Category: Europe

“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.