The outlook for European corporate and financial debt will turn distinctly more negative next year with credit ratings downgrades set to outnumber upgrades by two to one, according to Standard & Poor’s.

This would be the first time in more than three years that downgrades have outnumbered upgrades. Default rates are also expected to pick up from their record low levels, the agency said, although they should remain below the long-term European junk-rated average of 3.5 per cent.

Companies, banks and markets in general had benefited from a seemingly endless supply of funding and benign economic conditions over the last three years, which has helped drive a leveraged buy-out and consumer lending boom.

However, since the liquidity crunch began in late July, economic conditions have also started to appear less rosy, leading to concerns that heavily indebted companies and consumers could struggle to repay or refinance their borrowings, which would have a detrimental impact on the broader economy.

“The deteriorating macro-economic environment and continuing tensions in the financial markets will likely strain credit quality among European corporates and banks in 2008, at least in the first half of the year,” said Blaise Ganguin, chief credit officer at S&P.

“While we expect the majority of European firms to remain relatively resilient, as demonstrated by the majority of stable outlooks, their fortitude depends on the scale and duration of the current market dislocation. If market conditions deteriorate further, or if economic prospects weaken materially, ratings could be exposed to broader downward pressures.”

One of the most important areas of focus will be Europe’s banks, which have suffered direct losses from the problems with US subprime mortgages as well as having their balance sheets put under greater strain from the need to support segregated funding platforms – such as commercial paper conduits and structured investment vehicles – due to the liquidity squeeze. S&P expects credit risk to rise in 2008 as tighter credit conditions begin to affect broader economic activity.

The leveraged finance markets are another area of concern for the agency, which said that the high volume of deals and increasing leverage multiples for private equity-backed buy-outs had combined with declining credit quality of the emergent borrower.

Default rates would rise among leveraged loans, S&P said, adding: “low-cost refinancings are no longer a soft option for highly leveraged, underperforming credits”.

For the broader corporate debt market, the reduced risk of LBOs, merger and acquisitions activity and shareholder-friendly policies due to tighter credit conditions were to some degree balanced by higher risks related to corporate liquidity and the ability to refinance debt.

“On a positive note, many companies enter the tightening credit cycle with strong performance levels and sound financial positions,” said Mr Ganguin.

“Nevertheless, credit fundamentals are far less positive than a year ago.”