Key Takeaways:
- The “K-shaped” divide endures even as it evolves. Higher-income households keep benefiting from equity gains, home price appreciation, and solid earnings, while lower-income households face mounting pressure from elevated costs and tighter credit. But recent data suggest the story is becoming more nuanced.
- For investors, today's consumer credit stress looks idiosyncratic, not systemic. Subprime weakness traces largely to underwriting within specific 2022–2024 vintages rather than a broad decline in borrower quality, and – unlike 2008 – does not appear to pose systemic risks.
- Investors should favor discipline within consumer credit and other household-linked asset based finance investments. We believe investors looking to ABF today should favor high quality, seniority, vintage quality, and flexibility across collateral types rather than uncritical enthusiasm for the asset class or blanket caution.
Not all U.S. consumers are experiencing today’s economy the same way. Wealthier households continue to benefit from rising asset prices and solid earnings growth, while lower-income families are still absorbing the effects of years of elevated costs and tighter lending standards.
For investors navigating consumer-related credit and other household-linked investments, particularly within asset-based finance (ABF), this uneven economic backdrop – and how it’s evolving – matters. Today’s economic landscape has led us to favor select higher quality investments backed by consumers with strong balance sheets over subprime exposures and other areas of potential weakness.
See more: If Inflation Is the Problem, Why Aren't Wages?
ABF – a subset of private lending where investments are backed by specific collateral – also extends beyond consumer-related sectors, with other areas that can help investors diversify and mitigate consumer-specific risks.
A familiar divide, but with new wrinkles
The idea of a K-shaped or two-speed economy, where higher-income households pull ahead while lower-income households struggle to keep pace, has defined much of the post-pandemic expansion. But the latest data suggest the story is becoming more nuanced.
Higher-income households overall continue to benefit from the factors that have supported resilience throughout this cycle: strong equity markets, accumulated wealth, home-price appreciation, and healthy balance sheets. Household net worth as a percentage of disposable personal income is near the highest levels on record (see Figure 1). Wealthier households still account for a disproportionate share of consumption growth and remain an important pillar of overall economic strength.
Figure 1: Household net worth has risen as a percentage of disposable personal income
Meanwhile, the lower half of the income distribution remains pressured, although it is no longer deteriorating uniformly. Recent private-sector payroll and deposit-account data suggest wage growth among lower income earners has accelerated somewhat over the past year, narrowing a gap that had developed with higher earners. At the same time, employment gains have picked up in select lower-wage industries, including segments benefiting from the surge in AI-related infrastructure investment.
The result is an economy that remains bifurcated, but perhaps less cleanly than before. Rather than a simple divide between strong and weak consumers, the labor market increasingly appears characterized by pockets of strength alongside pockets of softness. Overall hiring remains subdued by historical standards, yet workers in certain industries continue to enjoy solid wage gains and employment opportunities.
That creates an unusual dynamic. Lower-income households are benefiting from some improvement in labor income, but many continue to face the cumulative effects of several years of elevated prices, depleted excess savings, and tighter credit conditions. Higher-income households, meanwhile, remain financially secure but may be more exposed to emerging risks associated with AI-driven disruption in white-collar employment.
An open question is whether AI ultimately narrows or widens these divides. Thus far, labor-market disruption has been concentrated in entry-level professional and technology-oriented occupations, while job growth in specialty trade construction has accelerated.
Evaluating risks and potential outcomes
For investors, the clearest signal of stress remains concentrated in subprime consumer credit. For example, 90-day delinquency rates on subprime auto loans have risen significantly in recent years even as the rate for prime auto loans has remained relatively stable (see Figure 2).
Figure 2: Delinquency rates for subprime auto loans have risen sharply relative to prime auto loans
As seen in subprime auto loan asset backed securities (ABS), a meaningful share of the increase in subprime consumer delinquencies over the past several years traces back to underwriting quality within specific 2022–2024 vintages – loans originated when competition for volume was intense – rather than a broader decline in borrower credit quality. Underwriting has since tightened, and outside of subprime, performance has been comparatively stable.
It’s worth considering whether today’s subprime weakness is a leading indicator of broader stress to come, or whether any broader stress would require an exogenous catalyst – a genuine labor-market shock, or an abrupt end to the AI capital-expenditure cycle – to materialize.
We do not think weakness in subprime lending today poses a similar risk to the broader economy as the subprime mortgage crisis did in 2008. We do not expect this cycle to replay that period, when balance-sheet weakness itself caused the crisis. Today’s pockets of stress look more contained and idiosyncratic.
But that view is worth testing, and we would grow more concerned if labor-market softening broadened beyond entry-level and AI-exposed roles into more durable job losses across income cohorts, or if higher-income households’ balance sheets – the segment currently offsetting weakness at the bottom of the K – came under pressure.
The investment opportunity
The overall resilience of the economy hides divergence and nuance underneath. That argues for being more selective when deploying capital within consumer credit and ABF, especially as some investors question whether today's tight spreads signal market complacency.
The good news: Today’s deals offer robust structural features designed to help mitigate downside risks. Even at today's tight spreads, it would take a much worse downturn than we expect to impair senior tranches.
PIMCO prefers to focus on the upper part of the K-shaped economy rather than the entirety of the consumer credit landscape. We favor specific, high-quality pockets where access to differentiated credit research and consumer data can unlock advantages for investors.
Prime and super-prime borrowers continue to perform well, with broadly stable-to-improving credit trends. Following the 2023 regional bank failures, many banks became more selective in consumer lending, creating financing gaps even among higher-quality borrowers. Spreads in this segment remain wider than historical fundamentals would indicate, largely due to the diminished footprint of banks.
With pressure concentrated in lower-income, payment-sensitive cohorts, we prefer to avoid subprime consumer credit, limiting exposure to the weakest borrowers.
In addition, ABF offers opportunities beyond consumer lending. Aviation finance, litigation finance, and music royalties are a few examples where hard assets and upfront, contractual cash flows make returns less tied to the business cycle than corporate credit or lower-quality consumer loans. Diversifying across these areas helps investors avoid over-reliance on consumer credit or any single collateral type.
Disclosures
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investments in asset-based lending and asset-backed instruments are subject to a variety of risks that may adversely affect the performance and value of the investment. These risks include, but are not limited to, credit risk, liquidity risk, interest rate risk, operational risk, structural risk, sponsor risk, monoline wrapper risk, and other legal risks. Asset-backed securities across various asset classes may not achieve business objectives or generate returns, and their performance can be significantly impacted by fluctuations in interest rates. Investments in residential and commercial mortgage loans, as well as commercial real estate debt, are subject to risks that include prepayment, delinquency, foreclosure, risks of loss, servicing risks, and adverse regulatory developments. These risks may be heightened in the case of non-performing loans. Investments in mortgage and asset-backed securities are highly complex instruments that may be sensitive to changes in interest rates and are subject to early repayment risk. Structured products, such as collateralized debt obligations, are also highly complex instruments that typically involve a high degree of risk; the use of these instruments may involve derivative instruments that could result in losses exceeding the principal amount invested. Private credit involves investments in non-publicly traded securities, which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Additionally, investments in private credit may be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control. Investing in banks and related entities is a highly complex field subject to extensive regulation, and investments in such entities may give rise to control person liability and other risks. Investing in distressed loans and bankrupt companies is speculative, and the repayment of default obligations contains significant uncertainties. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Collateralized Loan Obligations (CLOs) may involve a high degree of risk and are intended for sale to qualified investors only. Investors may lose some or all of their investment, and there may be periods during which no cash flow distributions are received. These investments are exposed to risks such as credit, default, liquidity, management, volatility, interest rate, and credit risk. AI Sector Risk. Investments with exposure to the artificial intelligence sector may involve heightened risks, including rapid technological change, competitive disruption, elevated valuations, regulatory uncertainty, data privacy and cybersecurity concerns, infrastructure dependencies, and reliance on third-party models or platforms. AI-related opportunities may not develop as expected, fail to produce anticipated productivity or revenue benefits, or be concentrated among a limited number of issuers, and could result in increased volatility or loss of capital.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.
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