WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Craig P. Holke Investment Strategy Analyst Paul Christopher, CFA Head Global Market Strategist July 11, 2017 Does Rising Mortgage Debt Signal an Economic Slowdown? Key Takeaways» Mortgage debt levels are rising in the U.S., and that raises questions of whether increasing household debt will trigger a consumer-spending slowdown.» This report examines whether increasing household mortgage debt is an early warning sign of a potential economic slowdown. What it May Mean for Investors» While households are accumulating more mortgage debt, consumer disposable income and spending both remain healthy. We believe that these trends will support the U.S. economy, and fuel higher corporate earnings and equity prices. Market participants and investors alike appear to be looking for clues of a potential turn in the U.S. economy, given the length of the current recovery. As one of the most important drivers of consumer spending, debt is a key variable to watch as the economic cycle matures and approaches that turning point. We believe that the economy s eventual flip from growth to contraction (a recession) usually triggers significant changes in portfolio weightings between equities and bonds, as equities typically become relatively less attractive once a recession begins. Yet, we believe that signals from lending markets suggest that a recession is not imminent, and we expect the U.S. economy to post positive gains this year. Nevertheless, some portfolio adjustments may be in order. In April, we discussed one investor concern related to how auto and student loan debt has grown following the recent recession. We concluded that the impact on the U.S. economy may not be enough to trigger another financial crisis or downturn. 1 We believe that the mortgage market, while in a similar trend, is not yet weighing on growth. While the dollar value of mortgage debt has increased, mortgage debt as a percent of consumer income has declined. In other words, household incomes are rising faster than mortgage debt. Consequently, it appears to be less of a threat to the economy today than it was in 2009. Mortgage debt grew by 2.7 percent on a year-overyear basis in the first quarter, faster than the overall economy, yet less than the 10-plus 1 Is Rising Auto and Student Loan Debt a Risk to Growth?, Global Macro Strategy Report, April 25, 2017. 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 5
percent growth rates seen in the run-up to the financial crisis. Further, banks have tightened credit standards and strengthened their balance sheets. As a result, mortgage delinquency rates have fallen. This is in contrast to developments leading up to the global financial crisis. Although mortgage debt is rising overall, data suggests that households ability to service that debt (reflected in low delinquency rates) is manageable. A good way to measure the burden of debt on consumers is to consider it as a percent of after-tax income. Chart 1 shows that a declining portion of after-tax income is consumed by overall consumer debt and mortgage payments today. Debt payments have been reduced through lower interest rates for mortgage and other debt. This reduction in debt payments leaves more money in consumers pockets to either save or to drive economic growth through increased spending. Chart 1. Household Debt Payments Have Fallen Along with Mortgage s Share Debt Payments, as Percent of Disposable Personal Income 14 13 12 11 10 9 8 8 7 6 5 4 3 2 Mortgage Payments, as Percent of Disposable Personal Income Debt Payments / DPI (lhs) Mortgage Payments / DPI (rhs) Sources: Federal Reserve, Wells Fargo Investment Institute, 7/5/17. Notes: Debt service is the quarterly total required mortgage and other credit household debt payments. Mortgage service is quarterly mortgage payments. Disposable personal income is measured as income (wages, interest, dividends, etc.) plus transfer payments (Social Security, Medicaid, etc.) minus taxes. Investment Implications Mortgage debt has been increasing, yet it remains an affordable component of household spending today. Further, we do not see evidence of consumers increasing leverage as they had in the run-up to the last recession. At that time, that level of debt accumulation typically preceded a reduction in disposable income and spending, which then slowed the U.S. economy into recession. While debt levels (mortgage, auto, credit card, and student loan) are currently rising, we do not anticipate that they will become an issue in the near term. We continue to expect U.S. economic growth to reaccelerate to our 2017 target of 2.3 percent and inflation to remain moderate. 2017 Wells Fargo Investment Institute. All rights reserved. Page 2 of 5
This economic backdrop generally supports our view that domestic equity prices have further potential upside, while U.S. bond yields could rise somewhat further. We believe that increased consumer spending and a stronger global economy should lead to higher corporate profits and stock valuations. Similarly, even as interest rates rise at a projected steady rate, bond valuations are supported by higher corporate earnings, easing companies interest-payment burdens. We believe that a normalization of interest rates from near-historic lows, combined with currently low inflation, is healthy for the bond market in the long term. For U.S. equities, although we believe that there will be a pullback before year-end, we expect earnings growth to support higher prices by the end of 2018. Any future uncertainty about Federal Reserve policy regarding interest rates also could give investors pause and trigger a pullback, until investors see that rates will rise moderately and not undermine the recovery. We continue to favor the Consumer Discretionary, Industrial, and Financial sectors, largely on a positive growth outlook. Our least-favored domestic sectors are Consumer Staples and Utilities, which we expect to underperform as economic growth improves and interest rates gradually rise. For fixed income, modest domestic growth and concurrently low inflation still indicate gradually rising long-term rates. We prefer bonds of intermediate maturities and of investment-grade quality. Credit spreads relative to Treasury bonds are very tight (low) by historical standards, and therefore, the potential return to non-investmentgrade debt looks unattractive, once defaults rise in the sector and credit spreads widen. 2017 Wells Fargo Investment Institute. All rights reserved. Page 3 of 5
Economic Calendar Date Report Estimate Previous 7/11/2017 NFIB Small Business Optimism 104.5 104.5 7/11/2017 JOLTS Job Openings -- 6044 7/11/2017 Wholesale Inventories MoM 0.30% 0.30% 7/11/2017 Wholesale Trade Sales MoM -- -0.40% 7/12/2017 MBA Mortgage Applications -- 1.40% 7/12/2017 U.S. Federal Reserve Releases Beige Book 7/13/2017 PPI Final Demand MoM 0.00% 0.00% 7/13/2017 PPI Ex Food and Energy MoM 0.20% 0.30% 7/13/2017 PPI Ex Food, Energy, Trade MoM -- -0.10% 7/13/2017 PPI Final Demand YoY 1.90% 2.40% 7/13/2017 PPI Ex Food and Energy YoY 2.00% 2.10% 7/13/2017 Initial Jobless Claims 245k 248k 7/13/2017 PPI Ex Food, Energy, Trade YoY -- 2.10% 7/13/2017 Continuing Claims 1950k 1956k 7/13/2017 Bloomberg Consumer Comfort -- 48.5 7/13/2017 Monthly Budget Statement -$23.0b -- 7/14/2017 CPI MoM 0.10% -0.10% 7/14/2017 CPI Ex Food and Energy MoM 0.20% 0.10% 7/14/2017 CPI YoY 1.70% 1.90% 7/14/2017 CPI Ex Food and Energy YoY 1.70% 1.70% 7/14/2017 CPI Core Index SA -- 251.329 7/14/2017 CPI Index NSA 245.1 244.733 7/14/2017 Real Avg Weekly Earnings YoY -- 0.60% 7/14/2017 Real Avg Hourly Earning YoY -- 0.60% 7/14/2017 Retail Sales Advance MoM 0.20% -0.30% 7/14/2017 Retail Sales Ex Auto MoM 0.20% -0.30% 7/14/2017 Retail Sales Ex Auto and Gas 0.40% 0.00% 7/14/2017 Retail Sales Control Group 0.30% 0.00% 7/14/2017 Industrial Production MoM 0.30% 0.00% 7/14/2017 Capacity Utilization 76.80% 76.60% 7/14/2017 Manufacturing (SIC) Production 0.30% -0.40% 7/14/2017 U. of Mich. Sentiment 95 95.1 7/14/2017 U. of Mich. Current Conditions -- 112.5 7/14/2017 U. of Mich. Expectations -- 83.9 7/14/2017 U. of Mich. 1 Yr Inflation -- 2.60% 7/14/2017 U. of Mich. 5-10 Yr Inflation -- 2.50% 7/14/2017 Business Inventories 0.30% -0.20% 7/17/2017 Empire Manufacturing -- 19.8 Source: Bloomberg as of 07/7/17 2017 Wells Fargo Investment Institute. All rights reserved. Page 4 of 5
Risks 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. 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 & 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 0717-01074 2017 Wells Fargo Investment Institute. All rights reserved. Page 5 of 5