Banks may deliver poor LT investment returns but their interaction with the wider economy provides important insights for corporate strategy, investment returns and asset allocation (#1).
Starting from a simple understanding of core banking services, we can build a quantifiable, objective and logical analytical framework linking all domestic sectors with each other and with the rest of the world (#2).
This framework allows us to challenge official UK forecasts that assume unprecedented behaviour and dynamism from UK households and corporates in support of unsustainable outcomes (#3).
It also allows us to debunk EA myths and identify the key factors that will determine the shape of any recovery in Europe and investment returns in 2021 (#4).
The messages from the UK and EA money sectors during the pandemic have been very similar, albeit with the UK demonstrating higher gearing to current dynamics, including any return to normality (#5).
They also contrast sharply with the messages associated with previous periods of monetary expansion (#6).
Finally, humility and a willingness to unlearn the so-called lessons of the past is important, especially in relation to banking and macroeconomics. The outlook for 2021 will depend, largely, on whether policy makers are willing to challenge orthodox fiscal thinking (#7).
Humility and the willingness to unlearn the lessons of the past
Lesson #7
The final lesson is the importance of humility and a willingness to unlearn the lessons of the past, especially in relation to banking and macroeconomics. It is, after all, only six years since the Bank of England debunked the widely taught and held view that banks act simply as intermediaries, lending out deposits that savers place with them.
In the current context of large-scale fiscal responses to the pandemic, its will be important to see how other (so-called) lessons from the past are treated e.g. governments should budget like households, governments spend taxpayers money, deficits are evidence of over-spending/crowding out of the private sector, Chancellors have moral duties to balance the books etc.
The shape and duration of any recovery and investment returns in 2021 will depend, for example, on whether the notion that fiscal expansion is indispensable to sustain demand is fully understood or not (#4). Will 2020-21 be a watershed moment in macro understanding/policy?
In this context, I am ending this series of summary posts with a link to a recent article published by David Andolfatto of the Federal Reserve Bank of St Louis on 4 December 2020. This important article may foreshadow a shift in macro policy understanding. In line with my preferred financial sector balances approach (#2), Andolfatto questions the “government as a household” analogy and also notes that, to the extent that government debt is held domestically, it constitutes wealth for the private sector. From here, and more significantly, he argues that:
“…it seems more accurate to view the national debt less as a form of debt and more as a form of money in circulation…The idea of having to pay back money already in circulation makes little sense, in this context. Of course, not having to worry about paying back the national debt does not mean there is nothing to be concerned about. But if the national debt is a form of money, wherein lies the concern?”
“Does the National Debt Matter?” Federal Reserve Bank of St. Louis, December 2020
Wherein indeed? Delicious food-for-thought for the Festive Season and for 2021…
2020 is not a re-run of 2008 – periods of monetary expansion can and do have different drivers and implications (Source: ECB; CMMP analysis)
Lesson # 6
The penultimate lesson(s) from the money sector is that periods of monetary expansion differ in terms of their drivers and implications and that there is no stable relationship between reserves, broad monetary conditions and inflation.
Broad money in the euro area (and the UK) may be growing at the same rates as 1Q2008 but current trends are not a repeat of 2008 dynamics.
Previous CMMP analysis compared the components and counterparts of both phases. The message in the pre-GFC period was one of (over-) confidence and excess credit demand. In contrast, the current message is one elevated uncertainty and subdued credit demand.
Today’s monetary expansion reflects fiscal and monetary easing in response to weak private sector demand and rising savings (with added uncertainty regarding the extent to which rising savings are forced or precautionary). The message from the money sector supports rather than contradicts the ECB’s modest inflation expectations out to 2023.
Similar messages, but is the UK more geared to recovery?
The key chart
What is the expansion in broad money in the UK and EA telling us? (Source: ECB; Bank of England; CMMP analysis)
Lesson #5
The UK and EA money sectors have been sending very similar messages during the pandemic, albeit it with more volatile YoY trends in the UK. Broad money is growing at the fastest rate since April 2008 in both regions with narrow money’s contribution to total money also reaching historic highs.
The overriding message here is that uncertainty reigns with HHs and NFCs maintaining a preference for holding highly, liquid assets despite earning negative/very low real returns. From a counterparts perspective, above trend NFC credit and resilient mortgage demand have been offsetting weak consumer credit. But again, the dominate message is one of subdued credit demand – the gap between money supply and private sector credit demand continues to hit new highs.
“Uncertainty” and “subdued credit demand” are four key words missing from the inflation hawks’ current narrative!
Looking forward, the key unknown is the extent to which increased savings are forced or precautionary. The OBR may be too optimistic in the assumed extent of recovery in HH consumption, but there is evidence here to suggest that the UK is likely to demonstrate a higher ST gearing to a return to normality than the EA.
Debunking myths and identifying key drivers of future returns
The key chart
So far, so good – but is the wider notion that fiscal expansion is indispensable fully understood? (Source: Eurostat, CMMP analysis)
Lesson #4
In addition to helping challenge UK official forecasts (lesson #3), financial sector balances (lesson #2) have also allowed us to debunk three myths from the euro area and identify the key factors that will determine the shape and duration of any recovery and investment returns in 2021.
Back in April 2020, I challenged the arguments that: (1) painful structural reforms post-2000 were the main driver of Germany’s recovery and resurgent competitiveness; (2) existing fiscal frameworks (including the Stability and Growth Pact) were still relevant; and (3) “this crisis [was] primarily the hour of national economic policy.”
Focusing here on (2), in response to COVID-19, EA households increased their savings sharply and corporates stopped investing. The ECB called correctly for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies.
Policy makers have acknowledged that private sector investment is unlikely to fill the gap left by COVID-19.
So far, so good. The wider question (see also lesson #7) is whether the notion that fiscal expansion is indispensable to sustain demand is fully understood.
Historic and forecast trends in financial sector balances for the UK private sector, UK government and RoW expresses as a % GDP (Source: OBR; CMMP analysis)
Lesson #3
Given the importance of financial sector balances (lesson #2), it is a surprise that they only occupied two paragraphs and one chart in the OBR’s 217-page, “Economic and fiscal outlook” for the UK (November 2020). A cynic might wonder if this was because the one chart (reproduced above) countered much of the content of the other 216 pages. A more reasoned response might be that the power and application of financial sector balances remains under-appreciated even at these levels, which makes the framework more powerful for those who understand its implications.
In the case of the UK, for example, this approach highlights that official forecasts ask us to believe that UK households, corporates and overseas investors will behave highly unusually and with unprecedented degrees of dynamism in the post-pandemic period. Even then, the assumed result is simply a return to the unsustainable position pre-COVID where combined private and public sector deficits are offset by increasing RoW surpluses.
If we assume that November’s OBR forecasts are now a base case priced into UK assets, then lesson #3 points to downside risks to UK growth, upside risks to the level of borrowing, inflation staying below target and rates remaining lower for longer. More simply, lesson #3 also suggests that official forecasts can/often do fail common sense tests (see also lesson #4).
Trends in EA financial sector balances since 2008 (Source: Eurostat; CMPP analysis)
Lesson #2
CMMP analysis focuses on the relationship between the financial sector and the wider economy i.e., households (HHs), corporates (NFCs), government and the rest of the world (RoW). The second lesson is that the core services provided by banks – payments, credit and savings – produce a stock of contracts that can be represented by financial balance sheets. These balance sheets link each of these economic agents over time and form a quantitative, objective and logical analytical framework.
A fundamental principle of accounting is that for every financial assets (FA) there is an equal and offsetting financial liability (FL). By definition, net financial wealth (NFW) is therefore equal to the sum of FAs less the sum of FLs. If we take all private sector FAs and FLs, it is also a matter of logic that the sum of all the assets must equal the sum of all the liabilities.
The key implication here is that for the private sector to accumulate NFW it must be in the form of claims against another sector i.e., governments, the RoW, or a combination of the two.
In the current climate of rising government deficits, this insight is crucial to debates over whether deficits: (1) are evidence of overspending; (2) a burden on future generations; and/or (3) crowd out private investment. The fact that the answers given to these questions are generally incorrect only goes to show how poorly the relationship between the financial sector and the wider economy is understood. It also explains why official economic forecasts can/often do fail common sense tests (lesson #3).
Relative performance of leading European banks (SX7E) versus the wider SXXE European index (Source: CMMP analysis)
Lesson #1
I started 2020 by arguing that the true value in analysing developments in the financial sector lies less in considering investments in developed market banks and more in understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. Banks have underperformed again (c20% YTD in Europe) but the messages from the money sector have been as important as ever.
Second, monetary developments have continued to provide reliable leading indicators of economic activity (that link directly into asset allocation models), key insights into the behaviour of households and corporates over time and between regions, and warnings of hidden risks in emerging economies. Third, the mechanical link between money supply and inflation has been challenged and replaced by an explanation of what will be required for LT secular trends (eg, growth vs value) to be reversed in a sustainable fashion.
And all from the simple observation that, “everyone has a balance sheet” (see Lesson #2).
Private sector financial surpluses and general government financial deficits since 2008 (Source: Eurostat, CMMP analysis)
The key message
Looking into 2021, the shape and duration of any economic recovery and the outlook for investment returns/asset allocation in the euro area (EA) depend critically on whether policy makers have learned from the mistakes of the past.
The region remained trapped by persistent, excess savings and out-dated policy rules at the start of 2020. A major policy reboot was already long overdue.
As COVID-19 hit, households (HHs) increased their savings sharply and corporates (NFCs) stopped investing. The private sector surplus returned to GFC levels. In response, the ECB called (correctly) for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies.
With broad money growing at the fastest rate since 2008, debate over future inflation and its implication for duration trades is growing. Today’s monetary trends are very different, however, and the message from the money sector remains one of heightened uncertainty and subdued credit demand in direct contrast to 2008.
Private sector investment alone is unlikely to fill the gap left by COVID-19. Investors betting on a reversal of existing secular trends must be confident, therefore, that the notion that fiscal expansion is indispensable to sustain demand is fully understood.
The EA has a unique opportunity to make greater use of fiscal policy to achieve its goals – will they seize it or waste it?
The charts that matter
In February 2020, I suggested that the EA was trapped by persistent, excess savings and out-dated policy rules and argued that a major policy reboot was long overdue. This was before the full economic and social impacts of the pandemic were understood. The EA private sector ran average financial surpluses/net savings of 4.4% GDP in the decade between 1Q10 and 1Q20. General government ran average financial deficits/net borrowings on 2.7% GDP over the same period, resulting in average net savings for the EA of 1.7% GDP (see key chart above). These trends placed downward pressure on growth and inflation over the period.
Trends in EA, UK and US private sector debt ratios (% GDP) since 2000 (Source: BIS, CMMP analysis)
The messages from the money sector at the time were clear. First, when the private sector is running a financial surplus in spite of negative/very low policy rates, this is a strong indication that the economy is still suffering from a debt overhang. As can be seen from the chart above, private sector deleveraging in the EA was delayed and more limited after the GFC than in both the UK and the US. Data released by the BIS this week, shows that the EA private sector debt ratio hit a new high of 174% of GDP in 2Q20 compared with ratios of 165% and 160% in the UK and US respectively. Second, fiscal space, like debt sustainability, is at its core a FLOW not a STOCK concept.
Trends in HH and NFC financial surpluses (+) and deficits (-) since 2008 (Source: Eurostat; CMMP analysis)
As COVID-19 hit, HHs increased their savings sharply and NFCs stopped investing. HH net savings, which had trended between 2-3% of GDP in the post-GFC period jumped to 5% in 2Q20. The NFC sector, which had resumed investing in 4Q18, also returned to net savings equivalent to 0.2% of GDP (see graph above). In aggregate, the net financial surplus/net savings of the EA private sector increased to 6% of GDP. (Note that basic accounting principles indicate that surpluses run by the private sector must equal deficits run by general government and/or the RoW -see graph below).
Basic national accounting principles in practice – trends in PS, government and RoW financial surpluses (+) and deficits (-) since 2008 (Source: Eurostat; CMMP analysis)
In response, the ECB called (correctly) for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies. In brief, general government deficits of 3.7% GDP and a ROW deficit of 2.1% offset the private sector surplus in the 2Q20 (see chart above).
Growth rates (%YoY) in EA broad money (Source: ECB; CMMP analysis)
With broad money growth accelerating, debate over future inflation and its implication for duration trades is growing. In October 2020, broad money grew 10.5% YoY. This is the fastest rate of growth recorded since April 2008 (see graph above).
Growth in M3 (%YoY) and contribution from M1 to M3 growth (ppt) since 2000 (Source: ECB; CMMP analysis)
Today’s monetary trends are very different, however, and the message from the money sector remains one of heightened uncertainty and subdued credit demand in direct contrast to 2008. From a components perspective, narrow money (M1) contributed 9.4ppt to October’ 10.5% growth as HHs, and to a lesser extent NFCs, maintained their preference for holding highly liquid overnight deposits, despite negative real returns (see chart above).
Monthly HH deposit flows for the EA (Source: ECB; CMMP analysis)
Monthly deposit flows provide a useful proxy for private sector uncertainty levels. In the HH sector, monthly flows are lower than in the March-April 2020 when uncertainty was at its peak, but October’s flow of €43bn was still 1.3x the average flow of €33bn recorded in 2019 (see chart above).
The widening gap between YoY growth rates in the supply of money and the demand for credit (Source: ECB; CMMP analysis)
From a counterparts perspective, private sector credit contributed 5.2ppt to broad money growth in October. The gap between money supply and private sector credit demand hit a new high of 5.9ppt, another clear indicator that the region is still suffering from a debt overhang (see chart above). In passing, it is worth noting the important role of QE, especially large-scale government bond purchases during the crises, in current monetary growth. Credit to general government contributed 7.3ppt to October’s 10.5% growth in M3 (see chart below).
Growth in M3 from a counterparts perspective (Source: ECB; CMMP analysis)
Conclusion
In a speech made on 12 October 2020, Isabel Schabel, a Member of the ECB’s Executive Board, argued that, “at times of significant uncertainty, private investment may not fill the gap left by the pandemic in spite of very favourable financing conditions. In these situations, monetary policy alone cannot unfold its full potential. Fiscal expansion is then indispensable in order to sustain demand and mitigate the long-term cost of the crisis.” CMMP analysis supports this view.
Investors betting on a reversal of existing secular trends (eg duration trades) must be confident, therefore, that the notion that fiscal expansion is indispensable to sustain demand is fully understood.
Outside the narrow focus of financial markets, the EA has a unique opportunity to make greater use of fiscal policy to achieve its goals – will they seize it or waste it?
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.
Increasing pressure on UK mortgage providers to digitalise
The key chart
Monthly flows (£bn) in UK lending to individuals throughout 2020 – mortgages have driven the recovery but this is still no time for providers to relax (Source: Bank of England, CMMP analysis)
The key message
The Bank of England’s latest Money and Credit release for October 2020 had three pieces of positive news for UK mortgage providers:
Mortgage demand remains relatively robust
Approvals for house purchases are at their highest levels since 2007
The effective interest rate on new mortgages has risen from its August low
This is no time for providers to relax, however. Current mortgage demand remains very subdued in relation to past cycles (despite the low cost of borrowing) and the pressure on net interest margins and revenue generation continues.
The strategic requirement to accelerate digitalisation across operations, sales, and finance and risk is growing.
“Lenders and brokers that use technology to differentiate and improve the customer experience will be the ones that ultimately come out ahead”
BSA, December 2020
Six charts that matter
Outstanding mortgages, YoY growth and monthly flows (£bn) throughout 2020 (Source: Bank of England; CMMP analysis)
In its October 2020, “Money and Credit” release, the Bank of England highlighted relatively robust UK mortgage demand. On a net basis, households borrowed £4.3bn in October, the third highest monthly borrowing total this year (see graph above). Outstanding mortgage balances grew 2.7% YoY in sharp contrast to the new record YoY decline in consumer credit (-5.6%YoY). Overall lending to individuals grew 1.6% YoY. As can be seen from the key chart above, mortgages accounted for £4.3bn out of a total (net) monthly flow of lending to individuals of £3.7bn. A rare bright spot.
Mortgage approvals for house purchase hit the highest level since September 2007 (Source: Bank of England; CMMP analysis)
Looking forward, mortgage approvals increased from 92,100 in September to 97,500 in October (see graph above). This is the highest level of approvals recorded since September 2007 and represents a 10x increase since May 2020’s low (9,400). High approval rates indicate that demand for mortgage borrowing should remain positive in the coming quarters.
Effective interest rate on new mortgages (Source: Bank of England; CMMP analysis)
The effective interest rate on new mortgages, which had been falling steadily since the end of 2018, increased to 1.78% in October. This compares with the recent low of 1.72% in August 2020 (see graph above). The effective rate has fallen 18bp YoY, however, and remains a negative drain on the rate on outstanding mortgages which has fallen 27bp YoY to 2.12% in October 2020.
Real growth rates in UK mortgage lending since October 2000 (Source: Bank of England; CMMP analysis)
Nonetheless, current mortgage demand remains relatively subdued in relation to past cycles despite the low cost of borrowing. In real terms, mortgage demand is growing at only 2.3% YoY, much slower than the double digit real growth rates seen before the GFC (see chart above). As described in previous posts, a key factor here is that, despite the deleveraging seen since 1Q10, the UK household debt to GDP ratio remains at 85%, the threshold level above which the BIS considers debt to be a drag on future growth (see chart below).
HH debt ratios remain elevated at the BIS threshold levels (Source: BIS; CMMP analysis)
Of on-going concern to mortgage providers, the effective rates on new and outstanding mortgages have fallen 10bp and 24bp YTD respectively. The gap between the rate in outstanding mortgages (which peaked at 55bp in February 2020) is still 34bp, indicating further downward pressure on net interest margins and revenue generation (see graph below).
The on-going challenge of delivering top-line growth (Source: Bank of England; CMMP analysis)
Conclusion
Despite the positive news noted above, this is not time for mortgage providers to relax. With subdued growth and further margin compression ahead, they need to embrace digitalisation to deliver effective market segmentation/client knowledge, alternative revenue sources, further efficiency gains and more effective liquidity and risk management.
As noted in a blog on the Building Societies’ Association website yesterday (2 December 2020), “Lenders and brokers that use technology to differentiate and improve the customer experience will be the ones that ultimately come out ahead.”
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately
