The economic outlook for Europe is less than rosy. DBRS Morningstar sees growth remaining sluggish. Consumer sentiment - one of the positive surprises of 2023 - will start trending down in 2024 as savings built up during the pandemic dwindle. Unemployment, meanwhile, will start to rise in several countries - including the UK, Germany and Spain. But a weak economy is far from the most pressing issue for the continents’ corporates.
“We’ve seen a recent upsurge in conflict, the redrawing of global energy resource maps and rapid technological progress,” says Anke Rindermann, head of European corporate finance at DBRS Morningstar. “The conundrums stemming from these changes will keep corporate management and boards very busy as we go into 2024.”
Inflation and its ripple effects will also impair firms’ financial health. Central banks have had some success in bringing down headline inflation, but wages have started to rise and DBRS Morningstar sees this trend continuing into next year. “Unions have started to fight hard for increased compensation, whether it’s US auto workers, German train drivers or Spanish airport staff,” says Rindermann. “We expect wage costs to grow in 2024, and this will erode into corporate profits alongside weak fundamental growth.”
Services in the spotlight
As DBRS Morningstar looks across the European landscape, Germany is one market that stands out as facing particularly difficult conditions. It is likely to be the only country to fall into recession in 2024 and high energy costs weigh on the growth outlook. Rindermann says talk of German deindustralisation is overly dramatic, but the economy is clearly under pressure. The UK is another market distinguished by its challenges. Key among these is sticky inflation, which the rating agency is watching closely. “Stubborn inflation could prompt more hikes from the Bank of England to bring it under control,” she says.
When it comes to specific sectors, the potential for wage cost inflation puts staff-heavy service industries in the spotlight. “This is everything from restaurants to healthcare and transportation,” Rindermann says. “We are also keeping a close watch on construction, where there are a few factors at play.” That industry has faced several years of cost inflation, and as spending power across the private and public sector slows this will weigh on activity across commercial and residential construction.
Rapid technological evolution is a headline issue, but although it adds to the uncertainty facing corporate management it is unlikely to be transformational in the short term. Rindermann notes the potential of AI adoption to boost productivity and help offset higher costs elsewhere. But in general, firms are likely to coalesce around a standard set of strategies to AI adoption. It is those companies that struggle to adopt a sound strategy and risk being left behind that will stand out.
Heavy high-yield supply
Investment grade companies with stronger cash flow profiles and lower leverage are in a better position to weather the ongoing uncertainty. There could be selective shifts to negative outlook, but DBRS Morningstar does not expect broad downgrades of investment grade firms even in the more challenged sectors. “The question for management at these companies will be more where to spend the money, rather than what action to take in order to protect their credit profiles,” she says.
The rating agency is more concerned about firms in its private credit group that are largely private equity-backed and have more aggressive leverage profiles. “Here the combination of higher interest rates and greater refinancing needs in the context of low growth and cost pressures will be more challenging,” she says. “We’ve already seen a significant number of rating downgrades for private credit. More than one-third of those companies are carrying negative outlooks, which signals the potential for more negative actions.”
In the capital markets, high yield firms are in the spotlight. Debt issued during the record years of 2020 and 2021 will prompt a rise in refinancing in 2024 and 2025. The European market has been bearish for high yield supply this year and last. Investor confidence needs to be robust in order to absorb the rise in issuance needed for refinancing. “If we don’t see the high yield market opening up strongly next year that could create significant challenges for the more leveraged firms in the second half of 2024,” Rindermann says.