Debunking myths and identifying key drivers of future returns
The key chart
So far, so good – but is the wider notion that fiscal expansion is indispensable fully understood? (Source: Eurostat, CMMP analysis)
Lesson #4
In addition to helping challenge UK official forecasts (lesson #3), financial sector balances (lesson #2) have also allowed us to debunk three myths from the euro area and identify the key factors that will determine the shape and duration of any recovery and investment returns in 2021.
Back in April 2020, I challenged the arguments that: (1) painful structural reforms post-2000 were the main driver of Germany’s recovery and resurgent competitiveness; (2) existing fiscal frameworks (including the Stability and Growth Pact) were still relevant; and (3) “this crisis [was] primarily the hour of national economic policy.”
Focusing here on (2), in response to COVID-19, EA households increased their savings sharply and corporates stopped investing. 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.
Policy makers have acknowledged that private sector investment is unlikely to fill the gap left by COVID-19.
So far, so good. The wider question (see also lesson #7) is whether the notion that fiscal expansion is indispensable to sustain demand is fully understood.
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 messages can be derived from the components and counterparts of current money growth and how do they compare with past cycles? (Source: ECB; CMMP analysis)
The key message
Broad money (M3) in the euro area (EA) is growing at its fastest rate since early 2008. However, CMMP analysis of the components and counterparts of this growth suggests that the associated “messages from the money sector” and their implications are very different.
The message in the pre-GFC period was one of (over-) confidence and excess credit demand. In contrast, the current message is one of heightened uncertainty and subdued credit demand. Today’s money growth reflects fiscal and monetary easing in response to weak private sector demand and rising savings (with added uncertainty regarding the extent to which rising savings are forced or precautionary).
The implications for inflation and policy options are clear. Inflationary pressures are likely to remain weak during the current cycle. Madame Lagarde may well signal more monetary support before the end of 2020 at this week’s ECB meeting, but the over-riding message from the EA money sector is that the route to economic recovery and higher inflation remains “fiscal, first and foremost.”
Seven charts that matter
Broad money (M3) in the euro area (EA) is growing at the fastest rate since early 2008. M3 grew 10.4% YoY in September, up from 9.5% in August. This is the fastest rate of YoY growth since April 2008 when M3 grew 10.6% YoY. However, CMMP analysis of the components and counterparts of these two growth phases suggests that the associated “messages from the money sector” are very different. Current trends are not a repeat of 2008 dynamics.
Different drivers and implications of monetary expansion – 2008 versus 2020 (Source: ECB; CMMP analysis)
Note that the components and counterparts of M3 provide different perspectives and explanations of changes in broad money. Monetary aggregates are derived from the consolidated monetary financial institutions (MFI) balance sheet and comprise monetary liabilities of MFIs and central government vis-à-vis non-MFI euro area residents.
The Eurosystem defines narrow (M1), intermediate (M2) and broad (M3) aggregates. They differ with respect the degree on “moneyness” or liquidity of the instruments included. M1, for example, comprises only currency in circulation and balances that can be converted into currency or used for cashless payments. Relative high holdings of M1 indicate a relatively high preference for liquidity and can be used as an inverse proxy for the level of private sector confidence.
The consolidated MFI balance sheet also provides the basis for analysing the counterpart of M3. All items other than M3 on the consolidated balance sheet can be rearranged to explain changes in broad money. The relationship between M3 and its counterparts rests on a simple accounting identity. What this means is that we have two identities that can be used to provide different perspectives on changes in broad money:
Components: Broad money equals M1 plus M2-M1 plus M3-M2
Counterparts: Broad money equals credit to EA residents plus net external assets minus longer term financial liabilities plus other counterparts (net)
What was the message from the money sector in the pre-GFC period? (Source: ECB; CMMP analysis)
The message in the pre-GFC period was one of (over-) confidence and excess credit demand. From a components perspective, for example, M1 was growing only 2.7% YoY in April 2008 and contributing just 1.2ppt to the overall 10.6% growth in total money. At this point M1 accounted for 43% of the outstanding stock of money. From a counterparts perspective, private sector credit was growing at 11.2% and contributing 17.6ppt to the growth in total money (offset by negative contributions from net external assets and LT financial liabilities). Credit to general government was contributing just 0.1ppt to broad money growth.
What is the message from the money sector now? (Source: ECB; CMMP analysis)
In contrast, the current message is one of heightened uncertainty and subdued credit demand. M1 grew 13.8% YoY in September 2020, up from 13.2% in August and contributed 9.4ppt to the overall 10.4% growth in broad money (versus 9.0ppt in August). M1 now accounts for 70% of the outstanding stock of money. The private sector is holding higher levels of the most liquid assets despite negative real returns on those instruments. This suggests high levels of uncertainty that have been exacerbated by the Covid-19 pandemic. (Note in passing that monthly flows showed a divergence between rising and above 2019-average household deposit flows and falling and below 2019-average NFC flows in September).
Uncertainty reigns – very different drivers of money growth (Source: ECB; CMMP analysis)
Private sector credit grew 4.6% YoY in September, unchanged from August. As before, relatively robust demand for NFC credit (7.1%) and resilient (and rising) mortgage demand (4.5%) continue to offset relative weakness in consumer credit (0.1%). However, private sector credit contributed only 5.2ppt to the overall 10.4% growth in broad money.
A key point here is that, in typical cycles, monetary aggregates and their counterparts move together. 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. The current relationship between money and credit cycles is far from typical, however. Indeed the gap between M3 and PSC is at a historic high reflecting the fact that the euro area is only emerging very gradually from a period of debt overhang.
Counterparts to M3 – the alternative view of what is driving money growth (Source: ECB; CMMP analysis)
Today’s money growth reflects fiscal and monetary easing in response to weak private sector demand and rising savings (with added uncertainty regarding the extent to which rising savings are forced or precautionary). Credit to general government and credit to the private sector contributed 6.8ppt and 5.2ppt respectively to the 10.4% growth in broad money (see graph above). This is in direct contrast to the pre-GFC period when money expansion was driven primarily by strong, or excess, private sector credit demand (see graph below).
Contrasting contributions of private sector credit and messages for the outlook for aggregate demand (Source: ECB; CMMP analysis)
Conclusion – don’t confuse the messages
The implications for inflation and policy options are clear. Inflationary pressures are likely to remain weak during the current cycle. Madame Lagarde may well signal more monetary support before the end of 2020 at this week’s ECB meeting, but the over-riding message from the EA money sector is that the route to economic recovery and higher inflation remains “fiscal, first and foremost.”
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Unusually high monthly flows into O/N deposits (despite negative real rates of return) indicate elevated levels of uncertainty among HHs and NFCs in the euro area (Source: ECB; CMMP analysis)
The key message
July’s monetary developments in the euro area suggest that the road to recovery will be long and uncertain. Broad money (M3) is growing at the fastest rate (10.2% YoY) since May 2008. Growth rates in the components of M3 indicate that uncertainty remains very elevated at the start of 3Q20. Overnight deposits, for example, contributed 8.3ppt to the growth in broad money alone (despite negative real returns). July’s overnight deposit inflow of €151bn was the second largest inflow after March’s €249bn and was 3x the 2019 average. In contrast, growth rates in the counterparts to M3 indicate that HH consumption is recovering and the NFC’s record “dash-for-cash” has peaked. However, before anyone gets too excited – the gap between subdued PSC growth (debt overhang?) and rapid M3 growth (elevated uncertainty?) hit a twenty-year peak in July.
In short, July’s message from the EA money sector is simple: the peak of the crisis may have passed but the road to recovery is likely to be long and uncertain.
The long and uncertain road in charts
Growth rates in broad (M3) and narrow (M1) money in the euro area (% YoY) – July’s M1 growth rate exceeded 2009 and 2015 peaks (Source: ECB; CMMP analysis)
July’s monetary developments in the euro area (EA) suggest that the road to recovery will be a long and uncertain one. Broad money (M3) grew by 10.2% YoY in July from 9.2% in June, the fastest rate of growth since May 2008.
Drivers of M3 growth (percentage points) – overnight deposits (8.3ppt) remain the key driver of M3 (Source: ECB; CMMP analysis)
Narrow money (M1) grew by 13.5% YoY in July from 12.6% in June, faster than the 13.1% (Aug 09) and 11.7% (July 15) peak growth rates recorded during the GFC and after the euro crisis. M1 growth contributed 9.2ppt to the total 10.2% growth in broad money. Within M1, overnight deposits grew 14.1% YoY and contributed 8.3ppt to the overall growth in M3 alone.
Growth rates in mortgage, consumer and corporate credit – passed the crisis peaks and troughs? (Source: ECB; CMMP analysis)
Adjusted loans to the private sector grew 4.7% YoY, slightly below the 4.8% recorded in June. The annual growth rate in loans to households (HHs) was unchanged at 3.0% while the equivalent growth rate in loans to corporates (NFCs) fell very slightly to 7.0% from 7.1%. No surprises here – above trend NFC credit and resilient HH mortgage demand continue to offset weakness in HH consumer credit.
An “old favourite” chart – the gap between the growth rates in PSC and M3 is at a new twenty-year peak (Source: ECB; CMMP analysis)
The gap between the growth in money supply (M3) and the growth in private sector credit (PSC) increased to 5.5ppt, a twenty year high. This reflects the combination of extraordinary uncertainty (driving M3) and the limited progress in dealing with the debt overhang in the EA (subduing PSC).
Monthly flows into O/N deposits since January 2019 – a surprise jump in July? (Source: ECB; CMMP analysis
The monthly flow data once again provides a more nuanced picture than the headline annual growth trends. Overnight deposits, which contributed 8.3ppt to the overall growth in M3 alone, rose by €151b. This represents the second largest monthly inflow of overnight deposits (after €249bn in March 2020).
Monthly deposit flows from HHs and NFCs since January 2019 (Source: ECB; CMMP analysis)
July’s data includes a €58bn swing from negative to positive flows from non-monetary financial corporations – n.b. these flows are typically more volatile than HH and NFC flows. That said, monthly flows by HHs and NFCs also increased MoM to levels 24% and almost 50% above the average 2019 inflows. Put simply, these trends suggest that HH and NFC uncertainty levels remain very elevated.
Monthly trends in HH credit demand – passed the low point? (Source: ECB; CMMP analysis)
On a more positive note, mortgage demand remains resilient and consumer credit has recovered. Loans for house purchase increased by €19b in July versus 9€10bn in June and above the average €14bn monthly flow recorded in 2019. After record repayments between March and May 2020, monthly flows of credit for consumption have exceeded €3bn for two months in a row, closing on the €3.4bn monthly average in 2019. NFC lending data suggests that we passed the peak “dash for cash” in March and April, although July’s monthly flow of almost €16bn remains above the 2019 average of €12bn.
Putting the NFC “dash-for-cash” into an historic context (Source: ECB; CMMP analysis)
Conclusion
The message from the money sector at the start of the 3Q20 is a mixed one. Growth rates in the components of M3 indicate that uncertainty remains very elevated. In contrast, growth rates in the counterparts to M3 indicated that HH consumption is recovering and the NFC dash-for-cash has peaked. In short, while the peak of the crisis appears to have passed, the road to road to recovery is likely to remain a long and uncertain one.
Please note that the summary comments and graphs above are extracts from more detailed analysis that is available separately.
History often rhymes and occassionally repeats itself
In his 1992 analysis “Maastricht and All That”, the late economist Wynne Godley argued that, “the present situation is screaming aloud for co-ordinated reflation, but there exists neither the institutions nor an agreed framework of thought which will bring about this obviously desirable result.” Yesterday, and almost thirty years later, Fabio Panetta, a member of the ECB’s Executive Board, called for a “strong and symmetric fiscal response that offsets the economic damage from the pandemic.” Echoing Godley, Panetta stressed the risks of the current, asymmetric fiscal responses, argued why a new framework was required and made the threat to the future of the single market very clear.
From a corporate, rather than an investment perspective, one of his most interesting observations was that, “uneven fiscal support implies that a firm’s location, rather than its business model, will be the decisive factor in determining whether it survives the crisis.” A new angle?
What links Godley and Panetta’s observations is the fact that by design, the nation states of the euro area (EA) have given up sovereignty of their national currencies – they have become users rather than issuers of currency – and have, in effect, limited policy options to controlling money supply and balancing budgets. Why does this matter? In previous posts, I have argued that: (1) monetary policy has been only partially successful, at best, but also carries hidden risks; (2) asymmetric rules that are tough on deficits but weak on surpluses are inappropriate in the current situation; and (3) this is the time for co-ordinated, counter-cyclical fiscal policy across the EA.
One of Godley’s criticisms of the Maastricht Treaty was that it created no new institutions other than the ECB and yet, somewhat ironically, it is the ECB that is now leading the arguments for a new and more appropriate policy framework (see also “Fiscal, first and foremost“). Panetta concluded that, “Acting now to create the conditions for a symmetric fiscal response will help all member countries to shorten the duration of the crisis period, protect the economic base on which their future production structures and exports rely, and – perhaps most importantly – uphold the premise of a shared and indivisible European destiny.”
I would concur up until the final point – most importantly acting now will minimise the appalling human costs not only of the pandemic itself but also of the subsequent economic downturn. This should be the top priority for all. EU leaders meet tomorrow (23 April 2020) to debate their response and to consider possible funding models. Their responsibilty is immense.
Please note that summary comments above are extracts from more detailed analysis (including extended links to Modern Monetary Theory and Balance Sheet Theory) that is available separately.
Household net worth is at a new high driven by persisent financial surpluses post GFC combined with positive revaluation effects from housing and financial assets (multiple of disposable income) Source: ECB; Haver; CMMP analysis
Examining wealth effects
Households (HH) in the euro area (EA) have been running persistent financial surpluses of between 2-3% GDP since the GFC. I considered the implications of these trends for the choice of policy mix in previous posts (see “Policy reboot 2020”). In this post, I examine the implications for the resilience of HH consumption in the face of the Covid-19 crisis.
HHs have run persistent financial surpluses since the GFC leading to a build up of financial assets (% GDP, 4Q sum) Source: ECB; Haver; CMMP analysis
HH net wealth (HNW), the difference between the value of HH assets and liabilities, is an important determinant of private sector consumption. Given that HH consumption accounts for 54 cents in every EURO of GDP, it is also an important determinant of overall GDP growth in the EA.
Changes in wealth affect consumption in the short run as HH feel richer or poorer and become more or less confident. The level of HNW is also an important driver of long term consumption since, along with income from employment, it determines the amount of economic resources available to HHs.
Trend and breakdown (NFAs, FAs, FLs,) of HNW over the past twenty years (EURO trillion) Source: ECB; Haver; CMMP analysis
HNW hit a new high in absolute terms (€52trillion) and as a multiple of disposable income (7.2x) at the end of 3Q19. This included non-financial assets (NFAs) of €34trillion, largely in the form of housing, and financial assets (FAs) of €26trillion, netted off against financial liabilities (FLs) of €8trillion.
Breakdown of changes to HNW highlights the importance of revaluation gains in NFAs (change in Euro per capita) Source: ECB, Haver, CMMP analysis
The growth in HNW reflects not only the build-up of FAs, but also revaluation gains in these and other NFAs. As discussed in “Fuelling the Fire”, Quantitative Easing has stimulated asset prices and led to increased housing and financial wealth (see graphs above and below).
QE has stimulated asset prices and increased housing and financial wealth (changes in per capita terms by quarter and as rolling 4Q sums) Source: ECB; Haver, CMMP analysis
Revaluation gains of NFAs have been particularly important in Portugal, Greece, Spain, Germany and Austria. However, ECB estimates suggest that while residential property prices remain undervalued in Greece, they were overvalued by 12%, 16% and 18% in Portugal, Germany and Austria respectively even before the impact of Covid-19 as felt.
Property prices were over-valued even before the impact of Covid-19 (3Q19) Source: ECB; Haver; CMMP analysis
Potential revaluation losses on NFA will have a negative impact on HNW for obvious reasons, but their impact on future consumption (marginal propensity to consume) is more challenging to determine (and varies between micro and macro levels).
To summarise the very extensive economic analysis in this area, the long-term housing effects on consumption are consistently weaker than those of financial wealth. Indeed, in a recent analysis of larger EA economies, the ECB concluded that, “Spain is the only large EA country for which consistently positive housing wealth effects have been estimated.”
HHs in the Netherlands, Belgium, Italy and France have higher gearing to changes in FA values Source: ECB; Haver; CMMP analysis
Significant heterogeneity exists in terms of the size and structure of HH financial assets. FAs are 2.2x the size of EA GDP on average, but above average in the Netherlands (3.6x), Belgium (3.0x), Italy (2.5x) and France (2.4x). Higher gearing to the value of financial assets in these economies is offset by the “absolute cushion” of higher per capita FA holdings in the Netherlands (€167k), Belgium (€121k) and France (€86k). However, in aggregate, Italian HHs have higher gearing than average but lower than average holdings of FAs per capita (€72k versus the EA average of €75k). Other Southern European economies also have smaller cushions in terms of FAs per capita – Greece (€25k), Portugal (€42k) and Spain (€50k).
Liquid assets are an important part of HH total FAs especially in Greece, Portugal, Austria, Germany and Spain. Source: ECB; Haver, CMMP analysis
FAs consist mainly of liquid assets (currency and deposits) and pension and life insurance-related assets. These assets account for 70% of total HH FAs with the remainder held in higher risk products including equity, debt and shares in investment funds. The share of higher risk assets has fallen from 40% pre-GFC to 30% currently suggesting that the negative impact of recent market falls may be less than after the GFC. In addition, HHs in Greece (59%), Portugal (44%), Austria (40%), Germany (40%) and Spain (39%) hold higher amount of their financial assets is liquid assets. However, on a per capita basis, the largest liquid holdings are in Belgium (€38k), Austria (€33k), Germany (€31k) and Ireland (€31k).
Conclusion
The stock of HH wealth in the EA has risen to new highs in absolute terms and as a multiple of disposable income and represents an important economic resource in the face of the Covid-19 crisis.
Revaluation gains of both NFA and FA assets have been important drivers of recent HNW growth, but both will turn sharply negative in the current environment. At the macro-level, long term housing effects on consumption difficult to measure but are consistently weaker than those of financial wealth (with the exception of Spain).
HHs in the Netherlands, Belgium, Italy and France have relatively high gearing to changes in the value of FAs, although with the exception of Italy this is offset by relatively high per capita holdings on FAs. HHs in Southern European economies typically have lower “cushions” in terms of per capital holdings of financial assets.
Since the GFC, there has been a de-risking of HNW holdings away from debt, equity and shares in investment funds in favour of liquid assets and pension and life insurance related assets. Lower risk assets now account for 70% of HH FAs. In addition, HHs in Greece, Portugal, Austria, Germany and Spain hold relatively high amounts of FAs in liquid assets. This suggests that the MPC from financial effects may be lower than after the GFC.
These conclusions come with the obvious caveat that the impact of changes in wealth on HH consumption differs substantially between countries, between NFAs and FAs and between HHs within the same country.
Please note that the summary comments above are extracts from more detailed analysis that is available separately
“A major policy shift to sustained fiscal loosening” – current OBR forecasts for the UK budget (solid line) compared with March 2019 forecasts (dotted line) as % GDP Source: OBR; CMMP analysis
A crucial week – part 1
On Wednesday 11 March 2020, the new UK Chancellor, Rishi Sunak announced the “largest sustained fiscal loosening since the pre-election Budget of March 1992” (OBR, 2020). Prior to the budget statement, the Bank of England also announced a package of measures – an unscheduled rate cut (to a historic low of 0.25%), the offer of cheap funding to banks, lowering banks’ capital buffers and expectations for banks to not increase dividends – in manner neatly described by the Chancellor as, “carefully designed to be complementary and to have maximum impact, consistent with our independent responsibilities.”
Government spending (% GDP) rising to late 1970s levels – a major shift Source: OBR; CMMP analysis
Viewed through my preferred financial sector balances approach (summarised in Wynne Godley’s identity below), the new budget addresses last year’s (partially) flawed assumptions behind the policy of fiscal tightening ie, that a move towards a public sector surplus would be accompanied by a narrowing of the RoW’s net financial surplus and a widening of the private sector’s net financial deficit including higher level of borrowing. Instead it incorporates a widening in the net financial surplus of the household sector – appropriate given the high level of UK HH debt and low level of UK HH savings – offset by a widening in the public sector deficit. The assumptions regarding the balances of the NFC and RoW sectors remain largely unchanged.
Domestic private balance + domestic government balance + foreign balance = zero
Wynne Godley
On a positive note, this appears a more balanced policy including an appropriate shift in responsibility away from the HH sector to the UK government. The co-ordination between fiscal and monetary policy is also a positive sign. Nonetheless, the Government’s gross financing requirement averages around £150 billion a year over the next five years, around half as much again as a share of GDP as in the five years prior to the financial crisis. Hence, the OBR concludes that, “public finances are more vulnerable to adverse inflation and interest rate surprises than they were.” On top of this, the reliance on the RoW as a net lender to the UK economy remains an additional and obvious risk.
Attention now turns to the ECB. As noted in “Are we there yet?” the EA is positioned better to ease fiscal policy than the UK but immediate risks remain that policy response may be limited. Watch this space, we are half way though a crucial week for UK and European policy makers.
The charts that matter
Last year’s (partially flawed) assumptions
Last year’s partially flawed assumptions expressed within the sector balances framework (% GDP) Source: OBR; CMMP analysis
“We expect the public sector deficit to narrow slightly, offset by a small narrowing in the rest of the world surplus. The corporate and household sector deficits are expected to remain broadly stable. The general profile of sector net lending is little changed from previous forecasts, although the size of the household sector deficit is slightly smaller than in our October forecast, consistent with an upward revision to our forecast for household saving. The size of the rest of the world surplus is slightly larger, reflecting the upward revision to our forecast of the current account deficit.” (OBR, 2019)
New versus old – the HH sector
HH sector is now expected to run wider net financial surpluses of between 1.3% and 1.6% of GDP Source: OBR; CMMP analysis
New versus old – the public sector (and the policy shift)
The end of austerity and a shift to sustained fiscal loosening (public sector net financial deficit as % GDP) Souce: OBR; CMMP analysis
New versus old – little change to NFC sector forecasts
NFC deficits are forecast to offset HH surpluses meaning that the private sector remains in deficit in aggregate (% GDP) Source: OBR; CMMP analysis
New versus old – still reliant on the RoW as a net lender
“Still very dependent” – the OBR assumes that the RoW will continue to run net financial surpluses of c.4% GDP over the forecast period (% GDP) Source: OBR, CMMP analysis
March 2020 forecasts expressed through sector balances
Widening HH surpluses offset by looser fiscal policy and widening NFC deficits (% GDP) Source: OBR; CMMP analysis
Conclusion
We are half way through a crucial week for UK and European policy makers. The first half saw a sustained loosening of fiscal policy by the new UK Chancellor, co-ordinated neatly with a package of measures from the Bank of England. This leaves a more balanced and appropriate policy mix.
In the second half, attention now focuses on the ECB and EA governments. The euro area is better placed than the UK to relax fiscal policy but the immediate risk remains that the policy response may be more limited. Watch this space.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Sharp falls in large European banks’ share prices reflect dramatic weakening in macro foundations – “macro building blocks matter” (% change YTD to 9 March 2020, SX7E index heavyweights) Source: FT; CMMP analysis
A crucial week
This is a crucial week for European policy makers. The coronavirus has weakened the European banking sector’s macro foundations in a dramatic fashion and has exposed wider policy weaknesses. The SX7E index of European banks has fallen 32% YTD and underperformed the wider SXXE index by 16%. This performance is consistent with my CMMP narrative that (1) macro building blocks matter, and (2) that last year’s bounce was a relief rally rather than the start of a period of sustained recovery.
GDP growth expectations, that are stable and subdued at best, now face obvious downside risks, credit growth is showing early signs of peaking, ST and LT rates are at new lows and the yield curve is inverted. In this adverse environment for European banks, attention now switches to policy makers. They are equally exposed.
QE has already shifted the balance of power from lenders to borrowers and carries hidden risks in terms of future growth, leverage, financial stability and income inequality. In recent posts, I have argued that the EA remains trapped by its debt overhang and outdated policy rules, and that a major policy reboot is long overdue. It makes little sense for collective fiscal policy to be about as tight now as any period in the past twenty years at a time when the private sector is running persistent net financial surpluses.
The immediate risk is that this week’s policy responses remain limited. The ECB meets on Thursday with expectations of GDP downgrades, a cut in rates (to -0.6%), liquidity measures (and a possible adjustment to macroprudential tools) potentially discounted already. Far more helpful, indeed necessary, is clear co-ordination between political leaders and central bankers globally. A policy reboot would be a silver lining to the current storm gripping financial markets and global economies.
Watch this space, this is a crucial week.
The charts that matter
Mind the gap
SX7E “heavyweights” have fallen sharply from their 2020 highs – Soc Gen, Credit Agricole, Deutsche, ING, UCI, BNP Paribas are all more than 35% below peaks (% change from 2020 high to close on 9 March 2020) Source: FT, CMMP analysis
MBB#1: Subdued GDP forecasts likely to be revised down
The ECB is likely to revise down its forecasts for GDP growth this week – current forecasts are based on global growth forecasts that have already been downgraded by the OECD, who have also downgraded EA GDP to 0.8% (2020e) and 1.2% (2021e) Source: OECD; ECB; EC; Haver; CMMP analysis
MBB#2: Credit growth remains a “relative” bright spot
HH (3.7% YoY) and NFC (3.2% YoY) credit growth is subdued in relation to past cycles but well above the levels associated with recession in the EA Source: ECB; Haver; CMMP analysis
MBB#3: ST rates locked at the base of the ECB corridor
A further cut in the deposit facility rate (t0 -0.6%) this week will be negative for NIMs in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending Source: ECB; Haver; CMMP analysis
MBB#4: LT rates at new lows and firmly in negative territory
10Y bond yields have returned to August 2019 lows of -0.71% Source: Haver; CMMP analysis
MBB#5: EA yield curve inverted again
The inversion of the yield curve has negative consequences for NIMs in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed-rate lending Source: Haver; CMMP analysis
Current policy has “hidden risks”
QE risks fuelling the growth in less productive FIRE-based lending with negative implications for leverage, growth, stability and income inequality Source: ECB; Haver; CMMP analysis
Policy needs to match context #1 – a favourite graph again!
The gap between the supply of money (M3) and the demand for credit has started to widen again, indicating an on-going deficiency in credit demand (and debt overhang) Source: ECB; Haver; CMMP analysis
Policy needs to match context #2 – what are balances saying?
The private sector continues to run financial surpluses in spite of negative/low rates (4Q sums, % GDP)a clear message that the debt overhang remains Source: ECB; Haver; CMMP analysis
Finally, does this make sense?
Does it make sense to run tight fiscal policy (1) at this point in the cycle, and (2) when the private sector is running persistent financial surpluses? Source: ECB; Haver; CMMP analysis
Conclusion
This remains a crucial week for European (and global) policy makers. The ECB is widely expected to downgrade its GDP growth forecasts and to cut the deposit facility rate to -0.6% (from -0.5%). Further liquidity support and adjustments to macroprudential tools are also probable. Unfortunately, this is unlikely to be sufficient to address market concerns, the impact of the debt overhang and slowing global growth. Far more hopeful, indeed necessary, is clear co-ordination between political leaders and central bankers globally. If there is to be a silver lining to the current storm, this would be it.
As noted in “Are we there yet?”, the EA is positioned better to ease fiscal policy than the UK (where both the private and public sectors are running simultaneous financial deficits) but we are more likely to see fiscal stimulus in tomorrow’s UK budget than in the former this week. Watch this space, this is a crucial week.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
Leading, coincident and lagging indicators have peaked
The key chart
Watch this space – leading (real M1), coincident (real HH) and lagging (real NFC) indicators have all peaked, but remain well above the levels associated with recessions risks (% YoY, real terms). Source: ECB; Haver; CMMP analysis
The key message
January’s monetary developments data for the euro area (EA) presented no surprises. Monetary aggregates are still growing well above the levels associated with heightened recession risks.
Broad money (M3) growth increased to 5.2% from 4.9% in December 2019. Narrow money (M1) remains the main component, contributing 5.3% to this growth (other ST deposits being the negative balancing item) and accounting for 69% of the outstanding stock of M3. There is now just under €9trillion residing in (cash and) overnight deposits despite negative real rates, indicating an enduring debt overhang in the region.
Private sector credit grew 3.8% YoY, a new high in nominal terms in the current credit cycle, but lags the growth in the supply of money, reflecting the on-going deficiency in credit demand.
However, an early warning sign is flashing within the context of my money, credit and business cycle framework. Growth rates in real M1 (a leading indicator), real HH credit (a coincident indicator) and real NFC credit (normally a lagging indicator) have all peaked at the aggregate level and in Germany and France, the two markets that have driven loan growth in the region. None of these indicators imply recession risks, but they do point to a slowdown in economic activity across the euro area. Watch this space…
The charts that matter
No headline surprises – broad money (M3) grew 5.2% in January versus 4.9% in December (% YoY, nominal terms) Source: ECB; Haver; CMMP analysisGrowth trends and breakdown of M3 by component – overnight deposits (red bars) remain the key driver of money supply growth. M1 contributed 5.3% of the total 5.2% M3 growth, other ST deposits were the negative balancing item(% YoY, nominal terms) Source: ECB; Haver; CMMP analysis Confirmation of the enduring debt overhang – c Euro 9 trillion sitting in (cash and) overnight deposits despite negative real returns (Euro billions) Source: ECB; Haver; CMMP analysis
M3 = credit to EA residents + net external assets – LT financial liabilities + other counterparts
From a counterparts perspective, and on a positive note, credit to other EA residents (the purple bars) has replaced credit to central government (the green bars, QE impact) as the main driver of M3 (%YoY, nominal terms) Source: ECB; Haver; CMMP analysisEarly warnings #1 – real growth in M1 (leading indicator) has fallen from recent peak of 7.3% in November 2019 to 6.8% in January (% YoY, 3m MVA) Source: ECB; Haver; CMMP analysisEarly warnings #2 – real growth in HH credit (co-incident indicator) has also fallen from recent peak of 2.6% in November 2019 to 2.3% in January (% YoY, 3m MVA) Source: ECB; Haver; CMMP analysis Early warnings #3 – real growth in NFC credit (typically a lagging indicator) peaked at 3.0% in October 2019 and has fallen to 2.0% in January (% YoY, 3m MVA) Source: ECB; Haver; CMMP analysisGermany is the second largest contributor to EA HH credit growth after France – growth hit a new peak of 4.5% in January in nominal terms, but has fallen from 3.4% in October 2019 to 2.9% in January in real terms(% YoY) Source: ECB; Haver; CMMP analysisGermany is the largest contributor to EA NFC credit growth. Nominal growth rates peaked at 7.0% in June 2019 and have fallen to 5.0% in January. Real growth rates peaked at 5.6% in August 2019 and have fallen to 3.3% in January (% YoY) Source: ECB; Haver; CMMP analysisFrance is the largest contributor to EA HH credit growth – in nominal terms, growth hit a new high of 6.5% in January, but peaked in real terms at 5.4% in October 2019 and has fallen to 4.7% in January Source: ECB; Haver; CMMP analysisFrance is the second largest contributor to EA NFC credit growth after Germany – nominal growth rates have fallen from 8.3% in August 2019 to 5.7% in January and real rates have fallen from 6.9% to 3.9% over the same period Source: ECB; Haver; CMMP analysis
Please note that the summary comments above are extracts from more detailed analysis that is available separately
Time for a policy reboot – does it make sense to run tight fiscal policy (1) at this point in the cycle, and (2) when the private sector is running persistent financial surpluses? (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
Introduction
In my previous post, “Policy reboot 2020?” I suggested that, “progress towards dealing with the debt overhang in Europe remains gradual and incomplete”. This prompted two follow-up questions:
How do I monitor this progress within the Macro Perspectives framework?
Why does it matter?
In this post, I present eight graphs that are key to monitoring this progress:
Private sector debt ratios (PSDRs)
Costs of borrowing
Lending spreads versus policy rates
Growth in broad money (M3)
Growth in private sector credit
Money supply vs demand for credit dynamic
Inflation
Private sector net financial balances
Summary and implications
The eight graphs confirm that the EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.
In spite of this, the collective fiscal policy of EA nations is (1) about as tight as any period in the past twenty years and (2) is so at a time when the private sector is running persistent net financial surpluses (largely above 3% GDP since the GFC).
An important lesson from Japan’s experience of a balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. These savings (at a time of zero rates) are responsible for weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary (Koo, R. 2019).
Ironically, the EA is positioned better to ease fiscal policy than the UK (where both the private and public sector are running simultaneous financial deficits) but we are more likely to see fiscal stimulus in the latter (March 2020) than in the former.
It’s time for a policy reboot in the EA for 2020 and beyond.
Eight key charts
Key chart 1: Private sector debt ratios
Too little, too late? Private sector deleveraging in the EA began later and has been more gradual than in the UK and the US (private sector debt as % GDP) Source: BIS; Haver; CMMP analysis
The first chart illustrates twenty-year trends in private sector debt ratios (PSDR) – private sector debt as a percentage of GDP – for the UK, EA and US. The three vertical, dotted lines mark the point of peak PSDR for each economy. This is the standard starting point for analysing debt overhangs.
Private sector deleveraging began much later and has been more gradual in the EA than in both the US and the UK. The PSDR in the EA is now the highest among these three economies.
The US PSDR peaked first at 170% GDP in 3Q08, fell to a post-GFC low of 147% GDP in 3Q15 (co-incidentally the point when the EA PSDR peaked) and is currently 150% GDP
The UK PSDR peaked one quarter later (4Q08) at 194% GDP, fell to 160% GDP in 2Q15 and is currently 163%
The EA PSDR continued to rise after the GFC before peaking at 172% in 2Q15 and declining slightly to 166% currently
For reference, but not shown here, household (HH) and corporate (NFC) debt ratios (the two sub-sets behind these totals) differ across the three economies. In the EA, the NFC PSDR is 108% (above the BIS’ maximum threshold of 90%) but the HH PSDR is only 58%. In the UK and US these splits are 79%:84% (see “Poised to disappoint”) and 75%:75% respectively. In other words, the risks lie in different places in each economy.
Key chart 2: Cost of borrowing
The cost of borrowing for HH and NFCs has fallen sharply, reflecting relatively weak credit demand (composite costs %, nominal terms) Source: ECB; Haver; CMMP analysis
The second chart illustrates the ECB’s composite measures for HH and NFC cost of borrowing (in nominal terms). The cost of borrowing typically falls in periods of debt overhang, reflecting weak demand for credit.
Weak credit demand is reflected in the cost of borrowing for EA HHs and
NFCs falling sharply.
HH and NFC costs of borrowing both peaked in
3Q08 at 5.6% and 6.0% respectively
The HH cost of borrowing hit a new low in
December 2019 of 1.41%
The NFC cost of borrowing hit a low of 1.52% in
August 2019 and is currently 1.55%
For reference, costs of borrowing in real terms (shown here) remain low at 0.11% for HH and 0.25% for NFCs but above their October 2018 lows of -0.49% and -0.65% respectively.
Key chart 3: Spreads vs policy rates
Lending spreads at, or close to, post-GFC lows (composite cost minus MRR, ppt) Source: ECB, Haver, CMMP analysis
The third chart illustrates the spread between composite borrowing
rates and the ECB’s main refinancing rate (MRR). These spreads typically narrow
during periods of debt overhang.
Spreads between borrowing costs and the ECB’s main policy rate are at,
or slightly above, post-GFC lows.
HH spreads have declined from 2.97% in May 2009 to a new post-GFC low of 1.41%
NFC spreads have declined from 2.76% in May 2014 to 1.55% currently, slightly above their post-GFC low of 1.55%
Key chart 4: Growth in broad money (M3)
Growth in M3 has been steady since 2014 easing, but subdued in relation to past trends (% YoY) Source: ECB; Haver; CMMP analysis
The fourth chart illustrates the twenty-year trend in the growth of
broad money (M3). Broad money reflects the interaction between the banking
sector and the money-holding/real sector.
Growth rates in broad money have been stable since ECB easing in 2014
but subdued in comparison with previous cycles.
In December 2019, M3 grew by 5.0% YoY
Narrow money (M1) contributed growth of 5.3% which was offset by negative growth in short term marketable securities
For reference, the share of M1 within M3 has risen from 42% in December 2008 to a new high of 68%, despite the fact that HH overnight deposit rates are -1.25% in real terms.
Key chart 5: Private sector loan growth
Private sector credit growing at the fastest rate in the current cycle, but growth is subdued in relation to past cycles (% YoY) Source: ECB; Haver; CMMP analysis
The fifth chart illustrates YoY growth in private sector credit, the main counterpart to M3.
Private sector credit is growing at the fastest rate in the current
cycle but also remains subdued in relation to past cycles and highly
concentrated geographically (Germany and France).
Private sector credit grew 3.7% YoY in December
2019 (3m MVA) above the average growth rate of 3.5%
Germany and France together contributed 2.8% of
the 3.7% growth in HH credit and 2.6% of the 3.2% growth in NFC credit in 2019
Key chart 6: Money supply vs credit demand
The gap between the supply of money and the demand for credit has started to widen again, indicating an on-going deficiency in credit demand Source: ECB; Haver; CMMP analysis
The sixth chart – one of my favourite charts – illustrates the gap between the supply of money (M3) and the demand for credit by the private sector. In typical cycles, monetary aggregates and their counterparts move together. 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.
The gap between the growth in the supply of money and the demand for
credit indicates on-going deficiency in credit demand in the EA.
Since 4Q11, broad money and private sector credit trends have diverged with gaps peaking in 3Q12 and 1Q15
The gap narrowed up to September 2018 but has widened out again recently
Key chart 7: Inflation
Inflation persistently below the ECB 2% target during 2019 (% YoY) Source: ECB; Haver; CMMP analysis
The seventh chart ilustrates the twenty-year trend in inflation (HICP) plotted against the ECB’s current inflation target. Again, inflation rates tend to much lower in periods of debt overhang.
Inflation remained below the ECB’s target throughout 2019 and finished
the year at 1.3%
Inflation ended 2019 at 1.3%, below the ECB’s target of 2%
Key chart 8: Private sector financial balance
The private sector is running a net financial surplus in spite of negative/low rates (4Q sums, % GDP) Source: ECB; Haver; CMMP analysis
The eighth, and final chart, illustrates trends in the private sector’s net financial surplus. In this analysis, 4Q sums are compared with GDP.
Finally, the private sector (in aggregate) is running a financial surplus in spite of negative/very low policy rates – a very strong indication that the economy is still suffering from a debt overhang
In aggregate, the EA private sector is running a
net financial surplus equivalent to 3.1% of GDP (3Q19) at a time when deposit
rates are negative (average -0.9% during 3Q19)
Why does this matter?
…Fiscal rules should be designed to favor counter-cyclical fiscal policies. Nevertheless, despite various amendments to strengthen the counter-cyclical features of the [EA] rules, the outcomes have been mainly pro-cyclical.
IMF, Fiscal rules in the euro area and lessons from other monetary unions, 2019
The EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.
Does this make sense #1? Collective fiscal policy is about as tight as at any point in past twenty years (Government net financial deficit, 4Q sum, % GDP) Source: ECB; Haver; CMMP analysis
In spite of all of this, the nations of the EA are collectively running a fiscal policy that is about as tight as at any period in the past twenty years. They are also doing this at a time when the private sector is running persistent net financial surpluses. Clearly, these developments fail a basic “common sense test”.
Does this make sense #2. The key chart again – what is the logic of running a tight policy when the private sector is running persistent surpluses (largely above 3% GDP) Source: ECB; Haver; CMMP analysis
Its worth noting that fiscal policy rules in the EA, including the Stability and Growth Pact, were created without reference to the private saving and for an economic environment that no longer exists (eg, positive rates, high inflation, government mismanagement etc.).
Are current rules still fit for purpose – government deficit/surplus as % GDP (y axis) plotted against government debt as % GDP (x axis)? Red lines indicate current SGP rules, green line indicates a balanced budget. These rules were designed for a different type of recession and constrain appropriate policy responses today Source: ECB; Haver; CMMP analysis
Leaving aside, the weak track record of adherence to these rules by member states, the obvious question is whether these rules remain relevant and whether the current policy mix is appropriate?
An important lesson from the experience of Japan’s balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists, such as Richard Koo, argue that these, “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary”.
Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.
The UK is not as well positioned as the EA to relax fiscal policy – the UK private and public sectors are running simultanous deficits – but we are more likely to see UK fiscal easing first, in the March 2020 budget (4Q sums, % GDP) Source: ONS; Haver; CMMP analysis
Ironically, the EU is positioned better to relax fiscal policy than the UK (where both the private and public sector are running simultaneous deficits) but we are more likely to see fiscal easing in the latter (March 20202 budget) before the former.
In short, it is time for a policy reboot in the EA for 2020 and beyond.
Please note that the summary comments above are extracts from more detailed analysis that is available separately.
