Household consumption was the main contributor to economic growth in 2022.1 This is remarkable, since the unwinding of fiscal support and surging inflation did not bode well for consumption. Yet real personal consumption rose 2.8% in 2022 despite a 6.4% drop in real disposable personal income.2
In our view, four factors help explain the discrepancy between household income and consumption: first, households dipped into the excess savings they accumulated during the first two years of the pandemic;3 second, households were still catching up on forgone spending during the pandemic, notably in services;4 third, overall household finances are in good shape;5 and fourth, there was no labor market stress.6
We believe the household sector will remain healthy in aggregate and is unlike to trigger stress as it did during the financial crisis. Yet we expect more divergence between income groups. In our view, lower-income households have largely exhausted their surplus savings, while their general finances are stretched. Furthermore, we think that lower-income households are exposed to prevailing inflation pressures and their income situation is more at risk if labor-market conditions deteriorate.
Given our expectation that lower-income households will come under heightened financial pressure, we think sub-prime consumer loans and mortgages will underperform. However, we do not expect a financial crisis and believe that credit pickers will find attractive opportunities, especially in prime credits with wider spreads.
The Federal Reserve estimates that households accumulated excess savings of about $2.3 trillion or 10% of GDP in 2020 and through the middle of 2021.7 The Fed notes that the distribution and sources of excess savings vary significantly by income group. The bottom income quartile benefitted the most from government transfers but also used much of the funds to compensate for income losses, leaving small excess savings, while the top-income quartile reduced spending significantly and accumulated the most excess savings (see Chart 1).8
Source: Board of Governors of the Federal Reserve System and ZAIS estimates 9
The build-up of excess savings started to reverse in the second half of 2021, as consumption picked up and government transfers faded.10 We reckon that total excess savings dropped by more than 50% from the peak in the third quarter of 2021 to the end of 2022. For the bottom income quartile, we estimate that excess savings dropped by 75% to $1,200 per household (see Chart 1 again). In our view, households in the bottom income quartile will exhaust all remaining excess savings during the first half of this year.
The government transfers during the pandemic were a welcome relief for lower-income households, which typically struggle to make ends meet and have little if any capacity to save (see Chart 2).11
A good measure that shows financial conditions for lower-income households remain stretched is the balance of cash and deposits minus consumer loans (see Chart 3). While the top half of households has been able to dramatically improve the balance into a surplus, the bottom half remains on a deteriorating trend.
Source: Karen E. Dynan, Jonathan Skinner, Stephen P. Zeldes12
Source: Board of Governors of the Federal Reserve System13
From an individual perspective, many factors can push households into financial difficulties. From a macro perspective, worsening employment conditions and rising cost of living most often create financial difficulties for lower-income households.14
So far, the absence of labor market stress has been a key support for households across all income groups.15 We are not expecting a deep recession and a surge in unemployment. However, we believe employment conditions will deteriorate on the margin going forward creating problems for some lower-income households.
According to the U.S. Bureau of Labor Statistics, about two-thirds of all salary and wage workers are paid hourly.16 Thus, it is important not only to have a job, but to be able to work the necessary number of hours. Based on the Consumer Financial Protection Bureau’s “Making Ends Meet” survey, reduction in work hours is the most often cited reason for income losses.17
While overall unemployment remains low, hours worked and overtime hours have started to drop, especially in manufacturing (see Chart 4).18 There has also been a deterioration in the mix of full-time and part-time employment. Over the last 6 months, almost all employment gains came from part-time jobs, while full-time employment stagnated.19
Source: U.S. Bureau of Labor Statistics20
We believe the decline in hours worked and the shift to more part-time jobs will continue in 2023 and also lead to declining wage growth and possibly moderate increases in unemployment as businesses adjust to tighter operating and financial conditions. The resulting income losses are likely to cause most difficulties for lower-income households.21
Lower-income households are also more vulnerable to cost-of-living pressures. One area is housing. Fifty five percent of households at the bottom-quintile are renting as opposed to 35% for all households.22 Rents increased 8.3% over the last year and 14.5% since the start of the pandemic.23 In contrast, mortgage service expenditures for existing home owners have only increased marginally over the last year and are still more than 7% lower compared to the start of the pandemic (see Chart 5).
Source: Board of Governors of the Federal Reserve System, US Bureau of Economic Analysis and U.S. Bureau of Labor Statistics24
Going forward, we forecast that mortgage servicing expenditures will gradually rise as old mortgages get refinanced and new mortgages come in at higher rates. Yet, we expect that rents will continue to rise faster than mortgage service expenditures due to growing rental demand – also because fewer people can afford to buy a home – and tight rental housing supply.
Utilities are another big ticket expense that lower-income households often have difficulties paying for.25 Residential electricity prices, especially, which are the largest utility expense for lower-income households, have surged 14.3% over the last year.26 The U.S. Energy Information Administration expects residential electricity prices will rise further in 2023 and exceed the pre-Corona level by nearly 20%.27
Food expenses also weigh heavily on the budget of lower-income households.28 Food prices rose 11.8% over the last year and the U.S. Department of Agriculture expects another rise of 8% in 2023, which is about four times faster than the long-term trend.29
Falling prices for gasoline and cars ¬– especially used cars – provide some relief, but the levels of gasoline and car prices are still far above pre-Corona levels.30 Falling car and gasoline prices are also less of a relief for lower-income households since they own fewer cars and so spend less on cars and their use.31
Summarizing, we expect cost-of-living pressures for lower-income households will decline less in 2023 than for all households. On the other hand, we forecast wage growth will ease, resulting at best in zero but more likely in ongoing negative real income growth for lower-income households.32
In aggregate, we observe no alarming stress in household credit and believe this will remain the case this year. Our main concern is that some subprime credits will experience difficulties and we believe this will become more visible in consumer loans as opposed to mortgages.
First, there are many more sub-prime borrowers in consumer loans than in mortgages.33 Borrowers with lower credit ratings are also more likely to come from lower-income households.34 Thus, our expectation that lower-income households will face more financial difficulties going forward suggests those stresses should impact consumer loans more than mortgages.
Second, debt service payments for consumer loans are higher than debt service payments for mortgages (see Chart 6). Going forward, we expect debt service payments for consumer loans will adjust faster to higher interest rates given the shorter maturity profile and the larger share of adjustable interest rates in consumer loans versus mortgages.35
Source: Board of Governors of the Federal Reserve System36
In our view, the pressure from rising debt-servicing payments will be felt the most by sub-prime consumer loan borrowers. For example, the effective interest rate for sub-prime credit card holders is roughly 5% points higher than for all card holders.37 Sub-prime credit card holders also pay significantly higher fees, notably for late payment.38
Source: Board of Governors of the Federal Reserve System39
The diverging credit outlook for consumer loans and mortgages is also reflected in the different degrees to which banks are tightening lending standards. Banks have tightened lending standards the most for credit cards and the least for mortgages (see Chart 7). Conversely, we expect tighter lending standards will make it more difficult for lower-income households, especially, to manage their finances and so will likely lead to more delinquencies.
Consumer loan delinquencies have already started to rise, albeit from low levels (see Chart 8). We expect this trend to continue in 2023 with delinquencies exceeding pre-pandemic levels. Credit card delinquencies with smaller banks, for example, have already reached the pre-Corona level.40 Morgan Stanley notes, in its latest ABS Dashboard, that sub-prime delinquency rates for auto loans reached 4.9% in December 2022, surpassing the level seen three years earlier and close to the highs of the last 15 years.41
Source: Federal Reserve Bank of New York42
Just like last year, we expect this year to be a credit pickers’ market, which will reward careful credit analysis and prudent risk-taking. We also expect significant dispersion in performance across subsectors, borrower groups, vintages and originators.
While we see less risk for mortgage backed credits in aggregate, we note that some subprime mortgage pools are likely to underperform significantly. Having said that, we see attractive opportunities in residential CRT with seasoned collateral and with tranches higher in the capital structure which we believe are adequately insulated from downside risks in the economy in general, and housing in particular.
In the consumer space, we are generally cautious versus subprime credits across all sub-sectors. Furthermore, we believe unsecured consumer loans will underperform and lag all other consumer loans, given the discretionary nature of the underlying borrowing purposes. Having said that, we expect branch-based installment loan lenders to demonstrate greater stability of credit performance versus purely online lenders, given their experience through the credit cycles.
Given the range of possible outcomes, we see generally better risk-reward ratios in debt tranches versus equity tranches. As we are not expecting a credit crisis, investment-grade credits with higher yields and wider spreads look attractive to us. For example, we see interesting opportunities in prime and super-prime auto loans. We even expect high-grade installment loans to become attractive once the lagging fundamentals have played out and the rating agencies re-confirm their credit ratings.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or email@example.com
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