December 18, 2018
Craig Holke, Investment Strategy Analyst
Are Rising Household Debt Concerns Warranted?
- Concerns have risen about the levels of U.S. household debt and whether debt at these levels will have a negative impact on the economy.
- Mortgage debt remains below the previous peak. Auto loans have increased significantly and delinquencies have risen. Credit card debt growth has slowed and delinquencies remain below pre-recession levels.
What It May Mean for Investors
- U.S. household debt growth has moderated and delinquencies remain mostly in check. We do not believe debt at these levels or growth rates poses a threat to our forecast for solid economic growth into 2019.
U.S. household debt was a significant contributor to the Great Recession of 2008-2009. The economy had been boosted by households taking on too much debt, including speculation in the housing and real estate market. The recovery following the recession was then hampered by households drastically cutting spending, increasing savings, and attempting to put their personal balance sheets back in order. Household debt levels have continued to rise in terms of absolute levels. This has raised concerns about the effect this may have on household spending and the economic growth. The Federal Reserve Bank of New York tracks household debt through the quarterly “Household Debt and Credit Report,” created by the New York Fed Consumer Credit Panel in conjunction with Equifax. While absolute levels of household debt have risen to new highs, with the exception of mortgage debt, we do not believe debt at these levels poses a significant threat to the U.S. economy at this time.
Chart 1 depicts the year-over-year growth in household mortgage, auto loan, and credit card debt. Prior to the Great Recession, mortgage debt grew; yet, the pace of this growth has declined as mortgage rates and home prices continued to rise. Being sensitive to interest rates, auto loan growth continued to decline as the Federal Reserve (Fed) began raising rates in mid-2004. Credit card debt growth continued to increase later in the cycle as households finance greater spending.
Debt growth turned negative during and right after the recession as households reduced spending and attempted to improve their personal finances. This was done voluntarily through reduced spending and refinancing, and involuntarily, through defaults and foreclosures. We then see the typical increase in debt accumulation while the economy and labor market recover. Auto loan growth was the first to recover as low interest rates and incentives from auto makers induced purchases. Credit card growth was slower to mend as households maintained discipline while paying down outstanding debt. Mortgage debt growth has been the slowest to recover. In fact, mortgage debt is the only major category of household debt that has not reached a new peak in terms of absolute level of debt.
We have now seen auto loan and credit card growth slow while the expansion has matured. This makes sense, in our opinion, as both forms of borrowing are sensitive to Fed interest rate hikes. Mortgage debt growth has leveled out, not reaching the peak seen during the real estate bubble prior to the Great Recession.
Rising defaults may pose an issue in the future
Concerns arise that households take on more debt than they are able to afford and then become unable to repay their debts. This is also a sign that spending, which drives economic growth, will decline. Chart 2 shows the amount that each form of debt has been delinquent for at least 90 days. Pre-recession, these delinquencies had remained stable for the most part—with the exception of mortgages as the housing market began to feel strains. As a mirror image of debt growth, delinquencies rise during and immediately following recessions, since slower economic growth and loss of jobs affects the ability of households to pay their debt.
Economic recovery and expansion allows for delinquencies to decline as household finances improve with the growing economy and labor market. Mortgage defaults currently remain low, with higher lending standards playing a key role. The current median credit score at the origination of a mortgage is 758—significantly higher than the low of 707 at the end of 2006. Auto loan delinquencies are approaching levels seen following the recession. Lending standards remained lower in auto loans and are now experiencing higher defaults. Credit card defaults are perpetually higher. While they have trended higher, they remain below pre-recession levels and are not showing signs of accelerating.
Rising debt levels are, in and of themselves, not a problem. The issue can arise when debt levels rise faster and higher than households are able to afford. Too much debt and consumers have less extra money to spend and, as a result, drive economic growth. Mortgage debt is the far largest component of household debt and is able to pose a systemic risk to the U.S. economy, as was seen in the Great Recession. Yet, levels of debt and growth rates remain below the previous peak, and tighter lending standards are limiting delinquencies. Auto loan debt had grown significantly, but has slowed as interest rates have risen and dealer incentives were reduced. The higher level of delinquencies is concerning for the signal it sends about future consumer spending. However, auto loans have solid collateral in the auto itself and do not pose a similar threat to the overall economy as mortgage debt did in the last recession. Credit card debt is very cyclical in nature. The growth rate has declined (which is positive) and delinquencies remain below even those prior to the last recession.
As such, we do not believe that, even though most categories have risen to new highs, household debt poses a significant threat to our current outlook for still strong, yet slowing economic growth in the U.S. This growth may be able to continue supporting solid levels of household saving and spending and to contribute to our favorable outlook on U.S. large-cap and mid-cap equities. This growth will also allow the Fed to continue raising rates into 2019. With higher yields from rising rates, we recommend investors focus on short-term fixed income opportunities.
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