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Defusing the debt bomb

Careful management of the consumer debt burden is essential to avoid plunging the economy into a great depression, says James Norrington
Defusing the debt bomb

Central bank intervention and a retreat of more apocalyptic narratives on Covid-19 can be credited for the FTSE All-Share rallying around 28 per cent from its March low. Investors in shares have had a reprieve, but a genuine recovery depends on the real economy, which is vulnerable to a dreaded second wave reigniting the fear factor.  

Ultimately, companies must justify share prices with profits and hard cash, which requires economic growth on the back of all-important consumer confidence. Household indebtedness, people’s ability to manage liabilities and carry on spending – and the effect fear of unemployment has on their willingness to do so – places a question mark against corporate profits.

Household debt was lower as a percentage of gross domestic product (GDP) going into the coronavirus lockdowns than it had been before the global financial crisis in both the UK (83 per cent at end-2019, but above 90 per cent in 2008) and the US (75 per cent versus 98 per cent before the financial crisis).

Of course, the end-2019 ratios will be altered by plummeting GDP figures thanks to the economic hibernation and the absolute amount of household debt (including mortgages) rising steadily, and now topping £1.677 trillion in the UK and $14.3 trillion in America.

Both countries are on a knife edge, hoping the coronavirus can be contained without further lockdowns, and that the more upbeat estimates for rebounds in GDP growth will prove correct. Britain saw a record 20.4 per cent monthly contraction in April 2020 and the International Monetary Fund (IMF) expects its economy to end up having shrunk 10.2 per cent in the full 2020 calendar year.

What transpires, and whether the UK meets or bests the return to growth projected by the IMF (6.3 per cent in 2021), will depend on two things: the virus itself, and whether the public remains fearful and health services have capacity to cope with flare-ups; and preventing economic panic.

The IMF’s worsening of its outlook since April (when it had the UK down to contract 6.5 per cent this year) has been prompted by the realisation that household consumption will be hit harder than in previous recessions, thanks to the virus and social distancing.

Chancellor of the Exchequer Rishi Sunak must wind down the furlough scheme that has saved millions of jobs as though he were defusing a bomb. Decisive action in support of employers’ wage bills has so far saved millions of jobs and the unemployment rate is still only at 3.9 per cent, with approximately 2.8m claiming jobseekers’ allowance in May.

In its stress tests for the UK economy and financial system, the Bank of England (BoE) used a scenario of around 9 per cent unemployment and GDP contracting 14 per cent for 2020. In such an environment it concluded the banking system could cope, even with more write-downs of consumer debt.

Prudent assessments are also important for commercial banks and, unfortunately, the side effect of accounting for more bad loans is share price jitters, as we have seen with Lloyds Banking (LLOY) recently.

Provisions should not be reported as forecasts, however. As the country exits furlough, it is crucial that those still in work aren’t spooked by headlines of job losses and continue to spend money, because if they don’t it becomes a vicious circle and becomes more likely that people are laid off.

Unsurprisingly, there is a correlation between people being out of work and debt delinquency, but a more granular assessment of which segments of society owe what and to whom is required before doom-mongering about a new Great Depression.  

In the first quarter of 2020, the BoE survey of lenders showed that the quarter-on-quarter change in the rate of credit card defaults had risen 14.1 per cent and, including other forms of debt such as hire purchase, the overall rate of default on unsecured household borrowings was up 11 per cent. Yet this was lower than in the first quarter of 2019, when the rate of increase was over 20 per cent and the figure was expected to decline slightly in Q2 2020.

It may be that lenders revise their estimates amid more pessimistic economic forecasting, but at least the rate of debt delinquency seems manageable, especially as it may be spread out with the support of payment holidays being offered by lenders. Obviously, that’s bad for banks’ profits and therefore bank shares, but it helps avert financial Armageddon.

If the BoE stress tests are believed, there is scope to absorb more loans going bad. The immediate risk to recovery is if the wealthier echelons who paid back a record £7.4bn of consumer credit in April continue to prioritise deleveraging and don’t spend enough to get the economy growing again.

Such a view is not to cynically discount the misery of poorer segments of society as jobs are lost, but if the pain doesn’t fall on companies’ main customers then their profits will be less impaired. If recurring spikes in coronavirus cases can be avoided, or at least contained without further blanket lockdowns, well-run businesses will get back on track more quickly.

Longer-term, it never pays to be flippant about rising social inequality, as recent civil unrest reminds us. The poorest decile of households, where job losses are likely to hit hardest, have debts that are three times their income and mostly unsecured loans. While proportionately more indebted, however, these households hold less debt, so their defaulting is less of a systemic risk.

 

Debt to income is more problematic for poorer households, but those on middle incomes account for most debt

 Property debt: total wealthFinancial debt: total wealthTotal debt: total wealthTotal debt £bn
1st (lowest) wealth decile1.191.843.0429
2nd wealth decile0.160.120.2819
3rd wealth decile0.430.070.5091
4th wealth decile0.370.040.41152
5th wealth decile0.260.020.28170
6th wealth decile0.180.010.19173
7th wealth decile0.110.010.12157
8th wealth decile0.080.010.08156
9th wealth decile0.050.000.05149
10th (highest) wealth decile0.030.000.03187

Source: Office for National Statistics

 

Inequality in society needs addressing as widening disparities can only drag on economic growth, but more immediately, investors will want to understand the probability of a debt crisis sending the stock market into a new meltdown. Being positive that can be averted, identifying companies with good growth prospects, even against a backdrop of higher levels of unemployment and distressed debt, will be key to returns in what is likely to be a disjointed and challenging recovery.

 

Optimism returns to some consumer stocks

Making forward estimates of company profits is still tough, yet looking at the performance of some consumer-focused stocks, investors seem happy to follow good news stories. Games Workshop (GAW) is up 71 per cent in the past three months, partly buoyed by a return to quality stocks on the back of stimulus programmes, but also a profit forecast upgrade in June.

Being a niche hobby retailer, Games Workshop may be prioritised more by its customers than other consumer discretionary purchases, but since the business has expanded in scale perhaps it is reasonable to question whether sales growth relies on softer demand than its hardcore devotees, even though there is excitement about growing royalties from the licensing of its intellectual property (IP) for video games and other entertainments.

For now, it is worth noting that the strength of the profit upgrade momentum falls short of Investors Chronicle’s Alpha earnings momentum screen’s criteria (forecast upgrades of at least 10 per cent for the current and next financial years). Furthermore, concerns remain around Games Workshop’s operational gearing (its high proportion of fixed costs makes profit margins go down more per lost unit of revenue).

Aim-traded fashion conglomerate Boohoo (BOO) has wowed markets with impressive sales growth at boohoo.com during lockdown and it has topped our Alpha momentum screen for Aim in June. At the time we ran the data (close prices for Friday, 20 June), the shares were up 115 per cent over three months, but the trailing three-month momentum looked less impressive after pullbacks at the start of the following week.

On the corporate side, Boohoo has had a good lockdown acquiring the Oasis and Warehouse chains, which has helped alleviate concerns after short interest from ShadowFall Research. The analysts queried Boohoo’s accounting treatments, but the company has also now taken a full stake in subsidiary PrettyLittleThing, the ownership of which was central to questions about the company’s free cash flow calculation.

Just as some businesses have advanced their strategies in lockdown, more solvent consumers also have potential to make purchases as money normally spent on leisure and going out has been earmarked for home improvements. This potential boost is less likely if news on unemployment makes people nervous and horde cash – President Franklin D. Roosevelt’s point about fearing fear itself rings true – but the outlook for well-run home retailers may not be so bad.

Store credit and part-hire purchases account for about £47bn of household debt in the UK (ONS figures for 2016-18), but credit risk is often passed on to finance companies, who pay retailers for sales and then collect payment on the customer’s loan. This, along with tight supply chain management, can help shorten working capital cycles.

How operational efficiencies feed through to financial solvency can be monitored with metrics such as the debtors’ ratio and payables payment periods. If it takes significantly longer to receive monies owed than it does to pay creditors, it does not bode well for operating cash flow and viability as a going concern.

Bad debt exposure may be well managed and a retailers’ solvency risk could come from simply not generating enough sales in a recession to meet portions of fixed liabilities (such as rents on premises) as they fall due. The government’s Covid-19 funding support and the Bank of England’s intervention in commercial paper markets will prevent many businesses going to the wall immediately, but sales activity will determine whether cheaply priced shares rebound.

 

Systemic risk of the consumer debt burden

Confidence is crucial and the crunch period is the end of furlough schemes. If companies feel that sales will pick up, they will be less likely to make sweeping redundancies, especially if governments provide continued interim support and central banks maintain liquidity and funding lines.

Businesses do have to be prudent and there is a delicate balance between managing expectation and building a destructive narrative. One of the retail winners of the coronavirus has been Tesco (TSCO), although rising supply chain and social distancing costs have constrained profits growth, and sensibly adding provisions for loan write-downs at Tesco Bank did weigh on the share price.

The major risk is a swathe of job losses among middle-class people with high levels of mortgage debt. Such a scenario would also precipitate falls in house prices – a key driver of sentiment for all consumers, especially in Britain.

Mortgages make up the bulk of the UK banks’ exposure to household debt and even though lenders were in far better shape going into this crisis than the one of their own making 12 years ago, widespread defaults on mortgage books is a nightmare scenario.

Other forms of lending have also been flagged as a risk, such as auto finance. In the UK, the Bank of England included impairment of £1.5bn auto loans as part of its stress test. In the US the $1.2 trillion auto debt pile poses a further systemic risk, which is another reason the 'whatever it takes' stance the Federal Reserve has taken to support financial lenders is vital.

Student loans have grown on both sides of the Atlantic, although in the UK, the long-term nature of the debt and the automatic payment holidays for those out of work make it inherently manageable, albeit a contributor to the generational wealth gap. In the US, where the loans are less forgiving, the fact a third of the $1.5 trillion student debt market is sub-prime quality provides yet another headache for policymakers.

Where consumer debt is concerned, if people keep repaying their purchase loans then finance companies will still be prepared to offer the facility, especially with central banks steadfastly behind them. It is true that flooding financial markets with liquidity helps widen the wealth gap in societies, but in practical terms, the blunt instruments of monetary policy are staving off a credit recession to go alongside the collapse of economic output caused by lockdowns.

For now, that means there is still reason to be hopeful. Being able to offer credit helps companies make sales. The more confident companies are on their revenues, the less likely we are to see widespread redundancies all happening at once, sending the economy plummeting into depression.

Of course, building back from this crisis, many sectors will face the need for structural change and that will involve redundancies, but if that is a smooth and transitionary process and other jobs are being created, then there is no need for panic. Payment holidays on mortgages and unsecured personal debt such as credit cards can help those between work, so a slight spike in frictional unemployment can be managed.

Just like the virus that caused this mess, hope is contagious and as internet businesses such as boohoo.com show us, there will be success stories to cheer investors. There are also companies out there that are showing the way with 21st century consumer commerce, and the likes of Visa (US:V), Mastercard (US:MA) and Paypal (US:PYPL) are holdings that often feature in quality funds that should form the backbone of equity portfolios.

Other expensive quality stocks are seeing positive trends in their business, but the jolts in the transition of the shift in sales will create blips in earnings. American sports footwear and apparel giant Nike (US:NKE) announced Q4 2020 earnings per share that were below analysts’ expectations. Yet the shift to online sales (up 75 per cent in the fourth quarter) bodes well for a direct-to-consumer strategy. Disappointments like the recent results could be a buy-in opportunity.

For satellite portfolio holdings, which can be more speculative, smaller and less expensive opportunities can be uncovered, too. For example, two months ago, Simon Thompson struck upon a company with a stake in an innovative payment-spreading system for online purchases.

Cautious and measured optimism should be the modus operandi for investors in shares. So, staying invested to capture upside from stimulus packages while being broadly circumspect with a bit more cash reserve than usual is a smart policy.

The Bank of England’s stress test scenario for debt default factored in unemployment of 9 per cent and GDP contracting by 14 per cent. Anything less than this, when the furlough scheme is ended, and disaster will probably be forestalled. For more widespread profits growth to return, however, we are hoping not only on this outcome but also evidence any second wave of coronavirus won’t require such a drastic and economically damaging response.