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The latest quarterly report on Household Debt and Credit by the Federal Reserve Bank of New York shows that household sector deleveraging continued in the second quarter of 2012. Household debt has now declined by 1.3 trillion from its peak in the third quarter of 2008.

This article looks into the important numbers in the credit report, the areas of concerns and the investment strategy in an environment of deleveraging.

The first chart gives the total debt balance for households and its composition as of Q2 2012.

(click to enlarge)

After peaking out in the third quarter of 2008, all categories of debt outstanding have declined except the student loan. The total outstanding student loan has increased by USD300 billion during this period to USD914 billion. I am of the opinion that the student loan can be a potential problem for banks in the future with relatively high level of unemployment.

The credit card loan balances also deserve a mention as the loan currently stands at USD672 billion (the lowest since the second quarter of 2002). This is reflective of the fact that consumers are increasingly cautious when it comes to spending on credit.

At the same time, consumers seem to be managing their cash flows relatively well with credit card delinquencies at the lowest level (10.9%) since the fourth quarter of 2008.

I am also of the opinion that the process of deleveraging will continue in the foreseeable future. Credit inquiries within six months (an indicator of credit demand) decreased for the second consecutive quarter. This is reflective of the point that individuals are not leveraging even in a low interest rate environment.

Coming to the potential problems for the banking system, the percentage of 90+ day delinquent loans were at 6.71% during the second quarter. This translates into nearly USD740 billion of seriously delinquent loans.

Clearly, the problems in the banking system are far from over. In line with this, banking stocks should be avoided for long term, with the economy expected to remain sluggish for an extended period.

Having said this, the percentage of seriously delinquent loans has declined from a high of 8.71% in the first quarter of 2010 to 6.71%.

(click to enlarge)

I had mentioned earlier about student loan being a potential problem in the future. The percentage of 90+ days' delinquent loans has been ticking up for student loan when seriously delinquent loans for almost all other categories have been on a decline. It remains to be seen if this worrying trend continues for the next few quarters for student loan.

Investment Strategy in a Household Deleveraging Environment

With a weak economic scenario and a weak job market, the household deleveraging is expected to continue in the medium term.

With consumption not expected to be robust, I would focus on stocks or ETFs providing exposure to necessities such as healthcare and consumer staples.

The Vanguard Health Care ETF (NYSEARCA:VHT) is an interesting investment option. The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the health care sector. The ETF has a higher exposure to the pharmaceuticals sector followed by the biotechnology and health care equipment sector. The ETF has a low expense ratio of 0.19% and an SEC yield of 1.85%.

The Vanguard Consumer Staples ETF (NYSEARCA:VDC) can also be considered for long term. The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the consumer staples sector. The ETF has a higher exposure to the soft drinks segment followed by the household products and tobacco segment. The ETF also has a low expense ratio of 0.19% and a relatively high SEC yield of 2.64%.

Source: Household Deleveraging Continued In Q2 2012