“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.
How does the ECB view the increase in household savings and why does it matter?
The key chart
To what extent is the increase in HH savings in response to COVID-19 “forced” or “precautionary” and why does it matter? (Source: ECB; Eurostat; CMMP analysis)
The key message
The overriding message from the European and UK money sectors remains one of heightened uncertainty and deficient credit demand. Narrow money (M1) is playing an ever-increasing role in broad money (M3) growth despite negative real returns on overnights deposit as the household propensity to save reaches unprecedented levels in response to COVID-19.
A recent chart repeated – M1 is playing an ever-increasing role in broad money growth in the EA and in the UK (Source: ECB; Bank of England; CMMP analysis)
The key unknown here is the extent to which the increase in savings is “forced” or “precautionary”. This matters because forced savings can be released relatively quickly to support economic activity while precautionary savings are unlikely to move straight into investment or consumption.
In the latest Economic Bulletin, ECB economists estimate the contribution of both factors to the increase in savings during 2020. They conclude that the rise in expected unemployment has led to a significant contribution of precautionary savings but that this alone cannot explain the increase. In contrast, they argue that, “forced savings seem to be the main driver of the recent spike in household savings” (see graph below).
ECB estimates of the drivers in the HH savings rate during 2020 (Source: ECB Economic Bulletin)
Despite this, they point to considerable uncertainty regarding pent-up demand in the short term. Recent CMMP analysis has highlighted a v-shaped recovery in EA consumer credit with monthly flows recovering to just below their 2019 monthly average.
Another repeated chart from earlier this month – monthly consumer credit flows in the EA in EUR billions (Source: ECB; CMMP analysis)
Counterbalancing these ST trends, the EC consumer survey covering the period to August 2020 suggests that in the next twelve months HHs expect to spend less on major purchases than at the beginning of 2020, despite the amount of savings they have accumulated.
It is hard to argue against the ECB’s conclusion that, “over the next year, precautionary motives may still keep households’ propensity to save at levels that are higher than before the COVID-19 crisis.”
Inflation hawks will need to be patient!
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Time for new terms of reference when analysing global debt levels (Source: BIS; CMMP analysis)
The key message
Last week’s data release from the BIS provides five important insights into the “macro-state-of play” at the end of 1Q20 – the point at which the Covid-19 pandemic intensified globally:
Insight #1: the pandemic coincided with a new peak in global debt ($192tr), with the global debt ratio coming within 0.2ppt of its previous 3Q16 and 1Q18 peaks. Up to this point, the split between private ($122tr) and public ($69tr) was broadly unchanged at 64% and 36% respectively (n.b. I have deal with the subsequent impact of global policy responses on public sector debt levels in previous posts).
Insight #2: the long-term trend of passive deleveraging by the private sector in advanced economies continues with direct implications for: the duration and amplitude of money, credit and business cycles; inflation; policy options; and the level of global interest rates.
Insight #3: China’s catch-up story has replaced the wider emerging market (EM) catch up story. EM debt accounts for 36% of global debt but with China accounting for 68% of EM debt now compared with only 30% twenty years ago – strip out China and EM debt is now a slightly smaller share of global debt than it was five years ago.
Insight #4: the traditional distinction between emerging and developed/advanced economies is less relevant and/or helpful, especially when analysing Asia debt dynamics.
Insight #5: it is more helpful to begin by distinguishing between economies with excess household and/or corporate debt and the RoW and then consider the rate of growth and affordability of debt in that context. More to follow on both…
In the meantime, the key message is the importance of distinguishing between the “event-driven” effects of the Covid pandemic and longer-term “structural-effects” associated with the level, growth and affordability of different types of debt.
Five key charts
Insight #1: The pandemic coincided with a new peak in global debt (Source: BIS; CMMP analysis)Insight #2: the LT trend of passive deleveraging by the private sector in advanced economies continues (Source: BIS; CMMP analysis)Insight #3: China increasingly dominates the “EM catch-up” story (Source: BIS; CMMP analysis)Insight #4: traditional distinctions between EM and advanced economies are less relevant, especially when analysing Asian debt dynamics (Source: BIS; CMMP analysis)Insight #5: the key chart repeated – new terms of reference are needed as the starting point for analysing global debt (Source: BIS; CMMP analysis)
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.
How do the messages from the money sectors compare?
The key chart
Broad money growth is accelerating in both regions, but how do the messages behind these trends compare and what do they mean? (Source: ECB; Bank of England; CMMP analysis)
The key message
Broad money growth is accelerating in both the euro area (EA) and the UK but how do the messages behind these trends compare and what do they mean for investors?
M1 dynamics are the key growth drivers here as EA and UK households and corporates maintain high preferences for holding liquid assets despite negative real returns. Above trend corporate credit and resilient mortgage demand is offsetting weakness in consumer credit in both regions but with more volatile YoY credit dynamics in the UK. The growth gap between the supply of money and the demand for credit has reached new 10-year highs.
The overriding message here is one of uncertainty and deficient credit demand, a more nuanced message than some inflation hawks suggest.
Looking at ST dynamics, uncertainty peaked in May in both regions, HHs have stopped repaying consumer credit and the NFC “dash-for-cash” has also peaked.
From an investment perspective, 2020 is seen best as a year when an extreme event (Covid-19) engulfed weak, pre-existing cyclical trends. The negative impacts of this event have peaked, at least from a monetary perspective. However, adverse (over-arching) LT structural dynamics that have their roots in excess levels of private sector debt remain with negative implications for money, credit and business cycles and future investment returns.
The charts that matter
The key chart above illustrates how growth in broad money (M3) is accelerating in both the EA and UK. In the EA, M3 grew 10.2% in nominal and 9.8% terms YoY in July, the highest rates of growth since May 2008 and July 2007 respectively. In the UK, M3 grew 11.9% in nominal and 10.8% in real terms in July, the highest rates of growth since April 2008 and June 2008 respectively (n.b. I am using M3 here for comparison purposes rather than the Bank of England’s preferred M4ex measure referred to in other posts). These trends have helped to ignite the “inflation versus deflation” debate which, in turn, requires investigation of trends in the components and counterparts of broad money growth.
M1 is playing an increasing role in M3 in the EA and the UK despite negative real returns from overnight deposits (Source: ECB; Bank of England; CMMP analysis)
From a components perspective, narrow money (M1) is playing an increasing role in this growth despite negative real returns as EA and UK households (HHs) and corporates (NFCs) maintain high preferences for liquid assets. In the EA, M1 now accounts for 70% of M3 compared with only 42% twenty years ago. In the UK, M1 now accounts for 65% of M3 versus only 48% twenty years ago (see chart above). In both cases, the share of narrow money in broad money is at a historic high – potentially negative news for inflation hawks as HH and NFCs continue to save in the face of high uncertainty levels. The key unknown here is the extent to which these savings are forced or precautionary. Forced savings can be released relatively quickly to support economic activity. In contrast, precautionary savings are unlikely to move straight into investment or consumption.
Similar NFC, mortgage and consumer credit trends but with more volatile YoY growth dynamics in the UK (Source: ECB; Bank of England; CMMP analysis)
From a counterparts perspective, above trend NFC credit and resilient HH mortgage demand is offsetting weakness in consumer credit, with the UK demonstrating more volatile YoY growth dynamics than the EA. The graph above illustrates YoY growth trends in NFC credit (green), mortgages (blue) and consumer credit (red) for the EA (dotted lines) and the UK (full lines) over the past 5 years.
NFC credit is growing well above trend in both regions, but below May’s recent peak levels. In the EA, NFC credit grew 7.0% in July versus 7.3% in May. In the UK, NFC credit grew 9.6% in July versus 11.2% in May. Mortgage demand has remained resilient in both regions growing 4.2% in the EA and 2.9% in the UK. Weakness in consumer credit appears to be stabilising (see monthly trends below). In the EA consumer credit grew 0.2% in July unchanged from June, but still a new low YoY growth rate. In the UK, consumer credit declined -3.6% YoY compared with a decline of -3.7% in June.
Counterparts versus components – new peak gaps in the growth of private sector credit and money supply (Source: ECB; Bank of England; CMMP analysis)
Diverging trends between the components and counterparts of broad money tell an important story – the gap between the growth in money supply and the growth in credit demand is at new 10-year peak levels. In the EA, the gap between M3 growth (10.2%) and adjusted loans to the PSC growth (4.7%) was 5.5ppt (or minus 5.5ppt in the graph above). This is a 10-year peak and the largest gap since 2001 (not shown above). In the UK, the gap between M4ex growth (12.4%) and M4Lex (5.5%) was 6.9ppt, again a new 10-year peak. In “normal cycles”, money supply and the demand for credit would move together but current trends are indicative of a basic deficiency in credit demand and a second potentially negative piece of news for inflation hawks.
Uncertainty proxies for EA HHs and NFCs (Source: ECB; CMMP analysis)
Looking at ST dynamics, “uncertainty” appears to have peaked at the same time (May 2020) in both the EA and the UK but remains very elevated against historic trends. In this context, trends in monthly flows into liquid assets offering negative real returns are used a proxy measure for uncertainty. In July, deposits placed by EA HHs totalled €53bn, below April 2020’s peak of €80bn but still above the 2019 average monthly flow of €33bn. NFC deposits increased by €59bn in July. Again this was below May 2020’s peak flows of €112bn but still well above the 2019 average monthly flow of €13bn (see chart above).
Uncertainty proxies for UK HHs and NFCs (Source: Bank of England; CMMP analysis)
In the UK, HH deposit flows totalled £7bn in July, down from the May 2020 peak of £27bn but above the 2019 monthly average flow of £5bn. NFCs deposits in July rose from £8bn in June to £ 12bn in July. These were also below the May 2020 peak of £26bn but well above the £0.8bn 2019 average (see chart above).
Monthly consumer credit flows in the EA (Source: ECB; CMMP analysis)
HHs have stopped repaying consumer credit and monthly flows have bounced back to just below (EA) or just above (UK) 2019 monthly average. In July, EA consumer credit totalled €3.2bn and €3bn in June and July respectively. This followed repayments of €-12bn, €-14bn and €-2bn in March, April and May respectively. The last two months’ positive monthly flows compare with the 2019 average of €3.4bn.
Monthly consumer credit flows in the UK (Source: Bank of England; CMMP analysis)
After four consecutive months of net repayments, UK consumer credit turned positive in July. The £1.2bn borrowed in July was above the average £1.2bn recorded in 2019. As noted above, the recent weakness in consumer credit means that the average growth rate (-3.6% YoY) is still the weakest since the series began in 1994.
Conclusion
In “August snippets – Part 1”, I highlighted the importance of disciplined investment frameworks and followed this in “August snippets – Part 2” by revisiting the foundations of my CMMP Analysis framework that incorporates three different time perspectives into a single investment thesis. How do July’s trends fit into this framework?
The overriding message here is one of uncertainty and deficient credit demand, a more nuanced message than some inflation hawks suggest. Looking at ST dynamics, uncertainty peaked in May in both regions, HHs have stopped repaying consumer credit and the NFC “dash-for-cash” has also peaked. From an investment perspective, 2020 is seen best as a year when an extreme event (Covid-19) engulfed weak, pre-existing cyclical trends. The negative impacts of this event have peaked, at least from a monetary perspective. However, the negative (over-arching) LT structural dynamics that have their roots in excess levels of private sector debt remain with negative implications for money, credit and business cycles and future investment returns.
If you go down to the woods today…
Please note that summary comments and graphs above are extracts from more detailed analysis that is available separately
Unusually high monthly flows into O/N deposits (despite negative real rates of return) indicate elevated levels of uncertainty among HHs and NFCs in the euro area (Source: ECB; CMMP analysis)
The key message
July’s monetary developments in the euro area suggest that the road to recovery will be long and uncertain. Broad money (M3) is growing at the fastest rate (10.2% YoY) since May 2008. Growth rates in the components of M3 indicate that uncertainty remains very elevated at the start of 3Q20. Overnight deposits, for example, contributed 8.3ppt to the growth in broad money alone (despite negative real returns). July’s overnight deposit inflow of €151bn was the second largest inflow after March’s €249bn and was 3x the 2019 average. In contrast, growth rates in the counterparts to M3 indicate that HH consumption is recovering and the NFC’s record “dash-for-cash” has peaked. However, before anyone gets too excited – the gap between subdued PSC growth (debt overhang?) and rapid M3 growth (elevated uncertainty?) hit a twenty-year peak in July.
In short, July’s message from the EA money sector is simple: the peak of the crisis may have passed but the road to recovery is likely to be long and uncertain.
The long and uncertain road in charts
Growth rates in broad (M3) and narrow (M1) money in the euro area (% YoY) – July’s M1 growth rate exceeded 2009 and 2015 peaks (Source: ECB; CMMP analysis)
July’s monetary developments in the euro area (EA) suggest that the road to recovery will be a long and uncertain one. Broad money (M3) grew by 10.2% YoY in July from 9.2% in June, the fastest rate of growth since May 2008.
Drivers of M3 growth (percentage points) – overnight deposits (8.3ppt) remain the key driver of M3 (Source: ECB; CMMP analysis)
Narrow money (M1) grew by 13.5% YoY in July from 12.6% in June, faster than the 13.1% (Aug 09) and 11.7% (July 15) peak growth rates recorded during the GFC and after the euro crisis. M1 growth contributed 9.2ppt to the total 10.2% growth in broad money. Within M1, overnight deposits grew 14.1% YoY and contributed 8.3ppt to the overall growth in M3 alone.
Growth rates in mortgage, consumer and corporate credit – passed the crisis peaks and troughs? (Source: ECB; CMMP analysis)
Adjusted loans to the private sector grew 4.7% YoY, slightly below the 4.8% recorded in June. The annual growth rate in loans to households (HHs) was unchanged at 3.0% while the equivalent growth rate in loans to corporates (NFCs) fell very slightly to 7.0% from 7.1%. No surprises here – above trend NFC credit and resilient HH mortgage demand continue to offset weakness in HH consumer credit.
An “old favourite” chart – the gap between the growth rates in PSC and M3 is at a new twenty-year peak (Source: ECB; CMMP analysis)
The gap between the growth in money supply (M3) and the growth in private sector credit (PSC) increased to 5.5ppt, a twenty year high. This reflects the combination of extraordinary uncertainty (driving M3) and the limited progress in dealing with the debt overhang in the EA (subduing PSC).
Monthly flows into O/N deposits since January 2019 – a surprise jump in July? (Source: ECB; CMMP analysis
The monthly flow data once again provides a more nuanced picture than the headline annual growth trends. Overnight deposits, which contributed 8.3ppt to the overall growth in M3 alone, rose by €151b. This represents the second largest monthly inflow of overnight deposits (after €249bn in March 2020).
Monthly deposit flows from HHs and NFCs since January 2019 (Source: ECB; CMMP analysis)
July’s data includes a €58bn swing from negative to positive flows from non-monetary financial corporations – n.b. these flows are typically more volatile than HH and NFC flows. That said, monthly flows by HHs and NFCs also increased MoM to levels 24% and almost 50% above the average 2019 inflows. Put simply, these trends suggest that HH and NFC uncertainty levels remain very elevated.
Monthly trends in HH credit demand – passed the low point? (Source: ECB; CMMP analysis)
On a more positive note, mortgage demand remains resilient and consumer credit has recovered. Loans for house purchase increased by €19b in July versus 9€10bn in June and above the average €14bn monthly flow recorded in 2019. After record repayments between March and May 2020, monthly flows of credit for consumption have exceeded €3bn for two months in a row, closing on the €3.4bn monthly average in 2019. NFC lending data suggests that we passed the peak “dash for cash” in March and April, although July’s monthly flow of almost €16bn remains above the 2019 average of €12bn.
Putting the NFC “dash-for-cash” into an historic context (Source: ECB; CMMP analysis)
Conclusion
The message from the money sector at the start of the 3Q20 is a mixed one. Growth rates in the components of M3 indicate that uncertainty remains very elevated. In contrast, growth rates in the counterparts to M3 indicated that HH consumption is recovering and the NFC dash-for-cash has peaked. In short, while the peak of the crisis appears to have passed, the road to road to recovery is likely to remain a long and uncertain one.
Please note that the summary comments and graphs above are extracts from more detailed analysis that is available separately.
In “August snippets – Part 1”, I highlighted the importance of disciplined investment frameworks. In this second snippet, I revisit the foundations of my CMMP Analysis framework. I start by describing how I combine three different time perspectives into a consistent investment thesis (“three pillars”). I then explain how the core banking services (payments, credit and savings) link different economic agents over time to form an important fourth pillar – financial sector balances. Finally, I present examples of how these four pillars combine to deliver deep insights into policy options and responses.
The central theme is my belief that the true value in analysing developments in the financial sector lies less in considering investments in banks but more in understanding the implications of the relationship between banks and the wider economy for corporate strategy, investment decisions and asset allocation.
Three perspectives – one strategy
As an investor, I combine three different time perspectives into a single investment strategy
My investment outlook at any point in time reflects the dynamic between them
My conviction reflects the extent to which they are aligned
Pillar 1: Long-term investment perspective
Example chart 1: growth trends in PSC illustrate how global finance is shifting East and towards emerging markets ($bn) (Source: BIS; CMMP analysis )
My LT investment perspective focuses on the key structural drivers that extend across multiple business cycles. Given my macro and monetary economic background, I begin by analysing the level, growth, affordability and structure of debt. These four features of global debt have direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options; investment risks and asset allocation. My perspective here reflects my early professional career in Asia and experience of Japan’s balance sheet recession. The three central themes are (1) global finance continues to shift East and towards emerging markets, (2) high, “excess HH growth rates” in India and China remain a key sustainability risk, and (3) progress towards dealing with the debt overhang in Europe remains gradual and incomplete. The following four links provide examples of LT investment perspectives:
Example chart 2:China’s HH debt ratio continued to rise sharply in 1Q20 – too much, too soon? (Source: National Bureau of Statistics; CMMP analysis)
Pillar 2 – Medium-term investment perspective
Example chart 3: growth rates in M1 and private sector credit demonstrate robust relationships with the business cycle through time and have proved more reliable indicators of recessions risks than the shape of the yield curve (Source: ECB; CMMP analysis)
My MT investment perspective centres on: analysing money, credit and business cycles; the impact of bank behaviour on the wider economy; and the impact of macro and monetary dynamics on bank sector profitability. Growth rates in narrow money (M1) and private sector credit demonstrate robust relationships with the business cycle through time. My interest is in how these relationships can assist investment timing and asset allocation. My investment experience in Europe shapes my MT perspective, supported by detailed analysis provided by the ECB. A central MT theme here is the fact that monetary developments: (1) have proved a more reliable indicator of recession risks than the shape of the yield curve; and (2) provide important insights into the impact, drivers and timing of the Covid-19 pandemic on developed market economies. The following four links provide examples of my analysis of MT investment perspectives:
Example chart 4: headling figures mask a more nuanced message from monthly flow data (Source: ECB; CMMP analysis)
Pillar 3: Short-term investment perspective
Example chart 5: banks played catch up from May 2020, but what kind of rally was this and was it sustainable? (Source: FT; CMMP analysis)
My ST investment perspective focuses on trends in the key macro building blocks that affect industry value drivers, company earnings and profitability at different stages within specific cycles. This perspective is influences by my experience of running proprietary equity investments within a fixed-income environment at JP Morgan. This led me to reappraise the impact of different drivers of equity market returns. I was able to demonstrate the “proof of concept” of this approach when I returned to the sell-side in 2017 as Global Head of Banks Equity Research at HSBC, most notably when challenging the consensus investor positioning towards European banks in 3Q17. A central ST theme is the importance of macro-building blocks in determining sector profitability and investment returns. The following four links provide examples of ST investment perspectives:
Example chart 6: why it was correct to question the conviction behind the SX7E rally during 2Q20 (Source: FT, CMMP analysis)
Pillar 4 – Financial Sector Balances
Example chart 7: Financial sector balances (and MMT!) can be understood easily by starting with the core services provided by banks to HHs and NFCs (Source: Bank of England; CMMP analysis)
In January 2020, I presented a consistent, “balance sheet framework” for understanding the relationship between the financial sector and the wider economy and applied it to the UK. I chose the UK deliberately to reflect the relatively large size of the UK financial system and the relatively volatile nature of its relationship with the economy. I extended this analysis to the euro area later. I began by focusing on the core services provided by the financial system (payments, credit and savings), how these services produce a stock of financial balance sheets that link different economic agents over time, and how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework. Central themes here were the large and persistent sector imbalances in the UK, why the HH sector in the UK was poised to disappoint and why a major policy review was required in the euro area even before the full impact of the COVID-19 pandemic was felt. The following four links provide examples of FSB analysis:
Example chart 8: Pre-Covid, the UK faced large and persistent sector imbalances and was increaingly reliant on the RoW as a net lender (4Q sum, % GDP) (Source: ONS; CMMP analysis)
Policy analysis
Example chart 9: “Fuelling the FIRE” – split in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans) (Source: ECB; CMMP analysis)
These four pillars provide a solid foundation for analysing macroeconomic policy options and choices. Since September 2019, I have applied them to identifying the hidden risks in QE, to arguing why the EA was trapped by its debt overhang and out-dated policy rules, and to assessing the policy responses to the COVID-19 pandemic. Central themes have included: (1) the hidden risk that QE is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality; (2) why the gradual and incomplete progress towards dealing with Europe’s debt overhang matters; (3) why Madame Lagarde was correct to argue that the appropriate and required response to the current growth shock “should be fiscal, first and foremost”; and (4) how three myths from the past posed a threat to the future of the European project. The following four links provide examples of policy analysis:
Example chart 10: failing the “common sense test”. What was the point of running tight fiscal policies when the private sector was running persistent financial surpluses > 3% GDP (Source: ECB; CMMP analysis)
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately
Bank performance and the importance of rigorous frameworks
The key chart
Was it correct to question the conviction behind the SX7E rally during 2Q20? Source: FT; CMMP analysis
The key message
In early June, I questioned the conviction behind the European bank sector’s rally that saw the SX7E index rise 45% from its April lows. I recommended viewing this more as a vote of confidence in the EC’s policy shift than a fundamental change in sector dynamics.
The index fell -17% subsequently, before rebounding since the end of July to a level -8% below the June peak.
Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.
In many cases, lower trading volumes have accompanied the recent lacklustre share price performance (do investors care?).
The 2Q20 interim results also supported my April conclusion that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic.
Significantly, three index heavyweights are now trading below the pre-LLP threshold multiple associated with peak EM and DM banking crises.
These banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets.
The lessons from 2020 include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.
Six key charts
In early June, I questioned the conviction behind the European bank sector’s rally that had seen the SX7E index rise 45% from its April lows (“EA banks: a high conviction rally?”). I noted that the rally had taken place (1) two months after the broader market, (2) despite a worsening operating environment, and (3) in the absence of the macro building blocks that are required for a sustained recovery in sector profitability. I also highlighted that the rally had coincided with the announcement of the EC’s proposed €750bn “Next Generation EU” fund and suggested that it could be seen better as a vote of confidence in the policy response rather than a fundamental shift in banking sector dynamics.
Poor absolute and relative share price perfomance (versus SXXE) from index heavyweights YTD. (Source: FT; CMMP analysis)
The index fell -17% subsequently, to a recent end-July low, before rebounding during August to a level -8% below the June peak. Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.
Share price and trading volume trends for BNP Paribas, the largest bank in the SX7E index by market capitalisation. (Source: FT; CMMP analysis)
In many cases, lower trading volumes have accompanied the recent lacklustre share price performance. The chart above illustrates YTD share price and trading volume trends (7d and 21d MVA) for BNP Paribas, the largest bank in the SX7E index by market capitalisation. The current 21d MVA is just over 4m shares, only 62% of the 2020 average of 6.5m and 35% of the 11.4m shares at the peak of the sell-off in March (note these are MVA figures). In the case of Deutsche Bank, the only index heavyweight to have delivered positive share price returns YTD, the current 21d MVA is 12m shares, only 55% of the 2020 average of 22m and 31% of the 39m shares traded at its peak (charts available on request).
EA banks’ vulnerability to rising provisions in the wake of the COVID-19 pandemic. Pre-provision profits were only 2.4x provisions in 4Q19. (Source: ECB; CMMP analysis)
The 2Q20 interim results also supported my April 2020 conclusion that weak pre-provision profitability levels left EA banks poorly positioned to absorb the impact of the COVID-19 pandemic (“If you want to go there…”). At the time, I expressed concern about the low “pre-provision profit” cover of only 2.4X at the end of 2019 and highlighted low cover levels in Portugal (1.5x), Germany (1.8x), Italy (1.8x) and Spain (1.9x).
Six months later, the 32 largest European banks have set aside €56bn to cover loan losses. Santander, which was the largest SX7E bank by market cap previously, set aside €7bn to cover loan losses alone and booked a large write-down on its UK business. This resulted in the first quarterly loss in the bank’s 163-year history. Santander’s share price is down -50% YTD, the second worst performer of the heavyweights after Soc Gen.
Pre-LLP provision multiples (2021e) for index heavyweights – red line indicates typical crisis threshold. (Source: Consensus forecasts, CMM analysis)
Three index heavyweights are now trading below the pre-LLP multiple that is associated with peak EM and DM banking crises. Based on my experience of multiple banking crises in EM and DM over the past thirty years, I believe that a pre-LLP multiple of 2x typically marks a key “crisis-threshold” for bank valuation. Consensus forecasts indicate that Santander, BBVA and Soc Gen are currently trading on 1.5x, 1.6x and 1.8x 2021e pre-LLP multiples respectively. Contrarian traders may note with interest the fact that Santander’s trading volumes (post-loss selling pressure?) have peaked at a time of very distressed valuation.
Share price and trading volume trends for Santander. (Source: FT, CMMP analysis)
These three banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets. Based on consensus 2021e forecasts the index heavyweights are trading on PBVs of between 0.22x (Soc Gen) and 1.04x (KBC) with an average of 0.45x. While these valuations appear attractive in absolute terms, they simply reflect depressed forecasts for 2021e ROEs, in my view. The average (no-growth) implied cost of equity for the index heavyweights is 10.8%. Given the very high risk to current forecasts, this implies a sector that is fairy-valued rather than genuinely cheap. Note, however, that implied costs of capital vary widely from 3.2% for Deutsche Bank to 16.1% for Santander. This suggests opportunities for active investors since such a dispersion usually indicates either (1) glaring valuations anomalies and/or (2) unrealistic forecasts.
2021e ROE versus PBV for European banks, index heavyweights highlighted (Source: Consensus forecasts; CMMP analysis)
Conclusion and key lessons
Recent lessons here include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.
The CMMP Analysis investment framework combines three different time perspective into a single investment thesis. The investment outlook at any point in time reflects the dynamic between these three different time perspectives. Conviction reflects the extent to which they are aligned – in June they were misaligned highlighting the fact that (absolute) valuation alone is not sufficient for sustained investment performance.
That said, the European and UK banking sectors have provided very important insights into wider macroeconomic trends and the pace, timing and nature of the recovery from the 2Q economic lows. This supports my view, that true value in analysis developments in the financial sector remains less in considering investments in DM banks but more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. More of this to follow in this “Autumn snippets” series.
Please note that the summary comments above are extracts from more detailed analysis that is available separately
Headline figures mask a more nuanced message from the monthly flow data Source: ECB; CMMP analysis
The key message
The “2Q20 message from the money sector” is simple: uncertainty in the euro area has peaked but remains elevated still.
Demand for overnight deposits remains the key driver of M3 growth
Above-trend NFC credit demand and resilient HH mortgage demand is offsetting weakness in consumer credit
Monthly flows into overnight deposits (and uncertainty) peaked in March at 5x 2019 average flows but remain 1.3x 2019 average flows
HHs have stopped paying down consumer credit and mortgage demand has remained resilient throughout the pandemic
The NFC “dash for cash” has also peaked and the monthly flow of corporate borrowing fell below the 2019 average in June
Despite negative real rates, almost €10trillion continues to sit in cash and overnight deposits
The key question – how much of this is “forced” versus “precautionary” savings – remains unanswered for now.
Six charts that matter
The headlines from the ECB’s money supply data for June 2020 suggest little change to the “message from the money sector” narrative (see key chart above). Growth in broad money (M3) rose to 9.2% YoY from 8.9% in May, the fastest rate of growth since July 2008. Narrow money (M1) grew 12.6% YoY from 12.5% in May and overnight deposits grew 13.1% YoY from 13.0% in May. M1 and overnight deposits contributed 8.5ppt and 7.6ppt to the overall M3 growth of 9.2% respectively. In short, households (HHs) and corporates (NFCs) continue to demonstrate a high preference for liquid assets despite negative real returns, which reflects high levels of uncertainty. No surprises here.
HH and NFC loans as a counterpart to M3 (% YoY) Source: ECB; CMMP analysis
Looking at the counterparts to broad money, credit to the private sector contributed 5.1ppt to M3 growth down from 5.3ppt in May. HH lending stood at 3.0% YoY, flat on the month, while growth in NFC lending fell to 7.1% YoY from 7.3% in May. As before, above-trend NFC credit and resilient HH mortgage demand (4.1% YoY) offset the lack of growth in consumer credit (flat, YoY)
Monthly flows of overnight deposits Source: ECB; CMMP analysis
Behind the headlines, the monthly flow data presents a more nuanced picture. Monthly flows into overnight deposits peaked at €250bn in March (5x the 2019 average flow) and have fallen back to €63bn in June (1.3x the 2019 average flow).
HH “uncertainty” peaked one month before NFC “uncertainty” – but both remain elevated Source: ECB; CMMP analysis
HH deposit flow peaked at €80bn in April and has fallen to €50bn in June. NFC deposit flow peaked a month later in May at €112bn and has fallen back even faster to €42bn. In both cases, however, the latest monthly flow is still 1.2x the respective 2019 averages.
HH no longer paying down consumer credit Source: ECB; CMMP analysis
After three months of negative flows, EA HHs have stopped paying down credit for consumption. They borrowed €1bn in June after negative flows of €-12bn, €-14bn and €-2bn in March, April and May respectively.
HHs also borrowed €10bn in June to purchase houses, down from €20bn in May. The smoothed 3m MVA of monthly mortgage flows has been trending between €10bn and €20bn for a sustained period reflecting resilient demand since mid-2017.
Passed the peak “dash for cash” Source: ECB; CMMP analysis
The “dash for cash” from NFCs appears to have peaked at €121bn flow in March 2020. Since then, the monthly flow has declined to €72bn (April) and €50bn (May) to €8bn (June), below the 2019 average monthly flow of €11bn.
Please note that the summary comments and graphs above are extracts from more detailed analysis that is available separately.
Monthly flow into O/N deposits is 3.2x the 2019 average monthly flow (3m MVA, EURO mn) Source: ECM; CMMP analysis
Summary
The latest message from the euro area (EA) money sector is clear – unprecedented levels of uncertainty continue to challenge the “v-shaped recovery” narrative.
The fastest YoY growth in M3 since July 2008 (8.9%) largely reflects increased holdings of overnight deposits, which contributed 7.6ppt to the headline growth alone. May’s monthly flow of overnight deposits of €167bn (3m MVA) was 3.2 times the average monthly flow in 2019. Households (HHs) and corporates (NFCs) continue to demonstrate strong liquidity preferences – €9.6trillion is currently sitting in (cash) and overnight deposits despite negative real rates of return.
From a counterparts’ perspective, credit to private sector contributed 5.3ppt to broad money growth with increasing demand from NFCs and resilient HH demand for mortgages offsetting on-going weakness in HH demand for credit for consumption. No major change in the message here.
Looking forward, there is some support for the argument that we may have passed the low point in the “sharpest and deepest recession in non-wartime history”, but little to suggest that the recovery will be anything other than “sequential (geographically), constrained and uneven” (M. Lagarde, 26 June 2020). The answer lies largely in the extent to which the increase in savings highlighted here is “forced” or “precautionary”. Forced savings can be released relatively quickly to support economic activity. In contrast, precautionary savings are unlikely to move straight into investment and consumption.
Previous CMMP analysis indicates persistent private sector net financial surpluses since the GFC and suggests a bias towards more precautionary savings. These are unlikely to more rapidly into either investment or consumption and pose an on-going challenge to the “v-shaped recovery” narrative.
Please note that the summary comments above and graphs below are extracts from more detailed analysis that is available separately.
The six charts that matter
O/N deposits are the main contributor to accelerating M3 growth (contribution in ppt, % YoY) Source: ECB; CMMP analysisHHs and NFCs continue to demonstrate strong liquidity preferences (EUR bn, 3m MVA) Source: ECB; CMMP analysisNo changes in the message from a counterparts’ perspective – increasing NFC and resilient mortgage demand offset weakness in consumer credit (% YoY) Source: ECB; CMMP analysisLooking for positives – O/N deposit monthly flows may have peaked in March? Source: ECB; CMMP analysisLooking for positives – mortgage credit demand is resilient and the contraction in consumer credit has slowed Source: ECB; CMMP analysisBut don’t forget, the private sector has been running persistent net financial surpluses since the GFC, despite negative/very low policy rates – a very strong indication that the economy is still suffering from a debt overhang Source: ECB, CMMP analysis
Messages from the money sector V – SMEs in the euro area
The key chart
Concerns over the availabilty of credit for SMEs in the EA are rising sharply (net percentage terms) Source: ECB/EC (22nd SAFE survey); CMMP analysis
Summary
The latest ECB/European Commission SAFE survey indicates that SMEs in the euro area (EA) are facing similar challenges to their UK-based peers.
SME turnover and profits were declining across the EA before the Covid-19 pandemic hit, despite accommodative financing conditions
Weaker turnover and lower profits have become obstacles to obtaining external finance for the first time since 3Q14 especially, but not exclusively, in southern Europe
The weakening economic outlook is compounding these trends with significant deteriorations noted in Germany, Italy and Finland
The survey indicates that SMEs see the availability of internal funds declining substantially and by more than during the 2012 sovereign debt crisis
External financing needs are rising, unsurprisingly, but SMEs indicate that they expect the availability of these funds (loans, credit lines and overdrafts) to deteriorate sharply, but to a lesser extent than the availability of internal funds.
Unorthodox monetary policy has been successful in reducing financing costs for SMEs in the EA and in the UK, but the challenge of accessing funding in sufficient volumes and in the face of declining operating performance remains.
SMEs in the EA are signalling rising operational, economic and financing risks and a widening financing gap vis-a-vis large corporates, raising concerns for investors in the sector and banks with relatively high SME exposure.
Introduction
I highlighted the widening financing gap between large UK corporates and SMEs in “Mind the financing gap” earlier this month. In this post, I summarise the results of the ECB/EC’s Survey on the Access to Finance for Enterprises (SAFE). This was conducted between March and April this year and the results were summarised in the ECB’s latest Economic Bulletin.
The key message from the euro area (EA) is similar to the UK version – while SMEs are benefitting from lower funding concerns, they are reporting a deterioration in activity and rising concerns about the future availability of external financing. Policy measures need to reflect and adjust to these concerns.
The charts that matter
What are the trends in SME turnover and profits? Source: ECB/EC (22nd SAFE survey); CMMP analysis
SME turnover and profits were declining across the EA before the Covid-19 pandemic hit and despite accommodative financing conditions. Turnover declined across the region for the first time since early 2014. Italian SMEs were hit particularly hard (19% fall), followed by SMEs in Slovakia, Greece and Spain.
SMEs also reported a sharp deterioration in profits, from -1% in the previous survey to -15%. Italian SMEs stood out again, with profit declines of 36%, followed by Greek, Slovakian and Spanish SMEs. This occurred despite accommodative financing conditions, with high labour costs highlighted as a key contributing factor, and the “industry” sector hit relatively badly by declining profits.
How do turnover trends vary across the EA? Source: ECB/EC (22nd SAFE survey); CMMP analysisHow do profit trends vary across the EA? Source: ECB/EC (22nd SAFE survey); CMMP analysis
Weaker turnover and lower profits have become obstacles to obtaining external finance for the first time since 3Q14. This applies across the EU (with the exception of Greece) but is particularly severe in Spain, Italy and Portugal.
Why does this matter? Source: ECB/EC (22nd SAFE survey); CMMP analysisWhere does this matter? Source: ECB/EC (22nd SAFE survey); CMMP analysis
The weakening economic outlook is compounding these challenges with significant deteriorations noted across the EA and particularly in Germany, Italy and France. The net percentage of firms signalling that the weakening in economic outlook was affecting access to finance rose to -30%, a level not seen since 1Q13.
And the economy? Source: ECB/EC (22nd SAFE survey); CMMP analysisHow widespread is the economic impact? Source: ECB/EC (22nd SAFE survey); CMMP analysis
The survey indicates that SMEs see the availability of internal funds declining substantially and by more than during the 2012 sovereign debt crisis. External financing needs are rising, unsurprisingly, but SMEs indicate that they expect the availability of these funds (loans, credit lines and overdrafts) to deteriorate sharply, but to a lesser extent than the availability of internal funds.
How urgent are SME external financing needs? Source: ECB/EC (22nd SAFE survey); CMMP analysisHow do actual and expected availability of external finance compare? Source: ECB/EC (22nd SAFE survey); CMMP analysis
Conclusion
Unorthodox policy has been successful in reducing financing costs for SMEs in the EA and in the UK, but the challenge of accessing funding in sufficient volumes and in the face of declining operating performance remains severe. The risks to SMEs are rising as are the risks for those banks with relatively high SME exposure.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
