Most Canadians are aware of the dangerous state of domestic consumer debt relative to average disposable income, but the relationship between household debt and economic growth is less well understood. History shows an important connection between gross domestic product expansion and consumer credit growth, with some surprising implications for the domestic economy.
The catalyst for this analysis was a comment by U.S. hedge-fund manager Matt Busigin, who noted that American consumers "get in trouble when credit growth exceeds nominal [U.S.] GDP growth."
The first chart backs up this thesis. Since 1980, there have been two extended time periods during which household debt growth has significantly exceeded nominal GDP growth. In both cases, an ugly drop in credit growth followed.
U.S. GDP growth began improving in late 1982, and credit growth climbed along with the economy through 1983. The economy's growth rate began falling, but credit expansion continued unabated until 1985, when it collapsed. U.S. household credit growth fell from 18 per cent in December, 1985, to an anemic 5.1 per cent by the early, recession-ridden 1990s.
The U.S. consumer credit binge between 2003 and 2006 – well above economic growth rates – sowed the seeds of the financial crisis. The plunge in borrowing from 12 per cent in March of 2006, to minus 3.7 per cent in 2009, crippled the country's economy.
Domestically, the relationship between consumer debt and GDP growth was very similar to the U.S. experience in the late 1980s and early 1990s, but much different in the aftermath of the financial crisis (second chart).
Like the Americans, Canadian consumers strapped on a lot of debt in the 2003-to-2006 time frame with year-over-year credit growth averaging 12 per cent. There was, however, no drastic plunge into negative territory for Canadian consumer credit growth. In essence, U.S. households deleveraged, decreasing debt levels primarily by walking away from underwater mortgages. Canadians continued borrowing, albeit at a steadily slowing rate.
The total amount of Canadian consumer debt relative to incomes and total GDP remains an issue for the economy. But as the chart shows, credit growth has not been that far out of line with nominal economic growth.
If there's any cause for concern, it's in the most recent data. Nominal GDP growth has dropped from 4.7 per cent in June, 2014, to 0.7 during the second quarter of 2015. At the same time, year-over-year consumer borrowing has continued to expand, rising 4.8 per cent (year-over-year) in the most recent reports.
Canadian households are already setting records for debt levels relative to income and the accompanying risks – mortgage defaults and bankruptcies, for example – will only rise if credit continues to grow. But declining credit growth and spending threatens a domestic economic recovery.
For investors, further divergence between falling economic growth and rising indebtedness would indicate rising risk of a sharp downward correction in domestic consumption that would negatively affect both the economy and markets.
Follow Scott Barlow on Twitter @SBarlow_ROB.