Capital Markets

Moody’s: Credit Quality on “Edge of the Cliff”

Consumer-focused companies will be worst affected by slowing economies, liquidity constraints and the spiralling cost of debt.
John ZhuOctober 2, 2008

The twin problems of a liquidity shortage and weak consumer spending will cause widespread pain among non-financial companies, according to quarter-end reports recently released by Moody’s Investors Service.

Daniel Gates, managing director at Moody’s in New York, notes that some non-financial companies are struggling under the “lethal combination” of high leverage and disappointing cash flow. “Recent events may make a bad situation worse by undercutting consumer spending and economic growth in the months ahead, which would push many more weak companies over the edge of the cliff,” he adds.

So far this year, speculative-grade defaults in Europe, the Middle East and Africa have not been as frequent as the ratings agency predicted. But as of mid-September, ratings downgrades continued to outpace upgrades by two-to-one among non-financial corporate issuers. As a result, the bond markets are “practically closed” for speculative-grade issuers, notes Jean-Michel Carayon, a senior vice president at Moody’s in Paris. This is a particularly unwelcome development, as the agency is “starting to see some issuers in Western Europe having less than 12 months of liquidity,” Carayon says.

Moody’s expects sectors dependent on discretionary consumer spending to experience the most negative rating actions. The share of companies with negative outlooks and ratings under review for downgrade has more than doubled over the past year in the airline, auto, newspaper, restaurant and gaming sectors. This is not to say that the pain will be felt across the board. “Upgrades are not precluded for strongly performing companies in a difficult sector,” Gates says. “For example, has a positive rating outlook, although our outlook on the credit fundamentals for the broader retail industry is negative.”

In Europe, Gates notes that consumers have less credit outstanding compared to their counterparts in the US. However, Europeans’ mortgages tend to be bigger, constraining credit-financed spending in the near term. Hawkish monetary authorities in Europe may also limit consumer borrowing.

As consumer spending slumps after a period of defiant resistance, Moody’s reckons that companies will cut investments and hoard cash. While a rational reaction, this could exacerbate the downturn, meaning that a recovery, when it comes, will be muted.