Economic Cycles Cut Both Ways
It’s easy to forget about the procyclicality of debt when basking in long upswings.
Life is procyclical. It’s a truism in the laws of physics: An object in motion acquires momentum, and hence becomes increasingly harder to stop — especially when it is going downhill. But the danger of procyclicality — particularly on the downside — is often overlooked in the economy and markets. That’s largely because broad-based economic downturns are so few and far between, and because we forget the influence of debt.
Although we should be thankful that we live in an age of very long business cycles, that doesn’t mean we shouldn’t be concerned.
In the 1950s and 1960s, the economy used to shift into reverse every few years. But according to the National Bureau of Economic Research Business Cycle Dating Committee (no, it’s not Tinder for data obsessives), the economy expanded from 10 full years, from March 1991 to March 2001, followed by a brief, shallow, eight-month recession. The next uptrend lasted 73 months before the Great Recession hit. Growth began again in July 2009, which means the economy has just entered its 95th month of expansion. Put another way, in the past 16 years, there have been 18 months of recession; and in the past 26 years, there have been 26 months of recession.
During uptrends, generally speaking, financial success begets more success. People earn wages and borrow money, which allows them to buy cars and homes. Because jobs are plentiful, they’re able to stay current on their debt, which boosts the profits and confidence of lenders — who then extend more credit, which allows more people to spend and invest. The longer the cycle, the greater the tolerance for risk. When everybody succeeds, everybody else succeeds. Between June 2004 and February 2007, for example, there were no bank failures in the United States, the longest such streak in history.
But procyclicality, as we learned in the mortgage and financial crisis, also moves in the other direction. And it can do so very quickly. When one party fails to keep up with an obligation — on a mortgage, lease, payment for services — it can push others to fail to keep up much larger obligations. And when there is a lot of leverage built into the system, the margin for error is smaller. For want of $5,000 in mortgage payments, somebody might lose their house, causing a bank to take a $300,000 loss on the mortgage, which leads instantly to larger losses in securities backed by those mortgages, which leads quickly to big losses for financial institutions that had borrowed money to invest in those securities, which leaves those financial institutions unable or unwilling to extend a mortgage to a homebuyer.
We’re starting to see what may be the very beginning of such a cycle. As incomes and jobs have grown, credit card debt has expanded — the total just topped US$1 trillion, according to the Federal Reserve. But after years of people doing a better job keeping up with credit card payments, delinquency rates are now slowly moving up.
Despite all our largely successful efforts to iron recessions out of our financial and economic lives, momentum doesn’t always push objects in a favorable direction.
Synchrony Financial, a large credit card lender, last week said that its charge-off rate (the percentage of balances it would have to write off as uncollectible) had risen to 5.33 percent in the most recent quarter, up from 4.65 percent in the previous quarter. At the same time, the proportion of balances on which payments were 90 days or more late rose to 2.06 percent from 2.03 percent in the previous quarter. These may seem like small moves in the wrong direction, but they are anything but as their implications ripple out. As a result of the unexpected increase, the company said it would set aside $1.31 billion in loss reserves for the quarter — which was $270 million more than analysts had expected. Investors reacted by pushing the stock down 14 percent, shaving $4.5 billion of its market capitalization. And of course, the natural tendency for lenders who suffer higher proportional losses is to reduce lines of credit, to be less willing to roll over balances, and to be less forgiving of those who fall behind — which often leads to more charge-offs.
A similar dynamic may just be kicking off in the auto industry, which is the U.S. economy’s largest manufacturing and retail sector. Car sales collapsed in the wake of the Great Recession. But for the last several years, sales of both used and new cars have risen smartly. Consumers have become increasingly confident about taking out loans to buy cars. (There are about $1.2 trillion in auto loans outstanding, up about 50 percent from 2010.) And automakers have responded by pushing expensive, feature-laden vehicles into the market.
But now the car market has shifted into neutral. For the first time in years, there are signs of weakness. In the first quarter of 2017, U.S. auto sales were down 1.5 percent from the first quarter of 2016. Which means the inventory of new cars is building. At the same time, there are a very large number of used cars on the market. All of which means automakers are being forced to ramp up incentives and discounts. Doing so not only hurts margins — it conditions consumers to believe that they should hold out for more discounts and makes the used cars on the market less appealing. This generally encourages further price cuts. At the same time, delinquencies on auto loans are rising, which suggests that consumers’ capacity to borrow large sums of money to buy cars might not be as robust as we thought. Oh, and we learned last week that the economy at large grew at only a .7 percent annual rate in the first quarter of 2017.
This is not to suggest that we are heading for a recession or widespread difficulty. Rather, it’s a reminder that, despite all our largely successful efforts to iron recessions out of our financial and economic lives, momentum doesn’t always push objects in a favorable direction. Cycles should be a factor in any business planning, and so should the procyclicality that makes the shifts in those cycles more intense.