Tag: Strategy

“The changing face of global debt”

Global finance continues to shift to the East and towards emerging markets making it unrecognisable from the industry that existed twenty years ago

The key chart

The changing face of global debt (% of total PSC) – shifting East and towards emerging markets
Source: BIS; Haver; CMMP analysis

Summary

In this post, I summarise my analysis of the latest Bank of International Settlement (BIS) Quarterly Review with respect to level and trends in global debt and global debt ratios. The key points are:

  • The level of global debt hit a new high of $183 trillion in 1Q19
  • Global debt ratios – debt expressed as a percentage of GDP – have rebounded since 3Q18, but remain below peak 1Q18 levels.
  • Deleveraging continues, however, in all sectors across the Euro Area
  • Emerging markets remain the most dynamic segment of global finance, accounting for 36% of total private sector credit compared to only 10% two decades ago
  • China remains the main driver of this growth, accounting for 24% of global PSC, but the misallocation of credit towards SOEs continues
  • Global finance continues to shift East and towards emerging markets making it unrecognisable from the industry that existed twenty years
  • Further research analyses (1) whether current trends are sustainable and (2) the associated investment risks.

A new high for global debt levels

The level and breakdown of global debt between governments, corporates (NFC) and households (HH)
Source: BIS; Haver; CMMP analysis

The level of global debt hit a new high of $183 trillion at the end of 1Q19. Corporate (NFC) credit is the largest sub-segment (39% of total) at $72 trillion. Government debt is the second largest sub-segment (35% of total) at $65 trillion, while household credit is the smallest sub-segment (25% of total) at $47 trillion.

Aggregating NFC and HH credit together, private sector credit totals $118 trillion or 65% of total global debt, down from 70% at the end of 2008. The shift in the balance of total debt from the private sector to government debt since the GFC reflects a shift from HH to government debt. In 2008, the split of total debt between HH, NFC and government debt was 31%, 39% and 30%. Today, the split it is 25%, 39%, 35% (1Q19).

The level and breakdown of global debt between the government and the private sector (PSC)
Source: BIS; Haver; CMMP analysis

Leverage is also rising again…

Trends in total global debt and global debt ratios
Source: BIS; Haver; CMMP analysis

Global debt ratios – debt expressed as a percentage of GDP – have risen for two consecutive quarters (an end to recent deleveraging trends) but remain below peak 1Q18 levels. The outstanding stock of global debt across all sectors fell between 1Q18 and 3Q18 before rebounding in 4Q18 and 1Q19. Debt ratios have rebounded but remain below peak levels.

Viewed over a twelve month period, we can observe different forms of deleveraging in action. In the HH and government sectors the absolute stock of debt has risen (to new highs) over the past twelve months but at a slower rate than the growth in nominal GDP. This represents a passive form of deleveraging as the debt ratio declines despite the stock rising in absolute terms. In contrast, the absolute level of NFC debt in 1Q19 ($72 trillion) is slightly below the level recorded in 1Q18 ($73 trillion). Hence the fall in the NFC debt ratio from 97% to 94% over the twelve months represents a mild form of active deleveraging.

Despite the recent rebound, the NFC sector has seen a mild form of active deleveraging over the past twelve months
Source: BIS; Haver; CMMP analysis

Recent developments provide some support for the concept of debt thresholds ie, the level of debt above which debt becomes a drag on growth. The BIS estimate that this threshold in 90% for the NFC sector and 85% for the HH and government sectors. At the end of 1Q2019, NFC debt stood above this threshold at 94%, government debt was just below at 84%, while HH debt was well below at 60%. In short, the different form of deleveraging in the NFC sector described above reflects the fact that NFC debt ratios remain too high and above the BIS thresholds.

…except in the Euro Area

Private sector credit in the Euro Area is slightly lower now ($21 trillion) than in 3Q09 ($22 trillion)
Source: BIS; Haver; CMMP analysis

However, gradual deleveraging continues in all sectors in the Euro Area. Interestingly, Euro Area deleveraging began first in the HH sector where debt ratios peaked at 64% in 4Q12. As elsewhere, this has been a passive form of deleveraging where the absolute stock of HH debt rises (to a new peak level in 1Q19) at a slower rate that the growth in nominal GDP. Total, PSC, NFC and government debt levels peaked later (1Q15) and have involved both passive and active forms of deleveraging. The stock of total debt reached new highs at the end of 1Q19 in total and in the PSC and HH sectors. In contrast, it is falling in the NFC and government sector where deleveraging is in its active form and where debt ratios of 105% and 98% remain above their respective BIS threshold levels.

On-going deleveraging in the Euro Area depresses global debt ratios – but progress is slow due to the type of deleveraging involved
Source: BIS; Haver; CMMP analysis

Emerging market dynamism…

Trends in global debt with breakdown between advanced and emerging markets
Source: BIS; Haver; CMMP analysis

Emerging markets remain the most dynamic segment of global finance, accounting for 36% of total private sector credit compared to only 10% two decades ago. Emerging market PSC totalled $42 trillion at the end of 1Q19 a rise of 225% over the past ten years or a CAGR of 12% per annum. Of this, NFC credit totalled $30 trillion (71% total PSC) and HH credit totalled $12 trillion (29% total PSC). NFC credit is typically larger than HH credit in emerging markets due to their relative stage in industry development. For reference the split between NFC and HH credit in advanced economies is currently 55% and 45% respectively.

Emerging market debt accounts for 36% of total PSC versus only 10% twenty years ago
Source: BIS; Haver; CMMP analysis

Debt ratios are catching up with the developed world and in some cases now exceed the BIS threshold levels too. PSC, HH and NFC debt levels reached 142%, 42% and 101% of GDP at the end of 1Q19 versus respective ratios of 162%, 89% and 72% respectively for advanced economies. Note that emerging NFC debt ratios currently exceed the BIS threshold but this reflects (1) the impact of China, which is discussed below, and (2) the fact that the BIS choses to include Hong Kong (NFC debt 222% of GDP) and Singapore (NFC debt 117% of GDP) in its sample of emerging economies.

Playing “catch-up” – emerging market PS debt ratios (% GDP) are close to advanced economies’ levels
Source: BIS; Haver; CMMP analysis

…driven by China

China remains the main driver of EM debt growth and now accounts for 24% of global private sector credit alone. PSC growth in China has grown 366% over the past ten years at a CAGR of 17% to reach $28 trillion at the end of 1Q19. Of this NFC credit was $21 trillion (74%) and HH credit was $7 trillion (26%), but it should be noted that China’s SOEs account for 68% of total NFC credit*.

Twenty years ago, China accounted from 3% of global debt and 31% of total EM debt. Today, these shares have risen to 24% and 67% respectively. China’s outstanding stock of debt exceeded the rest of EM in 3Q11.

China leaves the rest of EM behind after 3Q11 (PSC % GDP)
Source: BIS; Haver; CMMP analysis

The NFC debt ratio peaked at 163% of GDP in 1Q17 and fell to 152% in 4Q18 as the growth in NFC debt lagged growth in GDP. However, in the 1Q19, this ratio rose back to 155% and remains well above the BIS threshold of 90%.

*The supply of credit to (the more profitable) private sector NFCs remains constrained and well below the BIS threshold, highlighting the on-going misallocation of credit in the Chinese economy. Further analysis of China’s debt dynamics follows in future posts.

China’s NFC debt ratio is rising again despite being well above the BIS threshold (90%) and levels seen in the RoW
Source: BIS; Haver; CMMP analysis

Shifting East and towards EM

Growth in global debt increasing driven the China and EM ($ trillions)
Source: BIS; Haver; CMMP analysis

Global finance continues to shift to the East and towards emerging markets making it unrecognisable from the industry that existed twenty years. In March 2000, global debt was structured split between advanced economies ex Euro Area (70%), the Euro Area (20%), emerging markets ex China (7%) and China (3%). Today, those splits are 47%, 18%, 12% and 24% respectively. The face of global debt is changing dramatically.

My next research analyses (1) whether current trends are sustainable and (2) the investment risks associated with these trends

The changing face of global debt (% PSC debt outstanding)
Source: BIS; Haver; CMMP analysis

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

“Look beyond the yield curve II”

Monetary trends remain inconsistent with recession fears in the Euro Area

Messages from the money sector

Narrow money (M1) and broad money (M3) growth accelerates in August 2019
Source: ECB; Haver; CMMP

Earlier this month, I argued that (1) leading indicators were giving mixed messages about recession risks in the Euro Area; (2) that monetary indicators were comfortably above the levels the ECB associate with risks of recession; but (3) that the ECB was still expected to cut rates and to restart QE.

No surprises since then from the ECB. However, monetary indicators have moved even further away from levels associated with recession risks. Growth in real M1 (a leading indicator) accelerated in August, and real growth in household credit (a coincident indicator) and corporate credit (a lagging indicator) are at the highest levels in the current credit cycle. The message from the money sector in August is that current trends remain inconsistent with recession risks in the Euro Area.

No surprises from the ECB in September

The Deposit Facility Rate was cut from minus 0.4% to 0.5% in-line with expectations at this month’s meeting. The ECB also announced that it would restart buying €20bn of bonds per month until inflation hits its target of 2%. It also introduced a new “tiered” system of interest rates to reduce the cost to banks from negative rates (as discussed in “Power to the Borrowers”). No surprises here.

What are monetary developments telling us?

To recap, growth rates in real M1 and lending to the private sector demonstrate robust relationships with the business cycle through time. Real M1 tends to lead fluctuations in real GDP with an average lead time of four quarters. Real household (HH) credit growth tends to lead slightly (one quarter) or have a coincident relationship with real GDP. In contrast, real corporate (NFC) credit tends to lag fluctuations in real GDP with a lag of three quarters.

Growth in real M1 (my preferred leading indicator) is rising well above the levels associated with recessions in the Euro Area (% YoY, 3m MVA)
Source: ECB; Haver; CMMP calculations

Monetary indicators moved even further away from levels associated with recessions risks in August. Real M1, an alternative leading indicator with a stronger and more stable relationship with real GDP than the slope of the yield curve, grew 7.3% in August compared with 6.7% in July and 4.7% in January this year. This is the fastest rate of real growth in narrow money since January 2018.

Growth in real HH credit (a leading/coincident indicator) is at the highest level in the current credit cycle (% YoY, 3m MVA)
Source: ECB; Haver; CMMP calculations
Nominal HH credit growth driven by France, Germany, Benelux and Italy – but remains subdued in relation to past cycles (%YoY)
Source: ECB, Haver, CMMP calculations

Real HH credit (a leading/co-incident indicator) and Real NFC credit (a lagging indicator) grew at 2.4% and 3.3% respectively. In both cases, this was the fastest rate of growth in the current credit cycle. France (1.3%), Germany (1.2%), Benelux (0.3%) and Italy (0.2%) were the main contributors to HH credit growth (contributions here are in nominal terms).

Growth in real NFC credit (a lagging indicator) is also at the highest level in the current credit cycle (% YoY, 3m MVA)
Source: ECB; Haver, CMMP calculations

In the NFC sector, France (1.8%) and Germany (1.5%) were again the main country drivers, but Italy (-0.6%) and Spain (-0.2%) both made negative contributions to nominal Euro Area growth rates.

Nominal growth in NFC credit still dominated by France and Germany while Spain and Italy make negative contributions (% YoY)
Source: ECB; Haver; CMMP calculations

The message from the money sector in August is that current trends remain inconsistent with recession risks in the Euro Area. The domestic sectors are demonstrating resilience in contrast to the contraction seen in the more export-oriented manufacturing sectors. The latest trends remain supportive of current ECB and EC forecasts which point to a shallow recovery in growth in 2H19.

Monetary trends are more supportive of current EC (and ECB) forecasts for a shallow recovery in growth (% YoY)
Source: EC; Haver; CMMP

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

“Macro building blocks matter” – look at the SX7E

What are the key macro building blocks for European banks and why do they matter?

As a macro-economist, investor and ex-global banks sector strategist, I have a specific interest in the impact of macro and monetary dynamics on bank sector profitability (and conversely, on the impact of bank behaviour on the wider economy).

Macro building blocks for banks

In developed economies, I focus primarily on five key “macro building blocks” that drive bank sector profitability and share price performance:

  • growth in real GDP
  • growth in private sector credit
  • the level of ST rates
  • the level of LT rates
  • the shape of the yield curve

Net interest income – the main value driver for most banks – has a positive relationship with GDP, the level of rates and the shape of the yield curve. The level of ST rates is more important for banks in “floating rate” economies and market segments. In contrast, the slope of the yield curve is more important for banks in “fixed rate” economies and market segments.

Variable rate lending as %age of total new loans in the EA
Source: ECB; Haver; CMMP

In the Euro Area, 65% of new loans to HHs and NFCs are based on variable rates but only 19% of mortgages (down from 58% in November 2004). This means that EA banks are affected by both the level of ST rates and the slope of the yield curve, but that the sensitivity to the former is higher.

Variable rate lending as %age of total EA mortgages
Source: ECB, Haver, CMMP

Non-interest income – the second key value driver – has a positive relationship with GDP but a negative relationship with the level of ST rates while provisions have negative relationship with GDP and a positive relations with the level of ST rates.

Building blocks have weakened significantly

Macro building blocks in the EA have been softening since 1Q18 but have weakened significantly during 2019.

Twenty year trends in EA real GDP growth (% YoY)
Source: ECB, Haver, CMMP
  • Real GDP growth has slowed below LT average in all leading EA economies with the exception of the Netherlands, Spain and Portugal. Real GDP growth for the EA has fallen from 2.8% in 4Q17 to 1.1% in 2Q19, below the twenty year average growth rate of 1.4%. The weakest growth rates are currently in Italy (-0.1%) and Germany (0.4%) and Austria, Belgium and France are all growing at rates below their respective LT average. Of the major EA economies only the Netherlands (1.8%), Spain (2.3%) and Portugal (1.8%) are growing at rates above their LT average but interestingly the HH and NFC sectors are still deleveraging in each of these three economies. Looking forward, the ECB is forecasting growth to slow to 1.2% in 2019 before recovering to 1.4% in 2020 and 2021, in-line with LT average growth rates.
Twenty year trends in EA private sector credit growth (% YoY, 3M MVA)
Source: ECB; Haver, CMMP
Current growth rates in EA corporate and household credit (% YoY)
Source: ECB; Haver; CMMP
  • Private sector credit growth is at its highest level in the current cycle (3.6% YoY) but remains subdued in relation to past cycles (see graph above), concentrated geographically and increasingly directed towards less productive segments (see “Fuelling the FIRE” – the hidden risks of QE)
ST rates (EONIA) locked at the base of ECB’s corridor (marginal lending rate – deposit facility rate)
Source: ECB; Haver; CMMP
  • ST rates remain locked at the base of the ECB’s corridor and a further cut in the deposit facility rate this month is likely to have a negative impact on net interest margins in those countries (Austria, Italy, Portugal and Spain) and market segments (NFC lending) that are characterised by floating rate lending.
Euro Area 10Y bond yields collapsing into negative territory
Source: Haver; CMMP
  • LT rates have fallen sharply into negative territory. The yield on EA 10Y bonds has fallen from -0.23% at the end of 2018 to -0.64% currently, just above the recent weekly low of -0.71% at the end of August 2019.
  • The EA yield curve, which has been flattening since 4Q18, inverted in July 2019 with negative consequences for net interest margins in countries (Belgium, France, Germany and the Netherlands) and market segments (HH lending) that are more exposed to fixed-rate lending.
Spread between interest rate on new EA HH loans and 3M Euribor
Source: ECB; Haver; CMMP
Spread between interest rate on new EA NFC loans and 3M Euribor
Source: ECB; Haver; CMMP
  • Negative ST rates and inverted yield curves are compounded by on-going price competition that is evident in the on-going narrowing of spreads in the HH sector and to a lesser extent in the NFC sector.
Relative performance of SX7E versus SXXE over past twelve month (average prices)
Source: Haver; CMMP

The importance of macro building blocks on the performance of EA banks’ share prices is reflected in poor absolute (-14%) and relative (-10% versus SXXE) performance of the SX7E index of leading European banks over the past twelve months.

Little wonder then, that when reviewing the performance of European banks, FT Lex writers concluded recently that, “Europe is a nice place to live, but a terrible place to invest” (“European banks: the flyover continent”. Financial Times 23 July 2019)

Relative performance of SX7E versus SXXE over past decade (average prices)
Source: Haver; CMMP

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

“Look beyond the yield curve”

Leading indicators are giving mixed messages – but the ECB is still expected to cut rates and restart QE

Mixed messages 1: The inverted 10Y-3M yield curve raises “recession risks” concerns
Source: ECB; Haver; CMMP

Turning points in the slope of the yield curve typically lead turning points in real Euro Area (EA) GDP. The rapid flattening/inverting of EA yield curves YTD has surpassed trends seen in 2015 and 2016 and raises concerns that “recession risks” are rising across the region.

Mixed messages 2: Real growth in EA narrow money (an alternative leading indicator) remains well above the levels associated with recessions
Source: ECB; Haver; CMMP

To assess the severity of these risks, I examine trends in the key leading, co-incident and lagging indicators that represent the foundation of my “Money, Credit and Business Cycle” framework.

Growth rates in real M1 and lending to the private sector demonstrate robust relationships with the business cycle through time.

Real M1 tends to lead fluctuations in real GDP with an average lead time of four quarters. This reflects the fact that M1 is composed of funds that businesses and households can access quickly to support current spending.

Real household (HH) credit growth tends to lead slightly (one quarter) or have a co-incident relationship with real GDP. HHs typically increase their demand for credit when they expect house prices to recover and after house prices and interest rates have declined during a slowdown.

In contrast, real corporate (NFC) credit tends to lag fluctuations in real GDP with a lag of three quarters. NFCs typically rely on in internal sources of funds at the early stage of an economic recovery before turning to banks (and other external sources) for financing at later stages.

Leading indicator: growth in EA real GDP and real M1 (% YoY)
Source: ECB; Haver; CMMP

Real M1, an alternative leading indicator with a stronger and more stable historic relationship with real GDP than the slope of the yield curve, rebounded in February 2019 and is now growing at the fastest rate since February 2018. The relationship between real growth in M1 and real growth in GDP is well documented and is supported by CEPR evidence that shows that the real growth rate in M1, “went well into negative territory for prolonged period just before (or in coincidence with) all historic EA recessions.” (ECB Economic Bulletin, April 2019).

Real growth rates in M1 peaked back at 11.1% back in November 2015, but the moderation became more obvious during 2018 with a recent low of 4.3% in August 2018. A more sustained recovery began in February 2019 and the current (July 2019) growth rate of 6.7% is the fastest rate since February 2018. The current level of real M1 growth remains comfortably above the levels that the ECB associates with risks of recession in the near future.

Leading/coincident indicator: growth in EA real GDP and real household credit (% YoY)
Source: ECB; Haver; CMMP
Lagging indicator: growth in EA real GDP and real corporate credit (% YoY)
Source: ECB; Haver; CMMP

Real growth rates in HH credit (a leading/coincident indicator) and NFC credit (a lagging indicator) are also at their highest levels in the current credit cycle. According to ECB data released last week, HH credit grew 3.4% YoY in nominal terms and 2.4% in real terms in July 2019. This is the fastest rate of growth since July 2009 and the fastest rate of growth in the current cycle. France (1.4% contribution), Germany (1.2%), Benelux (0.3%) and Italy (0.2%) were the main drivers of growth. NFC lending grew 3.9% YoY in nominal terms and 2.9% in real terms. Again the real growth rate was the fastest in the current cycle and the fastest rate of growth since June 2009. In the NFC sector, France and Germany are again the key country drivers, both contributing 1.7% of total nominal growth.

In other words, the message from the EA banking sector is more consistent with current ECB and EC growth (subdued but stable) forecasts than with fears of an EA recession.

Real GDP growth in Euro Area showing current EC 2019-2020 forecasts (% YoY)
Source: ECB; EC; Haver, CMMP

However, with growth remaining below LT trends and with inflation 1ppt below the ECB’s target, expectations that the ECB will cut rates this month and restart QE are likely to be met.

Euro Area inflation (HICP) remains well below the ECB target of 2% (% YoY)
Source: ECH; Haver; CMMP

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

“Three perspectives – One strategy”

How I combine three different time perspectives into a consistent investment strategy

As an investor, I combine three different time perspectives into a single investment thesis or strategy

Long-term (LT) investment perspective

My LT investment perspective focuses on analysing key structural drivers that extend across multiple business cycles.

As a macro and monetary economist, I start by analysing the level, growth, affordability and structure of debt. In my experience, this is the most important feature of LT secular cycles with direct implications for: economic growth; the supply and demand for credit; money, credit and business cycles; policy options; investment risks and asset allocation.

My LT investment perspective reflects my early career in Asia and my experience of Japan’s balance sheet recession.

Medium-term (MT) investment perspective

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 investment perspective, supported by detailed analysis provided by the European Central Bank (ECB).

Short-term (ST) investment perspective

Finally, 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.

My ST investment perspective is influenced 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.

One strategy

My investment outlook at any point in time reflects the dynamic between these three different time perspectives.

My conviction reflects the extent to which they are aligned.