The key chart
The key message
Looking into 2021, the shape and duration of any economic recovery and the outlook for investment returns/asset allocation in the euro area (EA) depend critically on whether policy makers have learned from the mistakes of the past.
The region remained trapped by persistent, excess savings and out-dated policy rules at the start of 2020. A major policy reboot was already long overdue.
As COVID-19 hit, households (HHs) increased their savings sharply and corporates (NFCs) stopped investing. The private sector surplus returned to GFC levels. In response, the ECB called (correctly) for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies.
With broad money growing at the fastest rate since 2008, debate over future inflation and its implication for duration trades is growing. Today’s monetary trends are very different, however, and the message from the money sector remains one of heightened uncertainty and subdued credit demand in direct contrast to 2008.
Private sector investment alone is unlikely to fill the gap left by COVID-19. Investors betting on a reversal of existing secular trends must be confident, therefore, that the notion that fiscal expansion is indispensable to sustain demand is fully understood.
The EA has a unique opportunity to make greater use of fiscal policy to achieve its goals – will they seize it or waste it?
The charts that matter
In February 2020, I suggested that the EA was trapped by persistent, excess savings and out-dated policy rules and argued that a major policy reboot was long overdue. This was before the full economic and social impacts of the pandemic were understood. The EA private sector ran average financial surpluses/net savings of 4.4% GDP in the decade between 1Q10 and 1Q20. General government ran average financial deficits/net borrowings on 2.7% GDP over the same period, resulting in average net savings for the EA of 1.7% GDP (see key chart above). These trends placed downward pressure on growth and inflation over the period.
The messages from the money sector at the time were clear. First, when the private sector is running a financial surplus in spite of negative/very low policy rates, this is a strong indication that the economy is still suffering from a debt overhang. As can be seen from the chart above, private sector deleveraging in the EA was delayed and more limited after the GFC than in both the UK and the US. Data released by the BIS this week, shows that the EA private sector debt ratio hit a new high of 174% of GDP in 2Q20 compared with ratios of 165% and 160% in the UK and US respectively. Second, fiscal space, like debt sustainability, is at its core a FLOW not a STOCK concept.
As COVID-19 hit, HHs increased their savings sharply and NFCs stopped investing. HH net savings, which had trended between 2-3% of GDP in the post-GFC period jumped to 5% in 2Q20. The NFC sector, which had resumed investing in 4Q18, also returned to net savings equivalent to 0.2% of GDP (see graph above). In aggregate, the net financial surplus/net savings of the EA private sector increased to 6% of GDP. (Note that basic accounting principles indicate that surpluses run by the private sector must equal deficits run by general government and/or the RoW -see graph below).
In response, the ECB called (correctly) for fiscal responses, “first and foremost” and the EU and European governments responded appropriately with a shift to more proactive and common fiscal policies. In brief, general government deficits of 3.7% GDP and a ROW deficit of 2.1% offset the private sector surplus in the 2Q20 (see chart above).
With broad money growth accelerating, debate over future inflation and its implication for duration trades is growing. In October 2020, broad money grew 10.5% YoY. This is the fastest rate of growth recorded since April 2008 (see graph above).
Today’s monetary trends are very different, however, and the message from the money sector remains one of heightened uncertainty and subdued credit demand in direct contrast to 2008. From a components perspective, narrow money (M1) contributed 9.4ppt to October’ 10.5% growth as HHs, and to a lesser extent NFCs, maintained their preference for holding highly liquid overnight deposits, despite negative real returns (see chart above).
Monthly deposit flows provide a useful proxy for private sector uncertainty levels. In the HH sector, monthly flows are lower than in the March-April 2020 when uncertainty was at its peak, but October’s flow of €43bn was still 1.3x the average flow of €33bn recorded in 2019 (see chart above).
From a counterparts perspective, private sector credit contributed 5.2ppt to broad money growth in October. The gap between money supply and private sector credit demand hit a new high of 5.9ppt, another clear indicator that the region is still suffering from a debt overhang (see chart above). In passing, it is worth noting the important role of QE, especially large-scale government bond purchases during the crises, in current monetary growth. Credit to general government contributed 7.3ppt to October’s 10.5% growth in M3 (see chart below).
Conclusion
In a speech made on 12 October 2020, Isabel Schabel, a Member of the ECB’s Executive Board, argued that, “at times of significant uncertainty, private investment may not fill the gap left by the pandemic in spite of very favourable financing conditions. In these situations, monetary policy alone cannot unfold its full potential. Fiscal expansion is then indispensable in order to sustain demand and mitigate the long-term cost of the crisis.” CMMP analysis supports this view.
Investors betting on a reversal of existing secular trends (eg duration trades) must be confident, therefore, that the notion that fiscal expansion is indispensable to sustain demand is fully understood.
Outside the narrow focus of financial markets, the EA has a unique opportunity to make greater use of fiscal policy to achieve its goals – will they seize it or waste it?
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.