U.S. Auto Sales Breakdown in First Quarter: Several major automakers reported declines in 1st quarter U.S. sales in early April. Industry analysts followed these reports with expectations that the industry as a whole would see declines of 3% to 4% for the 1st quarter year-over-year, and as much as 5% year-over-year for the month of March, which is typically a strong month for the industry. Furthermore, analysts indicated that total vehicle sales for the year may end up below 17 million for the first time since 2014. Yet, for the most part, automakers have been able to support their bottom lines with higher margin sales coming from trucks and SUVs which have regained popularity in recent years.
Our Takeaways: The automotive industry is a rather intriguing area right now. Coming out of the Great Recession, companies were able to capitalize on pent-up demand in the U.S. by aggressively financing the lease and purchase of new vehicles in order to move product. Also, sales efforts by the major automakers in China really began to take off, which has added significantly to the overall global picture (China is now the world’s largest car market by sales). Now, consumer demand appears to be slowing, or at least shifting to the gently used models, and default rates on auto loans are skyrocketing. Clearly, there have been some over extensions on both sides (automakers and consumers) and some pull back would be expected as a result. In addition to the core business aspects of this story, the rise of new technologies in the industry such as electric vehicles and self-driving systems are creating another threat for legacy automakers. To be clear, we do not believe these new technologies will be commercially viable in the near to medium term, but the failure to make sizable investments in the development of these, and other, technologies will put the legacy automakers at a significant disadvantage in the long term. Failing to make these investments now will open the door to significant disruption by VC funded startups in the industry if consumer demand starts shifting towards these new technologies in a meaningful way.
When Was the Last Time a Bank Failed?: To answer that question directly before we go any further: December of 2017. This current run of 16 months is the third longest in U.S. history since 1933 with the 32 months prior to the Great Recession and a 20 month period after the end of World War II being the only two periods in this time frame with longer stretches. Until 2004, when the run up to the Great Recession started, we had never experienced a calendar year with no bank failures. Furthermore, only 6 times since 1933 had any 12 consecutive month period elapsed without any failures. While bank failures are not supposed to happen often, it is extremely rare to have such a long period go by without any. From 1943 to 1974, at least one bank failed every year, but there were never any more than 10 failures in any given year.
Our Takeaways: In 2006, the Office of the Comptroller of the Currency wrote the following in its annual report: “this was the second consecutive year in which no national bank failed. Capital was strong and earnings increased, driven by strong growth in noninterest income. Healthy loan growth helped compensate for narrowing net interest margins. Losses and delinquencies were minimal. In short, the picture at year-end was quite positive.” Coincidentally, the same could be said about today’s environment with very limited caveats. This is not to say we are on the precipice of another 2008, but the conditions for banks are strikingly similar. Essentially, what this statement is saying is that banks are (or as was the case - were) doing well because of activities outside, or not directly derived from, their core business of collecting interest on loaned capital. For most banks, noninterest income comes from activities such as loan or account fees, or other lines of business (e.g. wealth management, investment banking, etc.). So what is going on in banking right now that could explain such a long period without any failures? First, many smaller banks (which would otherwise be more prone to failure due to lack of income diversification and reliance on a more regional demand for loans) are being bought and rolled into larger banks. This is essentially creating adverse selection in the sample. Second, the market value of bank assets (loans) has remained high. Overall real estate values, the underlying collateral for much of a bank’s asset portfolio, have remained solid, delinquencies on loans have remained low, and as interest rates have fallen, demand for older, higher interest rate loans has increased - all of this leading to lower asset impairment. Finally, the market for collateralized loan obligations, or CLOs, has been very active. Essentially, this market allows banks to sell large pools of loans to private investors like hedge funds, insurance companies, endowments, etc. and not have to hold these loans on their balance sheet any longer. For banks, this is a great deal because they are able to make fees from the origination of the loans, can transfer the risk of the loans off of their balance sheet, and are recapitalized relatively quickly to start the process all over again. The CLO market has exploded since 2012 and seems poised to grow even larger, which - at least for the time being - appears like a positive for the banking industry.
Shifting Work Trends Distort Traditional Data: The Dallas Federal Reserve is out with a new paper that contends, among other recent trends in employment and consumer spending, that the so called “gig” economy is disrupting the way U.S. job, wage, and inflation data are tracked. The “gig” economy refers to contractor style employment arrangements such as Lyft and Uber drivers where the company contracts out their labor needs to a workforce that works as much or as little, and whenever, it wants or is able. While flexibility is clearly a positive aspect of these employment arrangements, it often comes with the downside of lower wages and few to no benefits when compared to full time employment arrangements. The way unemployment is currently measured, when a worker begins one of these “gigs” they are no longer counted among the unemployed. Even though these workers do not have many of the same strengths, economically speaking, that a full-time employee would have, they are still being counted in a similar manner. This report, combined with a similar one by the Boston Fed which concluded that the “gig” economy had “an economically significant” impact on lower wages, should put an end to economists’ debate over the reliability of recent employment and wage data.
Our Takeaways: The “gig” economy allows those who may otherwise be unable to have regular, full-time employment to work. However, this “work” is fundamentally different than typical full-time employment structures, and thus is clearly having some distorting effect on traditional economic metrics. The likelihood of this impact being meaningfully significant is probably slim, but the marginal effects have likely been enough to push recent reports into record low unemployment territory. Furthermore, the weight on reported wage growth according to the Boston Fed report pegged the year-over-year drag at between 0.5% and 1% which, in isolation, is probably not very impactful; but when that is carried over a number of years, then that underreporting starts to add up. The long-term impacts of the “gig” economy may prove to be negative for workers and the economy as a whole, but the inaccuracies in recent reporting point to short-term positive indications for the health of U.S. consumers. It appears, at least currently, the “gig” economy is mostly pulling marginal workers into the economy who may otherwise not have been productive and providing them with a source of income which they can then spend or invest back into the economy.
Changing Credit Profiles Threaten the Next Generation of Borrowers: The regional Feds were busy in April with the New York Federal Reserve releasing a report about the status of young Americans in the credit market. According to the report: “trends since 2008 have focused debt growth among older, higher credit score, and presumably wealthier, households.” This, in turn, has meant that many younger would-be borrowers are getting left out. Among the other reasons why younger, potential borrowers are not able to effectively access credit are higher student loan debt and higher auto and credit card delinquency rates as compared to borrowers of older demographics. The report then went on to describe the composition and health of the overall credit market, which it determined - despite the overall market being larger, relative to the overall economy - that the size was in line. Furthermore, credit quality is much higher than in previous years and housing related debt is a much smaller piece of the puzzle compared to the run up to the housing crisis. The report then circles back and hits on a key point which is that student loan debt and auto loans are currently making up a much larger portion of household debt than ever before and have been growing at rates “much higher than years past,” and “show little signs of abating, particularly the level of student loan debt, which has never fallen.”
Our Takeaways: Most of the findings from the NY Fed’s report should not come as a surprise to most people, especially if they have been paying attention to financial and economic news recently. Student loan debt in particular has seen such a dramatic increase (and thus impact on prospective borrowers) that many economists agree that data already shows those debt levels are impacting everything from household formation (i.e. marriage) to home ownership to even new business creation. This leaves us to ask: are any of the underlying factors that are causing the trends highlighted by this report likely to change? Banks in the short term are probably unlikely to change their lending practices. However, towards the end of the cycle, they might do so in order to stretch profitability just a little further. Student loan debt, both the total stock and new issuance, are unlikely to change quickly. The total stock is not likely to decrease in any meaningful way as long as repayment sources (i.e. people’s wages) remain in a modest growth pattern and the rate/size of new issuance stays high. Meanwhile, the rate/size of new debt issuance is unlikely to decrease materially any time soon. It will eventually hit a breaking point, but since student loan debt is federally backed, it will likely take a very, very long time before that point is ever reached. The auto piece of this debt puzzle seems the most poised to change quickly. The total outstanding stock is unlikely to fall dramatically in the short run, but the rate of new issuance could for reasons more thoroughly outlined in the earlier section of this letter about the automotive industry. Taking all of these possibilities together, the question then becomes whether $10,000 to $30,000 of less debt (because of a smaller auto outlay for a household) really moves the needle for a mortgage lender? Our opinion is that while it is certainly possible at the margin, it will not matter in a significant way.
Updates from Previous Commentary: Two updates from previous commentary. First, from our October 12th, 2018 commentary, we highlighted the dramatic decline in coffee bean prices. As of this month the slide continues and is shaping up to get worse. Brazil’s real has continued to fall relative to the dollar (encouraging producers to export more beans) and state funded technological improvements in growing and harvesting have greatly increased productivity. These factors together have allowed Brazilan growers to undercut the rest of the world’s cost of production which, if left unchecked, could further accelerate their dominance. The second update comes from our December 14th, 2018 letter where we highlighted the price declines in another commodity: orange juice. At that time, spot prices were between 130-135, but have recently fallen to around 100. As we outlined in our letter at the time, the deterioration in consumer demand is currently outweighing supply constraints that would otherwise push the price upwards. We expect that outside of a significant supply shock (i.e. widespread crop illness, large hurricane, etc.) the current price trend will continue for some time.
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