The financial media has been sounding the alarm on commercial & auto loans over the past few months. Just how big is this problem? How will it impact the U.S. stock market? Let’s take a look.
Commercial and Industrial Loans
The delinquency rate on Commercial and Industrial loans has risen since Q4 2014.
On the surface this seems scary. The delinquency rate “always” rises before an economic recession begins (and bear market or significant correction in stocks).
However, the majority of this increase is due to the energy sector bust of 2015-2016. Now that oil prices have stabilized in the $40-$50 range, the delinquency rate has plateaued.
The delinquency rate isn’t a very good economic indicator because its history isn’t very long. A better indicator is Commercial and Industrial loan growth. Commercial & Industrial loan growth has fallen significantly over the past few months, to the point where it is almost negative.
Should stock market investors be concerned? No. Expand the data. Commercial & Industrial Loan growth has a lot of false signals. It’s not a very good economic indicator either.
Credit card loans, Consumer loans
The delinquency rate on credit card loans has also been increasing since mid-2015.
But as you can see in the above chart, the increase is from an extremely low level, so some mean reversion is to be expected. In addition, the delinquency rate on credit card loans went up in 1995, 5 years before the bull market in equities ended. So this isn’t a great indicator for timing bear markets/recessions.
The delinquency rate on consumer loans paints a similar story. The delinquency rate is merely rebounding from an extremely low level. There’s nothing to fear (yet).
As we mentioned yesterday, the mortgage loan market is far bigger than any other loan market.
- There is $1.2 trillion of outstanding auto debt. 16% of this is subprime ($180 billion).
- There is $14 trillion of outstanding mortgage debt. That’s more than 10x bigger than the auto loan market.
- There is $1.4 trillion of outstanding student debt.
As a result, the mortgage market is a much greater risk than the auto and student loan markets. And right now, the mortgage market is doing just fine.
Yes, it’s true that student loan debt is going up. But student loan debt has been going up for a long time. This is hardly a new phenomenon.
- Student loan debt will not crush the U.S. economy right now. The debt is manageable as long as interest rates remain low.
- This will be a problem in 2-3 years when interest rates rise and this bull market/economic expansion end.
In addition, the student loan default rate is not a good indicator for recessions or bear markets. While student loans in nominal terms have been increasing, the default rate has been increasing for a long time as well! Here is a slightly older chart from the Federal Reserve Bank of St. Louis. Hence, this indicator isn’t useful for predicting recessions or bear markets either.
Recently there has been a lot of talk about the “surge” in subprime auto loan defaults. The American Banker wrote a great piece explaining why this isn’t a concern. Some key points:
- Following the Great Recession, subprime lending, not just in auto finance, nearly disappeared. Now, auto lending, like other consumer finance markets, has returned to “normal.” In other words, subprime lending, along with lending to all risk tiers, has grown over the last several years as consumers have returned to the auto market. With loan volume expanding, of course, there will be a rise in delinquent payments.
- After the trough of the recession in 2009, lenders had little funding to lend. So they focused on originating loans to prime borrowers. As the market stabilized and returned to normal lending standards, we started to see dramatic increases in year-over-year subprime lending. Therefore, it’s normal to see delinquencies in the consumer market grow as lenders maintain a certain risk tolerance.
Hence, it’s better to look at delinquency rates in the auto loan market as a whole and AS A PERCENT. Here’s a chart for the S&P/Experian Auto Default Index. Notice how auto defaults as a percent are actually going down.
High-yield bond market
The high-yield bond market is often an early warning sign for problems in the fixed income world. The high-yield spread tends to go up before a recession or bear market in stocks. HOWEVER, there are some false signals. The high-yield spread jumped in 2015 when oil crashed. There was no recession or bear market. An earnings recession (i.e. energy sector earnings crushed) doesn’t always lead to an economic recession (e.g. 1986).
Right now, the high-yield spread is flat. So this is not a threat to the stock market or economy.
Problems in auto and consumer debt are not significant enough to cause a bear market or significant correction in stocks right now. Perhaps this problem will worsen over the next few months, but it’s not a problem right now.
Let’s assume that this small problem eventually turns into a HUGE problem. Here’s the beauty about trading the S&P 500.
The U.S. stock market lags the real-time state of the economy. Bear markets only begin AFTER the economy is clearly deteriorating.
In the U.S. stock market, timing is just as important as being right. The bull market tends to continue until the problem is so glaringly obvious that even mom-and-pop investors can’t ignore it anymore. For example, the mortgage market started to crack in 2005, and it became a very obvious problem by 2006. The bull market in stocks continued until October 2007.
We have yet to reach the “glaringly obvious” point.
So even if the loan markets continue to deteriorate, we have plenty of time to let things crystallize before the bull market in equities will end. We are trading the S&P 500. We’re not trading the U.S. economy. The correlation between the economy and stock market isn’t one-to-one.