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Is Rising Consumer Credit a Good Thing? 

Kristina Hooper 

The Upshot 

5/12/2014 

When gauging whether a rise in consumer credit is a sign of progress or cause for concern, investors should look beyond debt levels to assess who’s taking on more debt and why, as well as the pace of economic activity, writes Kristina Hooper.
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Kristina Hooper, US investment strategist and head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

While speaking at a conference this week, I received a question on credit. A financial advisor asked me if we’re alarmed by the increase in consumer debt and what it means for the US economy.

Above all, any increase in leverage must be viewed in the context of whether the economy is improving or deteriorating. If economic growth is deteriorating, then an increase in consumer credit is a red flag. It suggests that consumers can’t cover their expenses with their income alone and must borrow in order to make ends meet.

Conversely, if economic growth is improving, then it’s typically assumed that increased borrowing is a good thing. It signals an improvement in consumer sentiment. More importantly, it indicates that more money will be moving into the economy in terms of spending and investment, which, in turn, should help the economy grow even more.

The Credit Litmus Test

Today, we’re seeing an increase in consumer credit. In fact, last week the Federal Reserve released data on consumer credit for March, showing that US consumer credit posted its largest increase in a year on substantial gains in non-revolving credit. One would assume that since our economy is growing, the fact that consumers are taking on leverage is a positive development.

Income Growth Chart


But some economists believe the litmus test for whether rising consumer credit is an encouraging sign is whether income growth is keeping pace with credit growth. Unfortunately, we’ve seen anemic wage growth, which is clearly not keeping up with the rise in credit.

Still, there are other economists who believe that the litmus test for whether credit growth warrants optimism is whether it’s accompanied by a similar growth in assets. We’ve seen a substantial rise in asset prices, helped primarily by the Fed’s highly accommodative monetary policy. Stock prices have risen dramatically over the past five years. Home prices are recovering too. Clearly, asset growth has more than kept up with credit growth.

While income inequality has grabbed a lot of headlines, asset inequality may be contributing just as much, if not more, to the precarious situation consumers find themselves in.”
However, those assets—especially stocks, which have seen the lion’s share of growth—are concentrated among a relatively small group of consumers. While income inequality has grabbed a lot of headlines, asset inequality may be contributing just as much, if not more, to the precarious situation consumers find themselves in. Why? Because a few high-net-worth consumers control most of the assets. In other words, the average consumer who has taken on debt recently may not have seen an accompanying growth in assets.

Looking Under the Hood

But it’s not just the amount and distribution of consumer debt. The makeup of consumer credit also plays a role in whether increased leverage is a positive sign for the economy. Most of the growth in consumer credit in the past few years has come from increases in non-revolving credit—auto and student loans—rather than revolving credit such as credit cards. For example, in March, non-revolving credit rose $16.4 billion while revolving credit rose just $1.1 billion, on the heels of a $2.7 billion decline in February.

While some economists argue that we’ll need to see greater growth in revolving credit for the economy to grow faster, there are some positive aspects to such substantial growth in non-revolving credit. First, this type of debt typically carries much lower interest rates than revolving credit. And it’s far more likely to be fixed for the life of the loan. That makes it easier for consumers to make the payments on the debt.

Second, spending on cars and education is what I like to call “personal cap ex” or consumers’ investments in their futures. A better educated populace, with reliable cars that can transport them to their jobs, should ultimately benefit the economy.

In short, expansion in consumer credit is typically an important part of economic expansion. It’s not surprising to see consumer credit growth now given that the economy is strengthening, sentiment is improving and rates are so low. After all, increased borrowing is one of the desired outcomes of financial repression and, in general, should be welcomed.

Still, we need to pay close attention to income growth and how much it’s lagging credit growth. Further, we’ll need to keep an eye on whether most consumers who are increasing their credit also own assets that are increasing in value. These issues will be critical to whether or not consumer credit growth can be an advantage for the economy going forward.



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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 

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