Eurozone. Outlook for. Ernst & Young Eurozone Forecast. Summer edition 2012

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1 Eurozone Ernst & Young Eurozone Forecast Summer edition 2012 Outlook for

2 Published in collaboration with

3 Andy Baldwin Head of Financial Services Europe, Middle East, India and Africa With key national elections in France and Greece, as well as a banking bailout in Spain, much has happened since our nothing has changed. Even the return of a pro-bailout government in Greece last month barely moved the dial. Similarly, the 100 million bailout of Spain s banks in June prompted only a short rally. After two years of turmoil, it seems that global investors are frustrated with short-term to the sovereign debt crisis. Unlike the markets, we continue to believe that the Eurozone is more likely than not to emerge from this crisis intact, but the outlook has deteriorated over the quarter. The continued uncertainty means that stock market volatility is high, while other Eurozone members such as Spain are being forced to pay up to 7% on their borrowings and bank share prices remain depressed. Unemployment, which is running at 25% in Spain and 22% in Greece, will continue to depress the economy, and a 0.6% contraction in the Eurozone s economy is forecast. services sector. In banking, the ECB s second long-term but the necessary painful restructuring has barely begun. review of the banks on 31 July to try to reassure the markets that the bailout has worked. The decision by Eurozone leaders at the summit on 28 June to restructure the bank recapitalization plan so that the loans do not add to Spain's public debt burden was a welcome move that will help to break the feedback loop between sovereign and banking sector risk. balance sheets by 1.6 trillion in As a result, corporate loans will contract, which will hit investment and feed back into the real economy. With banks facing further ratings downgrades as they write off sovereign debt, funding pressures will intensify, driving up interest rates as banks compete for new depositors. The insurance industry, meanwhile, is facing a dilemma. Muted stock performance has combined with low interest rates to hit investments at a time when quantitative easing is down their capital or switch allocations to riskier assets in the hope of improving returns. However, there is good news for consumers in that increased refocus on customer service. depressed equity markets and assets under management quarter of In the longer term, a resolution to the Eurozone crisis will boost stock markets, helping both insurers and asset managers. Despite market cynicism, Eurozone governments solution in the last few weeks. The election of François Hollande as President of France in April shifted the balance of power toward the southern European states, who argued in favor of economic stimulus instead of austerity. In June, objections to a limited pooling of sovereign liabilities. help stabilize the Eurozone at the June summit, including a single banking supervisor and changes to the rules governing EU bailout funds to allow direct purchases of sovereigns such as Spain and Italy. Considerable downside risks remain, not least that the Eurozone s richer northern members must convince their people to pay for this pooling of liabilities. Greece where the pro-bailout Government s political to leave the single currency without unraveling the euro. services informative and thought-provoking. Please visit our dedicated Eurozone website for more information: Contents Summer edition

4 Overview Despite a pro-bailout party getting the largest share of the vote in June s re-running of the Greek elections, uncertainty over the Eurozone s future continues. Consequently, stock market volatility is higher than it was early in the year, as are peripheral bond yields, while the euro, German government bond yields and bank share prices the Eurozone will stay intact, given the very negative economic impact of a break-up on all parties. Nevertheless, markets will continue to worry periodically about such a break-up, and policy-makers will continue to struggle to keep up with the demands of the market for Away from the Greek crisis, the key question for policy-makers has shifted from how to enforce austerity to how to improve a gloomy economic outlook. We forecast a mild contraction in the Eurozone this But since then the outlook has deteriorated, with a high degree of uncertainty about the future shape of the Eurozone likely to dampen deep and prolonged restructuring that will squeeze the availability of credit for some time. This is also likely to dampen business investment and consumer spending. Spain s decision to apply for Eurozone assistance to recapitalize its banks is a positive step and the decision by Eurozone leaders to inject the funds directly into the banking sector will help to break the adverse feedback loop between sovereign and banking sector risk. The decision to move change and a major step toward a broader banking union. Such a union would also need to include a resolution regime for failed banks and a pan-european deposit guarantee scheme. in many economies the contraction seems set to continue into Assuming the Eurozone remains in its current shape, with Spain, Italy and Portugal averting debt restructuring, 2013 may see a gradual recovery, with Eurozone GDP rising by 0.4%. But the recovery is likely to be weak into the medium term, with overall Eurozone growth unlikely to causing bank loan losses in much of the region. The jobless rate has risen to almost 25% in Spain, 22% in Greece, and 15% in Portugal, further undermining domestic demand and investment and the ability crunch. But the Eurozone banking sector still needs to go through a remains whether Greece is able to adhere even to diluted terms of a place even greater strains on the Eurozone and push up borrowing costs for Portugal, Ireland, Italy and Spain at best, this would impair the economic recovery further and, at worst, it could drive other peripherals toward default. Forecast for the Eurozone economy GDP Summer edition 2012

5 Sector highlights Banking Asset management Insurance Summer edition 2012

6

7 in the region are set to reduce their assets by some 1.6 trillion this banking system requires up to 62 billion in additional capital in order to withstand a worst case economic scenario. The 100 billion of EU bailout funds that have been made available to Spain should thus be shrink, curtailing consumer spending and business investment and, hence, overall economic growth. As the economy weakens, there will be increased upward pressure on leaders at the summit on 28 June to inject capital directly into the banking system, rather than routing it through the Spanish government, is also a positive step that will help to break the feedback loop between sovereign and banking sector risk. they will rise from an estimated 5.6% of total loans last year to reach a euro-era high of 6.5% during Chart 1.2 Eurozone non-performing bank loans 14 % total loans Forecast Italy 8 6 Eurozone 4 France Germany 2 Netherlands Chart 1.1 Eurozone banking sector assets and GDP Chart 1.3 Bank exposure to Spain % year Forecast Total bank assets Nominal GDP Rest of world 8 US 4 UK 0 France Government debt Private sector Banks Other -4 Germany Source: BIS US$b Summer edition

8 Although investment banks enjoyed a rebound in trading revenues at contract by 4.8% this year. sector loans are not forecast to surpass their pre-crisis peak of 4,827 billion until remainder of the year appears far more downbeat. Prospects in retail divisions also appear gloomy, given the shrinkage in loan books and the income for Eurozone banks to show only very modest growth of 1.5% this year, albeit an improvement from the estimated 1.4% fall banks in the core Eurozone, while banks in the periphery countries will suffer continued losses. Pressure on margins will continue to be a driving force behind restructuring in the banking sector, with the likely weakness in Q2 results giving added impetus to these efforts. Eurozone-Banking ,543 31,900 31,495 32,545 33,838 35,121 12,322 11,841 11,849 12,344 12,977 13,595 4,720 4,496 4,535 4,775 5,079 5, ,784 3,743 3,770 3,866 3,977 4, Forecast for the Eurozone economy Summer edition 2012

9

10 companies in the sector focused on re-engineering processes and high hedging costs, low business volumes due to the weak economic environment, and more onerous capital requirements will between interplay between historically low interest rates and capital requirements is a particular problem for the industry. In addition, the Eurozone life insurance industry has a gap to plug between historically low interest rates and the higher return by running down reserves or by investing in riskier assets such as equities or corporate bonds instead of high-quality government debt. Eurozone non-life premiums grew by 3.1% in 2011 as insurers were able to make rate improvements stick in some markets. However, due to the combination of weak new business growth, record catastrophe non-life industry suffered in customer acquisition costs. Chart 2.2 Life premium growth % Year on year the non-life insurance industry in the region will see premium growth in 2012 of just 1.5%, well below historical averages should see growth return to the Eurozone economy and premium growth rise to 2.2%. Premium growth is likely to stay at or below 3% until 2016, Germany France Italy Spain Netherlands Chart 2.1 Eurozone net operating surplus Chart 2.3 House prices 30 b Forecast 125 Level Forecast 120 France Germany Netherlands Italy Spain

11 challenging macro-economic environment will keep the life industry rather depressed. Weak GDP, job markets, income growth and housing business. Consequently, life premiums in the Eurozone will not fully recover in 2012 from 2011 s fall. onerous regulatory capital requirements. However, in the longer term, demand for savings products, longevity insurance and long-term care will be robust, due to the need of an ageing population to prepare for that it is responding to. There is considerable work under way to reshape life products and look for new hedging strategies. Eurozone-Insurance % year Life claims ratio (%) % year Non-life claims ratio (%) Forecast for the Eurozone economy Households Summer edition 2012

12 10

13 At the end of 2011 the Eurozone asset management industry had assets and a 16% fall in equity assets as the equity market fell 8% and investors withdrew assets. intervened to stabilize the Eurozone banking system and bring down pace of 4% 7%. This will help equity assets to grow, particularly those of the peripheral economies. The growth rates of bond assets across bond AUM in Germany, France and the Netherlands, but over this a fall in yields on peripheral debt. However, AUM probably fell again in the second quarter as another phase of the Eurozone debt crisis depressed equity markets and caused the yields of peripheral bonds to rise again. around, the decline in money market AUM. weakness in equity AUM to continue during In recent months, funds as investors have shied away from taking strong directional bets in the face of an uncertain policy outlook. We are forecasting a 3% rise in bond AUM during 2012, as strength in weakness in Spanish bond AUM, the Spanish market being at the epicentre of the Eurozone crisis in its current phase. Chart 3.2 Bond assets under management b Germany (left-hand side) Forecast Spain (right-hand side) Chart 3.1 Eurozone total assets under management Chart 3.3 Eurozone assets under management 6,000 b Forecast 600 b Forecast 5, , Mixed asset funds 3,000 2, Fund of funds 1, Summer edition

14 funds asset growth will be much more moderate than in the past, given that these funds are now no longer in vogue. Analysis included in the Spring forecast showed that there was a rising requirements for funding pensions. This suggested that pensions toward 50% of retail funds under management. Eurozone-Asset management % year ) *UCITS and non-ucits assets Forecast for the Eurozone economy Households ,564 2,314 2,531 2,895 3,236 3,526 15,581 15,853 16,671 17,912 19,040 19, ,820 5,927 6,009 6,561 6,965 7, Summer edition 2012

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