DBRS Morningstar's Takeaways from Its 2022 Credit Outlook Series: How Geopolitical Risks and Pandemic Concerns Will Affect Sovereign Ratings

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed during its 2022 Credit Outlook series. In the session titled "Sovereign Outlook - How Will the Omicron Variant Impact Economic Recovery?" Nichola James and Thomas Torgerson, Co-Heads of Sovereign Ratings at DBRS Morningstar, hosted a discussion on how geopolitical concerns and the ongoing global pandemic will affect the ratings of sovereign countries this year.

With heightened geopolitical concerns about Russia and Ukraine and lingering concerns about the global pandemic, DBRS Morningstar expects a stable outlook for global sovereigns in 2022.

"Our baseline outlook remains relatively stable, but the events of the past few days serve as a stark reminder of the risks all around us," said Torgerson.

The webinar was hosted just hours after Russia invaded Ukraine, but DBRS Morningstar does not see the military action having immediate effects on the company's sovereign ratings.

"At present, the military action in Ukraine is unlikely to have immediate rating implications for our public sovereign ratings," James said. "However, through various channels we could see consequences for some economies, and ultimately these implications could contribute to downward pressure on some sovereign ratings in the future."

However, James said factors such as market reaction, energy prices and inflation, refugee outflow from Ukraine, and sanctions and counter-sanctions—especially reductions in Russian oil and gas supply—will have consequences for some economies, particularly in Eastern Europe. This could lead to downward pressure on some sovereign ratings. "Geopolitical risks can have severe implications on sovereign ratings," she added.

By far, the Russia-Ukraine conflict "poses the greatest potential risk to European stability and to energy security" according to James, noting damage to pipeline infrastructure or the intentional cut-off of Russian gas supplies to Ukraine will impose immediate economic and social costs for European fuel-dependent countries.

This will be offset by a greater alignment between the European Union, the United Kingdom, and United States, and lead to increased investment in alternative energy supplies. Countries such as Hungary, Latvia, Slovakia, Lithuania, and large European countries including Germany, Italy, and Austria are most dependent.

"Geopolitical risks are critically important, and while focus now is on the Russia-Ukraine situation, we are mindful of the potential of the risks of escalation in Asia or the Middle East even in the midst of the Ukraine crisis," said James.

Since January 1, 2021, the majority of DBRS Morningstar's sovereign ratings were "confirmed" although there was a small number of upgrades in Europe, while Asia and the Americas saw one downgrade each. Further most of the ratings were "Stable" to "Positive" with no changes from a Stable trend to a Negative trend.

But James expects a different story in 2022 as the resolution of trends and new country-specific developments have potential to affect ratings leading to some upward or downward rating actions.

"Our current projections point to stability in most of our quantitative assessments underpinning our sovereign ratings, including some of the cyclical indicators such as fiscal balances and debt," said James. "Broad macroeconomic trends are likely to be favorable for most of our rated sovereigns, particularly in Europe, where continued recoveries could allow returns to fiscal improvement paths under way before the pandemic."

James sees a different story for Latin America where "weak potential growth and fragile public finances are key concerns".

Despite the geopolitical tensions taking centre stage, Torgerson said other challenges including the coronavirus pandemic "remain on our worry list."

Torgerson said the latest omicron variant data has been reassuring. Although the rapid spread of this variant, even among highly vaccinated populations, has raised some alarm bells as cases spiked in December and January, hospitalization rates have remained relatively subdued, particularly in countries and regions where vaccination rates are highest. These countries took additional measures to staunch the impact of the variant, but have since eased these countermeasures.

In fact, Torgerson contends, many countries appear to be resigned to "living with” the coronavirus as the optimal policy choice because vaccines are widely available and the health consequences are less severe.

"We worry it is premature to declare victory—or even to call this a victory—it feels more like a partial surrender," Torgerson said. "While we hope that future variants will be relatively benign, we are not comfortable with the assumption that COVID will not take another turn for the worse."

Any new variants that develop and "strike fear" into the population will likely pose a major setback, he added.

"We do not think the effects and after-effects of the pandemic can be fully tallied just yet, and we continue to watch for additional signs of political, economic, or financial stresses," he said.

Rising inflation and interest rates are also causing concern for economists as strong fiscal responses by the central banks coupled with rising house prices have propped up household balance sheets. The composition of demand has changed, favoring goods over services, while periodic work stoppages and other production challenges have constrained supply responses. Labor markets have tightened as well, though total employment remains below pre-pandemic levels in a few countries, particularly the United States. This has led to inflationary pressures broadening beyond food and energy prices.

Torgerson maintains a short-lived burst of inflation is not necessarily bad for sovereign credit risk, particularly when driven partially by supply constraints.

"After a prolonged period of ultra-low inflation in the major advanced economies, the immediate consequences of rising global inflation are generally positive for sovereign credit risk, reducing the real burden of outstanding debt," he said. "To the extent that the recent burst of inflation moderates and inflation expectations remain well-anchored to central bank targets without a need for highly aggressive monetary tightening, we would expect the medium-term impact to be relatively benign."

But Torgerson added additional shocks to inflation, including geopolitical and pandemic risks, can extend price pressures and impact expectations.

In the event of additional shocks, "a substantial shift in interest rates" may be needed for central banks to bring expectations back in line with inflation targets. If this materializes, this will expose more leveraged households and firms, and also gradually increase the real cost of sovereign debt from current historically low levels.

"While the current global environment has the potential to generate additional price shocks, we are not entirely convinced that the era of low interest rates in advanced economies has come to a sudden end," he said. "There are structural factors behind low interest rates that may gradually change but are not likely to disappear immediately."

Written by Scott Anderson

Notes:

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