Katie Falconi, Managing Director of Fitch Ratings Credit Policy Group, outlines why inflation risk is one of the key risks they are keeping an eye on, primarily because of the impact it has on policy and structural demand in the US and the knock-on effects for Emerging Markets, such as South Africa.
Fitch maintains a shortlist of 5-6 key global macro risks that they believe can affect the greatest number of Fitch’s rating if they were to materialise. One of these is US inflation for two reasons. Firstly, of all the major developed economies, inflation pressures are strongest in the US, both for policy and structural supply and demand reasons. The Fed has explicitly said that it will prioritise a return to full employment and is perfectly happy for inflation to run above target for a period of time. Meanwhile, supply chain disruptions set against ongoing robust demand, will continue to push consumer prices higher. The second reason is that if policymakers were to lose credibility and US inflation expectations become de-anchored among market participants, it could have a rapid contagion effect into financial and real estate asset valuations. At a high level, Fitch sees a wind down of the Federal Reserve’s asset purchases to be announced in the next 12 months. This, together with the strong US recovery is boosting inflation expectations. We expect this to lift real interest rates from their unprecedented lows. As the economic recovery gains traction this will put upward pressure on bond yields, even as the Fed keeps the Fed fund rates at its current range of 0-25bps until 2024. US 10-year nominal bond yields have already risen and steepened significantly this year as the financial markets anticipate these trends. But, real yields at between -0.5% and -1% over 2021 to date are more negative now than at any point after the GFC. Peace time real yields in the US have averaged 2% since 1900. Fitch’s economic team estimates that the US fundamental equilibrium real interest rate is around 1%, implying a long-term nominal rate of 3%, which is a long way from where we are today.
Fitch continues to evaluate the ways in which an inflation shock could feed through to ratings. They’ve started looking at the investment portfolios of large banks and other financial institutions to estimate how big of a challenge some combination of higher volatility in rates, rising US yields and a potential sell-off in risky assets could be for these issuers. This could then easily translate into rising risk premia and higher bond costs on a broader basis. At a corporate level, their analysts are much more concerned about inflation risk from the perspective of funding costs and market access, than a potential profit margin squeeze. While maturity risk remains manageable, the leveraged loan market is a floating rate asset class exposing issuers to rising rate risk if it takes hold.
A natural area of focus is the nexus between US inflation and emerging markets. At the moment, the so-called reflation trade is keeping the trade rated USD on a weakening trajectory, which is unusual when US growth prospects look so strong in the global context. From a debt perspective, relative to the last downturn, EM by and large have lower external financing needs, but rising local currency debt and higher participation by foreign investors in their local markets. We’ve already seen capital outflows pick up speed this year, which is something to keep an eye on if an inflation scare provokes a shift away from the reflation trade towards risk-off sentiment. In the meantime, countries with deep local markets may be tempted to double down on QE measures and those with access to non-resident capital may start to ramp up their foreign currency borrowing. Either of these could create future vulnerability profiles.
The aggregate increases in EM government debt to GDP in recent years has left these issuers more sensitive to higher interest rates through higher debt service costs and debt sustainability challenges. In the median EM, general government debt increased to 62% of GDP at the end of 2020, up from 34% at the end of 2012. In tandem, the median EM interest burden has roughly doubled over the past decade compared to DM, which have benefitted much more from low interest rates as their interest payments are declining despite growing debt burdens.