European stock investors on alert for heightened balance sheet stress

MILAN — Stock pickers have a message for company finance bosses and it’s getting louder: bolster your balance sheets before the downturn strikes.

After more than a decade of ultra-loose monetary policy, financing conditions are tightening, inflation is rising and the global economy looks poised to fall into its first recession since 2009.

Highly indebted businesses could be looking at trouble as their interest payments rise and profit growth shrinks, say fund managers, who are already switching out of debt-laden companies.

S&P Global believes global credit conditions are at an inflection point and expects heightened credit stress in late 2022 or early 2023.

Ratings downgrades are set to pick up and overall defaults of corporates globally are expected to double by mid-2023 from historically low levels currently, S&P says. Europe, which is grappling with an energy crunch and war at its borders, will see the biggest hit to credit quality.

“There seems to be a shift of attitude over the most indebted stocks,” said Gilles Guibout, head of European equity strategies at AXA Investment Managers in Paris.

“This is pushing investors towards companies that will not be affected by the rising cost of debt. And the pressure on executives (of indebted firms) is piling up,” he added.

Bank of America’s most recent fund manager survey shows 60% of investors want executives to use cash flow to improve balance sheets rather than increasing capex or dividends, roughly the same percentage as during the COVID-19 crash and the global financial crisis.

“Time has come to save something for rainy days,” said Giuliano Gasparet, head of equity at Generali Insurance Asset Management in Milan. “I wouldn’t be surprised if, in the next surveys, this percentage increases even further.”

The importance of a solid balance sheet has been reflected this month in a series of wild share price swings.

SBB, for example, jumped 46% over two days as lower bond yields offered the heavily-shorted property firm some relief over refinancing. The Swedish company sold property for SEK 700 million ($64 million) a few days later and on Wednesday launched a tender on bonds for a similar amount.

Real estate is Europe’s worst-performing sector this year with a 40% drop. Investors fear the highly leveraged industry could see restructurings and dividend cuts. SBB shares have fallen almost 75% this year.

It doesn’t end there. In Europe, Citi sees utilities and industrials in the firing line and estimates rising financing costs could reduce non-financial corporates’ net income by 2%. It estimates 15% of STOXX 600 debt is at floating rates, almost twice that of the S&P 500 .

Companies ranging from IT consultant ATOS, food company Delivery Hero, utility Enel, auto parts maker Faurecia, pharma group Grifols, drink maker Campari and phone company Telefonica have been mentioned by analysts and investors as potentially facing challenges from rising interest costs.

Debt-laden stocks have already lagged significantly this year and fund managers worried about credit stress have trimmed their exposure. AXA has cut down holdings in a couple of stocks because of their debt levels, Guibout said.

Citi’s basket of highly leveraged European stocks is down 33% this year.

Yet some firms might have been punished excessively, even though their cash flow and debt maturity profile give them enough headroom to pay down what they owe.

One example is AB Inbev, the world’s largest brewer, which refinanced and made its debt manageable while interest rates were low, Thomas O’Hara, portfolio manager at Janus Henderson Investors, said.

“A number of these big businesses have pushed out the maturity profile… There may be some opportunities where babies have been throw out with the bath water,” he said. ($1 = 10.9369 Swedish crowns) (Reporting by Danilo Masoni; Editing by Susan Fenton)