While U.S. Consumer credit increased less than expected in January, we are concerned with what we are seeing in consumer loans and debt in general across the world.
With our Cash-Strapped Consumer investing theme, the average amount financed and the duration of new auto loans continues to rise – same car, bigger loan and for longer means a more highly leveraged car owner.
We also see warnings sign with credit card debt as our Cash-Strapped Consumers struggle to make ends meet. At small banks, the share of outstanding card balances written off as a loss after consumers failed to pay hit 7.2% in the fourth quarter of 2017, up from 4.5% a year ago, according to Federal Reserve data. While overall card losses across all banks remain below the historical average of the last 30 years, they’ve been slowly climbing in the last two years. We believe these smaller banks are canaries in the coal mine as the average charge-off rate at those smaller banks is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010.
If an effort to compete with the large and increasingly larger banks, some smaller banks have taken to lowering lending standards, which means their credit cards are held by those that are first to feel economic angst. The subprime borrower is always the first to get hit when the economy weakens. For years, wage growth has been slower than the growth in expenditures, forcing many families to take on credit card debt just to pay for necessities. The rising charge-off rates indicate that these folks are in a perilous economic condition if wage growth doesn’t accelerate sufficiently and soon.
Education debt swelled to nearly $1.38 trillion at the end of 2017, with 11% of borrowers 90 days or more delinquent, according to the New York Fed. The U.S. federal government now owns over 30% of total consumer debt in the U.S., thanks to its utter dominance of the enormous student loan industry. Prior to the financial crisis, that number was less than 5%. Think about what that means concerning the reduced firepower of the federal government in the case of another financial crisis.
This area of lending reminds us of the dynamics in the housing market that led to the subprime mortgage disaster. The problem in subprime was that too many players had no real skin in the game. Thanks to various legislative acts, the banks issuing mortgages were incentivized to immediately turn around and sell them to Fannie Mae or Freddie Mac – particularly the subprime loans. This meant the issuing bank had no real interest in the quality of the loan.
With student loans, the student or prospective student has little ability to estimate the relative earnings advantage potential for any particular education. The seller of the education, the college or university, is financially indifferent as to whether the student will ever be able to pay off the loans and with the way student loans work, has no incentive to tie the cost of tuition to the improvement in future earnings it provides through its curriculum. This creates an entirely new generation of Cash-Strapped Consumers that start off their young lives already saddled with brutal debt levels, which often postpones the traditional cycle of car and home purchases as well as starting a family.
Emerging Market Debt
It isn’t just domestic debt that has us concerned. Another area of concern that we are watching has been in emerging market debt which has helped generate the Rise of the Middle Class investing theme in these economies. The 26 largest emerging markets monitored by the Institute of International Finance have seen their sovereign debt load rise from 148% at the end of 2008 to 211% of GDP at the end of the third quarter of 2017. Couple that with the pricing perversions driven by investors’ search for yield that have the 10-year Kenyan bond trading at 7.5% and the Dominican Republic 30-year at 6.5% while the 10-year and 30-year U.S. Treasury bonds trade at 2.87% and 3.15% respectively. Really? Not a whole lot of risk premium priced in there.
Then there is the incredible size of China’s financial system. As of the end of last year, assets in Chinese commercial banks were approximately $40 trillion, which is around 51% of global GDP. The highest the U.S. every reached was 32% of global GDP in 1985 and Japan at 27% in 1994. For additional perspective, at the end of last year, in the United States, that number was $17.4 trillion versus U.S. GDP of $19.4 trillion while China’s GDP is around $13.1 trillion. This is wholly unprecedented in the history of global finance.
Let’s not forget that over the weekend China removed term limits for Xi Jinping, allowing him to possibly rule for life. History tells us that a nation, controlled by a single leader, who is no longer bound by any sort of accountability thanks to his/her ability to rule for life, rarely experiences increasing individual freedoms, increased open trade and responsible debt management – yet another geopolitical concern to add to the pile.
The bottom line is the world has been awash in a whole heck of a lot of liquidity thanks to the concerted efforts of the world’s major central bankers. The intention was to suppress interest rates, thus induce borrowing. Well, it worked. The secondary effect, which was also intentional, was to inflate assets prices so as to induce the so-called wealth effect.
Done! Thanks to stock prices rising at a much faster rate than the economy, household wealth as a percentage of disposable income has reached a new record high.
The Federal Reserve is now attempting to increase interest rates and take away that liquidity and asset-price-inflating punchbowl without any major disruptions. The European Central Bank may join in here soon too as all are concerning that this post-financial crisis party may shift into inflation-mode, which no one wants. This too is wholly unprecedented in human history. While the mainstream financial media is all about the Goldilocks outcome, we remain skeptical and wary of highly leverage assets or those whose risks are significantly underpriced.