According to The New York Federal Reserve, consumer debt is at record highs.
At the end of 2022, U.S. consumer debt across all categories totaled $16.9 trillion. That was an increase of $1.3 trillion from one year ago. What's more alarming is that in 2019, the total U.S. consumer debt was $14.14 trillion.
So, while higher interest rates likely fueled some of the increase from 2021 to 2022, increasing consumer debt had occurred even before the Federal Reserve began its rate hikes.
What is concerning about the increasing consumer debt is what it says about the future of our economy. In 2017, the International Monetary Fund released a report that showed a correlation between rising consumer debt and the economy's health. The IMF concluded that rising consumer debt was good for the economy in the short term.
For example, the more consumers take out auto loans, the more the automotive industry, from the auto parts manufacturers to the big auto manufacturers to even the auto dealers, will experience an increase in labor needs. This increase reduces unemployment, which increases overall economic activity and spurs the economy.
Consumer debt rises related to the housing industry have the same effect but on an even larger scale. It's been reported that for every new home built in the U.S., 1.5 new jobs are created.
The IMF study clearly says that while consumer debt is increasing, there are economic benefits. But, in three to five years, those positive effects are reversed. The report states that growth is slower than it would have been if the debt had not increased, and more importantly, the odds of a financial crisis increased.
The IMF went into detail about how much consumer debt needs to grow in order to raise the likelihood of a financial crisis. Their calculations indicate that a five percent increase in the ratio of household debt to the gross domestic product over a three-year period forecasts a 1.25 percentage point decline in inflation-adjusted growth three years in the future.
If we look at nominal GDP from January 2019 to January 2023, it has gone up by almost 24.5%. Consumer debt during that same timeframe has gone up by 19.5%. That doesn't sound bad since GDP is growing faster than consumer debt.
However, we are looking at nominal GDP, which considers price inflation. That means if inflation causes prices of goods and services to rise, those increases are enough to cause GDP to go higher, even if actual output remains the same.
And this is an excellent time to remind everyone that since the middle of 2021, we have been experiencing relatively high inflation levels, both worldwide and in the U.S.
So what does all of this mean for investors?
Well, it could mean nothing, and the economy continues moving along, strong and healthy.
Or it could very well be predicting the next recession.
The IMF study would indicate the economy is still strong since GDP is growing faster than debt. Currently, the household debt to GDP ratio is at 76.83%, essentially the same as it was three years ago when it sat at 76.41%.
But, household debt is at an all-time high during a period of high inflation. All while the Federal Reserve continues to raise interest rates, making that high debt load even more expensive.
Due to all the factors floating around, it shouldn't shock market participants if default rates rise over the next few months, which could be enough to start the next recession.
We all should be watching defaults on all forms of debt, not just mortgage debt, which helped fuel the financial crisis in 07-08. Auto loans, personal loans, and credit card debt must be closely monitored as a sign that the start of the next recession is close.
Suppose you are wondering how you can benefit from rising consumer debt and the potential debt crisis caused by a high number of possible defaults. The best way would be to short the market as a whole.
There are no Exchange Traded Funds that focus on the companies that would be negatively impacted the most by high defaults, but it would cause the major indexes to decline. Thus if you buy something like the UltraPro Short S&P 500 ETF (SPXU) or the Direxion Daily S&P 500 Bear 3X Shares ETF (SPXS) you would have three times the inverse leverage of the S&P 500 and benefit significantly if the market were to head south.
Remember, though, at this time, the consumer debt doesn't indicate the market is ready to roll over, but that could change anytime. Watch for either debt to continue increasing rapidly, or massive defaults as your cues to get short the market.
Matt Thalman
INO.com Contributor
Follow me on Twitter @mthalman5513
Disclosure: This contributor did not hold a position in any investment mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.
