UK and EA consumers are still borrowing, despite higher rates
The key chart
Quarterly flows in UK and EA consumer credit (multiple of pre-pandemic flows) (Source: BoE; ECB; CMMP)
The key message
The Bank of England and ECB both argue that, (1) the best way they can make sure inflation comes down and stays down is to raise rates, and (2) that higher rates make it more expensive to borrow and hence people will spend less on goods on services.
Great in theory, but consumer credit flows have remained surprisingly strong during 3Q23 and in September 2023 when monthly flows in both regions were 1.2x their average pre-pandemic levels.
While unprecedented increases in the cost of borrowing have resulted in a very sharp slowdown in overall financing flows to the UK and EA private sectors, consumers in both regions are “still bashing the plastic”.
Bad news for investment and real estate, perhaps, but better news for consumer goods and services (at least for now).
And yet
“Higher interest rates make it more expensive for people to borrow money and encourages them to save. That means that, overall, they will tend to spend less. If people on the whole spend less on goods and services, prices will tend to rise more slowly. That lowers the rate of inflation”
Bank of England, 2 November 2023
UK consumer credit flows
UK consumer credit flows totalled £4.4bn in 3Q23, up from £4.3bn in the 2Q33, but down from £4.5bn in 1Q23 (see key chart above). Consumer credit flows in the past three quarters have been 1.2x their average pre-pandemic level of £3.6bn.
Trends in UK monthly consumer credit flows (Source: BoE; CMMP)
Monthly consumer credit flows during the 3Q23 were £1.3bn in July, £1.7bn in August, and £1.4bn in September. These resilient flows were 1.1x, 1.4x and 1.2x the average monthly pre-pandemic flow of £1.2bn (see chart above).
EA consumer credit flows
EA consumer credit flows totalled €9.3bn in 3Q23, up from €3.4bn in 2Q23 and €4.2bn in 1Q23. Consumer credit demand, which had been supressed since the pandemic, almost recovered to its pre-pandemic average level of €10.3bn.
Trends in EA monthly consumer credit flows (Source: ECB; CMMP)
Monthly consumer credit flows during the 3Q23 were €2.5bnbn in July, £3.0bn in August, and £3.9bn in September. These flows were 0.7x, 0.9x and 1.2x the average monthly pre-pandemic flow of €3.4bn (see chart above).
Conclusion
While unprecedented increases in the cost of borrowing have resulted in a very sharp slowdown in overall financing flows to the UK and EA private sectors, consumers in both regions are “still bashing the plastic”.
Bad news for investment and real estate, perhaps, but better news for on-going demand for goods and services.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
A tempting question to ask, but also the wrong one!
The key chart
Twenty-year trends in debt ratios (% GDP) broken down by type (Source: BIS; CMMP)
The key message
Denmark and the US are the only two, advanced economies that maintain absolute limits on the level of government debt. Interestingly, their public debt ratios (as opposed to debt levels) were essentially the same twenty years ago (54-55% GDP). Today, however, Denmark has the third lowest public debt ratio in the world (30% GDP), while the US has the seventh highest (103% GDP).
Unsurprisingly perhaps, while we hear little “political noise” about the Danish debt ceiling (or debt ratio), we are subjected to an overdose from the US. This leads some to ask, “Why can’t the US be more like Denmark”.
A tempting question to ask, but also the wrong one…
To understand why, we need to adopt a systemic view of the Danish and US financial systems that incorporates both public and private sector debt and reflects the reality of modern money creation.
Put simply, money creation relies on actions that add to bank deposits. Bank lending and government DEFICITS (despite what is taught in many textbooks) qualify, but in different ways. The repayment of bank loans and government SURPLUSES have the opposite effect – they destroy money.
In this context, a better question to ask is, “How do the processes of money creation in Denmark and the US differ and why does this matter?”
Total debt ratios have increased in both economies over the past two decades (see key chart above). In Denmark from 223% GDP to 246% GDP. In the US from 198% GDP to 256% GDP. The processes have been very different, however.
Denmark has effectively substituted government deficits and public debt (an asset of the non-government sector) with more private debt (a liability of the non-government sector) over the past two decades. In contrast, the US has substituted private debt – mainly household debt – with more public debt. In the process, the ratio of the stock of private debt (largely ignored by policy makers and economists) to public debt has risen from 3.2x to 7.2x in Denmark over the period. In the US, it has fallen from 2.6x to 1.5x.
The key point here it that private sector money creation faces unique supply (capital and regulation) and demand (ability of currency users to service debt) constraints. Despite more than a decade of HH sector deleveraging, for example, Denmark’s HH and NFC debt ratios remain above the levels where debt is considered a constraint on future growth. The result? Further private sector deleveraging, led by the HH sector.
Private sector models are also inherently less flexible, less stable and, in advanced economies, more prone to periods of crisis that require greater to levels of public debt to resolve/address.
While lending to the private sector is also the main source of money creation in the US, the government plays a much greater role than in Denmark. As a currency issuer, the US government does not face the same constraints as the private sector (although it does face other constraints). The US is also one of only three advanced economies where both HH and NFC debt ratios are below their respective threshold limits. In short, the structure of the US model provides more flexibility and more stability, as the response to the COVID-pandemic illustrated, and reduces the risk of crisis.
The US generates significantly more political noise about the management of government debt than Denmark, the only other country to maintain an absolute debt ceiling. This noise differential in not an accurate reflection of the relative strengths of the money creation processes in each economy. It is instead, a reflection of flawed macro thinking. Thinking that views public sector debt as a problem but largely ignores private debt and falsely equates the financial constraints of currency users and currency issuers.
The irony here is that a more accurate, systemic view of Danish and US money creations leads to a different question altogether – “Shouldn’t Denmark be more like the US?”
Why can’t the US be more like Denmark?
Twenty-year trends in public sector debt ratios (% GDP) (Source: BIS; CMMP)
Denmark and the US are the only two, advanced economies that maintain absolute limits on the level of government debt. Their public debt ratios (as opposed to debt levels) were essentially the same twenty years ago (54% and 55% GDP respectively, see graph above). Today, however, Denmark has the third lowest public debt ratio in the world (30% GDP, see graph below), while the US has the seventh highest (103% GDP).
BIS reporting nations ranked by 3Q22 public debt ratios (% GDP) (Source: BIS; CMMP)
Unsurprisingly, while we hear little political noise about the Danish debt ceiling (or debt ratio), we are subjected to an overdose of “political noise” from the US. This leads some to ask, “Why can’t the US be more like Denmark”. A tempting question to ask, but also the wrong one…
Money creation in Denmark and the US – a systemic view
To understand why, we need to adopt a systemic view of the Danish and US financial systems that incorporates both public and private sector debt and reflects the reality of modern money creation.
Money creation relies on actions that add to bank deposits, the main form of money today. Bank lending and government deficits (despite what is taught in many textbooks) qualify, but in different ways. The repayment of bank loans and government surpluses have the opposite effect – they destroy money.
In this context, a better question to ask is, “How do the processes of money creation in Denmark and the US differ and why does this matter?”
The changing nature of money creation – total debt broken down by type (% total debt) (Source: BIS; CMMP)
The graph above illustrates how Denmark has effectively substituted public debt (an asset of the non-government sector) with more private debt (a liability of the non-government sector) over the past two decades. In contrast, the US has substituted private debt – mainly household debt – with more public debt.
Note the relative scale of the stock of private sector debt (largely ignored by policy makers and economist) in relation to the stock of public sector debt over the period (see graph above). In Denmark, the ratio rose from 3.3x to almost 10x before the GFC, fell back and then rose again to 7.2x today. Again, in contrast, the US ratio has fallen from 2.6x to 1.5x over the period.
Twenty-year trends in Danish money creation (debt as % GDP) (Source: BIS; CMMP)
In other words, lending to the private sector is a far more important source of money creation in Denmark (see graph above) than in the US (see below). As an aside, the Danish government ran a budget surplus in 2022, destroying money in the process.
The key point here it that private sector money creation faces unique supply (capital and regulation) and demand (ability of currency users to service debt) constraints. Despite more than a decade of HH sector deleveraging, for example, Denmark’s HH and NFC debt ratios remain above the level where debt is considered a constraint on future growth (see graph below). For reference, the BIS considers that HH and NFC debt ratio of 85% GDP and 90% GDP represent threshold limits above which debt becomes a constraint on future growth.
HH debt ratios plotted against NFC debt ratios for selected BIS reporting nations – red lines represent BIS threshold limits (Source: BIS; CMMP)
The result? Further private sector deleveraging, led by the HH sector (see chart below). Note also that private sector models are also inherently less flexible, less stable and, in advanced economies, more prone to periods of crisis that require greater to levels of public debt to resolve/address.
Twenty-year trends in US and Danish HH and NFC debt ratios (% GDP) (Source: BIS; CMMP)
While lending to the private sector is also the main source of money creation in the US, the government plays a much greater role than in Denmark (see chart below). As a currency issuer, the US government does not face the same constraints as the private sector (although it does face other constraints). The US is also one of only three advanced economies where both HH and NFC debt ratios are below their respective threshold limits.
In short, the structure of the US model provides more flexibility and more stability, as the response to the COVID-pandemic illustrated, and reduces the risk of crisis.
Twenty-year trends in US money creation (debt as % GDP) (Source: BIS; CMMP)
Conclusion – shouldn’t Denmark be more like the US?
The US generates significantly more political noise about the management of government debt than Denmark, the only other country to maintain an absolute debt ceiling. This noise differential in not an accurate reflection of the relative strengths of the money creation processes in each economy. It is instead, a reflection of flawed macro thinking. Thinking that views public sector debt as a problem but largely ignores private debt and falsely equates the financial constraints of currency users and currency issuers.
The irony here is that a more accurate, systemic view of Danish and US money creation leads to a different question altogether – “Shouldn’t Denmark be more like the US?”
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Exposure to NFC lending (% total loans) plotted against exposure to HH deposit funding (% total deposits) (Source: ECB; CMMP)
The key message
The impact of ECB monetary policy differs at the country and bank segment levels creating relative winners and losers among banks, savers and borrowers in the process
The transmission mechanism of policy has operated largely as expected but with three striking features – the scale and pace of the policy response, the speed of the pass through to the costs of NFC borrowing, and the limited pass through to the cost of HH overnight deposits.
Current aggregate dynamics are more positive for banking sectors with relatively high exposures to retail funding and NFC lending – the Italian and Spanish banking sectors. They are less positive for banking sectors with relatively low exposures to HH funding and NFC lending – the Netherlands (see key chart above).
Important differences exist between the funding mixes of the Spanish, German and Italian banking sectors (relatively high exposures to HH deposits) and the Dutch and French banking sectors (relatively high exposures to NFC funding). Spanish banks enjoy relatively high exposures to HH ON deposit funding. They have also experienced a below average pass through to the cost of these deposits.
In contrast, French banks have higher than average funding exposures to NFC and HH deposits with agreed maturities (part of M2-M1) and have experienced relatively rapid increases in the cost of these deposits.
Turning to the other side of banks’ balance sheets, Italian, French and Spanish banks benefit from above average exposures to NFC lending. They have also experienced above average increases in NFC lending rates. Spanish banks have experienced above average increases in mortgage rates too.
Spanish dynamics dominate much of this analysis. Recent trends have been negative for Spanish borrowers and savers, but positive for Spanish banks. Spanish borrowers face above average increases in their cost of borrowing, while savers see below average increases in deposit rates. Spanish banks, in contrast, not only benefit from these trends, but they also enjoy business mixes skewed towards lending to NFCs and borrowing from HHs.
The market may not have responded well to Banco Santander’s results yesterday (the share price fell by almost 6%). But the fact that the 46% YoY increase in domestic net interest income was lost in the noise, may not have been a bad thing, at least from a PR perspective…!
The winners and losers from ECB hiking
This final post in the “Passing Through” series examines how the transmission mechanism of ECB monetary policy differs at both the country and bank segment levels and explores why these differences matter. The analysis focuses on the EA’s five largest banking markets – Germany, France, Spain, Italy and the Netherlands. Even in this small sample, the differences are real and meaningful.
Changes in EA policy, market, wholesale and retail rates (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
The transmission of ECB monetary policy in the current hiking phase has largely followed theory (see chart above). There was a rapid pass through from the policy rate (300bp) to the market rate (288bp). From here the pass through to the cost of borrowing, while incomplete, was more rapid for corporate loans (202bp) than for HH loans (127bp). Similarly, in terms of funding costs, wholesale funding reflected changes in policy rates faster than retail deposits. The key differences between the current cycle and previous cycles are the relatively rapid pass through to NFC lending rates and the relatively slow pass thought to the cost of retail deposits in the current cycle.
Exposure to NFC lending (% total loans) plotted against exposure to HH deposit funding (% total deposits) (Source: ECB; CMMP)
These high-level sector dynamics are positive for banking sectors with relatively high exposures to retail funding and NFC lending (see chart above). Among the largest EA banking sectors, Italian and Spanish banks enjoy above average exposures to both HH deposit funding (63% and 61% of total deposits respectively) and NFC lending (43% and 40% of total lending respectively). In contrast, banks in the Netherlands have relatively low exposures to HH funding (46% total deposits) and NFC lending (32% total lending).
Note the contrast (see chart above) between the Spanish, German and Italian banking sectors (with relatively high exposures to HH deposits) and the Dutch and French banking sectors (with relatively high exposures to NFC funding). Note also that overnight (ON) deposits represent a relatively large percentage of HH and total deposits in the case of Spanish banks (see chart below).
HH deposits as %age of total deposits by country (Source: ECB; CMMP)
The positive news for Spanish banks does not end though. Not only do they enjoy relatively high funding exposures to HH ON deposits, but they have also seen a below average pass through to the cost of these deposits (see chart below).
HH ON deposits: Pass through plotted against % total deposits (Source: ECB; CMMP)
HH ON deposits represent 57% of total deposits in Spain compared with an average of 35% for EA banks. The pass through to Spanish ON deposits has been only 6bp compared with a EA average of 12bp. Note that while Italian and German banks also enjoy relatively high exposures to HH ON deposit funding, they have also seen above average (but still limited) pass through to the cost of these deposits (16bp and 14bp respectively).
NFC AGR deposits: Pass through plotted against % total deposits (Source: ECB; CMMP)
In contrast, French banks have higher than average funding exposures to NFC and HH deposits with agreed maturity (part of M2-M1) and have experienced relatively rapid pass throughs to the cost of these deposits. NFC deposits with agreed maturity represent 8% of French banks deposits compared with an EA average of 4% (see chart above). The cost of these deposits has risen 2.62ppt since June 2002, versus and average EA rise of 2.41ppt. (Note in passing the relatively low pass through to Spanish bank deposits here).
HH AGR deposits: Pass through plotted against % total deposits (Source: ECB; CMMP)
HH deposits with agreed maturity represent 12% of total French bank deposits compared with an EA average of 8% (see chart below). Again, the increase in the cost of these deposits in France (2.14ppt) have been higher than the EA average (1.63ppt).
NFC loans: Pass through plotted against % total loans (Source: ECB; CMMP)
The good news for the Italian, French and Spanish banking sectors is that they have (slightly) above average exposures to NFC lending and have experienced above average increases in NFC lending rates. NFC loans account for 43%, 41% and 40% of total loans in Italy, France and Spain respectively compared with an EA average of 39% (see chart above). The lowest exposure in this sample is in the Netherlands (32% total loans). The increase in the composite cost of borrowing has been highest in Spain (2.34ppt), then France (2.10ppt) and then Italy (2.02ppt). These compares with an average EA increase of 2.02ppt.
HH mortgages: Pass through plotted against % total loans (Source: ECB; CMMP)
Spanish banks have also experienced an above average increase in the mortgage lending rates (see chart above). These have increased by 2.34ppt since June 2022 compared with an average rise of 1.27pp across the EA.
Changes in EA and Spanish policy, market, wholesale and retail rates (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
This analysis illustrates how the impact of the transmission mechanism of ECB monetary mechanism varies considerably at both the country and bank segment levels.
The stand out theme here is the impact in Spain. Recent trends have been negative for Spanish borrowers and savers, but positive for Spanish banks. Spanish borrowers face above average increases in their cost of borrowing, while savers see below average increases in deposit rates. Spanish banks, in contrast, not only benefit from these trends, but they also enjoy business mixes skewed towards lending to NFCs and borrowing from HHs.
The market may not have responded well to Banco Santander’s results yesterday (the share price fell by almost 6%). But the fact that the 46% YoY increase in domestic net interest income was lost in the noise, may not have been a bad thing from a PR perspective…!
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Trends in policy rate and composite cost of mortgage borrowing (Source: ECB; CMMP)
The key message
What do recent trends in the cost of euro area (EA) mortgages tell us about the transmission mechanism of ECB monetary policy?
Current ECB monetary policy is notable for both the speed and the scale of the (belated) response. Policy rates have risen 350bp since 27 July 2022, faster than in previous cycles. The speed of the transmission mechanism on the cost of new mortgages – 127bp over the same period – has been equally notable; exceeding the 123bp rise recorded over 32 months between December 2005 and July 2008. Banks and borrowers have had little time to adjust.
The speed of transmission has varied widely, however, even among the EA’s five largest mortgage markets. The cost of borrowing has increased by 174bp and 161bp in Spain and Italy respectively, for example, but by only 100bp in France.
The speed of the transmission mechanism on the cost of new mortgages bears little relationship with either the structure of loans (e.g. variable rate versus fixed rate) or the cost of borrowing at the start of the period. This suggests that country- and industry-specific factors e.g. the level of competition or central bank restrictions (as in the case of France) may be more important, in the short term.
There is a much closer relationship, however, between the speed of the transmission mechanism on the cost of borrowing on the outstanding stock of mortgages and loan characteristics. Some of the largest increases here have occurred in Estonia, Lithuania, Latvia and Finland – markets where the share of variable rate loans exceed 90% – while some of the smallest increases have occurred in the Netherlands, Germany and France – markets where the share is less than 25%.
In Spain, the EA’s fourth largest mortgage market, the share of variable rate mortgages has fallen from over 90% to 25%, in-line with the EA average. Despite this, the cost of borrowing for new and outstanding mortgages has risen faster than the EA average during the current hiking phase. This has led to political pressure domestically and questions for the ECB. The minority party in the coalition government is calling for a cap on the rates on variable loans, while the ECB considers this a matter between the banks and borrowers. Either way, seven consecutive months of net repayments since August 2022 and two consecutive months of negative YoY growth rates may be more significant.
In short, the transmission of monetary policy rates to mortgage rates (the largest segment of EA private sector credit) is both rapid and variable. Banks and borrowers have had little time to adjust to the scale and pace of current tightening. Country-and industry-specific factors are key in determining the speed of transmission on new lending. Loan characteristics are key in determining the speed of transmission on outstanding mortgages and banks’ net interest margins.
Passing through!
The current ECB policy response
Current ECB monetary policy is notable for both the speed and the scale of the (belated) response. Policy rates have risen 350bp in the space of only eight months. For context, in the last sustained period of monetary tightening between 6 December 2005 and 9 July 2008, the policy rate rose 225bp in the space of 32 months (see chart below).
Trends in ECB policy rate (%) (Source: ECB; CMMP)
The transmission mechanism – the background
The transmission mechanism of ECB monetary policy – the process through which monetary policy decisions affect the EA’s economies in general and the price level in particular – is characterised typically by long, variable and uncertain time lags. This makes predicting the precise effect of policy decisions difficult. Two factors to note:
Changes in the ECB’s monetary stance typically affect lending rates for new loans quickly (see below). However, more time may be needed to impact lending rates for banks outstanding loan portfolios.
Different loan characteristics also have a substantial impact on the speed of the transmission mechanism at the country level. These include the type of loans (variable rate versus fixed rate), the frequency of revision rates and loan maturities.
Share of variable rate mortgages (% total mortgages) over past 20 years (Source: ECB; CMMP)
There has been a shift away from variable rate mortgages since the GFC, which has only be reversed relatively recently (see chart above). Variable rate mortgages accounted for 59% of total mortgage in November 2004. This share fell to only 13% in January 2017 and stayed around this level until March last year. Since then, there has been a shift back towards variable rate mortgages. This peaked at 25% in December 2023, however, before falling back slightly to 24% in February 2024.
Loan characteristics by country (February 2023) (Source: ECB; CMMP)
As always, aggregate EA figures mask very different market structures across the EA. The share of variable rate mortgages in total new mortgages ranges from over 90% in Finland, Lithuania, Estonia and Latvia to only 4% in France, for example. Within the five EA economies that account for 85% of the region’s mortgages, this range extends from 46% in Italy to 4% in France.
Note that changes in ST rates typically have a great impact on net interest margins in countries and sectors that are characterised by floating rate lending.
The transmission mechanism in practice
Trends in policy rate and composite cost of mortgage borrowing (Source: ECB; CMMP)
Recent policy has had an immediate impact, especially (as expected) on the cost on new mortgages. The chart above illustrates trends in the policy rate (MRR) and the interest rate on new mortgage loans and outstanding mortgage loans with a maturity over five years. As can be seen, the rate on new mortgage loans (the blue line) reacts much faster than the rate on outstanding mortgage loans (the maroon line) to changes in the policy rate (the black line).
At the aggregate EA level, the cost of new mortgages has increase 127bp from 1.97% to 3.24%. This is a bigger increase than the 123bp recorded in the previous hiking cycle between December 2005 and July 2008. The cost of outstanding mortgages has increased 41bp, from 1.63% to 2.04%.
Change in CCOB (in ppt) since June 2022 (Source: ECB; CMMP)
The composite cost of new mortgages has risen 127bp since June 2022, from 1.97% to 3.24%. At the country level, the rise in the CCOB indicator has ranged widely from over 200bp in Estonia (276bp), Lithuania (275bn), Latvia (247bp), Slovakia (211bp) and Portugal (206bp) to less than 100bp in Greece (76bp), Ireland (25bp) and Malta (25bp). Among the largest five EA mortgage markets, the change has ranged from 174bp and 161bp in Spain and Italy respectively to only 119bp and 100bp in Germany and France respectively (see chart above).
Composite cost of new mortgages (%) as at end February 2023 (Source: ECB; CMMP)
The cost of new mortgages also varies widely between the five largest mortgage markets. The range extends from 3.79% and 3.76% in Italy and Germany respectively to only 2.35% in France (see chart above). France has the lowest composite cost of borrowing in the EA. Note that in addition to their relatively high exposure to fixed rate mortgages, French banks are also constrained by a limit, set by the Banque de France, on the amount they can charge for mortgages.
The speed of transmission
Change in CCOB for new mortgages plotted against loan characteristic (Source: ECB; CMMP)
The speed of the transmission mechanism on the cost of new mortgages bears little relationship with either the structure of loans (see chart above) or the cost of borrowing at the start of the period (see chart below). This suggests that country- and industry-specific factors (eg, the level of competition) may be more important, in the short term.
Change in CCOB for new mortgages plotted against CCOB in June 2022 (Source: ECB; CMMP)
There is a much closer relationship, however, between the speed of the transmission mechanism on the cost of borrowing on the outstanding stock of mortgages and loan characteristics (see chart below). These characteristics include not only the loan structure but also the frequency of revision rates and loan maturities.
Change in CCOB for outstanding mortgages plotted against loan characteristic (Source: ECB; CMMP)
In this case, some of the largest increases have occurred in Estonia, Lithuania, Latvia and Finland – markets where the share of variable rate loans exceed 90% – while some of the smallest increases have occurred in the Netherlands, Germany and France – markets where the share of variable loans is less than 25%.
What is happening in Spain?
Trends in EA and Spanish loan characteristics over past twenty years (Source: ECB; CMMP)
Spain is the EA’s fourth largest mortgage market after Germany, France and the Netherlands. The share of variable loans in Spain has fallen from over 90% (pre- and during the GFC) to 25%, in-line with the EA average.
Monthly trends in CCOB for new mortgages in EA and Spain (%) (Source: ECB; CMMP)
Despite this, the cost of borrowing for new and outstanding mortgages has risen faster than the EA average during the current hiking phase. Between June 2022 and February 2023, the cost of new mortgages in Spain increased 174bp from a below EA average 1.69% to an above EA average of 3.43% (see chart above).
Trends in ECB policy rate and composite cost of outstanding Spanish mortgage borrowing (Source: ECB; CMMP)
More importantly for domestic Spanish banks, the rates on outstanding mortgages have risen 129bp since June 2022, from a below EA average of 1.23% to an above EA average of 2.38% (see chart above).This has led to political pressure domestically and on the ECB. The minority party in the coalition government is calling for a cap on the rates on variable loans, for example.
“I’m sure that banks are ready to negotiate in order to ease the burden on households over time. It is in the banks’ interest to do so.”
ECB President Lagarde, 5 March 2023
In a 5 March 2023 interview with “El Correo”, ECB President Lagarde was asked: (1) if she had a comment for Spanish families suffering from higher rates; (2) if she thought that caps were feasible; and (3) whether Spanish banks should remunerate customer deposits. Perhaps unsurprisingly, Madame Lagarde, argued that these issues were determined by the relationship between borrowers and lenders.
In this context, a more telling response comes from industry dynamics instead. Spain has experienced seven consecutive months of net repayments since August 2022 (see chart above) and two consecutive months of negative YoY growth rates (see graph below).
Trends in annual growth rates in mortgages for EA’s five largest markets (Source: ECB; CMMP)
Conclusion
The transmission of monetary policy rates to mortgage rates (the largest segment of EA private sector credit) is both rapid and variable. Banks and borrowers have had little time to adjust to the scale and pace of current tightening. Country-and industry-specific factors are key in determining the speed of transmission on new lending. Loan characteristics are key in determining the speed of transmission on outstanding mortgages and banks’ net interest margins.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The BoE and ECB face different challenges from divergent consumer credit trends
The key chart
UK and EA consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: BoE; ECB; CMMP)
The key message
The Bank of England (BoE) and the ECB face different balancing acts. Both have achieved success in deflating their respective mortgage markets and slowing growth in less-productive FIRE-based lending. Divergent trends in consumer credit demand point to different challenges, however, in terms of balancing household (HH) consumption and inflation (BoE) and HH consumption and growth (ECB).
Increased borrowing is one way that HHs can offset the pressures of falling real incomes. Monthly consumer credit flows in the UK dipped slightly in February 2023 from January’s recent high, but remain 1.2x their pre-pandemic level. In contrast, monthly consumer credit flows in the EA remain well below (0.6x) their respective pre-pandemic level.
Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand and inflation. Resilient UK consumer credit demand suggests that the risks to the BoE’s balancing act lie towards inflation that is more persistent. In contrast, subdued EA consumer credit demand suggests that the risks to the ECB’s balancing act lie towards weaker growth/recession. Neither are easy to manage…
Different balancing acts – the details
UK consumer credit flows
The monthly flow of UK consumer credit decreased to £1.4bn in February 2023, down from the recent high of £1.7bn in January 2023 but above December 2022’s monthly flow of £0.8bn. February’s monthly flow was 1.2x the pre-pandemic flow of £1.2bn. The 3m MVA of UK consumer credit flows remained at £1.3bn, 1.1x the pre-pandemic flow (see chart below).
Trends in UK monthly consumer credit flows (Source: BoE; CMMP)
EA consumer credit flows
The monthly flow of EA consumer credit rebounded to €1.9bn in February, but remained only 0.55x the pre-pandemic average flow of €3.4bn. The 3m MVA flow fell to €1.1bn, from €1.2bn in January, 0.33x the pre-pandemic average flow. They key point here is that, in contrast to trends observed in the UK (and the US), consumer credit flows have failed to recover to their pre-pandemic levels (see chart below).
Trends in EA monthly consumer credit flows (Source: ECB; CMMP)
Conclusion
Trends in consumer credit demand matter because increased borrowing is one way that UK and EA HHs can offset the pressures from falling disposable incomes (along with reduced savings). Consumer credit is also the second most important element of productive COCO-based lending, after corporate debt. It supports productive enterprise since it drives demand for goods and services, hence helping corporates to generate sales, profits and wages.
Higher interest rates are supposed to deter borrowing and hence reduce aggregate demand. Resilient UK consumer credit demand suggests that the risks to the BoE’s balancing act lie towards inflation that is more persistent. In contrast, subdued EA consumer credit demand suggests that the risks to the ECB’s balancing act lie towards weaker growth/recession. Neither are easy…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Growth rate in M3 (% YoY) and contribution (ppt) of M1 and private sector credit (Source: ECB; CMMP)
The key message
Monetary developments in the euro area (EA) indicate a clear transition away from “pandemic-era” economics.
Growth rates in broad money (M3) recovered during 3Q22 but remained well below pandemic levels. Three important, positive developments lay behind the headline growth figures.
First, the period of heightened uncertainty and subdued demand for credit that reached a peak during the pandemic has ended.
Second, and following on from this, EA money and credit cycles are re-synching with each other as the demand from credit recovers to levels last seen in December 2008.
Third, and perhaps most importantly, the breakdown of private sector credit is shifting back towards increased demand for productive (COCO-based) lending – corporate credit is accelerating while mortgage demand is moderating slowly.
So far, so good.
Rising inflation is outweighing each of these positive developments, unfortunately.
Monetary trends adjusted from inflation, are sending very different and consistently negative messages. Real growth rates in M1, HH credit and NFC credit typically display leading, coincident and lagging relationships with real GDP. Each indicator is falling at an increasing rate.
If historic relationships between these variables continue, this suggests a deceleration in overall economic activity over the next quarters.
Completing the transition
Monetary developments in the euro area (EA) indicate a clear transition away from “pandemic-era” economics.
Growth rates (% YoY) in broad (M3) and narrow (M1) money (Source: ECB; CMMP)
Growth rates in broad money (M3) recovered during 3Q22 but remained well below pandemic levels. M3 rose 6.3% YoY in September, up from 6.1% YoY in August and 5.7% YoY in July. Despite this, broad money growth was 6.2ppt below its 12.5% YoY January 2021 peak (see chart above).
Narrow money (M1), a key component of broad money, rose only 5.6% YoY, however, down from 6.8% YoY in both August and July. Narrow money growth was 10.9ppt below its 16.5% YoY January 2021 peak.
Behind the headline YoY growth figures lie three important, positive developments.
Growth rate (% YoY) in M3 and contribution (ppt) of ON deposits and other components (Source: ECB; CMMP)
First, the period of heightened uncertainty and subdued demand for credit that reached a peak during the pandemic has ended. Recall that the hoarding of cash by HHs and NFCs, largely in the form of overnight deposits at banks, was the main driver of the spike in broad money during the pandemic (see graph above). M3 growth peaked at 12.5% YoY in January 2021. At the same time, M1 and overnight deposits grew 16.5% YoY and 17.1% YoY and contributed 11.3ppt and 10.1ppt to total broad money growth respectively.
With heightened levels of uncertainty, HHs were increasing their forced and precautionary savings. The key point here is that money sitting idly in overnight deposits at banks contributed to neither economic growth nor inflation.
Growth rate (% YoY) in M3 and contribution (ppt) of private sector credit (Source: ECB; CMMP)
Note also, that at the point of maximum M3 growth, private sector credit grew only 4.5% YoY and contributed only 5.4ppt to the 12.5% YoY growth in broad money (see graph above).
Fast forward to September 2022, and private sector credit grew 6.9% YoY in September, up from 6.8% YoY in August and 6.3% YoY in July. At the end of 3Q22, private sector credit contributed 5.4ppt to the total 6.3% YoY growth rate in broad money. This represents a clear break from the monetary dynamics seen during the pandemic (see key chart above).
Growth rates (% YoY) in M3 and private sector credit (Source: ECB; CMMP)
Second, and following on from this, EA money and credit cycles are re-synching with each other as the demand from credit recovers to levels last seen in December 2008.
As noted in “Don’t confuse the messages”, monetary aggregates and their counterparts move together in typical cycles. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing.
Growth rate (% YoY) in private sector credit minus growth rate in M3 (Source: ECB; CMMP)
The “pandemic-era” relationship between money and credit cycles was far from typical, however. In January 2021, the gap between the YoY growth rate in M3 (12.5% YoY) and private sector credit (4.5% YoY) reached a historic high of 8ppt (see chart above).
During 2021, CMMP analysis focused on this dynamic as one of the three key signals to monitor. In September 2022, private sector credit grew faster (6.9% YoY) than money supply (6.3% YoY) for the fourth consecutive month as money and credit cycles re-synched with each other.
Trends in the outstanding stock of private sector credit (EUR bn) with breakdown between COCO-based and FIRE-based lending (Source: ECB; CMMP)
Third, and perhaps most importantly, the breakdown of private sector credit is shifting back towards increased demand for productive (COCO-based) lending – corporate credit is accelerating while mortgage demand is moderating slowly.
Recall that the outstanding stock of loans that support production and income formation in the euro area (COCO-based loans) only recovered to the GFC period peaks in November 2021 (see chart above). Nearly all of the aggregate growth in euro area lending since the GFC has been in the form of less-productive FIRE-based lending (see “Fuelling the FIRE” and “It’s a record of sorts”).
Growth (% YoY) in PSC and contribution (ppt) of COCO-based and FIRE-based lending (Source: ECB; CMMP)
In September 2022, COCO-based and FIRE-based lending both contributed 3.3ppt to the total 6.6% YoY growth in (unadjusted) private sector credit (see graph above). This contrast sharply with the situation a year earlier in September 2021 when COCO-based and FIRE-based lending contributed 0.7ppt and 2.5ppt to the total 3.2% YoY growth rate.
Growth rates (% YoY) in mortgages and loans to NFCs (Source: ECB; CMMP)
Significantly, the growth rate in lending to NFCs (the largest element of COCO-based lending) grew faster (8.0% YoY) and contributed more to total lending (3.1ppt) than mortgage lending (the largest element of FIRE-based lending) which grew 5.1% YoY and contributed 2.1ppt to total lending.
So far, so good.
Rising inflation is outweighing each of these positive developments, unfortunately. Monetary trends adjusted from inflation, are sending very different and consistently negative messages.
Growth rates (% YoY in real terms) in M1, HH credit and NFC credit (Source: ECB; CMMP)
Real growth rates in M1, HH credit and NFC credit typically display leading, coincident and lagging relationships with real GDP. Each indicator is falling at an increasing rate (see chart above). If historic relationships between the variables continue, this suggests a deceleration in overall economic activity over the next quarters.
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.
UK and euro area (EA) money sectors have sent remarkably consistent messages throughout the COVID-pandemic. Shared trends in monetary aggregates, for example, provided similar conclusions regarding household (HH) behaviour, consumption and growth, the challenges facing policy makers, and the productivity of lending to the private sector (PSC).
The 4Q21 proved to be an important inflexion point in terms of HH confidence and behaviour in both regions. By December 2021, monthly deposit flows had moderated to 0.6x and 0.7x their pre-pandemic levels in the UK and EA respectively, leaving excess savings of c£162bn and c€285bn in the form of bank deposits. Demand for consumer credit recovered to 1.4% YoY and 1.2% YoY in the UK and EA respectively, and quarterly flows were positive in each of the past three quarters. So far, so good.
In addition to rising inflation, the Bank of England and the ECB both face on-going challenges in terms of the persistent desychronisation of money and credit cycles, which limits monetary policy effectiveness, and the fact that policy responses to date have fuelled growth in the wrong type of credit. The gap between the growth in money supply (ST liabilities of banks) and growth in PSC (key assets of banks) has narrowed but remains wide by historic standards. Nonetheless, the build-up of excess liquidity in both regions is slowing. Mortgage lending, the largest element of so-called “FIRE-based” lending, continues to be the main driver of PSC in the UK and the EA. This has potentially negative implications for growth, leverage, income inequality and financial stability.
In short, the money sectors in the UK and EA continue to sing from the same song sheet. The message for corporates, policy makers and investors alike is that an important inflexion point was reached in terms of HH confidence and behaviour in 4Q21. This is welcome news.
Of course, policy challenges remain and a slowdown in excess liquidity and/or a diversion into productive COCO-based lending rather than less productive FIRE-based lending may be less welcome news for financial assets in 2022.
The money sectors in the UK and the euro area (EA) have sent remarkably consistent messages throughout the COVID-19 pandemic. We know that narrow money (M1), and overnight deposits within M1, drove the expansion of broad money (M4ex, M3 respectively) in both regions during 2020, for example. In other words, the rise in broad money illustrated in the chart above was a reflection of the deflationary forces of increased savings and delayed consumption.
We also know that, as at the end of December 2021, M1 represented 68% and 73% of M3 in the UK and the EA, up from 48% and 51% respectively a decade earlier (see chart below). Preference for highly liquid assets remains high, despite the negative real returns earned from those assets.
Narrow money as a share of broad money since December 2011 (Source: BoE; ECB; CMMP)
A sustained recovery in both regions required/requires a reversal of these deflationary trends ie, a moderation in monthly HH deposit flows and a recovery in consumer credit (see “Three key charts for 2021”). Central banks also need to see a resynching of money and credit cycles. Why? Because, monetary policy effectiveness is based on certain stable relationships between monetary aggregates.
Monthly HH deposit flows as a multiple (x) of pre-pandemic levels (Source: BoE; ECB; CMMP)
As noted in “Missing the point?” in December 2021, HH behaviour reached a potentially important inflexion point at the start of the 4Q21. Monthly deposit flows (see chart above) peaked at 5.9x pre-pandemic levels in the UK in May 2020 and 2.4x pre-pandemic levels in the EA in April 2020. In December 2021, these flows had moderated to 0.6x and 0.7x pre-pandemic levels respectively. During this process HHs have accumulated excess savings in the form of bank deposits of £162bn in the UK and €285bn in the EA (CMMP estimates).
Annual growth rates in consumer credit reached a low point in February 2021 in both the UK (-10% YoY) and the EA (-3% YoY). In December 2021, however, annual growth rates had recovered to 1.4% YoY and 1.2% YoY respectively in the UK and EA respectively (see chart above). More importantly perhaps, quarterly flows of consumer credit have been positive and rising for the past three quarters (see chart below). The 4Q21 flows of £3bn and €4bn in the UK and EA respectively remain below pre-pandemic levels, however, especially in the EA where quarterly flows averaged €10bn during 2018-2019.
Quarterly flows in consumer credit (£bn, EURO bn) (Source: BoE; ECB; CMMP)
The COVID-19 pandemic exacerbated the desynchronisation of money and credit cycles in the UK and EA creating major challenges for policy makers, banks and investors alike. The degree of this desynchronisation peaked in early 2021 and reached its narrowest level since early 2020 in December 2021 (see chart below). That said, the gap between the growth rates of money supply (short-term liabilities of banks) and private sector lending (the main asset of banks) persists and remains high in a historic context.
Growth in lending (% YoY) minus growth in money supply (% YoY) (Source: BoE; ECB; CMMP)
Mortgage lending, the largest element of so-called “FIRE-based lending”, continues to be the main driver of PSC growth in both regions (see chart below). In December 2021, mortgage lending grew 5.1% YoY in the UK and 5.4% YoY in the EA. Lending to NFCs, the largest element of more productive “COCO-based lending”, rose 4.2% YoY in the EA but fell -0.4% YoY in the UK. As described above, consumer credit, another form of COCO-based lending grew 1.4% YoY and 1.2% YoY in the UK and EA respectively.
Breakdown on PSC growth by type of lending (% YoY) (Source: BoE; ECB; CMMP)
Conclusion
The money sectors in the UK and EA continue to sing from the same song sheet. The message for corporates, policy makers and investors alike is that an important inflexion point was reached in terms of HH confidence and behaviour in 4Q21. This is welcome news. Of course, policy challenges remain and a slowdown in excess liquidity and/or a diversion into productive COCO-based lending rather than less productive FIRE-based lending may be less welcome news for financial assets in 2022.
Please note that the summary comments and charts 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.
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
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
