The Scarred Consumer is in Rude Health
The US consumer has the balance sheet capacity and mental scars required to increase spending without breaking the bank or the consumer finance company.
Nugget: … T(ravel) & E(ntertainment) spend was up 90% compared to the first quarter of 2021. Of course, that was a very depressed quarter, but up around 20% from first quarter 2019 levels.
At the start of my career in Australia, I worked at a credit card company as an economist within the risk division. I was the first to fill the role and was provided with the simple KPI of “predict the next recession in Australia”. As it turned out, there was no recession on my watch but I learned a lot anyway.
What I learned
The most important thing I learned: people aren’t stupid.
Between 2003 to 2007, the RBA raised interest rates from 4.25% to 7.25%. With each increase in rates by the RBA, credit card customers increased the proportion of their revolving credit loan paid down monthly. It was an exact match.
The second most important thing I learned: companies can be really stupid.
A recession never occurred but it didn’t stop card companies losing money in Taiwan. In 2005, losses were increasing with no discernible change in the economy. Instead, the competitive situation had exploded, consumer credit had reached $US268billion. The dynamic was simple. Incumbents made 15-20ppt margins on credit card debt and new entrants wanted some of the action. The credit decisioning of the new entrants piggy-backed on the credit decisioning of the incumbents and the incumbents weren’t monitoring their previous credit decisions. Once the problem was spotted, the credit taps were turned off and a credit crunch ensued.
By example, a young woman in our office came in with her collection of ten Hello Kitty credit cards in a plastic folder. She’d collected every card. Her job in credit and collections, meant she had no interest in using them. But all the same, the total line of unsecured credit extended to her by these cards was ~$US300,000. It was insane.
Obviously, this doesn’t absolve the public from taking on the credit, but it does highlight the importance of supply in the credit equation.
Consumer Credit Demand in the US
This leads into a discussion about the recent increase in credit card debt in the US. For some, it’s one of the four horsemen of the apocalypse. The 3% monthly rise in credit card spending in March 2022, is a sure sign that stretched US consumers are using debt to afford basic living costs. For me, it’s a sign the economy is back, post the Omicron variant, and the consumer is feeling confident and comfortable spending.
What do the companies say?
Two large consumer finance companies, Capital One Financial and Ally Financial (car loans) reported Q1 numbers in the last month. Unsurprisingly, the focus of the earnings calls was on credit risk. The basic theme: they expect credit costs to normalise (loan losses to rise) but to date this hasn’t occurred.
Capital One’s CEO Richard Fairbank founded the company in 1988, has seen his share of cycles, and is a dialectical gaussian. He shares my view of the consumer and competitors:
I've got confidence in what consumers learn from the downturns and scares that they have and the choices that they make, and I think we're seeing very rational behavior by consumers. I worry more about markets and how competitors operate and lending practices and …
Learning from downturns and scares is important: Australian behaviour in 2003 to 2007 was directly impacted by the 1990s recession. Households knew rising rates would hurt them. For American consumers, the sub-prime crisis colours behaviour today.
How does Fairbanks explain the rise in outstanding credit in March 2022?
Just by way of comparison, T(ravel) & E(ntertainment) spend was up 90% compared to the first quarter of 2021. Of course, that was a very depressed quarter, but up around 20% from first quarter 2019 levels.
This matches with airline data showing Q1 was strong, particularly March, as omicron waned.
His assessment of the competitive landscape is interesting. There is increased marketing spend, but the focus is not on revolving credit but high spenders. High spenders have wonderful economics for credit card companies: high fees paid per dollar of spend, low interest fees and low charge offs. Good card companies market to spenders not borrowers.
But certainly, marketing levels are elevated. Competition in the rewards space is probably a notch more intense than pre-pandemic levels … APRs have generally been stable
The risk from a competitive perspective are the fintechs. The risk is that their credit decisioning data is too rosy:
… we've seen a lot of buy now, pay later activity. I think … the fintechs who are in the lending business have been lending in the greatest rearview mirror of credit -- industry credit performance that you could ever imagine.
The other problem for fintechs is less mature lending books. The older a client, the lower the risk. Fintechs have no old clients.
And so part of what you may be seeing on fintechs is … the proportion that their front book represents as a percentage of the whole is quite different. And it would be surprising if they didn't normalize faster given that typically, front books normalize faster than back books.
Ally Financial also provided useful insight. As in 2033-2007 Australia, pre-payment levels are high:
… we continue to see elevated payment rates across our customer base … payment rates are just well above pre-pandemic levels. One of the more recent drivers of higher payment rates is really the flip side of amazingly strong credit and healthy consumer balance sheets.
Further, as Cleveland Cliffs pointed out, auto inventories are very low in the US. Ally notes:
… there are some 4 million, 5 million customers that are on the sideline right now, just because they cannot find a vehicle to purchase.
Ally’s market presentation is rich in data. As the chart below shows, credit costs are rising but remain low and below 2016 to 2019 levels.
It includes some good data on household exposure to oil prices and current savings behaviour.
Conclusion
It’s way too early to be worrying about household consumers and their debt profiles. Indeed, the data from consumer finance companies paints a picture of a strong consumer, comfortable spending more with a strong balance sheet and the scars to ensure they do the right thing.
It’s tempting to add Capital One Financial and Ally Financial to the Lessep Global Equity Portfolio. The bear case: don’t buy cyclicals on low multiples (COF is 4.9x and ALLY is 4.8x). The bull case: earnings can grow sustainably from here for two to three years. There’s more work to be done.