Developed Markets Sovereign Rating Model

(from my colleague Dr. Win Thin)

We have produced this ratings model to assist investors in assessing relative sovereign risk over a wide range of Developed Markets (DM), 29 in all. 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, 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 agencies.

DEVELOPED MARKETS RATINGS SUMMARY

There were 12 DM rating actions that have been recorded this year. In a sign that some cracks in DM are reappearing, 4 were positive and 8 negative. Last quarter (Q4), there were 10 actions (5 positive, 5 negative). This year, however, Greece accounted for 6 of the 8 negative actions. Netting Greece out gives a more positive view on DM ratings.

With regards to Greece, S&P first put it on negative watch in January and then downgraded it twice, first from B to B- and then again to CCC+ with a negative outlook. Moody’s put Greece on review for downgrade in February and then cut it from Caa1 to Caa2 with a negative outlook. Lastly, Fitch downgraded Greece from B to CCC in March. The other 2 negative actions were both by Fitch. It downgraded Austria from AAA to AA+ with a stableoutlook, and downgraded Japan from A+ to A with a stable outlook.

On the positive side, Moody’s was the most upbeat with three actions. It upgraded Slovenia from Ba1 to Baa3 with a stable outlook, upgraded Latvia from Baa1 to A3 with a stable outlook, and upgraded Lithuania from Baa1 to A3 with a stable outlook. S&P provided the sole move for Portugal, raising the outlook on its BB rating from stable to positive.

(source: Bloomberg and BBH)

DEVELOPED MARKETS RATINGS OUTLOOK

The stronger AAA credits (mostly the dollar bloc and the Scandies) easily maintained their position this round. For this group, their model scores generally improved. In the rest of the AAA group, however, the scores were mixed. Switzerland, Luxembourg, and Finland saw their scores deteriorate a bit, while Germany, Austria, and the US saw their scores improve a little. None moved by enough to signal an imminent rating change, and we believe all are correctly rated at this time.

Within the AA credits, the UK and France saw their scores deteriorate. The UK still appears correctly rated at AA+/Aa1/AA+. However, France saw its implied rating fall a notch to AA-/Aa3/AA-. As such, it faces downgrade risks to its AA/Aa1/AA actual ratings. Implied ratings for Estonia and Belgium remained steady at AA/Aa2/AA, while Iceland saw its implied rating improve a notch to AA-/Aa3/AA- and underscores upgrade potential. 

Within the A credits, the story was mixed. Japan saw its score improve slightly but its implied rating was steady at A+/A1/A+. While we did not agree with Fitch’s recent one notch downgrade to A, we think that S&P’s AA- rating is too high. Ireland’s implied rating improved one notch to A+/A1/A +, signaling upgrade potential to actual ratings of A/Baa1/A-. Lithuania saw its implied rating fall a notch to A/A2/A, still above actual ratings of A-A3/A-. Slovakia, Latvia, and Italy all saw little change to their scores, and so their implied ratings remained steady. We see strong upgrade potential for Italy, as actual ratings are well below our implied rating of A-/A3/A-.

Within the BBB credits, the story was mixed too. Spain saw a steady score and implied rating of BBB+/Baa1/BBB+. However, Slovenia’s implied rating slid a notch to BBB/Baa2/BBB while Portugal’s rose a notch to BBB-/Baa3/BBB-. All face some upgrade potential.

Within the BB credits, the implied ratings for both Cyprus and Greece improved a notch to BB/Ba2/BB and BB-/Ba3/BB-, respectively. Greece deserves a special mention. The nation has undertaken a massive adjustment that has seen actual and structural budget deficits as well as the current account balance improve significantly. These improvements have been enough to move Greece into low BB territory, and yet the creditors are demanding even more and pushing it towards a potential default.

CONCLUSIONS

We expect ECB stimulus, low energy prices, and the weak euro to help boost the euro zone economies this year. Likewise, we believe the economic recoveries in the UK, US, and Japan will continue into 2016. As such, most metrics of credit quality should improve in DM this year.

However, it is clear that fundamentals are taking divergent paths for many countries across the DM universe. We continue to believe that our model helps to identify the winners and the losers within this trend.