Doomsayers warn that the boom in innovative borrowing options is a sign of looming economic apocalypse. The fact that people are more aggressively managing their debt, however, could simply signal a secular change for the financial services industry. It may mean it’s time to rethink some basic assumptions about saving and investing cycles.

The classic wealth-management paradigm has most people following a similar arc in their financial lives. While young, they are primarily consumers with little scope for savings and they are more willing to take risks with money. Middle age means incomes go up, mortgages are paid off and people are able to save in earnest. Wealth preservation and a lower tolerance of risk takes hold as individuals approach retirement, while the golden years involve using the savings to fund day-to-day existence.

This life cycle has numerous implications. It dictates much of the financial services industry’s approach to serving retail clients. It affects how financial advisors tackle the planning process. Some market-watchers also argue that it, in turn, feeds into the fundamentals of the capital markets. As the baby boomers retire, some expect a shift en masse from equities to fixed-income that could leave stocks with a serious shortage of buyers.

But what if the model is obsolete?

A recent paper by Derek Holt, RBC Financial Group’s assistant chief economist, says households are fundamentally changing the way they manage their finances. Essentially, he argues, with the help of increasingly flexible and sophisticated credit products, households are managing their finances more like corporations, smoothing income and consumption over their lifetimes.

This change in behaviour could render the classic wealth-management model irrelevant.
“The shifting of future earning power to the present through debt markets and postponement of liabilities may well mean that the pace of wealth accumulation is faster sooner in life and slower later on,” the paper says. “This smoothing of wealth over one’s lifetime also echoes modern business models based on companies with infinite lives;
instead of waiting for retirement to draw on wealth, such decisions can be made regardless of age.”

Holt cautions that some of the arguments the paper makes regarding the future of wealth management are more speculative than its explanation of the change in borrowing trends, and that data on the implications for saving patterns are still sparse. That said, he notes, there are signs the shift in behaviour is taking place.

> The data. Data in Canada are scarce. Holt reports, however, that the most current data from the U.S. (the 2001 survey of consumer finances) indicate that households headed by individuals younger than 35 years old are enjoying the fastest growth in median real asset holdings, the fastest growth in median financial asset holdings and the second-fastest rate of growth in median household net worth, compared with other age groups. The implication is that younger households are managing their finances prudently, and they seem to be generating more wealth at an earlier age.

Holt says the trend may signal changing behaviour, although he notes that the next set of data, due January 2006, should provide more insight into just what’s going on.

If the hypothesis is right, it will have a host of implications for the retail financial services industry. For one, it would overturn common assumptions about the path of wealth accumulation and dissipation for most households, implying that households may accumulate wealth faster and push liabilities further into the future. This could affect risk tolerances and asset-allocation decisions, and it implies that more actively managed borrowing will probably become a bigger part of the financial planning process. It may also have implications for the much-hyped inter-generational wealth transfer that is supposed to take place once the boomers start dying off.

Holt cautions: “Long-term predictions are extremely difficult. Predicting technology and behaviour — and, hence, how they influence work/retirement choices and longevity — are next to impossible to do.”

But it is nevertheless imperative for financial firms, advisors and policy-makers to seek some insight into the way households are managing their finances. Too often, the RBC paper contends, the greater use of more flexible financing options is “misread as a sign that a cross-section of households are grossly mismanaging their finances, with speculative behaviour being driven by a low interest rate environment.”

> The counter-argument. For some market-watchers, however, the fear that households are overextending themselves is stoked by continued strong consumer spending and ever higher real estate prices. Fears of a housing market bubble are growing, with some worrying that innovative lending products such as interest-only mortgages are feeding the bubble and creating a real estate wealth effect that is keeping consumers spending beyond their means. At the same time, savings rates in both Canada and the U.S. have dropped to about zero, further fanning fears that households are living above their means.

@page_break@Morgan Stanley chief economist Stephen Roach recently marvelled at the global economy’s ability to shake off remorselessly higher energy prices. Yet, he warns in a research note: “But consider the costs of that stellar accomplishment — a personal saving rate that has finally hit the zero threshold, debt ratios that continue to move into the stratosphere and asset-led underpinnings of residential property markets that are now firmly in bubble territory. Courtesy of surging oil prices, these costs are now at the breaking point, in my view.”

Roach suggests the resilience of consumer spending “may make sense in normal periods; it is the height of recklessness in the face of an energy shock.”

He sees three possible outcomes: oil prices fall and everything is OK; oil prices stay high and consumer spending collapses; or, oil prices stay high and the long-awaited U.S. current account adjustment finally happens.

“Over the years, I’ve learned to be wary of betting against the American consumer, but the history of energy shocks argues to the contrary. Moreover, today’s savings-short, asset-dependent, overly indebted consumer is far more vulnerable than in the past,” Roach notes. “After years of such warnings, investors, of course, have all but given up on that possibility. That’s precisely the time to worry the most.”

While there may be reason for worry, in a world of large, open, globally integrated economies there are so many moving parts that it’s hard to predict how it will all play out. There are also conflicting accounts of just what’s going on.

> Savings: too little or too much? On the face of it, zero saving sounds like a horrendous development. However, various economists give different accounts as to why it’s not such a bad thing.

One argument is that measures of personal savings underestimate actual savings because the data don’t capture items such as capital gains on assets. A research note published earlier this year by Waltham, Mass.-based economic research firm Global Insight, looking at a different measure of savings that captures these assets (the national balance sheet), says savings look much healthier. However, it notes, those savings are inherently more vulnerable to an asset price correction than, say, income-generated savings.

Second, as RBC argued in a report earlier this year, cyclical factors may keep savings rates low for the foreseeable future. Low inflation, low interest rates and a strong underlying economy (including strong employment markets) may all be tempering the perceived need to save. Not only that, it suggests that households have excess liquidity on their hands after shifting their financial assets away from equities in recent years.

Furthermore, there could be structural factors at play. Governments are generating surpluses, and many households may be feeling less need to save in anticipation of higher government spending and/or lower taxes, RBC says.

All of these factors suggest that low savings is indicative of a healthy underlying economy, robust government finances and strong consumer confidence.

Another line of reasoning, advanced by J.P. Morgan Securities Ltd. in a report earlier this year, is that there is actually a glut of global savings, thanks to much higher savings by corporations. North American households may not be saving much, but corporations are doing it for them.

It says household saving as a percentage of GDP is down 4.2% between 2000 and 2004 in Canada, but corporate saving is up 5.7% in that same period. The same trends are evident in the U.S., Japan, Britain and Australia.

“It is important to stress that the present situation is, in some sense, unnatural,” the report says. As populations age, it’s more typical to see households saving and corporations borrowing, not the other way around, it says. But corporations have been saving heavily in recent years, it argues, to pay off debt accumulated when their capital spending was heavy in the mid- to late 1990s. Households have also flipped to borrowing to take advantage of low interest rates.

If the lack of household savings isn’t a cause for concern, the prospect for a housing market bubble may be, particularly as much of the unmeasured household saving may be vulnerable to that bubble. Asset price bubbles are, by their nature, hard to predict until after they’ve popped. But, if nothing else, there appears to be a burgeoning bubble in bubble-watchers.

> The housing market bubble. Economists at both Bank of Montreal and TD Bank Financial Group recently released reports that aim to spot whether a housing market bubble is forming in Canada.

TD’s initial report finds little evidence of a national bubble despite the fact prices were up 8% across Canada in the quarter ended June 30 compared with a year ago, and they have gained 34% from their latest trough, back in 1998.

TD suggests the gains are justified by the underlying economic fundamentals and,
anyway, prices appear to be cooling.

That position is echoed by BMO, which says although housing prices are “currently in a range that have previously been associated with housing market bubbles, the recent rise in prices seems to reflect low interest rates rather than speculative activity, which characterized the late 1980s period.”

BMO also concludes the rise in housing prices in the past several years “does not reflect a housing market bubble but, rather, is an indication of strong underlying economic fundamentals.”

> The implications. If zero saving isn’t a problem, and there’s little evidence of a housing market bubble, then what about rising consumer debt? On that count, RBC sounds a similarly sanguine note: low interest rates are part of the story but, RBC contends, the shift reflects an overall decline in inflation expectations, as well as increased innovation by the financial services sector and fundamental changes in the nature of the workforce that require more flexibility in payments. Far from borrowing wildly to fund excessive consumption, it argues, the innovative new credit products are largely cannibalizing existing higher-cost products, such as credit cards, suggesting that households are managing their finances more efficiently.

RBC also suggests the trend can be expected to continue. “While there will always be cyclical variations that will cause some shifting in and out of floating vs fixed-rate products, we’re probably still in the early stages of a long-lived preference shift toward credit lines even if rates go up more than expected,” it predicts.

That means financial firms are going to be faced with more demand for flexible, innovative lending products. However, RBC adds, there’s also a greater need for financial advice.

“While households may be managing their finances more like corporations today,” the report says, “financial institutions must play the kind of role in guiding this change that is akin to the competent independent CFO of a small business in motivating sound choices.” IE