Weekly Reading 5/31/2022

With the Fed committed to hiking rates, the financial press is eagerly awaiting any data points that suggest a recession is imminent. A recent report from perpetual destroyer of shareholder value, Deutsche Bank called out rising auto delinquencies as a sign of a weakening consumer. Unsurprisingly, the press seized on this and headlines such as this suggest a steep recession is imminent and consumer credit is worsening. Let’s dive in a little more because there are really two issues at work: 1) auto credit and 2) the US consumer and the wider economy.

What are the management team seeing? What does the data suggest? Emphasis my own.

• Discover Financial Services (DFS) 1Q22 Call. April 28.
  • “The war in Ukraine and the resulting sanctions against Russia have also raised concerns about the risk of recession globally and domestically. We do not see any evidence of this across our consumer lending portfolio. Our credit metrics remain good, and there is nothing we’re seeing in terms of consumer spending or borrowing behavior that suggests that a broader downturn is imminent.”
• Capital One Financial (COF) 1Q22 Call. April 26th
  • “Yes, so let’s just talk about the health of the consumer. I think the US consumer continues to be strong. While the savings rate has reverted back to pre-pandemic levels, the cumulative impact of savings over the last two years is still a significant positive. We see this in higher bank account balances and higher household net worth, and it is true across the income spectrum.
  • Now of course, the bulk of government stimulus is now behind us, and most industry forbearance programs are winding down. But I think we’ll see some sustained benefits from consumer deleveraging through the pandemic. Debt servicing burdens are lower than they’ve been in decades supported both by deleveraging and by low interest rates.
  • On the other side of the consumer balance sheet, labor market demand remains strong. So in our own portfolio, we see continuing strength in roll rates, cure rates and recovery rates. And even as we see signs of normalization, our credit metrics remain strikingly strong by any historical standard. There are emerging headwinds as well, for example, high price inflation. Inflation has the potential to erode the excess savings consumers accumulated through the pandemic especially if price increases continue to run ahead of wage growth and also higher interest rates would push debt servicing burdens back up.”
• JP Morgan (JPM) Investor Day May 25th
  • “but big picture, the near-term credit outlook especially for the US consumer remains strong. And in fact, we are now projecting that the unusually low level of card charge-offs will persist into next year.”
• Target (TGT) 1Q22 Call May 18th
  • “While we anticipated a post-stimulus slowdown in these categories (apparel, home, and hardlines) and we expected consumers to continue refocusing their spending away from goods and into services, we didn’t anticipate the magnitude of that shift. As I mentioned earlier, this led us to carry too much inventory, particularly in bulky categories including kitchen appliances, TVs and outdoor furniture and with very little slack capacity after two years of unprecedented growth, we faced elevated costs to store and then began rightsizing our inventory position.
    Nevertheless, we’re still seeing healthy overall spending by our guests even as their spending continues to evolve. Notably, we continue to see meaningful spending surges around holidays including Easter in April and Mother’s Day a couple of weeks ago. Also notable in comparing this years weekly sales to pre-pandemic levels at the beginning of 2019, we’re actually seeing stronger three-year growth trends in recent weeks compared with the beginning of the first quarter, even in categories where we saw a rapid slowdown on a one-year basis.
    These encouraging, longer-term growth trends demonstrate the continued resilience of the American consumer and the trust they place in Target, even as they face multiple challenges.”
• Credit Acceptance Corp (CACC)
  • CACC is not a well-known company but they’ve been around since 1972. Their business is providing financing programs to dealerships so the dealership can sell vehicles to consumers regardless of the consumer’s credit history. Over 90% of CACC’s loans are originated to customers with either no FICO score or a FICO score <650. I’m not sure there is another company out there that has a better view into what’s happening in sub-prime auto credit.
  • As of May 2nd, CACC is forecasting 2022 charge-offs (credit losses) to be higher than 2020 or 2021 but roughly in-line with 2015-2019.

Credit delinquencies are near all-time lows. To get back to normal, delinquencies need to rise. This does not necessarily mean the consumer is under undue stress. As long as the labor market is tight, there is a healthy backdrop for the US consumer.

Beyond auto loans, all other consumer credit types look normal. The below chart shows the mortgage type by the percentage of balance that is more than 90 days past due. Mortgage and home equity (HE) are squeaky clean. Credit Card is normal. Student loans are currently getting a huge lift from the suspension of payments which is why it looks so good. The auto loan space isn’t necessarily ‘good’ but I wouldn’t call this level of auto delinquencies a serious problem… yet.

My takeaways are:

• Looking at the data, reading through the transcripts, and analyzing the companies, I’m generally optimistic that this isn’t a huge problem because the consumer looks strong right now.
  • The recent rise in delinquencies is a normalization. Credit wasn’t going to stay clean forever and consumers are now facing high inflation and lapping the generous stimulus payments of 2020/2021.
  • Sub-prime auto is getting worse and will continue to get worse. Yes, high food and gas prices hurt but the demographic with FICO’s below 600 is always in a recession regardless. BUT, sub-prime accounts for about 15% of auto originations. If the rest of the auto-market is okay, then a normalization of delinquencies is taken in stride.
  • Cars, unlike houses, can easily be seized/collected and sold to pay off any credit balance. High used car prices provide sub-prime lenders with protection.
  • The consumer looks like they’re in good shape! Inflation hurts but it’s not insurmountable. The tight labor market gives workers the ability to get raises to help offset.
  • If we tip into a recession but the consumer is strong, it’s logical that it would be a mild recession.
• There is the possibility that this gets significantly worse in the auto market or the wider economy. In my opinion, the probability of this scenario is low but the probability isn’t 0% either.
  • Something causes auto prices to take an unexpected step backwards.
    • This is more an issue for the auto market specifically, not the wider economy.
    • If the federal government unfreezes student loan payments, it certainly isn’t positive for auto credit. What is uncertain is the magnitude of this impact.
• The Fed causes a steep recession. This recession hits the labor market harder than the Fed planned.
  • Remember, the strong labor market is the consumer’s foundation. If employment isn’t strong, neither is the consumer.
  • The Fed’s mandate is to control inflation AND maximize employment so this would be a dire miscalculation on their part.

Our financial system is highly inter-connected.

• This is a good thing because it allows capital to efficiently flow throughout the economy.
• The downside is that a problem in one part of the financial system can have a profound impact somewhere else.
• It is important that these connections are understood, particularly by regulators.

The failure of TerraUSD and its native token LUNA is the largest collapse in the history of cryptocurrency

• The Mt Gox hack in 2014 was just $460 mil
• I have seen several numbers pegging the capital destruction from TerraUSD/LUNA at $50-$60 billion
  • At its peak, Lehman Brothers was $46 billion
• Yes, this is an apples-oranges type of comparison but the point is that cryptocurrencies are enormous and highly interconnected.
  • The opaque nature of this asset class means that we have very little understanding how cryptocurrencies impact one another or other financial assets.

I’m very interested in humans pushing the limits of what we think is possible. For example, in the history of running, 72 people have been able to achieve a marathon under 2 hours and five minutes. Only two people have gone 3 minutes faster and broken 2:02. Eliud Kipchoge is the current world record holder at 2:01:39. No one has ever broken 2 hours. This current limit to human performance is relatively easy to quantify.

What about limitations that are more difficult to quantify? What if we could measure perseverance? Who would rank in the top 100 worldwide? The ability to keep trying against all odds is amazing human attribute that can yield incredible results. Think of Thomas Edison’s effort to invent the lightbulb or Louis Zamperini’s story of survival featured in Unbroken.

It’s incredible when we see people push the extremes of what we though was possible or even reasonable. That brings me to my little side-bar story this week involving a struggling musician.

• Taylor Swift released her single Tim McGraw back in 2006 when she was only 16.
• Johnny Cash was just 23 when he released his first hit singles.
• Miley Cyrus was also just 16 when she released Party in the USA.
• The Jonas Brothers were all under the age of 20 when they released their debut album.

In show business, the few successful ones emerge at a young age.

That brings us to Rachel Platten.

A graduate of Trinity, Rachel side-stepped a career in diplomacy to pursue music full-time in 2003. She kept grinding and working hard. Touring the country, living out of her car, and chasing what she wanted. This went on for more than a decade.How many people would have given up after a year? Three years? Five years?Finally, at age 33, friends are settling down and her family is starting to get worried about her. Living in your car and existing on a diet of cereal is not a sustainable lifestyle. The music thing clearly wasn’t working.

Instead of giving up, she channeled that desperation into a new song. Fight Song was written in 2014 and slowly became a massive hit.

In describing the song’s origin, Rachel said,“It was about my own journey and my own fire that would not die, that was regardless of how much rejections I was getting, and how impossible it seemed for me to keep trying to make this dream happen, that I just wouldn’t give up. The song was written at a moment of really needing to decide, “Dude, I’m 32 or 31, this is a little pathetic. I need to figure this out and get on with my life.” Then I wrote “Fight Song” in this moment of just sheer desperation. I will not give up on myself. That’s where it came from.”

I might be older than Rachel Platten was but I’m still working my magnum opus…