(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2025—collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2025.)

Monetary easing and accelerating growth should improve corporate credit fundamentals, but trade tensions and sticky inflation are significant risks.

How This Will Shape 2025

Further monetary easing in 2025 should help ease financial pressures on corporates.   The rate of increase in interest costs has already started to slow down as policy rates fall and favorable financial sentiment makes refinancing easier and cheaper. With financing costs steadying, recession seemingly avoided, and EBITDA growth recovering, we anticipate a strong rebound in interest coverage after a period of weakness. However, there are still significant variations likely in the degree of improvement across credit ratings, with stronger entities seeing a more decisive improvement. Even so, we expect EBIT interest coverage for entities in the 'B' category will return to its 20-year average in 2025.

Historically, periods of falling interest rates have been difficult for corporate credit.   It's possible that receding recession risks, dwindling inflation, and buoyant financial markets may be as good as it gets for a while. There have been seven major interest rate cutting cycles in the U.S. since 1980 (excluding the short-lived adjustments amid financial market volatility in 1987 and 1998). Default rates rose in all but one of those episodes (the dot.com crash), with an average increase of 2.1%, and the mid-1980s and mid-1990s soft landings also saw defaults rise. The year ahead will need to deliver the improving fundamentals that tight credit spreads imply if risk premia are not to widen again.

What We Think And Why

Growth will likely take over as a cash flow driver, rather than profitability.   Sales and EBITDA growth have been relatively modest in recent results seasons. Chart 3 shows median revenue growth for three ratings categories of U.S. rated nonfinancial corporates, overlaid with rate cutting cycles since 1980. Revenue growth improving as rates fall is not the historical norm. Our base-case economic outlook, however, is more akin to the mid-decade rate adjustments of the 1990s, when revenue growth didn't see precipitous declines, and our analysts expect revenue growth to accelerate in the year ahead. Improving growth would help justify current risk premiums.

Margin improvement is unlikely to be such a prominent driver of corporate performance in the years ahead.   In the last decade, a trend of rising margins has largely been confined to stronger credits. Chart 4 shows the contrast between the sustained rise in profitability of 'BBB'-rated entities versus the much more modest upswing seen for the strongest speculative-grade credits. We suspect secular increases in profitability are unlikely to continue, with the gains from global outsourcing played out and at risk from political and social pressures, costly energy transitions under way, and upward pressure on labor costs in the wake of higher prices and interest rates. New technologies like AI offer the clearest opportunity for a productivity-linked boost to profits, but outcomes are uncertain even if the investment costs are real.

Encouragingly, we expect to see positive revenue and EBITDA growth for almost all sectors in 2025.   Charts 5 and 6 show our analysts' median revenue and EBITDA growth projections by global industry, both for investment and speculative grade. With the sole exception of flat revenues expected for investment-grade oil and gas, we currently anticipate growth in every other sector, in both rating groupings. With policy rates falling, significant refinancing achieved this year, and healthy growth projected, this suggests a favorable fundamental credit environment for the year ahead.

What Could Change

Inflation could be stickier and rates consequently higher than we anticipated.   Although not our base case, cost of living pressures, trade tariffs, and the reshoring of supply chains for geopolitical reasons could lead to higher inflation and constrain central banks' ability to lower policy rates. A more stagflationary growth environment would likely be less favorable for corporate credit.

Trade disputes and environmental transitions could also hamper revenues and profitability.   Europe and Asia-Pacific could take retaliatory measures if the incoming Trump administration applies tariffs as intended. This could also lead to higher input costs, as companies adjust supply chains to a bloc-based trading environment. Ongoing efforts to curb emissions are already necessitating significant capital expenditure in sectors such as utilities and autos. This also brings risk of new competition, as we have seen in autos where electrification has weakened European and Japanese automakers' competitive positions, relative to new competitors from China and the U.S. Elevated energy input costs are also a concern for heavier industrial sectors.

On the positive side, AI-induced productivity enhancements and emerging clean energy technologies could generate significant opportunities.   For example, we expect generative AI will transform pharmaceutical research and development by strengthening innovation, offering cost efficiencies, and accelerating the traditionally ponderous research-to-market cycle. In the tech sector, insatiable demand for AI services is causing capital expenditure to skyrocket. This is leading to deals for new nuclear electricity to power data centers and reach clean energy goals.

Read More

• Corporate Results Roundup Q3 2024, Nov. 25, 2024