It's no secret that low interest rates have been great news for stocks. But beyond making equities more attractive in relation to bonds and making it cheaper for companies to borrow money, low rates have had a profound impact on the economy — due to some important shifts in consumer behavior.
However unloved, the rally in equities we have seen since 2009 has been strong, consistent and resilient, with few prolonged drops. There is a long line of plausible, and no doubt partial, explanations for the phenomena.
Yes, we have seen the rise of passive investing with massive and regular inflows to long-biased index products. A relatively small number of mega-cap stocks have outsize influence on these indices and have been trading on momentum. The role of global central banks, swooping in to arrest or invert some downdrafts, has and does play a role. Recovery from seriously oversold territory during the 2008-2009 crash is a contributor. Still, it marches on.
For some, the run in stocks has validated path-dependent thinking that we see as outdated. We see opportunity building for those willing to find and factor new rules and new imbalances.
Rates are low; we are dependent on aggressive monetary subsidy. Rates will rise, and this must be closely watched. Rates will not return to historically normal levels unless forced there by a market sell-off that overwhelms the Fed. Consumption patterns in the US have changed. This is all widely understood.
But new groups and new tastes are only part of the story. Our income distribution, credit access and types of borrowing have shifted. This is underappreciated and vital to finding areas of strength and weakness and to identifying cycles. This is where our attention has been.
The American consumer led the slide in 2008 and has been stalwart in the recovery. If we look at the portion of household incomes going to debt service payment, we see the pattern. Debt built and the service ratio — that is, the portion of household disposable income required to service that debt — increased into the Great Recession. As the downturn came, foreclosures, defaults, declines in issuance and lower rates all combined to push the carry cost of debt down, down and down.
Now consumer debt loads are rising once again — but the composition of the debt has shifted away from mortgages and toward consumer credit. Consumer debt is shifting toward auto loans, 48-60 months, and credit cards. Notably, these types of debt are short maturity and interest rate sensitive. The chart below uses Federal Reserve Data to look at the cost of three types of debt — total, consumer and mortgage. The portion of income going to shorter maturing and more interest rate sensitive loans has risen and is now above the mortgage component.
A further disaggregation of the data reveals rising auto borrowing with falling average credit scores. Student and credit card borrowing are the other area of significant growth — offsetting the structurally less robust mortgage market. Growth has been heaviest in auto loans and student loans. These loan types have much higher delinquency and default rates than mortgage loans. Ten percent of student loan balances were delinquent, over 7 percent of auto loans and over 6 percent of credit card balances in Q2 2017.
Nothing here suggests any type of imminent 2008 scenario. What does emerge is that the nature of the macro environment has changed without the understanding or assumption set changing in lockstep. We are more sensitive to interest rates and the shorter end of the maturity curve than has been historically the case. In other words, those who are obsessing over the 30-year bond are looking at the wrong type of interest rates and would do better to examine short-term yields.
It is clear that few have noticed or factored this reality.
The largest generation in American history — 72-plus million millennials — have tastes and debt levels that are shifting. Younger Americans are forming households later, are more likely to rent, and are struggling with student loans and car payments. Alternative lending outlets proliferate. In part this is because more folks work in the "gig" economy with lumpy income streams. In part this is because they owe more rate sensitive, shorter maturity loans that are not tax advantaged. This helps explain why the rates and maturities of debt are shifting. Yet the recovery versus double dip debate has obscured the more culturally driven changes we can now see taking shape.
Digital products come first. Job stability is more elusive. Work is increasingly likely to be less stable, contract-type work reflected on a Form 1099 —and as a result, financial fragility is rising. On the spending side, the "subscription economy" model dominates. Products and services that are easy to turn on and turn off are preferred. Change will be transmitted further and faster.
The changes produced or highlighted by 2008-2009 are not fully reflected in asset market expectations and prices. Yes, the recession is over. Large segments of the U.S. economy did not — and likely will not — return to the conditions prevalent prior to 2008. There are new rules, and those who figure and factor these rules more rapidly and completely will outperform.
The future of consumption is fragile, digital, rental and subscription focused and very sensitive to credit terms and interest rates.
Ideally, investment outlooks will mirror these realities.