Outlook on Corporate Credit Quality
Following a year of economic growth concerns, sticky core inflation, increasing interest rates, and a rash of bank failures, treasurers have been acting as corporate risk firefighters, mitigating the impact of tumultuous events on their organisations’ bottom lines.
The past 18 months have seen the global economy enter an environment of stagflation, high inflation, low growth, and high interest rates. While there are signs that this period may be closer to the end than the beginning, there is still more to see on a macroeconomic level before stagflation can be declared officially over.
Alex Griffiths, Head of EMEA Corporate Ratings, Fitch Ratings, explains: “The situation is gradually moving through that process and approaching a transition, but we’re not there yet. Inflation is coming down, but nobody’s completely convinced that it’s over with. While we have revised our expectations down, we don’t think it will hit most central bank target levels until 2025.”
Interest rates are nearing their peak, with the Federal Reserve, European Central Bank and Bank of England pausing their hiking cycles in the late October/early November round of monetary policy meetings, so the end of the current hiking cycle is in sight. Despite this, market expectations are for rates to remain at their current elevated level for some time, rather than rate cuts being on the agenda in the short term.
Growth rate prognosis
Compounding the high inflation rates and sticky inflation is the poor growth shown by many economies. China provides an excellent example of this.
“China’s growth was up and down in 2023, with a strong growth early in the year after they relaxed COVID policies, weakening thereafter but recently stronger news.” Griffiths notes. “Our latest forecast for Chinese GDP growth is 5.3% decelerating to 4.6% in 2024. This is below the 6-7% rates we were used to pre-pandemic.”
One example of the ripples from China’s slowdown is the negative impact this has had in terms of exports from Europe. That contributed to a weaker 2023 European growth forecast from the European Commission, which in November was revised down to 0.6% from 0.8% three months ago. Another crucial factor in this downturn is the lack of Russian gas.
“Last winter, there was nothing like the issue many thought we’d have with turning off Russian gas – people were talking about minus 8% or 9% GDP last summer – and that didn’t happen,” reflects Griffiths. “But as we went through 2023, it became clear how much of a drag it was on some energy-intensive industries.”
While Fitch sees European growth accelerating in 2024 to 0.7% – a little better but still not particularly high growth – the US is, in some ways, the opposite, Griffiths says. “We think the US economy will grow at 2.4% this year, which is a pretty big revision upwards from where we were a few months ago. The US consumer just hasn’t stopped spending this year.”
This spending splurge has been triggered by the savings that people built up during the pandemic. However, these reserves are gradually being eroded, meaning spending is anticipated to drop in 2024. That, combined with the higher interest rates, could lead to a significant deceleration early in the year.
“Overall growth for the US is projected to halve to 1.2%, but we are no longer forecasting a recession in 2024,” comments Griffiths. The background to that has been an elongated period of disruption in the capital markets.
With events such as the 2008 global financial crisis and Covid-19, there were blips where the capital markets were closed, but then central banks took action and they opened again fairly quickly. That is not the case today. “This is the longest period of subdued capital market access that we’ve seen,” adds Griffiths.
Inflationary pressures driving costs
In such a volatile economic environment, risk management across various areas of corporate treasury becomes even more vital. For example, the elevated levels of inflation worldwide have caused inevitable headaches for treasurers in their efforts to keep costs under control. For marketing and advertising company S4Capital, this shows up most clearly in salary spend.
Christof Nelischer, the company’s Group Treasurer, comments: “We are essentially a people business, and inflation affects us quite significantly on the wage front. That’s our biggest cost item, particularly as we do more in the US than in the rest of the world put together.”
It is a similar situation at UK-headquartered information and analytics multinational RELX, where wage inflation is also the most significant cost pressure. The organisation’s Group Treasurer, Suzanne Perry, states: “Salaries are our biggest cost. We’re slightly insulated from inflation on our product lines. There it’s more indirect, such as if our customers have less money because their costs have gone up.”
For corporates with a sizeable amount of tangible assets on the balance sheet or tied up capital, higher inflation can also lead to a strain on working capital, with increased operating costs eroding profit margins. Strategies corporates can apply here include looking at flexible pricing approaches to pass on at least some of the increased costs to customers, and regular asset appraisals to get their book values in line with current market conditions.
Nelischer reflects: “Thankfully, we don’t have much of a balance sheet. Our inflation response is being part of the organisation’s general drive to keep costs under control and to counter these effects with a push for efficiency and manage costs proactively.”
The higher and uncertain inflation path of the past couple of years has also generated significant volatility in the FX market, creating another risk effect for treasurers. Multinationals face this challenge in their external relationships with suppliers and customers using different currencies, and internally among the various business units worldwide. This is particularly the case for S4Capital.
“We bring to market the combined force of intelligence, products, solutions and technology from around 30 businesses globally to the client under a single banner and a single P&L, which works very well for the client,” explains Nelischer. “But behind the scenes, we have a significant volume of intercompany transactions.”
Many of these transactions are naturally cross-border, which is where the FX element manifests. “What is good about that is it’s all internal, so there is great visibility,” Nelischer enthuses. “We decided to address that issue by simply managing it with discipline – not letting the challenge grow any bigger.”
S4Capital operates in a fast-paced industry where business cycles are typically short. People plan for the current or upcoming season, so the customer looks a few weeks ahead rather than anything longer term. The time horizon for any business the company does is naturally very short. Considering the FX risk generated by the market volatility, Nelischer took action to enhance the company’s risk mitigation.
“I introduced an intercompany netting programme to facilitate the payment and settlement as quickly as is feasible,” he says. “This adds another level of control for the FX risk, again by managing it with discipline.”
Counterparty risks in borrowing and funding
One of the biggest financial stories of the early part of 2023 was the banking turmoil that claimed several institutions in the US and Credit Suisse in Europe. While this run of bank failures was relatively self-contained compared with the 2008 global financial crisis, any corporates with exposures to the failed banks had to act quickly to preserve their capital.
Nelischer comments: “We are most active in the United States and witnessed a few failures there. A couple of those were banks that some of our businesses have traditionally worked with, but thankfully, the alarm system in treasury worked. We called the businesses affected and advised them to move their money out of risky banks there before it was too late, which they did, so that risk management safeguard worked.”
Over at RELX, a key part of treasury strategy is to monitor bank credit ratings and use these to set counterparty exposure limits. Perry reveals: “In some geographical regions where the local banks have lower ratings, we may often try to use an international banking partner because we feel more confident that they’ll be around for the long term.”
She also monitors data such as credit default swaps for any short-term indication that a bank might be getting into a sticky spot. “The main thing we do is try to sweep the cash regularly, keep our actual cash balances quite low and repay short-term debt,” Perry adds. “It’s more efficient that way.”
Elsewhere, the extent to which the disruption in the capital markets has impacted corporates depends on certain specific features. Aside from elevated borrowing costs, it might not be a huge problem for well-rated and understood corporates. However, for smaller, less well-understood companies that face any challenges, the markets may simply not open for them at a time of need.
This two-tier disparity is a significant issue and has also echoed in the divergence of rating outcomes in the past year.
“Investment-grade ratings have seen a pretty steady upgrade trend, with a net 15 upgrades in the first 11 months of 2024 - not massive but a gentle and positive trajectory,” reveals Griffiths. “But for ‘B’rated organisations, where the companies are smaller with more debt, it is almost the opposite picture. They stand at about minus 7 over the same period, a decent downgrade rate for a smaller population.”
The difficult conditions have caused many treasurers to review their funding options to find a way to retain liquidity while managing the risk of higher rates. The treasury team at S4Capital did precisely that. Nelischer admits: “I’ve reconsidered the funding mix, as the big credit instrument we have is based on variable rates which, of course, we’ve noticed going up.”
But when assessing the situation and looking at possible options, he found that the market had priced in an extremely high expectation of rising rates. “Contrary to popular misconception, hedging doesn’t mean locking in where you are today,” continues Nelischer. “It means locking in where the market expects you to be, which is much higher than the current market. You win only if reality is so much worse than expected. That was not an attractive proposition, so we decided to ride the market and knowingly accept rising rates.”
At RELX, there is a degree of leeway with its treasury policies regarding funding, but Perry notes that they have employed similar policies through the past few economic cycles. “We’re 50/50 fixed and floating, so we like to think we’re always half right,” she jokes. “We’re BBB-plus rated with Fitch, so we’re one of the better-rated companies, meaning we’ve still got good access to both the bond and commercial paper markets.”
One of the biggest challenges in the markets today for corporates is where the yield curves for both short-term and long-term rates have reached, which limits the strategies that treasurers can employ in their cash management.
“We can’t play the old trick where if we want a lower rate we go a bit shorter, because the short-term rates are, if anything, even worse,” adds Perry. “That will be my headache when we next come to decide whether we want to access the bond market or not.”
Supply chain squeeze
The recent macro environment has also posed a conundrum to treasurers on the supply chain side of their role. While tactics such as passing on costs and extending payment terms might be cheaper or more convenient in the short term, it could damage future supply chain relationships.
Nelischer advises: “Manage suppliers in the same way as your customers manage you: pay them on time, not necessarily early. Be sure that what you pay them is right and as agreed. In that context, I would advocate to look at them more as customers than suppliers because they are the ones who keep you in business.”
Indeed, in the current stagflation environment, every party, from the largest corporates through to individual end customers, may try to avoid payment as previously agreed to effectively finance themselves in the very short term. There is so much focus on cash, particularly in the corporate treasury department, that customers paying late is the last scenario businesses need.
“There’s also a question of counterparty exposure – customers that start paying later are often the ones that are having trouble,” adds Nelischer. “An ever-growing receivables portfolio with certain customers can quickly turn into a problem. Don’t allow that to happen.”
For treasurers in that situation, making the case for working capital management within the business is vital, ensuring that contact with the customers is maintained to ensure they pay. Understanding the avenues the organisation can explore to coax the payment from a customer is also crucial.
Perry reveals: “We have the luxury that, particularly with the digital products, we can turn them off if people don’t pay. That gives us quite a lot of leverage! But we have a negative working capital cycle, which puts us in a good position. We do make sure that we’re paying people on time. That’s not a way to try to save money. You have to be ethical.”
For manufacturing firms or where a company has a lot of medium-sized suppliers that need help, SCF works particularly well. The main corporate can provide this assistance by leveraging its good credit quality. Sometimes, there is a reciprocal arrangement where payable days will be lengthened, resulting in the suppliers receiving their money quicker and the corporate being paid swiftly. This essentially delivers improving credit quality for good companies. However, some obstacles remain that make SCF less appealing.
Griffiths outlines: “There’s more disclosure coming out under IFRS and, traditionally, disclosure has been patchy with these programmes. This requirement to disclose more might put some people off SCF.”
Think the unthinkable and plan ahead
Following a turbulent 2023, risk management will be high up on the agenda for treasurers heading into the new year. Awareness of the entire risk spectrum is vital to manage it successfully.
Nelischer cautions: “It may be a bit of an outlier, but the one big risk I have on the radar is political risk. More than anything, I’m looking at the democracy in the US.”
This reminder of the impact of election cycles on a country’s financial environment is well timed, with The Economist dubbing 2024 as the “biggest election year in history.”[1] With so many potential sources of economic disruption, treasurers must ensure they have contingencies in place.
Perry affirms: “It’s important to have a plan but also to think the unthinkable and build in those scenarios. If the worst case does occur, and who knows where the next global crisis will come from, having at least a little bit of a plan for everything can be a huge help.”
One critical factor here is the risk of underestimating the economic effects of the past 18 months’ interest rate rises. While market consensus is for a shallow global recession followed by a normalisation, this is still only speculation.
Griffiths concludes: “We’ve not seen a monetary tightening like we have over the past couple of years since the 1970s. What if we have underestimated the effects? What if that hit keeps going for longer than expected, with more of a negative impact on growth? Treasurers should be aware of that risk as 2024 unfolds.”
