EY ITEM Club Outlook for financial services - Minds made for empowering financial services

 
EY ITEM Club Outlook for financial services - Minds made for empowering financial services
EY ITEM Club
                    Outlook for
                    financial services
                    Minds made for empowering
                    financial services

Summer 2018

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About this report
The EY ITEM Club: Outlook for financial services examines the
implications of the EY ITEM Club’s economic projections for the
financial services sector. EY is the sole sponsor of the EY ITEM
Club, which is the only non-governmental economic forecasting
group to use the HM Treasury model of the UK economy.
Its forecasts are independent of any political, economic
or business bias.

In conjunction with ITEM’s Chief Economist Howard Archer, Oxford
Economics is responsible for producing the forecasts and analysis
provided in ITEM’s forecast reports. Oxford Economics is one of
the world’s foremost independent providers of global economic
research and consulting using unique global economic models.

EY is a leader in shaping the financial services industry
We are a global leader in assurance, tax, transaction and advisory services.
Over 30,000 of our people are dedicated to financial services, serving the
banking and capital markets, insurance, and wealth and asset management
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build a better working world.

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2   | EY ITEM Club Outlook Summer 2018
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Contents

04                       06
Macroeconomic overview   Banking

08                       10
Insurance                Wealth & Asset Management

                                       EY ITEM Club Outlook Summer 2018 |   3
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Macroeconomic overview
A weakening economic outlook                               Consumers face a renewed squeeze
presents a challenge to financial                          on disposable income and spending…
services firms                                             Inflation continues to decline, falling to 2.4% in
                                                           April and May from a peak of 3.1% last November.
The first quarter of 2018 saw an expansion of just 0.2%
                                                           But unfortunately, the next few months are likely to
in the UK’s gross domestic product (GDP), one of the
                                                           see a renewed squeeze on households’ spending power
weakest results in over five years. Growth may have
                                                           as oil reached a 3.5-year peak of $80 per barrel in
been affected by the severe winter weather, but we
                                                           May, and higher energy prices will take effect over the
have seen few convincing signs of a strong rebound
                                                           summer. On the upside, record levels of employment
since. Several factors, including slowing Eurozone
                                                           should provide support for consumption. Set against
growth and rising oil prices, mean that this forecast
                                                           that, sluggish wage growth means that real household
is less encouraging than the spring edition six months
                                                           disposable incomes will grow by just 1.3% this year
ago. We now expect GDP to grow by 1.4% this year.
                                                           and next. The household saving ratio also reached a
This is down from our previous prediction of 1.7% and
                                                           50-year low in 2017.
well below historic trends and current global averages.
That sluggish performance will make it difficult for       The resulting need to rebuild household savings means
financial services companies to grow and support the       that consumer spending is only expected to grow by
economy as much as they would like.                        1.2% this year and 1.5% in 2019.

     1.4%                                            2.4%                                           2.4%
GDP                                            Inflation                                      Mortgage lending
We now expect GDP to grow by 1.4% this         Inflation continues to decline, falling to     Mortgage lending will climb 2.4% this year
year. This is down from our previous           2.4% in April and May from a peak of           and experience its weakest growth since
prediction of 1.7% and well below historic     3.1% last November.                            2013 next year, 1.8%.
trends and current global averages.

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…whilst cooling global growth and                             We now expect the Bank of England
Brexit uncertainties raise questions                          to raise the interest rate only once
over exports and investment                                   this year
In 2017, the weak pound and buoyant worldwide growth          The Monetary Policy Committee’s focus on Q2’s
allowed net trade to make a sizable contribution to GDP.      rebound in consumer spending suggests that a further
But whilst the US economy remains strong, the outlook         hike in the Bank Rate could be looming. We expect a 25
for exports is increasingly clouded by growing global         basis point rise to 0.75% in August, although weak pay
protectionism and slowing growth in the Eurozone –            growth and Brexit uncertainty could delay that decision
the UK’s biggest export market.                               until November.

Our forecast assumes that Brexit uncertainty will
ease this year as the UK and EU move toward an
agreement on withdrawal and transition. That would
push up sterling but should reduce headwinds to inward
investment. However, there are clear downside risks
to this scenario. Political friction in the UK and the slow
pace of negotiations mean that a “no-deal Brexit” can’t
be ruled out. The resulting fall in sterling might provide
a short-term boost to exports, but such an outcome
could have serious negative implications for the
economy and the financial services sector in particular.

      4.7%                                              4.1%                                          1.2%
Business lending                                  Consumer credit                                Consumer spending
We forecast a 4.7% expansion in the stock         We expect consumer credit growth to            Consumer spending is set to climb by just
of business lending this year, with further       slow to 4.1% and 1.9% this year and next.      1.2% this year – the lowest rate since 2011.
growth of 2.5% in 2019

                                                                                                         EY ITEM Club Outlook Summer 2018 |   5
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Banking
Dampened household incomes                                                                      Despite this, we expect consumer credit growth to slow
                                                                                                to 4.1% and 1.9% this year and next. This dramatic shift
will hold back demand for lending                                                               in momentum reflects a combination of demand- and
this year                                                                                       supply-side pressures. On the demand side, we forecast
The next two years will see real household incomes                                              consumer spending to climb by just 1.2% this year –
limited by still-high inflation and slow employment                                             the lowest rate since 2011. Households need to bring
growth. This will keep a lid on household lending growth.                                       their spending levels back in line with real incomes,
Meanwhile, businesses’ preference for nonbank finance                                           especially in the light of 2017’s record low household
will continue, although it should weaken slightly this                                          savings ratio of 4.1%. Meanwhile, the Bank of England’s
year. These factors mean that banks’ total lending is                                           Credit Conditions Survey for the first quarter of 2018
now expected to grow by just 1.7% this year and 1.5%                                            shows that a net balance of nearly 40% of lenders
in 2019.                                                                                        expect the supply of credit to tighten. The first quarter
                                                                                                also saw a year-on-year fall from 30 to 26 months for
Household debt stabilises, whilst interest burden                                               average interest-free credit card transfer periods.
falls to a new record low
         %                                                                             %

                                                                                                The outlook for business credit
170                                                                                        14
160
                                                                                           12
150
                                                                                           10
                                                                                                looks modest, despite banks’
                                                                                                willingness to lend
140
130                                                                                        8

120                                                                                        6
                                                                                                Growth in business lending remains relatively soft,
110
100
                                                                                           4    following a contraction of 4.3% in the stock of business
    90
                                                                                           2    loans during 2017. The year to April saw modest
    80                                                                                     0    lending growth of 2%, but if repayments are taken
     1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
                                                                                                into account, the stock of loans only increased by
         Debt as % of income (LHS)   Interest payments as % of income (RHS)
                                                                                                1% over that period. This may seem odd, given solid
Source: EY ITEM Club                                                                            corporate profitability and the 6.2% expansion in
                                                                                                total UK corporate debt during 2017. The uncertain
The mortgage market is particularly                                                             investment outlook is one factor, but the leading
subdued…                                                                                        consideration is the continuing popularity of nonbank
                                                                                                finance. Investors’ thirst for yield is generating
The past few months have been quiet ones for the                                                sustained demand for UK corporate bonds, with
housing market. This reflects pressure on real incomes,                                         nearly three-quarters of net corporate borrowing
stretched affordability and expectations of higher                                              since 2007 coming via securities issuance.
interest rates. As a result, mortgage lending grew by
just 3.4% in the year to April 2018, around a third of                                          However, a 30 basis point increase in investment grade
the 1997–2006 average. We expect this stable but                                                sterling corporate bond spreads since early 2018
sluggish picture to continue, with net mortgage lending                                         suggests that banks could have a fresh opportunity to
climbing 2.4% this year and 1.8% in 2019 – the slowest                                          increase their lending, including to SMEs. We forecast
pace since 2013. Mortgage rates remain near historic                                            a 4.7% expansion in the stock of business lending this
lows, despite last November’s Bank Rate hike. But even                                          year, with further growth of 2.5% in 2019.
with house prices growing slowly, the ratio of prices to
                                                                                                A soft outlook for lending growth
average earnings remains high. According to Halifax,
                                                                                                % year
this was 5.6 in May, well above the 35-year average
                                                                                                25
of 4.2.                                                                                                                                                                            Forecast
                                                                                                20

                                                                                                15

…and although consumer credit
                                                                                                10

                                                                                                 5

keeps growing, it too will begin to                                                              0

cool this year                                                                                   -5

                                                                                                -10

Consumer credit growth has exceeded our predictions,                                            -15
                                                                                                  2002     2004     2006     2008     2010        2012      2014     2016   2018    2020
growing by 8.8% in the year to April 2018. This is slightly
                                                                                                      Consumer credit      Lending to companies          Mortgage lending
lower than November’s peak of 10.9%, but that is largely
due to weaker car financing, a market where most banks                                          Source: EY ITEM Club/Haver Analytics

are largely inactive. Personal lending and credit card
debt continue to expand, recording growth of 8.7% and
8.9%, respectively, during April.

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Banks face new funding pressures                          Meanwhile, the implications of last year’s Plevin ruling
                                                          on compensation for mis-sold payment protection
and a fresh surge in PPI costs                            insurance may be behind rising compensation costs in
The end of the Bank of England’s Term Funding             the run-up to the August 2019 deadline for claims. The
Scheme, which provided cheap financing to commercial      six months to March 2018 saw monthly compensation
banks, in February means that banks may have to           average £376m, 60% up on the £233m averaged in the
compete more aggressively for customer deposits.          same period in 2016–17. This pushed up the cumulative
With competition making it harder to charge borrowers     cost since 2011 to almost £31b. And the recent legal
more and the average interest rate on new deposits        ruling on commission thresholds could, if it creates
higher than the Bank of England rate, the loss of cheap   a precedent, result in a significant hike in the total
funding may weigh on banks’ profit margins, although      compensation bill.
the option of tapping the securitisation market could
reduce upward pressure on costs. Moreover, the
potential for increased transparency resulting from the
FCA’s review into retail banking business models could,
in the long run, reduce the income of some banks by
encouraging depositors to switch providers.

Banking sector recap
                                                   2016           2017           2018            2019             2020            2021
 Total assets (£b)                                6,995          7,332           7,460           7,501           7,666           7,903
 Total loans (£b)                                 6,077          6,372           6,566           6,666           6,826           7,042
 Business/corporate loans (£b)                     407            390             402             416                425           437
 Write-offs (% loans)                               0.5            0.3             0.4            0.6                1.0           1.1
 Consumer credit (£b)                              193            207             216             218                225           233
 Write-offs (% loans)                               1.6            1.3             1.3            1.5                1.7           2.1
 Residential mortgage loans (£b)                  1,155          1,205           1,234           1,256           1,292           1,329
 Write-offs (% loans)                              0.01           0.01            0.01            0.02            0.03            0.04
 Deposits (% year)                                  8.2           -0.8             2.6            0.5                1.2           3.2
 Loans/deposits (%)                                134            142             142             144                145           145
 Total income (£b)                                 134            136             137             139                143           149
Source: EY ITEM Club

                                                                                                        EY ITEM Club Outlook Summer 2018 |   7
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Insurance
Modest growth in real incomes                                            …and home insurance markets
is welcome but will give limited                                         remain tepid
support to non-life premiums                                             The sluggish home insurance market is another
Following a dismal 2017, when average inflation-                         contributor to slow non-life growth. Stretched
adjusted incomes fell by 0.6%, 2018 holds slightly                       affordability for potential buyers and a limited supply
more encouraging news for big-ticket spending and                        of properties coming to market mean that we expect
non-life premium growth. Unfortunately, we expect                        housing transactions to rise by little more than 1%
higher petrol prices and utility bills to weigh on                       a year from 2018 to 2021. For comparison, annual
household finances, limiting real income growth to                       transaction growth averaged 5.9% over the previous
1.3%. That is a long way off the 3.1% average annual                     five years.
increase seen between 1997 and 2007. This weak
                                                                         Housing transactions are forecast to see only
performance means that non-life premium growth
                                                                         modest growth
will be limited to 3.2% this year and 3.1% in 2019.
                                                                         000s

Motor insurance prices have started to fall                              450                                                                    Forecast

% year
                                                                         400
 20

 15                                                                      350

 10
                                                                         300
    5

    0                                                                    250

    -5
                                                                         200
-10                                                                            2000   2002   2004   2006   2008   2010   2012   2014   2016   2018   2020

-15
 2010           2011     2012     2013   2014       2015   2016   2017   Source: EY ITEM Club/Haver Analytics
         Home contents    CPI inflation   Motor insurance

Source: EY ITEM Club/ONS
                                                                         Prospects for asset markets are
                                                                         becoming less favourable to life
                                                                         companies
Motor insurance faces a mixed
                                                                         The softening global growth outlook, illustrated
outlook…                                                                 by the Eurozone slowdown and the rising risks of
Motor insurance faces some specific head winds.                          protectionism, suggests that the performance of
The most obvious is the continuing plunge in sales                       equity markets this year will not replicate that of
of new diesel vehicles. Slowing growth in Personal                       2017. And although bond yields should climb as the
Contract Purchases is another cooling factor, together                   Bank of England raises rates, life insurers won’t escape
with signs of a gradual shift away from car ownership.                   the pressures of a low-rate world for some time.
Car registrations are forecast to fall by 4.2% this year,                UK yields remain surprisingly weak, compared with
following 2017’s drop of 5.7%. We only expect to see                     US equivalents, and we anticipate just one 25 basis
modest growth of 1% in 2019.                                             point UK rate rise this year, with two more in 2019.

On the face of it, a 3.5% fall in motor pricing during the               As the world moves toward monetary tightening,
year to May is further bad news for insurers. This was                   we expect the 10-year gilt yield to average 2.6%
the second consecutive decline and contrasts with the                    between 2018 and 2021. In comparison, 10-year
11% rise recorded in May 2017. However, lower prices                     gilts were yielding just under 1.3% at the start of July,
do not necessarily indicate a turn in the rates cycle.                   down from a recent peak of 1.6% in April. We forecast
Reforms to the Ogden discount rate have so far had                       life premiums to rise by an annual average of 3.4%
a softer impact than expected.                                           between 2018 and 2021.

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Demographic changes could provide                          The recent Retirement Outcomes Review made it
                                                           clear that providers should expect ongoing change,
some support for profits…                                  starting with the launch of a consultation on consumer
Overall, we forecast insurance profits to grow by an       protection and competition in the retirement income
average of around 6% over the next few years, driven       market. The ongoing review into Defined Benefit to
in part by increasing bond yields and improving claims     Defined Contribution transfers is likely to put in place
ratios. The fact that the ONS sees UK life expectancy      more stringent controls on transfers into personal
gains as having tailed off since 2011 is troubling but     pensions or drawdown products, dampening the
could boost profits by enabling insurers to adjust their   market.
mortality assumptions. In time, this trend could also
                                                           Finally, 2018 has seen the first planned rise in auto-
reduce corporate pension scheme deficits, encouraging
                                                           enrollment contribution rates, without significant
buyouts by specialist insurers.
                                                           impact on opt-out rates. If 2019’s larger rise also
                                                           goes through smoothly, new money into pension
…though the impact of policy                               schemes should see a significant boost.

changes remains unclear
Looking ahead, policy changes will continue to affect
the life sector. The introduction of “pension freedoms”
led to over 1.5 million personal pension pots being
accessed between April 2015 and September 2017.
That marks a substantial shift toward drawdown and
away from annuities. The FCA continues to focus on
safeguarding customer outcomes.

Insurance sector recap
                                                    2016           2017            2018           2019              2020            2021
 Life gross premium (£b)                           163.1          166.4           170.2           173.5             179.2          188.0
 % year                                              1.0            2.0             2.3             1.9               3.3            4.9
 Life gross claims payments (£b)                   122.0          123.5           123.0           122.1             122.7          125.0
 Life claims ratio (%)                               75             74              72              70                68              66
 Non-life gross premium (£b)                        57.3           59.1            61.0            62.9             65.0            67.5
 % year                                             -2.8            3.2             3.2             3.1               3.4            3.8
 Non-life gross claims payments (£b)                31.3           33.4            34.0            34.6             35.2            36.0
 Non-life claims ratio (%)                           55             57              56              55                54              53

 Net profit (£b)                                     6.1            7.9             8.5             8.9               9.4           10.0

Source: ITEM, OECD, Swiss Re

                                                                                                          EY ITEM Club Outlook Summer 2018 |   9
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Wealth & Asset Management
2017 delivered the strongest rise in                                            …but cloudier global prospects
AUMs since 2010…                                                                suggest less strength ahead
2017 saw the FTSE 100 Index record a rise of 14.7%,                             Unfortunately, this strength is unlikely to be repeated
its biggest since the start of the decade. This, together                       in 2018. Sterling’s retreat against the dollar in recent
with buoyant global markets and a further weakening                             months will support UK equities, many of which have
in sterling, helped UK assets under management (AUM)                            significant foreign earnings. However, we forecast the
rise by 17.4% during the year. That was the strongest                           pound to stage a modest recovery over the coming
growth since 2010 and the second year running of                                year. This reflects a gradual rise in UK base rates
double-digit expansion. At the end of 2017, AUM                                 – expected to start in August – and our hopes for a
reached almost £1.3t, equivalent to 62.4% of UK GDP.                            gradual reduction in Brexit-related uncertainty.
As recently as 2016, that figure was less than £1t.                             If proved correct, that would reduce the mechanical
                                                                                boost to equities from sterling’s weakness.
Strong AUM growth in 2016/17 is forecast to cool
                                                                                A more mixed outlook for the world economy also
 £b

90
                                                                                suggests that global asset prices will perform less
            AUMs (£b)                                               Forecast
                                                                                well than we previously forecasted. The US economy
80          GDP (£b)

70
                                                                                continues to perform strongly, but the Eurozone has
60
                                                                                struggled to rebound from its slowdown in early 2018,
50
                                                                                and the growing risks of a global trade war are already
40
                                                                                dampening asset valuations. It’s worth noting that
30
                                                                                there are few signs of over-valuation; the FTSE’s price-
20
                                                                                earnings ratio at the end of June was 13.6, well below
10
                                                                                the 15-year average of almost 16. Even so, a projected
 0
                                                                                average annual rise of 4.8% in the FTSE All Share Index
     2002     2004      2006   2008   2010   2012   2014   2016   2018   2020
                                                                                between 2018 and 2021 is less than half the figure
Source: EY ITEM Club/Haver Analytics                                            achieved in 2016 and 2017. So whilst we expect some
                                                                                capital to shift from bonds to equities, the extent
                                                                                of the rotation will be modest – limiting the sector’s
                                                                                profitability growth.

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Auto-enrollment and high                                                                         High levels of UK employment will bolster inflows from
                                                                                                 auto-enrollment, and we expect AUM to receive a boost
employment offer some potential                                                                  as households face up to rebuilding saving ratios from
opportunities                                                                                    2017’s record low levels. Set against that, a slowdown
On the upside, the asset and wealth management                                                   in the growth of households’ financial assets could
sector is well-positioned domestically to benefit                                                create head winds to inflows. The level of UK household
from increasing mandatory saving. April 2018 saw                                                 wealth is already high by historical standards. Net of
employers’ auto-enrollment pension contributions                                                 financial liabilities, it equated to 352% of household
by employees rise from 1% to 2%, with a further                                                  incomes in the first quarter of 2018, compared with
increase to 3% planned for April 2019. The DWP now                                               an average of 282% since 1988. Household financial
expects auto-enrollment to add £19.7b per year to                                                assets grew at just 3% in the first quarter of 2018,
pension savings by 2019–20, equivalent to around 1%                                              down from 11.2% in the third quarter of 2016 and
of UK GDP. Although some savers might opt out as                                                 following a rare decrease of 1.2% in the final quarter
contribution rates rise, inertia suggests that most are                                          of the same year.
unlikely to do so without a triggering event such as a
job change.

AUMs forecast sees shift towards equities
  £b

1750
              Money market      Mixed                                  Forecast
1500          Fund of funds     Equities
              Property          Bonds
1250

1000

 750

 500

 250

   0
       2011      2012    2013    2014      2015   2016   2017   2018    2019      2020    2021

 Source: EY ITEM Club/Broadridge

Wealth & Asset Management sector recap
                                                                                    2016                2017           2018           2019              2020            2021
 Total Assets under management (£b)*                                               1,086                1,275          1,302          1,327            1,399           1,498
 % year                                                                              16.5                17.4            2.1            1.9              5.4             7.1

 Bonds (£b)                                                                          165                 187            186            186              188              190

 Equity (£b)                                                                         539                 647            670            684              727              784
 Fund of Funds (£b)                                                                  133                 158            160            163              172              189
 Hedge (£b)                                                                              1.3             1.3             1.3            1.3              1.3             1.3
 Mixed (£b)                                                                          159                 180            182            188              205              224
 Money Market (£b)                                                                       59               68             69             70               72               73
 Property (£b)                                                                           28               34             33             33               35               36

*UCITS and non-UCITS assets
Source: EY ITEM Club, Broadridge

                                                                                                                                              EY ITEM Club Outlook Summer 2018 |   11
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