Mending Lending

Story Highlights:

• The Fed’s Senior Loan Officer Opinion Survey showed strong business loan growth, but middling consumer loan growth.
• Firms are increasingly using debt to finance growth, buoying overall economic activity.
• Consumer loan demand was more tepid, but consumption has stayed firm thanks to higher incomes.
• Low rates are squeezing banks’ margins and could pressure bank stocks even as other areas of the US market perform better.

Want a loan? You’re in luck! The Fed’s quarterly Senior Loan Officer Opinion Survey showed banks are healthier, lending capacity is high, and overall lending is improving.

Businesses have been quick to take advantage, as Commercial and Industrial (C&I) loan growth was especially robust in Q1. While lending is only just coming up off its post-2008 lows, recent increases show more firms are once again using debt to finance growth through inventory restocking and M&A. It’s a good tactic: Borrowing costs are low, and last week’s US GDP reports howed businesses are getting a great return on debt. In fact, rising private inventory restocking was the single biggest contributor to Q1’s GDP growth. As C&I lending continues growing, business components of GDP—this expansion’s main driver—should remain strong overall, though there’s always some ebb and flow.

Other areas of lending presented more of a mixed bag, with demand for some loans remaining subdued. In terms of household lending, demand for auto loans increased—no shock, with some lenders offering 0% financing and manufacturers desperate to move inventory. But demand for credit cards and other consumer lending vehicles was flat as households continued deleveraging. Even two years after the recession, some folks are still shunning debt. Yet consumer spending has been stronger than expected despite deleveraging. Why? Today’s consumption isn’t necessarily dependent on debt, as is widely believed. It’s driven by higher incomes, which also surpassed expectations. That said, if you think spending needs a shot in the arm, consider that continued improvements in labor markets could decrease some risk aversion and spur consumer demand for credit.

And banks will probably be increasingly keen to dole it out, as their reported willingness to lend is at a 17-year high. And why not? Banks have massive amounts of cash on the sidelines and are reporting improved economic outlooks and credit quality, leading to the easing of standards and terms for some loans. Overall, banks appear healthier, providing plenty of underlying support for further economic growth, both for companies and households.

However, banks still face headwinds as profit margins remain squeezed, which has and will impact their earnings. With interest rates still historically low, it’s hard for banks to markedly improve yields. Today’s prime rate is 3.25%—a bank seeking to improve its margins by charging 25 basis points above that risks losing business. It’s a competitive environment, and high quality borrowers are unlikely to pay what can be seen as a large premium relative to current rates. Moreover, banks can’t justify premiums, since subsiding fears over macroeconomic weakness mean less perceived lending risk, lowering the spreads required to compensate. Perversely, less risk coupled with high supply (including the hoarded cash) is driving banks’ margins lower even as demand increases.

Still, that big US banks’ profit margins aren’t great right now doesn’t curtail prospects for the US economy, nor does it mean US stocks in other sectors need feel a pinch. Over the last year, US Financials had flattish returns, but the S&P 500 was still up double digits. Indeed, the majority of S&P 500 companies reporting Q1 earnings thus far have beaten expectations, and revenues have shown nice growth.

Worries about banks’ muted profit margins are an interesting illustration of improved sentiment considering that only two years ago, few would’ve cared about such minutiae—expectations were so low, any profit margins would have been cheered. Today, investors are more selective, driving widening dispersion between investing categories; not a bad thing by any stretch—just a sign of a transitioning bull market in an ongoing growth cycle.