Down the Road to Normalization
“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”
William Arthur Wood
Through last Friday the S&P 500 was up 7.9% year-to-date, meanwhile the mid-cap S&P 400 and smallcap S&P 600 rose 4.0% and declined 0.5%, respectively. Unlike the S&P 500, which set a new record high last week, these other indices reached their highs earlier in the year. Narrowing breadth reflects these returns for the S&P 400 and 600 indices. The gains in the S&P 500 are the result of the top 15 stocks generating over half of the increase this year. As earnings growth estimates continue to rise and investors believe the gains are achievable, expect a broadening in the markets.
The narrow breadth is mirrored in lower volume and low market volatility. High volatility is most often indicative of a declining market but, the Volatility Index has remained at historic lows since mid-April. The only exception was the brief sell off in mid-May. Technicians talk of this low volatility as a sign of complacency and as a precursor to a correction. However, others have cited the increased use of index ETFs as a contributor to the current low volatility. According to the Investment Company Institute, over the past ten years about $1.4 trillion flowed into domestic equity index funds. Over the same period, $1 trillion flowed out of active managed mutual funds. Today the top 50 ETF’s (2% of total) control twothirds of ETF assets, while the top 100 control 84% of the assets.
The US markets are benefiting from a pro-business sentiment. To date, the 2% economy remains as underlying strength improves. So far, buying into geopolitical fear, even if it comes about, has proven to be wrong. The recent rally which brought broader averages to new highs is about positive change, synchronous global growth, solid 1Q2017 earnings, and low interest rates. There is a change in attitude as individual investors are beginning to shift away from fixed income. Funds are being invested overseas in ETFs for Europe and Emerging Markets.
The Misrepresented Consumer
Over the past two years, our Reports have discussed at length, a “backloaded consumer” as the lynchpin to sustainable economic growth. Consumers are now in the best financial health since the Great Recession. But, interpretation of a report on consumer debt questions that outlook.
The New York Federal Reserve Bank recently released its “Quarterly Report on Household Debt and Credit” for 1Q2017. Aggregate household debt increased by $149 billion in 1Q2017 to a record $12.73 trillion, above the previous peak of $12.68 trillion in 3Q2008. Economists, market analysts, and the media jumped on the headlines and implied the debt cycle is once again in full swing. In reality, the raw data overwhelmingly show the strength of the consumer balance sheet, rather than focusing on the increase in liabilities. For example, not reported is the fact the debt reaching a new peak is about 103% of disposable income, down from record 133% in 4Q2007. This is the lowest level of the debt-to-income
since 2002. More importantly, the level of debt is more manageable as the quality of the average borrower has risen to a 700 credit score, a level not seen since 2005.
A shift in borrowing patterns, particularly with tighter regulation for home mortgages (68% of total debt), has reduced the level of risk significantly. Using credit scores as a barometer of borrower ability to pay, the quality of loans has increased dramatically. This is true across a broad range of consumer debt, with the exception of student loans. At the height of the housing depression, in 1Q2010, 8.9% of mortgage loans were delinquent over 90 days. Today that number is 1.7%. For credit cards the same pattern exists, delinquent loans of more than 90 days were over 13% in 2010-2012, but has since dropped to 7.5%. Both home equity and the “other” category, which account for 7.7% of the total loans, show the same pattern.
Auto loans (10% of the total) are somewhat troubling. However, the problem is being attended. Auto loan delinquencies are only at 3.8% of the $456 billion of the auto total. The length of the loan is more troubling because during the 2012-2015 period the overall credit quality of borrowers was low. Recently, credit quality has improved, raising the 720+ credit score for borrowers up to the 60-65% for new loans compared with the lower quality borrowers (below 720) which dropped below 40% after accounting for 60% or more over the past few years. Given the loan mix until 2016, it seems reasonable to assume many of the 6-7 year loans will fall into delinquency and repossession. This does not take into account the likelihood that many cars may not last the duration of the loan. If there is good news, it is that the current $17.2 billion delinquent is only 0.135% of total household debt.
Student loans are a well-known problem that is priced into the debt equation. Totaling about 10% of all household debt it is difficult to foresee a favorable outcome. With a delinquency rate of 11%, over 50% of these loans are for students who attended “for profit” colleges and have not graduated. Without a degree it will be almost impossible to collect these funds. This should not have a direct effect on the average consumer.
In conclusion, the record level of debt has been misrepresented as a burden for the consumer and a negative for the economy. Further examination shows a more robust consumer on the verge of increased income and better opportunities as full employment approaches. The rise in home prices and the stock market have been major contributors to the lowered ratio of household debt to net worth from a financial crisis high of 25.4% to 15.8%.
Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity. It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies. To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.