With the economy slowing, we expect a period of sustained high interest rates to significantly and negatively impact consumer balance sheets and consumption.
Alchemy
(Noun) – Any magical power or process of transmuting a common substance, usually of little value, into a substance of great value
Mysterious? Impressive? Controversial? Regardless of your answer, there is little doubt that the low-interest rate era of the 2010s had significantly affected economic growth and the evolution of balance sheets. Global central banks held rates at or near zero for an extended period. Through their various forms of forward guidance, they communicated an extremely accommodative policy meant to stimulate growth and heal economies damaged by the Global Financial Crisis (“GFC”), as we discussed in an earlier piece.
The injection of massive amounts of liquidity into the financial system had the benefit of stabilizing and boosting markets. Investors interpreted the Fed’s monetary policy actions and forward guidance as a method to dampen financial market volatility, raise asset prices, and create a wealth effect to increase consumer confidence and foster growth. Financial market stability, in effect, became the Fed’s third mandate.
Meanwhile, the housing market, and thus a broad cohort of consumers, benefited from cheap financing through low mortgage rates, auto loans (through zero-percent financing) and consumer credit (through zero-interest financing for consumer purchases and even credit card transfers). At the same time, both corporate and government debt issuance expanded to record levels as a percentage of GDP. Though easy to imagine in hindsight, a borrower, even an everyday consumer, could roll short-term debt at or near zero rates for years, essentially financing either consumption or investment free of cost. This is no longer the case.
Today’s environment is much different, with above-trend inflation driving the cost of capital to levels not seen in over 15 years. We believe a higher cost of capital is likely here to stay, marking what we call ‘The End of Low-Interest Rate Alchemy.’ Higher rates mean demand cannot be pushed forward anymore, with the economy experiencing a protracted period of softer growth and consumption. We expect this dynamic to significantly impact the economy’s three central balance sheets – consumer, corporate, and government. In this article, our focus will be on the consumer balance sheet.
Consumer Debt – Where Have We Come From?
Throughout the post-GFC era, consumers slowly repaired themselves, supported by increased savings rates, more robust bank lending standards, or simply defaulting on their debt and starting over. This led to a healthier consumer balance sheet than the years before the GFC, as measured by the consumer debt/GDP ratio (see the chart below). Although these have all been very positive developments, today’s consumer remains broadly constrained in her ability to take on additional housing debt.
This constraint is due to higher residential mortgage and consumer loan rates but is also driven by consumer debt levels that have not improved historically. The chart below illustrates U.S. Household Debt to GDP going back several decades. Despite the consumer balance sheet improvement, debt as a percent of GDP remains at levels last seen in the early 2000s, not all that far off from the housing bubble. But levels remain far above the consumer debt from the 1960s to the 1990s, suggesting that household debt has limited capacity to power forward-looking economic growth and that the debt levels reached during the GFC were unsustainable.
Consumer Debt Is Declining, but Remains Historically High
Source: Bloomberg
Housing Wealth – Plentiful Yet Inaccessible
The rebound in home prices during the 2010s was vital to the economic recovery and the Fed’s not-so-inconspicuous goal to make consumers ‘feel’ wealthier. Though mortgage lending standards improved, consumers still had the opportunity to monetize their increasing home equity, whether through traditional refi’s, cash-out refi’s, or home equity lines of credit (HELOC). Home prices boomed post-COVID and remained near all-time highs but with interest rates much higher.
Now, accessing housing wealth is significantly more difficult, as observed when looking at the current mortgage rates versus the average mortgage rate existing homeowners pay. Unless the homeowner is in dire need of cash, they will not swap their existing 3.5% mortgage to take a cash refi and lock in today’s near 8% rates. The silver lining to growth going forward is that higher mortgage rates will not immediately pressure most homeowners. But home equity won’t be the cash cow or booster shot to the economy as it once was.
Today’s Homeowners Are Paying Much Lower Rates than the Current Market Offers
Source: Bloomberg
Cracks Appearing in the Consumer Balance Sheet
The most significant market debate today – other than the future direction of Fed policy – is whether the U.S. will enter a recession in the first half of 2024. Many pundits on the side of a soft landing cite the consumer as the economy’s underpinning. But the pressure on the consumer continually increases, and we now see it in the data. Credit card delinquencies (90+ days) are up across all age cohorts. Notably, this is trending worse with younger folks, which is not surprising given they have been unable to experience the housing gains of the past decade. We are seeing the same trend with auto delinquencies. What concerns us is that the data is trending worse while unemployment is still very low. Additionally, consumer savings as a percentage of disposable income has been trending below average for over two years at about half of the 8.8% long-term average rate since 1960. The consumer is clearly under pressure, and the outlook is not likely to improve with the Fed purposely trying to soften the labor market to bring core rates to target levels.
Consumer Credit: Delinquencies Rising from Post-Pandemic Lows
Source: Bloomberg as of September 30, 2023
Consumer Spending: Shrinking Disposable Income
Source: Bloomberg as of September 30, 2023
Conclusion
The end of low-interest rate alchemy means the consumer can no longer ride the tailwind of lower rates by using cheap funding and harnessing the wealth effect. The Fed’s goal is not to reinflate but to disinflate, requiring the consumer to feel some pain. The aggregate consumer balance sheet is constrained by the additional debt it can take on and the current rates in the consumer and mortgage lending markets. Coupled with rising delinquencies and shrinking disposable income, the consumer faces some tough challenges. In a future article, we will examine how the end of low-interest rate alchemy will impact corporate and government balance sheets.
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