Consumer debt bubble and you

The U.S. economic recovery is well underway. So we can sit back and watch our investment portfolios grow steadily – right?

Not so fast. There’s still the pesky issue of a record-high consumer debt-to-income ratio blemishing the otherwise sparkling visage of the equity market landscape, particularly in Canada. The issue is by no means trivial: the consumer debt bubble may have a negative and lasting impact on corporate profits – and investor returns – for years.

The truth is, North Americans have been living beyond their means for decades, but it looks like the party may be over. American consumer savings rates are up significantly, to more than 5% of net disposable income, after hitting virtually zero just before the recession started in August 2007.

This means Americans are spending less and, for the first time in a generation, actually working to reduce their debt load, which doesn’t bode well for the corporate profit machine that relies on consumers.

Compounding the issue is the fact interest rates have nowhere to go but up, which provides even more incentive to consumers to focus on paying down debt.

Here in Canada we like to think we’ve been largely sheltered from the global economic storm. However, you only have to glance at recent statistics released by the Vanier Institute of the Family to see Canadian consumers are playing a game of Russian Roulette when it comes to family finances. The average Canadian family is now carrying a debt load of $100,000, and their debt-to-income ratio stands at a record 150%.

The Institute also says this ratio has been steadily climbing for the past 20 years. In 1990, average family debt stood at $56,800, with a debt-to-income ratio of 93%. The $100,000 figure represents a real increase of 78% over the past two decades.

The sad truth is Canadians’ debt-to-income ratio is now higher than Americans’ for the first time in a dozen years. In fact, Canada’s household debt hit a record of just over $1.5 trillion in December.

In the U.S., the Federal Reserve tracks the Household Debt Service Ratio or DSR, similar to our debt-to-income ratio. The fourth quarter of 2010 marked the seventh consecutive quarter the U.S. household DSR had fallen, returning to levels not seen since the end of the 1990s.

Americans are saving more of their money and, despite the almost desperate pleadings of the government to get people to spend money on more stuff, are taking tentative steps towards paying down their household debt.

The difference between Canadian and U.S. consumers is pronounced. However, Canadians are extremely vulnerable to any new economic shocks that may materialize, like runaway energy and food prices. And while we aren’t likely to suffer as long and hard as our neighbours to the south have, we may yet get steamrollered by our own economic hubris.

What’s the potential impact on investors’ portfolios? While the recovery in the U.S. is reflected in the recent performance of the equity markets, there are still enough trouble spots within the U.S. and global economies to warrant a go-safe approach.

North American equities, particularly those whose profits are driven by consumer demand, may well be close to being overbought. Of course, commodity prices keep rising, but there are danger signals on the horizon for many of these, too. Bonds still hold appeal, but even here the yield on many products may not adequately reflect the associated risks.

An investment approach guided by the sound principles of risk-minimization and capital protection will always point investors in the right direction. It may not be sexy or hip, but for most people, neither is losing your shirt.