US Economy and the Looming Debt Crisis

Why investors should pay attention

Whether you’re an investor in equities, FX, crypto or any other asset, it is important to have a macro perspective outside of the market you focus on. Keeping a pulse on different subjects and metrics will help you begin to see correlation, or lack thereof, across markets and identify signals that can help you anticipate shifts in trend or find a new edge.

While there is a low correlation between economic growth and market performance, the issues outlined below come at a time when the equities market is at a pivotal point. Will the bull trend continue or will this be the start of the next bear market? I’ll let you develop your own opinion and you’ll find out mine at the end.

After reading this you’ll have an understanding of the debt crisis brewing in the United States as well as growth issues in the US that are shared by Europe and China.

The US Debt Problem

Chairman Powell of the US Federal Reserve continues to argue that the US consumer is “strong”, yet the data surrounding consumer default risk tells a different story.

In 2007, the US faced the burst of the housing market, and now the US faces the mounting problem of student and auto loan debt.

Loosening and tightening of monetary policy by the Federal Reserve

From 2007 to 2015, the Federal Open Market Committee (FOMC), or what the public calls “the Fed,” shifted monetary policy into a period of easing where among other things, interest rates were held down. With lowered interest rates, businesses and consumers were able to borrow more money, in turn, stimulating the economy.

In Q4 of 2015, the FOMC shifted to a view that the economy was improving at a rate that made it necessary to switch to a policy of tightening, or raising interest rates.

Raising interest rates curbs inflation and strengthens the national currency. It also scares the market for the underlying reason that businesses will now have to pay debt at a higher rate. This affects the amount of cash a company should hold on their balance sheet, and can slow growth.

The words “slow growth” are the opposite of what investors want to hear.

Raising rates too fast will not only have an effect on markets, but also the ability of US consumers to repay debts they’ve accumulated since 2007.With the rise of interest rates, the US consumer is at a higher default risk. Default in the US is defined as being over 90 days late on payments.

The looming student loan bubble

In the US, education costs have been rising steadily between 3-5% each year according to the National Center for Education Statistics.

This means that a 4 year in-state, public university costing $34,000 today, will cost $93,000 in 20 years. A 4 year out-of-state, private university costing $129,640 will grow to $354,000.

As the job market has become more competitive, higher education has become seen in the US as a must. With enrollment numbers and tuition rates continuing to increase, so does student loan debt.

At the end of 2007, student loan debt totaled $540 billion. In the last 12 years this total has grown to over $1.5 trillion.

In January 2019, student loan debt accounted for 10.5% of US debt, ahead of auto loans at 9.28%. Home mortgages account for almost 7x that of student loans at 67.63%. While mortgage and credit card debt has stayed flat, student and auto loan debt has been growing at alarming rates.

student debt

Securitizing mortgages and student loans

There were a handful of variables that created the rolling effect of the 2008 housing bubble, but simply put, the MBS Mortgage Backed Securities (MBS) debt sold to investors was significantly higher than the value of the underlying assets (the homes). Once this realization came to light, the market collapsed.

The student loan bubble forming now is not so different. Just like mortgages of similar terms are pooled together and securitized to be sold to investors, so are student loans in the form of Student Loan Asset Backed Securities (SLABS).

Much like with a bond, investors receive semi-annual or monthly income derived from the principal and interest payments paid by the homeowners or students that hold the loans.

So, what’s the main difference between the two?

A mortgage is secured to a physical property with a value determined by supply and demand.

What is a student loan secured to? The assumed future earnings derived from a college degree. Or in other words… nothing.

The issue with SLABS

Since SLABS were created, many have seen them as a near risk-free investment since most student loans are government backed and can’t be discharged in a bankruptcy. If the student defaults, the US government assumes the entire liability.

With over 91% of the $1.5 trillion outstanding student loan debt consisting of federally backed loans, the government will continue to cover larger and larger amounts as the default rates increase. Eventually there will be a breaking point for the government as well as the banks and lenders who originally wrote the loans, just like during the housing bubble.

Two key differences to note are that the housing market is 12x larger than the student loan market, and certain derivatives that exacerbated the housing bubble don’t exist for student loans.

Unsustainable tuition growth

With the cost of higher education increasing at a rate over 5x that of wage growth, this path is not sustainable. Starting salaries have not increased to match the larger student loan payments recent graduates face.

Not to mention, that someone obtaining a data science degree and someone obtaining a degree in Shakespearean literature will both pay over $120,000 at a 4 year private university, and only one of those two will be likely to ever pay off that debt.Wage vs Tuition Graph

Investors are now dealing with student loan default rates of almost 11%, which is $165 billion of the $1.5 trillion outstanding debt. Keep in mind default rates aren’t including those who are 1-89 days late on their loan and heading towards that 90 day mark.

Nearly anyone can get a student loan and they are given out under the assumption that the value of the degree will warrant a means to repay the loan. The underwriting for a student loan is almost non-existent.

Remember, the definition of a bubble is when price far exceeds value.

Much like the housing bubble in 2008, the US is at a point where student loan debt far exceeds the value. Increasing default rates are a direct reflection of this fact.

Auto loan debt getting out of hand

Total outstanding auto loan debt of US consumers has grown by 55% to $1.269 trillion. As of January 2019, this is $454 billion more than it was at the peak of the last cycle in 2007 at $815 billion.

Much like student loans today and home loans before 2009, auto loans have nearly no underwriting regulation. With auto dealer slogans like, “your job is your credit” this comes as no surprise. Many lenders will offer loans without any documentation of income and limited credit reports.

Sounds awfully familiar to the “stated-income” home loans circa 2002-2007.

Young adults are driving increasing default rates

According to Pew Research, the US ranks second in the world in car ownership at 88% just behind Italy. Public transit infrastructure is weak compared to other developed countries and with sprawling suburbs,it’s near impossible to live without a car.

usa carownership

Young adults in the US view a new car as their first step to “adulthood”. Without a second thought, once they begin full-time work and believe they have enough money for a car, they buy one. With lenient underwriting, they can easily acquire one that is out of their means.

With mounting student loan debt and their first large purchase being a depreciating asset, it is no surprise to learn that adults 18-29 account for a majority of auto loan default.

The current auto loan default rate is 4.5%. In 2010, auto loan default rates hit a peak of 5%, which the US is on track to exceed in the next year.

The US economy

Conflicting data from labor markets

While default rates are increasing, surprisingly so has wage growth. A 9 year high of 3.1% was set in October 2018. Keep in mind inflation is 2% so in real terms, this is a 1.1% increase.Unemployment (U3) has been sitting around 19 year lows at 4% for the last year. u3

United States GDP outlook

Since Trump took office, the US GDP growth rate has slowly been trending up from 1% to a peak of 4.2% mid 2018. Trade wars with China and tariffs imposed on the rest of the world have had a negative impact on US GDP growth. September 2018 marked the first quarter in the past 11 where trade actually shrunk and with no plans to reduce tariffs or smooth relations with China, this negative growth is likely to continue.Trump’s stimulus to government spending on defense and infrastructure drove a large part of the increased growth seen in GDP while real consumer spending grew by a dismal 2%.This stimulus is set to decrease over the next 2 years revealing the true strength of the US economy.

With economic growth in the US likely slowing over the next 2-3 years, this may mark the top of the wage growth cycle and bottom of the unemployment cycle. Rising default rates at the peak of labor market strength isn’t a great sign for consumer strength or an economy in general.

Global credit risk

The Euro zone and China are experiencing similar economic metrics. While student debt issues are more a US phenomenon, the European Central Bank and People’s Bank of China have been following the FOMC in a policy of tightening. Rising interest rates have had the same effect of slowing growth in Europe and China, while raising default risk for the consumer.

Outlook on markets

Taking the above data into consideration it is hard for me to see how the equity markets will continue in a bull trend. If central banks put a pause on tightening or even reverted to loosening for a time being I could see the potential for a short lived continuation. The student loan bubble will burst eventually and only time will tell what effect it will truly have on markets, the United States and the global economy.

As economies contract and equity markets consolidate or shift to a downtrend, appetite for risk decreases. Bitcoin at its current state is a high-risk low-liquidity asset. While I believe the point of trend reversal for Bitcoin will come in the next 18 months, I expect the top of the next Bitcoin cycle to coincide with a time when investors are seeking extra risk, just as this past cycle.

This will be at a time when the equities market is performing exceptionally well and likely when major economies are seeing higher rates of growth, which is likely some time after the above debt issues have been resolved.