Is China’s Domestic Slowdown Driving A Global Trade Slump?

Fitch Ratings says the recent pattern of trade flows in Asia suggests that the sharp decline in world trade growth in the second half of 2018 was primarily due to the slowdown in domestic demand in China rather than the direct impact of tariffs associated with increased US-China trade tensions.

Fitch Ratings latest chart of the month shows that exports to China from a selection of other large economies in Asia have slowed much more sharply than their overall exports. Since intra-Asian trade flows are much less likely to have been affected by the tariff measures imposed by the US and China, this points to weakening domestic demand in China as a key driver of the slowdown. China’s year-on-year import growth (in nominal US dollar terms) turned negative at the end of 2018, despite rising import prices. This was the first decline since 2016 and reflects a slowdown in domestic investment and private consumption.

The US and the Eurozone have also seen their export growth to China falling more rapidly than total exports. Germany in particular has been hit hard by declining auto sales in China, although, for the Eurozone as a whole, exports have also been affected by declining sales in the UK and Turkey. US exports to China have fallen very sharply in recent months but these bilateral flows have been distorted by tariff measures, including possible front-loading of trade flows in mid-2018 ahead of anticipated further tariff hikes and the subsequent payback. The evidence from Asia suggests the outlook for Chinese domestic demand will be a key driver of global trade in 2019.

Eurozone 2019 Growth Forecast Cut to 1%; ECB Could Restart QE

Eurozone (EZ) GDP growth now looks likely to slow to just 1% this year according to a report published by Fitch Ratings‘ Economics team. The deterioration in growth prospects and declining inflation expectations will prompt the ECB to consider restarting asset purchases.

Economic activity data from the EZ has deteriorated more sharply than other parts of the world in recent months and has delivered the biggest negative surprise relative to market and Fitch’s own expectations.

“While numerous transitory factors are partly to blame, these cannot explain the breadth and depth of the slowdown. Rather, we believe that the slowdown has been primarily the result of deterioration in the external environment as net trade turned from a tailwind to a headwind,” said Fitch’s Chief Economist, Brian Coulton.

The domestic slowdown in China has, we believe, played a particularly important role here. Germany’s greater trade openness and larger exposure to China leave the largest European economy’s expansion more vulnerable to China’s domestic cycle and import demand. This is underlined by Germany having seen the biggest deterioration in activity data among the EZ economies – despite a healthy domestic economy with few of the imbalances that typically spark an abrupt downturn in domestic demand. Furthermore, the deterioration in manufacturing Purchasing Managers’ Indices (PMIs) since last summer has been greatest in countries with a large auto export sector, dragged down by the first decline in global car sales since 2009 and the first fall in vehicle sales in China for several decades.

The weakening in EZ external indicators has not been matched in the domestic economy. Labour market performance remains strong supporting household income growth, monetary policy remains supportive, bank lending conditions are easy and credit to households and businesses continues to grow. Only in Italy have we seen evidence of private sector borrowers reporting somewhat tighter credit availability. Fiscal policy is also being eased in the EZ and should be supportive of growth in 2019. Private sector debt ratios have improved significantly since 2012 in Italy, Spain and Germany.

EZ growth should recover through the course of 2019 as the policy response in China helps to stabilise its economy from the middle of the year, one-off impediments to growth in Germany unwind, and EZ macro policy is eased. However, early indications for 1Q19 and the profile of our China forecast mean that there will not be much of a pick-up in EZ quarterly growth before 2H19.

This suggests that EZ growth in 2019 is likely to be around 1% compared with our December 2018 GEO forecast of 1.7%, a substantial cut. Both Germany and Italy will see similar revisions, with 2019 GDP growth now forecast at around 1% and 0.3% respectively. Even with this lower forecast, downside risks remain from an escalation in global trade tensions, a deeper slowdown in China, a disorderly no-deal Brexit or increased uncertainty related to domestic political tensions.

The sharp deterioration in growth prospects and falling inflation expectations are likely to result in renewed monetary stimulus measures from the ECB.

“We had already been expecting the ECB to delay the start of its policy normalisation -both interest rates and balance sheet reduction – but we now believe it will seriously consider restarting QE asset purchases relatively soon,” added Robert Sierra, Director in Fitch’s Economics team..

We also foresee the ECB announcing a one- to two-year long-term refinancing operation (LTRO) in March to replace the existing TLTRO2 programme, which matures from June 2020. The rationale for a new targeted LTRO (TLTRO) is less convincing in light of improved conditions in the banking sector, but the ECB will want to avoid an unwarranted tightening in credit conditions by abruptly withdrawing liquidity facilities.

Fitch Says NAB’s Outlook Negative, But Affirms Australia’s Big Four

Fitch Ratings has affirmed the ratings of Australia’s four major banking groups: Australia and New Zealand Banking Group Limited (ANZ), Commonwealth Bank of Australia (CBA), National Australia Bank Limited (NAB) and Westpac Banking Corporation (WBC). At the same time it has revised the outlook on NAB’s Long-Term Issuer Default Rating to Negative from Stable. The Outlook on CBA’s Long-Term Issuer Default Rating remains Negative, while it is Stable for ANZ and WBC.

The rating review focuses on the Australian-domiciled entities within each group and therefore does not encompass their overseas subsidiaries.

NAB

The revision of the rating Outlook to Negative reflects the risk that NAB’s focus on remediating issues and changing culture means its ongoing operations may not receive sufficient management time, resulting in a weakening of NAB’s earnings relative to peers. Management changes may make this task more difficult in the short-term. The affirmation of NAB’s ratings reflects Fitch’s expectation that the bank will maintain its strong company profile in the short-term, which in turn supports its sound financial profile.

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and NAB’s self-assessment on governance, accountability and culture identified shortcomings within its management of operational and compliance risks, culture and governance. These were not aligned to what Fitch had previously incorporated into its ratings and resulted in a revision to our score for management and strategy, which also remains on negative outlook. NAB continues to have robust risk and reporting controls around other risks, including credit, market and liquidity risk, as reflected by its conservative underwriting standards and very high degree of asset-quality stability.

Fitch expects NAB’s asset quality and loan losses to display a very high degree of stability through business cycles, but could be more volatile than that of some domestic peers due to NAB’s greater business and corporate exposure.

Capitalisation and leverage are maintained with solid buffers over regulatory minimums, but ratios are at the lower end of those of domestic peers. However, these are likely to trend towards domestic-peer levels as NAB progresses towards meeting the Australian Prudential Regulation Authority’s “unquestionably strong” capital requirements by the 1 January 2020 implementation date. Additional capital requirements should be met in an orderly fashion given the bank’s strong market position and capital flexibility, with its capital position likely to be bolstered by the announced partial conversion of its NAB convertible preference shares into ordinary equity and slower forecast loan growth. The bank’s earnings and profitability are moderately variable over economic cycles and it remains reliant on offshore wholesale funding. Sound liquidity management provides some offset to this risk.

ANZ

The affirmation of ANZ’s ratings reflects the bank’s strong company profile and simple business model in its home markets of Australia and New Zealand, which support its financial profile. The bank’s strong market share across most products provides a higher degree of pricing power relative to smaller peers and allows it to generate strong and consistent operating returns through the cycle.

Australian household debt is still high relative to international peers, meaning households are susceptible to a sharp increase in interest rates or rising unemployment. The risk of external shocks also remains prominent in light of the geopolitical environment and potential impact on global growth. However, none of these scenarios are in Fitch’s base case.

The ongoing execution of ANZ’s simplification strategy supports the rating, as it is likely to reduce complexity, provide greater focus on key markets and improve the bank’s overall risk appetite. The focus on remediating and rectifying issues identified in various inquiries, including the royal commission, means there is a risk that the bank’s ongoing operations do not receive sufficient management focus, resulting in a weakening of its credit profile.

ANZ’s asset quality is likely to deteriorate modestly in 2019. Earning pressure should continue due to more modest loan growth, continued pressure on net-interest margins, rising funding costs, a probable rise in impairment charges and further remediation and compliance costs. ANZ maintains solid buffers over regulatory capital minimums and its common equity Tier 1 (CET1) capital ratio was the highest of Australia’s major banks as of September 2018. These buffers are likely to trend toward domestic-peer levels as asset sales are completed and capital returned to shareholders. There is a reliance on offshore wholesale funding, similar to other Australian major banks, but liquidity is managed well.

CBA

The affirmation of CBA’s ratings reflects Fitch’s expectation that the bank will maintain its strong company profile in the short-term, which in turn supports its sound financial profile. The Negative Outlook reflects challenges in remediating shortcomings in operational and compliance risk management that contributed to a number of conduct and compliance issues over more than a decade. Management’s focus may be diverted from ongoing operations when rectifying these shortcomings and increased compliance costs might manifest in weaker earnings, particularly in relation to domestic peers.

CBA’s remediation of these shortcomings is on track, but the process is only at an early stage and is complex. There have been significant changes in the last two years to the bank’s management and board, who appear committed to rectifying the outstanding issues. The group is also in the process of exiting its life insurance and wealth management operations, which may also distract management from core operations. Successful completion of the remediation and asset divestments without a significant erosion of the bank’s franchise would support the current ratings. The remaining operations after the asset divestments will focus on traditional banking operations in Australia and New Zealand.

CBA retains a market-leading position in Australian retail banking despite these issues and has invested heavily in technology to combat the looming threat of digital disruptors. The group continues to maintain peer-leading profitability, while asset quality is sound and capital has continued to improve. There is a reliance on offshore wholesale funding, similar to the other Australian major banks, but liquidity is managed well.

WBC

WBC’s strong company profile supports its ratings. The bank’s market share provides it with some pricing power relative to smaller peers in Australia and New Zealand and allows it to generate strong and consistent operating returns through the cycle, although in the short-term, we expect these to be affected by a challenging operating environment. In addition, WBC has been less affected by conduct-related issues than its domestic major-bank peers, meaning earnings may come under less pressure than for peers despite weaker system growth prospects. Nevertheless, WBC may still be susceptible to legal action from regulators and customers.

Partly offsetting the risks from high household debt is WBC’s loan underwriting, which Fitch believes is conservative in the global context. WBC has progressively tightened its underwriting for mortgages and commercial exposures, particularly property development, over recent years. This was driven in part by the regulator, mainly in relation to mortgages. The bank’s loan book is highly collateralised and we expect its asset quality to remain a strength relative to that of international peers, although loan impairments could rise modestly in 2019 from the current low levels.

WBC is unlikely to have difficulties to achieving “unquestionably strong” capital targets set by the regulator before the 2020 deadline – its CET1 capital ratio was already above the minimum at end-September 2018. Offshore wholesale funding reliance remains a weakness relative to many similarly rated international peers, although satisfactory liquidity management and diversification of funding helps offset some of this risk.

Volatility Strains Capital Markets at U.S. Banks

A spike in market volatility during fourth quarter 2018 dragged down overall capital markets results for the five major U.S. trading banks including: Bank of America Corporation (BAC), Citigroup, Inc. (C), The Goldman Sachs Group (GS), JPMorgan Chase & Co. (JPM) and Morgan Stanley (MS), according to the latest report from Fitch Ratings.

“Market volatility can be a boost to trading revenues; however, too much volatility in fixed income sales outweighed strength in equity trading and advisory revenues this quarter,” said Julie Solar, senior director, Fitch Ratings. “Too little volatility results in fewer trading opportunities, but too much keeps investors on the side lines.”

Total debt underwriting revenues fell 24% from the year-ago period, reflecting volatility, particularly impacting the high-yield market. Fitch expects that some volume was financed directly by commercial banks, which reported very strong commercial and industrial loan (C&I loan) growth trends in 4Q18.

However, despite a challenging final six weeks of the year, record earnings during the first part of the year contributed to the highest full-year results since 2009. Capital markets revenues for the five banks included in this report totalled $107 billion in 2018, approximately 4% higher than in 2017, aided mainly by a significant increase in equity sales and trading revenues.

M&A activity in 4Q18 increased a considerable 37% versus last year, buoyed by a significant rise in M&A completions and continued strength from the technology and healthcare sectors. Several banks noted that deal pipelines remain strong, although down on a linked-quarter basis.

“Even with a strong backlog of deals, continued volatility and market sentiment could impact banks’ ability to bring transactions to market, and the IPO pipeline may also feel an impact from the prolonged government shutdown as the SEC was unable to review pending IPOs for several weeks. 2019 is off to a strong start and the first quarter is typically the strongest of the year, but it is unclear how investment banking revenues could be impacted,” added Solar.

Global Government Debt Reaches New High

Global government debt reached USD66 trillion (converted at market exchange rates) at end-2018, nearly double its 2007 level and equivalent to 80% of global GDP, according to Fitch Ratings‘ new Global Government Debt Chart Book.

Developed market (DM) government debt has been fairly stable in US dollar terms, at close to USD50 trillion since 2012. In contrast, Emerging market (EM) debt has jumped to USD15 trillion from USD10 trillion over the same period, with the biggest increases in percentage terms being in the Middle East and North Africa (104%) and Sub-Saharan Africa (75%), though these regions still have comparatively low debt stocks, at less than USD1 trillion each.

“Government debt levels are high, leaving many countries poorly positioned for financial tightening as global interest rates begin to move higher,” said James McCormack, Global Head of Sovereign Ratings at Fitch.

While there are only 11 sovereigns rated ‘AAA’, they account for about 40% of global government debt, virtually unchanged over the last two decades. The US (AAA/Stable) is by far the world’s most indebted government in dollar terms, with consolidated general government obligations close to USD21 trillion. US debt is going up by about USD 1 trillion per year. To put that into perspective, the total debt stocks of France (AA/Stable), Germany (AAA/Stable), Italy (BBB’/Negative) and the UK (AA/Negative) were all in the range of USD2.4 trillion-USD2.7 trillion at end-2018.

Consistent with the dominance of ‘AAA’ sovereigns, 93% of global government debt carries an investment grade (BBB- or higher) rating. The ‘A’ category is the second-largest, as Japan (A) and China (A+) are the second- and third-largest government debt markets, with outstanding stocks of USD12 trillion and USD6 trillion, respectively.

The number of sovereigns rated in the ‘B’ category (or lower) has increased sharply in recent years, as several ‘BB’ commodity exporters were downgraded as they struggled with the correction in commodity prices, and the exceptionally low interest rate environment attracted new, less creditworthy, sovereigns to capital markets for the first time. Even so, sovereigns in the ‘B’ category (or lower) account for 28% of the rated portfolio but only 3% of global government debt.

There has been a steady deterioration in the credit quality of government debt in recent years. In DMs, the average rating (weighted by the sovereigns’ debt stocks in dollar terms) of outstanding government debt was just under ‘AA’ at end-2018, losing one notch since 2011. In EMs (excluding China), the average rating at end-2018 was slightly below ‘BB+’, its lowest since 2005.

Estimated effective interest rates faced by governments (calculated as interest payments divided by the debt stock) have drifted lower since 2000 in all regions and rating categories. The lowest effective rates by rating are found in the ‘A’ category, largely reflecting conditions in Japan, and the highest effective rates by region are in Latin America, as has been the case since 2010.

“In 2018 there were more upgrades than downgrades but, based on where we have negative rating outlooks, we believe 2019 looks less favourable, especially for the Latin America and Middle East and Africa regions,” added McCormack

“Common themes that have driven sovereign ratings in the last few years will dominate again in 2019, including tightening sovereign financing conditions, commodity price fluctuations and political and geopolitical developments. Slowing economic growth in some countries may bring fiscal concerns back to the fore, particularly given the high starting positions with respect to government debt,” said McCormack.

China Corporate Defaults Highlight Disclosure, Governance Issues Says Fitch

Three defaults in recent months have highlighted the risk of broader disclosure and governance problems among Chinese corporates, as well as the variable quality of local auditing, says Fitch Ratings. Shandong SNTON Group Co. (Snton, RD), Reward Science and Technology Industry Group Co. (Reward, RD) and Kangde Xin Composite Material Group Co. (KDX, WD) all defaulted on moderate amounts relative to their reported cash holdings.

Corporate defaults are usually driven by insufficient liquidity, but these companies’ stated cash balances cannot explain the non-payments. Snton was sued by the Hebei Bank Qingdao Branch on 25 September for CNY139 million, which included defaulted principal of two drawn facilities. It had a reported cash balance of CNY4 billion at end-June, of which we estimate roughly half was unrestricted, which should have provided a significant buffer against default. It was also able to raise CNY400 million through domestic bond issuance in 1H18, suggesting normal access to the domestic funding market, despite generally tight credit conditions.

Reward failed to repay CNY300 million of commercial paper on 6 December, despite having CNY4.9 billion in cash – just CNY548 million of which was restricted – at end-June 2018, and CNY4.2 billion at end-September, according to its management accounts. KDX failed to repay CNY1 billion of commercial paper on 15 January. It had reported available cash of CNY15 billion and a net cash position in September.

These companies did not show other typical signs of distress prior to the defaults. The rise in Snton’s leverage in 2017 was above Fitch’s expectations and drove our downgrade of the company’s rating in May 2018, but its FFO net leverage of around 3.5x at end-June 2018 did not indicate an unsustainable capital structure. Reward’s FFO interest coverage was over 3.5x in 9M18, while KDX was around 5x in 1H18.

The defaults call into question the actual availability and amounts of reported cash balances. The three companies reported their restricted cash balances in line with Chinese accounting standards – China GAAP – which mandate similar disclosures on cash encumbrances to international standards. It is unclear if there were less formal restrictions in place, such as agreements with lending institutions to keep sums in designated accounts to support facility access. In any case, Reward and KDX confirmed to Fitch shortly before their commercial paper due dates that their holdings of realisable cash were sufficient to meet obligations.

Uncertainty over the accuracy of the companies’ books and disclosure of pertinent information is ultimately related to governance and accounting quality. Governance issues – often challenging to uncover – have been a factor in Fitch’s ratings on Reward and KDX. Reward’s ratings have been constrained by its low transparency as a private unlisted company with concentrated share ownership. The company changed auditor and re-issued its 2017 accounts due to disclosure and accounting problems flagged by the regulator.

KDX is listed on the Shenzhen Stock Exchange (SSE), but an apparent problem with its disclosure of concerted party arrangements at shareholder level prompted an SSE investigation, which hampered access to funding and prompted our downgrade in December. Snton’s case demonstrates unpredictable financial management. It failed to repay domestic bank loans, but has continued to service onshore bonds.

All three companies are audited by domestic accounting firms. International bond investors have become more receptive of Chinese issuers choosing not to hire one of the “Big Four” international accounting firms over the past decade. However, the quality of domestic auditing is variable. It is not unprecedented for domestic audit firms to be reprimanded for shortcomings. The auditors of Snton, Reward and KDX have previously received reprimands, albeit not for their work on these companies.

Global Growth Outlook Dented Not Dismantled

Fitch Ratings says the outlook for global growth has been dented by a series of recent weak data releases, but not dismantled. The broad contours of the agency’s December 2018 Global Economic Outlook (GEO) forecasts for 2019 – with above-trend growth in the US and policy easing preventing growth dipping below 6% in China – still look intact. The eurozone outlook has weakened more significantly but some recovery in growth in 1H19 still looks likely after a very disappointing 4Q18.

A string of weak data releases since the GEO was released in early December have raised market concerns about the risk of a sharp downturn in global growth in 2019. Most dramatically, business sentiment in the manufacturing sector has seen a widespread deterioration across multiple geographies. Fitch’s economics team’s latest chart of the month shows the (unweighted) average manufacturing Purchasing Managers’ Index (PMI) for the 20 economies covered in the GEO and suggests that the upturn in the global manufacturing cycle seen from 3Q16 petered out in 2H18, consistent with the slowdown also seen in world trade through 2018.

A string of weak data releases since the GEO was released in early December have raised market concerns about the risk of a sharp downturn in global growth in 2019. Most dramatically, business sentiment in the manufacturing sector has seen a widespread deterioration across multiple geographies. Fitch’s economics team’s latest chart of the month shows the (unweighted) average manufacturing Purchasing Managers’ Index (PMI) for the 20 economies covered in the GEO and suggests that the upturn in the global manufacturing cycle seen from 3Q16 petered out in 2H18, consistent with the slowdown also seen in world trade through 2018.

This deterioration in the global manufacturing cycle has its roots mainly in the slowdown in growth in China, which became evident from the middle of last year and followed earlier credit tightening. China’s share of world GDP has continued to grow rapidly in recent years and its domestic economic cycle now has much more pronounced effects on the rest of the world than in the past. The current slowdown in China is substantial – particularly when measured in terms of nominal GDP growth, which peaked at nearly 12% y/y in early 2017 and likely fell below 9% y/y in 4Q18. Moreover, the latest slowdown has been reflected in consumer spending to a greater extent than in the past, including in car sales, which recorded a 4.3% decline last year. China accounts for around a third of global car sales and it seems likely that global auto sales – a key component of world manufacturing – declined last year for the first time since 2009.

However, our 2019 forecast for China’s real GDP growth of 6.1% still looks achievable despite recent weakness in the data. Retail sales, industrial production, profits and trade growth have all fallen further since early December but fixed asset investment growth has recovered in the last three months with infrastructure investment – which led the initial slowdown – returning to positive y/y growth. New housing starts also continue to grow robustly. Moreover the latest credit data showed tentative signs of stabilisation with aggregate financing to the real economy (adjusted to exclude equity and include local government bonds) growing 10.3% in December compared with 10.4% in November. This followed several months of much larger declines in the annual growth rate.

Policy in China has been eased further with the recent cut in banks’ required reserve ratios and the authorities’ commitment to tax cuts and supporting infrastructure spending has become more vocal in recent weeks. Our current baseline forecasts also assume that US tariffs on USD200 billion of Chinese imports will rise to 25% in early 2019, a shock that may be avoided if trade talks make further progress.

Manufacturing indicators in the US have also deteriorated but private sector demand still looks robust and ‘now-cast’ estimates of 4Q18 GDP based on high frequency data are pointing to annualised growth of around 3%, roughly in line with the December GEO. Strong job gains and rising nominal and real wage growth continue to support the consumer and lead indicators of business investment suggest prospects are still for decent growth in 2019, albeit at a slower rate than in 2018. The tightening in financial conditions has been modest and the Fed now looks likely to raise rates in 2019 by less than the three hikes predicted in the December GEO. The Federal government shutdown could take a toll on growth in 1Q19 but for now our working assumption is that fiscal policy continues to provide support to US domestic demand growth in 2019 as a whole.

There is a more material threat to our 2019 eurozone growth forecasts. Eurozone PMI’s have seen the largest falls in recent months and this has been corroborated by weak ‘hard’ industrial production data in the large member states. The December GEO forecast that 4Q18 GDP would rebound to 0.5% is not supported by the incoming data – instead this now points to another quarter of very subdued growth similar to the 0.2% expansion seen in 3Q18.

However, a number of temporary factors – including disruptions to car sales and production related to new emissions standards, weather related complications to domestic trade flows in Germany and social protests in France – have likely played a part in weak eurozone activity in 2H18. This suggests that some recovery in sequential growth should be seen in 1H19. Tightening labour markets and rising wage growth should also remain supportive of consumer spending. Nevertheless the slowdown in world trade and fading credit impulse now look likely to see eurozone growth heading back down towards potential (estimated to be below 1.5%) more quickly than previously expected. The possibility of a no-deal Brexit adds further downside risks. The weaker activity outlook reinforces our expectation that the ECB will likely modify its forward guidance on interest rates soon and possibly consider other accommodative moves related to bank financing.

Fitch Housing Outlook, Risks To The Downside

Fitch published their Global Home Housing And Mortgage Outlook for 2019. The story appears to one of falling values in some major centres and more uncertainty economically and politically. For Australia, they expect a national peak-to-trough home price drop of 12% in Australia with Sydney and Melbourne posting larger declines in 2019.

They say overheated home prices in several major cities have been a key theme in recent years. But prices fell or stalled in 2018 in Melbourne, Stockholm, Sydney, Toronto and Vancouver due to government actions to reduce foreign purchases, macro-prudential measures and/or stretched affordability. Fitch Ratings forecasts home prices to fall in Australia and Sweden in 2019 before stabilising in 2020, modest corrections in China and South Korea, and stalled growth in Canada. We have also seen regulators actively managing markets through the tightening and loosening of lending rules.

High Household Debt Amplifies Risks

Fitch says household debt-to-GDP ratios are at or over 100% in Australia, Canada, Denmark, the Netherlands and Norway, and over 85% in New Zealand, South Korea, Sweden and the UK. High household debt makes the wider economies more vulnerable to shocks in the financial sector and borrowers more exposed to downturns. Household debt growth has stalled in Denmark and the Netherlands due to affordability constraints and regulatory intervention. The household debt-to-GDP ratios in Australia,
Canada and Norway have stabilised after sharp growth while they have continued to grow in China and South Korea, albeit at a slower pace.

Political Uncertainty Affects Housing

Fitch highlights several cases of political risks in the report, including Brexit, a political appointment to oversee Fannie Mae and Freddie Mac, and new governments in Latin America. Their impact varies: our no-deal Brexit scenario analysis suggests price drops in the UK and much slower price growth in Ireland while uncertainty is already contributing to price falls in London; less government participation in the US mortgage market could
increase mortgage pricing and lead some lenders to reduce product offerings; in Brazil, there is uncertainty regarding the new government’s ability to enact market-friendly policies that would support home price growth.

Cracks Appear in Economic Growth Outlook

Fitch notes in its Global Economic Outlook that cracks are starting to appear in the global growth picture, with China and the eurozone slowing, further rate increases expected in the US, stubbornly low core inflation in the eurozone and Japan, and the dollar’s strength putting pressure on emerging markets.

These factors contribute to Fitch’s view that economic growth is slowing, albeit to a moderate degree and in many cases from a position of strength. However, our macroeconomic outlooks to 2020 for the 24 countries in this report are still mainly stable or improving, which supports our mostly stable housing and mortgage market evaluations.

Arrears Concerns Beyond 2020

Fitch does not forecast material increases in arrears in 2019 and 2020 for any country in the report. We expect the impact from weaker growth and generally slow mortgage rate rises to be relatively benign. But there is downside pressure in the medium term from rising rates, fading fiscal stimulus in the US and weaker growth in China, in the context of still high global debt. A faster-than-expected tightening in global financial conditions could worsen mortgage performance.

Mixed Impact from Rising Rates

The speed of mortgage rate rises will vary with North America expected to post the fastest increases and Japan and the eurozone the slowest. The impact will depend on whether mortgages have long-term fixed rates and the macroeconomic backdrop. Highly leveraged markets with large numbers of variable-rate loans, such as Australia, Norway, Sweden and the
UK, could see marked deterioration in loan performance should rates rise quickly. Markets with long-term fixed-rate loans, such as Belgium, France, Latin America, the Netherlands and the US, may see lenders gradually increase their appetite for higher-risk borrower and loan characteristics as their profitability suffers and competition intensifies.

Price Declines Set to Continue In Australia

Fitch forecasts a national home price decline of an additional 5% in 2019 before above-trend GDP growth and strong net migration should stabilise prices in 2020. The peak-to-trough decline of 6.7% as of December 2018 has been driven by lower investor demand reflecting macro-prudential limits on interest-only and investment lending, and tighter enforcement
of lending standards.

They expect price declines to continue at a similar pace in 2019 in Sydney and Melbourne, where larger falls have occurred (peak-to-trough declines of 11.1% and 7.2%, respectively, as of December 2018). The most expensive quartile of properties has experienced the largest declines with falls of 9.5%.

GDP Growth Supports Performance

They forecast loans in arrears over 90 days to increase slightly to 70bp by 2020. Properties in possession will take longer to sell as home prices fall, so loans will remain delinquent for longer. Early-stage mortgage arrears (30 to 90 days in arrears) will be broadly stable in 2019 at 60bp even though lenders have modestly raised mortgage rates for investment and interest only loans despite no policy rate increases. Mortgage performance will be supported by slowing but still solid economic growth, decreasing unemployment and only gradually rising policy and mortgage rates. Risks remain, stemming from the highest household-debt-to-GDP ratio in this
report at 121% as of 2Q 2018.

Credit Growth to Remain Low

Housing credit growth is projected to ease further in 2019 to 3.5% from 5.1% yoy growth in October 2018. This is due to tightened macro-prudential limits and a more conservative interpretation of regulatory guidelines for mortgage servicing in light of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Fitch believes
the commission’s final recommendations, due in February, may further reduce credit availability.

Investment loan origination has been hit by a limit to investment loan growth of 10% (introduced in 2014 and removed in July 2018 for lenders that can prove they have met regulatory requirements for the past six months) and a limit of interest-only origination to 30% of new lending (introduced in 2017 and removed from January 2019 for lenders that have
met regulatory requirements for the past six months) along with foreign investor levies and taxes from state governments.

U.S. Government Shutdown Illustrates Policy Weakness

The continuing U.S. government shutdown highlights the periodic weakness in its budget policymaking, Fitch Ratings says. Shutdowns have not directly affected the country’s ‘AAA’/Stable sovereign rating but can signal that disputes on other issues are a constraint on fiscal policymaking.

The partial federal government shutdown that began Dec. 21 is now the longest since October 2013 (the longest shutdown lasted three weeks in 1995/1996). President Trump’s refusal to sign temporary spending bills that did not include USD5.6 billion for border wall funding and which included appropriations for other programs exceeding those in the president’s budget triggered the shutdown.

When and how the government will reopen remains unclear. The advent of a new Congress on Thursday saw a similar spending package passed by the House of Representatives, where the Democrats now have a majority. The package did not include additional wall funding, is opposed by the Trump administration and will not be taken up by the Senate. Some Republican senators have advocated passing a continuing resolution to reopen the government.

U.S. fiscal policymaking coherence can be weak relative to peers. The policymaking process at times has entailed shutdowns (there were two short-lived shutdowns earlier in 2018) and debt limit brinkmanship.

Shutdowns are much less of a risk to sovereign creditworthiness than debt limit impasses. The partial nature of the current shutdown, affecting around 25% of the federal government, should limit its economic impact, although this will increase depending on its length.

Nevertheless, the ongoing shutdown suggests that the current arrangement of political forces, following November’s midterm elections that resulted in a divided Congress, limits policy consistency. It also makes it unlikely in the near term that medium-term fiscal challenges, such as rising mandatory spending will be addressed.

The main implication for our U.S. sovereign credit view will depend on whether we feel this shutdown foreshadows a more pronounced destabilization of fiscal policymaking, including brinkmanship over the debt limit, which happened in October 2013. The debt limit is due to come back into force in March, although the Treasury would have several months during which it could operate under extraordinary measures. We view the risk of a failure to lift the debt limit in time to prevent a U.S. federal debt default as remote. House Democrats’ adoption of a new version of the so-called Gephardt rule, linking debt limit suspension to the approval of budget resolutions, could make debt limit impasses less likely.

Evidence of greater dysfunction in fiscal policymaking could still contribute to negative pressure on the U.S. rating. This is especially the case as deficits continue to increase (pro-cyclical fiscal stimulus in 2018 helped widen the federal deficit in the fiscal year Sept. 30 by 17% to USD779 billion) at a time when growth is likely to slow.

Democratic control of the House reduces the prospect of additional, large tax cuts over the next two years, although spending consolidation is also unlikely. Policies enacted by the new Congress could influence U.S. fiscal outturns, although we expect relatively limited impacts on our deficit forecasts. These include plans to reintroduce the ‘PAYGO’ budget rule mandating that any changes to legislation affecting mandatory spending do not increase budget deficits. Democrats have also said they will amend the rule that requires a three-fifths majority in the House of Representatives to raise income taxes.

Sovereigns, Corporates in Focus as Credit Cycle Turns

Credit risks across many sectors are rising with a looming cyclical deterioration in credit conditions and global debt at near-record levels, says Fitch Ratings. However, the macroeconomic conditions and the sector breakdown of leverage in developed markets differ significantly from the last downturn in 2008. We expect governments and non-financial corporates to be at the center of any coming storm for credit conditions.

Since 2007, aggregate financial sector and household debt as a percentage of GDP globally has remained roughly steady according to data from the IIF. In contrast, governments and non-financial corporates have seen their debt rise significantly, up 27 percentage points (pp) and 16 pp, respectively. These sectors’ capacity to manage a macroeconomic slowdown accompanied by tightened financial conditions will thus be challenged.

Government debt/GDP ratios have increased substantially across most large and developed economies since 2007, leaving some sovereigns heavily exposed in the event of a future economic downturn with potential negative rating implications. A turn in the global credit cycle characterized by tighter financial conditions is more likely to be felt by emerging markets in the short term, which will face heightened volatility and capital flow disruption.

Non-financial corporates were not a primary source of risk during the last financial crisis. However, corporate leverage has risen markedly since then, enabled by low rates, rising equity valuations and the expansion of non-bank lenders. In addition, corporate borrowers have largely used this funding to expand shareholder returns and M&A, which have far outstripped capex. This has already driven negative rating trends for U.S. corporates over the past two years, despite relatively strong economic growth during that time. Ratings distribution in the U.S. corporates portfolios has changed significantly since the pre-crisis period, with ‘BBB’ category rated issuers rising relative to higher investment-grade categories.

Compared to sovereigns and non-financial corporates, banks in developed markets are in a more robust and resilient position compared to the last financial crisis. Capital levels and liquidity are significantly stronger, owing to a wave of regulatory reform, while reduced risk appetite and smaller loan portfolios have led to a significant reduction in banking assets as a proportion of GDP. While banks have retrenched, higher risk lending activity has moved into less visible areas of the non-banking financial system. This could increase uncertainty for the financial market heading into a downturn while adding to risks from the interconnectedness between non-bank financial institutions and the rest of the financial market.