MD Genesis Corporate Solutions
The economic impacts of the Covid-19 Pandemic have been felt worldwide. Driven by the global supply chain crisis, and decreased production capacities due to lockdowns, the cost of living worldwide has increased dramatically.
The world was in the process of finding coping mechanisms to deal with the worst impacts of the Pandemic when the Ukraine conflict started. This has massive global ramifications as the world announced economic sanctions on Russia. The price of crude oil has skyrocketed and there are fears of global food shortages as the bans on fertilizer (one of Russia’s major exports) presents major challenges for the farming industry.
The combination of rising oil prices and the challenges faced by farming is a potent cocktail for further increases in the cost of living.
As Fitch points out, this will have major ramifications when it comes to structured finance.
Anticipated increases
The article points out that rising living costs were anticipated in our UK structured finance asset performance outlooks for 2022, but the larger increases we now expect mean that their potential impact will be important to monitor over the coming months, Fitch Ratings says. Increased pressure on household finances could add to performance risks, for example, if weaker borrowers are exposed to rising interest rates, and could weigh on commercial property tenants in the retail sector.
The UK Consumer Price Index rose by 5.5% in the year to January 2022 – its highest level since May 1992. Annual inflation rates for electricity and gas prices were 19.2% and 28.3%, respectively, and household energy bills will increase further from April, when the default tariff price cap is raised to GBP1,971 from GBP1,277. Fitch now expects UK CPI to peak at 7% in April 2022 and average 5.5% this year, up from 4.5% in December’s Global Economic Outlook (our latest forecasts pre-date Russia’s assault on Ukraine).
The article adds that, Fitch’s ‘2022 Outlook: EMEA Structured Finance’, also published last December, noted that households faced higher costs, particularly for essentials such as energy and food, which will primarily test lower-income borrowers. We also noted that the Bank of England was about to begin raising policy rates, but felt that neither development presented borrowers with sufficient challenges to change our neutral outlook.
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Building buffers
The article points out that UK RMBS and ABS performance has remained strong in recent months amid a tight labour market, despite the withdrawal of Covid-19 support measures. UK households built up large buffers by posting high financial surpluses during the pandemic. Most unsecured consumer debt is fixed rate, as are auto loans.
For residential mortgage borrowers who have fixed their initial rates, refinancing risk at their reset date (typically two or five years after origination) will increase, and will only be partially offset by some amortisation as disposable incomes fall. However, healthy debt/income ratios at origination should prevent performance deterioration for most prime borrowers. Buy-to-let borrowers’ interest coverage ratios (ICRs) are typically strong at closing and they have benefited from strong rental appreciation in 2021.
Fitch thinks that the impact will be mostly restricted to non-prime or non-conforming borrowers, for whom energy and basic food are likely to absorb a higher proportion of their income. UK non-conforming mortgage borrowers typically have variable-rate mortgages and could see an immediate increase in their debt service costs as policy rates rise. First-time buyers with very high loan/value (LTV) mortgages may also be more affected, although those with LTVs of up to 80% typically have headroom to absorb higher costs.
Disposable income under pressure
The article points out that more households could be affected by a steeper rise in living costs. Rapidly rising energy bills will reduce disposable incomes, and nominal wage growth of about 4.5% in 2022 would mean that real incomes fall by about 1%. UK asset performance has been resilient to previous, mild declines in real wages, but these have coincided with periods of stable or declining interest rates. Our revised 2022 CPI forecast coupled with the monetary policy response imply increased performance risks in consumer and residential mortgage loans.
We do not see rising rates as a key risk driver for UK CMBS transactions, where LTV limits have been a much more meaningful constraint on lending than ICRs since the global financial crisis. UK commercial property yields have not sunk as low as those in core eurozone markets, diverging notably since the 2016 Brexit vote. However, the impact on household spending from rising living costs could slow or reverse the recovery in UK retail spending, potentially prolonging challenges for Fitch-rated UK CMBS secured on large regional shopping centres (although updated valuations already reflect the very large correction during the pandemic).
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The impact of rising costs in South Africa
As pointed out in previous thought leadership editorials, South Africa does not exist in a vacuum. Global trends, and challenges, will be felt in South Africa. The trends in the UK may be similar to South Africa, but the challenges that they face most certainly are.
As we have seen with the loadshedding that took place towards the middle of March, South Africa is in the middle of a severe energy crisis where a single event (breakdowns at key power stations) can have far reaching ramifications. Added to this is the fact that the National Energy Regulator of South Africa (Nersa) recently gave Eskom permission to increase its electricity tariffs by 9.61%.
So, like the UK, South Africans will also be facing rising energy costs. We face a unique challenge in that we are not facing a decrease in nominal wage growth but a full-blown unemployment crisis. Major structural reform will be needed to address this.
This means that structured finance in South Africa may face the same challenges that the UK faces. It will take innovative thinking and a lot of planning to address these challenges.
Phahlani Mkhombo is the MD of Genesis Corporate Solutions and is a Senior Business Rescue Practitioner
