A steady rise in leverage in recent years means Corporate Asia now has the most leveraged balance sheets globally. As Morgan Stanley’s Viktor Hjort notes, with Fed liquidity anticipated to slow, now the cycle turns more adverse. Asian corporate balance sheets face a combination of slower growth and higher funding costs. Slower economic growth is putting downward pressure on earnings growth and rising real rates is putting upward pressures on funding costs turning bad macro into even tougher micro. Asian banks are tightening lending standards in their procyclical way but Asian credit markets are facing a fundamental environment that for many corporate borrowers will feel like a recession.
Excerpted from Morgan Stanley’s Viktor Hjort,
Asian Risks Now Skewed To The Downside
The Backdrop: After Three Years of Rising Leverage Now the Credit Cycle Likely Turns Adverse
By the end of 2012, corporate leverage in Asia exceeded its 2008 peak, and at 2.67x for the broad corporate universe of large-cap corporates
That’s left Asia with the most leveraged balance sheets in the world today
Asia’s not alone in having releveraged since the global downturn, but the build-up has been more material than in other regions.
The rise of corporate animal spirits is often inversely related to the distance to the most recent downturn: fresh memories of a recession or crisis is a great moderator on balance sheet aggression (the eurozone today), but once those fade into distance (Asia’s last homegrown recession ended twelve years ago), credit risk starts to build.
Credit, as an asset class, tends to perform best just coming out of a downturn when a growth recovery, coupled with balance sheet discipline, drives significant improvements in credit profiles.
It can still do well in the middle parts of a cycle provided growth is stable and funding conditions benign, although carry is a more important return driver and idiosyncratic risks pick up as balance sheet trends become more mixed. However, the downside skews begin to emerge in the later stages of a cycle when leverage has already increased and the cycle turns more adverse, and that may be what is happening in Asia right now…
The Credit Environment Is Deteriorating Due to Both Slower Growth and Weaker Funding Conditions
The challenge to Asia’s credit cycle comes from both ends. An increasingly sluggish growth outlook creates downward pressures on earnings and internal cash generation. The slowdown is fairly widespread.
In addition, the cost of funding is on the rise. The rise in the cost of funding is ‘real’ – higher rates are no longer balanced by high inflation – and the rise now means that the gap between real GDP growth and real rates is the narrowest since the downturns in 2008/09 and before that 2001/02…
This macro environment – challenging operating as well as funding conditions – is particularly difficult for credit and unsurprisingly it has been associated with both rising corporate default rates and non-performing loans among banks in the past…
A good reason for capital – not just on liquidity withdrawal – to fundamentally withdraw from the world’s most-levered region. As Hjort concludes, at this point, downside risks are more material in Asia and they are rising.
Critically – as we noted here – the same reasoning applies to US markets where, though leverage has not risen as much, remains just as prone to the impact of higher costs of capital piled on to a re-leveraged balance sheet.