Warren Buffett once said, “You only find out who is swimming naked when the tide goes out.” But hey, why worry about low tide when you’re swimming in the high tide?
The World Bank recently reported it expects global growth of 2.7% for 2017 and 2.9% for 2018, with US growth at 2.1% in 2017, up from 1.6% in 2016. The US Federal Reserve anticipates a similar trajectory for the US economy, with GDP growth of 2.1% to 2.2% for 2017 and unemployment falling to 4.2% or 4.3%.
Based on everything I’ve seen, both forecasts fit well with the existing consensus. In fact, on 14 June, the Fed put its money where its mouth is, raising short-term interest rates by 25 bps and indicating that it plans more rate hikes in coming quarters. According to Fed chair Janet Yellen, the decision to raise rates “reflects the progress the economy has made.” In fact, the Fed also announced that it plans to begin reducing its $4.5 trillion balance sheet.
It’s been a long, tough slog since the 2008 financial crisis, but the US economy is now in expansion territory.
And it’s not only government agencies that are optimistic. According to Morgan Stanley CEO and chair James Gorman, “The dirty little secret here is the US economy is doing just fine. . . . not great, but fine.” Lloyd Blankfein, CEO of Goldman Sachs, recently said, “If you looked at things statistically, you looked at the numbers, you looked at the metrics, [the United States] at full employment, low energy prices, growth — a lot of the metrics are all positive.”
With respect to the national balance sheet, the delinquency rate on single-family residential mortgages has decreased to 3.93% from a peak of 11.53% in Q1 2010. Likewise, consumer debt service payments as a percentage of disposable personal income are now at roughly 10%, a level last seen in the early 1980s. Recently, the Fed reported that all US banks recently passed its stress test. In fact, Yellen is so confident, she even said, “Another financial crisis is not likely in our lifetime.”
In addition, the Trump administration is promising to lower taxes, improve health care costs, simplify regulations, and make the business environment easier.
Sounds like the economy is in good shape, right? Not so fast.
In its latest Global Financial Stability Report, the International Monetary Fund (IMF) warned that a sharp rise in interest rates could trigger 22% of US corporations to default. It identified these firms based on their low interest coverage ratios (ICRs). Firms with ICRs less than 1.o are considered “weak,” and firms with ICRs between 1.0 and 2.0 are considered “vulnerable.” Based on the IMF report data, the percentage of companies with weak or vulnerable ICRs is up from about 13% in 2010 to about 20% today. (The 22% is a forecast.)
Student loans outstanding in the United States have climbed to more than $1.4 trillion as of Q1 2017. Of this amount, student loans in default have risen to $137 billion, or roughly 10% of outstanding student loans. Because most student loan debt is owned by the federal government through Sallie Mae, however, these defaults haven’t hit the banks.
In contrast, subprime auto loans are owned in the private sector, by banks, shadow banks, and investors in asset-backed securities. Total US auto loans exceed $1.1 trillion outstanding. But recently, lenders have become concerned about rising delinquencies and auto loan growth has slowed.
Similarly, credit card defaults have recently begun to spike. According to Moody’s Investors Service, companies such as Bank of America, Capital One, Citigroup, and First National of Nebraska are all seeing defaults climb. The historical average charge-off rate is about 5%. As of March 2017, the rate is well below the average at about 3.5%, but that number has climbed sharply from about 2.9% just two quarters ago.
Another sobering issue: Central banks are now beginning the process of mopping up the massive liquidity stored on their balance sheets for much of the last decade. As noted, the Fed announced plans to reduce its $4.5 trillion balance sheet. The European Central Bank (ECB) and Bank of England (BOE), among others, are publicly discussing ending quantitative easing (QE). Central bankers apparently believe that the economy can handle slightly higher rates.
From a demographic standpoint, 1.5 million baby boomers will turn 70 each year for the next 15 years, according to economist David Rosenberg, who notes, “Research has shown that once you hit this age, you cut back on your spending.” Many boomers, however, are not only living longer than previous generations but also lack adequate retirement assets. Consequently, they are not leaving the work force. In fact, the fastest-growing segment of the job market is among people age 65 and older. This trend is likely displacing younger workers as the employment cycle changes. Perhaps it also helps to explain the rapid increase in student loan defaults.
Since the United States ended its QE program in Q4 2014, the US dollar has risen markedly and durable goods orders and exports have flattened. Change is in the air. Maybe this is what a peak in the cycle looks and feels like. Perhaps the high tide was manufactured by central banks. And now the central banks are beginning to decrease liquidity, possibly engineering the next low tide.
In Buffett’s words, we may soon discover just who has been swimming naked.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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