Debt Growth Reckless or Reasonable?

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1 Austin Pickle, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Debt Growth Reckless or Reasonable? February 6, 2018 Key takeaways» The availability of credit largely influences spending for businesses and households. In 2016, U.S. banks generally tightened lending standards, and spending suffered. Now, credit standards are easing, and domestic spending is increasing.» Relative debt growth for U.S. businesses and households overall is subdued, suggesting that increased spending is sustainable. In fact, the proportion of debt obligations to disposable income is as low as it was in the early 1990s and 1980s. We believe that this supports the continued economic expansion. What it may mean for investors» We favor most cyclical sectors (Consumer Discretionary, Financials, and Industrials) and believe that investors should have less exposure to defensive sectors (Energy, Utilities, and Consumer Staples).» We expect real estate investment trusts (REITs) to continue performing well. While we favor broadly diversified fixed-income holdings, the flattening Treasury yield curve diminishes the benefit from moving out to longer-maturity U.S. issues. Lending activity, to the economy, is like the gas pedal in a car. Press it too little and the economy idles along agonizingly slowly. Press it too much and the economy soon will be going too fast increasing the risk of a crash. After the financial crisis, U.S. lending activity essentially ground to a halt. Lending standards tightened, while businesses and households lost their appetite for debt. Financing activity has picked up since that time, but it is well below past levels. Is it a coincidence that domestic lending activity is relatively low and the current economic expansion has experienced the slowest average growth in modern history? We doubt it. In this report, we review both the supply side (banks willingness to lend) and the demand side (the appetite for debt) of the landscape in two main areas of the economy: businesses and households. We will illustrate how important lending standards are to the main driver of the U.S. economy spending, and we will question whether today s increased spending and current economic expansion are being threatened by reckless debt growth Wells Fargo Investment Institute. All rights reserved. Page 1 of 7

2 The supply side: the importance of lending standards to spending How important are bank lending standards 1 to business and consumer spending? They are quite important, as it turns out. The chart below compares the net percentage of banks that are tightening loan standards for large, mid-sized and small businesses, commercial real estate, and consumer credit cards (in the top panel) to the year-overyear change in business and consumer spending (in the bottom panel). Shaded areas represent recessions. Notice how the top panel and bottom panel mirror each other. As more banks tighten financing standards (lines increase in top panel), growth in spending declines (lines decrease in bottom panel); and as more banks ease loan standards, spending growth accelerates. Chart 1. Lending standards versus spending Sources: Bloomberg, Bureau of Economic Analysis (BEA), Federal Reserve, Wells Fargo Investment Institute. Top panel: quarterly data April 31, October 31, Bottom panel: consumer spending is monthly data from January 31, 1989 to December 31, 2017; business spending is quarterly data from March 31, 1989 to December 31, Consumer spending is represented by personal consumption expenditures. Business spending is represented by private fixed nonresidential investment. Chart 1 clearly shows that lending standards influence domestic spending. Notice how, after spiking in 2016, credit standards now are easing, or moving toward easing, and spending is increasing. Does this indicate that household and business debt growth is becoming worrisome? 1 In this report, bank lending standards are measured by the net percentage of banks that are increasing the minimum required credit score, the minimum required down payment, or collateral requirements; the premium charged for riskier loans; the cost of credit lines; the use of interest-rate floors; spreads of loan rates over the cost of funds; reductions of credit limits; the maximum maturity of credit lines; the maximum size of credit lines; and tightening of loan covenants Wells Fargo Investment Institute. All rights reserved. Page 2 of 7

3 The demand side: is debt growth worrisome? In order to determine whether business debt growth is sustainable or excessive, we compared how quickly debt has been growing to how quickly the U.S. economy has been growing (Chart 2). When the dark blue area is above zero, it means that businesses are adding debt faster than the economy is growing (and vice versa). Business debt generally grows faster than the domestic economy. Yet, when debt growth becomes extreme, it is a cause for concern that growth is unsustainable. Today, we are at roughly 1% relative debt growth. This is a far cry from the typical 6% spike we see toward the end of most business cycles. Currently, U.S. businesses are not adding debt at rates that are a cause for concern. Chart 2. Growth of business debt versus gross domestic product growth Debt/GDP growth (year-over-year %) 8% 6% 4% 2% 0% -2% -4% -6% Debt Growing Faster Than GDP Debt Growing Slower Than GDP % Sources: Bloomberg, Bureau of Economic Analysis (BEA), Federal Reserve, Wells Fargo Investment Institute. Quarterly data: December 31, September 30, GDP = gross domestic product. Shaded areas show recessions. Chart 3 is in the same format as Chart 2, but it measures household debt growth relative to disposable personal income. It shows that the scars of the financial crisis are only just beginning to heal for households. Notice how steeply negative the green area became after the financial crisis and how long it remained negative. In fact, relative household debt growth has only recently crossed into positive territory barely. This indicates that households are finally becoming more confident, but that they are nowhere near the peak optimism, or full-throttle debt growth, that was seen in the latter stages of prior business cycles Wells Fargo Investment Institute. All rights reserved. Page 3 of 7

4 Chart 3. Growth of household debt versus growth of disposable income Household Debt/Disposable Income (year-over-year %) 10% 8% 6% 4% 2% 0% -2% -4% Debt Growing Faster Than Income Debt Growing Slower Than Income % Sources: Bloomberg, Bureau of Economic Analysis (BEA), Federal Reserve, Wells Fargo Investment Institute. Quarterly data: December 31, September 30, Shaded areas represent recessions. Despite the recent rise in consumer debt, households are still in great financial shape. Chart 4 illustrates this with the financial obligations ratio, which measures the percentage of personal disposable income required to meet household debt obligations. Debt payments on mortgages, consumer debt, vehicle leases, rent, insurance, and property taxes are all considered in the ratio. Today s households are as financially healthy (low debt obligations relative to disposable income) as they were in the early 1990s and 1980s. Chart 4. Household financial obligations ratio 19 Financial obligations ratio Sources: Bloomberg, Federal Reserve, Wells Fargo Investment Institute. Quarterly data: December 31, September 30, Wells Fargo Investment Institute. All rights reserved. Page 4 of 7

5 On the supply side, bank lending standards largely determine spending growth for both businesses and households. In 2016, banks tightened loan standards, and spending suffered. Now, standards are easing, or moving toward easing, and spending is accelerating. On the demand side, relative debt growth for businesses and households is well within the range of what is considered normal and sustainable. In addition, the average household is financially healthy. It seems that the silver lining of the trauma from the financial crisis is that businesses and individuals alike are resisting the urge to overextend themselves on credit (as they did during the financial crisis). These conditions suggest continued modest debt growth. We believe that unsustainable U.S. household and business debt growth is unlikely in the near term. This environment supports the current economic expansion just don t expect highway speeds for U.S. economic growth anytime soon. Investment implications What does this mean to our investment outlook? Within equities, we believe that cyclical sectors tend to benefit most from an accelerating economy and a consumer that is unburdened by excessive debt obligations, while defensive stocks typically are less impacted. We continue to favor most cyclical sectors (including Consumer Discretionary, Financials, and Industrials) and we believe that investors should have less exposure to defensive sectors (including Energy, Utilities and Consumer Staples) in the current environment. Real estate and the companies that invest in real estate, such as REITs, should benefit from continued economic growth. Bank lending standards have tightened most dramatically for commercial real estate loans recently. This should keep commercial real estate supply in check. In turn, modest real estate supply supports low vacancy rates, high rents, and strong net operating income important benefits for this asset class. While modest business debt growth supports corporate bonds in general, high-yield credit spreads have declined to levels that warrant an unfavorable view. We favor broadly diversified global fixed-income holdings (including exposure to all major U.S. and international fixed-income classes and all domestic maturity categories). The flattening U.S. yield curve decreases the yield pickup from moving out to longer maturities and also diminishes the benefit from doing so. We favor cyclical over defensive stocks, and we believe that investors should maintain exposure to REITs and raise average credit quality as we continue to move through the latter part of the U.S. economic cycle Wells Fargo Investment Institute. All rights reserved. Page 5 of 7

6 Economic Calendar Date Report Estimate Previous 2/5/2018 MBA Mortgage Foreclosures % 2/5/2018 Mortgage Delinquencies % 2/6/2018 Trade Balance -$52.1b -$50.5b 2/6/2018 JOLTS Job Openings /7/2018 Consumer Credit $19.650b $27.951b 2/7/2018 MBA Mortgage Applications % 2/8/2018 Initial Jobless Claims k 2/8/2018 Continuing Claims k 2/8/2018 Bloomberg Feb. United States Economic Survey 2/8/2018 Bloomberg Consumer Comfort /9/2018 Wholesale Inventories MoM 0.20% 0.20% 2/9/2018 Wholesale Trade Sales MoM % 2/12/2018 Monthly Budget Statement -- $51.3b Source: Bloomberg, as of February 1, Wells Fargo Investment Institute. All rights reserved. Page 6 of 7

7 Risk Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 7 of 7