“August Snippets – Part 2”

Revisiting the foundations of CMMP analysis

The key message

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:

“The changing face of global debt” October 2019
“Sustainable debt dynamics – Asia private sector credit” October 2019
“Too much, too soon” November 2019
“Global debt dynamics post-Covid – Part 1” May 2020

**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:

“Look beyond the yield curve” September 2019
“Amber warnings in the EA?” February 2020
“Messages from the money sector” April 2020
“Uncertainty reigns” June 2020

**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:

“Macro building blocks matter – look at the SX7E” September 2019
“Tacking into the wind” February 2020
“EA banks: a high conviction rally?” June 2020
“August Snippets – Part 1” August 2020

**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:

“Lousy LT investments, but…” January 2020
“Everyone has one…” January 2020
“Poised to disappoint” January 2020
“Imbalances and dependencies” January 2020

**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:

“Fuelling the FIRE – the hidden risk in QE” September 2020
“Policy reboot 2020?” February 2020
“Fiscal, first and foremost” March 2020
“Covid-19s threat to the future of the EA” April 2020

**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

“August Snippets – Part 1”

Bank performance and the importance of rigorous frameworks

The key chart

**Was it correct to question the conviction behind the SX7E rally during 2Q20?**
Source: FT; CMMP analysis

The key message

In early June, I questioned the conviction behind the European bank sector’s rally that saw the SX7E index rise 45% from its April lows. I recommended viewing this more as a vote of confidence in the EC’s policy shift than a fundamental change in sector dynamics.

The index fell -17% subsequently, before rebounding since the end of July to a level -8% below the June peak.

Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.

In many cases, lower trading volumes have accompanied the recent lacklustre share price performance (do investors care?).

The 2Q20 interim results also supported my April conclusion that weak pre-provision profitability left European banks poorly positioned to absorb the impact of the COVID-19 pandemic.

Significantly, three index heavyweights are now trading below the pre-LLP threshold multiple associated with peak EM and DM banking crises.

These banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets.

The lessons from 2020 include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.

Six key charts

In early June, I questioned the conviction behind the European bank sector’s rally that had seen the SX7E index rise 45% from its April lows (“EA banks: a high conviction rally?”). I noted that the rally had taken place (1) two months after the broader market, (2) despite a worsening operating environment, and (3) in the absence of the macro building blocks that are required for a sustained recovery in sector profitability. I also highlighted that the rally had coincided with the announcement of the EC’s proposed €750bn “Next Generation EU” fund and suggested that it could be seen better as a vote of confidence in the policy response rather than a fundamental shift in banking sector dynamics.

**Poor absolute and relative share price perfomance (versus SXXE) from index heavyweights YTD.** (Source: FT; CMMP analysis)

The index fell -17% subsequently, to a recent end-July low, before rebounding during August to a level -8% below the June peak. Excluding Deutsche Bank, these trends leave the share prices of “index heavyweights” down between -21% (ISP) and -55% (Soc Gen) YTD.

**Share price and trading volume trends for BNP Paribas, the largest bank in the SX7E index by market capitalisation**. (Source: FT; CMMP analysis)

In many cases, lower trading volumes have accompanied the recent lacklustre share price performance. The chart above illustrates YTD share price and trading volume trends (7d and 21d MVA) for BNP Paribas, the largest bank in the SX7E index by market capitalisation. The current 21d MVA is just over 4m shares, only 62% of the 2020 average of 6.5m and 35% of the 11.4m shares at the peak of the sell-off in March (note these are MVA figures). In the case of Deutsche Bank, the only index heavyweight to have delivered positive share price returns YTD, the current 21d MVA is 12m shares, only 55% of the 2020 average of 22m and 31% of the 39m shares traded at its peak (charts available on request).

**EA banks’ vulnerability to rising provisions in the wake of the COVID-19 pandemic. Pre-provision profits were only 2.4x provisions in 4Q19.** (Source: ECB; CMMP analysis)

The 2Q20 interim results also supported my April 2020 conclusion that weak pre-provision profitability levels left EA banks poorly positioned to absorb the impact of the COVID-19 pandemic (“If you want to go there…”). At the time, I expressed concern about the low “pre-provision profit” cover of only 2.4X at the end of 2019 and highlighted low cover levels in Portugal (1.5x), Germany (1.8x), Italy (1.8x) and Spain (1.9x).

Six months later, the 32 largest European banks have set aside €56bn to cover loan losses. Santander, which was the largest SX7E bank by market cap previously, set aside €7bn to cover loan losses alone and booked a large write-down on its UK business. This resulted in the first quarterly loss in the bank’s 163-year history. Santander’s share price is down -50% YTD, the second worst performer of the heavyweights after Soc Gen.

**Pre-LLP provision multiples (2021e) for index heavyweights – red line indicates typical crisis threshold.** (Source: Consensus forecasts, CMM analysis)

Three index heavyweights are now trading below the pre-LLP multiple that is associated with peak EM and DM banking crises. Based on my experience of multiple banking crises in EM and DM over the past thirty years, I believe that a pre-LLP multiple of 2x typically marks a key “crisis-threshold” for bank valuation. Consensus forecasts indicate that Santander, BBVA and Soc Gen are currently trading on 1.5x, 1.6x and 1.8x 2021e pre-LLP multiples respectively. Contrarian traders may note with interest the fact that Santander’s trading volumes (post-loss selling pressure?) have peaked at a time of very distressed valuation.

**Share price and trading volume trends for Santander.** (Source: FT, CMMP analysis)

These three banks aside, low absolute valuations reflect poor 2021 profitability forecasts rather than indicating “real value” and suggest that EA banks remain “trading” not “investment” assets. Based on consensus 2021e forecasts the index heavyweights are trading on PBVs of between 0.22x (Soc Gen) and 1.04x (KBC) with an average of 0.45x. While these valuations appear attractive in absolute terms, they simply reflect depressed forecasts for 2021e ROEs, in my view. The average (no-growth) implied cost of equity for the index heavyweights is 10.8%. Given the very high risk to current forecasts, this implies a sector that is fairy-valued rather than genuinely cheap. Note, however, that implied costs of capital vary widely from 3.2% for Deutsche Bank to 16.1% for Santander. This suggests opportunities for active investors since such a dispersion usually indicates either (1) glaring valuations anomalies and/or (2) unrealistic forecasts.

**2021e ROE versus PBV for European banks, index heavyweights highlighted** (Source: Consensus forecasts; CMMP analysis)

Conclusion and key lessons

Recent lessons here include (1) the importance of disciplined investment frameworks and (2) understanding the real value of banking sector analysis – the subjects of my next August snippets.

The CMMP Analysis investment framework combines three different time perspective into a single investment thesis. The investment outlook at any point in time reflects the dynamic between these three different time perspectives. Conviction reflects the extent to which they are aligned – in June they were misaligned highlighting the fact that (absolute) valuation alone is not sufficient for sustained investment performance.

That said, the European and UK banking sectors have provided very important insights into wider macroeconomic trends and the pace, timing and nature of the recovery from the 2Q economic lows. This supports my view, that true value in analysis developments in the financial sector remains less in considering investments in DM banks but more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation. More of this to follow in this “Autumn snippets” series.

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

“2Q20 message from the money sector – the UK”

Part 2 – a similar message to the euro area

The key chart

**What uncertainty looks like – putting 2020 money holding trends into context**
Source: Bank of England; CMMP analysis

The key message

The 2Q20 message from the UK money sector is very similar to the corresponding euro area version.

Headline data points suggest little change to the existing narrative. Households (HHs) and corporates (NFCs) continue to increase their money holdings, with rolling 3m inflows for the past four months since March exceeding the total inflows recorded for the whole of 2019. High levels of uncertainty still prevail. Above trend NFC borrowing and a recovery in HH mortgage demand offset the weakest YoY trends in consumer credit (-3.6% YoY) since 1994.

Again, analysis of monthly flows presents a more nuanced picture. Flows into sterling money holdings peaked back in March 2020, but remain more than double 2019 average monthly flows. The message for UK consumption is “less negative” – HHs repaid only £86m compared with a record £7bn in April. For context, this compares with average new monthly consumer borrowing of over £1bn per month in 2019. NFCs remain active borrowers from banks and financial markets, with June’s £11bn of borrowing driven mainly by capital market issuance. Bank lending to NFCs saw divergent trends. Large corporates repaid record amounts, but SMEs borrowed an additional £10bn. The annual growth rate in SME lending hit an all-time high, reflecting the impact of government support schemes.

In short, uncertainty in the UK has also peaked but remains very elevated, still.

Six charts that matter

**HHs and NFCs continue to increase their sterling money holdings strongly**
Source: Bank of England; CMMP analysis

In-line with developments in the euro area (EA), the headlines from the Bank of England’s money supply data for June 2020 also suggest little change to the on-going “message from the money sector” narrative.

The UK’s headline money series (M4ex) grew 11.9% YoY compared with the monthly average of 2.9% in 2019. HH money holdings (64% total) increased 7.5%, NFC money holdings (23% total) increased by 23.2% (YoY), and the volatile but smaller non-intermediating financing company (NIOFC) holdings (15% of total) increased by 17.7%.

The key chart above places these trends into context. Money holdings increased by £82bn in total during 2019, at an average of just under £7bn per month. The rolling 3m sums of money holdings for the past four months – March ($86bn), April (£113bn), May (£159bn) and June (£109bn) – all exceed the 2019 annual increase. This is what uncertainty looks like!

**“Euro area trends on steroids” – above trend NFC credit and resilient HH mortgage demand offset weakness in HH consumer credit**
Source: Bank of England; CMMP analysis

Looking at the counterparts to money holdings, again the story is similar to the EA version but with more exaggerated trends. NFC lending grew 9.2% YoY, down from 11.2% in May, but above trend. Mortgage demand grew 3.0% YoY, resilient but slightly below the 2019 average growth of 3.3%. However, HH consumer credit fell by -3.6% YoY, the weakest growth rate recorded since this series began in 1994. No real surprises here (at least in terms of trends).

**Have uncertainty levels peaked, and if so, when? Monthly flows of sterling money holdings**
Source: Bank of England; CMMP analysis

Continuing the parallels with the EA message, the monthly flow data presents a more nuanced picture than the headline data suggests. Monthly flows into sterling money holdings peaked at £67bn in March, almost 10x the 2019 monthly average flow. They fell back to £16bn in June, but this is still 2.3x the 2019 average monthly flow. The more volatile NIOFC flows peaked in March, but HH and NFC monthly flows did not peak until May (both at £26bn before falling to £12bn and £8bn in June respectively). Note that these large inflows are occurring despite negative real returns. The effective interest rates on new HH time (0.73%) and sight (0.26%) hit new lows having fallen 31bp and 20bp since February 2020 respectively. The effective interest rates on NFC time (0.17%) and sight (0.13%) also fell 10bp in June 2020.

**HH lending recovers in June after 2 months of large repayments**
Source: Bank of England; CMMP analysis

After 2 months of large repayments (£7bn April, £3bn May), HH borrowing increased by almost £2bn in June. As can be seen from the chart above, the recovery in mortgage borrowing was the driver here. Looking ahead, mortgage approvals for house purchase also increased to 40,000 in June, up from the record low of 9,300 in May. However, June’s approvals were still well below February’s pre-Covid level of 73,700.

HHs repaid only £86m of consumer credit in June compared with £4bn, £7bn and £5bn monthly repayments in March, April and May respectively. Positive, or less negative, news for the UK economy, but note that this small repayment contrasts with an average of £1.1bn in new consumer borrowing per month in the 18 months to February 2020 (Bank of England, June 2020).

**Divergent trends in NFC borrowing – large corporates vs SMEs**
Source: Bank of England; CMMP analysis

NFC lending saw divergent large NFC and SME trends. Large NFCs repaid a record £16.7bn in June, following a £13bn repayment in May. Approximately half of these repayments came from public administration and defence. The YoY growth rate for large NFC lending fell to 4.8% (dotted red line above) from 15.5% YoY in April. In “Credit where credit’s due“, I highlighted the important increase in SME borrowing in May (£18bn). In June, SMEs borrowed an additional £10bn well above the previous largest monthly SME borrowing of £0.6bn in September 2016. The YoY growth rate in SME lending hit a new high of 17.7% reflecting, in part, loans arranged through the government support schemes (eg, Bounce Back Loan Scheme).

**June’s NFC financing driven by capital market issuance – bonds and equity**
Source: Bank of England; CMMP analysis

NFCs borrowed almost £11bn from banks and financial markets in June. This was below the £32bn and £16bn borrowed in March and April respectively, but similar to May’s borrowing level. June’s borrowing was driven by capital market issuance – £7bn in bond issuance and almost £4bn raised in equity.

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

“2Q20 message from the money sector”

Part 1 – the euro area narrative

The key chart

**Headline figures mask a more nuanced message from the monthly flow data**
Source: ECB; CMMP analysis

The key message

The “2Q20 message from the money sector” is simple: uncertainty in the euro area has peaked but remains elevated still.

Demand for overnight deposits remains the key driver of M3 growth
Above-trend NFC credit demand and resilient HH mortgage demand is offsetting weakness in consumer credit
Monthly flows into overnight deposits (and uncertainty) peaked in March at 5x 2019 average flows but remain 1.3x 2019 average flows
HHs have stopped paying down consumer credit and mortgage demand has remained resilient throughout the pandemic
The NFC “dash for cash” has also peaked and the monthly flow of corporate borrowing fell below the 2019 average in June
Despite negative real rates, almost €10trillion continues to sit in cash and overnight deposits
The key question – how much of this is “forced” versus “precautionary” savings – remains unanswered for now.

Six charts that matter

The headlines from the ECB’s money supply data for June 2020 suggest little change to the “message from the money sector” narrative (see key chart above). Growth in broad money (M3) rose to 9.2% YoY from 8.9% in May, the fastest rate of growth since July 2008. Narrow money (M1) grew 12.6% YoY from 12.5% in May and overnight deposits grew 13.1% YoY from 13.0% in May. M1 and overnight deposits contributed 8.5ppt and 7.6ppt to the overall M3 growth of 9.2% respectively. In short, households (HHs) and corporates (NFCs) continue to demonstrate a high preference for liquid assets despite negative real returns, which reflects high levels of uncertainty. No surprises here.

**HH and NFC loans as a counterpart to M3 (% YoY)**
Source: ECB; CMMP analysis

Looking at the counterparts to broad money, credit to the private sector contributed 5.1ppt to M3 growth down from 5.3ppt in May. HH lending stood at 3.0% YoY, flat on the month, while growth in NFC lending fell to 7.1% YoY from 7.3% in May. As before, above-trend NFC credit and resilient HH mortgage demand (4.1% YoY) offset the lack of growth in consumer credit (flat, YoY)

**Monthly flows of overnight deposits**
Source: ECB; CMMP analysis

Behind the headlines, the monthly flow data presents a more nuanced picture. Monthly flows into overnight deposits peaked at €250bn in March (5x the 2019 average flow) and have fallen back to €63bn in June (1.3x the 2019 average flow).

**HH “uncertainty” peaked one month before NFC “uncertainty” – but both remain elevated**
Source: ECB; CMMP analysis

HH deposit flow peaked at €80bn in April and has fallen to €50bn in June. NFC deposit flow peaked a month later in May at €112bn and has fallen back even faster to €42bn. In both cases, however, the latest monthly flow is still 1.2x the respective 2019 averages.

**HH no longer paying down consumer credit**
Source: ECB; CMMP analysis

After three months of negative flows, EA HHs have stopped paying down credit for consumption. They borrowed €1bn in June after negative flows of €-12bn, €-14bn and €-2bn in March, April and May respectively.

**Mortgage demand remains resilient**
Source: ECB; CMMP analysis

HHs also borrowed €10bn in June to purchase houses, down from €20bn in May. The smoothed 3m MVA of monthly mortgage flows has been trending between €10bn and €20bn for a sustained period reflecting resilient demand since mid-2017.

**Passed the peak “dash for cash”**
Source: ECB; CMMP analysis

The “dash for cash” from NFCs appears to have peaked at €121bn flow in March 2020. Since then, the monthly flow has declined to €72bn (April) and €50bn (May) to €8bn (June), below the 2019 average monthly flow of €11bn.

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

“Digitalisation coming ready or not”

Are UK building societies positioned to take advantage?

LT challenges – the key chart

**UK households save too little and borrow too much**
Source: ONS; ECB; CMMP analysis

The key message

The digitalisation of UK mortgage and savings is accelerating but structural and cyclical dynamics are challenging the strategies and profitability levels of building societies and compromising their ability to respond to the associated opportunities and challenges.

Summary of segmentation analysis

Building societies play an important role in UK financial services, helping their 25mn members to finance the purchase/building of their homes and to save.

The 43 societies currently account for 23% of outstanding UK mortgages (£337bn) and 18% of total HH savings (£297bn). The five largest account for c.90% of assets, members and industry profits. The balance sheet, members and annual profits of Nationwide, the UK’s largest building society, exceed the equivalent numbers for the rest of the industry combined.

CMMP analysis segments the industry by balance sheet, membership, infrastructure, P&L and geographic location and identifies four distinct tiers of building society.

It highlights how “the value” of members and branches and profitability drivers vary significantly across, and within, the four tiers and identifies those societies who enjoy neither the economies of scale of the Tier 1 societies nor the superior profitability (and income generation) of the smaller Tier 4 societies.

The Chairman of one society suggested recently, that many peers would be tempted to simply “trade through” the current crisis (supported by adequate capital) but that “they shouldn’t”. CMMP analysis not only supports this view but also provides a foundation for formulating the necessary strategic responses.

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

Key charts and slides

**Five building societies dominate the market and Nationwide, the largest, has more assets, shares, members and generates more profits than the rest of the industry combined**
Source: BSA, CMMP analysis

Challenges are reflected in divergent growth trends for assets and profits since 2015 (% CAGR)
Source: BSA; CMMP analysis

**Even the more profitable societies are experiencing challenges to their profitability levels**
Source: BSA; CMMP analysis

**Larger building societies enjoy economies of scale (Tier 1 blue, Tier 2 red, Tier 3 green)**
Source: BSA, CMMP analysis

**Smaller building societies’ profitability levels reflect superior income generation (Tier 4 grey)**
Source: BSA; CMMP analysis

**Membership numbers and contribution vary across and within the four tiers**
Source: BSA; CMMP analysis

**Branch numbers and efficiency levels also vary across and within the four tiers**
Source: BSA; CMMP analysis

**How sacred are the industry’s sacred cows in a digitalised world?**
Source: BSA; CMMP analysis

“Credit where credit’s due”

A positive SME message from the UK money sector

The key chart

**Positive news from the money sector – SMEs able to borrow a record £18bn in May**
Source: Bank of England; CMMP analysis

A snapshot on SME lending in the UK

In recent posts, I highlighted the widening financing gap between large corporates and SMEs in the UK and concerns that SMEs in the euro area were expecting the availability of external funding to deteriorate sharply.

**“This time it’s different” – monthly change in SME loans since 2011 (£mn)**
Source: Bank of England; CMMP analysis

This week’s “Money and Credit” release from the Bank of England brings some welcome, positive relief to this negative narrative. SMEs in the UK borrowed an extra £18bn from banks in May 2020. To put this into context, the previous largest increase in SME net borrowing was £589mn in September 2016. The Bank of England noted that this increase (11.8% YoY) “reflects businesses drawing down loans arranged through the government supported schemes such as the Bounce Back Loan Scheme”.

**What a difference a month makes – YoY growth rates in NFC lending since May 2017**
Source: Bank of England; CMMP analysis

These schemes helped reduce the effective interest rate on new loans to 0.98%, which is the lowest rate paid by SMEs since 2016 and compares very favourably with the 3.44% charged on new loans in February 2020.

**The “effective” rate on new loans has fallen to a new low of 0.98%**
Source: Bank of England; CMMP analysis

SMEs play a vital role in the UK economy. They account for 50% of total revenues generated by UK business and employ 44% of the UK’s workforce (McKinsey, June 2020). Up until this month, there were obvious concerns that limited access to funding and its relatively high cost were adding to the pressure of sharp revenue declines.

The large scale and lower cost of SME funding indicated in this week’s data release is a welcome, positive change in the message from the UK money sector.

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

“Forced vs Precautionary”

May’s message from the UK money sector – risks from the HH sector

The key chart

**The post COVID 19 outlook may be determined by the extent to which the dramatic increase in HH savings is forced or precautionary – financial sector balances provide important context here (£mn)**
Source: Bank of England; CMMP analysis

Summary of CMMP analysis

Households (HHs) play a dominant role in the UK economy – their consumption accounts for 63p in every pound of GDP and their borrowing accounts for 76p in every pound lent.

In this context, heightened uncertainty, debt repayments and a marked increase in savings represent clear and rising risks to the economy and to bank sector profitability.

The £26bn record increase in HH deposits in May (6x the 10-year average monthly flow) reflects extreme uncertainty. HHs are repaying loans, notably consumer credit which has fallen -25% (annualised) over the past three months and -3% YoY (the weakest rate since 1994).

Pre-COVID 19, HHs funded consumption by dramatically reducing savings…

…during COVID 19, the savings ratio jumped sharply from an 11-year low of 5.2% in 3Q19 to 8.6% in 1Q20 (in-line with its LT average)…

…Post-COVID 19, the key question is the extent to which these savings are “forced” (constraints on spending during lockdown) or “precautionary” (response to actual or possible unemployment) in the UK and in the euro area.

Financial sector balances provide important historic context here given that the UK economy was characterised by large and persistent sector imbalances previously. Increasing deposits and/or reducing loan liabilities are likely to be part of a structural shift towards higher levels of HH net lending/financial surpluses.

Financial flows may remain volatile but a sharp reversal with savings moving rapidly back into either consumption or investment appears unlikely given the UK’s starting position.

Look instead for further fiscal stimulus (eg, a temporary cut in VAT).

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

Six key charts

**The £26bn record increase in HH deposits in May reflects extreme uncertainty levels (£mn)**
Source: Bank of England; CMMP analysis

**HHs are actively repaying loans…(£bn on LHS, % YoY on RHS)**
Source: Bank of England; CMMP analysis

**…notably in consumer credit (credit cards and other consumer loans)**
Source: Bank of England; CMMP analysis

**Mixed messages from the mortgage market – HHs borrowed an additional £1bn in May after no growth in April (not shown here) but forward-looking approvals fell 66% on previous 6m average**
Source: Bank of England; CMMP analysis

**The HH savings ratio has jumped from an 11-year low of 5.2% in 3Q19 to 8.6% in 1Q20**
Source: ONS; CMMP analysis

A structural shift to higher HH net financial surpluses would suggest that a rapid shift of savings back into consumption and investment is unlikely. Look for further, offsetting fiscal stimulus instead? **(HH net financial surplus as % GDP)**
Source: ONS; CMPP analysis

“Uncertainty reigns”

May’s message from the EA money sector

The key chart

**Monthly flow into O/N deposits is 3.2x the 2019 average monthly flow (3m MVA, EURO mn)**
Source: ECM; CMMP analysis

Summary

The latest message from the euro area (EA) money sector is clear – unprecedented levels of uncertainty continue to challenge the “v-shaped recovery” narrative.

The fastest YoY growth in M3 since July 2008 (8.9%) largely reflects increased holdings of overnight deposits, which contributed 7.6ppt to the headline growth alone. May’s monthly flow of overnight deposits of €167bn (3m MVA) was 3.2 times the average monthly flow in 2019. Households (HHs) and corporates (NFCs) continue to demonstrate strong liquidity preferences – €9.6trillion is currently sitting in (cash) and overnight deposits despite negative real rates of return.

From a counterparts’ perspective, credit to private sector contributed 5.3ppt to broad money growth with increasing demand from NFCs and resilient HH demand for mortgages offsetting on-going weakness in HH demand for credit for consumption. No major change in the message here.

Looking forward, there is some support for the argument that we may have passed the low point in the “sharpest and deepest recession in non-wartime history”, but little to suggest that the recovery will be anything other than “sequential (geographically), constrained and uneven” (M. Lagarde, 26 June 2020). The answer lies largely in the extent to which the increase in savings highlighted here is “forced” or “precautionary”. Forced savings can be released relatively quickly to support economic activity. In contrast, precautionary savings are unlikely to move straight into investment and consumption.

Previous CMMP analysis indicates persistent private sector net financial surpluses since the GFC and suggests a bias towards more precautionary savings. These are unlikely to more rapidly into either investment or consumption and pose an on-going challenge to the “v-shaped recovery” narrative.

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

The six charts that matter

**O/N deposits are the main contributor to accelerating M3 growth (contribution in ppt, % YoY)**
Source: ECB; CMMP analysis

**HHs and NFCs continue to demonstrate strong liquidity preferences (EUR bn, 3m MVA)**
Source: ECB; CMMP analysis

**No changes in the message from a counterparts’ perspective – increasing NFC and resilient mortgage demand offset weakness in consumer credit (% YoY)**
Source: ECB; CMMP analysis

**Looking for positives – O/N deposit monthly flows may have peaked in March?**
Source: ECB; CMMP analysis

**Looking for positives – mortgage credit demand is resilient and the contraction in consumer credit has slowed**
Source: ECB; CMMP analysis

But don’t forget, the private sector has been running persistent net financial surpluses since the GFC, despite negative/very low policy rates – a very strong indication that the economy is still suffering from a debt overhang
Source: ECB, CMMP analysis

“Mind the financing gap II”

Messages from the money sector V – SMEs in the euro area

The key chart

**Concerns over the availabilty of credit for SMEs in the EA are rising sharply (net percentage terms)**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

Summary

The latest ECB/European Commission SAFE survey indicates that SMEs in the euro area (EA) are facing similar challenges to their UK-based peers.

SME turnover and profits were declining across the EA before the Covid-19 pandemic hit, despite accommodative financing conditions
Weaker turnover and lower profits have become obstacles to obtaining external finance for the first time since 3Q14 especially, but not exclusively, in southern Europe
The weakening economic outlook is compounding these trends with significant deteriorations noted in Germany, Italy and Finland
The survey indicates that SMEs see the availability of internal funds declining substantially and by more than during the 2012 sovereign debt crisis
External financing needs are rising, unsurprisingly, but SMEs indicate that they expect the availability of these funds (loans, credit lines and overdrafts) to deteriorate sharply, but to a lesser extent than the availability of internal funds.

Unorthodox monetary policy has been successful in reducing financing costs for SMEs in the EA and in the UK, but the challenge of accessing funding in sufficient volumes and in the face of declining operating performance remains.

SMEs in the EA are signalling rising operational, economic and financing risks and a widening financing gap vis-a-vis large corporates, raising concerns for investors in the sector and banks with relatively high SME exposure.

Introduction

I highlighted the widening financing gap between large UK corporates and SMEs in “Mind the financing gap” earlier this month. In this post, I summarise the results of the ECB/EC’s Survey on the Access to Finance for Enterprises (SAFE). This was conducted between March and April this year and the results were summarised in the ECB’s latest Economic Bulletin.

The key message from the euro area (EA) is similar to the UK version – while SMEs are benefitting from lower funding concerns, they are reporting a deterioration in activity and rising concerns about the future availability of external financing. Policy measures need to reflect and adjust to these concerns.

The charts that matter

**What are the trends in SME turnover and profits?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

SME turnover and profits were declining across the EA before the Covid-19 pandemic hit and despite accommodative financing conditions. Turnover declined across the region for the first time since early 2014. Italian SMEs were hit particularly hard (19% fall), followed by SMEs in Slovakia, Greece and Spain.

SMEs also reported a sharp deterioration in profits, from -1% in the previous survey to -15%. Italian SMEs stood out again, with profit declines of 36%, followed by Greek, Slovakian and Spanish SMEs. This occurred despite accommodative financing conditions, with high labour costs highlighted as a key contributing factor, and the “industry” sector hit relatively badly by declining profits.

**How do turnover trends vary across the EA?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

**How do profit trends vary across the EA?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

Weaker turnover and lower profits have become obstacles to obtaining external finance for the first time since 3Q14. This applies across the EU (with the exception of Greece) but is particularly severe in Spain, Italy and Portugal.

**Why does this matter?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

**Where does this matter?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

The weakening economic outlook is compounding these challenges with significant deteriorations noted across the EA and particularly in Germany, Italy and France. The net percentage of firms signalling that the weakening in economic outlook was affecting access to finance rose to -30%, a level not seen since 1Q13.

**And the economy?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

**How widespread is the economic impact?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

The survey indicates that SMEs see the availability of internal funds declining substantially and by more than during the 2012 sovereign debt crisis. External financing needs are rising, unsurprisingly, but SMEs indicate that they expect the availability of these funds (loans, credit lines and overdrafts) to deteriorate sharply, but to a lesser extent than the availability of internal funds.

**How urgent are SME external financing needs?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

**How do actual and expected availability of external finance compare?**
Source: ECB/EC (22nd SAFE survey); CMMP analysis

Conclusion

Unorthodox policy has been successful in reducing financing costs for SMEs in the EA and in the UK, but the challenge of accessing funding in sufficient volumes and in the face of declining operating performance remains severe. The risks to SMEs are rising as are the risks for those banks with relatively high SME exposure.

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

“EA banks: a high conviction rally?”

Or more a vote of confidence in Ursula von der Leyen?

The key chart

**Banks play catch up since 18 May 2020, but what kind of rally is this and can it be sustained?**
Source: FT, CMMP analysis

Summary

The SX7E index of leading European banks bounced 38% between 18 May and 5 June 2020, outperforming the broader SXXE index by 15%.

Among the index “heavyweights” (by market cap), the biggest share price gains corresponded with the largest previous YTD share price falls – BNP Paribas, ING, Unicredit and Soc Gen. Trading volumes also rose from recent lows but remained below those seen during March’s sell-off.

The rally took place (1) two months after the broader market, (2) despite a worsening operating environment, and (3) in the absence of the macro building blocks required for a sustained recovery in sector profitability.

It coincided with the announcement of the EC’s proposed €750bn “Next Generation EU” fund and can, therefore, be seen best as a vote of investor confidence in the policy response rather than a fundamental shift in banking sector dynamics (note parallels with the performance of the oil and gas sector).

Looking forward, the limited progress in dealing with the region’s private sector debt overhang still clouds the LT investment perspective. High debt levels explain, in turn, why money, credit and business cycles in the EA were already significantly weaker than in past cycles, why inflation remains well below target, and why rates were expected to stay lower for longer even before the Covid-19 pandemic hit.

Last week’s ECB forecasts indicate that the growth recoveries expected in 2021 and 2022 will not make up for the 8.5% real GDP contraction this year. Weak pre-provision profitability levels represent the key challenge facing EA banks in terms of addressing the associated challenges and suggest that the MT investment perspective also remains negative.

A positive investment case rests, therefore, largely on valuation (ST investment perspective). Banks established new support levels in terms of absolute price at distressed valuation levels (0.2-0.4 PBV). Despite rallying off these levels, share prices of large EA banks typically remain 20-30% lower than at the start of the year and valuations low in a historic context.

Bank valuations remain low/distressed in absolute terms and versus historic trends. Conviction in the current rally and sector outperformance is challenged, however, by the lack of alignment between the three investment perspectives that form the basis of the CMMP analysis investment framework.

In my view, the true value in analysing developments in the financial sector remains less in considering investments in developed market banks and more in understanding the implications of the relationship between the banking sector and the wider economy for corporate strategy, investment decisions and asset allocation.

As before, the key message from the money sector here, is the importance of the EC’s proposal for the “Next Generations EU” fund. 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 and the graphs below are extracts from more detailed analysis that is available separately.