Month: August 2020

“The long and uncertain road to recovery”

July’s message from the EA money sector

The key chart

Unusually high monthly flows into O/N deposits (despite negative real rates of return) indicate elevated levels of uncertainty among HHs and NFCs in the euro area (Source: ECB; CMMP analysis)

The key message

July’s monetary developments in the euro area suggest that the road to recovery will be long and uncertain. Broad money (M3) is growing at the fastest rate (10.2% YoY) since May 2008. Growth rates in the components of M3 indicate that uncertainty remains very elevated at the start of 3Q20. Overnight deposits, for example, contributed 8.3ppt to the growth in broad money alone (despite negative real returns). July’s overnight deposit inflow of €151bn was the second largest inflow after March’s €249bn and was 3x the 2019 average. In contrast, growth rates in the counterparts to M3 indicate that HH consumption is recovering and the NFC’s record “dash-for-cash” has peaked. However, before anyone gets too excited – the gap between subdued PSC growth (debt overhang?) and rapid M3 growth (elevated uncertainty?) hit a twenty-year peak in July.

In short, July’s message from the EA money sector is simple: the peak of the crisis may have passed but the road to recovery is likely to be long and uncertain.   

The long and uncertain road in charts

Growth rates in broad (M3) and narrow (M1) money in the euro area (% YoY) – July’s M1 growth rate exceeded 2009 and 2015 peaks (Source: ECB; CMMP analysis)

July’s monetary developments in the euro area (EA) suggest that the road to recovery will be a long and uncertain one. Broad money (M3) grew by 10.2% YoY in July from 9.2% in June, the fastest rate of growth since May 2008.

Drivers of M3 growth (percentage points) – overnight deposits (8.3ppt) remain the key driver of M3 (Source: ECB; CMMP analysis)

Narrow money (M1) grew by 13.5% YoY in July from 12.6% in June, faster than the 13.1% (Aug 09) and 11.7% (July 15) peak growth rates recorded during the GFC and after the euro crisis. M1 growth contributed 9.2ppt to the total 10.2% growth in broad money. Within M1, overnight deposits grew 14.1% YoY and contributed 8.3ppt to the overall growth in M3 alone.

Growth rates in mortgage, consumer and corporate credit – passed the crisis peaks and troughs? (Source: ECB; CMMP analysis)

Adjusted loans to the private sector grew 4.7% YoY, slightly below the 4.8% recorded in June. The annual growth rate in loans to households (HHs) was unchanged at 3.0% while the equivalent growth rate in loans to corporates (NFCs) fell very slightly to 7.0% from 7.1%. No surprises here – above trend NFC credit and resilient HH mortgage demand continue to offset weakness in HH consumer credit.

An “old favourite” chart – the gap between the growth rates in PSC and M3 is at a new twenty-year peak (Source: ECB; CMMP analysis)

The gap between the growth in money supply (M3) and the growth in private sector credit (PSC) increased to 5.5ppt, a twenty year high. This reflects the combination of extraordinary uncertainty (driving M3) and the limited progress in dealing with the debt overhang in the EA (subduing PSC).

Monthly flows into O/N deposits since January 2019 – a surprise jump in July? (Source: ECB; CMMP analysis

The monthly flow data once again provides a more nuanced picture than the headline annual growth trends. Overnight deposits, which contributed 8.3ppt to the overall growth in M3 alone, rose by €151b. This represents the second largest monthly inflow of overnight deposits (after €249bn in March 2020).

Monthly deposit flows from HHs and NFCs since January 2019 (Source: ECB; CMMP analysis)

July’s data includes a €58bn swing from negative to positive flows from non-monetary financial corporations – n.b. these flows are typically more volatile than HH and NFC flows. That said, monthly flows by HHs and NFCs also increased MoM to levels 24% and almost 50% above the average 2019 inflows. Put simply, these trends suggest that HH and NFC uncertainty levels remain very elevated.

Monthly trends in HH credit demand – passed the low point? (Source: ECB; CMMP analysis)

On a more positive note, mortgage demand remains resilient and consumer credit has recovered. Loans for house purchase increased by €19b in July versus 9€10bn in June and above the average €14bn monthly flow recorded in 2019. After record repayments between March and May 2020, monthly flows of credit for consumption have exceeded €3bn for two months in a row, closing on the €3.4bn monthly average in 2019. NFC lending data suggests that we passed the peak “dash for cash” in March and April, although July’s monthly flow of almost €16bn remains above the 2019 average of €12bn.

Putting the NFC “dash-for-cash” into an historic context (Source: ECB; CMMP analysis)

Conclusion

The message from the money sector at the start of the 3Q20 is a mixed one. Growth rates in the components of M3 indicate that uncertainty remains very elevated. In contrast, growth rates in the counterparts to M3 indicated that HH consumption is recovering and the NFC dash-for-cash has peaked. In short, while the peak of the crisis appears to have passed, the road to road to recovery is likely to remain a long and uncertain one.

Please note that the summary comments and graphs above are extracts from more detailed analysis that is available separately.

“August Snippets – Part 2”

Revisiting the foundations of CMMP analysis

The key message

In “August snippets – Part 1”, I highlighted the importance of disciplined investment frameworks. In this second snippet, I revisit the foundations of my CMMP Analysis framework. I start by describing how I combine three different time perspectives into a consistent investment thesis (“three pillars”). I then explain how the core banking services (payments, credit and savings) link different economic agents over time to form an important fourth pillar – financial sector balances. Finally, I present examples of how these four pillars combine to deliver deep insights into policy options and responses.

The central theme is my belief that the true value in analysing developments in the financial sector lies less in considering investments in banks but more in understanding the implications of the relationship between banks and the wider economy for corporate strategy, investment decisions and asset allocation.

Three perspectives – one strategy

  • As an investor, I combine three different time perspectives into a single investment strategy
  • My investment outlook at any point in time reflects the dynamic between them
  • My conviction reflects the extent to which they are aligned

Pillar 1: Long-term investment perspective

Example chart 1: growth trends in PSC illustrate how global finance is shifting East and towards emerging markets ($bn) (Source: BIS; CMMP analysis )

My LT investment perspective focuses on the key structural drivers that extend across multiple business cycles. Given my macro and monetary economic background, I begin by analysing the level, growth, affordability and structure of debt. These four features of global debt have direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options; investment risks and asset allocation. My perspective here reflects my early professional career in Asia and experience of Japan’s balance sheet recession. The three central themes are (1) global finance continues to shift East and towards emerging markets, (2) high, “excess HH growth rates” in India and China remain a key sustainability risk, and (3) progress towards dealing with the debt overhang in Europe remains gradual and incomplete. The following four links provide examples of LT investment perspectives:

Example chart 2: China’s HH debt ratio continued to rise sharply in 1Q20 – too much, too soon? (Source: National Bureau of Statistics; CMMP analysis)

Pillar 2 – Medium-term investment perspective

Example chart 3: growth rates in M1 and private sector credit demonstrate robust relationships with the business cycle through time and have proved more reliable indicators of recessions risks than the shape of the yield curve (Source: ECB; CMMP analysis)

My MT investment perspective centres on: analysing money, credit and business cycles; the impact of bank behaviour on the wider economy; and the impact of macro and monetary dynamics on bank sector profitability. Growth rates in narrow money (M1) and private sector credit demonstrate robust relationships with the business cycle through time. My interest is in how these relationships can assist investment timing and asset allocation. My investment experience in Europe shapes my MT perspective, supported by detailed analysis provided by the ECB. A central MT theme here is the fact that monetary developments: (1) have proved a more reliable indicator of recession risks than the shape of the yield curve; and (2) provide important insights into the impact, drivers and timing of the Covid-19 pandemic on developed market economies. The following four links provide examples of my analysis of MT investment perspectives:

Example chart 4: headling figures mask a more nuanced message from monthly flow data (Source: ECB; CMMP analysis)

Pillar 3: Short-term investment perspective

Example chart 5: banks played catch up from May 2020, but what kind of rally was this and was it sustainable? (Source: FT; CMMP analysis)

My ST investment perspective focuses on trends in the key macro building blocks that affect industry value drivers, company earnings and profitability at different stages within specific cycles. This perspective is influences by my experience of running proprietary equity investments within a fixed-income environment at JP Morgan. This led me to reappraise the impact of different drivers of equity market returns. I was able to demonstrate the “proof of concept” of this approach when I returned to the sell-side in 2017 as Global Head of Banks Equity Research at HSBC, most notably when challenging the consensus investor positioning towards European banks in 3Q17. A central ST theme is the importance of macro-building blocks in determining sector profitability and investment returns. The following four links provide examples of ST investment perspectives:

Example chart 6: why it was correct to question the conviction behind the SX7E rally during 2Q20 (Source: FT, CMMP analysis)

Pillar 4 – Financial Sector Balances

Example chart 7: Financial sector balances (and MMT!) can be understood easily by starting with the core services provided by banks to HHs and NFCs (Source: Bank of England; CMMP analysis)

In January 2020, I presented a consistent, “balance sheet framework” for understanding the relationship between the financial sector and the wider economy and applied it to the UK. I chose the UK deliberately to reflect the relatively large size of the UK financial system and the relatively volatile nature of its relationship with the economy. I extended this analysis to the euro area later. I began by focusing on the core services provided by the financial system (payments, credit and savings), how these services produce a stock of financial balance sheets that link different economic agents over time, and how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework. Central themes here were the large and persistent sector imbalances in the UK, why the HH sector in the UK was poised to disappoint and why a major policy review was required in the euro area even before the full impact of the COVID-19 pandemic was felt. The following four links provide examples of FSB analysis:

Example chart 8: Pre-Covid, the UK faced large and persistent sector imbalances and was increaingly reliant on the RoW as a net lender (4Q sum, % GDP) (Source: ONS; CMMP analysis)

Policy analysis

Example chart 9: “Fuelling the FIRE” – split in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans) (Source: ECB; CMMP analysis)

These four pillars provide a solid foundation for analysing macroeconomic policy options and choices. Since September 2019, I have applied them to identifying the hidden risks in QE, to arguing why the EA was trapped by its debt overhang and out-dated policy rules, and to assessing the policy responses to the COVID-19 pandemic. Central themes have included: (1) the hidden risk that QE is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality; (2) why the gradual and incomplete progress towards dealing with Europe’s debt overhang matters; (3) why Madame Lagarde was correct to argue that the appropriate and required response to the current growth shock “should be fiscal, first and foremost”; and (4) how three myths from the past posed a threat to the future of the European project. The following four links provide examples of policy analysis:

Example chart 10: failing the “common sense test”. What was the point of running tight fiscal policies when the private sector was running persistent financial surpluses > 3% GDP (Source: ECB; CMMP analysis)

Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately

“August Snippets – Part 1”

Bank performance and the importance of rigorous frameworks

The key chart

Was it correct to question the conviction behind the SX7E rally during 2Q20?
Source: FT; CMMP analysis

The key message

In early June, I questioned the conviction behind the European bank sector’s rally that saw the SX7E index rise 45% from its April lows. I recommended viewing this more as a vote of confidence in the EC’s policy shift than a fundamental change in sector dynamics.

  • The index fell -17% subsequently, before rebounding since the end of July to a level -8% below the June peak.
  • Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.
  • In many cases, lower trading volumes have accompanied the recent lacklustre share price performance (do investors care?).
  • The 2Q20 interim results also supported my April conclusion that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic.
  • Significantly, three index heavyweights are now trading below the pre-LLP threshold multiple associated with peak EM and DM banking crises.
  • These banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets.

The lessons from 2020 include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.

Six key charts

In early June, I questioned the conviction behind the European bank sector’s rally that had seen the SX7E index rise 45% from its April lows (“EA banks: a high conviction rally?”). I noted that the rally had taken place (1) two months after the broader market, (2) despite a worsening operating environment, and (3) in the absence of the macro building blocks that are required for a sustained recovery in sector profitability. I also highlighted that the rally had coincided with the announcement of the EC’s proposed €750bn “Next Generation EU” fund and suggested that it could be seen better as a vote of confidence in the policy response rather than a fundamental shift in banking sector dynamics.

Poor absolute and relative share price perfomance (versus SXXE) from index heavyweights YTD. (Source: FT; CMMP analysis)

The index fell -17% subsequently, to a recent end-July low, before rebounding during August to a level -8% below the June peak. Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.

Share price and trading volume trends for BNP Paribas, the largest bank in the SX7E index by market capitalisation. (Source: FT; CMMP analysis)

In many cases, lower trading volumes have accompanied the recent lacklustre share price performance. The chart above illustrates YTD share price and trading volume trends (7d and 21d MVA) for BNP Paribas, the largest bank in the SX7E index by market capitalisation. The current 21d MVA is just over 4m shares, only 62% of the 2020 average of 6.5m and 35% of the 11.4m shares at the peak of the sell-off in March (note these are MVA figures). In the case of Deutsche Bank, the only index heavyweight to have delivered positive share price returns YTD, the current 21d MVA is 12m shares, only 55% of the 2020 average of 22m and 31% of the 39m shares traded at its peak (charts available on request).

EA banks’ vulnerability to rising provisions in the wake of the COVID-19 pandemic. Pre-provision profits were only 2.4x provisions in 4Q19. (Source: ECB; CMMP analysis)

The 2Q20 interim results also supported my April 2020 conclusion that weak pre-provision profitability levels left EA banks poorly positioned to absorb the impact of the COVID-19 pandemic (“If you want to go there…”). At the time, I expressed concern about the low “pre-provision profit” cover of only 2.4X at the end of 2019 and highlighted low cover levels in Portugal (1.5x), Germany (1.8x), Italy (1.8x) and Spain (1.9x).

Six months later, the 32 largest European banks have set aside €56bn to cover loan losses. Santander, which was the largest SX7E bank by market cap previously, set aside €7bn to cover loan losses alone and booked a large write-down on its UK business. This resulted in the first quarterly loss in the bank’s 163-year history. Santander’s share price is down -50% YTD, the second worst performer of the heavyweights after Soc Gen.

Pre-LLP provision multiples (2021e) for index heavyweights – red line indicates typical crisis threshold. (Source: Consensus forecasts, CMM analysis)

Three index heavyweights are now trading below the pre-LLP multiple that is associated with peak EM and DM banking crises. Based on my experience of multiple banking crises in EM and DM over the past thirty years, I believe that a pre-LLP multiple of 2x typically marks a key “crisis-threshold” for bank valuation. Consensus forecasts indicate that Santander, BBVA and Soc Gen are currently trading on 1.5x, 1.6x and 1.8x 2021e pre-LLP multiples respectively. Contrarian traders may note with interest the fact that Santander’s trading volumes (post-loss selling pressure?) have peaked at a time of very distressed valuation.

Share price and trading volume trends for Santander. (Source: FT, CMMP analysis)

These three banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets. Based on consensus 2021e forecasts the index heavyweights are trading on PBVs of between 0.22x (Soc Gen) and 1.04x (KBC) with an average of 0.45x. While these valuations appear attractive in absolute terms, they simply reflect depressed forecasts for 2021e ROEs, in my view. The average (no-growth) implied cost of equity for the index heavyweights is 10.8%. Given the very high risk to current forecasts, this implies a sector that is fairy-valued rather than genuinely cheap. Note, however, that implied costs of capital vary widely from 3.2% for Deutsche Bank to 16.1% for Santander. This suggests opportunities for active investors since such a dispersion usually indicates either (1) glaring valuations anomalies and/or (2) unrealistic forecasts.

2021e ROE versus PBV for European banks, index heavyweights highlighted (Source: Consensus forecasts; CMMP analysis)

Conclusion and key lessons

Recent lessons here include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.

The CMMP Analysis investment framework combines three different time perspective into a single investment thesis. The investment outlook at any point in time reflects the dynamic between these three different time perspectives. Conviction reflects the extent to which they are aligned – in June they were misaligned highlighting the fact that (absolute) valuation alone is not sufficient for sustained investment performance.

That said, the European and UK banking sectors have provided very important insights into wider macroeconomic trends and the pace, timing and nature of the recovery from the 2Q economic lows. This supports my view, that true value in analysis developments in the financial sector remains less in considering investments in DM banks but more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. More of this to follow in this “Autumn snippets” series.

Please note that the summary comments above are extracts from more detailed analysis that is available separately