Destination of U.K Goods Exports, Sources: Oxford Economics, Bank of England

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1 February 19, 2016 Global Economic Research 50 South LaSalle Chicago, Illinois northerntrust.com Carl R. Tannenbaum Chief Economist Asha G. Bangalore Economist Ben Trinder Senior Analyst, Country Risk The British Question Bank Stocks Have Taken An Undeserved Beating U.S. Corporate Profits on the Watch List The relationship between the United Kingdom and European Union (EU) has historically been complex. A significant amount of the British public view EU laws as burdensome, object to inward migration, and take issue with U.K. funds contributing to EU budgets. The question of whether the U.K. should leave the EU is not a new one. Here, we look at the current state of play before examining the economic benefits of membership and the potential costs of leaving. U.K. Prime Minister David Cameron has obtained a draft deal from the President of the European Council, Donald Tusk, outlining reforms in four areas sovereignty, governance, competitiveness and welfare. Agreement is targeted for an EU summit February 18 and 19, after which Mr. Cameron will present the deal to the British public. He wants the vote to take place in June 2016, before a likely spike in migration has the chance to sour public sentiment. Current polls put the Remain and Leave camps neck and neck; however, given the dire performance of polling results in last year s general election, you would be forgiven for taking these with a pinch of salt. Destination of U.K Goods Exports, 2014 EU US Switzerland China ROW Top Contributors to EU GDP, Trillions Sources: Oxford Economics, Bank of England The EU consists of 28 member countries and 505 million people. Membership does involve some costs (a contribution to a collective budget, for example) but also carries substantial benefits. As a single entity, the EU is the largest economy in the world with gross domestic product (GDP) in 2014 hitting 11.3 trillion, beating that of the United States. Additionally, one third of global trade is with the EU, thus it carries substantial clout on the international scene when it comes to

2 The migrant issue has complicated the Brexit calculus. agreeing trade deals. One could argue that the United Kingdom, with its relatively small portion of the global trade pie, benefits from this economic muscle. Within the EU itself, there are no tariffs on exporters, reducing trade barriers. This is a huge positive for U.K. producers that sell their goods to other EU countries. The EU is the United Kingdom s largest trading partner, with a sizeable 44% of exports reliant on the union. Although trade does not make a net contribution to growth in the United Kingdom, the openness of the economy makes it sensitive to trade volumes. Additionally, the United Kingdom runs a service sector surplus to the EU, worth 17.1 billion. The EU services directive lowered barriers to trade in services across member states and studies suggest this added 0.8% to EU GDP. Given the United Kingdom s specialism in the service sector, it is quite possible the domestic benefit was even bigger. With regards to the free movement of people (a politically sensitive topic in the United Kingdom and a source of populism arguably the reason the referendum is being held in the first place), evidence has shown that migrants pay more into the welfare system than they take out. On top of this, the free movement of goods facilitates greater competition between firms, enhancing efficiency, and common regulations ensure a level playing field for business. The benefits are, of course, felt both ways. The United Kingdom is the second largest economy in the EU, so to lose it would be a significant blow. Additionally, EU exporters that send their goods to the United Kingdom would take a hit in the event of an exit. Around 53% of the United Kingdom s imports come from EU members any reduction could cause significant pain to producers U.K Goods & Services Balance, % of GDP Goods Services U.K. Trade in Services With the EU by Sector, Billion, Nominal Travel Government Construction Culture Transport Isurance Telecom & IT Intellectual Property Other Business Services Financial Total Sources: Haver Analytics, RBC Academic studies have tried to estimate the impact on U.K. growth from Brexit. However, given that a post-brexit world would be a huge unknown, the estimation process is extremely difficult. Some focus on lost trade being a negative, while others focus on a reduction in regulatory burdens being a positive. If tariffs increased on U.K. exports this could worsen the current account deficit, which is already a source of investor concern. Both Nomura and 2

3 Lost in the rhetoric are huge economic benefits of association. Goldman Sachs estimate that sterling could depreciate by 1 to 15% if investors become unwilling to finance the perennial shortfall. From the wider EU perspective, it is not in their interests for the United Kingdom to leave. In addition to losing its second largest economy, it would lose one of its two main military powers. The message this would send to the rest of the continent, and the rest of the world, could cause a significant loss of confidence. The question of Who s next? would inevitably arise. The financial services industry deserves special mention. The United Kingdom is the largest financial center in the EU, and one of the most important globally. Of total gross value added to EU financial services, 24% comes from the United Kingdom, and London is a leading center for numerous financial activities. In total, the sector accounts for 8% of national income. At present, financial service providers have passporting rights, allowing them to deliver financial services in other member states on a cross-border basis. In the event of an exit, this right may be lost, potentially forcing firms to relocate out of London In a worst case scenario, an upheaval in financial services could hurt national income, result in thousands of job losses and cost the treasury huge sums of lost tax revenue. There will always be those in the United Kingdom who are opposed to EU membership. Will this referendum settle the issue? If only a small majority vote to stay, then Eurosceptics could push for another chance. If the decision is to leave, then the only certainty is more uncertainty. This could prove disastrous at a time when European unity needs to be at its strongest. Banking on Recovery Since the beginning of the year, markets have been unsettled. Risk aversion has moved across financial centers amid heightened concern about the health of emerging markets and key industries. Among the latter is banking, which stands at the nexus of the credit system. Share prices of financial institutions have been under significant pressure; the KBW index of bank stocks has fallen nearly 2 so far this year, well beyond the 9% correction experienced by the S&P 500. If intermediaries falter, lending may be affected, which would be a hindrance to economic growth. At the extreme, there are those who fear a repeat of 2008, which saw a chain reaction of financial failures that rattled confidence and required significant amounts of public support. The memory of the Global Financial Crisis remains fresh in the minds of many, which is understandable given the depth of anxiety it produced. But a rerun is very unlikely. Financial companies are better capitalized and more carefully monitored than they were eight years ago, and are therefore much less likely to be agents of contagion. Banks in the United States are arguably in the best position. Lending activity in the United States has been very strong; commercial lending has expanded by more than 1 over the past year, and household credit is growing again after several stagnant years. Credit quality may be a little past its peak, but not by much. Energy exposure is generally a very small fraction of bank loan portfolios, and the low cost of fuel may improve the earnings and creditworthiness of borrowers in other industries. 3

4 15% 1 5% U.S. Lending Growth 13% 12% 11% 1 9% 8% Tier 1 Capital Ratio Top 10 U.S. Banks -5% C&I CRE RRE Credit Card Banks are better able to handle the losses that will inevitably arise, thanks to higher capitalization. In nominal terms, U.S. banks have almost twice the capital than they did a decade ago, and much more of that capital is in the form of common equity. Annual stress tests applied to the country s largest banks are designed to ensure an appropriate buffer against loss. Furthermore, U.S. banks have fewer off-balance-sheet risks than they once did, and many more transactions they are party to are handled on exchanges where they can be margined and monitored. Oversight of the financial system remains at a very high level; while this may not guarantee that another crisis will occur, it provides some level of insurance. 7% 6% 5% Sources: Federal Reserve, SNL, Haver Analytics U.S. banks are in a far stronger position than banks in Europe. Banks in America had certainly been looking forward to some additional interest rate increases from the Federal Reserve, which are typically helpful to earnings margins. Those seem less likely to occur, at least for now. But that is not enough to account for such significant bank stock underperformance. The banking situation in Europe is more challenging. The cleanup from the crisis moved more slowly in the eurozone, and the absence of a central banking supervisor was one reason why. The European Central Bank (ECB) has assumed authority over the large banks, but inherits that mandate at a challenging time. Bad loan levels remain elevated, and many large eurozone banks have significant exposure to emerging markets. A number of them will need to raise significant amounts of capital in the coming years to comply with new international standards. Further, the negative interest rate environment is impairing bank profitability in the eurozone. There has been reluctance to pass negative rates along to retail customers. This results in thinner margins, which will become thinner still if the ECB lowers its deposit rate again next month. Certain individual institutions have been the subject of heightened concern, primarily for idiosyncratic reasons. But we are a long way from another systemic meltdown. 4

5 Corporate Profits Are Slipping U.S. corporate profits surged in the early part of the current expansion to reach the highest mark as a share of GDP since This robust performance is in the past. The recent weak trend will affect the economy s overall performance if it fails to turn around. The large drop in oil prices is often assumed as the reason for the weak profit story. Digging into details reveals a more widespread phenomenon. Profits of U.S firms declined 5.1% from a year ago in the third quarter, the largest drop since Margins of both domestic and foreign industries fell. Regarding the former, the weakness was visible in both financial and nonfinancial sectors. Earnings from foreign operations were disappointing and they registered declines in five out of the last six quarters, with the third-quarter drop (-10.6% from a year ago) the largest since the Great Recession. The strength of the greenback reduced foreign income when it was converted to dollars. Corporate Profits Share of GDP Profits will suffer as wages move up. Year-over-year change % 58% 57% Labor (left) Profits (right) 15% 12% 9% 6% -2 56% 3% % Source: Haver Analytics We should note that the share of the oil industry s profits is less than 3. of overall profits, per national income and products data. Within the smaller universe of the S&P 500 firms, the energy sector accounts for 6.6% of market capitalization. So while earnings performance in this sector has been desultory, it does not fully account for the broader trend. Two other things may be at play. In the past, foreign operations helped to lift corporate profits as the globalization wave was unfolding. Emerging markets are in a different place now, and could be a drag on earnings. Further, recent wage gains have increased labor s share of GDP is moving up and holding down that of at the expense of corporate profits. Tight labor markets in the latter stages of expansion usually mean thinner corporate margins. Margin compression bodes poorly for capital expenditures and hiring prospects. Surveys indicate that capital expenditure plans have been scaled back in the past few months. And we will be watching upcoming employment news closely. At this mature phase of the business cycle, capital spending will be critical for maintaining and extending business momentum. 5