cgmallin – Page 21 – Chris Mallin Macro Perspectives

“Key drivers for 2021”

Have policy makers learned from past mistakes?

The key chart

**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.

“No time to relax”

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

“Really?”

OBR forecasts from a sector balances perspective

The key chart

**Historic and forecast trends in financial sector balances for the UK private sector, UK government and RoW expressed as % GDP** (Source: OBR; CMMP analysis)

The key message

The latest OBR forecasts for the UK economy and public finances support my argument that recent UK policy responses to the Covid-19 pandemic were timely, necessary and appropriate and that the UK government will maintain an increasingly interventionist role in the UK economy.

However, from my preferred “financial sector balances perspective” there are obvious risks to their forecasts for UK growth and for the level of government borrowing. First, they assume unprecedented levels of dynamism from both the UK household and corporate sectors and behavioural trends from these sectors and from the RoW that contrast sharply with those seen after the GFC. Second, while the OBR claims that “sectoral net lending positons return to more usual levels,” this does not make them sustainable.

In short, the latest forecasts point to a post-Covid, post-Brexit UK economy returning rapidly to persistent private and public sector deficits and an increasing reliance on the RoW as a net lender. Really…?

The charts that matter

The Office for Budget Responsibility (OBR) published its latest “Economic and Fiscal Outlook” yesterday (25 November 2020) in which it set out its forecasts for the UK economy and public finances to 1Q26. I have analysed these forecasts from the perspective of UK financial sector balances ie, the financial relationship between UK households (HHs), corporates (NFCs), government (GG) and the rest-of-the-world (RoW). As explained in a series of posts earlier this year, this approach builds on the key accounting identity pioneered by the late Wynne Godley that states that:

Domestic private balance + domestic government balance + foreign balance (must) = zero

**Trends in UK financial sector balalances since 2000** (Source: OBS; CMMP analysis)

The OBR’s analysis supports my view that the UK government’s policy response to the Covid-19 pandemic was timely, necessary and appropriate. The OBR expects the cost of government support to total £280bn in 2020, pushing the deficit to £394bn (19% GDP), the highest level since 1944-45 and the debt ratio to 105% GDP, the highest level since 1959-60. Seen through the context of financial sector balances, the OBR concludes that, “The spike in government borrowing [the green line above] …has meant that household and corporate incomes have not fallen nearly as fast as their output or expenditure.” Note that the OBR expects the household financial surplus [the blue line above] to rise to a historically high level of over 11% GDP, and the corporate balance to move from a deficit to a historically high surplus of 2.5% GDP.

The support provided to households and businesses has prevented an even more dramatic fall in output and attenuated the likely longer-term adverse effects of the pandemic on the economy’s supply capacity. And the Government’s furlough scheme has prevented a larger rise in unemployment. Grants, loans, and tax holidays and reliefs to businesses have helped them to hold onto workers, keep up to date with their taxes, and avoid insolvencies.
OBR, November 2020

**Historic and forecast trends for UK government financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** (Source: OBR; CMMP analysis)

The OBR forecasts also suggest that the UK government will continue to play an important part in economic activity. They predict that the government’s net borrowing peaks at -19% GDP in 1Q21, falls below -5% by 4Q22 and trends at around -4% GDP to 1Q26. These new forecasts imply higher levels of government borrowing than previously expected (note, there is no mention of balanced budgets or austerity). For government borrowing to fall in line with these expectations, HH and NFC spending have to rise more into line with income.

From a sector balances perspective, this is the point at which alarm bells begin to ring.

**Historic and forecast trends for UK household financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** (Source: OBR; CMMP analysis)

Turning to the key HH sector first, the OBR forecasts assume that the financial surplus will peak at just under 14% GDP in 1Q21 and then fall rapidly to under 2% GDP by 3Q22 in line with the previous March 2020 forecasts. The HH savings rate is expected to fall sharply from 28% GDP in 2Q20 to “settle at around 7.5% over the medium term.” This is below the average savings rate of 9% recorded between 1986 and 2019. The OBR argues that forced savings have played a greater role in the rise of HH savings than previously thought. Their new forecasts assume that, “more of the boost to HH finances from forced saving during the lockdown is spent as the economy returns to normality.” On this basis, the OBR now expects private consumption to return to its pre-virus peak by the middle of 2022, much earlier than they forecast in July 2020.

**Historic and forecast trends in UK household savings rate** (Source: ONS; OBR, CMMP analysis)

**How the UK household sector adjusted in the post-GF C period – sector balances % GDP** (Source: OBR; CMMP analysis)

To put these assumptions into a historic context, post the GFC, the HH sector’s financial surplus peaked at 6.1% GDP in 2Q10. It took 25 quarters for the surplus to fall below the 2% GDP level that the OBR now assumes HH will achieve in six quarters and sustain from 3Q22 onwards. Put simply, these forecasts ignore historical evidence from the UK and elsewhere that suggest that HH behaviour takes time to adjust from extreme shocks and implies obvious downside risks to the newly revised consumption and GDP forecasts, in my view.

**Historic and forecast trends for UK corporate financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** *(Source: OBR; CMMP analysis)*

Turning now to the NFC sector, businesses reduced investment during the pandemic and moved into financial surplus in 3Q20. The OBR assumes that this surplus will peak at 3.2% GDP in 1Q21 and settle at a deficit of around 2.5% GDP out to 1Q26. In other words, the forecasts assume both (1) relatively high future investment levels and (2) a relatively dynamic adjustment. Again for context, after the GFC, the NFC sector ran net financial surpluses for 17 consecutive quarters between 1Q09 and 1Q13.

**The complete picture – usual perhaps, but is this really sustainable?** (Source: OBR; CMMP analysis)

Finally, the OBR observes that, “over the medium term, sectoral net lending positions return to more usual levels.” While they may be usual in the sense that they are not new, that is not the same as saying that they are sustainable. The latest forecasts not only assume dynamic adjustments by the HH and NFC sectors but they also assume a sustained period during which combined private and public sector deficits are offset by increasing Row surpluses.

**Historic and forecast trends for RoW financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively.** *(Source: OBR; CMMP analysis)*

In other words, the current forecasts imply a return to persistent sector imbalances with the UK increasingly reliant on the RoW as a net lender (see Imbalances and dependencies).

Conclusion

If we assume that the OBR forecasts become the base case priced into UK assets, then financial sector balances point to downside risks to growth expectations, upside risks to the level of borrowing, inflation staying below target out to 1Q26 and rates remaining lower for longer. Plus ca change…

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

“Sacred duty?”

Policy responses versus theory debates

The key chart

**Trends in MMT interest levels versus peak interest levels** (Source: Google Trends, CMMP analysis)

The key message

The Office of Budget Responsibility (OBR) will publish its latest forecasts for the UK economy and public finances tomorrow (25 November 2020) alongside the Chancellor’s Spending Review.

In normal times, the focus would be on assessing progress against fiscal targets. A more interesting focus in the current “extraordinary times”, however, would be to assess policy and the accompanying rhetoric in the context of unprecedented shifts in UK financial sector balances and the on-going debate between orthodox fiscal thinking and Modern Monetary Theory (MMT) recommendations.

**Repeating a previous chart – UK private sector and general government net lending/borrowing positions from the capital account expressed as a percentage of GDP** (Source: ONS, CMMP analysis)

Despite the dramatic shift in the private sector’s net lending position this year, UK policy debate remains centred on “sacred duties to balance the books”, rumours of public sector pay freezes and speculation about tax rises. From the position of “orthodox fiscal thinking”, no surprises here.

MMT, which at its core is simply a description of financial flows in a modern capitalist economy with private banks and a government (Keen) provides an alternative view, however. Economists such as Stephanie Kelton argue that (as currency issuers) neither the UK nor US governments are dependent on tax revenues or borrowing to fund spending (the most important constraint on government spending being inflation instead). For Kelton, “the problem is that policy makers are looking at the picture with one eye shut.”

**Trends in UK CPI versus the Bank of England’s target of 2%** (Source: Bank of England, CMMP analysis)

The Bank of England does not agree, clearly! At yesterday’s (23 November 2020) Treasury Committee hearings, Professor Silvana Tenreyro (an External Member of the MPC) dismissed MMT be repeating the adage that “the good things are not new and the new things are not good,” and Andy Haldane (Chief Economist) argued that his problem with MMT was that it is not modern, not monetary and not really theory, merely “a trick that can only be pulled once” instead.

In this context, the packaging and analysis of tomorrow’s UK announcements (and on-going US policy debates) will provide an interesting indicator of the balance of economic debate and the extent to which MMT is influencing policy choices on either side of the Atlantic, if at all…

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

“Extraordinary responses to extraordinary times”

UK policy responses seen from a money sector perspective

The key chart

**UK private sector and general government net lending/borrowing positions from the capital account expressed as a percentage of GDP** (Source: ONS; CMMP analysis)

The key message

In this post, I consider last week’s coordinated policy responses from the UK government and the Bank of England in the context of UK financial sector balances and recent “messages from the money sector”.

Large and persistent sector imbalances, an over-reliance on the RoW as a net lender and a household sector that was already poised to disappoint were challenging the economy even before Covid-19 hit. The immediate “Covid-19” response from the private sector was to increase its net lending position to a record 22% of GDP, almost 3x the equivalent response after the GFC. The HH savings ratio increased to a record 29% and HH consumption fell by the largest amount ever recorded (£81bn). In direct response to this negative shock, the UK government increased its net borrowing position to negative 23% of GDP – a timely and appropriate response.

Since then, the message from the UK money sector has remained one of high uncertainty and slowing consumption even before the latest round of restrictions began. Hence, the latest coordinated responses are also timely, necessary and appropriate. Looking ahead, current trends also suggest that: (1) the UK government will maintain an increasingly interventionist role; (2) the Bank of England will remain committed to keeping nominal and real rates “lower for longer”; and (3) investors hoping for a shift away from long duration fixed income and equity trades may require considerable patience.

Seven charts that matter

On 5 November 2020, the UK government and the Bank of England coordinated a larger-than-expected fiscal and monetary response to the latest Covid-19 wave and the second national lockdown. Rishi Sunak, the Chancellor of the Exchequer announced the extension of the furlough scheme until March 2021 and the Bank of England increases its bond-buying programme by £150bn. In the latest CMMP analysis, I consider this joint policy response in the context of (1) UK financial sector balances and (2) recent messages from the money sector.

**The challenging starting point – trends in net lending/net borrowing expressed as a % GDP before the Covid-19 pandemic hit** (Source: ONS; CMMP analysis)

Large and persistent sector imbalances, an over-reliance on the RoW as a net lender (see graph above) and a household sector that was already poised to disappoint were challenging the economy even before Covid-19 hit. Up until the 4Q19, the UK private and public sectors were running net borrowing positions at the same time that were offset by the RoW’s persistent net lending. The HH sector was funding consumption by dramatically reducing its savings rate and accumulation of net financial assets. With real growth in disposable income slowing and the savings rare close to historic lows, the risks to the UK economy already lay to the downside and at odds with previous government forecasts.

**Trends in private sector net lending comparing the early-1990s recession and the GFC with 2020** (Source: ONS; CMMP analysis)

The immediate “Covid-19” response from the private sector was to increase its net lending position to a record 23% of GDP in 2Q20. In other words, the amount of money that the private sector had “left over” after all its spending and investment in 2Q20 was approximately 3x the equivalent amounts after the GFC and the recession of the early 1990s (expressed as a % of GDP).

**Trends in HH gross savings and the HH savings ratio** (Source: ONS; CMMP analysis)

The HH sector was the main driver here. HH gross savings rose to £104bn in 2Q20 and the savings rate increased to a record 29% compared with 10% in 1Q20 and 7% a year earlier. HH consumption fell by the largest amount ever recorded (£81bn), driven by large declines in spending on hotels, restaurants, travel, recreation and cultural services. The HH net lending position accounted for 20ppt of the total 23% private sector net lending in 2Q20, another record.

**Trends in HH final consumption expenditure – the largest quarterly decline ever** (Source: ONS; CMMP analysis)

In direct response to this negative shock, the UK government increased its net borrowing position to negative 23% of GDP – a timely and appropriate response. The main drivers here were the continuation of the Coronavirus Job Retention Scheme (CJRS), the introduction of the Coronavirus Self Employment Income Support Scheme (SEISS) and the Small Business Grant Fund.

**A timely and appropriate response from the UK government** (Spurce: ONS; CMMP analysis)

Since then, the message from the UK money sector has remained one of high uncertainty and slowing consumption even before the latest round of restrictions began. The latest Bank of England data showed that HH deposits increased by £7bn in September 2020. While this flow was below the £14bn, £16bn and £27bn monthly flows seen at the peak of uncertainty in March, April and June respectively it was still 1.5x the average 2019 monthly flows. Co-incidentally, September’s YoY growth rate in consumer credit was the weakest since records began (-4.6% YoY).

**Monthly HH deposit flows since January 2019** (Source: Bank of England; CMMP analysis)

2020 trends in HH consumer credit – flows and growth rates. (Source: Bank of England; CMMP analysis)

Conclusion

In summary, the latest coordinated fiscal and policy responses are timely, necessary and appropriate. Looking ahead, current trends also suggest that: (1) the UK government will maintain an increasingly interventionist role; (2) the Bank of England will remain committed to keeping nominal and real rates “lower for longer”; and (3) investors hoping for a shift away from long duration fixed income and equity trades may require considerable patience.

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

“Don’t bet on the consumer”

Uncertainty reigns and consumption remains subdued

The key chart

**The UK and EA money sectors sent a clear message this week** (Source: Bank of England; ECB; CMMP analysis)

The key message

The UK and euro area (EA) money sectors sent a clear message to investors this week – don’t bet on the consumer.

Uncertainty reigns among European households. Monthly flows into deposits in the UK and EA remain 1.5-2.0x the average seen in 2019, despite negative real returns.

Yes, household lending has recovered from recent lows, driven by resilient (and rising) mortgage demand. Consumer credit demand, however, remains negative/weak. UK HHs repaid £0.6bn of consumer credit in September after additional borrowing in July (£1.1bn) and August (£0.3bn). The annual growth rate fell to -4.6%, a new low since the data series began in 1994. EA HHs borrowed €1bn for consumer credit in September, down from €3bn in August and €5bn in July, but the 0.1% YoY growth rate was the slowest since consumer credit recovered back in May 2015.

High uncertainty and slowing consumer spending were in place even before the introduction of the latest round of restrictions across Europe. No wonder that Madame Lagarde was so emphatic in warning investors to expect something more dramatic in December.

A simple message in six charts

**Monthly UK household deposit flows since January 2019** (Source: Bank of England; CMMP analysis)

**Monthly EA household deposit flows since January 2019** (Source: ECB; CMMP analysis)

**YoY growth rates in UK and EA mortgage and consumer credit** (Source: Bank of England; ECB; CMMP analysis)

**Monthly UK household credit flows since January 2020** (Source: Bank of England; CMMP analysis)

**Monthly EA household credit flows since January 2020** (Source: ECB; CMMP analysis)

**Trends in EA and UK inflation versus target since 2010** (Source: Bank of England; ECB; CMMP analysis)

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

“Don’t confuse the messages”

Different M3 drivers with different implications

The key chart

**What messages can be derived from the components and counterparts of current money growth and how do they compare with past cycles?** (Source: ECB; CMMP analysis)

The key message

Broad money (M3) in the euro area (EA) is growing at its fastest rate since early 2008. However, CMMP analysis of the components and counterparts of this growth suggests that the associated “messages from the money sector” and their implications are very different.

The message in the pre-GFC period was one of (over-) confidence and excess credit demand. In contrast, the current message is one of heightened uncertainty and subdued credit demand. Today’s money growth 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 implications for inflation and policy options are clear. Inflationary pressures are likely to remain weak during the current cycle. Madame Lagarde may well signal more monetary support before the end of 2020 at this week’s ECB meeting, but the over-riding message from the EA money sector is that the route to economic recovery and higher inflation remains “fiscal, first and foremost.”

Seven charts that matter

Broad money (M3) in the euro area (EA) is growing at the fastest rate since early 2008. M3 grew 10.4% YoY in September, up from 9.5% in August. This is the fastest rate of YoY growth since April 2008 when M3 grew 10.6% YoY. However, CMMP analysis of the components and counterparts of these two growth phases suggests that the associated “messages from the money sector” are very different. Current trends are not a repeat of 2008 dynamics.

**Different drivers and implications of monetary expansion – 2008 versus 2020** (Source: ECB; CMMP analysis)

Note that the components and counterparts of M3 provide different perspectives and explanations of changes in broad money. Monetary aggregates are derived from the consolidated monetary financial institutions (MFI) balance sheet and comprise monetary liabilities of MFIs and central government vis-à-vis non-MFI euro area residents.

The Eurosystem defines narrow (M1), intermediate (M2) and broad (M3) aggregates. They differ with respect the degree on “moneyness” or liquidity of the instruments included. M1, for example, comprises only currency in circulation and balances that can be converted into currency or used for cashless payments. Relative high holdings of M1 indicate a relatively high preference for liquidity and can be used as an inverse proxy for the level of private sector confidence.

The consolidated MFI balance sheet also provides the basis for analysing the counterpart of M3. All items other than M3 on the consolidated balance sheet can be rearranged to explain changes in broad money. The relationship between M3 and its counterparts rests on a simple accounting identity. What this means is that we have two identities that can be used to provide different perspectives on changes in broad money:

Components: Broad money equals M1 plus M2-M1 plus M3-M2
Counterparts: Broad money equals credit to EA residents plus net external assets minus longer term financial liabilities plus other counterparts (net)

**What was the message from the money sector in the pre-GFC period?** (Source: ECB; CMMP analysis)

The message in the pre-GFC period was one of (over-) confidence and excess credit demand. From a components perspective, for example, M1 was growing only 2.7% YoY in April 2008 and contributing just 1.2ppt to the overall 10.6% growth in total money. At this point M1 accounted for 43% of the outstanding stock of money. From a counterparts perspective, private sector credit was growing at 11.2% and contributing 17.6ppt to the growth in total money (offset by negative contributions from net external assets and LT financial liabilities). Credit to general government was contributing just 0.1ppt to broad money growth.

**What is the message from the money sector now?** (Source: ECB; CMMP analysis)

In contrast, the current message is one of heightened uncertainty and subdued credit demand. M1 grew 13.8% YoY in September 2020, up from 13.2% in August and contributed 9.4ppt to the overall 10.4% growth in broad money (versus 9.0ppt in August). M1 now accounts for 70% of the outstanding stock of money. The private sector is holding higher levels of the most liquid assets despite negative real returns on those instruments. This suggests high levels of uncertainty that have been exacerbated by the Covid-19 pandemic. (Note in passing that monthly flows showed a divergence between rising and above 2019-average household deposit flows and falling and below 2019-average NFC flows in September).

**Uncertainty reigns – very different drivers of money growth** (Source: ECB; CMMP analysis)

Private sector credit grew 4.6% YoY in September, unchanged from August. As before, relatively robust demand for NFC credit (7.1%) and resilient (and rising) mortgage demand (4.5%) continue to offset relative weakness in consumer credit (0.1%). However, private sector credit contributed only 5.2ppt to the overall 10.4% growth in broad money.

A key point here is that, in typical cycles, monetary aggregates and their counterparts move together. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing. The current relationship between money and credit cycles is far from typical, however. Indeed the gap between M3 and PSC is at a historic high reflecting the fact that the euro area is only emerging very gradually from a period of debt overhang.

**Counterparts to M3 – the alternative view of what is driving money growth** (Source: ECB; CMMP analysis)

Today’s money growth 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). Credit to general government and credit to the private sector contributed 6.8ppt and 5.2ppt respectively to the 10.4% growth in broad money (see graph above). This is in direct contrast to the pre-GFC period when money expansion was driven primarily by strong, or excess, private sector credit demand (see graph below).

**Contrasting contributions of private sector credit and messages for the outlook for aggregate demand** (Source: ECB; CMMP analysis)

Conclusion – don’t confuse the messages

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

“Exceptional and temporary”

What now for bank capital distributions?

The key chart

The key message

The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.

The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD.

The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.”

Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. However, estimates by my colleagues at zeb consulting suggest that the average CET1 ratio of the largest 50 banks will remain on a sufficient level. More importantly, their analysis highlights significant differences among the sample banks. They find no statistically significant patterns regarding specific business models or country/regional exposure.

Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders remains subordinate to other priorities.

Six charts that matter

The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.

**And then they were gone – the recovery in bank dividends was a rare positive for EA banks** (Source: Macrobond; CMMP analysis)

The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Across advanced economies, banks’ dividend yields had recovered from the low levels that accompanied the rebuilding of capital after the GFC.

Euro area (EA) banks increased their shareholders’ yields via dividends but also tended to raise capital by issuing new shares. In contrast, the recovery in yields for US banks was more modest, as US banks have returned more cash through share buybacks instead. ECB analysis suggests that US and Nordic banks were the most generous in terms of shareholder remuneration recently, ahead of their UK, Swiss and EA peers (see graph below).

**EA banks increased shareholder yields via dividends but also tended to issue new shares** (Source: ECB; CMMP analysis)

Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD. In previous posts, I have (1) explained that the macro building blocks that are required for a sustained improvement in banks’ profitability and share price performance have been missing, (2) highlighted that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic, and (3) questioned the conviction of previous sector rallies. Despite a 2% recovery over the past month, the SX7E index has fallen 42% YTD and underperformed the wider SXXE index by 34%.

**Another miserable year for bank investors** (Source: Macrobond; CMMP analysis)

The 60% underperformance of EA banks over the past five years supports a central theme in CMMP analysis. The true value in analysing developments in the financial sector lies less in considering investments in banks and more in the understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.

**Why bother analysing banks/developments in the financial sector?** (Source: Macrobond; CMMP analysis)

The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. It is important to note that the implementation of post-GFC standards had improved the capitalisation of global banks and that the introduction of capital buffers also helped them to withstand stressed situations such as the current pandemic. When these buffers are drawn down to pre-determined levels, Basel standards place automatic limits on dividends, share buybacks and bonus payments. However, given the scale of the potential losses that might arise from the pandemic, supervisors moved to halt dividends and buybacks even if pre-identified capital limits had not been breached.

In the case of EA banks, Yves Mersch, a member of the Executive Board of the ECB and Vice Chair of its Supervisory Board, explained last month that “while prudent capital planning is the order of the day, the current economic uncertainty means that banks are simply unable to forecast their medium-term capital needs accurately. Such an unorthodox move was therefore justified by our ultimate goal to counteract procyclical developments and support banks’ capacity to absorb losses during the crisis without compromising their ability to continue lending to the real economy.”

Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.” Mersch also acknowledged that, “under normal conditions, profitable and healthy banks should not be prevented from remunerating their shareholders. Restricting dividends can increase banks’ funding costs, have an impact on their access to capital markets and make them less competitive than their international peers.”

**Expected losses to increase signficantly for Europe’s 50 largest banks** (Source: zeb consulting)

Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. Estimates from my colleagues at zeb consulting suggest that ELs could rise to between EUR 543-632bn in 2021 and EUR 611-833bn in 2022. Combined with a rise in RWAs, this would result in a drop in average CET1 ratios to between 11.4% and 12.3% in 2021 and 11.4% and 12.6% in 2022. In other words, the average CET1 ratio of the largest 50 banks in Europe is expected to remain sufficient despite higher ELs and RWAs.

**Capital positions expected to remain sufficient** (Source: zeb consulting)

Their analysis highlights significant differences among the sample banks. In several cases, banks are expected to consume their pre-Covid-19 capital cushions and will be forced to use the capital buffers release by regulators. In the “zeb base case”, eight of the top 50 European banks fall into this category. This number increases to 18 in their more “severe scenario”. However, none of the banks will end up with CET1 ratios below the reduced post-Covid-19 requirements.

More importantly in the context of the current debate, they find no statistically significant patterns regarding specific business models or country/regional exposure.

Conclusion

Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. Yes, European banks remain dependent on government support for private and corporate customers and regulatory easing regarding capital ratios and banks, regulators and governments also need to continue to work together to prevent future credit or liquidity crunches. ECB representatives are also correct to highlight the real challenges faced by banks in forecasting medium-term capital needs accurately and the argument that they and the IMF put forward in terms of the benefits of flexibility is valid (eg, additional capital preserved could be distributed to shareholders should it prove unnecessary).

Nonetheless, the significant differences that exist between European banks and the lack of significant patterns at the business model, country or regional exposure levels suggests that the case for a blanket approach to restrictions of banks capital distributions is much weaker now that it was at the start of the pandemic. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders is subordinated below other objectives and I conclude with the words of Andrea Enria, the Chair of the ECB’s Supervisory Board from a recent interview with Handlesblatt:

The ban on dividends is an exceptional measure. We do not intend to make it a regular supervisory tool. It was introduced when governments, the ECB and ECB Banking Supervision announced a major support package to deal with the fallout of the pandemic. The ECB has calculated that the full use of government guarantee schemes might reduce banks’ loan losses by between 15 to 20 per cent in the euro area. The package was intended to allow banks to grant loans to households and companies, not to compensate shareholders. The pandemic led to factory and school closures, and some of us were locked down for months. Why should dividends, of all things, be the only sacrosanct element in our societies?
Andrea Enria, Interview with Handlesblatt (12 October 2020)

Please note that the summary comments and charts above are abstracts from more detailed CMMP and zeb consulting analysis that is available separately.

“Crocodile jaws”

Resilient demand masks tough times for UK mortgage providers

The key chart

**Resilient mortgage demand masks tough times for UK mortgage providers (% YoY)** (Source: Bank of England; CMMP analysis)

The key message

The relative stability/resilience of mortgage markets in the UK (and in the euro area) has been a consistent theme in the “messages from the money sector” during the COVID-19 pandemic.

UK mortgages grew 2.9% YoY in August, unchanged from July, and monthly flows have been steadily increasing from their April 2020 lows. This recovery has also been the main driver in the rebound in overall household borrowing, with mortgages accounting for £3.1bn in August’s £3.4bn increase in total lending to individuals. Looking forward, the number of mortgage approvals for house purchases also increased sharply in August to 84,700, the highest number since October 2007.

So far, so good – but there is always a “but”…

Current mortgage demand is very subdued in relation to past cycles despite the low cost of borrowing. One factor here is that, despite the deleveraging seen since 1Q10, the UK household debt-to-HDP ratio remains at 85%, the threshold level above with the BIS believes that debt becomes a drag on future growth. Unsurprisingly, the CAGR in HH debt (primarily mortgages) has trended between only +/- 1% nominal GDP growth since early 2016 – not much of a “growth story” here.

More concerning for mortgage providers, the effective rates on new and outstanding mortgages have fallen 28bp and 32bp respectively over the past 12 months to new lows of 2.14% and 1.72% respectively. The gap between the rate on outstanding and new mortgages was 38bp in August, indicating further downward pressure on net interest margins and income.

With subdued growth and further NIM compression ahead, mortgage providers will need to embrace digitalisation to deliver effective market segmentation/client knowledge, alternative revenue sources, further efficiency gains and more effective liquidity and risk management.

Seven charts that matter

The relative stability/resilience of mortgage markets in the UK (and euro area) has been a consistent theme in the “messages from the money sector” during the Covid-19 pandemic. Outstanding mortgage balances grew 2.9% YoY in August, unchanged from July but slightly below the 3.1% growth recorded in June. In contrast, the growth in consumer credit hit a historic low (-3.9% YoY) while corporate lending grew 9.7% YoY (see key chart above).

**Monthly flows have recovered steadily since their April 2020 lows** (Source: Bank of England; CMMP analysis)

The recovery in monthly HH borrowing flows since April’s lows (see chart above) has been the key driver in the recovery in overall household lending (see chart below). In August, for example, mortgages accounted for £3.1bn out of a total £3.4bn monthly flow.

**Mortgages are driving the recovery in household lending** (Source: Bank of England; CMMP analysis)

**Approvals suggest positive momentum** (Source: Bank of England; CMMP analysis)

Looking forward, the number of mortgage approvals for house purchases also increased sharply in August to 84,700, the highest number since October 2007. This partially offsets the March-June weakness – there have been 418,000 approvals YTD, compared with 524,000 in the same period in 2019.

So far, so good – but there is always a “but”…

**Current demand is very subdued in relation to past cycles in nominal and real terms** (Source: Bank of England; CMMP analysis)

Current mortgage demand is very subdued in relation to past cycles (see chart above), despite the low cost of borrowing. One factor here is that, despite the deleveraging seen since 1Q10, the UK household debt-to-HDP ratio remains at 85%, the threshold level above with the BIS believes that debt becomes a drag on future growth (see chart below).

**HH debt ratios remain elevated at the BIS threshold level** (Source: BIS; CMMP analysis)

Unsurprisingly, the CAGR in HH debt (primarily mortgages) has trended +/- 1% nominal GDP growth since early 2016. The chart below comes from CMMP Relative Growth Factor (RGF) analysis, which considers the rate of growth in debt in relation to GDP on a three-year compound growth basis with the level of debt expressed as a percentage of GDP. This graph illustrates the UK HH RGF on a rolling basis. There is little to get excited about in this chart.

**An unexciting “relative growth” story – rolling 3-year CAGR in HH debt versus rolling 3-year CAGR in nominal GDP** (Source: BIS; CMMP analysis)

More concerning for mortgage providers, the effective rates on new and outstanding mortgages have fallen 28bp and 32bp respectively over the past 12 months to new low of 2.14% and 1.72% respectively. The gap between the rate on outstanding and new mortgages was 38bp in August, indicating further downward pressure on net interest margins and income.

**The challenge of delivering top-line growth** (Source: Bank of England; CMMP analysis)

Conclusion

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

“Extremes have peaked, but…”

…the road to recovery remains long and uncertain

The key chart

**“Extremes may have peaked, but…”** (Source: ECB; CMMP analysis)

The key message

Broad money (M3) growth in the euro area slowed from 10.1% YoY in July to 9.5% YoY in August, but remains elevated in relation to recent trends. Narrow money (M1) growth also slowed from 13.5% YoY in July to 13.2% in August, but still contributed 9ppt to the overall growth in broad money.

Monthly flow data supports the narrative that uncertainty levels have peaked but remain elevated. Household and corporate monthly deposit flows, for example, peaked in April and May, but still remain 1.4x and 2.1x their respective 2019 averages.

Growth in private sector credit, the main counterpart to M3, has also slowed from May’s recent high of 5.3% YoY to 4.6% YoY in August but the gap between growth in the supply of money and the demand for credit remains very wide. Private sector deleveraging in the euro area remains gradual and incomplete.

As before, relatively robust corporate demand for credit (7.1% YoY) and resilient mortgage demand (4.1% YoY) offset relatively weak demand for consumer credit (0.3% YoY). However, more extreme monthly variations in credit demand have moderated.

On a positive note, consumers in the euro area stopped repaying credit in May and monthly consumer credit flows over the past three months have been close to the average levels of 2019.

In short, no change to the message from the money sector in August – extreme monthly flows may have peaked, but the road to recovery in the euro area remains long and uncertain.

Six charts that matter

**Money supply growth slowed slightly in August but remains elevated** (Source: ECB; CMMP analysis)

**HH monthly deposit flows remain 1.4x their 2019 average** (Source: ECB; CMMP analysis)

**NFC monthly deposit flows also 2x their 2019 average** (Source: ECB; CMMP analysis)

**One of my favourite charts and a clear indicator of on-going balance sheet adjustments** (Source: ECB; CMMP analysis)

**PSC growth drivers remain unchanged** (Source: ECB; CMMP analysis)

**Finally, on a positive note – monthly consumer credit flows have bounced back to their 2019 levels** (Source: ECB; CMMP analysis)

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