Would-be borrowers used to complain, "You can't get a loan unless you don't need one." You don't hear that complaint much anymore; it seems like anybody can get a loan for just about anything. And if it's a car loan you want, the inflation-adjusted interest rate is actually a negative number!
The Federal Reserve Bank has been hoping that cheap loans will prime the GDP pump, but they sounded a little discouraged at their August meeting, concerned that the cash inoculation wasn't working. In the second quarter of this year, consumer credit (excluding mortgages) grew at a brisk annual inflation-adjusted rate of 5%, up from a 3% pace in the first quarter. Yet GDP managed only a feeble 1.1% improvement. Reminds me of the old Hillman Motorcar I drove my last year in college. When I would encounter a small grade on a country road, I'd downshift to second, press the accelerator against the floor and barely make the hill.
I've been thinking a lot about credit lately, and wondering just how important lending and borrowing is to the growth of our surprisingly sluggish economy; whether low rates can jump start consumer spending, and just how disruptive it might be to the stock and bond markets if lenders were to suddenly become more discriminating in their dealings with the borrowing public.
It's no secret that U.S. consumers have been pretty active at the credit trough the past decade or so. Their personal net worth has actually been shrinking at a 5% clip, unheard of in Postwar America. Non-federal debt is running at 155% of GDP versus 105% at the start of the late great bull market in stocks. And Goldman Sachs estimates that mortgage refinancing could pump $270 billion of fresh (borrowed) cash into consumer spending this year; this alone equals close to a 4% bump to annual consumption. Another sign that consumers are walking closer to the edge: Americans saved just 1.6% of their income last year, down sharply from 8% to 10% during the post-World Ware II era.
Nor have corporations been timid about leveraging their balance sheets; they've borrowed cash to buy back stocks to enhance the value of executive options. And why would they be shy when the likes of Citigroup and JP Morgan Chase proffered monster credit lines at below-market rates in return for an inside track to juicy investment banking fees. Freddie Mac and Fannie Mae have been able to leverage up at near risk-free rates, and GE Credit has maintained its top-drawer credit rating despite extraordinary dependence on commercial paper. All in all, credit has been pretty loose.
A lot of very large corporate borrowers have become more than a little wobbly since the equity implosion got underway; Kmart, WorldCom, Bethlehem Steel, US Air, not to mention the telecoms and Internet whiz-bangs. Though all this trouble is common knowledge; it doesn't seem to have generated much visible anxiety about the possibility of a credit crunch. But my clients pay me to worry about things that go bump in the night as well rosier possibilities, and I am getting concerned about credit-based risks. Think of this column as me worrying out loud that the overextension of credit might be one of those structural imbalances that needs to be corrected before we get back to clear skies and favorable breezes in the stock and bond markets.
Low Rates For Whom?
When money market rates plunged below 2% and Greenspan & Co. cut overnight money to 1.75%, sophisticated observers and economic model builders saw a classic stimulative environment, and they began looking for the usual recovery response. After all, with capital available at inflation-adjusted rates of practically zero (does this remind you of any large Asian economy?) what borrower could resist? Borrowing would pick up, followed closely by spending, production and employment. The usual cyclical drill.
But a funny thing happened on the way to the recovery ... nothing! Here we are three-quarters past the end of the so-called recession, and our economic engine is sputtering despite a more-than-adequate flow of fuel.
In this year's first quarter, GDP spurted 5% on only a 3% real increase in consumer borrowing (excluding mortgages). But in the second quarter (latest available at this writing), consumer credit outstanding grew at a faster 5% real rate, but this infusion only nudged GDP up 1.1%. In August, chain retailers almost uniformly reported that that their customers were losing enthusiasm for acquiring electronics, clothes and other essentials.
Nor are corporations taking advantage of free money to juice their capital spending plans. PIMCO's Bill Gross explains this lackluster corporate response to the free money piÒata when he points out that just eight corporations still boast a AAA credit rating. The cost of debt capital runs to double digits for the run-of-the-mill business. Bank lines, the foundation of the commercial paper market, are being withdrawn or sharply restricted, says Gross, forcing even high-quality borrowers into the term debt market and pressuring spreads ever wider. The below-investment-grade market is practically shut down in response to the third-worst default numbers in modern times (exceeded only by the 1930s and 1989-91, when the junk-bond market came unglued.)
But consumers, with easy access to home equity lines at 4.75% and to 0% auto financing and receiving daily offers of new credit cards, have done their patriotic best to sop up the output of our factories.
It is a good working assumption that American consumers will never let income constraints hamper their acquisitiveness unless their credit is cut off by an outside force. Willpower and prudence are not variables that need to be considered when forecasting consumer spending in America. We are a shop-'till-we-drop society, and spending will pretty much equal consumer income plus available credit until lenders (or the lenders' regulators or the investors who fund the lenders) say "no."
Some important variables now may be flashing yellow warning lights: a) jobs, which have a direct impact on consumer incomes and by extension on the availability of consumer loans, are becoming harder to get; b) The consumer debt-service burden is in record territory at 14.5% of CPI, up from 12% a few years back.
Money market mutual funds are sitting on a $2 trillion accumulation of cash. Because money funds pay their shareholders on the order of 1.5% interest, net of fund expenses, presumably that cash is being advanced for 60 days at a time to credit-worthy borrowers at something a little north of 2%. In a $10 trillion-a-year economy, $2 trillion is not an insignificant sum. That is a lot of pretty cheap money being tossed around. I suppose it helps explain how car companies, by making five-year interest-free loans, have been able to unload a record number of new vehicles on a public already up to its nose in IOUs ... and a public that is beginning to have a hard time finding good jobs.
My wife and I recently ordered new appliances for our kitchen renovation. I was surprised to learn that besides cash rebates the vendor offered 0% interest and no payments for a year. So cheap money is trickling down the economic food chain. You can buy a $200,000 house with nothing down and a 4.3% adjustable rate mortgage, a $30,000 car with nothing down and a 0% loan, and a $1,500 electric range for nothing down, 0% interest and no payments for a year. What's next, groceries?
A Serious Concern
What I am becoming concerned about is what would happen to GDP growth (and subsequently to corporate earnings and P/E ratios) if and when we reach the limits of consumer credit, whatever those limits are.
I don't suppose that American consumers will decide en masse that their cars are new enough or that their stove and fridge are adequate to their appointed tasks or, a really radical thought, that they will begin to be concerned enough about retirement security to start putting something aside out of each paycheck! The more realistic concern is that an increase in consumer defaults will start the process of drying up the sources of capital for lenders who, in turn, will have to start saying "no" more often.
Right now, my concern is not supported by the raw data. As a matter of fact, if the time should come when it is statistically demonstrable that credit has reached its limit, the thing I fear will already have happened. The markets have very sensitive ears. They have a way of discounting trouble. But right now, most of the numbers do not seem to indicate a serious problem. Credit card company charge-offs are in the high end of the normal range. In the seven months through July, consumer spending has been brisk, jobs have been growing, interest rates and fiscal policy are stimulative, and inflation is practically invisible. Most stock market commentators say we shouldn't worry because the economic recovery, while a little sluggish, is altogether viable.
But there are telltale signs that trouble me. Perhaps a weak back-to-school retail season is only a hiccup; after all cars and houses are still moving briskly. And the recent increase in unemployment claims? Well, that's a pretty volatile figure, and claims are well off last year's high. And jobs are still being created, even if not at the pace we need to keep unemployment from drifting higher. What about the unusually wide spread between corporate and Treasury rates? Oh, that's just because a bunch of telecom defaults all happened at once; when that's behind us the spread will go back to normal. Besides, nominal interest rates are really quite low, and a steep yield curve is very stimulative. Or at least it always has been.
A "Wimpy" Economy
Our firm recently had to write off a small receivable as uncollectible. Fortunately, this has been an extremely rare circumstance in the history of our practice. But it reminded my excellent business partner, Chris Parr, of the character Wimpy in the old Popeye comic strip. (His given name was actually J. Wellington Wimpy.) Along with other character defects, Wimpy was a habitual mooch, not to mention a deadbeat. So widespread was his reputation for continually deferring his financial obligations that he had difficulty borrowing enough for lunch. Anyone who enjoyed the Popeye comic strip in years past will remember Wimpy's oft-repeated request for a handout, "I will gladly pay you Tuesday for a hamburger today." Not surprisingly, he was usually refused.
I guess what I am wondering is whether the modern American consumer may be working himself into Wimpy's situation in which it is tough to get another loan. More significantly, I am wondering just what the limits for consumer (and corporate) credit might be, how close we might be to that limit, and what sort of a structural adjustment may eventually be required to restore our collective balance sheet to the condition where we could reasonably expect a sustainable 3.0% to 3.5% real GDP growth. Even more to the point, I am wondering how such an adjustment would play out in the markets where my retired clients have invested their life savings.
A Greater Risk
Even in "Accounting for Artists 101," they teach the connection between the income statement and the balance sheet. So we all know that if Americans are forced to repair their balance sheets, it will result in less vigorous spending; possibly even reduced spending. If this should happen in the near future, we would find ourselves back in a recession. Stock prices would fall, perhaps dramatically. For a retiree who may have already suffered two or three years of poor returns and who is still significantly invested in stocks, that's a risk worth weighing. We've prepared our average client's portfolio for that risk by keeping a low equity exposure (28% at last count), minimizing growth expectations (ie. avoiding funds managed in a growth style) and emphasizing upfront cash returns in the form of interest and dividends. (Remember dividends?) But there is a greater risk that concerns me, one that is harder to defend against.
That worse risk is a debt deflation that spirals out of control because it is so much harder to service debt when prices are falling and jobs are shrinking, and each default makes the condition worse. With debt burdens already very heavy, defaults running high (think Enron, WorldCom, Brazil et al), inflation teetering close to zero and real interest rates on some loans already negative, I have to allow myself to consider at least the possibility that credit-driven consumption may already be rushing towards the edge of its structural limits. Fed watchers hope that another cut in the funds rate will get things back on track, but if debt is getting close to unmanageable, low interest rates won't help any more than they have in Japan. And it is worth keeping in mind that Japanese consumers are still saving over 10% of each paycheck, a far cry from the penurious circumstances of the American populace. The asset class providing the best defense against the deflation scenario is very high-quality loans ... which may partly explain the painfully low yields on Treasuries today.
So when I discuss possible future market scenarios with my retired clients these days, we don't dwell on the 10.5% historic return on stocks, but Wimpy does come up in our conversations.
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.