emmanuel Volland, Paris
Ritesh Maheshwari, Singapore
*First seven months of 2009
© Standard & Poor’s 2009.
This report and the ratings contained within it are based on published
Governments
and related entities
74.6%
Financial institutions
information as of September 2, 2009 unless otherwise specified.
Corporations
Governments and related entities
Sukuk Defaults Were The Major New
Development In 2009
About S&P in Islamic Capital Markets
The global financial turbulence that has transformed into
a more general economic turbulence has hurt numerous
corporations and financial institutions around the world.
Although Islamic financial institutions have been more
resilient to the financial turbulence than their conventional
peers because they were not exposed to structured
investment products, the shift in the environment did
negatively affect some of them. Among these entities are
some sukuk issuers such as Kuwait-based The Investment
Dar Company K.S.C.C. (TID, not rated). Indeed, according
to publicly available information, the recycling of shortterm wholesale refinancing into longer-term assets-including private equity investments--resulted in liquidity
pressure for TID. That led TID to default on its sukuk
as part of a general debt restructuring program. TID has
been working with its advisors on a restructuring plan. As
of Sept. 30, 2008, TID had total assets of Kuwaiti dinar
(KWD) 1.5 billion.
Another noticeable example is Saudi Arabia-based Saad
Group (not rated), which has defaulted on some of its debt
in the recent past, including the Golden Belt B.S.C. (not
rated) sukuk that it issued in 2007. The market is also
Standard & Poor’s became the first major agency
to assign ratings to sukuk instruments in 2002
(Malaysia Sukuk) and we remain at the forefront of
developing an analytical framework for evaluating
innovative Islamic issuers and instruments. During
2009, S&P published ratings on 15 Islamic financial
institutions and 25 sukuk issues. S&P Index Services
offers a powerful line-up of 30 benchmark and
investable Shariah indices to enable Islamic investors
to slice and dice their exposure by country, region,
size, style, and sector.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
75
African Sovereign Outlook Commentary
African Sovereign Ratings, Global Shocks
and Multilateral Support
Contact:
Remy Salters, Credit Analyst, S&P Ratings Services,
London (44) 20 7176 7113
[email protected]
I
nitial hopes that sub-Saharan Africa (SSA) would prove
immune to the international financial crisis because of
its lack of financial integration were quickly dashed as the
effects of the crisis spread to the global real economy. Falling
commodity prices, remittances, foreign direct investment,
tourism, and the freezing of global capital markets all
combined to stifle the recent African boom. While GDP
growth has been resilient relative to other regions of the
world, SSA sovereigns continue to face pressures on the
fiscal and external sides.
This article examines fiscal and external pressures
in SSA, and the degree to which multilateral lending
institutions’ (MLI) concerted response has offset SSA
exposure. In our view, while greater MLI support has been
a new element in the past few months, creditworthiness is
ultimately most affected by the cogency of policy reactions
to the less favorable external environment. Looking ahead,
notwithstanding the nascent improvement in frontier
risk appetite, we also see risks for SSA as the tentative
global recovery takes shape, which add complexity to
the “decoupling/recoupling” debate on the continent.
Due to its different rating fundamentals, the Republic of
South Africa [foreign currency BBB+/Negative/A-2] is not
addressed here.
External Shocks Thick And Thin
SSA has not been immune to the effects of the global
financial crisis and subsequent downturn, although such
effects have come with a lag in some countries (see “African
Sovereigns Face Policy Test As Global Recession Intensifies
Existing Weaknesses”, published on April 24, 2009; and
“How Far Can Sub-Saharan Africa Resist The Global
Recoupling In 2009?”, published on Dec. 16, 2008, on
RatingsDirect).
Short-term capital
Remittances and portfolio investment retreated due to
developments in the countries of origin. While “family”
remittances tend to be resilient or even countercyclical,
76
remittances by expatriates for investment purposes are
more cyclically sensitive. Developments have not been
uniform, with some sovereigns hit harder due to the
relative magnitude of their reliance on remittances, and
the geographic location of their diasporas (for example
Cape Verde). Meanwhile, nonresident portfolio investment
reacted rapidly to the OECD financial crisis. The retreat in
short-term capital resulted in sharp currency movements
(see chart 1) and equity price drops, particularly in countries
with open capital accounts (for example Uganda). While
these flows are not large in absolute terms outside South
Africa, they are in some cases meaningful in relation to
foreign exchange turnover.
Long-term capital
A second, more lagged round of effects via the capital
channel is still unfolding on the foreign direct investment
(FDI) and aid fronts. Aid effects are difficult to measure,
since part of the damage will come through the opportunity
cost of stagnating commitments. Bilateral commitments
from donors with deteriorating debt profiles appear certain
to be affected to some extent, however. Similarly, the likely
weaker trend growth in OECD economies in the next few
years will affect potential FDI supply, although this may
be partly offset by South-South investment, in particular
from China.
Trade
With a lag, export volumes have been hit by weaker external
demand, both in North-South trade and, to a lesser extent,
in South-South trade following the so-called “recoupling”
of the world economy (that is, the extent to which emerging
economies were affected by the downturn in developed
economies instead of “decoupling”). Many export prices
have also been affected: after benefiting from some flightto-quality effects during 2008, commodity prices fell
sharply from the last quarter of that year, and only started
recovering moderately from the second quarter of 2009.
The recovery in Chinese economic performance should
cause some revival in South-South trade, but whether the
shape of that recovery, and of those in OECD economies,
will be a ‘V’ or a ‘W’ remains an open question.
Rating Pressure Points
The main vulnerability of the rated sub-Saharan economies
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Sub-Saharan Africa Currency Trends
Exchange rates against the U.S. dollar*
Ghana cedi
Kenya shilling
Uganda shilling
Botswana pula
Mozambique metical
Nigeria naira
160
(Indexed 01/01/2008)
150
120
110
100
90
02/07/2009
02/05/2009
02/03/2009
02/01/2009
02/11/2008
02/09/2008
02/07/2008
02/05/2008
80
02/03/2008
nths of current
s are included.
130
02/01/2008
Uganda
140
Source: Bloomberg. *This chart shows currency trends for those rated countries that do
not have a strict fixed exchange rate regime. NB: Botswana operates a crawling peg to
the South African rand, hence the pula trend has been driven by rand fluctuations.
© Standard & Poor’s 2009.
by weaker trade and/or transfers balances, in particular
for oil-exporting countries, while financial accounts have
suffered from the private sector’s reduced access to debt
and equity capital.
The external shock from the global downturn has of
course had differentiated effects. Country differences
partly stem from the extent to which terms of trade have
deteriorated. Those countries that were heavily affected
by the combination of high oil and food prices for the
better part of 2008 experienced some relief from the
collapse in oil prices, dampening the other effects of the
global downturn. In some cases, such as Ghana, the drop
in the oil import bill since late 2008 has been paralleled
by relative resilience in export commodities (gold and
cocoa), and macroeconomic problems have instead
stemmed from unsustainable policies. Likewise, countries
with a modest commodity base--such as Kenya, Uganda,
Benin, or Burkina Faso--have seen their external demand
shock somewhat cushioned by lower import prices. Other
countervailing factors have included conducive climatic
conditions (in West Africa) and continued, albeit fragile,
peace dividends for some rated sovereigns with formerly
unstable neighbors (Uganda).
The Multilaterals Respond
does not lie in the magnitude of their external leverage or
of their public sector debt burden, mainly owing to the
Chart
1 Originally
Sent!!!!!!!
past
decade’s
significant
debt forgiveness. From a ratings
perspective,
the main
pressure
points
have arisen from the
Sub-Saharan
Africa
Currency
Trends
need
to secure
liquidity
to finance external and
Exchange
ratessufficient
against the
U.S. dollar*
domestic
imbalances
as they occur, in
a global
Ghana
cedi
Kenya
shilling context that
has become
less conducive.
Uganda shilling
Botswana pula
OnMozambique
the fiscalmetical
side, the shallowness
of naira
domestic capital
Nigeria
markets circumscribes governments’ ability to raise debt
180
levels at short notice for countercyclical purposes. The
160
region’s banks were largely sheltered from the bank crisis
140
in developed markets, but strains on Ghanaian domestic
120
yields from mid-2008 were a reminder of local financial
100
systems’ capacity constraints, even if the root cause of
80
those strains was the running of unsustainably large
60
twin deficits (see “Ghana At A Crossroads: Twin Deficits,
40
Twin Straitjackets”, published on April 24, 2009, on
20
RatingsDirect).
0
On the external side, current accounts have been hit
02/01/2008
25/01/2008
19/02/2008
13/03/2008
08/04/2008
01/05/2008
26/05/2008
18/06/2008
11/07/2008
05/08/2008
28/08/2008
22/09/2008
15/10/2008
07/11/2008
02/12/2008
26/12/2008
21/01/2009
13/02/2009
10/03/2009
02/04/2009
27/04/2009
20/05/2009
12/06/2009
07/07/2009
30/07/2009
ria
Chart
Chart 11
The MLI response to the external shocks above, and in
particular to the risk of a procyclical stagnation or retreat
in bilateral aid, has been strong, although concrete flows of
funds are still building momentum:
n Increased amounts. The IMF, in particular, has increased
the amounts available to lend to low-income countries,
with a target of $17 billion in the period to 2014, of
which about $8 billion is expected in 2009-2010. It has
also increased its individual country borrowing limits.
The African Development Bank (ADB) has also boosted
its lending plans, and the size of its loans, starting with
a $1.5 billion budget support loan to Botswana (12%
of 2008 GDP). World Bank efforts have tended to
focus on frontloading disbursements under pre-existing
programs and/or enhancing relevant sectoral lending,
although it has also provided some budget support.
(Indexed, June 2007=100)
Given the increasing cogency of the response, and the
inevitable lag in MLI disbursements despite streamlined
procedures, amounts are likely to continue growing
significantly in the short term.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
Source: Bloomberg. *This chart shows currency trends for those rated countries that do
not have a strict fixed exchange rate regime. NB: Botswana operates a crawling peg to
the South African rand, hence the pula trend has been driven by rand fluctuations.
77
African Sovereign Outlook Commentary
African Sovereign Ratings, Global Shocks and Multilateral Support Continued
Estimated SDR Allocations 2009
0.7
Ghana c
0.6
Uganda
150
0.3
(Indexed 01/01/2008)
(months of CAPs)
160
0.4
0.2
0.1
0
Botswana
Cape
Verde
Ghana
Kenya Mozambique Nigeria
140
130
120
110
100
90
02/01/2008
80
© Standard & Poor’s 2009.
Source: Bloomber
Chart
3
Chart X
not have aY
strict fi
Chart
the South African
Commodit
Ghana And Gabon Bond Spreads In Context*
EMBIG Composite
Ghana
© Standard
& Poo
Cotton
Gabon
Gold
2000
1800
180
1600
160
1400
140 1 Or
Chart
120
Sub-Saha
100
Exchange
r
(Indexed 01/01/2009)
1200
1000
800
600
400
80
60
Ghana c
Uganda
200
40
0
20
Source: JP Morgan. *This chart shows spreads over US treasuries for Ghana, Gabon, and
the EMBIG index of emerging market bonds.
© Standard & Poor’s 2009.
180
160
140
120
0
02/01/2008
02/02/2008
02/08/2009
02/07/2009
02/06/2009
02/05/2009
02/04/2009
02/03/2009
02/02/2009
02/01/2009
02/12/2008
02/11/2008
02/10/2008
02/09/2008
02/08/2008
02/07/2008
02/06/2008
02/05/2008
02/04/2008
02/03/2008
02/02/2008
Mozamb
100
Source: Bloomber
80
©60
Standard & Poo
03-Apr-05
03-Apr-06
09-Apr-09
09-Sep-09
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
8
11-Apr-07
09-Apr-08
40
20
0
02/01/2008
25/01/2008
19/02/2008
some return of nonresident investor appetite for local bond
issuance.
The Z
tentative return of appetite for SSA risk is positive
Chart
for
capital flow prospects.
Nevertheless,
in our view, some
Sub-Saharan
African Sovereign
Ratings
Distribution*
78
Uganda
Source: S&P forecasts, IMF.
*This chart expresses the August-September 2009 SDR allocations in months of current
account payments (CAPs). Only rated sovereigns with their own currencies are included.
Market Rally Belies Lagged Risks
The deterioration in external and fiscal indicators since
late 2008 put to rest hopes of SSA economies “decoupling”
from global shocks. With this in mind, the gradual recovery
in risk appetite for frontier markets since the Spring of 2009
is noteworthy. Likewise, apart from the Ghanaian cedi and
the Nigerian naira, SSA floating currencies’ performance
has stabilised since the second quarter of 2009 (see chart
1), and piecemeal evidence suggests that there has been
Mozamb
0.5
02/01/2008
From a ratings perspective, other things being equal, the
MLI reaction is supportive in several respects:
n The funds are long term and are lower-cost than the
recipients could enjoy elsewhere;
n Despite relaxed conditionality, MLIs may act as a
policy anchor, assisting the formulation of coherent
macroeconomic policy responses to the shocks; and
n IMF funds relieve pressure on the balance of payments
(as in Ghana’s case), while loans intended for budget
support can relieve pressure on non-concessional
borrowing and related crowding-out risks, as well as
helping to avoid procyclical fiscal tightening.
Chart 1
Sub-Saha
Exchange r
Chart
Chart 22
(basis points)
n Streamlined processes. The speed of disbursement
is being enhanced through the introduction of new
facilities, while conditionality has generally been
relaxed. Thus, the IMF is revising its panoply of lending
instruments for low-income countries, and has dropped
structural performance criteria from loan conditions.
n Special Drawing Right (SDR) allocations. Following
the April 2009 G-20 initiative, the IMF approved SDR
allocations to all its members totaling SDR183 billion
(US$285 billion). These were disbursed in late August
and early September 2009, and somewhat strengthened
SSA foreign exchange reserve cushions, providing some
relief for strained balance of payments.
n Trade finance support. On the private sector side,
several initiatives have been launched to counteract the
effects of the global decline in trade credit, led by the
International Finance Corporation (IFC). Regionally,
the ADB has also made funds available for this purpose.
Other private sector support has included an initiative
by the IFC to provide support to viable infrastructure
investments potentially jeopardised by the ebb in risk
capital.
Source: Bloomber
not have a strict fi
the South African
Table 1: Rating Actions On SSA Sovereigns Between September 2008-2009
Issuer
To
From
Date
Botswana
Foreign currency A/
Negative/A-1; local currency
A+/Negative/A-1
Foreign currency A/
Stable/A-1; local currency
A+/Stable/A-2
19/02/2009
The negative outlook indicates that Standard & Poor's
could lower the ratings if the government's response
to the ongoing cyclical shock and revenue crisis is
not sufficient to contain spending and limit fiscal
weakening, leading to the rapid dissipation of its asset
buffers.
Reason
Ghana
Foreign currency B+/
Negative/B; local currency
B+/Negative/B
Foreign currency B+/
Stable/B; local currency
B+/Stable/B
16/03/2009
The negative outlook reflects the likelihood of a
downgrade if the planned fiscal correction is not fully
implemented or debt financing changes intensify in the
context of shallow domestic markets and weakened
global risk appetite.
Nigeria
Foreign currency BB-/
Negative/B; local currency
BB/Negative/B
Foreign currency BB-/
Stable/B; local currency
BB/Stable/B
27/03/2009
The negative outlook reflects the increased risk that the
institutional response to falling oil revenue will result
in a continued worsening of the business environment
and a deterioration of Nigeria's balance sheet beyond
our central assumptions. The ratings are unlikely to be
raised in the near future given Nigeria's deteriorating
terms of trade outlook and the opacity of public
accounts.
Nigeria
Foreign currency B+/
Stable/B; local currency B+/
Stable/B
Foreign currency BB-/
Negative/B; local currency
BB/Negative/B
21/08/2009
The lowering of the sovereign rating on Nigeria reflects
our view of the government's reduced fiscal flexibility
due to costs associated with its recent bail-out of
five large domestic banks, and also the fall-off in
government oil revenue. Downward pressure on the
ratings could build if liquidity or solvency problems
emerge in the rest of the banking sector or should
government oil revenues fall further. Upward pressure
on the ratings could emerge if progress is made in
the key areas identified by the current administration,
namely reducing Niger Delta militancy, improving the
non-oil business environment, and improving public
sector governance.
Senegal
Foreign currency B+/
Stable/B; local currency B+/
Stable/B
Foreign currency B+/
Negative/B; local currency
B+/Negative/B
26/05/2009
The outlook revision reflects our opinion that essential
progress has been made in the government's efforts
to improve public finance management, as reflected
in more rigorous spending and budget execution
procedures. The revision of the outlook furthermore
reflects our assessment that vital donor support has
been solidifying as last year's fiscal crisis has been
overcome and Senegal demonstrated its peaceful and
democratic credentials in March 2009. The ratings
would come under renewed downward pressure if the
improvements in fiscal performance and management
observable so far this year were to prove to be merely
transitory, or if donor support were to falter.
*Excludes South Africa, not covered in this article. Ratings are as of Sept. 9, 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
79
African Sovereign Outlook Commentary
African Sovereign Ratings, Global Shocks and Multilateral Support Continued
5
Not All About External Shocks
With the above in mind, table 1 summarises the rating
actions 3taken on SSA sovereigns since the last quarter of
2
2008. Two
features stand out. Firstly, relatively few ratings
1
have changed
in SSA, particularly when compared with
sovereign
0 ratings in Emerging Europe. Nevertheless, this
A to
A- the
BBB+fact
BBB that
BBB- SSA
BB+ has
BB BBB+ been
B
B-more
SD
is partly due
always
volatile and prone to adverse shocks, which is incorporated
*Ratings are long-term
currencycompared
sovereign ratings.with
Excludes
the Republic
of South
in generally
lowerforeign
ratings
other
regions.
Africa, not covered by this article.
Secondly, while the multiple external shocks over the
© Standard
Poor’s some
2009. direct rating impact (for example in
period
have&had
Botswana), the list is also a reminder of the importance of
80
EMBIG Composite
Cotton
Coffee
2000
Gold
Ghana
Aluminium
1800
180
1600
Chart Y
Commodi
Cotton
Gabon
Cocoa
Gold
WTI crude*
180
160
140
(Indexed 01/01/2009)
1200
140
1000
120
80
60
20
Source: JP Morgan. *This chart shows spreads over US treasuries for Ghana, Gabon, and
the EMBIG index of emerging market bonds.
Source:
Bloomberg.
© Standard
& Poor’s*West
2009. Texas Intermediate.
Chart 5
Chart Z
Sub-Saharan African Sovereign Ratings
Distribution*
03-Apr-05
03-Apr-06
09-Apr-09
09-Sep-09
11-Apr-07
09-Apr-08
8
7
6
5
4
3
2
1
0
A
A- BBB+ BBB BBB- BB+
BB
BB-
B+
B
B-
SD
*Ratings are long-term foreign currency sovereign ratings. Excludes the Republic of South
Africa, not covered by this article.
© Standard & Poor’s 2009.
0
Source: Bloomber
© Standard & Po
© Standard & Poor’s 2009.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
100
02/01/2008
02/02/2008
0
120
40
02/10/2008
02/12/2008
02/01/2009
02/11/2008
02/02/2009
02/12/2008
02/03/2009
02/01/2009
02/04/2009
02/02/2009
02/05/2009
02/03/2009
02/06/2009
02/07/2009
02/04/2009
02/08/2009
02/05/2009
02/09/2009
02/06/2009
02/10/2009
02/07/2009
02/11/2009
02/12/2009
02/08/2009
800
100
600
80
400
60
200
40
0
20
02/01/2008
02/01/2008
02/02/2008
02/02/2008
02/03/2008
02/03/2008
02/04/2008
02/04/2008
02/05/2008
02/05/2008
02/06/2008
02/07/2008
02/06/2008
02/08/2008
02/07/2008
02/09/2008
02/08/2008
02/10/2008
02/09/2008
02/11/2008
(Indexed 01/01/2009)
(basis points)
160
1400
(Number of issuers)
(Number of issuers)
For oil exporters (Gabon, Nigeria, Cameroon), these
factors will be significantly dampened if the oil price
Chart Zto recover in coming months. For oil importers,
continues
Sub-Saharan
Africanwould
Sovereign
however,
such a recovery
carry Ratings
its own downside
Distribution*
risks,
harking back to the commodity price shock of the
03-Apr-05
03-Apr-06
11-Apr-07
first half
of 2008. A
deterioration
in terms 09-Apr-08
of trade due to
09-Apr-09
09-Sep-09
a sustained
oil price
rally, combined with a slow OECD
recovery8 and its attendant effects on capital flows, could
lead to 7further economic adjustments in SSA in the next
few years.
6
4
Chart X
Chart
Chart 4Y
Ghana And Gabon Bond Spreads In Context*
Commodity Trends
02/08/2009
02/07/2009
02/06/2009
02/05/2009
02/04/2009
02/03/2009
02/02/2009
02/01/2009
02/12/2008
02/11/2008
02/10/2008
02/09/2008
02/08/2008
02/07/2008
02/06/2008
02/05/2008
02/04/2008
02/03/2008
02/02/2008
02/01/2008
(basis points)
of the key pressures on external balances will take some
X
timeChart
to dissipate,
particularly for non-oil exporters:
Ghanabanks
And will
Gabon
BondtoSpreads
Context* their
n OECD
continue
repair orIn
consolidate
balance
sheets
for
some
time
to
come,
and
may
EMBIG Composite
Ghana
Gabonbe subject
to 2000
higher capital requirements as regulatory reform
is implemented.
This is likely to dampen the pace of
1800
recovery
in private external debt flows to the continent.
1600
The1400
ongoing crisis in the Nigerian banking system, and
1200
transparency
issues that transpired from it, might also
1000
affect foreign banks’ appetite for Africa exposure (see
800
“Various Central Bank Initiatives Are Steps In The Right
600
Direction, But Risks Remain High For Nigerian Banks”,
400
published
Sept. 8, 2009, on RatingsDirect).
200
n The 0magnitude of the flattening in bilateral aid
commitments remains unknown, as concerns over the
rising debt burdens of key OECD economies are only
just taking shape.
n Employment trends tend to lag growth, so that
Source: JP Morgan. *This chart shows spreads over US treasuries for Ghana, Gabon, and
remittances
from market
SSA
affected by
the EMBIG index of emerging
bonds. expatriates
unemployment
in
the
OECD
could
take
longer to
© Standard & Poor’s 2009.
recover than headline growth in their host countries.
Table 2: Ratings On Sovereigns Covered By This Article
Sovereign
Foreign Currency Ratings
Local Currency Ratings
Botswana
A/Negative/A-1
A+/Negative/A-1
Burkina Faso
B/Stable/B
B/Stable/B
Cameroon
B/Stable/B
B/Stable/B
Cape Verde
B+/Stable/B
B+/Stable/B
Gabon
BB-/Stable/B
BB-/Stable/B
Ghana
B+/Negative/B
B+/Negative/B
Kenya
B/Positive/B
B/Positive/B
Mozambique
B+/Stable/B
B+/Stable/B
Nigeria
B+/Stable/B
B+/Stable/B
Senegal
B+/Stable/B
B+/Stable/B
Benin
B/Positive/B
B/Positive/B
Uganda
B+/Stable/B
B+/Stable/B
policy responses to shifting circumstances in shaping rating
outcomes.
Thus, in Ghana’s case, while the pre-Lehman oil shock
contributed to the deterioration in fiscal and external
imbalances, the revision of the outlook to negative in March
2009 was rooted in a failure to rein in an unsustainable
fiscal expansion in the midst of economic overheating. As
noted earlier, Ghana has actually benefited from tail winds
since the last quarter of 2008, in the form of improved
terms of trade. Likewise, in Nigeria’s case, the negative
rating actions of the past few months have been based
on the problematic institutional policy response to lower
oil price revenues, as well as the fallout from the past few
years’ unsustainable credit boom. Conversely, despite the
less favorable external environment, tentative fiscal policy
improvements in Senegal enabled a revision of the outlook
to stable from negative.
Looking ahead, creditworthiness in the short term is
likely to continue being most affected by the cogency of
policy reactions to the evolving external environment. In
the longer term, rating improvements in the region are
likely to hinge primarily on the extent to which structural
reforms and investment lay the foundations for faster
trend growth and greater resilience to the types of external
shocks we are seeing today.
ADDITIONAL CONTACT:
Moritz Kraemer, Managing Director, Frankfurt
This report and the ratings contained within it are based on published
information as of September 9, 2009 unless otherwise specified.
STANDARD & POOR’S EUROPE, MIDDLE EAST, AND AFRICA: MARKETS OUTLOOK 2010
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