The U.S. economy remains solid. The consumer sector, which powers roughly two-thirds of economic activity in the U.S., has led the way, with both spending and borrowing increasing at a healthy clip over the past few years. Analysts are expecting more of the same in 2017, which is good news for credit unions, though there are considerable risks to the outlook.
Labor Market, Consumer Fundamentals Remain Solid
Solid household financial conditions generally mean solid credit union financial performance. And solid household financial conditions begin with a solid job market.
Job growth remained strong in early 2017. Nonfarm payroll employment increased by 185,000 per month on average, keeping up with last year’s solid monthly pace. The unemployment rate edged down to a 10-year low of 4.4 percent in April, and is now at or below the level many believe is consistent with a fully employed economy. Other indicators of labor market slack are still slightly elevated, like the share of part-time workers who would prefer full-time jobs, but they are coming down. The number of job openings is high and the number of unemployed workers as a share of openings is at an all-time low of 1.3. Tighter labor market conditions have led to higher wages, boosting consumer income.
Consumer finances have also benefitted from rising stock prices and steady growth in home prices. The value of household assets reached a record high in the fourth quarter of 2016. Major U.S. stock indexes reached new peaks this spring and house prices continued to appreciate at a healthy pace through February, suggesting further improvement on the asset side of the consumer balance sheet. Meanwhile, low interest rates are keeping households’ monthly financial obligations near an all-time low.
The improvement in labor markets, along with rising income and wealth, have made consumers feel more confident about current conditions and the future. Key measures of consumer sentiment are currently at or near their highest levels since the early 2000s.
Consumer Spending and Lending Are Mixed
These consumer fundamentals point to significant support for consumer spending and borrowing. Home sales continued to strengthen at the start of the year. Altogether, sales of new and existing homes averaged 6.2 million at an annual rate in the first quarter, up from 6.0 million in 2016.
Still, for a variety of reasons (including delayed tax refunds and unusual weather), spending on some goods and services slowed in the first quarter. Retail sales fell in both February and March and for the entire quarter were up just 1 percent compared with a 1.8 percent increase in the fourth quarter.
This slowdown was particularly apparent in the motor vehicle market, an area where credit union lending plays a key role. Sales of new cars and light trucks declined to a 17.2 million unit annual pace in the first four months of this year from a record-setting 17.6 million unit annual total in 2016. And sales in March and April were below 17 million for the first time in nine months.
Some analysts are warning about signs of weakness in the auto loan market. Along with the slowing sales, used car prices are falling, which is affecting the value of the underlying collateral for many car loans. And late last year, the Federal Reserve Bank of New York reported that the share of seriously delinquent auto loans rose to 3.6 percent in the third quarter of 2016 as delinquencies on subprime auto loans jumped. The Fed’s data showed that the deterioration in auto credit quality was concentrated in loans originated by auto finance companies.
In general, credit unions are not particularly active in the subprime segment of the market—credit unions and banks together originate just one subprime loan for every 10 auto loans they originate, according to market sources. Credit union Call Report data show that the delinquency rate for credit union auto loans has been roughly stable in recent years, around 68 basis points, and, according to the latest Call Report data, was 72 basis points in the fourth quarter of 2016. Assuming no change in underwriting standards, credit union auto loan delinquency rates are unlikely to rise substantially unless the economy turns down significantly.
Despite these concerns about spending, consumer loan demand is strong, especially at credit unions. Federal Reserve data show that consumer credit balances at credit unions continued to rise at a solid pace early in the year and in March were 14 percent higher than a year earlier. That compares with a 6 percent increase in the total amount of consumer credit outstanding at all lenders combined over the same period. Strong growth in nonrevolving credit—roughly two-thirds of which is auto lending—has been a primary driver of the expansion of credit union consumer credit outstanding.
More of the Same Is Likely, but Risks Remain in the Outlook
Overall, the near-term outlook for the economy remains favorable. Most analysts continue to predict continued moderate growth and rising employment. The unemployment rate is forecast to decline slightly further by the end of next year, and inflation is projected to stabilize near 2 percent. New motor vehicle sales are expected to slow from last year’s record-setting pace, but remain well above their pre-recession average. Home sales are projected to increase further, although the pace of growth may slow somewhat because of tight inventories of homes for sale, higher mortgage rates and rising home prices.
Interest Rates Are a Wild Card
Changes in interest rates will also affect credit unions in the near term. In March, Federal Reserve policymakers raised their short-term interest rate (federal funds rate) target by 25 basis points to a range of 75 to 100 basis points. The Fed held short-term rates steady at their most recent meeting in early May, but with the economy near full employment and inflation close to the Fed’s 2-percent target, interest rates are expected to move higher over the next few years.
The Fed’s latest set of economic projections, released when the March increase was announced, indicated that two additional rate increases are likely before the end of the year. The median forecast from Fed policymakers shows the federal funds target rate reaching 140 basis points by this December and climbing an additional 70 basis points by the end of 2018.
The federal funds target rate is not the Fed’s only tool for influencing interest rates. In response to the financial crisis, Fed policymakers engaged in three rounds of large-scale purchases of long-term securities to lower interest rates and stimulate growth. Through this program, often called quantitative easing, the Fed boosted its bond holdings significantly. By increasing the demand for bonds and driving up their prices, the program lowered long-term interest rates. Analysts estimate that quantitative easing lowered the 10-year Treasury rate by 60 to 100 basis points. Federal Reserve officials are now considering shrinking the Fed’s balance sheet and that is expected to put upward pressure on long-term interest rates.
Now, Fed policymakers have not announced yet when they will begin to do this, but close to three-quarters of analysts surveyed by The Wall Street Journal in April expect the Fed will start to reduce its bond portfolio sometime this year, with a majority expecting the process to begin in December. Private forecasters are projecting the interest rate on the 10-year Treasury note will rise 30 basis points from its March level to 2.8 percent in December of this year and increase an additional 50 basis points to 3.3 percent by late 2018.
If these forecasts are correct, short-term interest rates will rise faster than long-term rates, and credit unions will face both a rising rate environment and a narrower term spread over the next two years. A narrowing term spread could compress net interest margins, particularly at credit unions with high exposures to fixed-rate assets relative to rate-sensitive liabilities. That could lead to a compression of earnings at these credit unions.
However, there is considerable uncertainty about these forecasts, and how all these factors will play out is unknown. Policymakers’ views on short-term interest rates range widely. A few Fed officials believe the current federal funds target rate of 0.75 to 1.00 percent will remain appropriate through the end of this year, while at least one policymaker thinks a rate of just over 2 percent could be appropriate by the end of 2017. Ultimately, the timing and pace of future increases will depend on how economic conditions evolve, whether risks to the outlook appear on the horizon and the potential effects of changes to federal tax and spending policies.
The Trump Administration has provided broad outlines of the policy changes it would like to implement, such as lower taxes, increased infrastructure spending and a reduced regulatory burden, but has not yet announced specific details. Fiscal policies that lead to stronger-than-expected growth and higher inflation could cause the Fed to raise short-term rates more than currently projected. In contrast, a downturn in the economy would likely cause the Fed to pause and hold rates steady, or even lower short-term interest rates.
Policies are not the only factors that can swing the outlook. For example, many analysts remain concerned that growth in China will suddenly slow, that growth in the U.K. may start to slow because of Brexit, and that political uncertainty around the world will lead to slower growth in the United States, and, potentially, lower U.S. interest rates as a result. These geopolitical risks add considerable uncertainty to the U.S. economic outlook.
In summary, the near-term outlook for the economy and credit unions remains good. The most likely scenario is that the U.S. will continue to see moderate economic growth and rising employment. That will support credit union loan and deposit growth, and help keep credit risk low. However, the high level of uncertainty around current forecasts suggests that credit unions will need to monitor emerging risks and policy changes, and understand the implications of a range of interest rate scenarios on their income statements and balance sheets.