July 2013 Fitch Credit Outlook

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Credit Market Research
Global

The Credit Outlook
Prospect of Monetary Stimulus Exit Reveals Latent Risks
Special Report
Volatility With Elusive Growth: Market volatility has increased as speculation regarding the timing of the inevitable wind-down of monetary stimulus in the US and Europe grows. This drives sentiment in both equity and credit markets as evidence of firm economic growth remains elusive. Fitch Ratings expects the prolonged and uncertain process of central bank exits from unprecedented quantitative easing and historically low interest rates to generate periodic bouts of market volatility. Emerging Markets Risk-Off: Emerging-Market (EM) bonds, currencies and equities were hit hard in the recent market sell-off. Although improved sovereign credit fundamentals reduce the risks from tighter global liquidity, higher interest rates and FX risk, weaker EMs face challenges. Credit growth and shadow banking trends in China are raising concern about financial stability. Housing Market Rate Sensitivity: Historically low and stable base interest rates have supported recovering US and European housing markets, with improved loan affordability and asset performance in RMBS transactions. There are signs the increased rates may hamper turnover in this market which is central to broader economic recovery. Banks Face Investment Losses: Rising interest rates and a steepening yield curve will put pressure on investment portfolios and capital ratios as unrealised losses flow through financial statements. Market volatility will also affect funding costs and market access. Corporate Issuance Headwinds: Rising rates could slow the pace of issuance, especially for lesser established lower-quality credits, as investors turn more selective. Growth remains anaemic, especially in Europe, and several sectors continue to struggle with excess capacity and weak cash flow generation. Improving profits are mainly due to efficiency programmes, not top-line growth. Economic Recovery Flagged: Global growth should gradually pick up pace in H213 and 2014-15 as the US gathers steam and the eurozone approaches a cyclical turning point. A broad-based economic recovery across the currency union is a prerequisite for crisis resolution. Many EMs face more challenging growth conditions. Rating Outlooks and Mix: The proportion of ratings on Negative Outlook or Watch remained high across most sectors during H113, reflecting weak economic conditions in many regions and the unresolved eurozone crisis. However, financial institutions, corporates and project finance had modest 1-2pp reductions in this ratio. By contrast, sovereigns, international public finance and structured finance trended in the opposite direction. The rating mix deteriorated in most sectors but at a more moderate pace than in prior years.
Figure 1

The Credit Outlook provides an overview of Fitch Ratings‘ outlook across all rated sectors and regions, identifying the main macro factors that will drive credit trends over the next 12-24 months. It is published semi-annually.

Analysts
Monica Insoll +44 20 3530 1060 [email protected] Mariarosa Verde +1 212 908 0791 [email protected] Trevor Pitman (Regional Credit Officer– EMEA and APAC) +44 20 3530 1059 [email protected] Eileen Fahey (Regional Credit Officer — US) +1 312 368 5468 [email protected]
a

Negative Rating Outlooks and Watches
Negative outlooks (% of portfolio) 60 50

Sovereign Corporates

US Publ Fin Infrastructure

Intl Publ Fin SF

Financials

40 30 20 10 0

See appendix for full author list.

Q108

Q107

Q207

Q307

Q407

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

Q211

Q311

Q411

Q112

Q212

Q312

Q412

Q113

Source: Fitch

(Quarter/year)

www.fitchratings.com

17 July 2013

Q213

Credit Market Research
Outlook Trend
 Downward pressure on eurozone sovereigns less intense.  Positive momentum for EMs slowing.

Sovereigns
Global sovereign ratings remain under downward pressure due to the eurozone crisis, high public- and private-sector debt levels, weak banking sectors, a difficult growth and economic policy environment and idiosyncratic EM political and other credit developments. In H113 there were 13 notches of downgrades of foreign-currency ratings, compared with 10 notches of upgrades. The ratio of Negative to Positive Outlooks is just under 3:1, signalling that further downgrades are likely, with ten developed-market (DM) names on Negative Outlook and none on Positive Outlook.
Figure 2 Figure 3

Negative Outlooks & Watches
(% of portfolio) DM EM All

Rating Distribution
As at 30 Jun 2013
B 18%

40 35 30 25 20 15 10 5 0

CCC & below AAA 2% 13%
AA 10%

BB 17%

A 11%

Q208

Q410

Q213

Q207

Q407

Q408

Q209

Q409

Q210

Q211

Q411

Q212

Q412

Source: Fitch

(Quarter/year)

BBB 28% Source: Fitch

There were also two recordings of a comparative rarity: the sovereign defaults of Jamaica and Cyprus (Local-Currency IDR). The trend of convergence in the ratings of DM and EM ratings is continuing, with the majority of the foreign-currency downgrades year to date taking place in DM and most of the upgrades in EM countries. This trend should continue in 2013 and 2014. Fitch Ratings expects global growth to gradually pick up in H213 and 2014-15 as the US gathers steam and the eurozone approaches a cyclical turning point. Its latest forecasts for world GDP growth are 2.4% in 2013, 3.1% in 2014% and 3.2% in 2015. However, forecasts are lower for many EMs owing to strains from spill-overs from advanced countries and China, more difficult policy trade-offs, a decline in credit growth, and structural bottlenecks. US Federal Reserve forward guidance on the timing of the tapering of quantitative easing (QE) and eventually raising interest rates precipitated a broad market sell-off and increase in volatility from the middle of May, even though the comments should not have been a great surprise and reflect more upbeat US growth prospects. Other major central banks, including the ECB and Bank of England have indicated that monetary tightening is distant, while the Bank of Japan plans to continue expanding its balance sheet aggressively. Nevertheless, US monetary policy has the greatest impact on global interest rates and risk appetite owing to the role of the US dollar as the pre-eminent reserve currency and main denomination for foreign-currency borrowing, as well as the size of the US capital markets. Key Risks
 Eurozone crisis.  Sharp slow-down in China.  Tightening of US monetary policy, triggering more adverse financing conditions.

Fitch expects the prolonged and uncertain process of central bank exit from unprecedented QE and historically low interest rates to generate periodic bouts of market volatility.

Developed Markets
The eurozone crisis and related economic, fiscal, political and financial trends are continuing to drive negative rating actions. However, the intensity of the crisis eased in H113, despite recession, record unemployment, uncertainty following the Italian elections and the bail-out in Cyprus which led to bank failure, capital controls and a domestic debt default. Fitch‘s longstanding view is that a resolution of the crisis will require ongoing country-level fiscal and structural adjustment, greater progress towards a banking union and a broad-based economic recovery across the currency union.

The Credit Outlook July 2013

2

Credit Market Research
Overall, nine DM sovereigns (six in the eurozone) are on Negative Outlook and none on Positive Outlook. The net four rating notches of downgrades in H113 compares with 18 (across seven countries) in 2012, of which 16 were in the first half of the year. There were two DM upgrades: Greece (B-/Stable) and Iceland (BBB/Stable), demonstrating the potential for crisishit countries to regain some lost rating ground as they start to recover. In H213, Fitch downgraded France to ‗AA+‘/Stable from ‗AAA‘/Negative.

Emerging Markets
The strong net upward momentum in EM sovereign ratings since 2010 has slowed as many face more challenging growth conditions and political pressures. Future EM rating changes are likely to be driven more by country-specific factors than global macro trends. Several large EMs are experiencing strains from spill-overs from advanced economies as well as China, difficult policy trade-offs, a declining impact from credit growth and structural bottlenecks. 2012-13 will see the second-weakest BRICs' growth (after 2009) since the Russian crisis in 1998. Fitch has reduced its 2013-2014 growth forecasts for all four of the BRIC nations, although forecasts for China remain high with projected growth of 7.5% in 2013 and 2014, followed by 7% in 2015 despite current challenges. In H113, the balance of EM upgrades and downgrades remained skewed slightly to the upside, with upgrades of Lithuania, Mexico, Thailand, Jamaica, Philippines and Uruguay – the latter two to investment grade. Three-quarters of the J.P.Morgan Emerging-Market Bond Index (EMBI) is now rated investment grade by Fitch, up from one-third in 2008. But there were downgrades for Egypt, Jamaica and South Africa, as well as China local-currency ratings. The latter mainly reflects an increase in risks to financial stability related to rapid credit growth and size of the banking and shadow-banking sectors, as well as the increased indebtedness and contingent liabilities of local governments. So far in H213, Egypt was downgraded again following an intensification of political instability, while Mozambique and Latvia was upgraded, the latter after the decision that it will adopt the euro in January 2014. EM bonds, currencies and equities were hit disproportionately hard by the market reappraisal of US monetary policy, despite prior concerns over excessive capital inflows and strong exchange rates. Fitch does not anticipate widespread EM credit distress owing to a secular improvement in credit fundamentals, which reduces risks from tighter global liquidity, higher interest rates and FX risk. However, the Fed move adds to worries over slowing growth, China‘s financial stability, softer commodity prices and a series of political shocks. Prospective Fed tightening raises risks facing weaker EMs, such as those with large external financing needs and low foreign reserves, high levels of leverage, vulnerable debt structures, those that have seen strong inflows of hot money and bank credit growth, or have weak policy frameworks or credit fundamentals. The Fed‘s early move may be for the better in the long term for EM by taking some froth off the top of the market, slowing the pace of hot money capital inflows, easing the pace of credit growth and preventing a misallocation of risk storing up greater problems further down the line.

Related Research
2013 Mid-Year Sovereign Review and Outlook (July 2013) Sovereign Data Comparator (June 2013) Global Economic Outlook (June 2013) Banking Union's Impact on Sovereigns (June 2013) Why Sovereigns Can Default on Local Currency Debt (May 2013) Ageing Costs: The Second Fiscal Crisis (January 2013)

The Credit Outlook July 2013

3

Credit Market Research
Outlook Trend
 Mostly stable for state governments.  Local governments facing financial pressure from slow recovery in tax revenues and continued spending pressures.  Revenue-supported issuers mostly stable, but GSEs negative outlooks weigh on the housing sector.  Healthcare sector vulnerable to changes in federal policy and deficit reduction negotiations.

Public Finance – US
Figure 4 Figure 5

Negative Outlooks & Watches
(% of portfolio) Rev. supported Tax supported All

Rating Distribution
As at 30 Jun 2013
CCC & B BB 0.4% below 0.3% 2% AAA 13%

12 10 8 6 4 2 0

BBB 8%

A 26%

Q209

Q211

Q407

Q208

Q408

Q409

Q210

Q410

Q411

Q212

Q412

(Quarter/year) Source: Fitch

Q213

AA 49% Source: Fitch

Key Risks
 Rising employee healthcare, pension and other benefit related costs.  A low growth economy.  Negative economic effects following deep or accelerated federal deficit reduction.

Outlook Remains Stable for US States
The stable outlook reflects the expectation of manageable budget challenges in an environment of continued slow economic and revenue growth. A modest recovery has helped stabilise the financial position of most states through fiscal year 2013 and enabled rebuilding of financial cushions. Continued austerity in education and other spending is expected, as spending for Medicaid and pensions continues to outpace revenue growth in many cases. The key uncertainty in the outlook is the impact of potential federal deficit reduction decisions. State revenue systems quickly reflect changing economic conditions, so any negative economic effects of federal fiscal consolidation could open budget gaps. In the area of direct federal funding, unless there are significant cuts to Medicaid, by far the largest area of federal funding to the states, Fitch expects direct reductions to be manageable.

Local Governments Still Facing Challenges
Slow revenue recovery combined with continued spending pressures will continue to present budgetary challenges. An extended period of declining to flat revenue has taken its toll on localgovernment budgets and service levels. Property tax base declines have generally reversed, although taxable property values remain well below the pre-recession peak. Tax revenue is showing moderate growth overall. State aid is likely to be stable assuming potential federal aid reductions to states are manageable. After four to five years of cuts many local governments are less able to reduce discretionary spending, while upward pressure on pension and other inflexible costs continues.

Revenue Sectors Mostly Stable
While each of the tax-backed sectors faces challenges, all the revenue sectors, with the exception of housing, have stable outlooks. The essential services provided by the water and sewer sector, monopolistic business nature, and local rate setting are key factors in the sector‗s performance stability. Drought conditions persist in much of the central and western part of the US. However, historical development of supplies and storage across the nation largely has insulated municipal credits from operational issues, and in turn, financial weakening. Strong fundamentals for the public power sector, including autonomous rate-setting authority, electric service essentiality, and reliable cash flow, should allow the sector to retain a solid fiscal foundation and support its stable outlook despite the persistent challenges of expanded environmental regulation and stagnant demand. For colleges and universities, Fitch expects relatively stable balance-sheet management and enrollment, although pressures on the latter are anticipated in certain market segments due to the continuing rise in tuition costs. In addition, the full impact of sequestration as it relates to research funding has yet to be determined, but large research institutions typically have the budgetary flexibility to manage through the potential uncertainties.

Related Research
U.S. Public Finance Credit View: States (May 2013) U.S. College Tuition and Affordability (May 2013) Hospitals, Medicare,and Sequestration Cuts (March 2013) U.S. Public Power Peer Study (June 2013) Local Government Pension Analysis (April 2013)

The Credit Outlook July 2013

4

Credit Market Research
Non-profit hospitals and healthcare systems management initiatives addressing the changing environment should result in another year of stable operating performance. However, Fitch believes that there is more uncertainty beyond 2013 as opportunities for further cost cutting wane and as a wave of expected reimbursement reductions are realised under the full implementation of the Patient Protection and Affordable Care Act (PPACA) beginning in 2014. Sequestration cuts were mainly manageable for most hospitals. However, longer-term deficit reduction negotiations could result in larger than expected reductions in healthcare funding. The outlook for the tax-exempt housing sector remains negative, reflecting primarily the Negative Outlook on GSE-guaranteed mortgage-backed securities backing state housing finance agency issues. Outlook Trend
 Negative Outlooks on almost half the portfolio with risks concentrated in France, Italy and Spain.  Balance of portfolio has mostly Stable Outlooks.

Public Finance – International
Figure 6 Figure 7

Negative Outlooks & Watches
(% of portfolio) 60 50 40 30 20 10 0

Rating Distribution
As at 30 Jun 2013
B 6% BB 20% AAA 10% AA 16%

A 9%

Q407

Q212

Q213

Q207

Q208

Q408

Q209

Q409

Q210

Q410

Q211

Q411

Q412

BBB 40% Source: Fitch

Source: Fitch

Key Risks
 A sovereign downgrade in France, Italy or Spain would lead to multiple downgrades.  Weaker economic performance or austerity measures could lead to reduced financial flexibility and downgrades.  Changes in methods of funding or increased responsibilities could result in downgrades.

Developed Markets
Almost half the portfolio of international public finance issuers with foreign-currency ratings remain on Negative Outlook despite some stabilisation in the most recent quarter. The majority of these Negative Outlooks reflect the Negative Outlook attached to the sovereign of the country in which the issuers are located – mainly Italy or Spain. In the past year, numerous issuers in the ‗A‘ category, notably in Italy and Spain, have been downgraded, boosting the proportion of ratings in the ‗BBB‘ category. There could still be selective downgrades in these countries and possibly in France and Poland, as either the local economy weakens, expenditure rigidity increases or central government tightens its purse strings. Meanwhile, issuers in the ‗BB‘ category have grown , partly due to several new issuers having been assigned ‗BB‘ category ratings. Fitch has introduced a rating floor for regiona l issuers in Spain, currently set at ‗BBB−‘ or one notch below the sovereign rating. Based on the creation of an emergency liquidity fund, giving issuers access to government funding, the agency believes that sovereign support would be forthcoming for selected Spanish entities at an investment-grade level of probability. Elsewhere in Europe there is mostly stability. In Germany, for example, a constitutional mechanism, obliging the sovereign and other Laender to support a Land in difficulties, underpins the ‗AAA‘ ratings of the Laender.

Related Research
French Regions Financial Monitor 2013 (June 2013) Group of Mexican States Rated by Fitch: Medians of Key Indicators (April 2013) Public Finance (EMEA) International Rating Criteria Hierarchy (April 2013) Russian Subnationals: Stable Performance Amid Increasing Centralisation (March 2013) The Credit Outlook July 2013

An increasing proportion (18%) of the portfolio is composed of specialised public-sector entities not directly supported by tax revenues, as distinct from local or regional governments. This reflects governments seeking to instil a more market-aware approach in their departments, agencies and subsidiaries; and to encourage markets to share more directly in the risks of certain government supported activities. Fitch expects this trend to intensify as these entities seek to reduce their dependence on sovereign or subnational governments for funding and expand their scope of action.

5

Credit Market Research
Emerging Markets
In contrast, IPF issuers in emerging markets show much greater stability than in the developed markets, with over 75% of international ratings on Stable Outlook. Of the balance, about one third has a Negative Outlook and two thirds a Positive Outlook, signifying greater stability in sovereign ratings and scope for issuers to strengthen their financial condition. For example, for Russian entities rated in the ‗BB‘ category with Positive Outlooks structural improvements in infrastructure, the economy and prosperity could lead to upgrades.

Financial Institutions
Outlook Trend
 Risks are most pronounced in peripheral Europe.  Globally capital and liquidity levels now provide healthy buffers to limit downside rating risk as earnings and asset quality remain under pressure.  Support remains a key factor driving rating Outlooks and IDRs and sovereign rating volatility will flow through to bank ratings
Figure 8 Figure 9

Negative Outlooks & Watches
(% of portfolio) EMEA EM NA All

Rating Distribution
As at 30 Jun 2013
CCC & B below 11% 1% BB 12% A 34% BBB 34% Source: Fitch AAA 1%

60
50 40 30 20

AA 7%

10
0

Q207

Q408

Q210

Q407

Q208

Q209

Q409

Q410

Q211

Q411

Q212

Q412

Source: Fitch

(Quarter/year)

Key Risks
 Macroeconomic trends in developed markets remain weak (Europe), tepid (US) and driven by government programmes (Japan).  Investor caution regarding reduced monetary stimulus will produce volatility in market pricing and funding access as evidence of firm economic growth remains elusive.  Regulatory moves to establish resolution regimes that place more burden on financial stakeholders will continue to influence funding levels and the cost of capital.  Increased restrictive regulation could promote movement of some core and profitable business activities from regulated banks to less supervised areas present in shadow banking.

Developed Europe
The level of banks carrying Negative Outlooks remains above historical norms. This is partly a result of roughly one-third of European banks having IDRs driven by the Support Rating Floor. Rating actions, including Outlook changes, at the sovereign level will remain a key variable in rating actions for many banks. Low economic growth, elevated levels of sovereign indebtedness and unemployment are pressure points for sovereign and bank ratings. These challenges slow bank progress toward establishing levels of profitability and asset quality seen prior to the crisis. More positively, the credit outlook for banks continues to improve at the fundamental level as they have built the level and quality of capital as well as creating improved liquidity cushions. The establishment of these financial buffers is providing improved operating flexibility and limiting the magnitude of any potential rating downgrades. The improvements are expected by Fitch to serve as a foundation for further improvement in bank funding profiles. Banks that have borrowed from the ECB‘s Long Term Refinancing Operation facility have reached the half -way point of its three year life. Some has been repaid, but the ability of these banks to borrow in the financial markets remains important in the next 18 months to enable the remainder of the LTRO to be repaid on time. Structural and regulatory reforms aimed at stabilising the financial system and removing taxpayer subsidies continue to progress to the benefit of bank credit profiles. The pace of reform is measured, in order to avoid unnecessarily disrupting banks‘ progress in shoring up their financial profiles. Overall, the approach to bank support has been mixed. In Cyprus uninsured bank depositors were ―bailed in‖. Generally, subordinated debt has been subject to haircuts in order to recapitalise banks and therefore distressed bank situations are bringing clarity to creditors (junior creditors so far) and shareholders taking on the primary burden for absorbing losses. Continued greater clarity on resolution frameworks is expected as the EU Recovery and Resolution Directive moves toward a vote in late October. The ultimate impact of resolution frameworks on the cost of senior debt will be an important factor to determining expected levels of future profitability for European banks.

Related Research
Asset Quality: New IFRS Impact on CreditLoss Reserves (July 2013) U.S. Banks: Interest Rate Risks (What Happens When Rates Rise) (June 2013) EM Banking System Datawatch (June 2013) Global Quarterly Bank Rating Trends Q113 (May 2013) Peer Review: Global Trading and Universal Banks (Balance Sheets Stronger but Profitability Could be Improved) - Amended (May 2013)

The Credit Outlook July 2013

Q213

6

Credit Market Research
North America
US banks possess buffers in the form of enhanced capital levels, improved funding, strengthened liquidity profiles and broad-based stability in key asset quality metrics. Generally North American banks have strengthened credit quality more than Developed European ones. These should promote continued rating stability in an environment which still presents some challenges. Key issues to navigate in coming quarters include rising interest rates and a steepening of the yield curve as policy rates are expected to remain low into 2014. This will produce pressure on investment portfolios and capital ratios as unrealised losses flow through financial statements. Tepid economic growth limits opportunities to expand loan portfolios and constrains the opportunity for margin expansion for a universe that is generally structured to benefit from higher rates. The increase in intermediate rates in response to the Fed‘s tapering announcement in June may hamper the recovery in the residential real estate market. Residential mortgage loan portfolios remain the weakest area of bank loan portfolios. The regulatory environment also remains fluid as regulators strive to finalise the details of a broad range of new regulations in response to the recent crisis. Progress on key areas such as capital rules and resolution process for large banks will help remove uncertainty that is clouding investor decision-making. Canadian banks remain a bright spot with little to no change in ratings throughout the crisis and turmoil over the past few years. Conditions and trends in the domestic residential real estate market mirrored some of the trends that produced bubbles in other countries. However, the authorities seem to have taken timely action to ease immediate pressure.

Emerging Markets
The credit profiles of banks across emerging markets will be affected by how recent asset growth seasons and how future growth is managed. Broadly, economic conditions remain relatively stable and risk management should continue to help keep the level of developing problem assets at manageable levels. These dynamics can be seen at work in Brazil where sharper than expected economic deceleration following high asset growth is producing some downward pressure on bank performance. However, ratings (some recently upgraded to investment grade) are expected to hold as liquidity and capital buffers are proving resilient. Contrary to the situation in developed markets, a dozen sovereign ratings have been upgraded to investment grade (three being restored to investment grade) since the onset of the crisis. This has provided lift for support-driven IDRs, but more importantly highlights potential for a more favourable operating environment for banks, albeit still subject to periods of volatility. Credit trends in China are raising concern given the level of growth and the activity of shadow banking making system asset quality trends difficult to track. Outlook Trend
 Stable outlooks dominate majority of markets.  Negative sector outlooks continue in Taiwan, Italy and French Life.

Insurance
Greater economic stability in 2013 has steadied insurance companies‘ financial strength, and especially those in EMEA, which is reflected by the decline in Negative Outlooks. Most insurers maintain moderate debt and have not been encouraged by low interest rates to issue disproportionate volumes of debt. Any upward movement in interest rates is therefore not expected to materially raise interest costs. In most major developed countries, the sovereign rating remains two or three notches above the highest-rated domestic insurer. In Spain, however, the highest-rated domestic insurer is at the same level as the sovereign, and in Italy and Japan – as a result of international diversification – at one notch higher than the sovereign, making it more likely that these ratings would move if the sovereign rating were downgraded.

Key Risks
 Continuing low interest rates or significant spike of 500 bp or more (slow steady increase would be a positive).  Potential reach for greater yield adding to asset risk.  Sovereign downgrades or contagion.

The Credit Outlook July 2013

7

Credit Market Research
In Europe, sovereign risks have generally diminished since July 2012, resulting in lower yields and gains in value, to the benefit of many insurers. With expectations of improved economic conditions through 2014, interest rate rises will probably follow, causing a drop in debt securities‘ values. Most bond portfolios are currently holding large unrealised net gains and net unrealised losses would develop if rates rose by more than approximately 200bp.
Figure 10 Figure 11

Negative Outlooks & Watches
EMEA
(% of portfolio) 70 60 50 40 30 20 10 0

Rating Distribution
All

NA

As at 30 Jun 2013
BB 3% BBB 33% B AAA 1% 0.5% AA 9%

Q208

Q209

Q412

Q207

Q407

Q408

Q409

Q210

Q410

Q211

Q411

Q212

Source: Fitch

(Quarter/year)

Q213

A 52%

Source: Fitch

Life
The greatest concern for life insurers is the risk of a prolonged low interest rate environment as asset rollover is putting pressure on interest margins. As a consequence, insurers are increasingly considering placing a small portion of investments in higher-yielding assets, including mortgage loans in the US and infrastructure and commercial real estate investments in Europe. Credit risks may increase, but in view of the small volumes and slight additional risk involved, should remain manageable over a short-term period. Heightened scrutiny of the use of captive reinsurers led by New York regulators, who highlighted the shadow insurance industry in a recent report, could spur some change in current financing and risk management practices.

Non-Life
More frequent and severe losses from catastrophes since 2011 have not depleted the reserves or earnings of reinsurers as much as might have been anticipated. Sound risk management has generally kept claims manageable, premiums remain at economic levels and investors in search of diversification and better yields have been willing to provide sufficient quantities of funding and capital at reasonable rates. The low interest rate environment is also impacting non-life insurers, but to a lesser extent than life insurers. Non-life insurers are seeing steady improvement in 2013 earnings.

Related Research
Workers‘ Compensation Insurance Market Update (June 2013) Hurricane Season 2013 (A Desk Reference for Insurance Investors) (May 2013) 2012 Statutory Trends for U.S. Life Insurance Sector (May 2013) Property/Casualty Industry Statutory Results and Forecast (May 2013)

The Credit Outlook July 2013

8

Credit Market Research
Outlook Trend
 US corporates have financial resources to support positive economic growth prospects.  EMEA corporates forecasts include a mixture of anaemic local growth and higher levels for emerging markets.  Increased interest costs already factored into Fitch‘s forecasts.

Corporates
Figure 12 Figure 13

Negative Outlooks & Watches
(% of portfolio) 40 EMEA EM NA All

Rating Distribution
As at 30 Jun 2013
CCC & below 2% AA 1%

30
20 10 0

B 16%

A 18%

BB 20%

Q208

Q209

Q412

Q207

Q407

Q408

Q409

Q210

Q410

Q211

Q411

Q212

Source: Fitch

(Quarter/year) Source: Fitch

Key Risks
 Interest rate increases negatively affecting US and European HY bond markets.  EMEA recession and disruptive market access.

North America
The outlook for US corporate credit quality continues to be favourable with a definite bias towards affirmations and upgrades outnumbering downgrades. Credit conditions in the US corporate market remain stable despite lacklustre first quarter GDP growth and profitability remains at very healthy levels. First-quarter earnings were largely within expectations, with shortfalls occurring predominantly in revenues rather than profits. Efficiency programmes and weaker commodity prices point to continued favourable margin performance, and headcount reductions remain commonplace. This should result in a stronger second half, but full-year expectations have moderated. Capital spending remains constrained due to lack of end-demand, with few sectors needing increased capacity. Longer-term overseas expansion plans in markets such as China and Brazil have also been restrained. Regulatory concerns remain prominent with US issuers as the implementation of the Affordable Care Act approaches, and climate change and tax reform remain on the political agenda. Although M&A activity was not as strong as expected in the first half, strategic acquisitions should pick up as the cost of capital remains attractive and topline growth remains slow. Shareholder-friendly actions continue to increase, particularly among investment-grade names.

EMEA
Fitch continues to rate EMEA corporates assuming anemic economic growth prospects, with most turnover growth above 2% to 3% attributable to issuers with EM exposure. Negative Outlooks are concentrated within the Italian, Portuguese and Spanish utility portfolio, reflecting weak domestic growth and energy demand), regulatory and fiscal interference, and structural changes in generation (renewables, nuclear). The recent market upheaval caused a pause in bond issuance. Lesser established lower quality credits may find even 8%-10% coupon debt harder to place as investors are more selective.

APAC
Related Research
Fitch 50 Europe (July 2013) Fitch 50 - Structural Profiles of 50 Leveraged U.S Credits (July 2013) US Corporate Bond Market: First-Quarter 2013 Rating and Issuance Activity (May 2013) Scenario: Effects of a European Lost Decade on Corporates (May 2013) Asia-Pacific Corporates: Financial Forecast Update (April 2013)

Speculation surrounding the scale of the Fed‘s asset purchase programme will continue to drive sentiment in both equity and credit markets. However, Fitch expects longer-term asset price movements to reflect corporate fundamentals that cannot be obscured entirely by the flow of liquidity into the markets and a reach for yield by investors in a low-rate environment. Optimism about higher Chinese growth in early 2013, which saw a flood of cross-border corporate bond issuance in both investment grade and high yield (HY) averaging more than USD17bn a month, has been tempered by market reactions to potential US reductions in QE. Nonetheless, growth remains steady across the majority of countries within the region and is supportive of stable and improving corporate credit profiles in most sectors. Rating figures have

The Credit Outlook July 2013

Q213

BBB 43%

9

Credit Market Research
been distorted by concentrations of downgrades (outnumbering upgrades 2:1 so far this year) in the technology and natural resources sectors. Yen depreciation has had an impact on trade flows, boosting export performance for many Japanese entities who have struggled with competition over the last few years particularly from South Korean corporates.

High Yield
The threat of rising interest rates could provide headwinds to the US HY bond market and slow the pace of issuance from its record-setting start in 2013 (H113: USD150bn). The leveraged loan market (H113: USD610bn) seems less affected by the recent pullback as demand continues to outstrip supply. In the absence of a global shock, leveraged loan activity is expected to pick back up and spreads to tighten at some point in H213. Refinancing and repricing will probably continue to drive most new issues in the near term as issuers continue to lengthen their debt profiles. However, opportunistic financings could increase if spreads are attractive and demand for loans remains strong. European HY investors may increasingly focus more on fundamental credit quality than search for yield. Global liquidity has supported asset price performance, yet European growth remains anemic and several sectors continue to struggle with excess capacity and weak cash flow generation. Rising benchmark borrowing rates may pull global liquidity from this market. These prospects will probably hit aggressively priced ‗BB‘ as well as ‗B‘ credits exposed to excess capacity in their sectors that may also exhibit high leverage. New issuance in 2013 remains firmly on track to surpass the EUR65bn recorded in 2012 (H113: EUR60bn).

Outlook Trend
 North American infrastructure largely stable with a negative outlook in the merchant power sector.  Latin American infrastructure largely stable; latent demand outweighs potential slower economic growth.  EMEA infrastructure largely stable in northern Europe but trending to negative in southern Europe.  UK whole-business sector remains negative despite a few bright spots.

Global Infrastructure and Project Finance
Figure 14 Figure 15

Negative Outlooks & Watches
NA WE EM All

Rating Distribution
As at 30 Jun 2013
CCC & B below AAA 5% 2% 3%

(% of portfolio) 80 70 60 50 40 30 20 10 0

BB 8%

AA 20%

Q212

Q412

(Quarter/year) Source: Fitch

Q213

Q409

Q210

Q410

Q211

Q411

BBB 26%

A 36%

Source: Fitch

Key Risks
 Continued slow growth in US and LatAm economies.  Recession deepening and spreading in Europe.  Government budget pressure destabilising cash flows in European projects.

EMEA
Slow growth and recession are having varied effects on European transportation. Size matters and outlooks are stable for international gateway and primary hub airports, large toll-road networks and ports with strong and diverse franchises. Negative outlooks are concentrated in smaller concessions, facilities in ramp-up, or assets exposed to the weaker economies in southern Europe. The prospects for energy infrastructure projects are varied. The outlook is negative for renewable energy projects in southern Europe exposed to the risk of tax increases and additional operating requirements that may reduce net revenues, as recently observed in Spain and Italy. Oil and gas project outlooks are stable as these continue to benefit from high selling prices and strong demand despite a sluggish international economy. Transmission networks for UK offshore windfarms have a stable outlook given supportive regulation and solid operating performance to date. The outlook for UK whole-business securitisations remains predominantly negative. Pub groups continue to suffer declines in rents and beer income as consumer habits change and

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even the more resilient managed pub sector is facing some challenges. Healthcare operating margins will continue to decline as fee increases are unlikely to offset rising costs.

North America and Latin America
Growth in the US and the principal Latin American economies continues to be modest, but supports Stable Outlooks on most energy projects and transportation infrastructure debt. The potential extent and effect of US deficit reduction remains an uncertainty. Growth in US air travel, traffic on roads and bridges, and activity at ports are expected by Fitch to remain low, reflecting the weak economy. Energy prices in all US markets are expected to remain low due to lower natural gas prices brought about by shale gas development. Most energy infrastructure projects are stable as they can pass through macroeconomic risks to higher rated off-taker counterparties. US merchant power generation projects which cannot pass through risks are the exception, have Negative Outlooks and will continue to be under pressure. Infrastructure assets in the principal Latin American economies benefit from pent-up demand. Brazil is facing economic and socio-political headwinds as it remains focused on key deliverables for major international sporting events. We expect modest inflation and continued low interest rates to facilitate transportation and energy investment plans in the other major economies. Therefore Outlooks are broadly stable for Latin American infrastructure projects.

Related Research
Toll Road Network Peers‘ Positioning (June 2013) Peer Review of U.S. Toll Roads, (May 2013) Peer Review of U.S. Ports (April 2013) Infra-Read: Semi-Annual Newsletter for the Infrastructure Sector (April 2013)

Structured Finance
Outlook Trend
 Stable in the US as economic recovery gathers pace.  Negative for the recession-mired eurozone periphery.
Figure 16 Figure 17

Negative Outlooks & Watches
EMEA NA All

Rating Distribution
As at 30 Jun 2013
CCC 14% B 12% BB 9%

(% of portfolio) 70 60 50 40 30 20 10 0

AAA 26%

AA 11% BBB 14%
A 14%

Q408

Q212

Q209

Q409

Q210

Q410

Q211

Q411

Q412

(Quarter/year) Source: Fitch

Q213

Source: Fitch

Key Risks
 Market volatility blows US recovery off course.  Persistent deepening recession in the eurozone.

US
The overall outlook for US structured finance ratings remains stable. Fitch also expects collateral asset performance to continue on a trend of either stability or gradual improvement in most sectors. While the US economic recovery has been shallow, it has nevertheless been sufficient to support a strengthening of credit performance across most sectors. This is expected to continue, although perhaps unevenly. Downside risks associated with macroeconomic, fiscal and monetary issues remain. Market volatility has also increased, as speculation regarding the timing of the inevitable winding down of the QE3 monetary stimulus grows. While shocks from these sources may affect the pace of economic growth and cause periodic market turbulence, we do not expect their magnitude to be sizeable enough to significantly impact ratings.

ABS
In auto ABS the outlook remains stable for performance of prime assets and positive for ratings, and stable for subprime asset performance and ratings. Asset quality metrics in auto ABS have begun to weaken slightly but Fitch believes this represents a return to more long-term sustainable levels, and base-case loss assumptions and positive rating momentum should not be materially affected. In the credit card ABS sector, continued rating stability is expected, with continued declines in personal bankruptcy filings being positive for performance, and reflecting improvement in consumer quality, as economic growth supports a slowly falling unemployment
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rate. In contrast, the rating outlook for most student loan ABS remains negative, reflecting the link in Federal Family Education Loan Program transactions to the long-term sovereign rating via the guarantee provided by the Department of Education, as well as continuing asset performance weakness in pre-recession private student loan securitisations. However, more recently issued private student loan ABS carry stable outlooks as they benefit from more stringent underwriting standards and robust structures.

CMBS
The outlooks for CMBS asset performance and ratings are generally stable. Property market fundamentals are expected to continue the improving trend underway since 2010, benefiting from economic growth coupled with limited new supply resulting from low construction. The multifamily and hotel sectors in particular have recovered strongly, and income levels for such properties in many markets have reached and even surpassed pre-recession peaks. The sustainability of trailing-twelve month income is being carefully scrutinised in these sectors, especially where higher income levels have attracted new construction in stronger markets. Recovery of office properties has been strong among class A assets in core urban markets, but uneven elsewhere. Retail has seen a slight improvement overall, but property-specific trends vary widely, with some very high loss severities on properties in challenged areas or with idiosyncratic issues. Rating stability will continue to be greater for investment-grade classes, as lower-rated bonds still have some vulnerability to idiosyncratic losses on individual properties.

RMBS
An improving housing market and relatively stable macro environment have supported improvement in asset performance metrics in most legacy RMBS. Fitch expects the trend of increased rating stability in this sector to continue, although positive rating pressure will be limited in the near term. Pre-crisis RMBS securities will continue to face a number of challenges. Increases in house prices have outpaced the improvement in economic fundamentals in many areas, and in some cases reflect more technical factors such as limited supply and/or investor-driven demand. Furthermore, improvement in asset performance has not been uniform across sectors and vintages, as pre-2005 prime transactions continue to see performance deterioration from the effects of adverse selection. Asset quality for transactions issued since 2009 remains exceptionally strong with very strong performance supported by low LTVs, full documentation and solid credit enhancement reserves.

Structured Credit
Fitch expects CLO collateral performance trends and ratings to remain stable, as these transactions continue to benefit from historically low levels of HY defaults coupled with ongoing deleveraging of their capital structures. Ratings of structured-finance CDOs are also expected to remain stable as many have already accumulated enough credit enhancement to provide a buffer against limited downgrades to their collateral assets, and the performance trends of the latter are now generally stabilising or improving.

EMEA
Related Research
Fitch Voice: Structured Finance (April 2013) US RMBS 3Q12 Sustainable Home Price Projection (April 2013) US CMBS Loss Study: 2012 (April 2013) US CMBS 2012 Loan Default Study (April 2013) Student Loan ABS and the College Tuition Bubble (July 2013) SME Market Review: UK (June 2013) SME Market Review: Spain (June 2013) Covered Bonds Surveillance Snapshot (April 2013)

The continuing recession in the eurozone is resulting in persistently high unemployment in a number of countries. Combined with fiscal austerity and tightening of credit terms, this will pose a challenge for the performance of securitised assets, especially in peripheral Europe. Price declines and liquidity issues that are affecting residential and commercial property markets are expected to put further pressure on transactions whose performance is closely related to cash flows from property sales or refinancing. The macroeconomic environment is unlikely to improve sufficiently in the next 6-12 months to moderate the sovereign-linked maximum ratings currently applied to Spanish, Portuguese, Irish, Greek and most recently Italian transactions. For France and the Netherlands only downgrades of several categories would result in caps on ratings below ‗AAAsf‗.

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Financial institutions remain challenged by the weak macroeconomic position in Europe but have been strengthening their balance sheets. There will, however, continue to be a limited number of financial institutions with sufficiently high ratings to support the senior SF ratings.

ABS
The asset performance outlook for consumer ABS remains broadly stable. Jurisdictions such as Germany and the UK have more positive outlooks, where default and delinquency levels have consistently outperformed our base case expectations. Even in economies that have suffered greater stress, such as Spain, asset performance now appears more stable. Defaults and delinquencies in Spain remain at high levels compared to other countries but are no longer deteriorating. There is a greater risk of deterioration in asset performance in Italy and France as delinquencies have previously been relatively low and economic strains are increasing. Across ABS, the majority of negative rating Outlooks reflect ratings capped by, or linked to, sovereign ratings. Indeed, the only negative Outlooks for Spain relate to the sovereign‘s negative Outlook. Negative Outlooks for asset performance are most prevalent in Italian ABS.

RMBS
Similarly, the asset performance outlook for RMBS is also in large part driven by unemployment and disposable income trends, mitigated for more recent transactions by stricter post-crisis underwriting. Asset performance is supported by exceptionally low and stable base interest rates, which have improved loan affordability. While an increase in base interest rates would be negative for performance, rating outlooks assume continued low rates for the next two years. Despite low base rates, the availability and terms associated with new mortgage debt continue to deter or exclude potential purchasers. Very low property market liquidity and falling property values have depressed loan recovery prospects and extended recovery times generally, but especially in distressed markets (Greece, Ireland and Spain). Further pressure could come from more extensive government intervention (payment holidays, restrictions on foreclosures, forced debt forgiveness), which is already a factor in Ireland, Greece, Spain and Italy. Rating Outlooks vary by country with expectations of deterioration in the peripheral eurozone, but with stability generally expected elsewhere.

CMBS
Refinancing risk continues to be the main factor driving the largely negative Outlooks. New credit availability for commercial property will remain low, focused on top-quality assets. Financing is expected to gradually shift from bank to non-bank provision (senior debt funds, insurance companies). With legal bond maturities totalling EUR3.1bn until the end of 2015, then EUR5.0bn in 2016 and peaking at EUR10.4bn in 2017, servicers may be forced to liquidate collateral on unfavourable terms with low recoveries, especially for transactions backed by non-prime assets. These pressures are already reflected in ratings, with Stable Outlooks for transactions backed by prime properties and a mixture of stable and negative for non-prime assets.

Structured Credit
Lending constraints are also a major concern for leveraged loan CLOs, where traditional banking and structured finance-related funding sources have dried up. Over the past two years, these transactions have seen the refinancing wall reduced and pushed back thanks to intense ―amend and extend‖ activity. The return of the European CLO, albeit on a limited basis, should provide a financing exit for some credits, notably those that cannot tap other means of financing. Nonetheless, a portion of underlying obligors are likely to default and recoveries will be lower due to the cyclical and highly leveraged nature of those obligors. Outlooks are stable on the most senior classes and stable to negative on the mezzanine and junior classes. The Outlooks for SME CLOs is stable, as Fitch anticipates that asset performance deterioration affecting Spanish, Italian and Portuguese transactions will be offset by high levels of credit enhancement and amortisation. In these countries, the prolonged recession and property market downturn will lead to further rises in arrears and falls in recovery rates.
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Covered Bonds
While Outlooks are stable in the rest of the world, it is negative for the peripheral eurozone and nearly all covered bond ratings in Greece, Italy, Portugal, Spain and Ireland have a Negative Outlook. This reflects the Outlooks on the related sovereigns and bank Issuer Default Ratings in the case of the first four, and in the case of Ireland, the considerable challenges faced by its housing and mortgage market. Sovereign-related risk has continued to dominate the negative covered bond rating actions taken within the eurozone and downward rating pressure is expected to continue while banking and sovereign challenges remain in the eurozone. Banking union will reduce bank support which could have a negative impact on covered bond ratings.

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Appendix: Contributing Analysts
Monica Insoll +44 20 3530 1060 [email protected] Mariarosa Verde +1 212 908 0791 [email protected] Trevor Pitman (Regional Credit Officer– EMEA and APAC) +44 20 3530 1059 [email protected] Eileen Fahey (Regional Credit Officer — US) +1 312 368 5468 [email protected] Ed Parker (Sovereigns) +44 20 3530 1176 [email protected] Matthew Taylor (Public Finance - International) +44 20 3530 1094 [email protected] James E. Moss (Financial Institutions) +1 312 368 3213 [email protected] Peter Patrino (Insurance) +1 312 368 3266 [email protected] John Hatton (Corporate) +44 20 3530 1061 [email protected] Thomas McCormick (Public Finance - US; Global Infrastructure and Project Finance) +1 212 908 0235 [email protected] Stuart Jennings (Structured Finance) +44 20 3530 1142 [email protected] Michael Larsson +44 20 3530 1260 [email protected]

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