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As we navigate an increasingly challenging environment, fintech stocks are already pricing in a combination of recession and/or long-term growth impairment, in our view. However, even in a recession, we believe many of these stocks are quite cheap versus both their own history and in absolute terms. Though every company will be impacted if a recession happens, we expect several areas of fintech (the payments industry, in particular) will be affected less than what is implied by current valuations.
In this piece, we explore the current environment for fintech and highlight a few factors that show why the outlook for payments and other related subindustries may be less challenging than many may anticipate.
A recession impacts real consumption, which is the base layer of payments industry growth. We think about a decline in real personal consumption expenditure (PCE) as a relatively linear decline in growth across consumer payments companies. For example, a 400-basis point (bps) decline in real PCE should have a similar 400-bps growth impact on a payments company growing 20% and a payments company growing 8%. All else equal, growth would shift down to 16% and 4%, respectively.
Notably, however, historical consumption data going back more than 60 years helps to show why we expect payments industry growth to be relatively resilient even as consumer spending likely weakens over the next several quarters. On a rolling 12-month basis since 1960, the only period that saw declining nominal consumer spending was the global financial crisis (GFC). Nominal spending grew through every other recession/macro crisis since 1960.1 That fact holds true on a monthly basis as well.
Large-cap/mature growth payments stocks have outperformed the broad market year to date, but we do not think the market is engaging with the idea that these businesses will have durable (albeit slower) growth even in a consumer recession. All-time-low valuations coupled with these businesses growing at reasonably attractive rates even in a recession represents good value in our opinion.
Importantly, today’s inflation environment could be a positive for the payments industry as revenue is generally tied to the price consumers pay — nominal transaction volumes. Therefore, high nominal inflation likely improves the industry’s outlook as inflation could offset real PCE declines for most payments companies. For instance, a 6% inflation, 0% real PCE growth world is better for a payments company’s top-line growth than 2% inflation, 2% real PCE growth.
The goods/services spending dynamic is another significant factor in a potential recession as the composition of spending is almost as important as headline nominal PCE growth. The payments industry is more levered to services than goods spending, which we expect should hold up better than aggregate consumer spending in a slowdown. In addition, the ratio of services to goods is still recovering to its normal 55/45 split, which should be a continued, moderating tailwind aiding payments industry growth.
The growth differential between services and goods generally favors services, which is a trend that could be exacerbated by the amount of spending that took place on goods over the past two years. Moreover, some buckets of “discretionary” spend behave in a less discretionary way than one may think. For instance, the worst restaurant spending environment from 1992 to 2019 over any rolling TTM period was -1% growth.2 Going out to eat seems like the ultimate discretionary item, but that is not how consumers have treated it historically. If nominal PCE is 2% next year, it is possible we will have normal services spending and a goods spending depression, which on balance would be better for the payments industry.
Employment is another key macro factor for the industry, particularly for payroll companies and credit bureaus. There is a linear relationship between employment and payroll growth, similar to real PCE for payments companies.
Importantly, the average increase in unemployment over 10 historical economic cycles was 3.7% and the average unemployment rate at the high point was 7.8%.3 Adding 400 bps to the current unemployment rate would get us to about 8%. In our view, that 400-bps headwind would have a reasonably linear impact on payroll industry growth.
In a related area of fintech, employment also matters for credit bureaus as a second-order impact, as it is a key predictor of credit delinquency. However, in our view, the bureau stocks are miscast as being pure plays on the credit cycle as we estimate less than half of their business today is what we would think of as the legacy bureau. We expect growth would be more resilient than market expectations in a recession, but we do not think the stocks will engage with that narrative until we start to see proof if/when there is a consumer recession.
Offsetting most of the earnings impact from higher unemployment in the payroll industry is higher interest rates. Many payroll companies have significant investment portfolios that invest tax receipts in short-duration, high-quality fixed income instruments. The investment strategies vary by company, but we would expect the payroll industry to see the benefit of rising interest rates by the end of 2024 at the latest.
In fact, many payroll companies will likely begin to see the benefits of rising rates in the second half of 2022. Notably, though investors do not assign the same multiple to float income as other sources of earnings, we think having that earnings revision cushion available is a unique positive in this environment.
The rising risk of a recession has proven challenging for much of the fintech market. However, we believe the payments industry has a more nuanced outlook than current valuations imply. In our view, there are many aspects of payments and other related subindustries that may be more resilient in a recession than many investors expect, creating potential investment opportunities.
1Data as of 21 June 2022. Sources: St Louis Federal Reserve and the US Bureau of Economic Analysis. | 2ibid. | 3Data as of 21 June 2022. Sources: St Louis Federal Reserve and the US Bureau of Economic Analysis. Economic cycles referenced include 1949, 1954, 1958, 1961, 1971, 1975, 1982, 1992, 2003, and 2009.
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