The threat to recovery
For more than a decade, relatively easy access to low interest rate loans has encouraged higher spending, allowing us to purchase everything from our home to our car or the latest appliance. This has played a significant role in fuelling economic growth. As a result of the credit crunch, the positive factors that have enabled this are starting to fade.
Debt represents borrowing from the future to spend money today. Previous economic recoveries have been firmly supported by people borrowing in order to spend more than they would ordinarily be able to afford. In light of this, we ask James Carrick, Economist at Legal & General Investment Management (LGIM), to identify the key factors which influence how much we borrow and discuss their role in the developed world’s economic recovery.
"Things will return to normal, won’t they?"
There is a belief that after the credit crunch things will return to ‘normal’ and household debt, which includes things like a mortgage, credit card debt and car loans, can continue to rise just like it has during the last few decades. It’s our view at LGIM that this is too optimistic.
Four reasons why we feel debt levels will fall
Our analysis suggests there are four key factors which have led to high debt levels in the past. I’ll explain why these are likely to play a far smaller role in the future.
- Demographics
In theory, people borrow money to afford now what they’d eventually be able to afford based on their future income, i.e. cars, homes, holidays etc. This suggests an important role for demographics. A young population will borrow a lot, but as they age they’ll have earned enough to not need to borrow.
Many developed world countries are ageing, the post World War II ‘baby boomers’ are now approaching retirement. This would suggest that borrowing should be falling. - Interest rates
Lower interest rates allow people to borrow more without having a big impact on how much they can spend on other things during the repayment period. Falling interest rates encourage people to borrow, therefore spend more, and discourage people from saving money. This encourages economic activity. Despite the Bank of England base rate being at its lowest in its 315 year history, the average interest rate on a mortgage only fell to 4.28% in October 2009. This is in contrast to the 2003 low of 3.98% (source Council of Mortgage Lenders Regulated Mortgage Survey December 2009). Therefore, it is unlikely that falling interest rates will be as important a driver as they have been in the past. - Terms of borrowing
The amount people will borrow also depends on the terms available, for example they’ll be able to borrow more if they’re allowed to make repayment over a longer period or pay a smaller deposit. Our analysis has shown there is a relationship between the amount people borrow and the terms of borrowing. Since 2007 the terms of borrowing have become less attractive. - Subprime lending
The terms of borrowing, above, only covers so called ‘conventional’ borrowing and doesn’t take non-conventional loans and mortgages into consideration. Non-conventional lending includes features such as interest only, small deposits or lending to people with low credit scores.
In the US in 1998, subprime mortgages accounted for only one in every 55 mortgages, before soaring to one in seven by 2005. More recently, this has fallen to one in nine (source: Mortgage Bankers Association December 2009) and is likely to continue to fall as banks continue to refuse to offer subprime products. This further highlights the increased difficulty people will face in borrowing.
How will this affect an economic recovery?
Combining all of the factors above, we at LGIM would conclude that people are likely to continue to borrow less in the coming years. As lower borrowing means lower spending, this implies that the contribution to the economic recovery from consumer spending will be lower, making the recovery weaker.
The borrowing party is not over
Our analysis so far has focused on developed nations, where we expect borrowing to reduce, but that’s not to say the same can be said for developing markets. Car sales recently reached record highs in Brazil, India and China. China has also seen home sales jump (source: Reuters Ecowin December 2009). So attention will now switch to these emerging markets to see if they can help to support the global recovery.
Past performance is not a guide to future performance.
The views expressed in this newsletter are those of Legal & General (Portfolio Management Services) Limited and LGIM, who may or may not have acted upon them.
