What stagflation could mean for financial firms

Banks and other financial firms in emerging markets are most at risk from the threat of stagflation brought on by the effects of war in Ukraine, according to Fitch Ratings.

In a scenario where inflation surges and the global economy slows sharply, financial institutions in certain emerging markets “would face the highest risks of negative rating actions,” the rating agency said in a report.

The scenario assumes global oil prices average US$150 per barrel, U.S. inflation tops 10%, central banks raise rates aggressively, equities markets drop by 10% to 15%, and economic growth slows to zero in the U.S. and Europe in 2023.

According to the report, banks in emerging Europe (including Poland, Turkey, Romania and Hungary) are most exposed to the direct effects of a stagflation scenario, and to the prospect of sovereign rating changes.

Countries in the Middle East and Africa would also come under pressure from much higher commodity prices and weakening currencies.

“In particular, Egyptian and Jordanian banks appear susceptible to rating changes,” Fitch said.

The report indicated that banks in Canada and the U.S. wouldn’t see any impact as their ratings are “generally well positioned, with sufficient headroom to weather more volatile market conditions and slightly depressed consumer sentiment.”

Additionally, U.S. and Canadian banks generally have little direct exposure to Russia and Ukraine, as well as strong capital positions.

“They have a positive sensitivity to rising interest rates and are cushioned by historically strong asset-quality and reserve metrics,” Fitch said.

Banks in western Europe (namely certain French, Italian and Austrian banks) have the highest exposures to Russian counterparties, Fitch said — yet the risks overall remain moderate. A handful of banks may face downgrades, but most would see no impact.

“Although losses on cross-border exposures to Russian counterparties could have a material effect on loan impairment charges, these are unlikely to trigger rating downgrades by themselves,” the report said. “Second-order effects (higher inflation, weaker growth, more challenging markets for trading) would have a greater impact.”

Among securities firms, most regions would be affected by weak capital markets in a stagflation scenario, the report noted.

“These could expose issuers to sharper swings in market volatility, trading losses and inventory markdowns, and potentially elevated counterparty credit risk. Fee-oriented activities are also likely to be weaker,” the report said.

Traditional asset managers would also face some risk due to weaker cash flow amid a drop in equity prices, “which would pressure margins, cash-flow leverage and interest coverage.”

Alternative managers were seen as having lower risk, as their assets “are typically not subject to near-term redemption risk, while fees are largely charged on the basis of committed capital rather than market values.”

“Depressed asset prices may also provide opportunities to deploy committed but uncalled capital at more attractive levels,” the report noted.