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The Federal Reserve’s (Fed) rate hikes over the last year have led to a sharp increase in borrowing costs, raising concerns that a consumer-driven economic recession could be looming. Recent bank failures are likely to result in tighter lending standards or a contraction in available credit to consumers, which is generally negative for overall consumer health. While I do anticipate pockets of weakness, I also observe some mitigating factors that could keep US consumption elevated and support economic growth, which could be further bolstered if the Fed deviates from its “higher for longer” policy rate trajectory in the pursuit of financial stability.
1. Credit card use is increasing but payment rates are high
The Fed’s data on consumer credit shows that credit card limits have grown steadily, along with a pickup in utilization rates — the percentage of a credit card limit used by a borrower. But credit utilization still remains below pre-pandemic levels and well below the heights reached during the stress of the global financial crisis (GFC). It’s important to point out that credit card balance data is the sum of all credit card borrowers’ most recent statement balances; balances that are paid in full or partially paid each month are also included in this data. To better ascertain actual consumer behavior, I look at monthly payment rates (MPR) from credit card companies. MPRs are high (~40%) and have grown as limits have increased over time (Figure 1).
Bottom line: While consumer performance is softening, consumers are paying all or a portion of their credit card balances in a timely manner; delinquencies are low.1 Yes, credit card balances are higher, but in my view, much of this reflects the evolution to a cashless society, as opposed to a worrisome trend of consumers taking on unmanageable debt burdens.
Figure 1
2. Demographics may explain consumer resilience
Roughly speaking, baby boomers — those born between 1946 and 1964 — account for around a fifth of the US population. But boomers represent an outsize proportion of consumption; almost every other dollar spent is spent by a baby boomer. Benefiting from a combination of favorable economic conditions and time, baby boomers hold the largest share of assets in the US in the form of excess savings, real estate, and equities.
In this new, higher interest rate environment, these assets are a source of additional income and security, with excess savings now generating 3.5% – 4.5% in interest rather than 0%. Boomers also have a high rate of homeownership. Many of them may own their homes outright, but those that don’t probably benefit from locked-in, ultra-low, fixed mortgage rates. No such luck for renters, who have instead been exposed to rising costs as property owners increase rents.
All of this means that baby boomers on the wealthier side of the spectrum tend to have robust balance sheets — bolstering their ability to access credit even as standards tighten. Those tighter lending standards are more likely to impact subprime borrowers, who are perceived as riskier. In short the cohort that spends the most is likely to continue spending the most — driven by the tailwinds of higher rates on income from savings and asset appreciation.
3. Tighter lending standards may have shielded subprime consumers from rising costs of debt
The subprime consumer has been most adversely impacted by higher inflation given that their consumption basket weighs more heavily to fuel, food, and shelter. While some of these pressures have subsided, this consumer will continue to feel the strain of ongoing rent growth and the impact of higher rates on auto loans and other short-term debt. But this is somewhat offset by wage growth and a tight labor market, which should support subprime consumers for longer.
Many have noted the tightening in credit lending standards (which may tighten even further due to the banking sector turmoil), to which the subprime consumer cohort is most exposed. In my view, auto and consumer loan lenders originated too many questionable loans to lower-tier borrowers in late 2021 and 2022. As performance deterioration started to materialize in the form of late payments and increased delinquencies, lenders responded by tightening their standards throughout 2022, moving higher up in quality and slowing originations.
Subprime borrowers may have been negatively impacted by being unable to access as much credit in the latter half of 2022 but will benefit from avoiding the rising costs of servicing that debt and thereby decreasing the risk of delinquencies. As such, I expect materially better performance of 2023 underwriting despite continued headwinds.
Consider which debts consumers need to prioritize
These mitigating factors may keep consumer spending fairly robust despite higher rates. However, if the unemployment rate starts to pick up, the priority of payments will be critically important to the performance of consumer debt-related assets.
I suggest that allocators focus their investments in areas that are the highest priority for consumers to repay when cash is tight. Mobile phones, auto loans, mortgages, and, to a lesser extent, general purpose cards remain in this category. Student loans, consumer loans, and store-branded credit cards are some of the lowest priority debts, and therefore have less investment appeal.
17.67% of credit card balances were 90+ days delinquent as of 31 December 2022, according to the New York Fed Consumer Credit Panel, compared to an average of 9.34% since 31 March 2003.
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