Wednesday 7 March 2018

Macro and Credit - Intermezzo

"It was one of those March days when the sun shines hot and the wind blows cold: when it is summer in the light, and winter in the shade." -  Charles Dickens
Looking at the pyrrhic victory for the European technocrats in Brussels thanks the consolidation of Germany's Merkel coalition and the results of the Italian elections (which amounts to "Hunga Hunga"), and given the "regime change" put forward by many pundits thanks to the return of volatility after years of central banking repression, when it came to selecting our title analogy we reminded ourselves of the musical term "Intermezzo". In music, an intermezzo is a composition which fits between other musical or dramatic entities, such as acts of a play or movements of a larger musical work. In music history, the term has had several different usages, which fit into two general categories: the opera intermezzo and the instrumental intermezzo. In the 19th century, the intermezzo acquired another meaning: an instrumental piece which was either a movement between two others in a larger work, or a character piece which could stand on its own. As CITI's Chuck Prince said nicely in July 2007:
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing" - Chuck Prince
To some extent, early market jitters such as the ones caused by the explosion of the pig's "short-vol" house of straw amounted to an "intermezzo" we think. A larger musical work is at play and it is the evolution of the credit cycle. It is slowly and gradually turning, with macro hard data erring on the soft side recently (US durable goods orders falling 3.7% in Jan, vs 2.0% drop expected) while consumer confidence, being soft data, printing on the strong side. When it comes to liquidity, it is being withdrawn by the Fed through its "Quantitative Tightening" (QT). While we have already seen some casualties such as the short-vol ETN complex amounting to the equity tranche in the capital structure, it remains to be seen where and when will the next larger fishes will show belly up at some point down the tightening road, but, we think the time has not yet arrived.

In this week's conversation, we would like to look at the situation of the US Consumer, given in various recent musings we were asking ourselves if he had been "maxed out" and rely heavily these days on credit card use to sustain his consumption habits. As pointed out by famous French economist Frédéric Bastiat, there is always what you see and what you don't see particularly in a country boasting a very high Gini coefficient such as the United States. 

  • Macro and Credit - Thanks to Gini coefficient, when it comes to consumer leverage, it's not always what you see
  • Finals chart - Let the good times roll?

  • Macro and Credit - Thanks to Gini coefficient, when it comes to consumer leverage, it's not always what you see
Back in March 2017 in our conversation "The Endless Summer" we concluded our long conversation asking ourselves if the US consumer was somewhat "maxed out". We indicated as well that this on-going "Endless Summer" had created a significant windfall for the holders of financial asset. The "wealth effect" has globally lifted all "financial" boats but, in our book a credit cycle's length is around 10 years, so we do believe we are entering the last inning and that the final melt-up in asset prices could be significant before the usual "Bayesian" outcome. When it comes to the US economy, US consumer credit matters a lot. We continue to monitor that space given any weakness in US consumer credit could be an additional sign the US economy is reaching a turning point. In January 2018, in our conversation "The Lindemann criterion", we indicated that measuring the level of indebted households matters and in particular the use of Consumer Credit and in particular non-revolving credit:
"US consumer debt surged by the most in over 2 years to $3.8 trillion and jumped by 8.8% in November, the most in two years, to $3.83 trillion, according to the Federal Reserve. Clearly in the coming months US Consumer Credit should be on everyone's radar in conjunction with SLOOs we think." - source Macronomics, January 2018
Another sign that caught our attention as of late has been the article in the WSJ pointing towards mounting credit card losses in their article from the 4th of March entitled "Credit-Card Losses Surge at Small Banks":
"Small banks have been fighting for a bigger piece of the credit-card market in search of higher returns. Now, they’re contending with rising losses.
Missed payments on credit cards at small banks have risen sharply over the past year, a sign that their cardholders are taking on more debt than they can handle. Their charge-off rate, or the share of outstanding card balances written off as a loss after consumers failed to pay, hit 7.2% in the fourth quarter, up from 4.5% a year ago, according to Federal Reserve data.
Concerns have been mounting in the broader credit-card industry about the recent trend of rising delinquencies. While overall card losses are still relatively low—below the historical average of the last 30 years, for instance—they’ve been slowly climbing in the last two years.
But they’ve especially surged at smaller banks, those outside the 100 largest by assets that have less than around $10.4 billion in assets. There, the average charge-off rate is near an eight-year high, while the 3.5% loss rate at large banks remains well below the 10.6% seen in 2010." - source WSJ
The US savings rate has been falling while consumer credit has been on the rise with a significant usage of the credit card in recent months it seems. This is something to be mindful about, particularly when as we will see in our conversation that when it comes to consumer leverage in the US all is not what it seems. Monitoring Fed Senior Loan Officer and Opinion Survey (SLOOS) will be paramount this year.

There were as well some additional interesting points in the WSJ article:
"The small banks’ experience is “simply a leading indicator of a downturn to come,” said Robert Hammer, founder and chief executive of credit-card industry consultant R.K. Hammer. In the run-up to the last recession, he noted, losses accelerated for small banks before they did for big ones.
Some small banks have viewed credit cards as a way to cross sell their customers and to bring in new creditworthy customers. That became a challenge as big banks pursued the same set of borrowers by charging low interest rates for promotional periods. Personal loans offered by a growing number of lenders provided even more competition.
That left many small banks with card applicants who had lower credit scores." - source WSJ
Is it a worrying sign? You would have to take into account the impact on "millenials" into the equation we think. Since the Great Financial Crisis (GFC), Congress passed the CARD Act of 2009, a comprehensive credit card reform legislation to protect consumers. Under the bill, lenders cannot issue credit cards to a consumer under the age of 21 unless they prove they have independent income or obtain a cosigner. Also, many millennials are clearly "credit mature" in their 20s compared to the previous generations. As millennials come of prime working age, many are having a hard time obtaining credit cards because lenders are unwilling to extend credit to individuals that have a short or no credit history (yes dear readers in your FICO score, credit history is the most important factor!). This is indeed slowing credit creation somewhat for them. Due to the experience of the GFC, millennials could be less inclined to "buy" using credit or are "convenience users" who pay off their entire credit card balance every month, limiting the need for multiple credit cards.

But the "millenials" are only part of the story. There is much more to it and necessitate a bigger dive into the US consumer credit market. On that very subject we read with interest Deutsche Bank's State of the US Consumer report from the 26th of February entitled "Robust Consumer with Pro-cyclical and Seasonal Tailwinds on the Horizon".

One of the most important points made in this report was the Employment Cost Index (ECI) pointing towards rising inflation:

"One measure of wage inflation is the Employment Cost Index. The ECI measures total labor costs for companies, including wages, salaries, and benefits. Historically, labor costs have been predicted with a nine month lead by companies’ plans to raise worker compensation, see chart below. Both series have trended higher since 2010 but are now beginning to reach levels at or above previous peaks, signs that the labor market could start to overheat and bring higher inflation." - source Deutsche Bank
From the above, there is indeed a potential for a surge in inflation particularly with trade war rhetoric heating up which could add to inflationary pressures building up in the near term (and that's bullish gold by the way). A move toward trade protection in the US could lead to a further decline in global trade, making everyone worse off. Also, corporations have spread their supply chains across the world in the last ten years and they could be impacted seriously via a rising cost bases due to protectionism and trade war on top of a surging ECI index.

Returning to consumer credit, more concerning and well documented has been the rise in student loans since 2007 as indicated by Deutsche Bank in their report:
"Federal student loan performance worth monitoring
Average student loan balances continue to rise, despite the leveling of the number of consumers with student loans, as outstanding balances have more than doubled since 2010. Since 2007, student loans have risen from 15% to now over a third of the entire consumer debt complex (ex- mortgage).
With the rise of student balances, student debt leverage has also continued to rise steadily since 2003. Among the bottom 60% of income households, DTI from student loans has seen an average increase of +10% pts since 2007.
While the leverage within student lending may have a spillover effect for other consumer loan categories, we note nearly ~20% are deferred or in forbearance (i.e. the impact is being pushed out). Although defaults are currently at ~15% of total recipients, the highest % of defaulted accounts are for the lowest average loans (~2/3 of defaults are for loans & $10k) with defaults usually relating to noncompletion of school.
- source Deutsche Bank

So yes Student Loans have been rising significantly since 2007 and the onset of the Great Financial Crisis (GFC) but it is part of a significant increase in overall leverage of the US consumer. Again, there is what you see and what you don't see as pointed out by Deutsche Bank in their thorough report:
"Items to watch
Lower income consumers are more levered than they appear: The aggregate deleveraging post-crisis has largely benefited from mortgage leverage sitting at its lowest level since 2001. However, other consumer leverage (card, student, auto, and personal) continues to grind higher into 2018 and is now at all time highs (~26%). Excluding disposable income for the Top 5% income bracket of US consumers, consumer debt levels are closer to 43% of adjusted disposable income—almost double the reported measure of ~26%. The latest triennial Fed Survey of Consumer Finances highlights this dynamic, with the bottom 40% income households running at ~50% non-mortgage DTI, which is ~10% more than LT averages.

The subprime/low income consumer is stretched: Sluggish wage growth and rising healthcare and rent expenses as a percentage of income (non-debt obligations near 25 year highs) among lower income households have stretched subprime consumers as they look to augment rising expenses with debt.

Banks have met this increased demand by providing deeper credit access to subprime (increased participation, especially for cards), leading to higher leverage and an increased severity risk of loss as delinquencies start to diverge for lower quality consumers. Like DTI, adjusting debt payment burdens to exclude the top 10% income brackets almost doubles the reported Fed figure (9.6% PTI vs. 5.8% reported PTI by the Fed).
Socio-economic divide driving credit cycle: While aggregate consumer fundamentals remain robust, subprime consumers are seeing rising delinquencies and losses starting to normalize much faster than other credit tiers: +90-day DQs within subprime cards have rose+300bps Y/Y in 3Q17 vs. only~30bps on average for near prime/prime borrowers. ~45% of Americans would have difficulty paying a surprise medical bill of ~$500 (Kaiser Foundation), while ~50% of US consumers live paycheck to paycheck (FITB). Taken all together, a disconnect between the lower credit tier borrowers and the economic cycle is starting to emerge.
Monitoring FICO score inflation: Consumers with a FICO score below 600 have declined from 25.5% in 2010 to ~20% (40m consumers) in April 2017, while aggregate FICO scores have increased from 680 in 1999 to 703 in 2Q17. FICO score inflation has been driven by a robust macro environment, extension of a steady business cycle, demographic aging, and methodology changes. Additionally, non-prime consumers with the same FICO score is more risky today than coming out of the recession as the long business cycle helped bankruptcies off the credit report and solid job market has enabled consumers to pay their bills." - source Deutsche Bank
Indeed as per the above, some credit cracks are starting to show, particularly within the lower credit tier borrower which had been saved by the bell thanks to central banks stepping in with its ZIRP policies and QE to stave off defaults and bankruptcies.

Of course the missing part so far of the "inflation equation" has been wage growth. Over time there has been a stable relationship between wage growth and total consumer debt but it seems that since 2013, there has been a change in the narrative as per Deutsche Bank's report:
"Modestly widening gap between wage growth and debt growth
Wage growth and total consumer debt growth have been relatively stable in the low- to mid-single digit range since 2013; however, the gap between wage growth and debt growth has widened modestly in 2017, with non-mortgage consumer debt now growing at a faster clip than wage growth (with the gap narrowing tightly in 4Q17).
Aggregate non-mortgage consumer debt expansion has come in at +5.5% Y/Y vs. 7% to start the year, and other than the pullback in 2016, has been running at 6% to 6.5% since 2013. The current 5.5% rate is ~150bps lower than the median growth rate since 1965, suggesting non-mortgage consumer debt still has room for growth heading into 2018.

- source Deutsche Bank

The rapid pace in credit card growth aka non-mortgage consumer debt expansion is running hot currently and needs to be closely monitored in the months ahead, particularly if it is starting to bite the lower tier credit borrower with already strains showing up within small banks. No surprise in the above quoted article from the WSJ that smaller banks are experiencing rising defaults given the acceleration seen in credit growth from small issuers aka small banks but also non-banks have been playing the game at an accelerating pace as well.

We pointed out the importance of tracking the quarterly Fed SLOOs for additional signs of tightening lending standards which are still quite loose. The trend though is pretty clear for auto and card, banks are starting to tighten their credit standards in these areas as indicated by Deutsche Bank:
"Banks continue to tighten credit standards on auto and card
As the credit cycle continues to slowly normalize, 4Q17 saw a continuation of a net percentage of banks starting to tighten credit card and auto lending standards, with ~10% of banks reporting tightening card standards on average so far through 2017. We believe it will take a couple years of tightened originations to reflect into total outstanding balances.
Why tightening consumer lending standards should not hurt the economy yet. 
The tightening has been driven in large part by prime/subprime auto (which is needed) and by the smaller banks in card (which does not matter as much, and given small issuers have recently returned to ~11% growth). The Fed’s senior loan officer survey includes 60 banks, but does not adjust for size, which will likely distort results. For example, in credit card, the Top 10 banks control 70% + of card balances and many are actually loosening lending standards (ie Chase and Discover, for example). Furthermore, non-banks have become a larger driver of consumer credit post-Crisis. For example, banks are only 30% of auto and personal lending. TransUnion credit bureau data shows that while banks in net aggregate have started to tighten lending standards, consumer participation across all products outside of HELOCs continues to grow at a healthy clip in 4Q17.
2017 bankcard originations tracking just slightly below highs set in 2016
With data provided by Equifax, total bankcard originations FY17 are tracking just below 2016 levels (through 3Q17) with a slight tightening in originations coming from subprime credit tiers giving prime and near-prime originations a slightly higher percent of total bankcard originations. Interestingly, private label retail cards have actually seen a slight increase of subprime consumers percent of total originations increase at the expense of prime borrowers (likely as retailer woes leave retailers looking to loosen credit standards in order to boost sales).
Card delinquencies and charge-offs are rising, but still well below 30-year averages
Concerns over credit deterioration had been worrisome in 2017, with delinquency rates starting to rise in auto and card products. While card losses have been on the rise from post-crisis lows set in 2015, they still remain ~70bps below precrisis averages and are exhibiting a steady normalization path, considering recent industry growth and the seasoning of these vintages. Outside of auto and card, other financial products are actually either improving in performance or remaining flat in 1Q18.
Within card, normalization occurring across all credit quality
Delinquencies have seen an uptick across credit tiers, however still remain below pre-crisis levels, in aggregate. Score inflation masking the underlying credit quality of the consumer, a change in the mix with newer vintages, and outsized growth for newer vintages (growth math) are contributing to higher delinquencies across these credit tiers.
Retail card delinquencies peaking faster and higher
Retail private label cards (specifically the 2015 and 2016 vintage) are exhibiting a shorter time to delinquency and a higher DQ rate than even pre-crisis vintages. We see a combination of mix shift towards lower FICO score customers, potential retail bankruptcies, and FICO score inflation as contributing factors. Regarding retailer bankruptcies, an analysis by Moody's suggests that increased charge-offs for the retailer ahead of a bankruptcy filing are more common, as these retailers start to loosen their credit standards and aggressively market to lower end consumers in order to bolster sales. Whether consumers also feel less inclined to pay off a card for a retailer that has recently gone bankrupt could be another factor to monitor." - source Deutsche Bank
It certainly feels that we are in 2007ish environment at the moment, hence our "intermezzo" title, yet given the lateness in the credit cycle as indicated by more M&A deals, a flattening of the US yield curve and a continuation of buybacks. As per our prognosis and Deutsche Bank thorough analysis, there is what you see, and what you don't see when it comes to the US consumer. As pointed out by the Kansas City Fed, 43% of the increase in average FICO scores from 1999 to 2007 is attributable to the aging of the US population. Demography is indeed "destiny" and if it looks like credit scores are higher thanks to demographics, leverage as we have seen is much higher than anticipated. This is a continuation as well from the theme we tackled back in March 2017 as well in our conversation "The Endless Summer" when we asked ourselves if "boomers" were bust, given that they are more leveraged than previous generations were ahead of retirement. Sure most of them have a relatively small exposure to student debt as their enter their golden years, but their retirement "preparedness" remains a very big issue. During the next 20 years, roughly 74 million "boomers" will retire in the United States. That is an average of more than 10,000 new retirees a day...

For now soft data in the US is strong whereas hard data is somewhat weaker, and it seems Wall Street is more pessimistic than Main Street. In our final charts below we will look at consumer confidence which seems diverging to the prevalent mood in Wall Street thanks to trade war rhetoric as of late.

  • Finals chart - Let the good times roll?
Whereas there has been a change in the narrative in Wall Street with the returns of higher volatility and more gyrations in financial markets, it seems that the US consumer has remained more unfazed and upbeat as per the rise seen in consumer sentiment. Our final charts come from Wells Fargo Economics Group from the 2nd of March entitled "Consumers Remain Unfazed By Market Volatility" and displays not only Consumer Sentiment Survey but more importantly expectations of higher income to come as well as a very interesting chart displaying the US consumer uncanny ability in calling a market top in the housing market, or to put it simply, when Main Street is better at forecasting than Wall Street:
"Consumers Remain Upbeat About the Economy and Incomes
Consumer sentiment rose 4 points in February to 99.7 and is just 1 point below its recent high hit in October of last year. Consumers appear to be unfazed by the recent volatility on Wall Street. Relatively few consumers cited the stock market as a factor influencing their views on the economy and, surprisingly and reassuringly, a larger proportion of those that cited it as having an impact said it was positive for the economy rather than negative.
Consumers are clearly more focused on the underlying fundamentals. Our below chart shows consumers’ assessment of current economic conditions, which rose 4.4 points in February to 114.9.
The University of Michigan noted that more consumers reported they had recently heard favorable news about the economy in February than any other time since 1984. Two-thirds of consumers reported their attitudes were influenced by the recently enacted tax cuts and stronger overall employment growth.
The persistent improvement in consumer sentiment provides some relief for folks concerned about ballyhooed threats, such as rising interest rates or steel tariffs. Consumers are not turning a blind eye towards the threats, but appear to be balancing them against expectations for stronger job and income growth. Consumers’ assessment of their finances has improved greatly over the past year. Fifty-four percent of consumers said that their finances had improved over the past year, which is the highest share since January 2000.
Consumers are also optimistic about the labor market and income growth going forward, with a significantly larger share of consumers expecting the unemployment rate to fall over the next year (35 percent) than expecting it to rise (23 percent). The percentage of consumers expecting their income to rise over this year rose 3.8 percentage points to 55.3 percent. An even larger share (57 percent) of consumers stated that they expect the country will have continuous good times over the next 12 months, up 3 percentage points from January.

The increased confidence in job and income prospects should be good news for consumer discretionary spending, which has recently shown some signs of cooling off following a strong holiday shopping season.
While consumers are remarkably upbeat, they are still aware of many of the key risks present today. An overwhelming 77 percent of consumers said that they expect interest rates to rise over the next 12 months and 48 percent expect gasoline prices to increase. Consumers just seem to be doing a better job than the financial markets in putting these risks into perspective. Stronger economic growth and increased job security are far more important to consumers and that is apparent in buy plans for major household items, which rose 6 points in February. On a more cautionary note, plans to buy a car or a house both rose much less during the month, although the proportion of consumers stating that now is a good time to sell a house jumped 7 points to 73 percent."
- source Wells Fargo

In this ongoing "intermezzo" period giving us that 2007 feeling, what is really striking to us is that the amount of leverage for the US consumer is not what it seems, and no matter how strong the willingness of the Fed to hike is, it appears to us that much sooner than in previous hiking cycle, the Fed is going to "break" something. As per the above chart, it seems to us that Main Street has a pretty good forecasting record in calling housing market tops it seems, much better than some sell-side pundits but we ramble again...

"Pessimism of the spirit; optimism of the will." - Antonio Gramsci, Italian politician

Stay tuned!

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