Declared “Public Enemy No. 1” in 1974 in the United States, inflation continues to drastically affect consumers and businesses today at its historically high levels. In this article, we first take a closer look at how rising inflation relates to consumer & business credit losses and interest rates. We demonstrate how inflation can also become a “private” enemy for investors by decreasing the values of assets they hold. As an example, we compare the prices of Euro Area consumer & SME marketplace loans under a base scenario and an inflationary stress scenario where default rates and discount rates both increase.

Introduction

Inflation is the rate of increase in prices over a certain period, usually a year. It is calculated as the percent change in the price index of a basket of goods and services commonly consumed by households. Positive inflation refers to an overall increase in the price level and cost of living in an economy and means a decline in the purchasing power of the money.

Since the beginning of 2021, inflation has been rising in many countries worldwide (Figure 1). In November 2021, the annual inflation was recorded at historically high levels in major economies:

• US: 6.8%, highest inflation since 1982 [1]
• Eurozone: 4.9%, highest inflation since 1997 [2]
• UK: 5.1%, highest inflation in a decade [3]

Figure 1: Inflation across the world. Source: OECD

Three main factors drive the increase in inflation [4]:

• A pickup in the economic activity boosted by accommodative pandemic-related support policies, rebound in consumer demand, and release of excess savings accumulated during the pandemic following the reopening of the economy.
• Rapidly rising commodity and house prices and particularly surging energy prices since the start of 2021. The year-on-year change in energy prices in the Eurozone was 23.7% in October 2021 (Figure 2). Energy price inflation also spreads to other items in terms of higher costs.
• Input shortages and supply chain disruptions due to the COVID-19 pandemic, exacerbated by the emergence and the spread of new variants, led to an increase in producer prices.

Figure 2: Inflation in the Euro Area – Components. Source: OECD

To tackle high rates of inflation, both the Fed [5] and the ECB [6] adopted a new course of action at their last meetings of 2021. Both central banks decided to end the pandemic-era bond purchases in March 2022 and to double the pace of tapering while raising their inflation projections for 2022. However, the inflation outlook is still significantly uncertain due to the threat of prolonged supply chain bottlenecks; commodity, housing and food price pressures, the fast-spreading Omicron variant of COVID-19, and new pandemic lockdowns [7]. In its latest World Economic Outlook, the IMF emphasized that inflation could stay elevated in 2022, with the aforementioned uncertainties increasing worries about persistently high inflation [8].

High and increasing rates of inflation, combined with the rolling back of pandemic support programmes, could considerably disrupt financial markets. During such periods of inflationary pressures, asset holders can benefit from maintaining an up-to-date accurate valuation of their portfolios and quantifying their portfolios’ inflation risks. Accurate valuations allow asset holders to weather market developments by arming them with information that allows them to timely identify vulnerabilities within their portfolios and to highlight opportunities to exit mispriced assets [9]. In addition, having a clear view of the impact of inflationary shocks on the price of their portfolios provide valuable insights to asset holders facing today’s uncertain economic outlook.

In the rest of this article, we assess the potential performance of marketplace loan portfolios under a stress environment of increasing inflation. We first examine how rising inflation relates to consumer & business credit losses and interest rates to derive stress assumptions. Later, we investigate the effect of an inflationary shock on the fair prices of European consumer & SME loans through a default rate shock and a mark-to-market impact. We calculate the change in prices from the base scenario and illustrate the average changes by risk grade and remaining term.

Inflation and Credit Losses

For consumers, inflation means an increase in the cost of living and a decline in purchasing power. The prices of goods and services typically change faster than wages, as wages are established by long-term contracts and tend to be sticky in the short term. In an inflationary environment, unevenly rising prices inevitably reduce consumers’ budgets [10] and therefore decrease their ability to serve debt obligations. For businesses, inflation means an increase in input costs. The effect of inflation on revenues depends on the extent businesses can pass on higher costs to prices, the impact of higher costs on their production, and the interplay between supply and demand conditions in the market.

We take a look at the historical data on inflation and credit losses to derive their relationship. Figure 3 shows the bank nonperforming loan (NPL) ratios and the 2-year lagged inflation in the Euro Area. We observe that lagged inflation and bank NPL ratios co-move, especially between 2011-2017 in Italy and Spain. The use of available savings to repay the loans might explain the lag in the co-movement.

Figure 3: Bank Nonperforming Loans Ratio and Inflation (2-year lag) – Euro Area. Source: World Bank

A stronger correlation between lagged inflation and credit losses is observed in the US credit market: Figure 4 illustrates the charge-off and delinquency rates on consumer & business loans and the 2-year lagged inflation in the US between 1987-2021. We observe that lagged inflation and credit losses follow a similar trend with upticks coinciding in the crisis periods of 1991, 2001-2002, 2008-2009 and the beginning of the COVID-19 pandemic in 2020.

Figure 4: Charge-off and Delinquency Rates on Consumer & Business Loans vs Inflation (2-year lag) – US. Source: Board of Governors of the Federal Reserve System, retrieved from FRED

An increase in credit losses lowers the cash flows investors receive, leading to a decline in the prices of assets they hold. To quantify the shock to credit losses in inflationary periods, we scatterplot the 2-year changes in charge-off rates on consumer & business loans and lagged inflation in the US between 1987-2021. Figure 5 shows the positive association between lagged inflation and credit losses: A 100 bps increase in lagged inflation corresponds to a 19 bps and 23 bps increase in default rates in 2 years, for consumer and business loans respectively. The beta coefficients in both regressions are statistically significant with p-values lower than 5%. However, it is important to highlight that these regressions do not fully reflect the relationship between inflation and credit losses since inflation is not the sole driver of credit losses. Credit losses are affected by multiple factors omitted in this analysis, including but not limited to macroeconomic conditions, economic cycles, unemployment rates and idiosyncratic borrower conditions.

Figure 5: 2-year Change in Charge-off Rate on Consumer & Business Loans vs 2-year Change in Inflation (2-year lag) – US. Source: Board of Governors of the Federal Reserve System, retrieved from FRED, LoanClear

Inflation and Interest Rates

The Fisher Effect describes the relationship between expected inflation and interest rates: nominal interest rates tend to follow the changes in expected inflation. As inflation depreciates the purchasing power of future nominal cash flows, banks and other lenders raise the nominal interest rates on newly issued loans in line with the expected inflation. Figure 6 plots the bank interest rates on consumer & business loans and inflation in the Euro Area. We observe that inflation and interest rates share a common trend particularly between 2006-2015.

Figure 6: Interest Rates on Consumer & Business Loans and Inflation – Euro Area. Source: ECB, Board of Governors of the Federal Reserve System, retrieved from FRED

Prices of existing fixed-income securities fall when the interest rates on newly issued securities increase since their projected cash flows will be discounted at higher rates. To quantify this mark-to-market impact, we scatterplot the 1-year changes in interest rates on consumer & business loans versus the 1-year change in inflation in the Euro Area between 2006-2015. Figure 7 shows a positive relationship between inflation and interest rates: A 100 bps increase in inflation coincides with a 15 bps and 23 bps increase in interest rates in 1 year, for consumer and business loans respectively. The beta coefficients in both regressions are statistically significant with p-values lower than 1%. We should however note that other factors such as credit risk, market conditions, and real interest rates also affect the nominal interest rates and are not controlled for in this analysis.

Figure 7: 1-year Change in Interest Rate on Consumer & Business Loans vs 1-year Change in Inflation – Euro Area (2006 - 2015). Source: ECB, Board of Governors of the Federal Reserve System, retrieved from FRED, LoanClear

Valuation under Base and Stress Scenarios

Having discussed how credit losses and interest rates are linked with inflation, we proceed with a practical example of the potential impact of inflationary shocks on the prices of loan portfolios through a default rate shock and a mark-to-market impact. Following a discounted cash flow methodology, we value Euro Area marketplace consumer & SME loans under a base scenario, and under an inflationary stress scenario where default rates and discount rates both increase. The data is retrieved from two leading marketplace loan platforms active in several jurisdictions with high lending volumes and market shares in Europe. Loans that we value were originated between 2015-2021, and are amortizing, denominated in euros, and currently performing.

To determine the magnitude of default rate and discount rate shocks under the stress scenario, we first assume a degree of potential absolute change in inflation. Assuming that the inflationary trend continues and by calculating the average yearly change in inflation in the Euro Area between January-October 2021, we approximate a 180 bps increase in inflation for the stress scenario. To calculate the default rate shock for each risk grade, we assume an average of 20 bps increase in default rates (in 2 years, per 100 bps increase in inflation), which is then scaled by the average annual bank NPL ratio of 4.84% in Euro Area between 2005-2020. We assume an average increase of 36 bps in interest rates (in 1 year, 20 bps increase per 100 bps increase in inflation) added as a margin to discount rates. Our analysis is supported by assumptions that align with our prior findings but is limited as we keep prepayment and recovery rate assumptions unchanged in the stress scenario.

We value the loans under the base and the stress scenarios and calculate the deltas in dirty prices by subtracting the base dirty prices from stressed dirty prices for each loan in the portfolios. Figure 8 shows the average dirty price deltas by risk grade and remaining term for consumer & SME loans. We observe the adverse effect of inflation on the prices as the average price deltas are negative across all cohorts. On a portfolio level, average dirty prices dropped by 43 bps and 45 bps under the stress scenario, for consumer and SME loans respectively.

Figure 8: Consumer & SME Loans – Average Dirty Price Delta (Stressed Price - Base Price). Source: LoanClear

Figure 8 also shows two heterogeneities in the average price deltas across cohorts: Riskier loans tend to be more sensitive to the inflationary scenario due to relatively higher default rate shocks. Secondly, the average decline in prices is more severe with higher remaining terms, as more cash flows are discounted at higher rates. However, these patterns are not strict as the impact can be distorted by coupon rates, where cohorts with higher weighted average coupon rates are less affected by an increase in interest rates.

Conclusion

2021 was a year marked by historically high and increasing inflation levels across the globe. Inflation profoundly hurts consumers and businesses, and investors holding fixed-income securities in their portfolios. In this article, we first evaluate how rising inflation relates to rising default rates and interest rates. Subsequently, we value Euro Area marketplace consumer & SME loans under a base scenario, and under an inflationary stress scenario where default rates and discount rates both increase. Through these effects, we show that asset prices decline under rising inflation, where the decline in prices is more severe with increasing risk and remaining term. Inflation is expected to remain elevated in 2022 with considerable uncertainty surrounding its outlook. Quantifying the inflation risks in their portfolios will therefore continue to be crucial for investors.

References

[1] The Guardian, US inflation rate rose to 6.8% in 2021, its highest since 1982

[2] The Guardian, Inflation in eurozone soars to 4.9% - highest since euro was introduced

[3] The Guardian, UK inflation soars to 10-year high of 5.1%

[4, 8] International Monetary Fund, World Economic Outlook October 2021

[5] Reuters, Fed signals three rate hikes in the cards in 2022 as inflation fight begins

[6, 7] Reuters, ECB dials back stimulus in tense meeting

[9] LoanClear, Asset Performance under Periods of Stress

[10] International Monetary Fund, Inflation: Prices on the Rise

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