EY ITEM Club. Outlook. for financial services. Spring 2015

EY ITEM Club Spring 2015 Outlook for financial services

Contents About this report 04 Macroeconomic highlights 05 Introduction 06 Macroeconomic overview 08 Banking forecast The ITEM Club outlook for financial services examines the implications of the ITEM Club s economic projections for the financial services sector. EY is the sole sponsor of the 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. 10 Insurance forecast 12 Wealth and asset management forecast 2 Outlook for financial services EY ITEM Club Forecast Spring 2015 Outlook for financial services EY ITEM Club Forecast Spring 2015 3

Introduction Macroeconomic highlights Introduction The latest outlook for the UK economy is positive. GDP is on the rise; business investment continues at a strong pace; and we expect to see export performance improving. The plunging oil price has given UK economic growth a quick boost. But there are still uncertainties on the horizon. CONTACT +44 20 7951 2313 cprice1@uk.ey.com 2.6% GDP 2.9% GDP 0% 1.3% The increased by 2.6% in 2014, the UK s strongest performance since 2007. growth is forecast to accelerate to 2.9% in 2015, partly as a result of the boost provided by the fall in oil prices. Annual inflation is forecast to average zero in 2015 well below the Monetary Policy Committee s 2% target. Eurozone economy is expected to grow by 1.3% in 2015, which should help UK exports to improve. Chris Price Managing Partner UK Financial Services In global terms, the UK stands to be one of the winners from the recent collapse in global energy prices. This has prompted the EY ITEM Club to raise its GDP growth forecast for 2015 from 2.4% in October 2014 to 2.9% today. However, that doesn t mean this year will be plain sailing for the UK. Political risk will dominate the outlook for 2015, with the general election in May. For financial services, the run up to the poll will raise three major concerns. Divisive debate on Europe The first worry is Europe in terms of both events unfolding in the Eurozone and the risk of the UK s political parties getting locked into an increasingly polarised debate on UK membership of the European Union (EU). There s an argument to say that we have precisely the wrong amount of European power and influence at the moment: too little to achieve real EU wide coordination, but enough to feel like a constraint on national decision making. With a possible in out referendum looming, there s clear scope for the debate on Europe to be highly divisive and damaging to the UK s position. Rebalancing is not reassuring The second concern is around the rebalancing of the UK economy. A shift away from a consumer led recovery and towards growth driven by exports and manufacturing innovation would be good news for the economy. However, this year s uptick in growth will continue to be driven largely by consumer spending, which has been boosted by cheap energy. If the political debate remains focused on reducing dependence on financial services rather than increasing competiveness in other sectors, the effect will be destructive rather than constructive for the economy. It would be more reassuring to hear politicians talking about playing to the UK s global strengths of which financial services is arguably one of the most significant. Under the microscope The third is the extent to which serious issues such as corporate culture, conduct, tax avoidance and market manipulation become trapped in mounting political rhetoric around the election. These are difficult issues and would not be well served by being made the subject of electoral soundbites by parties wanting to appear tough on the less positive aspects of corporate behaviour. The UK s reputation as a well governed, well regulated and fair acting international financial centre has been a challenged one over the last few years, and it would not be helped by the progress being made on those issues being undermined by political point scoring. All too visible risks Outside of the UK election, we can add further macroeconomic and geopolitical worries ranging from the risk of a sharp downturn in China to the rise of European nationalism. There s also the negative impact of a rock bottom oil price on innovation in areas like green energy. While the last decade has seen its fair share of uncertainties, they have usually been a consequence of unforeseen shocks. Today, the risks are all too visible, and the odds are that the global economy can t avoid them all. 4 Outlook for financial services EY ITEM Club Forecast Spring 2015 Outlook for financial services EY ITEM Club Forecast Spring 2015 5

Macroeconomic overview Robust economic growth The UK economy performed strongly in 2014, and growth is set to continue this year. Business investment is also forecast to rise, while exports should see some improvement. GDP increased by 2.6% in 2014, the strongest performance since 2006. This puts the UK in first place in the G7 growth rankings. GDP growth is forecast to accelerate to 2.9% in 2015 on the back of the boost provided by the plummeting oil price. Business investment was the star performer among GDP components in 2014, but some slowdown compared with 2014 seems likely. Political uncertainty surrounding May s general election could caution companies appetite to spend. The UK s export performance should see some improvement in 2015. The US economy is expected to grow by 3% in 2015 and the Eurozone by 1.3%. These developments are unlikely to be enough to turn net trade into a significant driver of growth, though. A rise in bank rate looks unlikely before the early part of 2016. Net external finance raised by public nonfinancial companies b Loans Alternative finance Lending to businesses is set to increase for the first time in six years, but appetite for alternative finance continues to rise 80 60 40 20 0 20 40 60 80 100 2009 50.3 95.5 2010 6.1 2011 28.5 65.1 65.8 2012 1.7 21.6 2013 34.6 29.6 2014(YTD) 71.7 18.6 Predicted lending In 2015, the stock of business loans is set to increase by 1b In 2014, the UK economy grew at its fastest pace in seven years The UK s ageing population will see the retirement market grow Population aged 65 2.9% GDP growth is forecast to accelerate to 2.9% in 2015 and continue at a similar rate through 2016 0.5% Interest rates are likely to remain on hold for the sixth successive year The general election will put financial services under the political microscope and could caution companies appetite to spend 11.6m 12.2m 11.6m 2015 2018 Predicted growth of UK retirement market +8% = + 2b 2015 16 by end 2016 +5.2% (+0.6m) 6 Outlook for financial services EY ITEM Club Forecast Spring 2015 Outlook for financial services EY ITEM Club Forecast Spring 2015 7

Banking forecast Key points from the forecast The value of banks assets and loans stabilised in 2014 after three years of decline. The strength of the UK economy should see the sector s performance continue to strengthen from 2015. But the economy will remain a long way from a credit boom. Changing times Net mortgage lending continued to run at subdued levels in 2014, rising by only 2.2% on the 2013 level to 1.12t. Consumer credit saw the fastest rate of growth in 2014 compared with other categories of household borrowing and is expected to rise at an average rate of just over 4% from 2015 to 2018. 2014 was another year of decline for net business lending, continuing a trend that began in 2008. Viewpoint The outlook may be brighter, but it s not enough to support real growth in the banking industry. Omar Ali Partner UK Banking & Capital Markets Leader D espite the rise in UK banks income and assets in 2014, lending to companies and households remained subdued. The picture looks brighter for 2015, but the jury is out on whether faster economic growth underpinned by low energy prices and rising real incomes will do enough to support the growth in bank revenues and margins that investors are hoping for. A permanent change The contraction in real incomes since 2008 means that even rising consumption is unlikely to trigger anything more than a modest recovery in household borrowing. And, while business lending is predicted to grow for the first time in six years, the figures from 2014 show that both corporates and SMEs have not just dropped alternative forms of financing in favour of borrowing from the banks. With bond and equity issuance looking to keep trending up, it may be that the recent long term bank lending drought permanently changed behaviour. With demand remaining subdued in many traditional activities, banks will need to continue to invest in new, differentiated products and services to ensure growth. But they will also need to keep an eye on challengers. There s definitely scope for more challenger brands and services, especially in particular pockets of the market, such as financial technology and peer to peer lending. We expect another 5 to 10 companies will make it over the line and into the market in 2015, which should make for a dynamic year as new players and old jostle for position. With bond and equity issuance looking to keep trending up, it may be that the recent long term bank lending drought permanently changed behaviour. Regulatory demands Against this backdrop, the Competition and Markets Authority review of personal current accounts and SME banking services is a tough ask. And it won t be made any easier by the moving pieces introduced by some of the major regulatory reforms. Both the introduction of the Senior Managers Regime and discussions with the regulator on ring-fencing plans have the potential to force rethinks about the shape of the industry this year. Stability is still elusive In order to truly focus on driving renewed growth and returns, the industry needs a return to a more stable and certain environment. But at the moment, thanks to uncertainty surrounding the Eurozone economy, the outcome of the UK general election and a possible subsequent referendum on the UK s EU membership, this scenario still looks some way off. The proportion of SMEs using only bank loans, bank overdrafts or credit cards declined from 29% to 20% between 2011 and the first half of 2014. 3.7% Expected average annual growth rate of mortgage lending in the three years from 2015 177b Level of consumer loans in 2015, up 12% from 2013 395b Net business lending in 2015, down from 405b in 2013 1 Only 1 of 8 large UK lenders failed the Bank of England s stress test in 2014 8 Outlook for financial services EY ITEM Club Forecast Spring 2015 Outlook for financial services EY ITEM Club Forecast Spring 2015 9

Insurance forecast Key points from the forecast Limited growth Viewpoint Mark Robertson Partner UK Insurance Leader The projected acceleration in UK economic growth is positive news for the insurance industry as a whole and for general insurers in particular. But, while strong GDP growth and equity prices may have been enough to boost insurance profits in the past, history is unlikely to repeat itself exactly in the coming years. Each sub-sector faces specific challenges that will limit its ability to translate positive economic indicators into performance improvement across the industry. Consolidation in specialty insurance Specialty insurance continues to have a glut of globally mobile capital looking for a home. As niche-focused strategies start to unravel and pressures on premiums, expenses and talent continue, M&A activity is expected to pick up, with the industry seeking scale from consolidation. The key question, though, is: how much of this activity is cyclical and how much structural? An underlying shift across the market is that the matching adjustments under Solvency II are making reinsurance less attractive, driving repatriation of some risks by insurers and growing use of alternative risk transfer models. Uncertain future for life and pensions Meanwhile, the growth outlook for life and pensions (L&P) providers remains relatively flat in the short term, despite strong fundamental long term demand. The muted prospects reflect the fact that L&P providers have probably never been as uncertain about the future behaviour of both customers and regulators. Wealth and asset managers are looking to invade L&P s home turf as a result of the incoming pension reform, and the sector is also seeing M&A activity as companies seek volume to cover high-cost bases, or seek financial engineering solutions to improve performance. But, looking further ahead, there are massive opportunities for L&P companies that succeed in building deeper and wider customer relationships that echo those traditionally owned by banks. Those that lack the imagination to do this may ultimately find themselves frozen out and consolidated. Insurance sub-sectors each face specific challenges that will limit their ability to translate positive economic indicators into performance improvement. Economic growth in the UK is good news but may not translate into performance improvement for insurers. 4m General insurers well placed For their part, general insurers stand to reap the greatest benefit from the renewed momentum of the wider UK economy. However, the intense competition and overcapacity in the sector mean that boosting margins will demand real focus and discipline. In retail property and casualty, for example, insurers with a strong distribution franchise and brand should be able to maintain margins through strategies that might include, for example, using telematics to build customer loyalty and fend off the commoditising effect of the aggregators. But other players with me too brands may face a stark choice between gaining market share and concentrating on profitable niches. Each route comes with its own potential pitfalls. Insurers received a buffeting in 2014, but this year offers the prospect of more stability. However, for the life sector in particular, there is still a lot of uncertainty on the horizon. General insurers should continue to benefit from the fairly buoyant housing market (albeit less so than in 2014), but growth in home and motor insurance premiums will remain squeezed. Tax changes and pension reforms will create a challenging environment for life insurers. At the same time, the ongoing rollout of pension auto-enrolment to small and micro employers from April 2015 will boost pension providers. Based on macroeconomic factors and 2014 s performance, we forecast that insurance sector profits will rise by an average of 13% per year from 2015 to 2018. But there are significant downside risks to the forecast. 10.4% Year-on-year rise in house prices in 2014 Number of additional savers in workplace pension schemes as a result of auto-enrolment 9m Projected number of extra savers when auto-enrolment is extended to all firms 8.1b Insurers profits in 2014, more than double the 2013 figure 10 Outlook for financial services EY ITEM Club Forecast Spring 2015 Outlook for financial services EY ITEM Club Forecast Spring 2015 11

Wealth and asset management forecast Key points from the forecast Opportunities to expand Viewpoint With the opportunity to capture a significant share of assets that, in the past, would have gone to insurance companies, prospects for the wealth and asset management sector look bright. AUM are forecast to grow by 6.5% per year from 2015 to 2018, reflecting robust economic growth and rising household wealth. From April 2015, pension reforms will give asset managers the power to retain or target assets that would otherwise have gone into annuities. The prolonged period of very low inflation will support bonds; however, we forecast bonds share of total AUM to decline from 17.3% in 2014 to 14.7% in 2018. In Q3 2014, direct holdings of equities as a share of UK households total financial assets rose to 13.1%, the highest since the middle of 2011. Gillian Lofts Partner UK Wealth & Asset Management Leader management industry. But the changes are welcomed and managers are diligently responding. The key point here is not the size of the accessible annuities market today, but how accumulation and decumulation products will develop and grow to meet consumer demands over the medium term. It is widely acknowledged that there is currently a lack of supply of these products, and managers are stepping in to provide the investment building blocks, which will then be wrapped and distributed by banks and insurers. Product development in the asset management industry is a measured process and, quite rightly, managers are incubating funds that we expect to see entering the market at a steady pace over the coming period. A pivotal role As UK economic growth picks up, the other key development for the sector is the pivotal and growing role that asset managers are playing in financing the real economy. This shift which is evident across Europe, but is especially prevalent in the UK was highlighted by a recent EY sponsored study 1. The research found that European asset managers hold 23% of European debt securities outstanding, which is equivalent to 32% of the value of European bank lending. Similarly, the value of equity held by European asset managers corresponds to nearly 40% of the free float of European listed firms. Practically speaking, we are seeing a greater constituency of firms involved in alternative credit, private equity, real estate and infra-capital. A combination of risk profiling, retirement demands As UK economic growth picks up, a key development is the pivotal and growing role that asset managers are playing in financing the real economy. Current developments give asset managers an opportunity to win business that is traditionally the preserve of banks and insurers. 3b Market conditions for UK asset managers remain favourable and have seen assets under management (AUM) at record levels and rising. Looking forward, socio demographic, economic and policy developments are also offering growth opportunities for managers. Pension reforms present opportunities The major UK pension reform coming in April will give retirees more control over their pension pots. At an estimated 12b, the accessible annuities pot is not revolutionary for the asset and economic backdrop will likely see this trend continue. In the face of concerns that ever larger trading volumes in financial markets may carry no benefits for society, this report confirms that the asset management industry has been instrumental in making markets more frictionless places in which to deal. This translates into lower trading costs and higher net performance for all participants. Actual and/or prospective changes in the political landscape in the UK and Europe are likely to create some uncertainty for both investors and managers in the coming period. The greatest antidote to this will be the continuity of policy developments and regulatory and physical frameworks. 1. Jens Hagendorff, Professor of Finance & Investment at the University of Edinburgh, Societal and Economic Impacts of the European Asset Management Industry, 2014 1.4t The amount held in currency and deposits by UK households The amount that would be added to net flows into AUM if investment products captured a quarter of the current annuity market 7% Forecast growth of equities under management over the three years from 2015 40% Expected increase in AUM between 2015 and 2018 12 Outlook for financial services EY ITEM Club Forecast Spring 2015 Outlook for financial services EY ITEM Club Forecast Spring 2015 13

UK Special Report on consumer spending EY ITEM Club The outlook for consumer spending in summary EY solely sponsors the ITEM Club as part of its Over the past two years, the steady upturn offering as a global leader in consumer spending has supported the in professional services. wider economic recovery. Yet in early EY ITEM Club is the only 2014 consumer spending was still below its non-governmental economic early-2008 peak. At the same point in the forecasting group to use the 1990s recovery, spending was 15% above its HM Treasury model of the previous peak in real terms. UK economy, independent of any political, economic or Going forward, we expect real consumer business bias. This report spending growth to remain steady but modest summarises the latest peaking at 2.5% this year before slowing to special report and gives just 2% in 2017. EY s assessment. Combining our skills in assurance, tax, So, what s happening? As our special report transaction and advisory highlights, consumers are in a lost decade on services, we are wellplaced to help businesses have fallen significantly. And the likelihood the real wage front. Since 2008, real wages work through the detailed of a fairly modest recovery in wages over the implications of changes in coming years means that, even by 2017, real the economic environment. take-home pay for individuals at all income levels will still be less than in 2008. Contacts This subdued picture for pay has been the Peter Spencer trade-off for very strong employment growth. Chief Economic Put simply, more people than ever have jobs, Adviser, EY ITEM Club boosting the collective spending power of UK Mark Gregory Chief Economist, EY Chris Price Managing Partner, UK FS, EY households. But on average, each household has less real income to spend. We re confident the consumer upturn is sustainable. But the lost decade is creating winners and losers: for example, workers in the squeezed middle will see their pay grow more slowly than their higher- and lower-paid peers. Peter Spencer Business implications in summary According to this report, the current recovery in UK consumer spending is much weaker than after previous recessions. Unlikely to get stronger in the foreseeable future, as increases in household incomes continue to be driven by employment growth rather than real wages. However, this gloomy outlook masks significant variations. Middle-income earners will continue to see their real wages squeezed harder than those at the top and bottom ends of the income scale, and older people will be in a much better position than the young. And different product and service categories will see differing rates of spending growth, with an overall shift away from big-ticket items like cars, and towards recreation, culture and infotainment. Among consumer selling businesses, this complex and evolving environment will produce winners and losers. Hotels, restaurants, and companies selling AV equipment for example should see higher than-average growth, while education providers may struggle. Shoes will do better than clothes. For UK companies, the key is to work out how their product portfolios and customer base are positioned for the coming shifts in consumer spending, and adapt their business model, supply chain and pricing accordingly. Getting this right is all the more vital at a time when neither Europe nor emerging markets are offering strong alternative sources of growth. Mark Gregory More information EY Eurozone forecast and outlook for financial services Our Eurozone forecast provides an overview of developments across the Eurozone and the 17 individual Member States. It uses the ECB model and governmental statistics to offer insight into the issues that affect the region s governments, businesses and financial services. Eurozone EY Eurozone Forecast December 2014 EY ITEM Club: outlook for financial services online Visit us online at for more data, analysis and the interactive version of the EY ITEM Club: outlook for financial services Spring 2015. To find out more and to download the report, go to ey.com/fseurozone EY Rapid-growth markets forecast The quarterly forecast analyses 25 rapid-growth markets that have an influence on the world economy. To find out more and to download the report, go to ey.com/rapidgrowth Growing Beyond Rapid-growthmarkets EY Rapid-Growth Markets Forecast July 2014 EY ITEM Club: special report on consumer spending Our latest report uses macroeconomic forecasts and EY analysis to provide an outlook for trends in consumer lending and what it means for business and financial services. To find out more and to download the report, go to ey.com/uk/economics Economics for business A lost decade for wage growth takes its toll on spending 14 Outlook for financial services EY ITEM Club Forecast Spring 2015

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