Monetary indicators continue to move away from levels associated with recession risks in the Euro Area.
Narrow money (M1) grew 8.4% in nominal terms in October, up from 7.9% in September. In real terms, M1 grew 7.6% which is the fastest rate of real growth since October 2017 (8.0%) and compares with a real growth rate of only 4.7% in January this year. Given the leading indicator qualities of trends in real M1, this data supports the narrative that recession fears in the Euro Area have been overdone.
Households and corporates are also increasing their borrowing at the fastest rates in the current cycle. HH credit (a co-incident indicator) grew 3.5% in nominal terms and 2.8% in real terms, the fastest rate of real growth since April 2008. NFC credit (a lagging indicator) grew at 3.8% in nominal terms and 3.1% in real terms. The real growth was marginally below the level of 3.2% recorded in August 2019, but again these rates are the highest real growth rates since June 2009.
Of course, credit growth remains relative subdued in relation to LT trends and concentrated geographically (HH in France, Germany, Benelux and Italy; NFC is France, Germany and Austria) and the demand for credit continues to lag the supply of money which indicates that the Euro Area has still to recover fully from the debt overhang (see graph below).
A simple conclusion
Nonetheless, the message from October is simple: current monetary trends remain inconsistent with recession fears in the Euro Area
Please note that the summary comments above are abstracts from more detailed analysis that is available separately
The PBOC published its annual Financial Stability Review (2019) this week in which it highlighted the risks associated with the rapid accumulation of household (HH) debt in China. It noted that, “the debt risks of the household sector and some low-income households in some regions are relatively prominent and should be paid attention to.” (Financial Times, 2019). This supports my recent analysis of debt sustainability in Asia, in which I concluded that “relatively high excess HH growth rates in India and China remain a key focus point.“
I understand* that the PBOC’s analysis considers the period up to the end of 2018. In this post, I analyse how these risks have developed over the first three quarters of 2019 and conclude that they remain considerable. China’s HH debt ratio has risen further during 2019, with HH credit growing 9ppt faster than GDP on a three year CAGR basis. The rate of “excess credit growth” has moderated very slightly, but is still of concern given that China’s HH debt ratio (56%) is now close to the average HH debt ratio (60%) for all BIS reporting countries.
My analysis highlights two key points: (1) the level of debt needs to be considered in relation to its rate of growth (and its affordability and structure); and (2) even, in the most benign outcome, China’s increasing HH debt burden represents a key headwind for economic growth and the transition to a consumption-driven economy.
(* n.b. I have been unable to find an English version of the 2019 FSR, so my comments on its content here are based on secondary sources)
A review of last month’s analysis
Last month I concluded that:
“In summary, the risk associated with excess credit growth across EM are lower than in previous cycles. Asia stands out, however, because the highest rates of growth have occurred in economies that already have high debt ratios. In China and Hong Kong, these risks are compounded by high debt service ratios indicating rising “affordability” risks. RGFs in both economies are adjusting sharply lower in response. Risks in intermediate and emerging Asian economies appear lower, but the relatively high excess HH growth rates in India and China remain a key focus point.“
2019 update (as at end 3Q19)
HH credit has continued to grow strongly YTD. The average monthly YoY growth rate was 17% in nominal terms over the first nine months of 2019. This compares with an average of 19% for the full year 2018. HH credit growth continues to exceed nominal GDP growth – by 8ppt in 3Q19. As highlighted above, this is despite the fact that China’s HH debt ratio of 56% (3Q19 estimate) is closing rapidly on the average HH debt ratio for all BIS reporting economies.
Experience suggests that the key risk here is less to do with the level of debt and more to do with its rate of growth. In “Sustainable debt dynamics“, I introduced the simple concept of relative growth factor (RGF) analysis that I have used since the 1990s as a first step in analysing the sustainability of debt dynamics. In short, this approach compares the rate of “excess credit growth” with the level of debt penetration in a given economy. Red flags are raised when excess credit growth continues in economies that exhibit relatively high levels of leverage.
The trend in China’s HH RGF is illustrated in the chart above (rolling 3Y basis). The rate of excess HH credit growth has slowed in relation to recent history but remains unsustainably high in absolute terms, in my experience. At the recent peak, HH credit was growing 11ppt faster than nominal GDP (4Q17), hence the steep gradient in the earlier chart illustrating the HH debt ratio. As at the end of 3Q19, my estimates suggest that this excess growth rate has slowed to 9%.
Conclusion
As a macro and monetary economist, I start by analysing the level of debt in absolute terms and in the context of its rate of growth, affordability and structure. In my experience, this is the most important feature of the LT secular investment outlook with direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options investment risks and asset allocation.
The risks associated with excess HH credit growth in China remain elevated and this analysis presents a relatively extreme example of the importance of considering the level of debt together with its rate of growth. History suggests that current trends in China are unsustainable. The most benign outcome is that the rate of growth in HH borrowing slows more rapidly with negative implications for consumption and aggregate demand. In short, China’s increasing HH debt burden represents a key headwind in the transition to a consumption-driven economy.
Please note that the summary comments above are abstracts from more detailed analysis that is available separately
The FSR is suitably cautious, but misses a key chart
The key (missing) chart
Summary
The ECB published its November 2019 Financial Stability Review (FSR) this week with a suitably cautious outlook for financial stability, economic growth, and banking sector profitability in the euro area (EA).
The analysis is as insightful and thorough as usual and supports many of my current views. However, it “falls short” in one key respect – the FSR presents its analysis through the traditional household (HH) versus corporate (NFC) framework, rather than through the increasingly more relevant COCO versus FIRE-based credit framework.
The risk here is that it underplays the hidden risks in QE, namely that the majority of credit in the EA is directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit. As such, current policies to support/stimulate credit demand have potentially negative (if unintended) implications for leverage, growth, stability and income inequality.
Key messages from the FSR (Nov 2019)
The FSR states that the “the euro area financial stability outlook remains challenging“. It highlights four key issues:
Signs of asset mispricing suggest potential for future correction
Lingering private and public sector debt sustainability concerns
Growing challenges from cyclical headwinds to bank sector profitability (“75% of EA significant banks have ROE < 8%”)
Increased risk-taking by nonbanks may pose risks to capital market financing
In mitigation, the FSR notes that: (1) euro area banks are adequately capitalised with a 14.2% CET1 ratio; and (2) all Euro Area countries have activated macroprudential measures. Nonetheless, it concludes that “more active use of macroprudential policies could be appropriate to contain vulnerabilities“.
The FSR argues that the economic outlook has deteriorated and that growth is expected to remain subdued for longer, with risks tilted to the downside. It also concludes that “while the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain“. Four headwinds facing banks are cited: eroding interest margins; slightly higher costs of risk; high cost inefficiencies, and plateauing capital positioning.
I have covered many of these factors in recent posts including:
The FSR presents its analysis of the HH and NFC sector separately. The HH sector is discussed in Section 1.3 (Euro area household resilience supported by low interest rates) and the NFC sector in Section 1.4 (Emerging pockets of corporate sector vulnerability).
In summary, the FSR describes HH lending as “robust, with continued divergence across countries and types of loans”, HH indebtedness stable (with considerable heterogeneity across EA countries) and risks to HH debt sustainability contained. My comments:
HH credit is growing at the fastest rate in the current cycle (3.4% nominal and 2.6% real YoY growth) but rather than robust, I would describe this growth as relatively subdued especially in relation to historic cycles
As noted in previous posts, and illustrated in the graph above, HH growth is concentrated in Germany, France and the Benelux
In “Debt dynamics in the developed world” I agreed with the conclusion that excess credit growth risks in developed economies were relatively contained (and limited largely to non-EA countries such as Norway, Switzerland, Canada and Sweden, see graph below).
In the NFC sector, the FSR highlights the deceleration in corporate profits, along with increases in external financing and slightly elevated corporate indebtedness, but suggests that risks are offset by favourable financing conditions and large liquidity buffers.
I would suggest that this underestimates risks in this sector:
The NFC debt ratio (% GDP) is currently 105% in the EA, above the 94% average for all BIS reporting countries and the BIS maximum threshold level of 90%
At the country level, only Italy, Germany and Greece have NFC debt ratios below the BIS threshold
My analysis also highlights relative high “growth” and “affordability” risks in the French NFC sector.
An alternative framework
In September, I presented an alternative framework for analysing global debt dynamics. I argued that, in its broadest sense, lending can be split into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO”-based lending (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE”-lending (FInancials and Real Estate).
In short, COCO-based lending typically supports production and income formation, while FIRE-based lending typically supports capital gains through higher asset prices. Lending in any economy will involve a balance between these different forms, but to repeat the key point from September: a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.
Over the past twenty years, FIRE-based lending has increased from 48% of total loans to 55% as at the end of September 2019. The current level represents the highest share of FIRE-based lending. Only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending: Greece; Austria, and Italy.
Why does this matter?
The hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.
Leverage: while COCO-based lending increases absolute debt levels, it also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage
Growth: similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly
Stability: the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers. The FSR notes that house prices rose faster than GDP in 1H19 and highlights signs of overvaluation, which now exceeds 7% on average, “but with a high degree of cross-country heterogeneity” (see graphs below)
Inequality: the returns from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.
Conclusion
The FSR’s outlook for financial stability, economic growth and bank sector profitability is in-line with the views expressed in my recent posts (albeit with some differences in emphasis). However, the hidden risks associated with the ECB’s unorthodox monetary policy are potentially understated, in my view.
The alternative framework presented here, that draws the distinction between productive COCO-based lending and unproductive/less-productive FIRE-based lending, provides a clearer perspective of these risks.
The on-going shift in the balance of lending in the Euro Area has negative implications for leverage, economic growth, financial stability and income inequality.
Please
note that the summary comments above are abstracts from more detailed analysis
that is available separately.
In early September 2019, I outlined the five key “macro building blocks” that drive bank sector profitability and share price performance (see “Macro building blocks matter”– look at the SX7E). I highlighted how they had weakened significantly during 2019, and noted how this had been accompanied by poor absolute and relative performance of the SX7E index of leading European banks over the previous twelve months.
Since then, the SX7E index has risen 26% from its 15 August low of 77 to a recent high of 97, before falling back to 93 currently (6% lower than 12 months ago). In this short update, I consider this performance in the context of my macro building block framework to ask: is this a relief rally or the start of a period of sustained recovery and share price outperformance?
Macro building blocks recap
In developed economies, I focus primarily on five key “macro building blocks” that drive bank sector profitability and share price performance:
growth in real GDP
growth in private sector credit
the level of ST rates
the level of LT rates
the shape of the yield curve
Net interest income – the main value driver for most banks – has a positive relationship with GDP, the level of rates and the shape of the yield curve. The level of ST rates is more important for banks in “floating rates” economies and market segments. In contrast, the slope of the yield curve is more important for banks in “fixed rate” economies and market segments.
In the Euro Area, 63% of new loans to HHs and NFCs are based on variable rates but only 18% of mortgages (down from 58% in November 2004). This means that EA banks are affected by both the level of ST rates and the slope of the yield curve.
Non-interest income – the second key value driver – has a positive relationship with GDP but a negative relationship with the level of ST rates, while provisions have a negative relationship with GDP and a positive relationship with the level of ST rates.
Building blocks revisited
Real GDP growth has slowed from the recent high of 3.0% (4Q17) to 1.1% (3Q19), the weakest rate of growth since 4Q13 and below the region’s twenty year average of 1.4%. All of the major Euro Area economies are growing below their LT averages with the exception of Spain and Portugal.
The European Commission revised down its 2019e, 2020e and 2021e GDP forecasts recently to 1.1%, 1.2% and 1.2% respectively. The latest ECB forecasts are the same for 2019e and 2020e, but they see growth returning to the LT trend of 1.4% by 2021e. These forecasts are consistent with monetary sector indicators (see “Look beyond the yield curve II”)
On a more positive note, private sector credit growth remains at/close to the highest level in the current cycle. The 3m MVA of PSC, NFC and HH YoY credit growth were 3.7%, 4.0% and 3.4% in September 2019. However, these growth rates remain subdued in relation to past cycles, concentrated geographically and increasingly directed towards less productive segments (see “Fuelling the Fire – the hidden risks of QE)
ST rates remain locked at the base of the ECB’s corridor (-0.46%) and the Governing Council “now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%”. This is negative for net interest margins in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending
LT rates have recovered from their lows but remain in negative territory. Ten year bond yields have recovered from the August lows of -0.71% to -0.26%, but are 49bp lower than at the start of the year.
The EA yield curve has steepened 42bp from its recent inverted low (-0.28%) and moved back into positive territory at 0.14%. This is still 40bp flatter than at the start of the year which has negative consequences for net interest margins in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed rate lending.
Negative ST rates and flat yield curves are compounded by on-going price competition. On-going narrowing of spreads has been a key feature of the HH sector. Over the past twelve months the spread on new HH loans has fallen 24bp from 2.13% to 1.89%. In contrast, the spread on new NFC loans has remained relatively constant at 1.77%.
Sustained recovery?
European banks continue to generate a lot of noise but little overall direction. The recent rally in the SX7E index is consistent with less negative bond yields and the end of the period of yield curve inversion. Nonetheless, current macro building blocks are not sufficient to support a sustained recovery in banking sector profitability across the region, in my view.
The purpose of this website is not to make investment recommendations (and ignores valuation), but my analysis suggests that the recent rally in European banks share prices represents a relatively ST relief rally rather than a period of sustained recovery and outperformance.
Please note that the comments above are abstracts from more detailed analysis that is available separately.
The developed world continues to deleverage but risks remain
The key chart
Summary
The developed world continues to deleverage. This process has already led to dramatic shift in the structure of global private sector debt (see “The Changing Face of Global Debt”). With private sector debt levels still “too high” in the developed world, this trend is set to continue.
Risks associated with excess credit growth in the developed world are lower than in past cycles and remain concentrated by economy (Sweden, Switzerland, Canada and France) and by sector (NFC credit more than HH credit). Despite lower borrowing costs, affordability risks are still evident is both the NFC (Canada, France) and HH sectors (Norway, Canada, and Sweden).
Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist while unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).
Trends in DM debt ratios
The developed world continues to deleverage. Private sector credit as a percentage of GDP has fallen from a peak of 181% in 3Q09 to 162% at the end of the 1Q19. This has involved a (relatively gradual) process of “passive deleveraging” where the stock of outstanding debt rises but at a slower rate than nominal GDP.
The process of deleveraging in the Euro Area started later. Private sector credit as a percentage of GDP peaked at 172% in 1Q15 and has fallen to 162% at the end of 1Q19, in-line with the average for the BIS’ sample of advanced economies.
This process has led to a dramatic shift in the structure of global debt. In 1Q00, the advanced world accounted for 90% of global private sector credit, with advanced economies excluding the Euro Area accounting for 70% and the Euro Area 20%. Emerging markets accounted for only 10% of global private sector credit with 7% from emerging markets excluding China and 3% from China.
At the end of 1Q19, the advanced world’s share of global debt had fallen to 64% (advanced economies ex Euro Area 47%, Euro Area 18%) while the emerging markets share has increased to 36% (EM ex China 12%, China 24%).
Where are we now?
With debt levels remaining “too high” in the advanced world this trend is likely to continue. The BIS considers corporate (NFC) and household (HH) debt ratios of 90% and 85% respectively to be maximum thresholds above which debt becomes a constraint on future growth.
In our sample of advanced economies, only Greece, Germany, Italy, Austria and the US have debt ratios below these thresholds in both sectors. In contrast both NFC and HH debt levels are above the BIS thresholds in the Netherlands, Sweden, Norway, Switzerland, Denmark and Canada. NFC debt ratios remain above the threshold in Ireland, Belgium, France, Portugal and Spain and while the UK has “excess” HH debt. In short, progress towards dealing with high levels of private sector debt remains incomplete.
Associated risks
Private sector growth risks
Risks associated with “excess credit growth” in developed markets are lower than in past cycles. I introduced my Relative Growth Factor analysis in “Sustainable debt dynamics – Asia private sector credit”. In short, this simple framework compares the relative growth in credit versus GDP (3 year CAGR) with the level of debt penetration in a given economy.
In terms of total private sector debt, the highest “growth risks” can be seen in Sweden, Switzerland, Canada and France. Private sector credit in each of these economies has outstripped GDP growth on a CAGR basis over the past three years despite relatively high levels of private sector debt. Canada has made the most obvious adjustment among this sample of relatively high risk economies with the RGF falling from over 4% two years ago to 1.8% currently.
NFC sector growth risks
In the NFC sector, the highest risks can be observed in
Switzerland, Sweden, Canada and France. RGFs for these for these economies were
3.9%, 3.0%, 2.7% and 1.8% respectively, despite NFC debt levels that are well
above the BIS threshold. As above, Canada’s rate of excess NFC credit growth is
slowing in contrast to trends in Switzerland and Sweden.
HH sector growth risks
In the HH sector, RGF analysis suggest that the highest risks are in Norway, Switzerland, Canada, Norway (and the UK). RGFs in these economies were 1.3%, 1.1%, 0.7% and 0.4% respectively. In other words, excess HH credit growth risk is lower than in the NFC sector. Furthermore, the rates of excess HH credit growth in each of these economies is lower than in the recent past, especially in Norway and Canada.
Affordability risks
Despite lower borrowing costs, affordability risks remain. BIS debt service ratios (DSR) provide, “important information about the interactions between debt and the real economy, as they measure the amount of income used for interest payments and amortisations.” (BIS, 2017). The perspective provided by DSRs complements the analysis of debt ratios above but differs in the sense that they provide a “flow-to-flow” comparison ie, the debt service payments divided by the flow of income. In the accompanying charts, DSR ratios for private sector, corporate and household credit are plotted against the deviation from their respective long term averages.
NFC affordability risks are highest in Canada and France. Debt service ratios (57% and 55% respectively) are not only high in absolute terms but they also illustrate the highest deviations from their respective long-term averages (47% and 49% respectively). In the HH sector, the highest affordability risks are seen in Norway, Canada and Sweden, although the level of risk is lower than in the NFC sector.
Implications for the Euro Area
Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist. The European Commission recently revised its 2019 forecast down by -0.1ppt to 1.1% and its 2020 and 2012 forecasts down by -0.2ppt to 1.2% in both years, with these forecasts relying on “the strength of more domestically-oriented sectors.
Growth in broad money (5.5%) and private sector credit (3.7%) in September remains positive in relation to recent trends but relative subdued in relation to past cycles. Furthermore, the renewed widening in the gap between the growth in the supply of money and the demand from credit (-1.8%) indicates that the Euro Area continues to face the challenge of deficiency in the demand for credit.
This has on-going implications for policy choices. Unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).
Please note that the summary comments above are abstracts from more detailed analysis that is available separately.