“Policy reboot 2020?”

The EA remains trapped by PS debt levels and outdated policy rules

The key chart

Slowing GDP growth confirms the need for a major policy reboot (% YoY)
Source: ECB; Haver; CMMP analysis

Summary

Today’s 4Q19 GDP data confirms that the euro area (EA) is growing at its slowest rate since the ECB introduced expansionary measures in June 2014 (0.1% QoQ, 0.9% YoY).

The region remains trapped by its debt overhang and out-dated policy rules – a major policy reboot is long overdue.

The root causes are captured clearly by my Macro Perspectives analysis that incorporates (1) global debt dynamics, (2) money, credit and business cycles, and (3) financial sector balances in a consistent analytical framework.

Progress towards dealing with the debt overhang in Europe remains gradual and incomplete. The EA continues to display the characteristics of a “private sector balance sheet-driven” slowdown rather than a “structural slowdown”. In this context, it is unsurprising that unorthodox monetary policy measures (1) have been only partially successful, at best, and (2) have unintended, negative consequences for growth, leverage, financial stability and income inequality.

Financial sector balances send clear message about the causes of the slowdown (4Q sum, % GDP)
Source: ECB; Haver; CMMP analysis

Last month, I introduced my balance sheet framework and applied it to the UK economy. There are two key messages from this framework that are applicable to the current EA situation:

  • When the private sector is running a financial surplus in spite of negative/very low policy and deposit rates (see graph above), this is a strong indication that the economy is still suffering from a debt overhang
  • Fiscal space, like debt sustainability, is at its core a flow concept, not a stock concept (see graph below)

Following from this (and deliberately simplifying a complex policy debate), when growth, inflation and inflation expectations are below target and when interest rates are already zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by guaranteeing low interest rates for as long as needed. In short, this is a very different economic context to the one that existed when the current fiscal policy rules were chosen.

Germany’s private and public sectors are running simultaneous net financial surpluses in the face of slowing economic growth – does this make sense for Germany and/or the EA?
Source: ECB; Haver; CMMP analysis

Unfortunately, despite strong and repeated calls for fiscal stimulus by the ECB, fiscal policy is only expected to be moderately supportive in 2020. Rules, designed to address different challenges at different times, are preventing stimulus in counties where policy makers would like to spend more (Italy, Spain) and national policy choices are limiting policy expansion in countries that have room for further stimulus (German, Netherlands). This is compounded by the lack of a central fiscal capacity at the euro area level that could strengthen the ability to deploy fiscal policy, complementing monetary policy, in case of significant euro area-wide downside dynamics (see https://www.imf.org/en/News/Articles/2020/01/28/sp012820-vitor-gaspar-fiscal-rules-in-europe ).

Are current fiscal rules still fit for purpose – government deficit/surplus as % GDP (y axis) plotted against government debt as % GDP (x axis)? These rules were designed for a different typ of recession and constrain required policy responses today. (Red lines indicate current rules)
Source: ECB; Haver, CMMP analysis

Conclusion

Marco Perspectives frameworks illustrate why a major policy review that begins with differentiating between different types of recessions is required if the EA is to escape from the current debt and policy trap. The ECB has announced a review of monetary policy in the EA, but the need for a wider fiscal policy review/reboot appears more urgent, in my view.

I presented the investment implications of this analysis at “The 5th Global Independent Research Conference” in London earlier this month. Please contact me to dicusss these implications and for access to the detailed analysis behind the summary comments above.

chris@cmmacroperspectives.com

“Tacking into the wind”

EA banks battle against the headwinds

The key chart

The cost of borrowing for EA households (HH) and corporates (NFC) ended 2019 at, or close to, historic lows (%, nominal terms)
Source: ECB; Haver; CMMP analysis

Gusting force 9-10

The latest ECB bank interest rate statistics for the euro area (EA) show rates on household (HH) and corporate (NFC) lending at, or close to, new lows at the end of 2019.

In the HH sector, rates fell the most in 2019 (absolute bp terms) in Germany, Italy and the Netherlands, although France and Portugal also saw noticeable declines despite starting the year with rates well below the EA average. In the NFC sector, rates fell the most in Portugal, Spain, France and Italy but rose in Ireland, the Netherlands and Austria. Spreads (versus 3m Euribor) also hit new lows in the HH sector and were close to lows in the NFC sector.

Negative rate and spread developments are offsetting subdued loan growth and present an on-going challenge in terms of delivering sustainable top-line revenue growth. As noted in “Power to the borrowers“, QE has shifted the balance of power firmly from lenders to borrowers.

With the exception of the Spanish, Portuguese and Irish HH sectors, rates on new loans are also below rates on the outstanding stock of loans, indicating that downward pressures will continue.

Strong margin/spread headwinds remain for EA banks, compounding negative trends in the basic macro building blocks that are required to support sustained improvements in profitability and share price performance.

For more details, please contact me at chris@cmmacroperspectives.com.

The charts that matter

In real terms, the cost of borrowing remains low but above the 2018 lows of negative real borrowing costs. The ECB has been successful in achieving its goal to “ensure that HHs and NFCs should be able to borrow more and spend less to repay their debts” (%, real terms)
Source: ECB; Haver; CMMP analysis
In the HH sector, rates fell the most in Germany, Italy and the Netherlands during 2019 (YoY change in basis points).
Source: ECB; Haver; CMMP analysis
France and Portugal also saw noticeable declines in HH lending rates despite starting 2019 with rates well below the EA average
Source: ECB; Haver, CMMP analysis
In the NFC sector, rates fell the most in Portugal, Spain, France and Italy but rose in Austria (slightly), the Netherlands and Ireland (YoY change in basis points)
Source: ECB; Haver; CMMP analysis
Average HH spreads on new loans hit a new post-GFC low (versus 3m Euribor)
Source: ECB; Haver; CMMP analysis
Shifting the balance of power to HHs – lending rates have fallen further than 3m Euribor and the MRR since May 2014 in all economies except Ireland. The biggest falls have been in Portugal, France, Italy and Belgium (change in bp since May 2014)
Source: ECB; Haver; CMMP analysis
Shifting the power to NFCs – most pronounced shifts in NFC lending rates seen in Portugal, Spain, Italy, France and Germany (change in bp since May 2014).
Source: ECB; Haver; CMMP analysis
Exceptions to the rule – rates on new Spanish HH loans are above the rates on the outstanding stock. Along with the Irish and Portuguese HH sectors, this is an outlier – elsewhere in the EA, rates on new loans are below the rates on the outstanding stock (%, nominal terms)
Source: ECB; Haver; CMMP analysis
Where are we now? Lending rates in Germany and France, the two economies driving growth in PSC in the EA, remain well below average (%, nominal terms)
Source: ECB; Haver; CMMP analysis

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

“Follow the Euro-money”

2019’s end-of-year message

The key chart

Leading (real M1), coincident (real HH) and lagging (real NFC) indicators moved further away from the levels associated with recession risks in the euro area during 2019 (% YoY, real terms)
Source: ECB; Haver; CMMP analysis

The message from 2019

Monetary indicators moved away from the levels associated with recession risks in the euro area (EA) during 2019.

A very brief summary

Nominal growth rates in narrow money (M1), broad money (M3) and private sector credit (PSC) ended the year at, or close to, 12-month highs and well above the levels recorded in 2018. In real terms, M1 grew 6.6% in 2019 versus 5.0% in 2018 (with a 2019 high of 7.6% in October). Given the leading indicator qualities of trends in real M1, this data supports the narrative that recession fears in the EA have been overdone. Household credit (a coincident indicator) grew at 3.7% in nominal terms, the fastest rate in the current cycle and 2.4% in real terms. The main inconsistency in this data was the slowdown in NFC lending over 2019 particularly in the final months (trends in real NFC credit are typically considered lagging indicators).

These positive trends were offset by three counterbalancing trends: (1) while PSC growth ended 2019 close to its high, current growth remains subdued in relation to LT trends; (2) the demand for credit continues to lag the supply of money which indicates that the EA has still to recover fully from the debt overhang; and (3) ECB policies are fuelling growth in less-productive FIRE-based lending (see “The ECB’s missing chart“) with potentially negative implications for leverage, growth, financial stability, and income inequality.

The charts that matter

Growth rates in narrow money (M1), broad money (M3) and private sector credit (PSC) ended the year at, or close to, 12-months highs (% YoY, nominal terms)
Source: ECB; Haver; CMMP analysis
Leading indicator – real M1 grew 6.6% YoY in 2019 versus 5.0% YoY in 2018 (% YoY in real terms)
Source: ECB; Haver; CMMP analysis
Co-incident indicator – real HH credit growth of 2.4% , driven by sustained mortgage demand (% YoY in real terms)
Source: ECB; Haver, CMMP analysis
Lagging indicator – the slowdown in real NFC credit in 4Q19 was inconsistent with other trends (% YoY in real terms)
Source: ECB; Haver; CMMP analysis
PSC credit growth ended the year on a high, but remains subdued in relation to LT trends (% YoY 3m MVA in nominal terms)
Source: ECB; Haver; CMMP analysis
Deficient demand – private sector credit demand lags the supply of money. The EA has still to recover fully from the debt overhang (% YoY 3m MVA in nominal terms)
Source: ECB; Haver; CMMP analysis
Fueling the FIRE – ECB policies are supporting growth in less-productive FIRE-based lending with potentially negative implications for leverage, growth, financial stability, and income inequality (% total EA loans)
Source: ECB; Haver; CMMP analysis

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

“Imbalances and dependencies”

Spotlight on the UK 5 – implications for growth and policy

The key chart

The UK faces large and persistent sector imbalances and is increasingly reliant on the ROW as a net lender (4Q sum, % GDP)
Source: ONS; Haver; CMMP analysis

Introduction

I began this series of five posts by stating that:

“the true value in analysing developments in the financial sector lies less in considering investments in developed market banks – they have been lousy LT investments – 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.”

Lousy LT investments – UK, US and EU banks have signficantly underperformed local markets (relative performance 2004-2019)
Source: Haver; CMMP analysis

Over the next three posts, I presented a consistent, “balance sheet framework” for understanding this relationship and applied it to the UK economy and the three core sectors within the private sector – Financial Institutions (FIs), Households (HHs) and Non-Financial Corporations (NFCs).

I chose the UK economy deliberately to reflect the relatively large size of the UK financial system, and the relatively volatile nature of its relationship with the economy. Of course, the framework is applicable to any economy and my conclusion here will make reference to similar analysis for the euro area, and Germany specifically. More analysis of sector balances in Europe will follow soon.

The UK faces large and persistent sector imbalances and is increasingly reliant on the “rest of the world” (ROW) as a net lender.

At the end of 3Q19, the UK private and public sectors were running net financial deficits of -3.4% and -2.0% GDP respectively. These were offset by the ROW’s net financial surplus of 5.4%.

The key (OBR) assumptions behind the policy of fiscal tightening were that a move towards a public sector surplus would be accompanied by a narrowing of the ROWs net financial surplus and a widening of the private sector net financial deficit including high levels of borrowing. The first assumption proved wrong and the second only partially correct.

The 2020 OBR forecasts published in March will shed light on the government’s current assumptions but in the meantime I see downside risks to consumption and UK GDP growth and to further fiscal consolidation.

UK spotlights 1-4 in review

“Lousy LT investments, but…”

Contrasting trends between the relative sizes of the real and money sectors’ financial assets in the UK and euro area (multiple of GDP)
Source: ONS; ECB; Haver; CMMP analysis

In “Lousy LT investments, but…” I presented a mapping exercise for the UK economy and its financial system. The key message was that a distinguishing feature of the UK economy was the relatively large size (and hence potential impact) of the money sector and the volatile nature of its relationship with the wider economy.

“Everyone has one…”

I started with examples of three (of the four) core services provided by the financial system to HHs and NFCs
Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin 2015 Q2 article

In “Everyone has one…”, I focused on the core services provided by the UK financial system (payments, credit and savings), how these services produce a stock of contracts that can be represented by financial balance sheets that link different economic agents over time, and how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework. This post built up to the key identity pioneered by the late Wynne Godley that states that:

Domestic private balance + domestic government balance + foreign balance = zero.

“Poised to disappoint”

Over the past thirty years, there have been two (post-crises) phases when UK HHs have reduced their net financial savings dramatically (4Q sums, % GDP)
Source: ONS; Haver; CMMP analysis
Both phases have been associated with declines in the absolute level of savings (£ millions, LH scale) and in the savings rate (%, RH scale)
Source: ONS; Haver; CMMP analysis
… but only the first one was also associated with a signficant rise in HH leverage (HH debt as % GDP)
Source: ONS; Haver; CMMP analysis

In “Poised to disappoint…”, I highlighted the dominant role that UK households play in economic activity (FCE/GDP) and bank lending (the desire to buy properties) and their important role as investors in financial and non-financial assets. The key message was that while the HH was typically a net saver, the sector has been funding recent consumption by dramatically reducing its savings rate and accumulation of net financial assets (but not by increasing debt ratios). With real growth in disposable income slowing and the savings rate close to historic lows, I suggested that risks to UK growth lay to the downside and at odds with (past) government forecasts.

“Alternative investments”

UK NFCs are typically net borrowers in financial markets ie, investment vehicles for other sectors in the balance sheet framework (4Q sum, % GDP)
Source: ONS; Haver; CMMP analysis

In “Alternative investments”, I described the key economic roles of the NFC sector and explained that its (typical) requirement to borrow in financial markets in order to invest in non-financial assets meant that NFCs represent an important alternative investment vehicle for other sectors – offering stakes in their earnings (dividends) or interest payments in their debt. I concluded by asking that if NFCs widened their deficits further in order to fund investment, which sector will be increasing its surplus as an offset?

Imbalances and dependencies

The key chart repeated – The UK faces large and persistent sector imbalances and is increasingly reliant on the ROW as a net lender (4Q sum, % GDP)
Source: ONS; Haver; CMMP analysis

Roles and balance sheets revisited

To re-cap, FIs, HHs and NFCs – the three core “economic groups” comprising the UK private sector – have distinct economic roles. In fulfilling these roles, they produce a stock of contracts that can be represented by financial balance sheets. These balance sheets link each group together (directly and indirectly) and form a highly quantitative, objective and logical analytical framework. A fundamental principle of accounting is that for every financial asset there is an equal and offsetting financial liability. In other words, if we take all of the financial assets and financial liabilities it is a matter of logic that the sum of the financial assets must equal the sum of the financial liabilities.

Financial sector balance sheets by sector as at end 3Q19 (£ billions)
Source: ONS; Haver; CMMP analysis

An important implication of this analysis is that for the private sector to accumulate net financial wealth (financial assets minus financial liabilities) it must be in the form of claims on another sector. In the simplified case of a two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. In this case, it is impossible for the private and public sectors to run surpluses at the same time.

In a simplified, two-sector economy this would not be possible. The UK private and public sectors are running net financial deficits at the same time. (4Q sums, % GDP)
Source: ONS; Haver; CMMP analysis

Of course, in reality these domestic sectors are also linked economically to foreign FIs, NFCs, HHs and governments, collectively termed the “rest of the world” (ROW). Hence, the private sector can accumulate net financial assets equal to public sector liabilities, the ROW’s net liabilities or a combination of the two.

The private, public and ROW sectors can be treated as having income and savings flows over a given period. If a sector spends less than it earns it creates a budget surplus. Conversely, if it spends more that it earns it creates a budget deficit. A surplus represents a flow of savings that leads to an accumulation of financial assets while a deficit reduces net wealth. If a sector is running a deficit it must either reduce it stock of financial assets or it must issue more IOUs to offset the deficit. If the sector runs out of accumulated financial assets, it has no choice other than to increase its indebtedness over the period it is running the deficit. In contrast a sector that runs a budget deficit will be accumulating net financial assets. This surplus will take the form of financial claims on at least one other sector.

Implications for growth and policy

Large and persistent imbalances – net financial balances for the UK private and public (G0v) sectors and the ROW (4Q sums, % GDP, averages and snapshots)
Source: ONS; Haver; CMMP analysis

Applying this framework to the UK economy, I see large and persistent sector imbalances. Prior to the global financial crisis (GFC), the UK government ran an average net financial deficit of 2.5% GDP between September 1989 and September 2008. Of course, in the aftermath of the GFC, the private sector moved sharply into net financial surplus as one would expect. More surprisingly, given movements in real effective exchange rates, the ROW net financial surplus also remained high. The offset over this period was the widening of the government deficit to 10.4% which was an appropriate and necessary response to prevent a much deeper recession. Since December 2009, the average government net financial deficit has been 5.5% (ie more than double the pre-crisis average). This has been offset by private sector and RoW surpluses of 1.3% and 4.2% respectively.

The UK is becoming increasingly reliant on the ROW as a net lender. The trend in the ROW net financial balance since 1989 (4Q sum, % GDP)
Source: ONS; Haver; CMMP analysis

I also see an increasing reliance on the RoW as a net lender to the UK economy. The key (OBR) assumptions behind the policy of fiscal tightening after the GFC were that the move towards a public sector financial surplus would be accompanied by a reduction in the ROWs net financial surpluses and a widening of the private sector’s net financial deficit driven by higher borrowing. The first assumption proved wrong and the second assumption on partly correct.

As at the end of 3Q19, the ROWs net financial surplus was 5.4% of GDP. This was offset by a narrow government deficit of 2.0% GDP and a wider private sector deficit of 3.4% GDP. Both the private and public sectors in the UK are running net financial deficits at the same time, something that can only happen is the ROW is running a compensating net financial surplus.

No borrowing boom. Trends in NFC and HH debt ratios (% GDP)
Source: BIS; ONS; Haver; CMMP analysis

NFCs (and FIs) have increased their debt ratios slightly since 2015, but the HH sector debt ratio has remained stable. As discussed in “Poised to disappoint”, the HH sector has been funding consumption by slowing its rate of savings (sharply) and accumulation of net financial assets.

Its important, so worth repeating – UK HHs have reduced their absolute levels of savings (£ millions, LH scale) and their savings rate (%, RH scale)
Source: ONS; Haver; CMMP analysis

From this, I see risks to consumption and UK GDP and to further fiscal consolidation. High absolute levels of HH debt (% GDP) are constraining HH borrowing. Trends in disposable income and savings are, therefore, likely to be key factors driving HH consumption and growth in the UK. With real growth in disposable income disappointing and savings rates close to historic lows, the risks to UK growth from this analysis appear tilted to the downside.

Previous assumptions behind the policy of fiscal consolidation have already been revised to reflect the persistence of large RoW net financial surpluses. However, even the 2015 OBR forecasts that still assumed a narrowing of this surplus, required ambitious assumptions regarding the propensity of the private sector to increase their borrowing and financial deficits.

With larger than forecast ROW net financial surpluses, further fiscal consolidation requires even more private sector borrowing which I see as unlikely. The 2020 OBR forecasts published in March will shed light on the government’s forecasts but in the meantime, I see further risks to their previous assumptions.

What next? Europe…

In future posts, I will be analysing euro area economies through the same balance sheet framework. Dependency on the ROW is also relevant, but for very different reasons. In direct contrast to the UK trends described above, the German private and public sectors are both running net financial surpluses. These are offset by ROW net financial deficits.

Mirror, mirror – Germany is dependent of ROW remaining net borrowers (4Q sums, % GDP)
Source: ECB; Haver; CMMP analysis

The UK is dependent on ROW remaining net lenders, Germany is dependent on the ROW remaining net borrowers.

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

“Alternative investments”

Spotlight on the UK 4 – how do NFCs fit in?

The key chart

UK NFCs are typically net borrowers in financial markets ie, investment vehicles for other sectors in the balance sheet framework (4Q sum, % GDP)
Source: ONS; Haver; CMMP analysis

Introduction

This is the fourth in a series of five posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK. The focus here is on the non-financial corporations (NFCs) and their key economic role as:

  • Producers of good and services
  • Investors in non-financial assets (which leads to the future production of good and services)
  • Borrowers (or lenders) in financial markets

Summary

The balance sheet framework allows each of these roles to be considered in the context of the relationship between NFCs and other sectors of the economy.

NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together (see “Everyone has one…”, earlier this month).

Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in this production process is in place. Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. The shift in balance sheet structures back towards NFAs (since the GFC) is also an important indicator that NFCs believe that the returns from investing in productive assets will exceed the returns from financial assets. Productive fixed assets remain the largest segment of non-financial assets but the value of land is an increasingly important driver of the net worth of UK NFCs.

Financial assets are comprised mainly of equity, deposits and loans and their breakdown suggests a increased desire to hold liquid assets. Financial liabilities are dominated by equities, loans and (increasingly) pension fund liabilities.

Between 1999 and 2009, there was a shift away from equities in favour of debt financing that saw debt-equity ratios reach unsustainable levels (111%). The unsustainability of these trends was also reflected in the NFC debt ratio hitting a high of 113% GDP, well above the 90% BIS “maximum” threshold level. Since then the debt-equity ratio has fallen significantly (65%) and the debt ratio has fallen below the BIS average and threshold level (79% GDP).

Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings that match their investment needs. The NFC sector moved into financial surplus after the GFC but since 1Q11, NFCs have funded investment firstly by reducing this surplus and, since 4Q12, by returning to net borrowing. In contrast to the UK HH sector, debt levels in the NFC sector suggest scope for an increase in borrowing. 

These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy. Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.

Role 1: Producers of goods and services

NFCs are responsible for a large share of economic activity in most advanced economies and their role as producers of goods and services is captured neatly in the “monetary circuit concept” which links NFCs, households (HHs) and banks together. In short, this circuit starts with expected demand which leads NFCs to pre-finance production. NFCs pay their employees by a transfer of deposits at banks. These employees demand goods and services which (partially or otherwise) validates the NFCs expectations of future demand. The deposits of the firm will be replenished by the spending of households.

Role 2: Investors in non-financial assets

Investment in non-financial assets (NFAs) is critical to ensuring that the capital used in the production process to meet the demand for goods and services is in place. Put simply, to remain viable, NFCs need to invest in productive assets (gross fixed capital formation or GFCF in national accounts.) In the UK, GFCF typically accounts for just under 20% of annual GDP.

Trends in UK NFC balance sheets 1995-2018 (£ trillions)
Source: ONS; Haver; CMMP analysis

Unsurprisingly, therefore, NFAs represent an important part in NFC balance sheets. At the end of 2018, UK NFCs balance sheets totalled £6.4 trillion, comprising £3.9 trillion (61%) NFAs and £2.5 trillion (39%) financial assets (FAs).

Note the contrast here with the HH sector (see “Poised to disappoint”). The UK HH balance sheet has total assets of £12.2 trillion, spilt between £6.5 trillion (54%) of FAs and £5.6 trillion (46%) of NFAs. UK HHs are more exposed to FAs and these FAs, in turn, are larger than the total NFC balance sheets.

Breakdown of UK NFC balance sheets 1995-2018 (% total assets)
Source: ONS; Haver; CMMP analysis

The current breakdown of NFC balance sheets indicates that they believe that the returns from investing in productive assets will exceed the returns from FAs. NFCs will invest where they believe returns are highest. If they feel that investing in fixed assets (machines, buildings) will bring significant returns to their owners, they will focus on the acquisition of NFAs. Conversely, if their expectations about the demand for goods and services are weak or declining, they may decide that they can earn better returns by directing funds towards FAs rather than NFAs.

In the mid-1990s, the breakdown of NFC balance sheets was 70%:30% between NFAs and FAs respectively, indicating relatively high expectation of returns from investing in NFAs to support future production. By 2008, however, the split had changed to 56%:44% respectively, highlighting changed expectations of returns between different asset classes. Since then the balance has shifted again with funds increasingly directed towards investment in real assets.

Productive fixed assets remain important but land is playing an increasingly important role in the net worth of UK NFCs (% total of NFAs)
Source: ONS; Haver; CMMP analysis

Productive fixed assets remain the largest segment of NFAs but the value of land is an increasingly important driver of the net worth of UK NFCs. NFAs comprise “produced assets” including fixed assets (building, machinery, IP) and inventories and “non-produced assets” (largely land). At the end of 2018, produced assets represented 57% of total NFAs and non-produced assets 43%. This compares with respective splits of 70%:30% in 2002 and 67%:33% in 2008. In other words, the value of land has played an increasingly important part in the net worth of UK NFCs.

Size and structure of NFC financial assets 1999, 2009, 2019 (£ billions, % total)
Source: ONS; Haver; CMMP analysis

Financial assets are comprised mainly of equity, deposits and loans, and their breakdown indicates a propensity to hold more liquid assets. At the end of 3Q 2019, NFC financial assets totalled £2.6 trillion, with equities of £1.2 trillion (47%), deposits of £745 billion (29%) and loans of £345 billion (13%). The breakdown of financial assets has remained relatively constant over the past twenty years, other than an increase in holdings of more liquid assets. Deposits currently account for 29% of total financial assets compared with 24% ten years ago and 21% twenty years ago.

NFC financial negative net worth reached its highest point in 3Q19 – an investment vehicle for other sectors… (£ millions)
Source: ONS; Haver; CMMP analysis

Financial liabilities are dominated by equity, loans and (increasingly) pension fund liabilities. At the end of 3Q19, NFC financial liabilities totalled £6.2 trillion, with equity of £3.1 trillion (50%), loans of £1.4 trillion (22%) and pension fund liabilities of £1 trillion (16%).  

Gearing up, gearing down – trends in UK NFC debt-equity ratio 1999-2019
Source: ONS; Haver; CMMP analysis

Between 1999 and 2009 there was a shift away from equities in favour of loans and debt financing. Balance sheet gearing rose sharply over the period. Using the ONS definition of outstanding debt (debt, loans and receivables) the aggregate NFC debt to equity ratio rose from 52% in September 1999 to 91% in September 2009 (below the March 2009 peak of 111%) before falling back to 65% at the end of September 2019.

The unsustainability of these trends was reflected in the NFC debt ratio over the same period. In September 1999, the NFC debt ratio was 84% GDP. By March 2009, this had risen to a high of 113% GDP. Since then the debt ratio has fallen back to 90% GDP.

Trends in UK NFC and all BIS reporting countries’ NFC debt ratios 1999-2019 (% GDP) plotted against the BIS maximum threshold level of 90% GDP
Source: ONS; Haver; CMMP analysis

Using the narrower BIS definition, it is noteworthy that the current NFC debt ratio of 79% (2Q19) is below the level of 95% for all reporting countries and, more importantly, below the 90% threshold that the BIS considers is the level of NFC debt above which debt becomes detrimental to future growth (see graph above).

NFC and HH net financial worth hit new lows/highs at the same time (£ millions)
Source: ONS; Haver; CMMP analysis

Net financial worth – financial assets minus financial liabilities – hit a new low of £3.6 trillion in 3Q19. Interestingly, and coincidently, the net worth of UK HHs and NFCs hit new highs and new lows respectively in 3Q19.

Role 3: Borrowers in financial markets

Non-financial investments are the link between NFCs’ “real accounts” and their “financial accounts”. If NFCs are able to generate savings in excess of their non-financial needs, in a given period, they become net lenders or net financial investors. In contrast, if they are unable to generate savings that match their investment needs, they become net financial borrowers. The relevant balancing item is the net lending/net borrowing position. Non-financial investments can be financed through the use of internal funds (current and retained earnings) or by borrowing funds from other sectors.

To link this back to “Everyone has one”, in the event that NFCs require external funding, other sectors must be willing to provide them with funds.

Typically net borrowers and investment vehicles for other sectors – UK NFC net financial surplus/deficit (4Q sum, % GDP) 1989-2019
Source: ONS; Haver; CMMP analysis

The NFC sector is typically a net borrower reflecting the fact that they are unable to generate savings to match their investment needs. However, as in the HH sector, there were dramatic shifts in their position since the GFC. Since 1989, the UK NFC sector has run an average financial deficit equivalent to 0.5% of GDP. In response to the GFC, NFC increased their net savings from -2.6% GDP in June 2008 to 2.4% GDP in March 2011. This substantial negative shift equivalent to 5% of GDP occurred at exactly the same time as a similar shift in the HH sector. Since then, there has been a reversal of a similar scale to bring the current financial deficit to -2.1% GDP, below the LT average.

Since 1Q11, the NFC sector has been funding investment firstly, by reducing its financial surpluses and since 4Q12 by becoming a net financial borrower. Up until June 2015, UK NFCs were deleveraging. The debt ratio fell from 103% GDP to 87% GDP over the period and aggregate debt equity ratios fell from 77% to 69%. A complicating factor over this period has been the rise in NFC pension liabilities. In March 2011, pension fund liabilities were £339 billion accounting for 8% of total financial liabilities. By June 2015, they had risen to £748 billion accounting for 16% of total financial liabilities. Today, pension fund liabilities account for the same percentage (16%) of total liabilities.

NFC debt service ratio (affordability of debt) has fallen below LT average
Source: BIS; Haver; CMMP analysis

In contrast to the UK HH sector, NFCs have scope to increase their borrowing. Debt ratios are below the BIS threshold and debt servicing ratios are below their long term average. Indeed, real NFC growth is now at the highest level recorded in the current (mini) credit cycle.

NFC borrowing has recovered and is growing faster than GDP (% YoY, real terms)
Source: BoE; Haver; CMMP analysis

Conclusion

These dynamics highlight the final key role of NFCs in the economy – an investment vehicle for investors from other sectors. They offer stakes in their earnings (dividends) or interest payments on debt. The end result, which links directly back to the balance sheet framework, is that claims on NFCs can be found on the balance sheets of other sectors in the economy.

Hence, the wider question is, if NFCs widen their deficits further in order to fund investment, which sector will be increasing its financial surplus as an offset? I will return to this question in the fifth and final post in this series.

Building to the end game in the final post – UK sector balances for the private sector, government and RoW (4Q sum, % GDP)
Source: ONS; Haver; CMMP analysis

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

“Poised to disappoint”

Spotlight on the UK 3 – where next for UK households…?

Introduction

This is the third in a serious of posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy and apply it to the UK.

I have chosen to focus on households (HH) in this first, “sector-themed” post, to reflect the dominant role that they play in UK economic activity (FCE / GDP) and UK bank lending (the desire to buy properties).

Three key charts

Over the past thirty years, there have been two (post-crisis) phases when HHs have reduced their financial net savings dramatically (4Q sums as % GDP)
Source: ONS; Haver; CMMP analysis
Both phases have been associated with declines in the absolute level of savings (£ millions) and in the savings rate (%, RHS)
Source: ONS; Haver; CMMP analysis
…but only the first one was also associated with a significant rise in HH leverage (HH debt as a %age of GDP)
Source: ONS; Haver; CMMP analysis

Summary

HHs play a dominant role in the UK economy and in the demand for credit – 65p in every pound of UK GDP is related directly to HH consumption, and 78p in every pound lent is borrowed by HHs.

UK HHs are also important investors in financial and non-financial assets (largely property), with balance sheets skewed towards financial assets. Financial assets, comprising mainly of pensions, deposits and equities, are just over 3x the size of annual GDP. Financial liabilities are, unsurprisingly, mainly mortgage loans. Net financial worth – financial assets minus financial liabilities – hit a new high in 3Q19 and provides support for future consumption and welfare over the medium term.

The HH sector is typically a net saver/net lender in the UK (and other developed economies) but dramatic two-way shifts since the GFC have left financial surpluses well below historic averages (see first key chart above).

  • HHs have been funding consumption by slowing their rate of savings and accumulation of net financial assets
  • After a period of deleveraging post GFC, HH debt levels have stabilised (around the maximum BIS threshold level) but debt servicing costs remain low, highlighting HHs’ sensitivity /risk to a normalisation in interest rates
  • The two periods of declining net financial surpluses – 4Q92-2Q06 and 2Q10-3Q18 – reflect different combined trends in savings and/or HH borrowing

In the immediate future, trends in disposable income and savings are likely to be key factors driving HH consumption and, therefore, GDP growth in the UK. With real growth in disposable income slowing and the savings rate close to historic lows, the risks to UK growth from this analysis appear tilted to the downside, and at odds with the (now out-dated) OBR forecasts and assumptions.

Why start with HHs?

65p in every pound of GDP” – HH final consumption expenditure (FCE) as a % of total GDP 1999-2019
Source: Eurostat; Haver; CMMP analysis

HHs play a dominant role in the UK economy and in the demand for credit. HHs drive GDP growth via consumption (directly), and through government consumption on their behalf (indirectly). In 3Q19, HH consumption accounted for 65% of UK GDP, plus another 17% if government consumption on behalf of HHs is included. In other words, 65p (or 82p) in every pound of UK GDP is related directly (and indirectly) to HH consumption. For comparison, HH consumption accounts for 54% of GDP across the euro area.

The desire to buy properties is also the main driver of UK private sector credit demand. As of November 2019, total HH lending and HH lending for property purchases accounted for 78% and 69% of total UK private sector credit respectively. As can be seen from the graphs above and below, both factors have been enduring features of the UK economy and banking sectors.

78p in every pound lent” – breakdown of UK lending 1999-2019 (% total loans)
Source: BoE; Haver; CMMP analysis

HH balance sheets

Trends in UK HH balance sheets 1995-2018 (£ trillions)
Source: ONS; Haver; CMMP analysis

UK HH are also important investors in financial and non-financial assets, with balance sheets skewed towards financial assets. At the end of 2018, the aggregate, UK HH balance sheet totalled £12.2 trillion, comprising financial assets of £6.5 trillion (54%) and non-financial assets of £5.6 trillion (46%). The breakdown of total assets had shifted from 65%:35% respectively in 1999 to 50%:50% respectively in 2007 before shifting back towards financial assets after the GFC.

Breakdown of UK HH balance sheets 1995-2018 (% total assets)
Source: ONS; Haver; CMMP analysis

Financial assets are comprised mainly of pension assets, deposits and equities. At the end of 3Q 2019, HH financial assets totaled £7.3 trillion, with pensions (insurance and guarantees) of £4.2 trillion (57% total financial assets), deposits of £1.7 trillion (24%) and equities of £1.1 trillion (15%). The breakdown of HH financial assets has been broadly similar over the past two decades albeit with a shift towards deposits and away from equities. Since 2000, HH financial assets have averaged 3x the size of annual GDP. At the end of 3Q19, this ratio had risen above this average to 3.3x GDP.

Size and structure of HH financial assets 1999, 2009, 2019 (£ billions, % total)
Source: ONS; Haver; CMMP analysis

HH financial liabilities are dominated by mortgage loans, unsurprisingly. Financial liabilities totaled £2.0 trillion at the end of 3Q2019, with mortgage loans accounting for £1.4 trillion out of the total HH loans of £1.8 trillion. Again the breakdown of HH financial liabilities is little changed over the past two decades. Net financial worth – financial assets minus financial liabilities – hit a new high in 3Q2019 providing adequate MT support for future consumption and welfare.

Trends in UK HH financial assets, liabilities and net worth 1999-2019 (£ millions)
Source: ONS; Haver; CMMP analysis

HH sector financial flows

The analysis above has focused on stocks of financial assets and financial liabilities. I turn now to the flows (of income and savings) that accumulate into these stocks. Note that HH accumulation of net financial assets over the course of a year is only possible when spending is less than income over the same period. Put another way:

HH are net savers when savings – income minus consumption minus taxes – are higher than investment.

Note also, one of the key messages from “Everyone has one”, that if one sector is going to run a budget surplus, at least one other sector must run a budget deficit.

The HH sector is typically a net saver/net lender in the UK (and other developed economies) but dramatic two-way shifts since the GFC have left financial surpluses well below historic averages. Since 1989, the UK’s HH sector has run average financial surpluses equivalent to 3.8% of GDP (from a flow perspective). In response to the GFC, however, HHs increases their net savings from 2.6% of GDP in June 2008 to 6.9% of GDP in June 2010, a substantially negative shift equivalent to 4.3% of GDP. Since June 2012, HH have reduced their net surplus from 5.3% of GDP to a recent low of 0.0% in September 2018 and 1.1% currently. This trend reversal represented a substantially positive shift equivalent to 4.2% of GDP, in effect a mirror image of the trends immediately after the GFC.

UK HH net financial surpluses (4Q sum, % GDP) 1989-2019, highlighting their response to GFC
Source: ONS; Haver; CMMP analysis

HHs have been funding recent consumption by slowing their rate of savings/accumulation of net financial assets. Since early 2010, there have been two periods when UK HHs have reduced their savings significantly. The first occurred between March 2010 and March 2013 when HH savings fell from -41% from £37 billion to £22 billion and the second occurred between March 2015 and March 2017 when HH savings fell -61% from £35 billion to £14 billion. Between March 2010 and March 2017 the HH savings ratio fell from 13% to 4%, a thirty year low.

Trends in HH savings (£ millions) and savings rates (%, RHS) since 2008
Source: ONS; Haver; CMMP analysis

After a period of deleveraging post GFC, HH debt levels have stabilised (around the BIS maximum threshold level) but debt servicing costs remain low highlighting UK HHs’ sensitivity to changes in interest rates. The HH debt ratio is currently 86% of GDP compared with a high of 102% in March 2019. The BIS considers 85% to be the threshold level above which HH debt becomes a constraint on future growth.

While the debt ratio remains high, the HH debt service ratio of 8.9% is below the LT average of 10.1% and the September 2008 high of 12.3%. In other words, the risks associated with UK HH debt relate to the level of the debt rather than its affordability. They are reflected in (real) demand for credit remain very subdued.

Subdued demand for credit – trends in real UK GDP and real HH credit (%)
Source: BoE; Haver; CMMP analysis

The two periods where the accumulation of net financial assets by the HH sector has slowed dramatically have illustrated different drivers. In the first, between 4Q92 and 2Q06, the HH net surplus fell from 8.6% of GDP to –0.1% GDP (HH became slight net borrowers).

Trends in UK HH debt to GDP ratio (%) 1989-2019
Source: ONS; Haver; CMMP analysis

Over this period the HH debt ratio rose from 64% of GDP to 92% of GDP (see above) . At the same time, the HH savings ratio fell from 15% to 7% (see below). HH were increasing their borrowing and reducing their saving at the same time.

In the second, between 2Q10 and 3Q18, the HH net surplus fell from 6.9% of GDP to 0% of GDP. However, the HH debt ratio fell from 98% of GDP to 86% of GDP. In this second case, the main driver was the reduction in the HH savings rate from 13% to 6% (with a 3Q17 low of 4.0% described earlier).

Trends in UK savings (£ millions) and savings rate (%, RHS) 1989-2019
Source: ONS; Haver; CMMP analysis

Conclusion

Trends in real disposable income (% YoY) 1989-2019
Source: ONS; Haver; CMMP analysis

In the immediate future, therefore, trends in disposable income and HH savings are likely to be key factors driving GDP growth. UK HHs appear to have little appetite for taking on more borrowing. With real growth in disposable income slowing and savings rate already at/close to historic lows, the risks to UK growth from this analysis appear tilted to the downside. My analysis and data challenges the assumptions in the last (now out-dated) OBS forecasts for the UK economy. I will return to this issue when the OBR updates its assumptions on UK sector balances in 1Q20.

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

“Everyone has one…”

Spotlight on the UK 2 – balance sheets are at the heart of every economy

The key charts

From this (a simplified model of financial transactions)…

I start simply with examples of three (of the four) core services provided by the financial system to households and corporates…
Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin. 2015 Q2 article

To this (quantitative, objective and logical macro analysis)….

…and arrive (in an accelerated fashion) at a highly quantitative, objective and logical analytical framework – “UK sectoral financial balances”
Source: ONS; Haver; CMMP analysis

Introduction

This is the second in a series of posts in which I develop a consistent “balance sheet framework” for understanding the relationship between the banking sector and the wider economy. The first post presented a simple mapping of the UK economy and its financial system and highlighted the relatively large size of the UK financial system and the relatively volatile nature of its relationships with the UK economy. In this second post, I focus on:

  • the core services provided by the UK financial system
  • how these services produce a stock of contracts that can be represented by financial balance sheets that link different economic agents over time
  • how these balance sheets form the foundation of a highly quantitative, objective and logical analytical framework.

Summary

The UK financial system’s core services include making payments for goods and services, moving money from tomorrow to today (credit) and moving money from today to tomorrow (savings). The resulting “monetary circuit” facilitates the supply of goods and services and the subsequent consumption by households.

The core services also produce a stock of financial contracts that link different economic agents together over time. A fundamental principle of accounting is that for every financial asset there is an equal and offsetting financial liability. By definition, net financial wealth is therefore equal to the sum of financial assets less the sum of financial liabilities. If we take all the private sector financial assets and liabilities it is also a matter of logic that the sum of all the assets must equal the sum of all the liabilities.

The implication here is that for the private sector to accumulate net financial wealth it must be in the form of claims on another sector. In the case of a simple two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. The key message here is that in a two-sector economy, it is impossible for the public and private sectors to run surpluses at the same time. Of course, in reality these domestic sectors are also economically linked to foreign governments, firms and households, collectively termed the “rest of the world” (ROW). Hence, the private sector can accumulate net financial assets equal to public sector liabilities, the ROW’s net liabilities or a combination of two.

The three sectors described below – the domestic public sector, the domestic government sector and the ROW – can be treated as having income and savings flows over a given period (typically a quarter or a year). Extending the accounting principles described above any deficits run by one or more sectors must equal surpluses run by other sector(s). This leads to the key identity pioneered by the late Wynne Godley:

Domestic private balance +domestic government balance +foreign balance = zero

I analyse these trends for the key economic agents in the UK economy and their implications in more detail in my next post.

The core financial services

The core services of the UK’s (and any economy’s) financial system include:

  • Making payments for goods and services
  • Moving money from tomorrow to today (credit)
  • Moving money from today to tomorrow (savings)
  • (Managing risk – a core service but outside my analysis here)

By way of illustration, the diagram below depicts a series of transactions between six economic agents in a simplified (closed) domestic economy:

  • two households (the Smiths and the Khans)
  • two non-financial companies (Jane’s consumer durables and John’s commercial vehicles)
  • two financial institutions (a bank and a unit trust company/NBFI)
The first key chart repeated: the core services of the financial system – payments, credit and savings
Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin. 2015 Q2 article

The red arrows in this diagram represent a flow of money between each of the six economic agents. The yellow boxes show what was purchased with these funds (two non-financial assets, an apartment and a van ) and the pale blue boxes highlight the resulting financial assets. In turn:

  • Payments of goods and services: the Smiths buy an apartment from the Khans and Jane’s consumer durables buys a transport van from John’s commercial vehicles. The payments might be made directly in cash between the four parties, but are more likely to be made via banks’ payments systems. Note that, modern economies need efficient payment systems to enable agents to pay each other for goods and services. An economy based on a complex division of labour would be unable to thrive without an efficient payments system.
  • Moving money from tomorrow to today (credit): the Smiths finance the purchase of the Khan’s apartment via credit from the bank in the form of a mortgage. Jane’s company finances the purchase of the van by raising funds (selling shares) to the unit trust company. The financial system provides credit to both a household (HH) and a corporate (NFC) in this example.
  • Moving money from today to tomorrow (savings): the Khans saved the money they received from the Smiths by investing in an equity fund offered by the unit trust company, while John’s company put the proceeds of the sale into a bank account to pay wages and raw materials in the future. The financial system provides different forms of savings products to the HH and NFC in this example.

This simple example is, in effect, an alternative to the well-known economic concept of “the monetary circuit.”

The monetary circuit

The main reason why people borrow in the UK is to purchase property! Breakdown of UK bank lending 1999-2019 (% total lending)
Source: Bank of England; Haver; CMMP analysis

The monetary circuit concept argues that the purpose of a monetary economy is to facilitate the supply of goods and services and their subsequent consumption by households. Leave aside, for the moment, that the main reason for borrowing in the UK (and other developed markets) is the desire of HHs to purchase property (see graph above). With regards to production activities the main cause of borrowing is often that NFCs expect the demand for their goods and services to increase and therefore want to pre-finance production. In this scenario, the monetary circuit starts with expected demand which leads NFCs to pre-finance their production. NFCs pay their employees by a transfer of deposits at banks. These employees demand goods and services which (partially or otherwise) validates the NFCs expectations of future demand. The deposits of the firm will be replenished by the spending of households. These flows are illustrated in the simplified monetary circuit framework diagram below.

The simplified monetary circuit framework
Source: Ehnts, D. MMT and European Macroeconomics. Routledge 2017

Foreshadowing a theme that I will return to in later posts, it is worth nothing the scenarios in which the monetary circulation described above fails:

  • Holders of deposits decide to uses them to repay outstanding loans
  • Holders of deposits are happy to hold rather than spend them (idle deposits)
  • Holders may transfer deposits to other forms of savings
  • Holders may use taxes to pay taxes

Of course, the decision to hold some form of excess deposits as a buffer against unforeseen circumstances is perfectly rational. Nevertheless with regards the monetary circuit and its main purpose – to facilitate production and consumption – there is a serious problem with hoarding/excess saving which has important implications for macro policy choices. More to follow on this theme in later posts…

Transactions to balance sheets

The three core services described above produce a stock of financial contracts that can be represented by financial balance sheets that, in turn, illustrate how different economic agents are linked together over time.

When the Smiths took out their mortgage from the bank in order to buy the Khan’s apartment, the bank provided them with the funds in exchange for a commitment from the Smiths to make repayments over time. In other words, the mortgage represents an asset for the bank and a liability for the Smiths and illustrates the connection between them. The diagram below illustrates the financial assets (yellow) and liabilities (blue) that result from each of the transactions above.

Core services produce a stock of financial contracts that illustrate key linkages
Source: adapted from “Mapping the UK financial system”, Bank of England Quarterly Bulletin. 2015 Q2 article

A fundamental principle of accounting is that for every financial asset there is an equal and off-setting financial liability. Hence, in this illustration, the Smith’s mortgage is a liability that is offset by an asset for the bank. Similarly, John’s commercial vehicles bank account is an asset that is offset by a liability for the bank.

Note, however, that while the assets and liabilities match each other, the associated future flows of money travel in the opposite direction to the flows of money created in the original transactions. The Smiths will have to repay their mortgage and the bank will have to provide funds if John’s commercial vehicles decides to withdraw money from its account. The physical assets shown in the earlier diagram are not included here as, unlike financial assets, they do not create an on-going relationship between the agents.

Note also the unique feature of banks in this relationship. They create deposits via lending not (as is commonly believed) the other way round. Of course, the bank needs to have liabilities to fund the lending but these do not have to be secured in advance of the loan being granted. The unique feature of banking is the fact that banks can simultaneously create loans and deposits and hence alter the quantity of money circulating in the economy. This is not the case for the unit trust company, which can only buy shares in Jane’s consumer durables by first securing an investment.

The key message at this stage is that balance sheets are at the very heart of the economy. The Bank of England has a balance sheet. The UK government has one, and as illustrated above UK banks, HHs and NFCs have balance sheets too. My balance sheet framework has the advantage of being both highly quantitative and objective since it focuses on transactions, debts, balance sheets and core accounting principles. It also allows me to follow the logic of the UK economy by monitoring the transaction records that show what is actually happening:

  • The stocks and flows of credits and debits
  • Who owes what to whom
  • Who the creditors are
  • Who the debtors are
  • How they came to have these roles

Financial net wealth/worth

Financial assets and financial liabilities are unlikely to have the same value
Source: ONS; Haver; CMMP analysis

In general, at any given point in time, it is unlikely that any individual or economic agent has financial assets and financial liabilities of the same value (see graph above). Since, any balance sheet has to balance, we need to create an equilibrium value by inserting the entry “net financial wealth” into the left hand side of the balance sheet. (This is merely convention and there is an argument that net wealth should be shown on the asset side of the balance sheet with an inverted sign, as it is claim of the owner against the balance sheet).

Financial assets minus financial liabilities = financial net worth. The example of UK HHs 2000-2018 (£ millions)
Source: ONS; Haver; CMMP analysis

In the case of the UK, HHs had financial assets of £6.7trillion and financial liabilities of £1.9trillion at the end of 2018. In other words, their net financial worth was £4.7trillion. In contrast, NFCs had financial assets of £2.5trillion and financial liabilities of £5.6 trillion ie, net financial worth of minus £3.1trillion.

Contrasting trends in HH and NFC financial net worth 2000-2018 (£ millions)
Source: ONS; Haver; CMMP analysis

Implications for analysis

Returning to basic accounting principles, if we take all the private sector financial assets and liabilities it is a matter of logic that the sum of all the assets must equal the sum of all the liabilities. This means that the net wealth of the private sector would have to be zero if we include only private sector IOUs (assuming that the public sector is not holding any private sector debt.)

The implication here is that for the private sector to accumulate net financial wealth it must be in the form of claims on another sector. In the case of a simplified two sector economy compromising the private sector (HHs and NFCs) and the public sector (all levels of government), the private sector could accumulate “outside wealth” in the form of government currency and/or government ST bills and T bonds. Note that the private sector can only accumulate net financial assets if its spending is less than its income in a given period. In this example, these financial assets are government/public sector liabilities (currency, bills and bonds). The government liabilities arise when it is spending more that it is receives in the form of tax revenues. The resulting deficit accumulates to the stock of government debt which is equal to the private sector’s accumulation of financial wealth over the same period.

In the case of a simple two sector economy, the net financial assets held by the private sector are exactly equal to the net financial liabilities of the government. If a government runs a balanced budget where spending is equal to tax revenue, the private sectors net financial wealth will be zero as a result. If the government runs a budget surplus with spending less than tax receipts, the net financial wealth of the private sector will be negative. The key message here is that in a two-sector economy, it is impossible for the public and private sectors to run surpluses at the same time. (In future posts, I will show that this is exactly what is occurring in Germany in practice)

Of course, in reality these domestic sectors are also economically linked to foreign governments, firms and households, collectively termed the “rest of the world” (ROW). Hence, the domestic private sector is able to accumulate net claims against the ROW even if the domestic government is running a balanced budget. In this case the private sector’s accumulation of net financial assets is equal to the ROW’s issue of net financial liabilities, although in reality it is more likely that the private sector will accumulate net financial wealth combining both domestic and ROW liabilities.  

Flows, stocks and sector balances

From an analysis perspective, the three sectors described here – the domestic public sector, the domestic government sector and the ROW – can be treated as having income and savings flows over a given period (typically a quarter or a year). If a sector spends less that it earns it creates a budget surplus. Conversely, if it spends more than it earns, it creates a budget deficit. A surplus represents a flow of savings that leads to an accumulation of financial assets while a deficit reduces net wealth. If a sector is running a deficit it must either reduce its stock of financial assets or it must issue more IOUs to offset the deficit. If the sector runs out of accumulated financial assets, it has no choice other than to increase its indebtedness over the period it is running the deficit. In contrast, a sector that runs a budget surplus will be accumulating net financial assets. This surplus will take the form of financial claims on at least one other sector. More details of how this works in practice will follow in later posts.

The end game! A quantitative, objective and logical analytical framework. Quarterly sectoral balances for the UK (4Q MVA as % GDP)
Source: ONS; Haver; CMMP analysis

Conclusion – “where the money flows, there too the future goes.”

Having started this post with the observation that every economic agent has a balance sheet it seems appropriate to conclude by returning to basic accounting principles. Following the original economic work of Wynne Godley, we know that if we sum the deficits run by one or more sectors this must equal the surpluses run by other sector(s). Hence, Godley’s key identity:

Domestic private balance + domestic government balance + foreign balance = 0

In my next post, I will analyse these trends for the key economic agents in the UK economy and their implications in more detail.

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

“Lousy LT investments, but…”

Spotlight on the UK 1- mapping the system

The key chart

“An ever-present feature of most people’s lives and a critical part of the economy” Bank of England, 2015

“An ever-present feature” – the relative size of financial assets for the “real” and “money” sectors in the UK and EA (multiple of annual GDP)
Source: ONS; ECB; Haver; CMMP analysis

Happy New Year

A central theme in CMMP analysis is that the true value in analysing developments in the financial sector lies less in considering investments in developed market banks – they have been lousy LT investments – but more in understanding the wider implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.

To begin 2020, I am publishing a series of posts in which I develop a consistent “balance sheet framework” for understanding this core relationship and apply it to the UK economy. The choice of the UK is deliberate, reflecting both the relatively large size of the UK financial system and the relatively volatile nature of its relationship with the UK economy (see the key chart above).

This first post presents a simple mapping exercise for the UK economy and its financial system.

Summary

Financial assets represent the largest segment of the UK’s £42 trillion national balance sheet, accounting for 75% of total assets at the end of 2018. The UK’s “money sector”, in turn, accounts for 68% of financial assets (compared to 58% in the EA), highlighting the important role of the sector in terms of absolute size. Within the money sector, MFIs remain the dominant players, but “other FIs” are playing an increasingly important role in both the UK and EA economies.

A key distinguishing feature of the UK economy is the relative size (and hence potential impact) of the money sector and the volatile nature of its relationship with the wider economy. The money sector’s financial assets rose from 6x GDP in 2000 to 15x GDP in 2008 and remain 10x GDP currently (3Q19). The unsurprising conclusion here, is that the UK’s financial system is “an ever-present feature of most people’s lives and a critical part of the economy” (Bank of England, 2015).

In my next post, I will develop this analysis by considering the core services provided by finance institutions and how they produce a stock of contracts that can be represented by financial balance sheets that link different economic agents together over time.

Lousy LT investments, but…

At various stages in my career, I have run top-rated bank equity research teams. In the face of LT bank under-performance throughout this experience, I have been struck by (1) the enduring, positive bias from sell-side analysts and (2) the scale and expense of the sell-side and buy-side resources dedicated to individual bank stock-picking.

Lousy LT investments – UK, US and EA banks have significantly under-performed local markets (relative performance since 2004)
Source: Haver; CMMP analysis

Over the past 15 years, UK banks have under-performed the FTSE 100 by 75%, US banks have under-performed the S&P 500 by 53% and EA banks have under-performed the SXXE by 58%. Yet, how many sell ratings have been published over this period?

In my view, the same (expensive) resources would be better applied to understanding the implications of the relationship between the banking sector (and even the wider economy and/or the impact of macro developments on banks’ future profitability and cash flows!). Returns here are likely to be more attractive, hence my focus at CMMP.

The UK’s national balance sheet

The importance of financial assets to the UK economy – breakdown of non-financial and financial assets within the UK’s national balance sheet since 1995 (£ trillions)
Source: ONS; Haver; CMMP analysis

Financial assets represent the largest segment of the UK’s national balance sheet, accounting for 75% of total assets. At the end of 2018, the UK’s national balance sheet was £42 trillion, largely unchanged in terms of total size since 2016. Financial assets totaled £31 trillion (75% of the total) and non-financial assets – largely land and other fixed assets – totaled £11 trillion (25% of the total).

The share of financial assets peaked in 2008 – breakdown of UK assets since 1995 (% total assets)
Source: ONS; Haver; CMMP analysis

The share of financial assets rose in the build-up to the GFC to peak at 82% in 2008, but is currently similar to the level seen in 2000. The UK’s financial liabilities totaled £32 trillion at the end of 2018, resulting in a net worth of just over £10 trillion. As an aside, the 3% growth in the UK’s net worth in 2018 was the slowest rate of growth since 2012.

UK’s net worth growing, but at the slowest rate since 2012 (£ trillions)
Source: ONS; Haver; CMMP analysis

The role of the UK financial system

The financial system accounts for the bulk of UK financial assets – growth in UK financial assets since 2000 showing split between the money and real sectors (£ millions)
Source: ONS; Haver; CMMP analysis

The financial system, comprising MFIs, other FIs and insurance companies and pension funds (ICPFs), accounts for 68% of the UK’s financial assets compared with 58% in the Euro area (EA). At the end 2018, the financial assets of the UK financial system totaled £21 trillion a 7% CAGR since 1995. Of course, as can be seen in the graph below, this growth occurred up to 2008 (15% GAGR between 1995 and 2008) when the system’s financial assets peaked at almost £24 trillion, 11% higher than at the end of 2018. At the 2008 high point, the financial system or “money sector” accounted for 78% of the UK’s financial assets compared with 58% in 2000.

A game of two “halves” – the growth in money sector financial assets occurred before 2008 (£ trillions)
Source: ONS; Haver; CMMP analysis

Monetary financial institutions – the Central Bank, deposit taking FIs and money-market funds – represent the largest sub-sector within UK financial services. At the end of 3Q19, the assets of UK MFIs totaled £12.6 trillion or 53% of total money sector financial assets. The assets of other FIs and ICPFs were £6.3 trillion (27%) and £4.8 trillion (20%) respectively as shown in the diagram below which illustrates the financial assets and liabilities of the domestic sectors in the UK economy. I will be returning to the differences in financial net worth (financial assets minus financial liabilities) across the different economic sectors in subsequent posts.

Financial sector balance sheets for the domestic sectors of the UK economy as at the end of 2Q19
Source: ONS; Haver; CMMP analysis

The rise of “other FIs”

Other FIs are playing an increasing important role in both the UK and EA economies. This sub-sector comprises non-money market funds (investment trusts, unit trusts and other collective investment schemes whose investment fund shares or units are not close substitutes for deposits), other financial intermediaries (eg, security and derivative dealers, finance leasing companies, venture and development capital companies, and export and import financing companies), financial auxiliaries (insurance brokers, investment advisers, fund managers and payment institutions) and captive financial institutions (holding companies and SPVs) and money lenders.

Other FIs gaining market share at the expense of ICPFs – breakdown of UK money sector financial assets (% total assets) since 2000
Source: ONS; Haver; CMMP analysis

UK other FIs have increased their share of the money sector’s financial assets from 19% in 2000 to 27% at the end of 2Q19. This has been at the expense of ICPFs who have seen their share fall from 32% to 20% over the same period. A similar, if more muted trend, has also occurred in the EA where the share of other FIs has risen from 25% of money sector financial assets in 2000 to 30% at the end of 2Q19. In this case, however, this has been at the expense of EA MFIs who have seen their share fall from 61% to 56% over the same period.

The rise of other FIs is a Europe-wide trend – market share of total money sector financial assets for the UK and EA other FIs (% total financial assets)
Source: ONS; ECB; Haver; CMMP analysis

The UK’s key distinguishing feature

One of the UK’s distinguishing features – the size (and its variability) of the UK money sector’s financial assets (as a multiple of annual GDP)
Source: ONS; ECB, Haver; CMMP analysis

A key distinguishing feature of the UK economy is the relative size (and potential impact) of the money sector and the volatile nature of its relationship with the wider economy. In September 2000, the UK’s money sector’s financial assets were 6x larger than GDP. This compares with a multiple of 4x in the EA. By December 2008, the same ratio had risen to 15x GDP in the UK but only 6x in the EA. Since then, the UK’s ratio has fallen back to, a still very large, 10x GDP while the EA’s ratio has risen more steadily to 7x.

Contrasting trends between the relative size in the real and money sectors’ financial assets (multiple of annual GDP)
Source: ONS; ECB; Haver; CMMP analysis

In contrast, the relationship between the size of the “real economy’s” financial assets and GDP has been more stable. In 2000, the UK real economy’s financial assets were 4x larger than GDP. At the end of 2008, this ratio was also 4x and is only 5x currently. In the EA, the same ratio rose from 4x in 2000 to 6x in 2008 before falling back to 5x currently.

In other words, the ratio of the size of real economy’s financial assets to GDP is much lower and more stable in both the UK and the EA. However, it is much larger for the money sector and, equally importantly, more volatile in the case of the UK.

Conclusion

The unsurprising conclusion of this first post, is that the UK’s financial system is “an ever-present feature of most people’s lives and a critical part of the economy” (Bank of England, 2015). In my next post, I will develop this analysis by considering the core services provided by finance institutions and how these services produce a stock of contracts that can be represented by financial balance sheets that illustrate how different economic agents are linked together over time.

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

“Fading recession risks?”

A short update from the Euro Area monetary sector

The key chart

Real growth in M1 (leading indicator), HH credit (coincident indicator) and NFC credit (lagging indicator) continue to move away from levels associated with recession risks in the Euro Area
Source: ECB; Haver; CMMP analysis

The message from October’s data

Monetary indicators continue to move away from levels associated with recession risks in the Euro Area.

Leading indicator: Growth in real M1 has rebounded and is at the highest level since October 2017
Source: ECB; Haver; CMMP analysis

Narrow money (M1) grew 8.4% in nominal terms in October, up from 7.9% in September. In real terms, M1 grew 7.6% which is the fastest rate of real growth since October 2017 (8.0%) and compares with a real growth rate of only 4.7% in January this year. Given the leading indicator qualities of trends in real M1, this data supports the narrative that recession fears in the Euro Area have been overdone.

Coincident indicator: Real growth in HH credit at its highest level since April 2008
Source: ECB; Haver; CMMP analysis

Households and corporates are also increasing their borrowing at the fastest rates in the current cycle. HH credit (a co-incident indicator) grew 3.5% in nominal terms and 2.8% in real terms, the fastest rate of real growth since April 2008. NFC credit (a lagging indicator) grew at 3.8% in nominal terms and 3.1% in real terms. The real growth was marginally below the level of 3.2% recorded in August 2019, but again these rates are the highest real growth rates since June 2009.

Lagging indicator: Real NFC growth at/close to its highest level since June 2009
Source: ECB; Haver; CMMP analysis

Of course, credit growth remains relative subdued in relation to LT trends and concentrated geographically (HH in France, Germany, Benelux and Italy; NFC is France, Germany and Austria) and the demand for credit continues to lag the supply of money which indicates that the Euro Area has still to recover fully from the debt overhang (see graph below).

Don’t get carried away – the demand for credit from the private sector (PSC) still lags the supply of money. The Euro Area continues to suffer from a deficiency in the demand for credit.
Source: ECB; Haver; CMMP analysis

A simple conclusion

Nonetheless, the message from October is simple: current monetary trends remain inconsistent with recession fears in the Euro Area

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

“The ECB’s missing chart”

The FSR is suitably cautious, but misses a key chart

The key (missing) chart

Are ECB policies fuelling growth in less productive FIRE-based lending at the expense of productive COCO-based lending (% total loans)? What are the implications for leverage, growth, stability and income inequality?
Source: ECB; Haver; CMMP analysis

Summary

The ECB published its November 2019 Financial Stability Review (FSR) this week with a suitably cautious outlook for financial stability, economic growth, and banking sector profitability in the euro area (EA).

The analysis is as insightful and thorough as usual and supports many of my current views. However, it “falls short” in one key respect – the FSR presents its analysis through the traditional household (HH) versus corporate (NFC) framework, rather than through the increasingly more relevant COCO versus FIRE-based credit framework.

The risk here is that it underplays the hidden risks in QE, namely that the majority of credit in the EA is directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit. As such, current policies to support/stimulate credit demand have potentially negative (if unintended) implications for leverage, growth, stability and income inequality.

Key messages from the FSR (Nov 2019)

The FSR states that the “the euro area financial stability outlook remains challenging“. It highlights four key issues:

  1. Signs of asset mispricing suggest potential for future correction
  2. Lingering private and public sector debt sustainability concerns
  3. Growing challenges from cyclical headwinds to bank sector profitability (“75% of EA significant banks have ROE < 8%”)
  4. Increased risk-taking by nonbanks may pose risks to capital market financing

In mitigation, the FSR notes that: (1) euro area banks are adequately capitalised with a 14.2% CET1 ratio; and (2) all Euro Area countries have activated macroprudential measures. Nonetheless, it concludes that “more active use of macroprudential policies could be appropriate to contain vulnerabilities“.

The FSR argues that the economic outlook has deteriorated and that growth is expected to remain subdued for longer, with risks tilted to the downside. It also concludes that “while the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain“. Four headwinds facing banks are cited: eroding interest margins; slightly higher costs of risk; high cost inefficiencies, and plateauing capital positioning.

I have covered many of these factors in recent posts including:

The ECB’s framework

The FSR presents its analysis of the HH and NFC sector separately. The HH sector is discussed in Section 1.3 (Euro area household resilience supported by low interest rates) and the NFC sector in Section 1.4 (Emerging pockets of corporate sector vulnerability).

Robust or subdued? Nominal HH credit growth is much lower than in past cycles (%YoY) and concentrated geographically (France, Germany, Benelux)
Source: ECH; Haver; CMMP analysis

In summary, the FSR describes HH lending as “robust, with continued divergence across countries and types of loans”, HH indebtedness stable (with considerable heterogeneity across EA countries) and risks to HH debt sustainability contained. My comments:

  1. HH credit is growing at the fastest rate in the current cycle (3.4% nominal and 2.6% real YoY growth) but rather than robust, I would describe this growth as relatively subdued especially in relation to historic cycles
  2. As noted in previous posts, and illustrated in the graph above, HH growth is concentrated in Germany, France and the Benelux
  3. In “Debt dynamics in the developed world” I agreed with the conclusion that excess credit growth risks in developed economies were relatively contained (and limited largely to non-EA countries such as Norway, Switzerland, Canada and Sweden, see graph below).
CMMP analysis shows that HH sector growth risks are relatively low (HH RGF versus HH debt ratio)
Source: BIS; Haver; CMMP analysis
…as are HH affordability risks in the Euro Area in contrast to Norway, Canada and Sweden (HH DSR as at end 1Q19 and deviations from LT average)
Source: BIS; Haver; CMMP analysis

In the NFC sector, the FSR highlights the deceleration in corporate profits, along with increases in external financing and slightly elevated corporate indebtedness, but suggests that risks are offset by favourable financing conditions and large liquidity buffers.

NFC debt levels remain above the average for BIS reporting countries and the BIS maximum threshold
Source: BIS; Haver; CMMP analysis
CMMP analysis shows that only Italy, Greece and Germany (among large EA economies) have NFC debt levels below the BIS maximum threshold
Source: BIS; Haver; CMMP analysis

I would suggest that this underestimates risks in this sector:

  1. The NFC debt ratio (% GDP) is currently 105% in the EA, above the 94% average for all BIS reporting countries and the BIS maximum threshold level of 90%
  2. At the country level, only Italy, Germany and Greece have NFC debt ratios below the BIS threshold
  3. My analysis also highlights relative high “growth” and “affordability” risks in the French NFC sector.
France is among the four economies that have seen the fastest rates of “excess NFC credit growth” despite having high levels of NFC (% GDP)
Source: ECB; Haver; CMMP analysis
…while also displaying relatively high levels of NFC affordability risk (NFC DSR as at end 1Q19 versus deviation from LT average)
Source: BIS; Haver; CMMP analysis

An alternative framework

In September, I presented an alternative framework for analysing global debt dynamics. I argued that, in its broadest sense, lending can be split into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO”-based lending (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE”-lending (FInancials and Real Estate). 

EA lending is increasingly directed towards less productive FIRE-based lending (% total lending) which now accounts for 55% of total loans
Source: ECB; Haver; CMMP analysis

In short, COCO-based lending typically supports production and income formation, while FIRE-based lending typically supports capital gains through higher asset prices. Lending in any economy will involve a balance between these different forms, but to repeat the key point from September: a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

Only three of the large EA economies have COCO-based lending above (Greece, Austria) or equal to (Italy) FIRE-based lending (% total loans)
Source: ECB; Haver; CMMP analysis

Over the past twenty years, FIRE-based lending has increased from 48% of total loans to 55% as at the end of September 2019. The current level represents the highest share of FIRE-based lending. Only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending: Greece; Austria, and Italy.

Why does this matter?

The hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.  

  1. Leverage: while COCO-based lending increases absolute debt levels, it also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage
  2. Growth: similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly
  3. Stability: the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers. The FSR notes that house prices rose faster than GDP in 1H19 and highlights signs of overvaluation, which now exceeds 7% on average, “but with a high degree of cross-country heterogeneity” (see graphs below)
  4. Inequality: the returns from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.
EA house prices have risen faster than GDP in 1H19 and are estimated to be overvalued by 7%
Source: ECH; Haver; CMMP analysis
Residential property prices are estimated to be overvalued in all large EA economies (and in the UK) with the exceptions of Italy and Ireland
Source: ECH; Haver; CMMP analysis

Conclusion

The FSR’s outlook for financial stability, economic growth and bank sector profitability is in-line with the views expressed in my recent posts (albeit with some differences in emphasis). However, the hidden risks associated with the ECB’s unorthodox monetary policy are potentially understated, in my view.

The alternative framework presented here, that draws the distinction between productive COCO-based lending and unproductive/less-productive FIRE-based lending, provides a clearer perspective of these risks.

The on-going shift in the balance of lending in the Euro Area has negative implications for leverage, economic growth, financial stability and income inequality.

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