Historic and forecast trends in financial sector balances for the UK private sector, UK government and RoW expresses as a % GDP (Source: OBR; CMMP analysis)
Lesson #3
Given the importance of financial sector balances (lesson #2), it is a surprise that they only occupied two paragraphs and one chart in the OBR’s 217-page, “Economic and fiscal outlook” for the UK (November 2020). A cynic might wonder if this was because the one chart (reproduced above) countered much of the content of the other 216 pages. A more reasoned response might be that the power and application of financial sector balances remains under-appreciated even at these levels, which makes the framework more powerful for those who understand its implications.
In the case of the UK, for example, this approach highlights that official forecasts ask us to believe that UK households, corporates and overseas investors will behave highly unusually and with unprecedented degrees of dynamism in the post-pandemic period. Even then, the assumed result is simply a return to the unsustainable position pre-COVID where combined private and public sector deficits are offset by increasing RoW surpluses.
If we assume that November’s OBR forecasts are now a base case priced into UK assets, then lesson #3 points to downside risks to UK growth, upside risks to the level of borrowing, inflation staying below target and rates remaining lower for longer. More simply, lesson #3 also suggests that official forecasts can/often do fail common sense tests (see also lesson #4).
Relative performance of leading European banks (SX7E) versus the wider SXXE European index (Source: CMMP analysis)
Lesson #1
I started 2020 by arguing that the true value in analysing developments in the financial sector lies less in considering investments in developed market banks and more in understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. Banks have underperformed again (c20% YTD in Europe) but the messages from the money sector have been as important as ever.
Second, monetary developments have continued to provide reliable leading indicators of economic activity (that link directly into asset allocation models), key insights into the behaviour of households and corporates over time and between regions, and warnings of hidden risks in emerging economies. Third, the mechanical link between money supply and inflation has been challenged and replaced by an explanation of what will be required for LT secular trends (eg, growth vs value) to be reversed in a sustainable fashion.
And all from the simple observation that, “everyone has a balance sheet” (see Lesson #2).
Trends in MMT interest levels versus peak interest levels (Source: Google Trends, CMMP analysis)
The key message
The Office of Budget Responsibility (OBR) will publish its latest forecasts for the UK economy and public finances tomorrow (25 November 2020) alongside the Chancellor’s Spending Review.
In normal times, the focus would be on assessing progress against fiscal targets. A more interesting focus in the current “extraordinary times”, however, would be to assess policy and the accompanying rhetoric in the context of unprecedented shifts in UK financial sector balances and the on-going debate between orthodox fiscal thinking and Modern Monetary Theory (MMT) recommendations.
Repeating a previous chart – UK private sector and general government net lending/borrowing positions from the capital account expressed as a percentage of GDP (Source: ONS, CMMP analysis)
Despite the dramatic shift in the private sector’s net lending position this year, UK policy debate remains centred on “sacred duties to balance the books”, rumours of public sector pay freezes and speculation about tax rises. From the position of “orthodox fiscal thinking”, no surprises here.
MMT, which at its core is simply a description of financial flows in a modern capitalist economy with private banks and a government (Keen) provides an alternative view, however. Economists such as Stephanie Kelton argue that (as currency issuers) neither the UK nor US governments are dependent on tax revenues or borrowing to fund spending (the most important constraint on government spending being inflation instead). For Kelton, “the problem is that policy makers are looking at the picture with one eye shut.”
Trends in UK CPI versus the Bank of England’s target of 2% (Source: Bank of England, CMMP analysis)
The Bank of England does not agree, clearly! At yesterday’s (23 November 2020) Treasury Committee hearings, Professor Silvana Tenreyro (an External Member of the MPC) dismissed MMT be repeating the adage that “the good things are not new and the new things are not good,” and Andy Haldane (Chief Economist) argued that his problem with MMT was that it is not modern, not monetary and not really theory, merely “a trick that can only be pulled once” instead.
In this context, the packaging and analysis of tomorrow’s UK announcements (and on-going US policy debates) will provide an interesting indicator of the balance of economic debate and the extent to which MMT is influencing policy choices on either side of the Atlantic, if at all…
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.
Uncertainty reigns and consumption remains subdued
The key chart
The UK and EA money sectors sent a clear message this week (Source: Bank of England; ECB; CMMP analysis)
The key message
The UK and euro area (EA) money sectors sent a clear message to investors this week – don’t bet on the consumer.
Uncertainty reigns among European households. Monthly flows into deposits in the UK and EA remain 1.5-2.0x the average seen in 2019, despite negative real returns.
Yes, household lending has recovered from recent lows, driven by resilient (and rising) mortgage demand. Consumer credit demand, however, remains negative/weak. UK HHs repaid £0.6bn of consumer credit in September after additional borrowing in July (£1.1bn) and August (£0.3bn). The annual growth rate fell to -4.6%, a new low since the data series began in 1994. EA HHs borrowed €1bn for consumer credit in September, down from €3bn in August and €5bn in July, but the 0.1% YoY growth rate was the slowest since consumer credit recovered back in May 2015.
High uncertainty and slowing consumer spending were in place even before the introduction of the latest round of restrictions across Europe. No wonder that Madame Lagarde was so emphatic in warning investors to expect something more dramatic in December.
A simple message in six charts
Monthly UK household deposit flows since January 2019 (Source: Bank of England; CMMP analysis)Monthly EA household deposit flows since January 2019 (Source: ECB; CMMP analysis)YoY growth rates in UK and EA mortgage and consumer credit (Source: Bank of England; ECB; CMMP analysis)Monthly UK household credit flows since January 2020 (Source: Bank of England; CMMP analysis)Monthly EA household credit flows since January 2020 (Source: ECB; CMMP analysis)Trends in EA and UK inflation versus target since 2010 (Source: Bank of England; ECB; CMMP analysis)
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately
What now for bank capital distributions? Absolute and relative performance of SX7E index YTD (Source: Macrobond; CMMP analysis)
The key message
The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.
The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD.
The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.”
Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. However, estimates by my colleagues at zeb consulting suggest that the average CET1 ratio of the largest 50 banks will remain on a sufficient level. More importantly, their analysis highlights significant differences among the sample banks. They find no statistically significant patterns regarding specific business models or country/regional exposure.
Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders remains subordinate to other priorities.
Six charts that matter
The current 3Q20 results season is refocusing the attention of investors, banks and regulators on the “exceptional and temporary” restrictions imposed on bank capital distributions during the COVID-19 pandemic.
And then they were gone – the recovery in bank dividends was a rare positive for EA banks (Source: Macrobond; CMMP analysis)
The gradual recovery in banks’ dividend payouts up to that point had been a rare positive in an otherwise negative investment outlook for the sector. Across advanced economies, banks’ dividend yields had recovered from the low levels that accompanied the rebuilding of capital after the GFC.
Euro area (EA) banks increased their shareholders’ yields via dividends but also tended to raise capital by issuing new shares. In contrast, the recovery in yields for US banks was more modest, as US banks have returned more cash through share buybacks instead. ECB analysis suggests that US and Nordic banks were the most generous in terms of shareholder remuneration recently, ahead of their UK, Swiss and EA peers (see graph below).
EA banks increased shareholder yields via dividends but also tended to issue new shares (Source: ECB; CMMP analysis)
Their suspension added to the list of on-going negatives including “low profitability, high costs, the lack of sustainable business models at certain banks and insufficient investment in new technologies,” (ECB, 2020) that help to explain why banks have been the worst performing sector YTD. In previous posts, I have (1) explained that the macro building blocks that are required for a sustained improvement in banks’ profitability and share price performance have been missing, (2) highlighted that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic, and (3) questioned the conviction of previous sector rallies. Despite a 2% recovery over the past month, the SX7E index has fallen 42% YTD and underperformed the wider SXXE index by 34%.
Another miserable year for bank investors (Source: Macrobond; CMMP analysis)
The 60% underperformance of EA banks over the past five years supports a central theme in CMMP analysis. The true value in analysing developments in the financial sector lies less in considering investments in banks and more in the understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.
Why bother analysing banks/developments in the financial sector? (Source: Macrobond; CMMP analysis)
The exceptional status of these restrictions reflects the fact that they applied to all banks irrespective of whether pre-determined capital limits had been breached or not. It is important to note that the implementation of post-GFC standards had improved the capitalisation of global banks and that the introduction of capital buffers also helped them to withstand stressed situations such as the current pandemic. When these buffers are drawn down to pre-determined levels, Basel standards place automatic limits on dividends, share buybacks and bonus payments. However, given the scale of the potential losses that might arise from the pandemic, supervisors moved to halt dividends and buybacks even if pre-identified capital limits had not been breached.
In the case of EA banks, Yves Mersch, a member of the Executive Board of the ECB and Vice Chair of its Supervisory Board, explained last month that “while prudent capital planning is the order of the day, the current economic uncertainty means that banks are simply unable to forecast their medium-term capital needs accurately. Such an unorthodox move was therefore justified by our ultimate goal to counteract procyclical developments and support banks’ capacity to absorb losses during the crisis without compromising their ability to continue lending to the real economy.”
Their temporary status was a recognition of the perceived and real risks associated with such a “one-size-fits-all policy.” Mersch also acknowledged that, “under normal conditions, profitable and healthy banks should not be prevented from remunerating their shareholders. Restricting dividends can increase banks’ funding costs, have an impact on their access to capital markets and make them less competitive than their international peers.”
Expected losses to increase signficantly for Europe’s 50 largest banks (Source: zeb consulting)
Looking forward, higher expected losses (ELs) and risk-weighted assets (RWAs) resulting from the economic downturn and increase in non-performing loans will lead to a deterioration in capital ratios. Estimates from my colleagues at zeb consulting suggest that ELs could rise to between EUR 543-632bn in 2021 and EUR 611-833bn in 2022. Combined with a rise in RWAs, this would result in a drop in average CET1 ratios to between 11.4% and 12.3% in 2021 and 11.4% and 12.6% in 2022. In other words, the average CET1 ratio of the largest 50 banks in Europe is expected to remain sufficient despite higher ELs and RWAs.
Capital positions expected to remain sufficient (Source: zeb consulting)
Their analysis highlights significant differences among the sample banks. In several cases, banks are expected to consume their pre-Covid-19 capital cushions and will be forced to use the capital buffers release by regulators. In the “zeb base case”, eight of the top 50 European banks fall into this category. This number increases to 18 in their more “severe scenario”. However, none of the banks will end up with CET1 ratios below the reduced post-Covid-19 requirements.
More importantly in the context of the current debate, they find no statistically significant patterns regarding specific business models or country/regional exposure.
Conclusion
Further vigilance is required but the case for maintaining blanket restrictions on capital distributions has weakened. Yes, European banks remain dependent on government support for private and corporate customers and regulatory easing regarding capital ratios and banks, regulators and governments also need to continue to work together to prevent future credit or liquidity crunches. ECB representatives are also correct to highlight the real challenges faced by banks in forecasting medium-term capital needs accurately and the argument that they and the IMF put forward in terms of the benefits of flexibility is valid (eg, additional capital preserved could be distributed to shareholders should it prove unnecessary).
Nonetheless, the significant differences that exist between European banks and the lack of significant patterns at the business model, country or regional exposure levels suggests that the case for a blanket approach to restrictions of banks capital distributions is much weaker now that it was at the start of the pandemic. However, just because regulators should return to judging the merits of capital distributions on a case-by-case basis does not mean that they will. Sympathy towards banks and their shareholders is subordinated below other objectives and I conclude with the words of Andrea Enria, the Chair of the ECB’s Supervisory Board from a recent interview with Handlesblatt:
The ban on dividends is an exceptional measure. We do not intend to make it a regular supervisory tool. It was introduced when governments, the ECB and ECB Banking Supervision announced a major support package to deal with the fallout of the pandemic. The ECB has calculated that the full use of government guarantee schemes might reduce banks’ loan losses by between 15 to 20 per cent in the euro area. The package was intended to allow banks to grant loans to households and companies, not to compensate shareholders. The pandemic led to factory and school closures, and some of us were locked down for months. Why should dividends, of all things, be the only sacrosanct element in our societies?
Andrea Enria, Interview with Handlesblatt (12 October 2020)
Please note that the summary comments and charts above are abstracts from more detailed CMMP and zeb consulting analysis that is available separately.
“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
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
