Tag: #strategy

“Beyond the headlines”

Growth, affordability (and structure) matter too

The key chart

Are the risks associated with excess growth re-emerging? Excess credit growth versus penetration rates (Source: BIS; CMMP)

The key message

Risks associated with “excess credit growth”, which had been declining in the pre-Covid period, have re-emerged during the pandemic.

Some of the highest rates of excess credit growth are currently occurring in economies where debt levels exceed maximum threshold levels (Singapore, France, Hong Kong, South Korea, Japan, Canada).

Affordability risks are also increasing within and outside (Sweden, Switzerland, Norway) this sub-set despite the low interest rate environment.

Risks are more elevated in the corporate (NFC) sector than in the household (HH) sector but are not unique to either the developed market (DM) or emerging market (EM) worlds – one more reason to question the relevance of the current DM v EM distinction

Much of the debate relating to global debt focuses exclusively on the level of debt and, to a lesser extent, on the debt ratio (debt as a percentage of GDP). This analysis highlights how the addition of growth and affordability factors provides a more complete picture of the risks associated with current trends and their investment implications.

Introduction

As noted above, much of the recent debate about global debt has been restricted to its level in absolute terms or as a percentage of GDP. The addition of other factors – the rate of growth in debt, its affordability and, in the case of many EMs, its structure – provides a more complete picture, however.

In this post, I add condsideration of the rate of growth in global debt to my previous analysis in “D…E…B…T, Part II.” The approach is based on the simple relative growth factor (RGF) concept which I have used since the early 1990s as a first step in analysing the sustainability of debt dynamics. I also link both to the affordability of debt as measured by debt service ratios (DSRs).

In short, this approach compares the rate of “excess credit growth” with the level of debt penetration in a given economy. The three-year CAGR in debt is compared with the three-year CAGR in nominal GDP to derive a RGF. This is then compared with the level of debt expressed as a percentage of GDP (the debt ratio).

The concept is simple – one would expect relative high levels of excess credit growth in economies where the level of leverage is relatively low and vice versa. Conversely, red flags are raised when excess credit growth continues in economies that exhibit relatively high levels of leverage or when excess credit growth continues beyond previously observed levels.

The key trends

Rolling private sector RGF for all BIS reporting, developed and emerging economies (Source: BIS; CMMP)

In the pre-COVID period, the risks associated with excess credit growth had been declining in developed (DM) and emerging (EM) economies (see chart above illustrating rolling RGF trends). In response to the pandemic, however, credit demand has risen while nominal GDP has fallen sharply. As a result, the RGF (as at the end of 3Q20) for all economies, DM and EM have risen to 3%, 2% and 4% respectively. As can be seen, these levels are elevated but remain below those seen in previous cycles during the past 15 years.

Private sector credit snapshots

Excess PS credit growth versus PS debt ratios as at end 3Q20 (Source: BIS; CMMP)
Top ten ranking of private sector RGF by country (Source: BIS; CMMP)

Importantly, out of the top-ten economies experiencing the highest rates of excess private sector credit, six have private sector debt ratios higher than the threshold levels above which debt is considered a constraint to future growth – Singapore, France, Hong Kong, South Korea, Japan and Canada. In the graph above, and in similar ones below, the orange bar indicates where debt ratios exceed the threshold level.

Excess PS credit growth versus PS debt ratios as at end 3Q20 in LATEMEA (Source: BIS; CMMP)

Argentina and Chile have the highest private sector RGFs among the sample of LATEMEA economies. The associated risks are higher in the case of Chile than in Argentina given the two economies debt ratios of 169% GDP and 24% GDP respectively. As highlighted below, the risks in Chile relate primarily to excess growth in the NFC sector.

DSR and deviations from 10-year averages (Source: BIS; CMMP)

Within this subset, the debt service ratios in absolute terms and in relation to respective 10-year averages are also relatively high in France, Hong Kong, South Korea, Japan and Canada despite the low interest rate environment. Outside this subset, affordability risks are relatively high in Sweden, Switzerland and Norway where DSR’s are relatively high in absolute terms and in relation to each economy’s history.

NFC credit snapshots

Excess NFC credit growth versus NFC debt ratios as at end 3Q20 (Source: BIS; CMMP)
Top ten ranking of NFC RGF by country (Source: BIS; CMMP)

Similarly, out of the top-ten economies experiencing the highest rates of excess NFC credit, seven have NFC debt ratios above the threshold level (90% GDP) – Singapore, Chile, France, Canada, Japan, South Korea and Switzerland.

DSR and deviations from 10-year averages (Source: BIS; CMMP)

Within this second subset, the debt service ratios in absolute terms and in relation to respective 10-year averages are relatively high in France, Canada, Japan and South Korea. Despite lower rates of excess NFC credit growth affordability risks are also relatively high in Sweden, Norway and the US. (Note that the availability of sector DSRs is more restricted than overall private sector DSRs).

HH credit snapshots

Excess HH credit growth versus HH debt ratios as at end 3Q20 (Source: BIS; CMMP)
Top ten ranking of HH RGF by country (Source: BIS; CMMP)

In contrast, out of the top-ten economies experiencing the highest rates of excess HH credit, only two have HH debt ratios above the threshold level – Hong Kong and Singapore. This is not surprising given that HH debt ratios are lower than NFC debt levels in general. Of the 42 BIS reporting countries, 11 have HH debt ratios above the 85% GDP HH threshold level whereas 20 have NFC debt ratios above the 90% GDP NFC threshold level.

Rolling HH RGFs for China and Russia (Source: BIS; CMMP)

That said, experience suggests that the current levels of excess HH credit growth in China and Russia indicate elevated risks, especially in the former economy. In “Too much, too soon?“, posted in November 2019, I highlighted the PBOC’s concerns over HH-sector debt risks – “the debt risks in the HH sector and some low income HHs in some regions are relatively prominent and should be paid attention to.” (PBOC, Financial Stability Report 2019). Excess credit growth remains a key feature nonetheless.

DSR and deviations from 10-year averages (Source: BIS; CMMP)

Within this third subset, the debt service ratio in absolute terms and in relation to respective 10-year averages is relatively high in South Korea. Again, despite lower rates of excess HH credit growth, affordability risks are also relatively high in Sweden and Norway.

Conclusion

This summary post extends the analysis of the level of global debt and debt ratios to include an assessment of the rate of growth in debt and its affordability. Together, these factors provide a more complete picture of the sustainability of current debt trends.

Risks associated with excess credit growth are re-emerging and will be a feature of the post-COVID environment going forward. The two key risks here are: (1) some of the highest rates of excess credit growth are currently occurring in economies where debt levels exceed threshold levels; and (2) affordability risks are increasing within (and outside) this sub-set despite the low interest rate environment.

To some extent, little of this is new news – I have been flagging the same risks in an Asia context for some time – and the implications are the same. Despite recent market moves, the secular support for rates remaining “lower-for-longer” remains, albeit with more elevated sustainability risks in the NFC sector.

“D…E…B…T, Part II”

Revisiting the level and structure of global debt six months on

The key chart

What are the implications of new highs in global debt and debt ratios? (Source: BIS; CMMP)

The key message

Global debt hit new highs in absolute terms ($211tr) and as a percentage of GDP (277%) at the end of 3Q20, driven largely by government ($79tr) and NFC debt ($81tr).

Public sector and NFC debt ratios both hit new highs above the maximum threshold level that the BIS considers detrimental to future growth.

These trends provide on-going support for the “lower-for-longer” narrative but also raise concerns about sustainability risks in the NFC sector.

The US and China account for nearly 50% of global debt alone and more than 75% with Japan, France, the UK, Germany, Canada and Italy – but only Japan and France are included in the top-ten most indebted global economies.

The post-GFC period of private sector deleveraging/debt stability in advanced economies has ended as the private sector debt ratio increased to 179% GDP.

China’s accumulation of debt has eclipsed the “EM catch-up story”. Chinese debt now accounts for just under 70% of EM debt and EM x China’s share of global debt has remained unchanged over the past decade.

The traditional distinction between advanced/developed markets and emerging markets is increasingly irrelevant/unhelpful, especially when analysing Asian debt dynamics.

New terms of reference are required for analysing global debt trends that distinguish between economies with excess HH and/or corporate debt and the rest of the world. From this more appropriate foundation, further analysis can be made of the growth and affordability of debt…

D…E…B…T, Part II

Breakdown of global debt and trend in debt ratio since 2008 (Source: BIS; CMMP)

Global debt hit new highs in absolute terms and as a percentage of GDP at the end of 3Q20, driven largely by public sector debt and NFC debt. According to the BIS, total debt rose from $193tr at the end of 1Q20 to a new high of $211tr. Within this:

  • Government, NFC and HH debt all hit new absolute highs of $79tr, $81tr and $51tr respectively
  • The global debt ratio increased from 246% GDP in 1Q20 to a new high of 278% GDP
  • The public sector debt ratio increased from 88% GDP to 104% GDP and the NFC debt ratio increased from 96% GDP to 107% GDP over the same period. In both cases, the debt ratio was a new high and above the maximum threshold level of 90% above which the BIS considers the level of debt to become a constraint on future growth
  • The HH debt ratio also increased from 61% GDP to 67% but remains below its historic peak of 69% (3Q09) and the respective BIS threshold level of 85% GDP.

These trends provide on-going support for the “lower-for-longer” narrative but also raise concerns about sustainability especially in the NFC sector.

3Q20 ranking of BIS reporting economies by total debt and cumulative market share (Source: BIS; CMMP)

The US and China account for nearly 50% of global debt, but neither is ranked in the top-15 most indebted economies. At the end of 3Q20, total debt reached $61tr (29% global debt) in the US and $42tr in China (20% global debt). In absolute terms, these two economies are followed by Japan $21tr, France $10tr, UK $8tr, Germany $8tr, Canada $6tr and Italy $tr. In other words, the US and China account for almost a half of global debt and together with the other six economies account for over three-quarters of global debt. Note, however, that only two of these eight economies rank among the top-ten most indebted global economies (% GDP).

3Q20 ranking of BIS reporting economies by total debt as % GDP (Source: BIS; CMMP)

The post-GFC period of private sector deleveraging/debt stability in advanced economies has ended as the private sector debt ratio rose to 179% GDP, close to its all-time-high. Following the GFC, the private sector debt ratio in advanced economies had fallen from a peak of 181% GDP in 3Q09 to 151% in 1Q15. It had then stabilised at around the 160% of GDP level.

Private sector debt in advanced economies in absolute terms and as % GDP (Source: BIS; CMMP)

As discussed in “Are we there yet?”, this had direct implications for the duration and amplitude of money, credit and business cycles, inflation, policy options and the level of global interest rates. In subsequent posts, I will examine the implications of these recent trends on the sustainability and affordability of private sector debt in advanced economies.

Trends in China’s private sector debt and share of EM private sector debt (Source: BIS; CMMP)

China’s accumulation of debt has eclipsed the “EM catch-up story”. Fifteen years ago, China’s debt was just under $3tr and accounted for 35% of total EM debt. At the end of 3Q20, China’s debt had increased to $33tr to account for 67% of total EM debt. The so-called EM catch-up story is in effect, the story of China’s debt accumulation. Excluding China, EM’s share of global debt in unchanged (12%) over the past decade.

China and EMx China’s share of global debt (Source: BIS; CMMP)

The traditional distinction between advanced/developed markets and emerging markets is increasingly irrelevant/unhelpful, especially when analysing Asian debt dynamics. The BIS classifies Asian reporting countries into two categories: three “advanced” economies (Japan, Australia and NZ) and eight emerging economies (China, Hong Kong, India, Indonesia, Korea, Malaysia, Singapore and Thailand).

Asian NFC and HH debt ratios (Source: BIS; CMMP)

The classification of Japan, Australia and New Zealand as advanced economies is logical but masks different exposures to NFC (Japan) and HH (Australian and New Zealand) debt dynamics.

The remaining grouping is more troublesome as it ignores the wide variations in market structure, growth opportunities, risks and secular challenges. I prefer to consider China, Korea, Hong Kong and Singapore as unique markets. China is unique in terms of the level, structure and drivers of debt and in terms of the PBOC’s policy responses. Korea and Hong Kong stand out for having NFC and HH debt ratios that exceed BIS maximum thresholds. Hong Kong and Singapore are distinguished by their roles as regional financial centres but have different HH debt dynamics. Malaysia and Thailand can be considered intermediate markets which leaves India and Indonesia as genuine emerging markets among Asian reporting countries (see “Sustainable debt dynamics – Asia private sector credit”).

Global NFC and HH debt ratios (Source: BIS; CMMP)

New terms of reference are required for analysing global debt trends that distinguish between economies with excess HH and/or corporate debt and the rest of the world. In this case, excess refers to levels that are above the BIS thresholds. Among the BIS reporting economies (and excluding Luxembourg) there are:

  • Eight economies with excess HH and NFC debt levels: Hong Kong, Sweden, the Netherlands, Norway, Denmark, Switzerland, Canada and South Korea
  • Eleven economies with excess NFC debt levels: Ireland, France, China, Belgium, Singapore, Chile, Finland, Japan, Spain, Portugal, and Austria
  • Three economies with excess HH debt levels: Australia, New Zealand, the UK
  • The RoW with HH and NFC debt levels below the BIS thresholds

These classifications provide a more appropriate foundation for further analysis of the other, key features of global debt – its rate of growth and its affordability. These will be addressed in subsequent posts.

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

“Riding to the rescue”

Or are UK HHs poised to disappoint again?

The key chart

Historic and forecast trends in HH net savings (% GDP, rolling annual average) (Source: OBR; CMMP)

The key message

UK households (HHs) play a vital role in the UK economy and in the demand for credit. Looking forward, the key question is will the HH sector ride to the rescue or is it poised to disappoint again?

Official forecasts assume a strong recovery in HH consumption over the 2H21 as the economy starts to open. If all the additional savings accumulated during the pandemic were spent over the next four quarters, it would add c.6% to consumption in 2021 and 2020. Such a bullish scenario is unlikely for three reasons:

  • HHs typically save most unanticipated sources of wealth rather than spend them
  • The rise in savings is skewed towards high-income households who typically have lower marginal propensities to consume;
  • History suggests that HHs (and NFCs) typically take time to re-adjust after periods of significant financial and/or economic shock.

That said, the scale of accumulated HH savings provides support for a more rapid re-adjustment than after the GFC (the central OBR forecasts is consistent with HHs on average spending 5% of the extra deposits) and suggests that the UK has a higher level of gearing to a recovery than the euro area (EA). Potentially good news for suppliers of consumer durables…

Riding to the rescue

HHs matter

UK households (HHs) play a vital role in the UK economy and in the demand for credit. HH consumption accounts for 65p in every pound of UK GDP and lending to HHs accounts for 66p in every pound of M4 Lending. HHs are important investors in financial and non-financial assets (mainly property), with balance sheets skewed towards financial assets. The sector is typically a net saver/net lender in the UK (and other developed economies). However, notable shifts in the HH net financial balances have occurred in the post-GFC period and during the COVID-19 pandemic. A key theme in the analysis below it that the unwinding of HH savings built up during the pandemic will play an important role in determining the scale, pace and sustainability of any economic recovery.

Disappoint or ride to the rescue?

Looking forward, the key question is will the HH sector ride to the rescue or is it poised to disappoint again? The sector was poised to disappoint at the start of 2020 with risks to official forecasts tilted clearly to the downside.

HH debt (LHS, £bn) and debt/GDP ratio (RHS, %) (Source: BIS; CMMP)
HH gross savings (LHS, £bn) and savings rate (RHS, %) (Source: ONS; CMMP)

HH debt levels peaked at 96% GDP in 1Q10 and, after a period of “passive deleveraging”, stabilised at c.85% GDP from 2Q14 onwards (note that 85% GDP is the maximum threshold level above which the BIS assumes that debt becomes a constraint on future growth). Despite low debt servicing costs, HHs chose to fund consumption by slowing their rate of savings (and accumulation of net financial assets) rather than by increasing their debt levels. With real growth in disposable income slowing, however, and with the savings rates still close to historic lows, the risks to HH consumption and GDP growth were tilted clearly to the downside before COVID-19 hit.

20192020e2021e2022e2023e2024e2025e
GDP (%)1.4-9.94.07.31.71.61.7
HH cons. (ppt)0.7-7.11.87.00.81.10.8
Forecasts for GDP growth and contribution from HH consumption (Source: OBR; CMMP analysis)

Official forecasts assume a strong recovery in HH consumption over the 2H21 as the economy starts to open (see table above). After falling 11% in 2020, HH consumption is forecast to recover 2.9% in 2021, contributing 1.8ppt to GDP growth of 4.0% and then to grow 11.1% in 2022 contributing 7.0ppt to GDP growth of 7.3% (OBR, March 2021 forecasts).

What if?

If all the additional savings accumulated during the pandemic were spent over the next four quarters, it would add c6% to consumption in 2021 and 2020. In recent posts, I have noted the increase in HH deposits (“COVID-19 and the flow of financial funds in the UK”).

HH money monthly flows and 2019 average monthy flow (Source: BoE; CMMP)

HHs increased their deposits by £100bn in the first three quarters of 2020 and by a further £53bn in the 4Q20 alone. The OBR expects the level of “additional deposits” to reach £180bn by the middle of 2021. In the unlikely scenario that all these additional deposits were spent over the next four quarter, the OBR estimates that it would add c6% to consumption in 2021 and 2020.

Not so fast…

Such a positive scenario is unlikely for three key reasons. First, HHs typically save most unanticipated sources of wealth rather than spend them. Traditional consumption theory suggests that rather than spending all of an unanticipated increment to their wealth immediately, HHs are instead more likely to save most of it to allow for higher consumption in the future. An autumn 2020 BoE survey supports this theory. Only 10% of HHs planned to spend the additional savings built up during the pandemic. In contrast, around 66% planned to retain them in their bank account. (Note, that the first of the CMM three key charts for 2021 measures monthly HH deposit flows in relation to past trends).

NMG survey responses on what HHs plan to do with additional savings built up during the pandemic (Source: BoE; OBR; CMMP)

Second, the rise in savings is skewed towards high-income HHs. Another recent BoE survey notes that 42% of high-income HH were saving more and 16% saving less, compared to 23% of low-income HHs saving more and 24% saving less. This matters because high-income HHs typically have lower marginal propensities to consumer than low-income HHs. Empirical evidence suggests that annual spending typically rises by between 5-10% of unanticipated, incremental increases in wealth.

HH net savings (%GDP) 2007-2017 (Source: ONS; CMMP)

Third, history suggests that HHs (and NFCs) typically take time to re-adjust after periods of significant financial and/or economic shock. In the aftermath of the GFC, for example, the net savings of the HH sector peaked at 6.1% GDP in 2Q10. It took 26 quarters before net savings fell below 2% GDP (4Q16).

How COVID-19 altered the OBR’s forecasts for HH net savings (Source: OBR; CMMP)

The COVID-19 pandemic was a greater financial, economic (and mental) shock than the GFC. In response, the HH sector’s net savings increased from 0.4% at the end of 2019 to 7.0% in 3Q20. OBR forecasts indicate that net savings increased to 8.7% at year-end and are expected to peak at 10.4% GDP in 1Q21 (4.3ppt higher than post-GFC). Their forecasts also assume a rapid re-adjustment by HHs as vaccination levels rise and the economy re-opens with HH net savings falling below 2% by 3Q22 (ie, in six quarters) and remaining below 0.5% out to 1Q26. In my view, risks to these assumptions lie to the downside ie, HH net savings will remain higher than forecast here as HHs maintain larger precautionary savings.

But, what if size does matter…

The scale of accumulated HH savings provides support, however, for a more rapid re-adjustment than after the GFC and suggest that the UK has a higher level of gearing to a recovery than the euro area (EA).

The central OBR forecasts is “consistent with HHs on average spending 5% of the extra deposits accumulated during the pandemic each year, but somewhat front loaded into 2H21 and 1H22.” In other words, the OBR forecasts suggest that c.25% of the total stock of £180bn built up during the pandemic will have been used for consumption by 1Q26. This seems a reasonable assumption, in my view.

UK and EA HH monthly deposit flows expressed as a multiple of 2019 average monthly flows (Source: BoE; ECB; CMMP)

Note also that the “messages from the money sector” indicate that the scale of additional deposit flows in the UK, in relation to past trends, is higher in the UK than in the EA. In December 2020, for example, the monthly flow of HH money (£20bn) was 4.5x the average monthly flow recorded in 2019. In the EA, the respective multiple was 1.8x.

Potential beneficiaries?

If correct, the rebound in HH consumption is potentially good news for suppliers of consumer durables. So-called “social consumption” will naturally benefit too, but there is only so much lost time that can be made up (you can only eat so many meals in one day!). It is reasonable to assume, therefore, that a large proportion of additional expenditure is directed towards durable goods whose consumption is more likely to have been delayed during lockdown (eg, car sales).

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

“COVID-19 and the flow of financial funds in the UK”

How did the flow of funds between sectors change?

The key chart

Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn) (Source: OBR; BoE; ONS; CMMP)

The key message

The OBR’s “Economic and fiscal outlook – March 2021” provides valuable insights into the impact of the COVID-19 pandemic on the flow of funds between the different sectors of the economy.

The UK government issued £227bn gilts in the first three quarters of 2020 to finance the support given to HHs and NFCs (and increased it net liability position by £130bn).

The BoE purchased a similar quantity of gilts in the secondary market (via APF) and financed this through the issuance of reserves. These reserves form liquid assets for the rest of the financial sector, counterbalanced by additional deposits from HHs and NFCs. Note that the net asset/liability positions of the money sector (the BoE and FIs) remained broadly unchanged at this point.

HHs increased their deposits by £102bn and their net asset position increased by £111bn. This increase in HH savings was intermediated to the UK government via the money sector, meaning that UK HHs have been the most important source of additional lending during the pandemic.

In contrast, the net lending position of NFCs and the RoW remained broadly unchanged.

Understanding how these flows will be unwound in the post-COVID period is the key to determining the speed and duration of the recovery in the UK economy. My next post will examine the HH sector dynamics in more detail.

Recall that the financial sector balances approach reognises that any net borrowing by one sector must be accompanies by net lending from another sector(s). The table below illustrates this balance in practice during the COVID-19 pandemic.

£ bnC Bk reservesCurr. & dep’sGiltsLoans and debtOtherTotal
Gov0-13-2274465-130
BoE APF-25902312800
FIs ex-APF259-20447-47-478
HHs0102126-18111
NFCs01231-79-3016
RoW0-9-532730-5
Balance000000
Net borrowing by one sector must be accompanied by net lending from another sector(s) (Source: OBR; BoE; ONS; CMMP)

COVID-19 and the UK flow of funds

The OBR’s “Economic and fiscal outlook – March 2021” provides valuable insights into the impact of the COVID-19 pandemic on the flow or funds between the different sectors of the economy. The analysis compares the patterns of financial flows between the five key sectors in the economy – HHs, NFCs, FIs, government and the RoW – in the first three quarters of 2020 and the final three quarters of 2019.

Recall that the financial sector balances approach recognises that any net borrowing of one sector must be accompanied by net lending from another sector(s).

Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn) (Source: OBR; BoE; ONS; CMMP)

As highlighted in my previous post, the UK government has provided unprecedented support to HHs and NFCs during the COVID pandemic. According to the OBR, this was financed (in net terms) by issuance of £227bn in gilts in the first three quarters of 2020. This compares with £34bn issuance in the final three quarters of 2019. The net liabilities of the government increased by £130bn over the period.

A similar quantity of gilts (£231bn) was purchased on the secondary market by the BoE’s Asset Purchase Facilty (APF) as part of quantitative easing (QE). The BoE financed this purchase by issuing an equivalent amount of its own liabilities (reserves). As a result the Bank’s net asset/liability position was unchanged.

Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn) (Source: OBR; BoE; ONS; CMMP)

The reserves issued by the BoE constitute assets for the rest of the UK financial sector. The counterpart/balance to these reserves is mainly the additional deposits from HH and NFCs that arose from the government’s support measures. Note again, that the net lending position of the financial sector remained broadly unchanged at this point.

Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn) (Source: OBR; BoE; ONS; CMMP)

The rise in HH deposits has been a consistent message from the money sector in 2020. The OBR notes that HH deposits increased by £102bn in the first three quarters in 2020. These savings have been intermediated to the government via the financial sector and the BoE through the flows described above. The net assets of the HH sector increased by £111bn.

Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn) (Source: OBR; BoE; ONS; CMMP)

The NFC sector also increased its deposits by £123bn over the period, while increasing net loans and other liabilities by £109bn. In aggregate, the net lending of NFCs changed little as a result but this masks significant differences in the experience of firms in different sectors.

Change in net aquisition of assets between first 3Qs 2020 and final 3Qs 2019 (£bn) (Source: OBR; BoE; ONS; CMMP)

Foreign investors have played a limited role in the financing the increase in UK government borrowing over the period. The net lending positions changed little over the first nine months of 2020.

Conclusion

The COVID-19 pandemic and the associate responses from the UK government led to significant changes in the flow of funds between the key economic agents. The composition of these flows changed for most sectors but the main changes in net assets and liabilities were recorded by the HH and government sectors.

UK HHs represent an important source of additional lending over this period, with the increase in their liquid savings being intermediated to the government via the money sector (financials and the BoE).

The OBR is forecasting a 4% increase in real GDP in 2021 from a fall of 9.9% in 2022, followed by growth of 7.3%, 1.7%, 1.6% and 1.7% in the next four years out to 2025 respectively. The pace and sustainability of these forecasts depend on how the financial flows described above are unwound. In the next post, I will examine the outlook for the HH and NFC sectors in more detail.

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

“Patience, patience…”

Three key signals – January 2021 update

The key chart

The biggest fail so far – money and credit cycles diverge even further in January 2021 (Source: BoE; ECB; CMMP)

Tke key message

Investors waiting in anxious anticipation for reflationary messages from the money sector will require some patience yet.

January 2020’s money supply data shows that households (HHs) in the UK and euro area (EA) continue to increase their holdings of liquid assets, money and credit cycles are diverging even further (to new highs), and consumer credit remains very weak. In other words, behind the headline figures, rising money supply in both regions remains a function of deflationary rather than inflationary forces – elevated HH uncertainty, relatively subdued demand for credit, and weak HH consumption. The drivers and implications of rapid money growth in the UK and the EA are very different from past cycles. Behind the headlines, and with three fails so far, the message from the UK and EA money sectors remains the same – “not so fast”.

Three key signals – January 2021

Fail #1 – monthly flows in HH money holdings expressed as a multiple of 2019 average monthly flows (Source: BoE; ECB; CMMP)

HHs in the UK and the EA continue to increase their holdings of highly liquid assets. In response to the COVID-19 pandemic, the levels of forced and precautionary savings have risen sharply. Today’s (1 March 2021) data release from the BoE, shows UK HHs increasing their money holdings by £18.5bn in January 2021, 4x the average monthly flows recorded in 2019. This is despite the fact that the effective interest rate paid on new time deposits remains at the lowest level (0.42%) since the series began. As noted, in my previous post, January’s monthly flows of HH deposits in the EA (€60bn) also remained almost 2x their 2019 average.

Money sitting idly in savings accounts contributes to neither GDP nor inflation.

Fail #2 – the gap between the money and credit cycles have widened to new record levels (Source: BoE; ECB; CMMP)

Rather than re-synching with each other, money and credit cycles in both regions widened to historic degrees in January 2021. The gap between the YoY growth in UK money (15.0%) and lending (4.4%) widened to a record 10.6ppt in January, while the gap between EA money (12.5%) and lending (4.4%) widened to 8.1ppt. Credit demand remains relatively subdued in both regions, despite the low cost of borrowing, while money supply has accelerated.

Fail #3 – growth rates (% YoY) of consumer credit in the UK and EA (Source: BoE; ECB; CMMP)

Consumer credit growth remains very weak. In the UK, HHs made net repayments of consumer credit of £2.4bn, the largest repayment since May 2020. The annual growth rate of -8.9% is yet another series low since the series began in 1994. Similarly, the -2.5% fall in consumer credit in the EA was the weakest level since February 2014.

Note that consumer credit represents one section of more productive COCO-based lending. It supports productive enterprise since it drives demand for goods and services, hence helping NFCs to generate sales, profits and wages. As before, with HHs hoarding cash and lockdown measure remaining in place, this weakness in consumer credit is not unexpected.

Conclusion

I have explained previously that the drivers and implications of rapid money supply growth in the UK and the EA are very different from past cycles and that the message from the money sectors in both regions for investors positioned for a sustained rise in inflation was, “not so fast.” The message from January’s data releases remains the same. Patience, patience…

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

“What if…”

…EA yield curves steepen but ST rates stay low?

The key chart

10y-3m yield curves (7dMVA) in the US, Germany and France since 2018 (source: zeb; CMMP)

The key message

The gradual steepening of EA yield curves has led to renewed questions about the relative importance of the shape of the yield curve vis-à-vis the level of ST rates for the region’s banks (and their share price performance).

Banks’ NIMs have a positive relationship with both factors but, generally, the former is more important in countries and sectors exposed to higher fixed-rate lending and vice versa. Despite a shift away from floating-rate lending since 2009, just under 60% of all new loans to HHs and NFCs in the EA carry a floating rate. In other words, sensitivity to the level of ST rates remains high. As always, however, significant variations exist at the country, sector (and individual bank) levels. In France and the Netherlands, for example, only 36% of new loans carry a floating rate and only 15% of new mortgage loans for the entire EA carry a floating rate.

A scenario of steeper yield curves combined with delayed ST rate rises is broadly positive for the sector, and would favour fixed-rate countries (France, Netherlands, Belgium) and fixed-rate mortgage lending markets (France, Belgium, Germany, Netherlands, Italy, Ireland, Spain, Austria). This is very different from the (short-lived) period in early 2018 when expectations focused on higher ST rates combined with flatter yield curves. This favoured floating-rate economies (Finland, Portugal, Italy, Austria and Spain), NFC-lending sectors and floating-rate mortgage markets (Finland, Portugal) and led to brief outperformance from Italian, Spanish banks (and Erste Bank).

Investors’ expectations were dashed ultimately in 2018 and the case for a sustained steepening in EA yield cases remains unproven today (especially given M Lagarde’s comments on 22 February that the ECB was “closely monitoring” the market for government bonds).

On Thursday this week (25 February), the ECB will release its first review of monetary developments in the EA for 2021. As noted in my previous post, the key signals to look for then and in subsequent 2021 releases are: a moderation in monthly deposit flows; a resynching of money and credit cycles; and a recovery in consumer credit.

“What if?” – The charts that matter

Trends in German and French 10y-3m yield curves (7d MVA) over past 6 months (Source: zeb; CMMP)

Yield curves in the euro area’s (EA) two largest economies have steepened YTD (see chart above) albeit to a lesser extent than in the US (see key chart). This leads to the obvious question about the relative importance of the shape of the yield curve vis-à-vis the level of ST rates for the region’s banks (and their share price performance).

Yield curves versus ST rates – the background

Banks’ net interest margins (NIMs) have a positive relationship with both the shape of the yield curve and the level of ST rates. In short, this reflects two core functions of services that banks provide – a maturity transformation service (yield curve) and a deposit transaction service (ST rates). The relative importance of each factor depends largely on whether lending is predominantly fixed or floating-rate lending.

The slope of the yield curve is more relevant in countries or sectors with relatively high exposure to fixed-rate lending. In contrast, changes in ST rates have a greater impact on net interest margins in countries or sectors that are characterised by floating-rate lending. Furthermore, banks prefer a fixed rate when they expect reference rates to decline in the future and prefer a variable rate when they expect reference rates to increase. Borrowers have opposite preferences. In this regard, differences between loan characteristics provide an indication about the expectations of banks and borrowers with respect to the evolution of rates and their respective bargaining power. This in turn depends on factors such as banks’ funding conditions, competitive dynamics and borrowers’ levels of solvency.

(The impact of bank size is acknowledged here but is beyond the scope of this summary. However, it is worth noting that bank size may also have an impact on the sensitivity to both factors. This reflects the fact that larger banks are typically able to hedge their interest rate risk exposures better than smaller banks.)

Yield curves versus ST rates – the EA context

Share of new loans to HH and NFC with a floating rate (Source: ECB; CMMP)

Despite a shift away from floating-rate lending since 2009, 59% of all new loans to HHs and NFCs in the EA carry a floating rate (or an initial fixation period of up to one year). The peak level of floating rate lending in the past 15 years occurred after the GFC in January 2009 (84%). The lowest level occurred very recently in November 2020 (55%). As explained below, this trend affects both country and sector effects.

The key point here is that, while the sensitivity to the shape of the yield curve has increased, EA banks remain highly sensitive to the level of ST rates (at the aggregate level).

Share of new loans to HH and NFC with a floating rate by country, December 2020 (Source: ECB; CMMP)

As always, however, significant variations exist at the country, sector (and individual bank) levels. The highest shares of floating-rate lending in new loans are currently found in Finland (93%), Portugal (78%), Italy (73%), Austria (68%), Spain (68%) and Ireland (66%). In contrast floating-rate lending in the Netherlands and France accounts for only 37% and 36% of total new loans respectively (see chart above).

Share of new mortgage loans with a floating rate (Source: ECB; CMMP)

While NFC lending remains largely floating-rate, only 15% of new mortages carry a floating rate (see chart above). Again significant differences exist here at the country level. The share of floating rate mortgages in total new mortgages ranges from highs of 98% and 67% in Finland and Portugal respectively to lows of 10%, 4% and 2% in Germany, Belgium and France respectively (see chart below).

Share of new mortgage loans with a floating rate by country, December 2020 (Source: ECB; CMMP)

Yield curves versus ST rates – different scenarios

A scenario of steeper yield curves combined with delayed ST rate rises is broadly positive for the sector, and would favour fixed-rate countries (France, Netherlands, Belgium) and fixed-rate mortgage lending markets (France, Belgium, Germany, Netherlands, Italy, Ireland, Spain, Austria).

This is very different from the (short-lived) period in early 2018 when expectations focused on a scenario of higher ST rates combined with flatter yield curves. This favoured floating-rate economies (Finland, Portugal, Italy, Austria and Spain), NFC-lending sectors and floating-rate mortgage markets (Finland, Portugal) and led to ST outperformance from Italian, Spanish banks (and Erste Bank).

Conclusion

Investors’ expectations were dashed ultimately in 2018 and the case for a sustained steepening in EA yield cases remains unproven today, especially given M Lagarde’s comments on 22 February that the ECB was “closely monitoring” the market for government bonds. This was interpreted as a sign that the ECB might act to prevent rising yields undermining any economic recovery.

On Thursday this week (25 February), the ECB will release its first review of monetary developments in the EA for 2021. As noted in my previous post, the key signals to look for then and in subsequent releases are: a moderation in monthly deposit flows; a resynching of money and credit cycles; and a recovery in consumer credit (see, “Three key charts for 2021”)

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

“Three key charts for 2021”

And the trends that investors SHOULD be looking for…

The key chart

Growth rates (% YoY) in UK and EA broad money aggregates (Source: BoE; ECB; CMMP)

The key message

Should investors positioned for an upturn in inflation and sustained outperformance from cyclical and value plays and/or shorter duration trades be hoping for stronger or weaker money supply growth in the UK and EA in 2021?

Contrary to the popular narrative, the answer is likely to be the latter not the former. In this post, I summarise why this is the case and highlight the three key charts to follow in 2021.

Over the past decade, we have witnessed a sustained shift in the components of broad money supply (M3) with greater contribution coming from holdings of the most liquid assets ie, narrow money (M1). The reaction of UK and EA households to the COVID-19 pandemic has accelerated this trend, as levels of forced and precautionary savings have risen sharply, particularly in the UK.

The challenge for inflation hawks here is that money sitting idly in savings accounts contributes to neither GDP nor inflation.

Analysis of the counterparts of monetary aggregate highlights the extent to which money and credit cycles are diverging in both regions. Within subdued overall levels of private sector credit demand, relatively robust NFC credit and resilient mortgage demand offset weakness in consumer credit during 2020. Weakness in consumer credit was more noticeable in the UK, where net repayments of £17bn made 2020 the weakest year for consumer credit on record.

There are three key signals among the messages from the money sector in 2021 to look for:

  • First, a moderation in monthly deposit flows
  • Second, a re-synching of money and credit cycles
  • Third, a recovery in consumer credit.

Trends in 2020, suggest that the UK has a relatively high gearing to each of these trends.

The charts that mattered in 2020

Share of narrow money in UK and EA broad money since 2010 (Source: ECB; BoE; CMMP)

Over the past decade, we have witnessed a sustained shift in the components of broad money supply (M3) with greater contribution coming from holdings of the most liquid assets ie, narrow money (M1). At the end of 2010, M1 accounted for 46% and 51% of M3 in the UK and EA respectively. By the end of 2020, these shares had risen to 67% and 71% respectively (see chart above).

In other words, changes in holdings of notes and coins and overnight deposits are having a greater impact on the behaviour of money supply. As noted in, “The yawning gap”, for example, M1 contributed 10.7ppt to the 12.3% growth in EA M3 in 2020.

Monthly flows of HH money in the UK (Source: BoE; CMMP)

The reaction of UK and EA households to the COVID-19 pandemic has accelerated this trend, as levels of forced and precautionary savings have risen sharply.

The first COVID-related death in the UK was recorded on 5 March 2020 and the first lockdown began 18 days later on the 23 March 2020. UK households increased their money holdings by £14bn, £17bn and £27bn in March, April and May 2020 respectively. This £58bn increase in holdings was greater than the total flow of £55bn recorded in 2019. Households began to increase then money holdings sharply again in October 2020, even though the second lockdown did not come into effect until 5 November 2020. In the last three months, UK households increases their money holdings by £13bn, £18bn and £21bn (£52bn in total), 3-4x the average monthly flows in 2019 (see chart above).

Monthly flows of HH deposits in the EA (Source: ECB; CMMP)

Similar household behaviour was seen in the euro area albeit with slightly different timings and scale. In the early stage of the pandemic, household deposits increased by €78bn and €75bn in March and April 2020 respectively, more than double the average 2019 monthly flows. In November and December 2020, monthly flows increased again to €61bn and €53bn (see chart above).

The challenge for inflation hawks here is that money sitting idly in savings accounts contributes to neither GDP nor inflation.

Growth in private sector credit minus growth in money supply in the UK and EA (Source: BoE; ECB; CMMP)

Analysis of the counterparts of monetary aggregate highlights the extent to which money and credit cycles are diverging in both regions. As noted last month, in typical cycles, monetary aggregates and their key counterparts move together. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing.

At the end of 2019, the gap between the growth in lending and the growth in money supply was 0.6ppt and -2ppt in the UK and EA respectively. By the end of 2020, these gaps had widened to record levels of -9.9pt and -7.6ppt (see chart above). Simply put, credit demand has remained relatively subdued in both regions, despite the low cost of borrowing, while money supply has accelerated.

Trends in NFC credit, mortgages and consumer credit since 2018 (Source: BoE; ECB; CMMP)

Within subdued overall levels of private sector credit demand, relatively robust NFC credit and resilient mortgage demand offset weakness in consumer credit during 2020 in both regions (see chart above). The YoY growth in NFC credit in the UK increased from 3.3% in 2019 to 7.7% in 2020. Similarly, the respective growth rates in the EA increased from 3.2% in 2019 to 7.0% in 2020. Mortgage growth in the UK moderated slightly from 3.4% in 2019 to 3.0% in 2020 but rose from 3.9% in 2019 to 4.7% in 2020 in the EA. Consumer credit grew 6.1% and 6.0% in the UK and EA in 2019 respectively, but fell 7.5% and 1.6% in 2020 respectively.

2020 monthly trends in HH consumer credit in the UK (Source: BoE; CMMP)
2020 monthly trends in HH consumer credit in the EA (Source: ECB; CMMP)

The weakness in consumer credit was more significant in the UK than in the EA. Net repayments of £17bn made 2020 the weakest year for consumer credit on record. UK households repaid consumer credit in the last four months of 2020 and the annual growth rate of minus 7.5% represented the weakest rate of growth since the series began in 1994 (see first of the charts above). EA households also repaid consumer credit in three of the last four months of 2020, but the YoY decline of minus 1.6% was more moderate than in the UK.

Conclusion and three charts to watch in 2021

A sustained upturn in inflation and outperformance from cyclical and value sectors and shorter duration trades will require confidence, consumption and investment to return fully. There are three key signals to look for in the messages from the UK and EA money sectors in 2021.

Monthly deposit flows as a multiple of the 2019 monthly average (Source: BoE; ECB; CMMP)

First a moderation in monthly deposit flows, especially by the household sector, and slower growth in narrow money (M1) and hence broad money (M3).

The yawing gap between money supply and private sector credit demand (Source: BoE; ECB; CMMP)

Second, a re-synching of money and credit cycles with a corresponding rebalancing in the counterparts of broad money growth.

Trends in YoY growth rates for UK and EA consumer credit (Source: BoE; ECB; CMMP)

Third, and finally, a recovery in consumer credit. Consumer credit represents one section of COCO-based lending (see “Fuelling the FIRE”). Its supports productive enterprises since it drives demand for goods and services, hence helping NFCs to generate sales, profits and wages.

The relative scale in the shift of money holdings and weakness in consumer credit suggests that the UK has a higher gearing than the EA to a reversal of 2020’s COVID-19 induced dynamics. Watch this space in 2021…

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

“Bouncing back”

Relative cheer from UK mortgages

The key chart

Positive volume trends (outstanding balances, monthly flows, YoY growth) for UK mortages in 4Q2020 (Source: BoE; CMMP)

The key message

UK mortgages provide some relative cheer among otherwise downbeat messages from the money sector:

  • Individuals borrowed £5.6bn in the form of mortgages in December 2020, unchanged from November, while repaying £1.0bn in consumer credit.
  • Quarterly flows (£15.9bn) in 4Q2020 were the highest since 1Q2008.
  • Despite this strong recovery, mortgage borrowing in 2020 (£43.3bn) was lower than in 2019 (£48.1bn) and current demand remains subdued in relation to previous cycles.
  • Looking forward, mortgage approvals (103,400) were the second highest since August 2007, and suggest positive future volume trends.
  • The effective interest rate on new mortgages rose 7bp in December to 1.9%, the highest rate since October and the spread between this and the rate on the outstanding stock narrowed to 22bp, from 55bp in February 2020.

Among mortgage providers, the sector winners are not simply riding these trends but are also increasingly embracing digitalisation across operations, sales, finance and risk management to differentiate themselves and improve the experience for their members.

The six charts that matter

Monthly flows in UK retail lending (£bn) for 2020 (Source: BoE; CMMP)

The UK mortgage market continues to provide some relative cheer among otherwise downbeat messages from the money sector (see chart above). Individuals borrowed an additional £5.6bn in the form of mortgages in December 2020, broadly unchanged from November. In contrast, households repaid £1.0bn in consumer credit, having repaid £1.5bn, £0.6bn and £0.8bn in the three preceding months.

UK mortgage volumes “bounced back” strongly from 2Q low (Source: BoE; CMMP)

Quarterly mortgage flows totalled £15.9bn in 4Q20 compared with £11.1b, £3.8bn and £12.5bn in the three preceding quarters respectively. As can be seen in the chart above, this was the largest quarterly flow in the past five years and the largest since 1Q2008.

But real growth remains subdued in relation to past cycles (Source: BoE; CMMP)

Despite this strong recovery, however, total 2020 mortgage borrowing of £43.3bn was below 2019’s total of £48.1bn. Current mortgage demand also remains subdued in relation to past cycles (see chart above). In real terms, the 3-month MVA for mortgage demand was only 2.3% in December 2020, essentially stable real growth over the 2H2020

Trends in approvals for house purchases (Source: BoE; CMMP)

.Looking forward and more positively, mortgage approvals, which have proved a reliable indicator of future lending, were 103,400 in December, the second highest level since August 2007 (see chart above), and totalled 818,500 in 2020, the largest yearly number since 2007.

Effective interest rates on new mortgages and on the outstanding stock (Source: BoE; CMMP)

The effective interest rate on new mortgages rose 7bp in December to 1.9%, the highest rate since October 2019 (see chart above). This rate remains below the rate on the outstanding stock of mortgages (2.12%) but the spread between the two effective rates has narrowed to 22bp from 55bp in February 2020 (see chart below).

Downward pressure on NIMs starting to ease? (Source: BoE; CMMP)

Among mortgage providers, the sector winners are not simply riding these trends but are also increasingly embracing digitalisation across operations, sales, finance and risk management to differentiate and improve the experience for their members.

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

“Out-of-synch”

What are the implications of the widening divergence between money and credit cycles?

The key chart

The widening gap between growth in lending and growth in money supply (Source: ECB; Bank of England; CMMP analysis)

The key message

Current money cycles in the EA and UK, (1) differ from previous cycles in terms of their drivers and implications, (2) are out-of-synch with the respective credit cycles, and (3) diverging from credit cycles at historically rapid rates. The implications here for growth, inflation, policy choices, investment returns and asset allocation are missing from many recent “2021 Investment Outlooks”.

Is it wise to ignore the “messages from the money sector”?

This week’s data releases show broad money growing at the fastest rate in the current money cycle in both the EA (11.0%) and the UK (13.9%). What is this telling us?

Households are increasing their money holdings at 2-4x the average 2019 monthly rate, delaying consumption and repaying existing consumer credit with negative implications for economic growth and inflation.

In terms of policy choices, monetary policy effectiveness requires stable relationships between monetary aggregates, but these are increasingly absent. The gap between growth rates in money supply and private sector credit demand is at record highs in both regions – one more reason to add to the list of why the required policy response is, “fiscal, first and foremost.”

For some, rising money supply suggests higher inflation in the EA and the UK and supports asset allocation shifts towards cyclical and value plays and shorter duration trades. The message from the money sector with elevated uncertainty, low confidence, weak consumption and subdued credit demand is, “not so fast.”

The charts that matter

Growth trends in EA and UK broad money aggregates in % YoY (Source: ECB; Bank of England; CMMP analysis)

This week’s ECB and Bank of England data releases show broad money growing at the fastest rate in the current money cycle in both the EA and the UK (see chart above). M3 in the EA grew 11.0% YoY in November 2020, up from 10.5% in October. M4ex in the UK grew 13.9% YoY in November 2020, up from 13.2%.

To understand what these trends are telling us, and to understand how the current money cycle differs from previous cycles, we need to examine both the components and counterparts to broad money rather than focus simply on the headline numbers.

Growth in M3 (% YoY) and contribution of M1 (ppt) to total growth (Source: ECB; CMMP analysis)

From a components perspective, we can see that growth in narrow money i.e. notes and coins in circulation and, more importantly, overnight deposits is the key driver of overall money growth (see chart above). In the EA, for example, M1 grew at 14.5% YoY and contributed 9.9ppt to the 11.0% YoY growth in M3. Overnight deposits grew 15.0% YoY and contributed 8.9ppt to the total growth alone.

Share of narrow money (M1) in broad money (M3) since 2000 (Source: ECB; Bank of England; CMMP analysis)

Recent trends are an extension/acceleration of longer-term secular shifts in the composition of EA and UK money supply (see chart above). Twenty years ago, M1 accounted for 42% and 48% of M3 in the EA and UK respectively. The shares were the same at the height of the GFC in 2008. Today, however, M1 accounts for 71% and 68% of M3 in the EA and the UK respectively. This increase in liquidity preference/money holdings reflects an increasingly lower opportunity cost of holding money as rates have fallen and, more recently, a sharp rise in both forced and precautionary savings by the regions’ households.

Trends in monthly HH deposit flows 2019-2020 YTD (Source: ECB; CMMP analysis)

Households are increasing their money holdings at 2-4x the average 2019 monthly rate, delaying consumption and repaying existing consumer credit with negative implications for economic growth and inflation. In the EA, household money holdings increased by EUR61bn in November, almost double the average flow of EUR33bn recorded during 2019 (see chart above). This reflects similar, albeit more volatile, trends in the UK highlighted in, “And now, the not-so-good-news” and to repeat the message in that post – money sitting in savings accounts does not contribute to GDP or higher inflation.

Trends in monthly consumer credit flows and YoY growth rate (Source: ECB; Bank of England)

EA households are not only delaying consumption, they are also repaying existing consumer credit. In November 2020, net repayments totalled EUR4bn, the largest amount since the peak of the first wave of the pandemic in April. On a YoY basis, consumer credit declined by 1.1%, the weakest level in the current slowdown (see chart above). In the UK, households repaid consumer credit for three consecutive months between September and November 2020 and YoY declines are the weakest since records began.

Repeating the key chart – the widening gap between growth in lending and growth in money supply (Source: ECB; Bank of England; CMMP analysis)

In terms of policy choices, monetary policy effectiveness requires stable relationships between monetary aggregates, but these are increasingly absent. The gap between growth rates in money supply and private sector credit demand is at record highs in both regions. In the EA, the gap between the supply of money (11.0%) and private sector demand for credit (4.7%) was 6.3ppt. In the UK, money supply grew 13.9%, 9.4ppt faster than private sector credit demand. This is one more reason to add to a lengthening list of why the required and sustained policy response should be, “fiscal, first and foremost.” In my next post, I will up-date my analysis to add another factor to this list i.e. credit is increasingly shifting towards less productive sectors of the economy (see also “Fuelling the FIRE – the hidden risk in QE“).

A preview of the theme in my next post – COCO-based versus FIRE-based lending (Source: ECB; CMMP analysis)

Conclusion

What does this all mean? (Source: ECB; Bank of England; CMMP analysis)

For some, rising money supply suggest higher inflation in the EA and the UK, and supports asset allocation shifts towards cyclical and value plays and shorter duration trades. The message from the money sector remains, “not so fast.”

One of my favourite current charts! Growth in M3 and contribution of M1 and PSC. (Source: ECB; CMMP analysis)

CMMP analysis of the components and counterparts of broad money tell a very different story from previous money cycles. The EA and UK money sectors are consistent signalling elevated uncertainty, low confidence, weak consumption and subdued credit demand – even before the introduction of further, more stringent lock-down policies in January 2021.

If there is a positive interpretation of current trends, it is that there is a large element of forced savings and hence pent-up consumer demand. That is true, but history also tells us that households and corporates can take time to adjust to major economic shocks and caution us against expecting a rapid reversal in confidence and consumption.

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

“Really?”

OBR forecasts from a sector balances perspective

The key chart

Historic and forecast trends in financial sector balances for the UK private sector, UK government and RoW expressed as % GDP (Source: OBR; CMMP analysis)

The key message

The latest OBR forecasts for the UK economy and public finances support my argument that recent UK policy responses to the Covid-19 pandemic were timely, necessary and appropriate and that the UK government will maintain an increasingly interventionist role in the UK economy.

However, from my preferred “financial sector balances perspective” there are obvious risks to their forecasts for UK growth and for the level of government borrowing. First, they assume unprecedented levels of dynamism from both the UK household and corporate sectors and behavioural trends from these sectors and from the RoW that contrast sharply with those seen after the GFC. Second, while the OBR claims that “sectoral net lending positons return to more usual levels,” this does not make them sustainable.

In short, the latest forecasts point to a post-Covid, post-Brexit UK economy returning rapidly to persistent private and public sector deficits and an increasing reliance on the RoW as a net lender. Really…?

The charts that matter

The Office for Budget Responsibility (OBR) published its latest “Economic and Fiscal Outlook” yesterday (25 November 2020) in which it set out its forecasts for the UK economy and public finances to 1Q26. I have analysed these forecasts from the perspective of UK financial sector balances ie, the financial relationship between UK households (HHs), corporates (NFCs), government (GG) and the rest-of-the-world (RoW). As explained in a series of posts earlier this year, this approach builds on the key accounting identity pioneered by the late Wynne Godley that states that:

Domestic private balance + domestic government balance + foreign balance (must) = zero

Trends in UK financial sector balalances since 2000 (Source: OBS; CMMP analysis)

The OBR’s analysis supports my view that the UK government’s policy response to the Covid-19 pandemic was timely, necessary and appropriate. The OBR expects the cost of government support to total £280bn in 2020, pushing the deficit to £394bn (19% GDP), the highest level since 1944-45 and the debt ratio to 105% GDP, the highest level since 1959-60. Seen through the context of financial sector balances, the OBR concludes that, “The spike in government borrowing [the green line above] …has meant that household and corporate incomes have not fallen nearly as fast as their output or expenditure.” Note that the OBR expects the household financial surplus [the blue line above] to rise to a historically high level of over 11% GDP, and the corporate balance to move from a deficit to a historically high surplus of 2.5% GDP.

The support provided to households and businesses has prevented an even more dramatic fall in output and attenuated the likely longer-term adverse effects of the pandemic on the economy’s supply capacity. And the Government’s furlough scheme has prevented a larger rise in unemployment. Grants, loans, and tax holidays and reliefs to businesses have helped them to hold onto workers, keep up to date with their taxes, and avoid insolvencies.

OBR, November 2020
Historic and forecast trends for UK government financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively. (Source: OBR; CMMP analysis)

The OBR forecasts also suggest that the UK government will continue to play an important part in economic activity. They predict that the government’s net borrowing peaks at -19% GDP in 1Q21, falls below -5% by 4Q22 and trends at around -4% GDP to 1Q26. These new forecasts imply higher levels of government borrowing than previously expected (note, there is no mention of balanced budgets or austerity). For government borrowing to fall in line with these expectations, HH and NFC spending have to rise more into line with income.

From a sector balances perspective, this is the point at which alarm bells begin to ring.

Historic and forecast trends for UK household financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively. (Source: OBR; CMMP analysis)

Turning to the key HH sector first, the OBR forecasts assume that the financial surplus will peak at just under 14% GDP in 1Q21 and then fall rapidly to under 2% GDP by 3Q22 in line with the previous March 2020 forecasts. The HH savings rate is expected to fall sharply from 28% GDP in 2Q20 to “settle at around 7.5% over the medium term.” This is below the average savings rate of 9% recorded between 1986 and 2019. The OBR argues that forced savings have played a greater role in the rise of HH savings than previously thought. Their new forecasts assume that, “more of the boost to HH finances from forced saving during the lockdown is spent as the economy returns to normality.” On this basis, the OBR now expects private consumption to return to its pre-virus peak by the middle of 2022, much earlier than they forecast in July 2020.

Historic and forecast trends in UK household savings rate (Source: ONS; OBR, CMMP analysis)
How the UK household sector adjusted in the post-GF C period – sector balances % GDP (Source: OBR; CMMP analysis)

To put these assumptions into a historic context, post the GFC, the HH sector’s financial surplus peaked at 6.1% GDP in 2Q10. It took 25 quarters for the surplus to fall below the 2% GDP level that the OBR now assumes HH will achieve in six quarters and sustain from 3Q22 onwards. Put simply, these forecasts ignore historical evidence from the UK and elsewhere that suggest that HH behaviour takes time to adjust from extreme shocks and implies obvious downside risks to the newly revised consumption and GDP forecasts, in my view.

Historic and forecast trends for UK corporate financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively. (Source: OBR; CMMP analysis)

Turning now to the NFC sector, businesses reduced investment during the pandemic and moved into financial surplus in 3Q20. The OBR assumes that this surplus will peak at 3.2% GDP in 1Q21 and settle at a deficit of around 2.5% GDP out to 1Q26. In other words, the forecasts assume both (1) relatively high future investment levels and (2) a relatively dynamic adjustment. Again for context, after the GFC, the NFC sector ran net financial surpluses for 17 consecutive quarters between 1Q09 and 1Q13.

The complete picture – usual perhaps, but is this really sustainable? (Source: OBR; CMMP analysis)

Finally, the OBR observes that, “over the medium term, sectoral net lending positions return to more usual levels.” While they may be usual in the sense that they are not new, that is not the same as saying that they are sustainable. The latest forecasts not only assume dynamic adjustments by the HH and NFC sectors but they also assume a sustained period during which combined private and public sector deficits are offset by increasing Row surpluses.

Historic and forecast trends for RoW financial sector balances – the bold and dotted lines represent March 2020 and November 2020 forecasts respectively. (Source: OBR; CMMP analysis)

In other words, the current forecasts imply a return to persistent sector imbalances with the UK increasingly reliant on the RoW as a net lender (see Imbalances and dependencies).

Conclusion

If we assume that the OBR forecasts become the base case priced into UK assets, then financial sector balances point to downside risks to growth expectations, upside risks to the level of borrowing, inflation staying below target out to 1Q26 and rates remaining lower for longer. Plus ca change…

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