“Macro building blocks matter” – look at the SX7E

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.

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.

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.

• 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.

• 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 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.

• 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.

• 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.

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)

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