Markets are beginning to ask whether companies will be capable of passing on higher costs to the U.S.’ less than financially robust middle class, according to Moodys.
The U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a leveling off of global business activity.
Missing from last week’s discussion of a record ratio of U.S. nonfinancial-corporate debt to GDP was any mention of 2017’s near-record high ratio of total U.S. private and public nonfinancial-sector debt relative to GDP. The yearlong averages of 2017 showed $49.05 trillion of total nonfinancial-sector debt and $19.74 trillion of nominal GDP that put nonfinancial-sector debt at 249% of GDP—or just a tad under 2016’s record 250%.
The leveraging up of the U.S. economy has coincided with a downshifting of U.S. economic growth. From 1961 through 1979, U.S. real GDP expanded by an astounding 3.9% annually, on average, while total nonfinancial-sector debt approximated 133% of nominal GDP. When real GDP’s average annual rate of growth eased to the 3.2% of 1979-2000, the ratio of nonfinancial-sector debt to GDP rose to 176%. Since the end of 2000, U.S. economic growth has averaged only 1.8% annually and, in a possible response to subpar growth, nonfinancial-sector debt has soared to 232% of GDP
High Systemic Leverage Reins in Benchmark Yields
Over time, the record shows that the climb by the moving 10-year ratio of nonfinancial-sector debt to GDP has been accompanied by a declining 10-year moving average for the 10-year Treasury yield. For example, as the moving 10-year ratio of debt to GDP rose from 1997’s 183% to 2017’s 245%, the 10-year Treasury yield’s moving 10-year average fell from 7.31% to 2.59%.
Two factors may be at work. First, lower interest rates encourage an increase in balance-sheet leverage. Second, to the degree an elevated ratio of debt to GDP heightens the economy’s sensitivity to an increase in interest rates, lofty readings for leverage limit the upside for interest rates. Moreover, as shown by the historical record, if higher leverage tends to occur amid a slower underlying pace of economic growth, then the case favoring relatively low interest rates amid high leverage is strengthened.
None of this dismisses the possibility of an extended stay above 3% by the 10-year Treasury yield. Instead, today’s record ratio of debt to GDP warns of greater downside risk for business activity whenever interest rates enter into a protracted climb.
As reported in the Business Insider, Moody’s Investor Services thinks there will be further declines to come, suggesting that Sydney prices will suffer a “correction” in the year ahead.
“Incomes in NSW have increased faster than the national average and underpin some of the recent gains in home values,” Moody’s says, pointing to the chart below. “However, housing values have risen even faster and are overvalued relative to equilibrium value. Therefore, Moody’s Analytics expects a correction across NSW.”
Wells Fargo’s review of its wealth management business threatens to broaden its reputational damage, according to Moody’s.
Last Thursday, Wells Fargo & Company filed its annual 10-K report with the US Securities and Exchange Commission. The report disclosed the existence of an ongoing review by Wells Fargo’s board of directors into potentially inappropriate referrals or recommendations at its Wealth and Investment Management (WIM) business, as well as a separate company review of fee calculations within WIM that resulted in overcharges for some customers. The existence of these reviews is credit negative.
Before last week’s disclosures, Wells Fargo’s inappropriate sales practices centered on its large retail banking operations. Since September 2016, when Wells Fargo first announced regulatory settlements related to retail banking sales misconduct, the bank has also disclosed issues in its auto lending business and in its assessment of fees for mortgage rate-lock extensions. These disclosures have resulted in significant reputational damage.
Consequently, we believe Wells Fargo’s reputation would suffer further if inappropriate practices were found in its nationwide WIM business.
Wells Fargo has made rebuilding trust its top priority, and over the past year and a half has taken numerous credit-positive steps to strengthen its governance and risk oversight. However, the widespread nature of Wells Fargo’s wrongdoing also resulted in a broadly publicized consent order with the US Federal Reserve that restricts the bank from growing its balance sheet beyond its year-end 2017 size and calls for more enhancements to its governance and risk management.
These circumstances, and the heightened scrutiny that Wells Fargo faces, magnify each additional revelation of inappropriate practices. Therefore, although the newly disclosed reviews into Wells Fargo’s WIM business are in their preliminary stages, we believe they undermine the bank’s effort to rebuild trust.
Moreover, the board’s review into whether there have been inappropriate referrals or recommendations affecting WIM’s brokerage and other customers was initiated in response to inquiries from US government agencies, raising the possibility of another regulatory sanction at the conclusion of the review. Similarly, Wells Fargo’s filing highlighted a separate internal review of policies, practices and procedures in its foreign-exchange business that is also a response to inquiries from government agencies.
Wells Fargo’s 10-K also included a report from its auditor, KPMG, in which KPMG expressed an unqualified opinion on Wells Fargo’s financial statements and an unqualified opinion on the effectiveness of its internal controls over financial reporting. This is positive because it indicates that Wells Fargo’s auditors do not believe the bank’s aggressive sales practices compromised its financial reporting in any material respect.
Norway, one of the countries mirroring the Australian mortgage debt bubble (223%) has taken steps to tighten mortgage lending further. This includes a limit of 5x gross annual income and a 5% interest rate buffer.
According to Moody’s, last Wednesday, the Norwegian Financial Services Authority (FSA) proposed to the Ministry of Finance a new regulation on requirements for residential loans. The proposed national regulation is based on existing and Oslo-specific policy measures introduced in January 2017 and scheduled to expire 30 June 2018 that cap the portion of a mortgage that does not comply with the national applicable loan-to-value (LTV) ratio limit at 8% from 10% previously. Extending these measures past their scheduled expiration will contain borrower leverage, a structural risk for Norway’s banking sector, and dampen house price inflation, both credit positive.
The proposal maintains the maximum LTV for home equity credit lines at 60%, continues to cap the LTV on mortgages at 85%, and leaves unchanged the limit on borrowers’ aggregate debt at 5x gross annual income. However, the FSA suggests eliminating the existing LTV limit of 60% for secondary homes located in Oslo (see exhibit).
Household debt reached a record 223% of disposable income in June 2017, far above that of other Nordic countries, and we expect it to remain close to current levels over the next 12-18 months. This trend remains a structural risk for Norway’s banking sector.
Although the Ministry of Finance will make the final decision on whether to accept the recommendation and in what form, the proposal is a step to improve mortgage underwriting standards by containing borrower leverage. Norwegian banks are retail focused, with mortgages accounting for almost 50% of their total lending. The proposed expansion of the previously Oslo-specific measures will improve banks’ asset quality and increase mortgage competition in Oslo. Smaller regional banks will be able to compete for mortgages in Oslo with DNB Bank ASA (Aa2/Aa2 negative, a34), which has the largest share of Oslo’s retail market, because they will be able to account for deviations from the suggested LTV limits against their entire loan book rather than the small share of Oslo-originated loans in accordance with current regulation.
House prices in Norway have declined 4.2% since peaking in March 2017. The decline followed the Ministry of Finance’s 2017 implementation of tighter mortgage lending criteria in response to accelerating property price inflation and rising household indebtedness. The restrictions have cut demand for investment properties in large city centres, particularly the Oslo metropolitan area, where house prices have grown fastest in recent years.
Moody’s says a possible $975 billion increase in U.S. government debt for fiscal 2018 would leave Q3-2018’s outstanding federal debt up by 5.9% annually. As of Q3-2017, federal debt outstanding grew by $597
billion, or 3.8%, from a year earlier.
Into the indefinite future, federal debt is likely to materially outrun each of the other broad components of U.S. nonfinancial-sector debt. Because of non-federal debt’s relatively slow growth, the private and public debt of the U.S.’ nonfinancial sectors may grow no faster than 4.3% annually during the year ended Q3-2018 to a record $50.77 trillion. For the year-ended Q3-2017, this most comprehensive estimate of U.S. nonfinancial-sector debt rose by 3.8% to $48.64 trillion.
Though expectations of faster growth for total nonfinancial-sector debt complements forecasts of higher short- and long-term interest rates for 2018, the quickening of total nonfinancial-sector debt growth may not be enough to sustain the 10-year Treasury yield above the 2.85% average that the Blue Chip consensus recently predicted for 2018.
The projected growth of nonfinancial-sector debt looks manageable from a historical perspective. For one thing, 2018’s projected percent increase by debt lags far behind the 9.1% average annual advance by U.S. nonfinancial sector debt from the five-years-ended 2007. Back then, unsustainably rapid growth for total nonfinancial-sector debt and 2003-2007’s 2.1% annualized rate of core PCE price index inflation supplied a 4.4% average for the 10-year Treasury yield of the five-years-ended 2007. By contrast, the 10-year Treasury yield’s moving five-year average sagged to 2.2% during the span-ended September 2017 as the accompanying five-year average annualized growth rates descended to 4.4% for nonfinancial-sector debt and 1.5% for core PCE price index inflation.
Last Wednesday, the Australian Prudential Regulation Authority (APRA) proposed key revisions to its capital framework for authorized deposit taking institutions (ADIs). The revisions cover the calculation of credit,
market and operational risks. These proposed changes are credit positive for Australian ADIs because they will improve the alignment of capital and asset risks in their loan portfolios. Moody’s says the key proposals are as follows:
- Revisions to the capital treatment of residential mortgage portfolios under the standardized and advanced approaches, with higher capital requirements for higher-risk segments
- Amendments to the treatment of other exposures to improve the risk sensitivity of risk-weighted asset outcomes by including both additional granularity and recalibrating existing risk weights and credit
conversion factors for some portfolios
- Additional constraints on the use of ADIs’ own risk parameter estimates under internal ratings-based approaches to determine capital requirements for credit risks and introducing an overall floor to riskweighted assets for ADIs using the standardized approach
- Introduction of a single replacement methodology for the current advanced and standardized approaches to operational risks
- Introduction of a simpler approach for small, less complex ADIs to reduce the regulatory burden without compromising prudential soundness
A particularly significant element of the new regime is a reform of the capital treatment of residential mortgages, given that more than 60% of Australian banks’ total loans were residential mortgages as of January 2018.
The improved alignment of capital to risk for residential mortgages will come from hikes in risk weights on several higher-risk loan segments. APRA proposes increased risk weights for mortgages used for investment purposes, those with interest-only features and those with higher loan-to-valuation ratios (LVR). At the same time, risk weights for some lower-risk segments likely will drop. For example, under the standardized approach, standard mortgages with LVR ratios lower than 80% will require risk weights of only 20%-30%, down from 35% under current requirements.
The higher capital charges on investment loans will better reflect their higher sensitivity to economic cycles. During periods of economic strength investment loans perform well. As Exhibit 1 shows, on a national basis
and during a time of strong economic growth, defaults on investment loans have been lower than owner occupier loans.
However, in Western Australia, where the economy has deteriorated following the end of the investment boom in resources, defaults on investment loans have been higher than owner-occupier loans, as Exhibit 2 shows.
Investment loans also are sensitive to the interest rate cycle. During periods of rising interest rates, investment loans tend to experience higher default rates than owner-occupier loans, as shown in Exhibit 3.