Consumer Debt: Not a One-Size-Fits-All Investment Strategy
What’s going on with US consumers? This question is always top of mind for investors, and an easy one to ask. But it’s full of nuances, especially late in the credit cycle with mixed signals emerging. Lingering pandemic-related distortions have made it even harder to get a firm handle on consumer health, but getting that handle is critical to investing effectively.
Bearish Signals…but Not Broad Weakness
A snapshot of consumer fundamentals and macro trends today reveals a mixed picture. There are plenty of bearish signals. The labor market shows signs of weakening. Prices on many consumer staples remain high. Savings rates have declined while delinquency rates have been rising. And higher interest rates are starting to weigh on consumers with multiple forms of debt.
But while there may be conservatism in consumer behavior, we don’t see broad weakness in the fundamentals. Household debt growth is slowing and net worth is increasing, while unemployment remains low by historical standards. And the Federal Reserve is getting closer to an interest rate cut, which could alleviate borrowing costs.
What’s more, lending standards have been tightening over the last two years. Yes, delinquencies are up—but they’re rising from historic lows to what we consider more normal levels. As we see it, the coupons available on most consumer loans today better reflect the prevailing interest rate and risk environment.
A Formula Creating More Opportunity for Investors
Mixed signals can create a formula for a promising investment environment. We’ve seen varied performance across consumer asset classes this year (and even across originators within asset classes) in the massive $6.3 trillion asset-based finance market. For investors who can be discerning with their capital, this backdrop can be compelling.
Of course, while broad macro views can provide important insight into the data, investors in consumer debt must focus on specific loan opportunities, not aggregated loan data. To use an analogy borrowed from equity markets, we think the most effective approach focuses on “single names” rather than the total index.
This much is clear to us: consumers aren’t monolithic, nor is consumer-debt performance throughout a cycle. Investors should look to buy from specific loan originators that specialize in particular loan types. It might be an auto loan, a consumer loan or a credit card receivable to someone who is underserved by traditional banks. We believe the right investment approach is a targeted one.
Perhaps most importantly, we think it’s critical to invest in a specific approach to underwriting, which we consider one of the most important indicators of likely performance.
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