cgmallin – Page 26 – Chris Mallin Macro Perspectives

“The ECB’s missing chart”

The FSR is suitably cautious, but misses a key chart

The key (missing) chart

Are ECB policies fuelling growth in less productive FIRE-based lending at the expense of productive COCO-based lending (% total loans)? What are the implications for leverage, growth, stability and income inequality?
Source: ECB; Haver; CMMP analysis

Summary

The ECB published its November 2019 Financial Stability Review (FSR) this week with a suitably cautious outlook for financial stability, economic growth, and banking sector profitability in the euro area (EA).

The analysis is as insightful and thorough as usual and supports many of my current views. However, it “falls short” in one key respect – the FSR presents its analysis through the traditional household (HH) versus corporate (NFC) framework, rather than through the increasingly more relevant COCO versus FIRE-based credit framework.

The risk here is that it underplays the hidden risks in QE, namely that the majority of credit in the EA is directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit. As such, current policies to support/stimulate credit demand have potentially negative (if unintended) implications for leverage, growth, stability and income inequality.

Key messages from the FSR (Nov 2019)

The FSR states that the “the euro area financial stability outlook remains challenging“. It highlights four key issues:

Signs of asset mispricing suggest potential for future correction
Lingering private and public sector debt sustainability concerns
Growing challenges from cyclical headwinds to bank sector profitability (“75% of EA significant banks have ROE < 8%”)
Increased risk-taking by nonbanks may pose risks to capital market financing

In mitigation, the FSR notes that: (1) euro area banks are adequately capitalised with a 14.2% CET1 ratio; and (2) all Euro Area countries have activated macroprudential measures. Nonetheless, it concludes that “more active use of macroprudential policies could be appropriate to contain vulnerabilities“.

The FSR argues that the economic outlook has deteriorated and that growth is expected to remain subdued for longer, with risks tilted to the downside. It also concludes that “while the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain“. Four headwinds facing banks are cited: eroding interest margins; slightly higher costs of risk; high cost inefficiencies, and plateauing capital positioning.

I have covered many of these factors in recent posts including:

The ECB’s framework

The FSR presents its analysis of the HH and NFC sector separately. The HH sector is discussed in Section 1.3 (Euro area household resilience supported by low interest rates) and the NFC sector in Section 1.4 (Emerging pockets of corporate sector vulnerability).

**Robust or subdued? Nominal HH credit growth is much lower than in past cycles (%YoY) and concentrated geographically (France, Germany, Benelux)**
Source: ECH; Haver; CMMP analysis

In summary, the FSR describes HH lending as “robust, with continued divergence across countries and types of loans”, HH indebtedness stable (with considerable heterogeneity across EA countries) and risks to HH debt sustainability contained. My comments:

HH credit is growing at the fastest rate in the current cycle (3.4% nominal and 2.6% real YoY growth) but rather than robust, I would describe this growth as relatively subdued especially in relation to historic cycles
As noted in previous posts, and illustrated in the graph above, HH growth is concentrated in Germany, France and the Benelux
In “Debt dynamics in the developed world” I agreed with the conclusion that excess credit growth risks in developed economies were relatively contained (and limited largely to non-EA countries such as Norway, Switzerland, Canada and Sweden, see graph below).

**CMMP analysis shows that HH sector growth risks are relatively low (HH RGF versus HH debt ratio)**…
Source: BIS; Haver; CMMP analysis

**…as are HH affordability risks in the Euro Area in contrast to Norway, Canada and Sweden (HH DSR as at end 1Q19 and deviations from LT average)**
Source: BIS; Haver; CMMP analysis

In the NFC sector, the FSR highlights the deceleration in corporate profits, along with increases in external financing and slightly elevated corporate indebtedness, but suggests that risks are offset by favourable financing conditions and large liquidity buffers.

**NFC debt levels remain above the average for BIS reporting countries and the BIS maximum threshold**
Source: BIS; Haver; CMMP analysis

**CMMP analysis shows that only Italy, Greece and Germany (among large EA economies) have NFC debt levels below the BIS maximum threshold**
Source: BIS; Haver; CMMP analysis

I would suggest that this underestimates risks in this sector:

The NFC debt ratio (% GDP) is currently 105% in the EA, above the 94% average for all BIS reporting countries and the BIS maximum threshold level of 90%
At the country level, only Italy, Germany and Greece have NFC debt ratios below the BIS threshold
My analysis also highlights relative high “growth” and “affordability” risks in the French NFC sector.

**France is among the four economies that have seen the fastest rates of “excess NFC credit growth” despite having high levels of NFC (% GDP)**…
Source: ECB; Haver; CMMP analysis

**…while also displaying relatively high levels of NFC affordability risk (NFC DSR as at end 1Q19 versus deviation from LT average)**
Source: BIS; Haver; CMMP analysis

An alternative framework

In September, I presented an alternative framework for analysing global debt dynamics. I argued that, in its broadest sense, lending can be split into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO”-based lending (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE”-lending (FInancials and Real Estate).

**EA lending is increasingly directed towards less productive FIRE-based lending (% total lending) which now accounts for 55% of total loans**
Source: ECB; Haver; CMMP analysis

In short, COCO-based lending typically supports production and income formation, while FIRE-based lending typically supports capital gains through higher asset prices. Lending in any economy will involve a balance between these different forms, but to repeat the key point from September: a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

**Only three of the large EA economies have COCO-based lending above (Greece, Austria) or equal to (Italy) FIRE-based lending (% total loans)**
Source: ECB; Haver; CMMP analysis

Over the past twenty years, FIRE-based lending has increased from 48% of total loans to 55% as at the end of September 2019. The current level represents the highest share of FIRE-based lending. Only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending: Greece; Austria, and Italy.

Why does this matter?

The hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.

Leverage: while COCO-based lending increases absolute debt levels, it also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage
Growth: similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly
Stability: the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers. The FSR notes that house prices rose faster than GDP in 1H19 and highlights signs of overvaluation, which now exceeds 7% on average, “but with a high degree of cross-country heterogeneity” (see graphs below)
Inequality: the returns from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

EA house prices have risen faster than GDP in 1H19 and are estimated to be overvalued by 7%
Source: ECH; Haver; CMMP analysis

**Residential property prices are estimated to be overvalued in all large EA economies (and in the UK) with the exceptions of Italy and Ireland**
Source: ECH; Haver; CMMP analysis

Conclusion

The FSR’s outlook for financial stability, economic growth and bank sector profitability is in-line with the views expressed in my recent posts (albeit with some differences in emphasis). However, the hidden risks associated with the ECB’s unorthodox monetary policy are potentially understated, in my view.

The alternative framework presented here, that draws the distinction between productive COCO-based lending and unproductive/less-productive FIRE-based lending, provides a clearer perspective of these risks.

The on-going shift in the balance of lending in the Euro Area has negative implications for leverage, economic growth, financial stability and income inequality.

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

“Macro building blocks revisited”

SX7E – relief rally or genuine recovery?

The key chart

The SX7E index of leading European banks has rallied strongly and outperformed the EURO STOXX index since the August 2019 low (graph illustrates relative performance based on average monthly prices). Is this merely a relief rally or the start of a sustained recovery?
Source: Haver; CMMP analysis

Summary

In early September 2019, I outlined the five key “macro building blocks” that drive bank sector profitability and share price performance (see “Macro building blocks matter”– look at the SX7E). I highlighted how they had weakened significantly during 2019, and noted how this had been accompanied by poor absolute and relative performance of the SX7E index of leading European banks over the previous twelve months.

Since then, the SX7E index has risen 26% from its 15 August low of 77 to a recent high of 97, before falling back to 93 currently (6% lower than 12 months ago). In this short update, I consider this performance in the context of my macro building block framework to ask: is this a relief rally or the start of a period of sustained recovery and share price outperformance?

Macro building blocks recap

In developed economies, I focus primarily on five key “macro building blocks” that drive bank sector profitability and share price performance:

growth in real GDP
growth in private sector credit
the level of ST rates
the level of LT rates
the shape of the yield curve

Net interest income – the main value driver for most banks – has a positive relationship with GDP, the level of rates and the shape of the yield curve. The level of ST rates is more important for banks in “floating rates” economies and market segments. In contrast, the slope of the yield curve is more important for banks in “fixed rate” economies and market segments.

**Variable rate lending as %age of total new loans in the EU**
Source: ECB; Haver; CMMP analysis

In the Euro Area, 63% of new loans to HHs and NFCs are based on variable rates but only 18% of mortgages (down from 58% in November 2004). This means that EA banks are affected by both the level of ST rates and the slope of the yield curve.

**Variable rate lending as %age of total EA mortgages**
Source: ECH; Haver; CMMP analysis

Non-interest income – the second key value driver – has a positive relationship with GDP but a negative relationship with the level of ST rates, while provisions have a negative relationship with GDP and a positive relationship with the level of ST rates.

Building blocks revisited

**Real GDP growth in the EA has slowed below the average rate over the past twenty years (% YoY)**
Source: ECB; Haver; CMMP analysis

Real GDP growth has slowed from the recent high of 3.0% (4Q17) to 1.1% (3Q19), the weakest rate of growth since 4Q13 and below the region’s twenty year average of 1.4%. All of the major Euro Area economies are growing below their LT averages with the exception of Spain and Portugal.

The European Commission revised down its 2019e, 2020e and 2021e GDP forecasts recently to 1.1%, 1.2% and 1.2% respectively. The latest ECB forecasts are the same for 2019e and 2020e, but they see growth returning to the LT trend of 1.4% by 2021e. These forecasts are consistent with monetary sector indicators (see “Look beyond the yield curve II”)

**Twenty year trends in EA private sector credit (%YoY, 3M MVA)**
Source: ECB; Haver; CMMP analysis

**Current growth rates in EA corporate and household credit (% YoY)**
Source: ECB; Haver; CMMP analysis

On a more positive note, private sector credit growth remains at/close to the highest level in the current cycle. The 3m MVA of PSC, NFC and HH YoY credit growth were 3.7%, 4.0% and 3.4% in September 2019. However, these growth rates remain subdued in relation to past cycles, concentrated geographically and increasingly directed towards less productive segments (see “Fuelling the Fire – the hidden risks of QE)

ST rates (EONIA) locked at the base of the ECB’s corridor (MLR – deposit facility rate)
Source: ECB; Haver; CMMP analysis

ST rates remain locked at the base of the ECB’s corridor (-0.46%) and the Governing Council “now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2%”. This is negative for net interest margins in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending

**Euro Area 10Y bond yields remain in negative territory**
Source: Haver; CMMP analysis

LT rates have recovered from their lows but remain in negative territory. Ten year bond yields have recovered from the August lows of -0.71% to -0.26%, but are 49bp lower than at the start of the year.

**The 10Y-3M yield curve is no longer inverted**
Source: Haver; CMMP analysis

The EA yield curve has steepened 42bp from its recent inverted low (-0.28%) and moved back into positive territory at 0.14%. This is still 40bp flatter than at the start of the year which has negative consequences for net interest margins in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed rate lending.

**Spread between interest rate on new EA HH loans and 3M Euribor**
Source: ECB; Haver; CMMP analysis

**Spread between interest rate on new EA NFC loans and 3M Euribor**
Source: ECB; Haver; CMMP analysis

Negative ST rates and flat yield curves are compounded by on-going price competition. On-going narrowing of spreads has been a key feature of the HH sector. Over the past twelve months the spread on new HH loans has fallen 24bp from 2.13% to 1.89%. In contrast, the spread on new NFC loans has remained relatively constant at 1.77%.

Sustained recovery?

European banks continue to generate a lot of noise but little overall direction. The recent rally in the SX7E index is consistent with less negative bond yields and the end of the period of yield curve inversion. Nonetheless, current macro building blocks are not sufficient to support a sustained recovery in banking sector profitability across the region, in my view.

**Relative performance of SX7E versus SXXE over past twenty years (average monthly prices)**
Source: Haver; CMMP analysis

The purpose of this website is not to make investment recommendations (and ignores valuation), but my analysis suggests that the recent rally in European banks share prices represents a relatively ST relief rally rather than a period of sustained recovery and outperformance.

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

“Debt dynamics in the developed world”

The developed world continues to deleverage but risks remain

The key chart

**Only Italy, Austria, Greece, Germany and the US have NFC and HH debt ratios (% GDP, 1Q19) below BIS “maximum threshold” levels (dotted red lines)**
Source: BIS; Haver; CMMP analysis

Summary

The developed world continues to deleverage. This process has already led to dramatic shift in the structure of global private sector debt (see “The Changing Face of Global Debt”). With private sector debt levels still “too high” in the developed world, this trend is set to continue.

Risks associated with excess credit growth in the developed world are lower than in past cycles and remain concentrated by economy (Sweden, Switzerland, Canada and France) and by sector (NFC credit more than HH credit). Despite lower borrowing costs, affordability risks are still evident is both the NFC (Canada, France) and HH sectors (Norway, Canada, and Sweden).

Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist while unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).

Trends in DM debt ratios

Aggregate private sector debt ratios for the Euro Area, and the BIS sample of advanced and emerging economies (% GDP) – the developed world continues to deleverage while the emerging world plays “catch-up”
Source: BIS; Haver, CMMP analysis

The developed world continues to deleverage. Private sector credit as a percentage of GDP has fallen from a peak of 181% in 3Q09 to 162% at the end of the 1Q19. This has involved a (relatively gradual) process of “passive deleveraging” where the stock of outstanding debt rises but at a slower rate than nominal GDP.

The process of deleveraging in the Euro Area started later. Private sector credit as a percentage of GDP peaked at 172% in 1Q15 and has fallen to 162% at the end of 1Q19, in-line with the average for the BIS’ sample of advanced economies.

**The outstanding stock of debt continues to rise ($ billion) but at a slower rate than nominal GDP**
Source: BIS; Haver; CMMP analysis

This process has led to a dramatic shift in the structure of global debt. In 1Q00, the advanced world accounted for 90% of global private sector credit, with advanced economies excluding the Euro Area accounting for 70% and the Euro Area 20%. Emerging markets accounted for only 10% of global private sector credit with 7% from emerging markets excluding China and 3% from China.

**The changing face of global debt (% GDP) – shifting East and towards emerging markets**
Source: BIS; Haver; CMMP analysis

At the end of 1Q19, the advanced world’s share of global debt had fallen to 64% (advanced economies ex Euro Area 47%, Euro Area 18%) while the emerging markets share has increased to 36% (EM ex China 12%, China 24%).

Where are we now?

**The key chart repeated. The Netherlands, Sweden, Norway, Canada, Switzerland and Denmark have** **NFC and HH debt ratios (% GDP, 1Q19) above BIS threshold levels (dotted red lines)**
*Source: BIS; Haver; CMMP analysis*

With debt levels remaining “too high” in the advanced world this trend is likely to continue. The BIS considers corporate (NFC) and household (HH) debt ratios of 90% and 85% respectively to be maximum thresholds above which debt becomes a constraint on future growth.

In our sample of advanced economies, only Greece, Germany, Italy, Austria and the US have debt ratios below these thresholds in both sectors. In contrast both NFC and HH debt levels are above the BIS thresholds in the Netherlands, Sweden, Norway, Switzerland, Denmark and Canada. NFC debt ratios remain above the threshold in Ireland, Belgium, France, Portugal and Spain and while the UK has “excess” HH debt. In short, progress towards dealing with high levels of private sector debt remains incomplete.

Associated risks

Private sector growth risks

**The highest rates of “excess credit growth” (3-year RGF 1Q19) have occurred in economies where PSC debt levels are already high: Switzerland, Sweden, Canada, France**
Source: BIS; Haver; CMMP analysis

Risks associated with “excess credit growth” in developed markets are lower than in past cycles. I introduced my Relative Growth Factor analysis in “Sustainable debt dynamics – Asia private sector credit”. In short, this simple framework compares the relative growth in credit versus GDP (3 year CAGR) with the level of debt penetration in a given economy.

**Among the high risk economies, Canada has seen the most obvious adjustment (trends in 3-year RGFs since March 2002)**
Source: BIS; Haver; CMMP analysis

In terms of total private sector debt, the highest “growth risks” can be seen in Sweden, Switzerland, Canada and France. Private sector credit in each of these economies has outstripped GDP growth on a CAGR basis over the past three years despite relatively high levels of private sector debt. Canada has made the most obvious adjustment among this sample of relatively high risk economies with the RGF falling from over 4% two years ago to 1.8% currently.

NFC sector growth risks

In the NFC sector, the highest risks can be observed in Switzerland, Sweden, Canada and France. RGFs for these for these economies were 3.9%, 3.0%, 2.7% and 1.8% respectively, despite NFC debt levels that are well above the BIS threshold. As above, Canada’s rate of excess NFC credit growth is slowing in contrast to trends in Switzerland and Sweden.

**Contrasting trends between NFC sector risks in Canada versus Switzerland and Sweden**
Source: BIS; Haver; CMMP analysis

HH sector growth risks

In the HH sector, RGF analysis suggest that the highest risks are in Norway, Switzerland, Canada, Norway (and the UK). RGFs in these economies were 1.3%, 1.1%, 0.7% and 0.4% respectively. In other words, excess HH credit growth risk is lower than in the NFC sector. Furthermore, the rates of excess HH credit growth in each of these economies is lower than in the recent past, especially in Norway and Canada.

**Rapid adjustments in Norway and Canada among relatively high HH sector growth risk economies**
Source: BIS; Haver; CMMP analysis

Affordability risks

Despite lower borrowing costs, affordability risks remain. BIS debt service ratios (DSR) provide, “important information about the interactions between debt and the real economy, as they measure the amount of income used for interest payments and amortisations.” (BIS, 2017). The perspective provided by DSRs complements the analysis of debt ratios above but differs in the sense that they provide a “flow-to-flow” comparison ie, the debt service payments divided by the flow of income. In the accompanying charts, DSR ratios for private sector, corporate and household credit are plotted against the deviation from their respective long term averages.

**Canada and France display the highest NFC affordability risk levels (1Q19 DSR versus LT average)**
Source: BIS; Haver; CMMP analysis

NFC affordability risks are highest in Canada and France. Debt service ratios (57% and 55% respectively) are not only high in absolute terms but they also illustrate the highest deviations from their respective long-term averages (47% and 49% respectively). In the HH sector, the highest affordability risks are seen in Norway, Canada and Sweden, although the level of risk is lower than in the NFC sector.

**Norway, Canada and Sweden display the highest HH sector affordability risk (albeit lower than in the NFC sector)**
Source: BIS; Haver; CMMP analysis

Implications for the Euro Area

Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist. The European Commission recently revised its 2019 forecast down by -0.1ppt to 1.1% and its 2020 and 2012 forecasts down by -0.2ppt to 1.2% in both years, with these forecasts relying on “the strength of more domestically-oriented sectors.

**Subdued Euro Area growth forecast to continue (% YoY)**
Source: European Commission; Haver; CMMP analysis

Growth in broad money (5.5%) and private sector credit (3.7%) in September remains positive in relation to recent trends but relative subdued in relation to past cycles. Furthermore, the renewed widening in the gap between the growth in the supply of money and the demand from credit (-1.8%) indicates that the Euro Area continues to face the challenge of deficiency in the demand for credit.

**Gap between growth in supply of money and demand for credit illustrates the fundamental problem – a deficiency in credit demand across the Euro Area (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP analysis

This has on-going implications for policy choices. Unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).

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

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

“Sustainable debt dynamics” – Asia private sector credit

Global finance is shifting East but are current Asian PSC debt dynamics sustainable?

The key chart

**Figure 1: A striking feature in Asia is that the highest levels of “excess credit growth” (3-year RGF 1Q19) have occured in economies where debt ratios are already high**
Source: BIS; Haver; CMMP analysis

Summary

In “The Changing Face of Global Debt”, I argued that global finance was shifting East and towards emerging markets. In this post, I summarise my analysis of the sustainability of current Asian PSC trends. The key points:

Classifications of Asian economies as either “advanced” or “emerging” economies are over-simplistic and unhelpful
Relative growth factor (RGF) analysis provides a simple, first tool for assessing the sustainability of debt dynamics
The risks associated with “excess credit growth” across EM are much lower than in previous cycles
The striking feature in Asia, however, is the fact that the highest levels of “excess credit growth” have occurred in economies that already exhibit high debt levels (Hong Kong, China, Korea and Japan)
In Hong Kong and China, these risk are compounded by debt service ratios that are close to peak levels and well above LT averages (“affordability risk”)
RGF-related risks appear relatively low in Asia’s two large and “genuine emerging markets” – India and Indonesia
Relatively high excess HH growth rates in India and China remain a key focus point.

Time for new classifications?

The BIS classifies Asian reporting countries into two categories: three “advanced” economies (Japan, Australia and New Zealand) and eight “emerging” economies (China, Hong Kong, India, Indonesia, Korea, Malaysia, Singapore and Thailand).

Such broad classifications are unhelpful, at best, and inaccurate, at worst. The classification of Japan, Australia and New Zealand as advanced economies is logical but masks different exposures to HH (Australia and New Zealand) and NFC (Japan) debt dynamics.

**Figure 2: HH and NFC debt ratios (% GDP) for Asian reporting economies plotted against BIS threshold levels (in red)**
Source: BIS; Haver; CMMP analysis

The grouping of China, Hong Kong, India, Indonesia, Korea, Malaysia, Singapore and Thailand together as emerging economies is more troublesome as it ignores the wide variations in market structure, growth opportunities, risks and secular challenges.

I prefer to consider China, Korea, Hong Kong and Singapore as unique markets. China is unique in terms of the level, structure and drivers of debt and in terms of the PBOC’s policy responses. Korea is unique in terms of having NFC and HH debt ratios that exceed both advanced economy averages and the BIS thresholds above which debt becomes a drag on future growth. Hong Kong and Singapore are both distinguished by their roles as regional financial centres but have different HH debt dynamics.

Malaysia and Thailand can be considered intermediate markets given that either both HH and NFC debt ratios (Malaysia) or one debt ratio (Thailand HH) exceed the average for emerging markets ex China. This leaves India and Indonesia as genuine emerging markets among the BIS reporting economies, with debt ratios below the emerging markets ex China average and well below BIS threshold levels (see Figure 2 above).

RGF analysis – “excess credit growth”

The theory

I have used the simple concept of relative growth factor (RGF) analysis since the early 1990s as a first step in analysing the sustainability of debt dynamics. In short, this approach compares the rate of “excess credit growth” with the level of debt penetration in a given economy.

The three year CAGR in debt is compared with the three year CAGR in nominal GDP to derive a relative growth factor. This is then compared with the level of debt expressed as a percentage of GDP (the debt ratio).

The concept is simple – one would expect relative high rates of “excess credit growth” in economies where the level of leverage is relatively low and vice versa. Conversely, red flags are raised when excess credit growth continues in economies that exhibit relatively high levels of leverage.

Low average risk in EM

**Figure 3: Risks associated with “excess credit growth” across emerging markets are lower than in previous cycles (Trends in EM 3-year RGFs since March 2002)**
Source: BIS; Haver; CMMP analysis

Figure 3 above, illustrates rolling 3-year RGF trends for EM economies highlighting previous unsustainable levels that peaked in 1Q04, 3Q09, 4Q11 and 2Q15. The current excess growth rate of 1.3% suggests, however, that EM sustainability risks are relatively low. If anything, the lack of growth/slowing growth are more immediate challenges

How does Asia stand out?

**Figure 4: The key chart repeated! Asia RGF analysis illustrated as at end 1Q19 (3-year CAGR)**
Source: BIS; Haver; CMMP analysis

Spotlight on Asia’s unique markets

A striking feature across Asia has been that some of the fastest rates of excess credit growth have occurred in economies where debt levels are already very high – Hong Kong, China, Korea and Japan (see Figure 4 above).

**Figure 5: Trends in RGF for Asian economies with already high PSC debt ratios. China and Hong Kong slowing rapidly, Japan recovering**.
Source: BIS; Haver; CMMP analysis

The level of excess credit growth is already slowing sharply in Hong Kong and China from peak levels in excess of 6% (Figure 5). With debt service ratios in both economies close to peak levels and well above LT averages (Figures 6 and 7) a return to recent periods of excess growth is (1) unlikely and/or (2) would be associated with high levels of risk.

**Figure 6: Hong Kong’s PSC debt service ratio is close to its historic high and well above LT average**
Source: BIS; Haver; CMMP analysis

**Figure 7: China’s PSC debt service ratio is also close to its historic high and well above LT average**
Source: BIS; Haver; CMMP analysis

In contrast, Japanese PSC growth is recovering from sustained periods of deficient credit demand, helped by relatively low debt service ratios that are well below their LT averages (Figure 8 below). The recent uptick in excess Korean growth is unlikely to be sustainable, however, given that both HH and HFC debt levels are above BIS thresholds (Figure 2 above)

**Figure 8: Japan’s PSC debt service ratio displays a very different dynamic – the DSR is low in absolute terms and well below LT average**
Source: BIS; Haver; CMMP analysis

Asia’s intermediate and emerging markets

RGF factors for intermediate and emerging Asian markets indicate relatively low levels of sustainability risk. Both India and Indonesia have been through periods of adjustment from previous phases of excess credit growth.

**Figure 9: Rolling 3-year RGFs for Asia’s intermediate and emerging economies**
Source: BIS; Haver; CMMP analysis

In the former case, there are very different dynamics between the rapidly growing HH and slow growing NFC sector. The risks associated with excess credit growth in the HH sector (from a low base) are rising but remain relatively low in the NFC sector which is still in an adjustment phase.

**Figure 10: India’s HH and NFC sectors are displaying sharply contrasting debt dynamics**
Source: BIS; Haver; CMMP analysis

Indonesia’s growth rates have adjusted from the 2000-14 period of “super-charged” growth which was driven largely by exogenous factors including the commodities super-cycle and portfolio inflows during the period of global QE and record low US interest rates.

In summary, the risk associated with excess credit growth across EM are lower than in previous cycles. Asia stands out, however, because the highest rates of growth have occured in economies that already have high debt ratios. In China and Hong Kong, these risks are compounded by high debt service ratios indicating rising “affordability” risks. RGFs in both economies are adjusting sharply lower in response. Risks in intermediate and emerging Asian economies appear lower, but the relatively high excess HH growth rates in India and China remain a key focus point.

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

“The changing face of global debt”

Global finance continues to shift to the East and towards emerging markets making it unrecognisable from the industry that existed twenty years ago

The key chart

**The changing face of global debt (% of total PSC) – shifting East and towards emerging markets**
Source: BIS; Haver; CMMP analysis

Summary

In this post, I summarise my analysis of the latest Bank of International Settlement (BIS) Quarterly Review with respect to level and trends in global debt and global debt ratios. The key points are:

The level of global debt hit a new high of $183 trillion in 1Q19
Global debt ratios – debt expressed as a percentage of GDP – have rebounded since 3Q18, but remain below peak 1Q18 levels.
Deleveraging continues, however, in all sectors across the Euro Area
Emerging markets remain the most dynamic segment of global finance, accounting for 36% of total private sector credit compared to only 10% two decades ago
China remains the main driver of this growth, accounting for 24% of global PSC, but the misallocation of credit towards SOEs continues
Global finance continues to shift East and towards emerging markets making it unrecognisable from the industry that existed twenty years
Further research analyses (1) whether current trends are sustainable and (2) the associated investment risks.

A new high for global debt levels

**The level and breakdown of global debt between governments, corporates (NFC) and households (HH)**
Source: BIS; Haver; CMMP analysis

The level of global debt hit a new high of $183 trillion at the end of 1Q19. Corporate (NFC) credit is the largest sub-segment (39% of total) at $72 trillion. Government debt is the second largest sub-segment (35% of total) at $65 trillion, while household credit is the smallest sub-segment (25% of total) at $47 trillion.

Aggregating NFC and HH credit together, private sector credit totals $118 trillion or 65% of total global debt, down from 70% at the end of 2008. The shift in the balance of total debt from the private sector to government debt since the GFC reflects a shift from HH to government debt. In 2008, the split of total debt between HH, NFC and government debt was 31%, 39% and 30%. Today, the split it is 25%, 39%, 35% (1Q19).

**The level and breakdown of global debt between the government and the private sector (PSC)**
Source: BIS; Haver; CMMP analysis

Leverage is also rising again…

**Trends in total global debt and global debt ratios**
Source: BIS; Haver; CMMP analysis

Global debt ratios – debt expressed as a percentage of GDP – have risen for two consecutive quarters (an end to recent deleveraging trends) but remain below peak 1Q18 levels. The outstanding stock of global debt across all sectors fell between 1Q18 and 3Q18 before rebounding in 4Q18 and 1Q19. Debt ratios have rebounded but remain below peak levels.

Viewed over a twelve month period, we can observe different forms of deleveraging in action. In the HH and government sectors the absolute stock of debt has risen (to new highs) over the past twelve months but at a slower rate than the growth in nominal GDP. This represents a passive form of deleveraging as the debt ratio declines despite the stock rising in absolute terms. In contrast, the absolute level of NFC debt in 1Q19 ($72 trillion) is slightly below the level recorded in 1Q18 ($73 trillion). Hence the fall in the NFC debt ratio from 97% to 94% over the twelve months represents a mild form of active deleveraging.

**Despite the recent rebound, the NFC sector has seen a mild form of active deleveraging over the past twelve months**
Source: BIS; Haver; CMMP analysis

Recent developments provide some support for the concept of debt thresholds ie, the level of debt above which debt becomes a drag on growth. The BIS estimate that this threshold in 90% for the NFC sector and 85% for the HH and government sectors. At the end of 1Q2019, NFC debt stood above this threshold at 94%, government debt was just below at 84%, while HH debt was well below at 60%. In short, the different form of deleveraging in the NFC sector described above reflects the fact that NFC debt ratios remain too high and above the BIS thresholds.

…except in the Euro Area

**Private sector credit in the Euro Area is slightly lower now ($21 trillion) than in 3Q09 ($22 trillion)**
Source: BIS; Haver; CMMP analysis

However, gradual deleveraging continues in all sectors in the Euro Area. Interestingly, Euro Area deleveraging began first in the HH sector where debt ratios peaked at 64% in 4Q12. As elsewhere, this has been a passive form of deleveraging where the absolute stock of HH debt rises (to a new peak level in 1Q19) at a slower rate that the growth in nominal GDP. Total, PSC, NFC and government debt levels peaked later (1Q15) and have involved both passive and active forms of deleveraging. The stock of total debt reached new highs at the end of 1Q19 in total and in the PSC and HH sectors. In contrast, it is falling in the NFC and government sector where deleveraging is in its active form and where debt ratios of 105% and 98% remain above their respective BIS threshold levels.

**On-going deleveraging in the Euro Area depresses global debt ratios – but progress is slow due to the type of deleveraging involved**
Source: BIS; Haver; CMMP analysis

Emerging market dynamism…

**Trends in global debt with breakdown between advanced and emerging markets**
Source: BIS; Haver; CMMP analysis

Emerging markets remain the most dynamic segment of global finance, accounting for 36% of total private sector credit compared to only 10% two decades ago. Emerging market PSC totalled $42 trillion at the end of 1Q19 a rise of 225% over the past ten years or a CAGR of 12% per annum. Of this, NFC credit totalled $30 trillion (71% total PSC) and HH credit totalled $12 trillion (29% total PSC). NFC credit is typically larger than HH credit in emerging markets due to their relative stage in industry development. For reference the split between NFC and HH credit in advanced economies is currently 55% and 45% respectively.

**Emerging market debt accounts for 36% of total PSC versus only 10% twenty years ago**
Source: BIS; Haver; CMMP analysis

Debt ratios are catching up with the developed world and in some cases now exceed the BIS threshold levels too. PSC, HH and NFC debt levels reached 142%, 42% and 101% of GDP at the end of 1Q19 versus respective ratios of 162%, 89% and 72% respectively for advanced economies. Note that emerging NFC debt ratios currently exceed the BIS threshold but this reflects (1) the impact of China, which is discussed below, and (2) the fact that the BIS choses to include Hong Kong (NFC debt 222% of GDP) and Singapore (NFC debt 117% of GDP) in its sample of emerging economies.

**Playing “catch-up” – emerging market PS debt ratios (% GDP) are close to advanced economies’ levels**
Source: BIS; Haver; CMMP analysis

…driven by China

China remains the main driver of EM debt growth and now accounts for 24% of global private sector credit alone. PSC growth in China has grown 366% over the past ten years at a CAGR of 17% to reach $28 trillion at the end of 1Q19. Of this NFC credit was $21 trillion (74%) and HH credit was $7 trillion (26%), but it should be noted that China’s SOEs account for 68% of total NFC credit*.

Twenty years ago, China accounted from 3% of global debt and 31% of total EM debt. Today, these shares have risen to 24% and 67% respectively. China’s outstanding stock of debt exceeded the rest of EM in 3Q11.

**China leaves the rest of EM behind after 3Q11 (PSC % GDP)**
Source: BIS; Haver; CMMP analysis

The NFC debt ratio peaked at 163% of GDP in 1Q17 and fell to 152% in 4Q18 as the growth in NFC debt lagged growth in GDP. However, in the 1Q19, this ratio rose back to 155% and remains well above the BIS threshold of 90%.

*The supply of credit to (the more profitable) private sector NFCs remains constrained and well below the BIS threshold, highlighting the on-going misallocation of credit in the Chinese economy. Further analysis of China’s debt dynamics follows in future posts.

**China’s NFC debt ratio is rising again despite being well above the BIS threshold (90%) and levels seen in the RoW**
Source: BIS; Haver; CMMP analysis

Shifting East and towards EM

**Growth in global debt increasing driven the China and EM ($ trillions)**
Source: BIS; Haver; CMMP analysis

Global finance continues to shift to the East and towards emerging markets making it unrecognisable from the industry that existed twenty years. In March 2000, global debt was structured split between advanced economies ex Euro Area (70%), the Euro Area (20%), emerging markets ex China (7%) and China (3%). Today, those splits are 47%, 18%, 12% and 24% respectively. The face of global debt is changing dramatically.

My next research analyses (1) whether current trends are sustainable and (2) the investment risks associated with these trends

The changing face of global debt (% PSC debt outstanding)
Source: BIS; Haver; CMMP analysis

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

“Look beyond the yield curve II”

Monetary trends remain inconsistent with recession fears in the Euro Area

Messages from the money sector

**Narrow money (M1) and broad money (M3) growth accelerates in August 2019**
Source: ECB; Haver; CMMP

Earlier this month, I argued that (1) leading indicators were giving mixed messages about recession risks in the Euro Area; (2) that monetary indicators were comfortably above the levels the ECB associate with risks of recession; but (3) that the ECB was still expected to cut rates and to restart QE.

No surprises since then from the ECB. However, monetary indicators have moved even further away from levels associated with recession risks. Growth in real M1 (a leading indicator) accelerated in August, and real growth in household credit (a coincident indicator) and corporate credit (a lagging indicator) are at the highest levels in the current credit cycle. The message from the money sector in August is that current trends remain inconsistent with recession risks in the Euro Area.

No surprises from the ECB in September

The Deposit Facility Rate was cut from minus 0.4% to 0.5% in-line with expectations at this month’s meeting. The ECB also announced that it would restart buying €20bn of bonds per month until inflation hits its target of 2%. It also introduced a new “tiered” system of interest rates to reduce the cost to banks from negative rates (as discussed in “Power to the Borrowers”). No surprises here.

What are monetary developments telling us?

To recap, growth rates in real M1 and lending to the private sector demonstrate robust relationships with the business cycle through time. Real M1 tends to lead fluctuations in real GDP with an average lead time of four quarters. Real household (HH) credit growth tends to lead slightly (one quarter) or have a coincident relationship with real GDP. In contrast, real corporate (NFC) credit tends to lag fluctuations in real GDP with a lag of three quarters.

**Growth in real M1 (my preferred leading indicator) is rising well above the levels associated with recessions in the Euro Area (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP calculations

Monetary indicators moved even further away from levels associated with recessions risks in August. Real M1, an alternative leading indicator with a stronger and more stable relationship with real GDP than the slope of the yield curve, grew 7.3% in August compared with 6.7% in July and 4.7% in January this year. This is the fastest rate of real growth in narrow money since January 2018.

**Growth in real HH credit (a leading/coincident indicator) is at the highest level in the current credit cycle (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP calculations

**Nominal HH credit growth driven by France, Germany, Benelux and Italy – but remains subdued in relation to past cycles (%YoY)**
Source: ECB, Haver, CMMP calculations

Real HH credit (a leading/co-incident indicator) and Real NFC credit (a lagging indicator) grew at 2.4% and 3.3% respectively. In both cases, this was the fastest rate of growth in the current credit cycle. France (1.3%), Germany (1.2%), Benelux (0.3%) and Italy (0.2%) were the main contributors to HH credit growth (contributions here are in nominal terms).

**Growth in real NFC credit (a lagging indicator) is also at the highest level in the current credit cycle (% YoY, 3m MVA)**
Source: ECB; Haver, CMMP calculations

In the NFC sector, France (1.8%) and Germany (1.5%) were again the main country drivers, but Italy (-0.6%) and Spain (-0.2%) both made negative contributions to nominal Euro Area growth rates.

**Nominal growth in NFC credit still dominated by France and Germany while Spain and Italy make negative contributions (% YoY)**
Source: ECB; Haver; CMMP calculations

The message from the money sector in August is that current trends remain inconsistent with recession risks in the Euro Area. The domestic sectors are demonstrating resilience in contrast to the contraction seen in the more export-oriented manufacturing sectors. The latest trends remain supportive of current ECB and EC forecasts which point to a shallow recovery in growth in 2H19.

**Monetary trends are more supportive of current EC (and ECB) forecasts for a shallow recovery in growth (% YoY)**
Source: EC; Haver; CMMP

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

“Fuelling the FIRE” – the hidden risk in QE

The hidden risk in QE is that the ECB is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality

**“Fuelling the FIRE” – spilt in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans)**
Source: ECB; Haver; CMMP

How successful has the “Fourth Phase” of ECB monetary policy been?

**The (real) cost of borrowing for EA households (HH) and corporates (NFC) has declined since the Fourth Phase began in July 2014**
Source: ECB; Haver; CMMP

An important goal of the current “Fourth Phase” of ECB monetary policy is “to ensure that businesses and people should be able to borrow more and spend less to repay their debts”.

**“Shifting the balance of power” – trends in official (MMR), ST money market (3m Euribor) and household (HH) and corporate lending (NFC) rates since end May 2014 (change in bp)**
Source: ECB; Haver; CMMP

The ECB has achieved partial success here with private sector credit in the Euro Area now growing at the fastest rate in the current credit cycle (in nominal terms) thanks in part to lower borrowing costs.

Following the standard transmission mechanism of monetary policy, the cut in official rates has fed through into money market interest rates (and expectations) and into the cost of borrowing for corporates (NFCs) and households (HHs) in the Euro Area. Since the end of May 2014, the MRR has fallen by 25bp, 3m Euribor by 69bp, and the composite cost of borrowing for NFCs and HHs by 123bp and 134bp respectively. This has represented an important shift in the balance of power from lenders/creditors to borrowers/debtors (see “Power to the Borrowers” – who are the winners from QE?). Private sector credit (PSC) stopped falling in March 2015 and is currently growing at 3.6%, the fastest nominal rate of growth in the current credit cycle.

The obvious caveats to this success story are the facts that current growth is (1) muted in relation to past cycles, and (2) limited geographically. Progress in emerging from the Euro Area’s debt overhang remains slow and incomplete. Economic cycles are shallower, money supply is subdued and credit demand is relatively week. These trends are entirely consistent with the “Balance Sheet Recession” concept and trends seen previously in Japan.

**Growth in HH lending is subdued in relation to past cycles and dominated by growth in Germany and France** (% YoY)
Source: ECB; Haver; CMMP

The current growth rate in PSC of 3.6% is well below the average of 8.3% in the decade between June 1999 and June 2009 and the peak growth of 11.7% reached in September 2016. Current growth is also dominated by Germany and France rather than broad based across the Euro Area. HH credit is growing 2.9% YoY (outstanding stock basis) of which France contributes 1.3%, Germany 1.2% and the Benelux 0.3%. Similarly, NFC credit is growing 3.1% YoY with Germany contributing 1.9% and France 1.6% while Spain, Italy, and Greece, Ireland and Portugal (GIP) all making negative contributions.

**Growth in NFC lending is also subdued in relation to past cycles and also dominated by Germany and France (% YoY)**
Source: ECB; Haver; CMMP

COCO versus FIRE – contrasting productive and unproductive credit

A less obvious, but more important, caveat is that the majority of Euro Area credit is now directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit.

In the broadest sense, lending can be spilt into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO” credit (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE” credit (FInancials and Real Estate). Dirk Bezemer (www.privatedebtproject.org) neatly distinguishes between the productivity of these different forms of lending:

COCO-based lending typically supports production and income formation

CO: loans to NFCs are used to finance production which leads to sales revenues, wages paid, profits realised and economic expansion. Bezemer notes that these loans are used to realise future cash revenues from sales that land on the balance sheet of the borrower who can then repay the loan or safely roll it over. The key point here is that an increase in NFC debt will increase debt in the economy but it will also increase the income required to finance it

CO: consumer debt also supports productive enterprises since it drives demand for goods and services, hence helping NFCs to generate sales, profits and wages. It differs from NFC debt to the extent that HH take on an additional liability since the debt does not generate income. Hence the consumer debt is also positive but has a slightly higher risk to stability

**Share of total EA lending (%) accounted for by COCO-based lending (1999-2019)**
Source: ECB; Haver; CMMP

FIRE-based lending typically supports capital gains through higher asset prices

FI: loans to NBFIs (eg, pension funds, insurance companies) are used primarily to finance transactions in financial assets rather than to produce, sell or buy “real” output. This credit may lead to an increase in the price of financial assets but does not lead (directly) to income generated in the real economy

RE: mortgage or real estate lending is used to finance transactions in pre-existing assets rather than transactions in goods and services. Such lending typically generates asset gains as opposed to income (at least directly)

**Share of EA lending (%) accounted for by FIRE-based lending (1999-2019)**
Source: ECB; Haver; CMMP

Lending in any economy will involve a balance between these different forms, but the key point is that a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

Over the past twenty years, FIRE-based lending has increased from 48% of total Euro Area loans to 55% as at June 2019. The current level represents a historic high. At the individual country level, the ECB has provided a breakdown on MFI balance sheets since December 2002. At the starting point of this data, COCO-based lending exceeded or equalled FIRE-based lending in six out of ten large Euro Area economies: Austria (73%:27%); Greece (73%: 48%); Italy (58%:42%); France (58%:42%); Spain (56%:44%) and Portugal (50%:50%).

As of June 2019, only three of the countries in this sample have COCO-based lending above or equal to FIRE-based lending: Austria and Greece (54%:46%) and Italy (50%:50%).

**As of July 2019, only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending (% total lending)**
Source: ECB; Haver; CMMP

To what extent is QE fuelling the fire?

The shift towards these forms of credit pre-dates the introduction of QE in the Euro Area. As the data above suggests, this is part of a longer term trend. Indeed, at both the Euro Area level and the country level, the split between COCO-based and FIRE-based lending is broadly unchanged since both May 2014 and March 2015.

The shift is more noticeable since the end of the Global Financial Crisis however and may also reflect that NFC debt levels (expressed as a percentage of GDP) remain high and above the threshold levels that the BIS considers detrimental to future growth.

Nevertheless, the hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.

As noted above, while COCO-based lending increases absolute debt levels, is also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage.

Similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly.

From a stability perspective, the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers.

Finally, the return from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

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

“Power to the Borrowers” – who are the winners from QE?

Watch to see if the ECB introduces compensation measures for banks this week

**Trends in official ECB and ST money market rates (%)**
Source: ECB; Haver, CMMP

The ECB is widely expected to cut its deposit rate next week and to announce a restart of its QE (bond purchase programme) from October.

**QE in action – scale (EUR mn) and breakdown by instrument**
Source: ECB; Haver, CMMP

Previous non-standards monetary policy measures – the expanded asset purchase programme (APP), the introduction of negative deposit rates and the targeted longer-term refinancing operations (TLTROs) – all contributed to a steady and widespread decline in bank lending rates while narrowing their dispersion across countries in the Euro Area (EA).

**Falling (real) cost of borrowing for EA households and corporates**
Source: ECB; Haver; CMMP

Since the announcement of the credit easing package in early June 2014, lending rates have declined significantly more than market reference rates and policy rates.

In the household (HH) sector, EA lending rates have fallen 134bp since May 2014 compared with a 25bp reduction in the Main Refinancing Rate (MRR) and a 69bp reduction in 3M EURIBOR.

The largest contraction in HH lending rates have been seen in Portugal (-201bp), France (-175bp), Italy (-164bp) and Belgium (-156bp).

**Shifting the balance or power: cost of borrowing for households and corporates has fallen faster than ST money market and official rates (change in bp since end May 2014)**
Source: ECB; Haver; CMMP

In the corporate (NFC) sector, EA lending rates have fallen 123bp over the same period, with relatively large contractions in Portugal (-320bp), Spain (-193bp), and Italy (-192bp).

These trends are entirely consistent with the stated goal of the ECB to “ensure that businesses and people should be able to borrow more and spend less to repay their debt.” They also represent a clear shift in the balance of power from lenders to borrowers.

**Shifting balance of power reflected in underperformance of SX7E (leading EA banks) versus SXXE**
Source: Haver; CMMP

With 2Q19 results showing the negative impact of these trends on EA banks’ profitability levels (volume growth insufficient to compensate for spread erosion) and with EA banks’ share prices underperforming and trading at discounts to their tangible book value, the key question this week is not will the ECB cut rates and/or restart QE, but will they introduce measure to compensate banks for the obvious negative side effects of negative interest rates.

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

“Macro building blocks matter” – look at the SX7E

What are the key macro building blocks for European banks and why do they matter?

As a macro-economist, investor and ex-global banks sector strategist, I have a specific interest in the impact of macro and monetary dynamics on bank sector profitability (and conversely, on the impact of bank behaviour on the wider economy).

Macro building blocks for banks

In developed economies, I focus primarily on five key “macro building blocks” that drive bank sector profitability and share price performance:

growth in real GDP

growth in private sector credit

the level of ST rates

the level of LT rates

the shape of the yield curve

Net interest income – the main value driver for most banks – has a positive relationship with GDP, the level of rates and the shape of the yield curve. The level of ST rates is more important for banks in “floating rate” economies and market segments. In contrast, the slope of the yield curve is more important for banks in “fixed rate” economies and market segments.

**Variable rate lending as %age of total new loans in the EA**
Source: ECB; Haver; CMMP

In the Euro Area, 65% of new loans to HHs and NFCs are based on variable rates but only 19% of mortgages (down from 58% in November 2004). This means that EA banks are affected by both the level of ST rates and the slope of the yield curve, but that the sensitivity to the former is higher.

**Variable rate lending as %age of total EA mortgages**
Source: ECB, Haver, CMMP

Non-interest income – the second key value driver – has a positive relationship with GDP but a negative relationship with the level of ST rates while provisions have negative relationship with GDP and a positive relations with the level of ST rates.

Building blocks have weakened significantly

Macro building blocks in the EA have been softening since 1Q18 but have weakened significantly during 2019.

**Twenty year trends in EA real GDP growth (% YoY)**
Source: ECB, Haver, CMMP

Real GDP growth has slowed below LT average in all leading EA economies with the exception of the Netherlands, Spain and Portugal. Real GDP growth for the EA has fallen from 2.8% in 4Q17 to 1.1% in 2Q19, below the twenty year average growth rate of 1.4%. The weakest growth rates are currently in Italy (-0.1%) and Germany (0.4%) and Austria, Belgium and France are all growing at rates below their respective LT average. Of the major EA economies only the Netherlands (1.8%), Spain (2.3%) and Portugal (1.8%) are growing at rates above their LT average but interestingly the HH and NFC sectors are still deleveraging in each of these three economies. Looking forward, the ECB is forecasting growth to slow to 1.2% in 2019 before recovering to 1.4% in 2020 and 2021, in-line with LT average growth rates.

**Twenty year trends in EA private sector credit growth (% YoY, 3M MVA)**
Source: ECB; Haver, CMMP

**Current growth rates in EA corporate and household credit (% YoY)**
Source: ECB; Haver; CMMP

Private sector credit growth is at its highest level in the current cycle (3.6% YoY) but remains subdued in relation to past cycles (see graph above), concentrated geographically and increasingly directed towards less productive segments (see “Fuelling the FIRE” – the hidden risks of QE)

**ST rates (EONIA) locked at the base of ECB’s corridor (marginal lending rate – deposit facility rate)**
Source: ECB; Haver; CMMP

ST rates remain locked at the base of the ECB’s corridor and a further cut in the deposit facility rate this month is likely to have a negative impact on net interest margins in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending.

**Euro Area 10Y bond yields collapsing into negative territory**
Source: Haver; CMMP

LT rates have fallen sharply into negative territory. The yield on EA 10Y bonds has fallen from -0.23% at the end of 2018 to -0.64% currently, just above the recent weekly low of -0.71% at the end of August 2019.

The EA yield curve, which has been flattening since 4Q18, inverted in July 2019 with negative consequences for net interest margins in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed-rate lending.

**Spread between interest rate on new EA HH loans and 3M Euribor**
Source: ECB; Haver; CMMP

**Spread between interest rate on new EA NFC loans and 3M Euribor**
Source: ECB; Haver; CMMP

Negative ST rates and inverted yield curves are compounded by on-going price competition that is evident in the on-going narrowing of spreads in the HH sector and to a lesser extent in the NFC sector.

**Relative performance of SX7E versus SXXE over past twelve month (average prices)**
Source: Haver; CMMP

The importance of macro building blocks on the performance of EA banks’ share prices is reflected in poor absolute (-14%) and relative (-10% versus SXXE) performance of the SX7E index of leading European banks over the past twelve months.

Little wonder then, that when reviewing the performance of European banks, FT Lex writers concluded recently that, “Europe is a nice place to live, but a terrible place to invest” (“European banks: the flyover continent”. Financial Times 23 July 2019)

**Relative performance of SX7E versus SXXE over past decade (average prices)**
Source: Haver; CMMP

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

“Look beyond the yield curve”

Leading indicators are giving mixed messages – but the ECB is still expected to cut rates and restart QE

**Mixed messages 1: The inverted 10Y-3M yield curve raises “recession risks” concerns**
Source: ECB; Haver; CMMP

Turning points in the slope of the yield curve typically lead turning points in real Euro Area (EA) GDP. The rapid flattening/inverting of EA yield curves YTD has surpassed trends seen in 2015 and 2016 and raises concerns that “recession risks” are rising across the region.

**Mixed messages 2: Real growth in EA narrow money (an alternative leading indicator)** **remains well above the levels associated with recessions**
Source: ECB; Haver; CMMP

To assess the severity of these risks, I examine trends in the key leading, co-incident and lagging indicators that represent the foundation of my “Money, Credit and Business Cycle” framework.

Growth rates in real M1 and lending to the private sector demonstrate robust relationships with the business cycle through time.

Real M1 tends to lead fluctuations in real GDP with an average lead time of four quarters. This reflects the fact that M1 is composed of funds that businesses and households can access quickly to support current spending.

Real household (HH) credit growth tends to lead slightly (one quarter) or have a co-incident relationship with real GDP. HHs typically increase their demand for credit when they expect house prices to recover and after house prices and interest rates have declined during a slowdown.

In contrast, real corporate (NFC) credit tends to lag fluctuations in real GDP with a lag of three quarters. NFCs typically rely on in internal sources of funds at the early stage of an economic recovery before turning to banks (and other external sources) for financing at later stages.

**Leading indicator: growth in EA real GDP and real M1 (% YoY)**
Source: ECB; Haver; CMMP

Real M1, an alternative leading indicator with a stronger and more stable historic relationship with real GDP than the slope of the yield curve, rebounded in February 2019 and is now growing at the fastest rate since February 2018. The relationship between real growth in M1 and real growth in GDP is well documented and is supported by CEPR evidence that shows that the real growth rate in M1, “went well into negative territory for prolonged period just before (or in coincidence with) all historic EA recessions.” (ECB Economic Bulletin, April 2019).

Real growth rates in M1 peaked back at 11.1% back in November 2015, but the moderation became more obvious during 2018 with a recent low of 4.3% in August 2018. A more sustained recovery began in February 2019 and the current (July 2019) growth rate of 6.7% is the fastest rate since February 2018. The current level of real M1 growth remains comfortably above the levels that the ECB associates with risks of recession in the near future.

**Leading/coincident indicator: growth in EA real GDP and real household credit (% YoY)**
Source: ECB; Haver; CMMP

**Lagging indicator: growth in EA real GDP and real corporate credit (% YoY)**
Source: ECB; Haver; CMMP

Real growth rates in HH credit (a leading/coincident indicator) and NFC credit (a lagging indicator) are also at their highest levels in the current credit cycle. According to ECB data released last week, HH credit grew 3.4% YoY in nominal terms and 2.4% in real terms in July 2019. This is the fastest rate of growth since July 2009 and the fastest rate of growth in the current cycle. France (1.4% contribution), Germany (1.2%), Benelux (0.3%) and Italy (0.2%) were the main drivers of growth. NFC lending grew 3.9% YoY in nominal terms and 2.9% in real terms. Again the real growth rate was the fastest in the current cycle and the fastest rate of growth since June 2009. In the NFC sector, France and Germany are again the key country drivers, both contributing 1.7% of total nominal growth.

In other words, the message from the EA banking sector is more consistent with current ECB and EC growth (subdued but stable) forecasts than with fears of an EA recession.

**Real GDP growth in Euro Area showing current EC 2019-2020 forecasts (% YoY)**
Source: ECB; EC; Haver, CMMP

However, with growth remaining below LT trends and with inflation 1ppt below the ECB’s target, expectations that the ECB will cut rates this month and restart QE are likely to be met.

**Euro Area inflation (HICP) remains well below the ECB target of 2% (% YoY)**
Source: ECH; Haver; CMMP

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