DM Sovereign Rating Model For Q2 2020

The major ratings agencies are downgrading corporates at a record-setting pace due to the impact of the coronavirus, and it’s only a matter of time before their focus turns to the sovereigns. Our own sovereign ratings model suggests that the recent Fitch downgrade to the UK was only the beginning.

We have produced this interim ratings model to assist investors in assessing relative sovereign risk across the major Developed Markets (DM).  While the situation is still fluid with regards to the ultimate coronavirus impact on the global economy as well as the policy responses, we thought it would be useful to measure the potential ratings impact of this unprecedented economic crisis.

We have to stress that we are assuming that the ratings agencies have not changed their methodologies.  Our own model was constructed on the long-standing metrics that help determine a country’s creditworthiness.  With most countries blowing out their budget deficits and many engaging in Quantitative Easing, many lines have blurred.  This bears watching, but the fact that Fitch recently downgraded the UK after its virus response (see below) suggests no change yet in the agencies’ way of thinking.  Stay tuned.

 

DEVELOPED MARKETS RATINGS SUMMARY

There have been many major DM rating actions recorded this year.  Since the spread of the coronavirus picked up in Europe, most have been negative and it will only get worse.

Fitch has made the most negative moves this year with three.  It downgraded the UK a notch to AA- with negative outlook.  Our model shows this was justified and warns of further downgrades.  Fitch also downgraded the outlooks on Belgium’s AA- rating and Cyprus’ BBB- rating to negative and stable, respectively.  S&P has made one negative move this year, downgrading the outlook on Australia’s AAA rating from stable to negative.  Our model shows Australia moving dangerously close to dropping into AA+ and bears watching.  Moody’s has made two negative moves this year.  It downgraded Hong Kong one notch to Aa3 with stable outlook and moved the outlook France’s Aa2 rating from positive to stable.  We do not think the Hong Kong move was justified, but our model points to further downgrade risks to France.

It’s worth noting that not every recent move has been negative.  Just this month, S&P affirmed Japan’s A+ rating with positive outlook, which This lines up with our implied rating.   S&P also just affirmed the US’ AA+ rating with a stable outlook, while Fitch also affirmed its AAA rating for the US with stable outlook in late March.  We are very surprised that the US is getting a pass now, as our model has shown downside risks for several quarters and now culminating in a sharp drop to AA-.  Fitch also affirmed its ratings on Switzerland (AAA), Ireland (A+), and Norway (AAA) in early March, all with stable outlooks.  Moody’s affirmed New Zealand’s Aaa rating this month with stable outlook, as did S&P on its AA rating with positive outlook.

The few positive moves have been concentrated in the smaller eurozone economies.  S&P upgraded the ratings of Lithuania and Latvia and upgraded the outlooks of Estonia and Malta.  Fitch upgraded the ratings of Lithuania and Greece and upgraded the outlook of Finland. Moody’s has not made any positive moves this year.

DEVELOPED MARKETS RATINGS OUTLOOK

Within the AAA credits, most scores fell sharply across the board.  The two exceptions were Singapore and Norway.  Whilst the stronger AAA credits (mostly northern eurozone and the Scandies) easily maintained their implied ratings, the drop is overall creditworthiness is nonetheless worrisome.  Australia’s implied rating is right on the cusp of moving into AA+ territory, whilst Canada’s is getting somewhat close to that threshold.  There are no ratings implications here yet, but bears watching.

The US warrants a special comment.  Its implied rating fell into AA- territory.  It had been going back and forth between AAA and AA+ for several quarters but this crisis has pushed the implied rating down even further.  This means that the US stands a decent chance of losing its Aaa and AAA ratings from Moody’s and Fitch.  S&P already took its AAA rating away back in August 2011.

Within the AA credits, scores were broadly lower.  Furthermore, the revised scores had a direct impact on the implied ratings.  Both Hong Kong’s and Ireland’s implied rating dropped down to AA/Aa2/AA.  This puts both of them  close to actual ratings and we see no ratings implications yet.

Within the A credits, all scores worsened.  Here too, the scores dropped enough to impact the implied ratings.  Japan’s implied rating fell a notch to A+/A1/A+, which puts it close to actual ratings of A+/A1/A.  France’s fell sharply from AA-/Aa3/AA- to A/A2/A, which suggests strong downgrade risks to actual ratings of AA/Aa2/AA.  Also of note, the UK’s implied rating fell two notches to A-/A3/A- and continues to suggest strong downgrade risks to actual ratings of AA/Aa2/AA-.

Within the BBB credits, Spain deteriorated.  Its implied rating fell two notches to BBB-/Baa3/BBB-.  This suggests strong downgrade risks to actual ratings of A/Baa1/A-.  Furthermore, Spain’s implied rating is getting very close to dropping down into sub-investment grade BB+/Ba1/BB+ and so bears watching.  If the agencies were to agree with our assessment, this would make Italy sub-investment grade for the first time ever.

Within the BB credits, Italy’s score worsened modestly.  However, it was enough to push its implied rating down a notch to sub-investment BB+/Ba1/BB+.  If the agencies were to agree with our assessment, this would make Italy sub-investment grade for the first time ever.

 

CONCLUSIONS

DM sovereign creditworthiness is falling precipitously because of the virus.  Virtually all model scores worsened, with many leading to significant downgrades to the implied ratings.  While the ratings agencies have been focusing on corporate issuers recently, we believe sovereigns will be next to come under significant downgrade pressures.  We continue to believe that our model helps investors identify dislocations and potential divergences in the agency ratings.

 

METHODOLOGICAL APPENDIX

Scores directly reflect a country’s creditworthiness and its underlying ability to service sovereign debt obligations.  Each country’s score is determined through a weighted compilation of fifteen economic and political indicators, which include debt/GDP, current account/GDP, GDP growth, actual and structural budget balance, per capita GDP, political risk, banking sector strength, and inflation.  These scores translate into a BBH implied rating that is meant to reflect the accepted rating methodology used by the major rating agencies.

In order to make our model more forward looking, we had to come up with estimates for 2020 macroeconomic data across countries.  We used Bloomberg consensus forecasts for GDP.  We contemplated using the forecasts in the just-released IMF World Economic Outlook.  However, the IMF is much more bearish and so we decided to go conservatively with market consensus.  Budget deficit numbers were derived by using those growth forecasts to generate revenue and expenditure projections, using past recessions as a guideline.  Lastly, these deficit numbers were adjusted to reflect proposed virus relief packages, as estimated by the IMF.  These forecasts were all plugged into our ratings model to generate likely rating movements this year.