It’s the economy, not the budget, that has to balance
The key chart
UK financial sector balances (4Q rolling averages, £bn) (Source: ONS; CMMP)
The key message
Note to Rishi – a “pragmatic” and “responsible” fiscal outcome for the UK is one that delivers a balanced economy not a balanced budget.
Pre-COVID, the UK was running large and persistent sector imbalances and was increasingly reliant on the rest-of-the-world (RoW) as a net lender. The HH sector, which plays a critical role in the UK economy (FCE/GDP) and bank lending, had been funding consumption by dramatically reducing its savings rate and accumulation of net financial assets and was poised to disappoint.
In the face of the pandemic, the UK private sector shifted to an unprecedented net lending position of 21% GDP, 13ppt above the 4Q09 post-GFC peak. The HH sector alone moved from a net borrowing position of 0.4% GDP in 3Q19 to a net lending position of 15% GDP in 2Q20 as the HH savings ratio rose to a record high of 23% GDP. Extraordinary and co-ordinated responses to these extraordinary times came from the UK government and the Bank of England, including extensions to the furlough scheme and increases in the central bank’s buying programme. The responses were both timely and appropriate. The UK government increased its net borrowing positions to 25% GDP in 2Q20 and 14% in 3Q20.
According the latest ONS statistics, the net lending position of the UK private sector was still 6% GDP at the end of 2Q21, down from 10% in the previous quarter but still well above the LT (pre-COVID) average of just under 1% GDP. Both non-financial and financial corporations increased their net lending positions in 2Q21 to 1% of GDP respectively. In contrast, the HH’s net lending position fell from 9% GDP (£52bn) in 1Q21 to 5% GDP (£27bn) in 2Q driven by a recovery in spending. Note, however, that it remains double its LT average. On a positive note, the HH savings rate fell to 12% in 2Q21 from 18% in 1Q21 (the second highest rate on record).
The recent messages from the UK money sector suggest that HHs remain uncertain with monthly HH deposit flows rising again in August to double their pre-pandemic levels and demand for consumer credit remaining weak. So-called “faster-indicators” also indicate that credit and debit card payments remain below their pre-pandemic levels.
As the UK emerges from the COVID pandemic, large sector imbalances remain but in very different ways to the pre-COVID period. The private sector continues to disinvest, HHs remain uncertain and credit demand (ex-mortgages) remains subdued. UK HHs have built up c£160bn of excess savings during the pandemic but history suggests that (1) they take time to respond to shocks and (2) that unanticipated increases in wealth tend to be saved rather than spent. The co-ordinated fiscal and monetary policy response to the pandemic was timely and appropriate but it remains premature to be discussing significant fiscal adjustments and/or an end to “bigger government”.
Contrary to some of the current political rhetoric, budget outcomes are inappropriate goals in themselves. The correct budget outcome is the one that delivers a balanced economy, not a balanced budget.
Pre-COVID, the UK was running large and persistent sector imbalances and was increasingly reliant on the rest-of-the-world (RoW) as a net lender (see chart above). The HH sector, which plays a critical role in the UK economy (FCE/GDP) and bank lending, had been funding consumption by dramatically reducing its savings rate and accumulation of net financial assets and was poised to disappoint (see chart below).
Poised to disappoint – HH gross savings and savings ratio (Source: ONS; CMMP)Private sector net lending position as % GDP (Source: ONS; CMMP)
In the face of the pandemic, the UK private sector shifted to an unprecedented net lending position of 21% GDP, 13ppt above the 4Q09 post-GFC peak (see chart above). The HH sector alone moved from a net borrowing position of 0.4% GDP in 3Q19 to a net lending position of 15% GDP in 2Q20 as the HH savings ratio rose to a record high of 23% GDP (see chart below).
A record high in HH savings (Source: ONS; CMMP)
Extraordinary and co-ordinated responses to these extraordinary times came from the UK government and the Bank of England, including extensions to the furlough scheme and increases in the central bank’s buying programme. The responses were both timely and appropriate (see chart below). The UK government increased its net borrowing positions to 25% GDP in 2Q20 and 14% in 3Q20.
UK policy responses from a sector balances perspective (Source: ONS; CMMP)
According the latest ONS statistics, the net lending position of the UK private sector was still 6% GDP at the end of 2Q21, down from 10% in the previous quarter but still well above the LT (pre-COVID) average of just under 1% GDP. Both non-financial and financial corporations increased their net lending positions in 2Q21 to 1% of GDP respectively (see chart below).
Breakdown of private sector net financial balances (Source: ONS; CMMP)
In contrast, the HH’s net lending position fell from 9% GDP (£52bn) in 1Q21 to 5% GDP (£27bn) in 2Q driven by a recovery in spending. Note, however, that it remains double its LT average (see chart below). On a positive note, the HH savings rate fell to 12% in 2Q21 from 18% in 1Q21 (the second highest rate on record). The recent messages from the UK money sector suggest that HHs remain uncertain with monthly HH deposit flows rising again in August to double their pre-pandemic levels and demand for consumer credit remaining weak. So-called “faster-indicators” also indicate that credit and debit card payments remain below their pre-pandemic levels.
HH sector net lending position (Source: ONS; CMMP)
Conclusion
As the UK emerges from the COVID pandemic, large sector imbalances remain but in very different ways to the pre-COVID period. The private sector continues to disinvest, HHs remain uncertain and credit demand (ex-mortgages) remains subdued. UK HHs have built up c£160bn of excess savings during the pandemic but history suggests that (1) they take time to respond to shocks and (2) that unanticipated increases in wealth tend to be saved rather than spent.
The co-ordinated fiscal and monetary policy response to the pandemic was timely and appropriate but it remains premature to be discussing significant fiscal adjustments and/or an end to “bigger government”. Contrary to some of the current political rhetoric, budget outcomes are inappropriate goals in themselves. The correct budget outcome is the one that delivers a balanced economy, not a balanced budget.
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately.
In “August snippets – Part 1”, I highlighted the importance of disciplined investment frameworks. In this second snippet, I revisit the foundations of my CMMP Analysis framework. I start by describing how I combine three different time perspectives into a consistent investment thesis (“three pillars”). I then explain how the core banking services (payments, credit and savings) link different economic agents over time to form an important fourth pillar – financial sector balances. Finally, I present examples of how these four pillars combine to deliver deep insights into policy options and responses.
The central theme is my belief that the true value in analysing developments in the financial sector lies less in considering investments in banks but more in understanding the implications of the relationship between banks and the wider economy for corporate strategy, investment decisions and asset allocation.
Three perspectives – one strategy
As an investor, I combine three different time perspectives into a single investment strategy
My investment outlook at any point in time reflects the dynamic between them
My conviction reflects the extent to which they are aligned
Pillar 1: Long-term investment perspective
Example chart 1: growth trends in PSC illustrate how global finance is shifting East and towards emerging markets ($bn) (Source: BIS; CMMP analysis )
My LT investment perspective focuses on the key structural drivers that extend across multiple business cycles. Given my macro and monetary economic background, I begin by analysing the level, growth, affordability and structure of debt. These four features of global debt have direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options; investment risks and asset allocation. My perspective here reflects my early professional career in Asia and experience of Japan’s balance sheet recession. The three central themes are (1) global finance continues to shift East and towards emerging markets, (2) high, “excess HH growth rates” in India and China remain a key sustainability risk, and (3) progress towards dealing with the debt overhang in Europe remains gradual and incomplete. The following four links provide examples of LT investment perspectives:
Example chart 2:China’s HH debt ratio continued to rise sharply in 1Q20 – too much, too soon? (Source: National Bureau of Statistics; CMMP analysis)
Pillar 2 – Medium-term investment perspective
Example chart 3: growth rates in M1 and private sector credit demonstrate robust relationships with the business cycle through time and have proved more reliable indicators of recessions risks than the shape of the yield curve (Source: ECB; CMMP analysis)
My MT investment perspective centres on: analysing money, credit and business cycles; the impact of bank behaviour on the wider economy; and the impact of macro and monetary dynamics on bank sector profitability. Growth rates in narrow money (M1) and private sector credit demonstrate robust relationships with the business cycle through time. My interest is in how these relationships can assist investment timing and asset allocation. My investment experience in Europe shapes my MT perspective, supported by detailed analysis provided by the ECB. A central MT theme here is the fact that monetary developments: (1) have proved a more reliable indicator of recession risks than the shape of the yield curve; and (2) provide important insights into the impact, drivers and timing of the Covid-19 pandemic on developed market economies. The following four links provide examples of my analysis of MT investment perspectives:
Example chart 4: headling figures mask a more nuanced message from monthly flow data (Source: ECB; CMMP analysis)
Pillar 3: Short-term investment perspective
Example chart 5: banks played catch up from May 2020, but what kind of rally was this and was it sustainable? (Source: FT; CMMP analysis)
My ST investment perspective focuses on trends in the key macro building blocks that affect industry value drivers, company earnings and profitability at different stages within specific cycles. This perspective is influences by my experience of running proprietary equity investments within a fixed-income environment at JP Morgan. This led me to reappraise the impact of different drivers of equity market returns. I was able to demonstrate the “proof of concept” of this approach when I returned to the sell-side in 2017 as Global Head of Banks Equity Research at HSBC, most notably when challenging the consensus investor positioning towards European banks in 3Q17. A central ST theme is the importance of macro-building blocks in determining sector profitability and investment returns. The following four links provide examples of ST investment perspectives:
Example chart 6: why it was correct to question the conviction behind the SX7E rally during 2Q20 (Source: FT, CMMP analysis)
Pillar 4 – Financial Sector Balances
Example chart 7: Financial sector balances (and MMT!) can be understood easily by starting with the core services provided by banks to HHs and NFCs (Source: Bank of England; CMMP analysis)
In January 2020, I presented a consistent, “balance sheet framework” for understanding the relationship between the financial sector and the wider economy and applied it to the UK. I chose the UK deliberately to reflect the relatively large size of the UK financial system and the relatively volatile nature of its relationship with the economy. I extended this analysis to the euro area later. I began by focusing on the core services provided by the financial system (payments, credit and savings), how these services produce a stock of 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. Central themes here were the large and persistent sector imbalances in the UK, why the HH sector in the UK was poised to disappoint and why a major policy review was required in the euro area even before the full impact of the COVID-19 pandemic was felt. The following four links provide examples of FSB analysis:
Example chart 8: Pre-Covid, the UK faced large and persistent sector imbalances and was increaingly reliant on the RoW as a net lender (4Q sum, % GDP) (Source: ONS; CMMP analysis)
Policy analysis
Example chart 9: “Fuelling the FIRE” – split in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans) (Source: ECB; CMMP analysis)
These four pillars provide a solid foundation for analysing macroeconomic policy options and choices. Since September 2019, I have applied them to identifying the hidden risks in QE, to arguing why the EA was trapped by its debt overhang and out-dated policy rules, and to assessing the policy responses to the COVID-19 pandemic. Central themes have included: (1) the hidden risk that QE is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality; (2) why the gradual and incomplete progress towards dealing with Europe’s debt overhang matters; (3) why Madame Lagarde was correct to argue that the appropriate and required response to the current growth shock “should be fiscal, first and foremost”; and (4) how three myths from the past posed a threat to the future of the European project. The following four links provide examples of policy analysis:
Example chart 10: failing the “common sense test”. What was the point of running tight fiscal policies when the private sector was running persistent financial surpluses > 3% GDP (Source: ECB; CMMP analysis)
Please note that the summary comments and charts above are extracts from more detailed analysis that is available separately
Appropriate and necessary responses cannot hide on-going vulnerabilities
The key chart
Government debt ratios are expected to increase to new highs and by more than in response to the GFC- breakdown by region in percentage points for 2020 Source: IMF; CMMP analysis
Policy makers have introduced extraordinary fiscal and monetary policy measure in response to the crisis that have, in many cases, exceeded the measures introduced in the aftermatch of the GFC. These measures have been appropriate and necessary but cannot hide on-going regional and country vulnerabilities. Despite relatively high debt levels, advanced economies are positioned better than emerging and LIDC economies thanks to their ability to borrow at historically low rates that are likely to remain even after Covid-shutdowns end.
The EA policy response has been impressive in scale but assymetric in delivery and risk. Government debt levels across the EA are forecast to increase by between 4ppt and 24ppt taking the aggregate government debt ratio above 100% GDP. A major complicating factor here, is that the countries with the weakest economies, which includes those that have been hit hardest by the virus, have limited fiscal headroom to do “whatever it takes” to stimulate their economies. The sustainability of government debt levels in these economies is at risk of a more severe and prolonged downturn. The enduring myth that this is “the hour of national economic policy” means that this risk cannot be fully discounted. While the balance of power is shifting towards a common-European solution, execution risks remain.
Investment returns, including the impact of country and sector effects, will be driven by how this debate concludes as will the future of the entire European project.
Responses and vulnerabilities
The level, growth, affordability and structure of debt are key drivers of LT global investment cycles with direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options; investment risks and asset allocation.
Global debt levels and debt ratios were already at, or close to, all-time highs when Covid-19 hit Source: BIS; Haver; CMMP analysis
Global debt levels and debt ratios were at all time highs (levels), or very close to them (ratios), when the Covid-19 pandemic hit global economies. At the end of 2019, global debt totalled $191trillion of which $122trillion (64%) was private sector debt and $69trillion (36%) was public sector debt. Private sector debt included $57trillion (46%) of debt from advanced economies excluding the euro area (EA), $23trillion (18%) of EA debt, $15trillion (12%) of debt from emerging economies excluding China and $29trillion (24%) of Chinese debt.
“Global debt is shifting east” – trends and breakdown of private sector debt 1999-2019 ($billions) Source: BIS; Haver; CMMP analysis
The breakdown of global debt is largely unchanged since previous analysis. The total debt ratio (debt as a % of GDP) was 243% at the end of 2019, very close to its 3Q16 high of 245% GDP. Similarly, the global PSC debt ratio of 156% was also very close to its 3Q18 high of 159% of GDP. Total EM and Chinese debt ratios both hit new highs of 194% GDP and 259% of GDP respectively.
Trends in global and EA total debt and PSC debt ratios since 2004 – develeraging in the EA began later and has been more gradual than in other advanced economies Sourrce: BIS; Haver; CMMP analysis
The exception here was the euro area (EA) which remained, “trapped by its debt overhang and out-dated policy rules.” EA total debt and private sector debt ratios both peaked in 3Q15 at 281% and 172% respectively. At the end of 2019 these ratios had fallen to 262% and 165% respectively but remained above the respective global averages of 245% and 156%. As detailed in “Are we there yet?”, high debt levels help to explain why money, credit and business cycles in the EA are significantly weaker than in past cycles, why inflation remains well below target, and why rates have stayed lower for longer than many expected. In spite of this, the collective pre-crisis fiscal policy of the EA nations was (1) about as tight as any period in the past twenty years and (2) was so at a time when the private sector was running persistent net financial surpluses (largely above 3% GDP) since the GFC. A policy reboot in the EA was overdue even before the pandemic hit.
Covid-19 elevated the need for fiscal policy action to unprecedented levels (global budget deficit as a percentage of GDP, broken down by region) Source: IMF; CMMP analysis
Policy makers have introduced extraordinary fiscal and monetary policy measures in response to the crisis that have, in many cases, exceeded the measures introduced in the aftermath of the GFC. IMF forecasts suggest that the aggregate, global fiscal deficit will total -6.5% of GDP in 2020e versus -4.9% in 2009. The US will be the main driver (-2.37% GDP 2020e versus -1.63% 2009), followed by the EA (-1.01% GDP versus -0.85% GDP), China (-1.0% GDP versus –0.15%), emerging economies (-0.65% GDP versus -1.09% GDP) and the RoW (-1.17% GDP versus -1.20% GDP).
Global debt ratios expected to hit new highs (% GDP) in 2020e Source: IMF; CMMP analysis
As a result, government debt ratios are expected to reach new highs in 2020e of 96% of GDP a rise of 13ppt over 2019. Advanced economies’ government debt is expected to reach 122% GDP versus 105% in 2019 and 92% in 2009. Emerging markets’ government debt is expected to reach 62% GDP versus 53% in 2019 and 39% in 2009. LIDC government debt is expected to reach 47% GDP versus 43% in 2019 and 27% in 2009.
EM and LIDC debt levels remain relatively low in comparison with advanced economies, but are growing rapidly in contrast to more stable trends in advanced economies Source: IMF; CMMP analysis
While these responses have been necessary and appropriate, they have also exposed underlying vulnerabilities relating to the starting position of individual regions and countries with the advanced world being having greater reslience than emerging and LIDC economies (IMF classifications). The effectiveness of fiscal responses is a function of the level of debt, the cost of servicing that debt, economic growth and inflation. While debt levels in emerging and LIDC ecomomies remain relatively low in comparision with advanced economies they have continued to grow rapidly in contrast to the more stable trends in advanced economies (at least up until 2020).
LIDC borrowing costs have risen sharply and have become more volatile (interest expense to tax revenue) Source: IMF; CMMP analysis
Governments in advanced economies are able to borrow at historically low rates and these rates are forecast to remain low for a long period even after the Covid-induced shutdowns end (IMF, Global Financial Stability Review, April 2020). In contrast, for many frontier and emerging markets (and, at times, some advanced economies), borrowing costs have risen sharply and have become more volatile since the coronavirus began spreading globally (IMF, Fiscal Monitor, April 2020). These contrasting trends are illustrated in the graph above which shows IMF forecasts of LIDC interest to tax revenue ratios increasing from 20% in 2019 to 33% in 2020e. This compares with a ratio of 12% in 2009 and the current ratio of 10% for advanced economies (which is largely unchanged since 2009 despite the increase in government debt levels).
Trends in EA budget deficits (% GDP) – the EA policy response has been impressive in scale Source: European Commission; Haver; CMMP analysis
The EA policy response has been impressive in scale but assymetric in delivery and risk. All member states have introduced fiscal measures aimed at supporting health services, replacing lost incomes and protecting corporate sectors. Measures have included tax breaks, public investments and fiscal backstops including public guarantees or credit lines. According to European Commission forecast, the 2020e budget deficit for the EA will total -8.5% of GDP but will vary widely from between -4.8% in Luxembourg to -11.1% in Italy. The ECB notes that, while this projected headline is signficantly larger than during the GFC, it is comparable to the relative decline in GDP growth.
Debt levels across the EA are forecast to increase by between 4ppt (Luxembourg) and 24ppt (Italy), taking the aggregate EA government debt ratio to 103% GDP in 2020e. In its May 2020 Financial Stability Review, the ECB also notes that a number of countries, including Italy, Spain, France, Belgium and Portugal, “face substantial debt repayments needs over the next two years”. The key point here is that while current fiscal measures are important in terms of mitigating against the cost of the downturn and hence providing some defence against debt sustainability concerns, a worse-than-expected recession would give rise to debt sustainability risks in the medium term.
“Limited headroom” – forecast changes in government debt to GDP ratios plotted against 2019 actual debt to GDP ratios Source: European Commission; Haver; CMMP analysis
A major complicating factor here is that the countries with the weakest economies, which includes those that have been hit hardest by Covid-19, have limited fiscal headroom to do whatever it takes to stimulate their economies. The largest percentage point increased in government debt ratios are forecast to occur in Italy (24ppt), Greece (20ppt), Spain (20ppt) and France (18ppt) – compared with an increase of 17ppt for the EA as a whole – economies that ended 2019 with above average government debt to GDP ratios (135%, 177%, 95% and 98% GDP respectively).
Differences in funding costs for different EA economies versus Germany (spread in respective 10Y bond yields in ppt, 26 May 2020) Source: Haver; CMMP analysis
The sustainability of government debt levels in already highly indebted EA countries would be put at risk by a more severe and prolonged economic downturn. Funding costs are already higher in Greece (2.1ppt), Italy (2.0ppt), Spain (1.2ppt) and Portugal (1.1ppt) than in Germany based on current 10Y bond yields and more volatile – see graph of the spread between Italian and German 10Y bond yields below.
The spread between Italian and German 10Y bond yields continues to be volatile, highlighting the on-going debt sustainability risks (spread in ppt) Source: Haver; CMMP analysis
The enduring myth that this is “the hour of national economic policy” means that these risks cannot be discounted. The May 2020 Bundesbank Monthly Report states, for example, that, “fiscal policy is in a position to make an essential contribution to resolving the COVID19 crisis. [But] This is primarily a national task.” This view is also supported by the so-called “frugal four” ie, the Netherlands, Austria, Denmark and Sweden who have been opposed to various “common solutions”, most recently the EC proposal to issue joint debt to fund grants to those countries hit hardest by the crisis.
The EC is supported, however, by the ECB. In a recent interview, Christine Lagarde, the President of the ECB, argues that, “The solution, therefore, is a European programme of rapid and robust fiscal stimulus to restore symmetry between the countries when they exit from the crisis. In other words, more help must be given to those countries that need it most. It is in the interests of all countries to provide such collective support.”
The balance of power is shifting towards a common-European solution recently but execution risks remain. As I write this post (27 May 2020), Ursual von der Leyen, the EC President, has announced plans to borrow €750bn to be distributed partly as grants (€500bn) to hard-pressed member states – the “Next Generation EU” fund. Added to her other plans, this would bring the total EA recovery effort to €1.85trilion.
The scale of this intervention/borrowing is unprecedented and includes plans to establish a yield curve of debt issuance with maturities out to 30 years. Repayments would not start until 2028 and would be completed by 2058. France’s President Macron was among EA leaders who quickly welcomed this proposal and pressure is mounting on the so-called “frugal four” countries – Austria, Denmark, the Netherlands and Sweden – to soften their opposiion to the use of borrowed money for grants.
Investment returns, including the impact of country and sector effects, will be driven to a large extent by how this debate concludes, as will the future of the entire European project.
Please note that the summary comments 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.
