CIO of BMO GAM offers economic, market outlook as indebted North Americans face more expensive debt
North American households owe a significant amount of money. Canadians owed a total of $2.34 trillion as of Q2, with an average credit card balance of $4,000 according to TransUnion. The New York Fed reports that US household debt sat around $17.06 trillion in Q2, with total credit card debts in excess of $1 trillion. In a new era of ‘higher for longer’ interest rates there is growing concern that household debt levels could present a structural risk to markets and economies.
Sadiq Adatia, Chief Investment Officer of BMO Global Asset Management, explained that while the levels of household debt pose risks to the system, the relative strength of the North American consumer going into this period means investors may not be in for as rough a ride as they might expect. He believes, rather, that currently-high levels of consumer debt in North America, coupled with higher borrowing costs, should result in a slightly weakened consumer — but one that retains enough resilience to ensure relative stability in what may be a slowing global economy.
“It’s a tricky market and we are seeing higher volatility, we are also seeing consumers starting to slow down,” Adatia says. “But there’s an analogy I like to use, which is that we’re looking at an egg beginning to crack. The question is, are we looking at a raw egg or a hard-boiled egg? The raw egg will make a mess, but the hard-boiled egg will be fine. I think when it comes to our outlook for the consumer and for a possible recession ahead, we’re looking at a hard-boiled egg.”
Where are consumers strong, and where are they weakening?
Adatia’s view begins with the relative strength of the North American consumer leading into this rate hiking period. Adatia caveats that assessment with the note that consumers in the US are generally less indebted and less interest-rate sensitive than their Canadian counterparts. Nevertheless, savings rates and asset levels were higher, and home values had skyrocketed. The strength of that consumer has been key to the surprising resilience of the American and — to a lesser extent — Canadian economies so far this year. Looking at the present-day, however, he is starting to see those cracks forming.
Those cracks include weakness in the labour market, where numbers are still strong but softening, as well as pullbacks in retail statistics and spending levels. From an investment standpoint, equity markets have shown softness, and bond markets have seen a historic collapse. Housing markets, too, have dropped some value. All of that, in Adatia’s view, points to a weakening consumer and more pain down the road.
One key area Adatia thinks many analysts haven’t factored into their analysis of consumer strength is US student debt. US student loans were covered by a government forbearance program since March of 2020, but on September 1st of this year that program ended and US student loan payments resumed. According to the Federal Reserve Americans owe around $1.77 trillion in student loan debt and the resumption of repayments to that debt will take a lot of money out of consumers’ pockets and out of the US economy.
As consumers start to feel the impact of higher rates more acutely, now, Adatia believes they will significantly adjust their spending patterns. Over the next two or three years he predicts a shift in patterns towards staples and away from discretionary spending. If and when we hit a recession, Adatia thinks banks will cut rates and ensure that it doesn’t last more than a few quarters. But a rate cut from current levels will still be an increase for consumers who enjoyed near-zero interest in the leadup to and aftermath of the COVID-19 pandemic. This consumer shift stemming from higher cost debt, in Adatia’s view, should prompt advisors to reconsider their asset allocations.
Investing as consumers weaken
In terms of equities, Adatia believes many consumer discretionary stocks will struggle in this environment. Middle class consumers will shift away from luxury goods and stocks will see a rotation to value that is typical of a slowing growth environment. While he takes a positive view on technology, he believes that advisors need to be more selective with their tech allocations — noting that recent earnings reports are already showing divergence between big tech names.
Conversely, Adatia sees promise in staples and quality companies. However, he thinks that the nature of our modern world is such that advisors should reconsider what they view as a consumer staple. Consumers may be more reticent than expected to cut their Netflix subscriptions and data plans, for example. He thinks the healthcare sector should show resilience and benefit from the aging baby boom generation’s growing need for healthcare. Valuations in that sector, he says, are attractive enough for advisors to consider.
Overall, diversification remains Adatia’s watchword, noting that there are a number of significant unknowns in this economic environment. If corporations feel a deeper pinch from weakening consumption, for example, there may be more job cuts, prompting a longer recession. To prepare for any eventuality, he thinks advisors need to be selective about their bond allocations and consider alts exposure as part of a long-term volatility moderation strategy.
Consumer debt levels can provoke panic among some clients. Whether in the scale of some numbers, or the immediate pinch they feel as their own borrowing becomes costlier. As advisors face worried clients and explain their asset allocation tweaks, Adatia says they need to keep their clients’ focused on the plan and provide context and background behind their portfolio changes.
“Long-term goals shouldn’t be changed by short-term situations unless there’s a structural change going on,” Adatia says. “Hopefully advisors will be saying that we are going to expect some choppy markets, but your portfolio is positioned for the long-term. If we get pullbacks but we believe in the long-term picture we should be adding to our portfolios. If they hear that nervousness, they should think about what sort of things they can put into the portfolio to give us that protection.”