EY ITEM Club Outlook for financial services Minds made for empowering financial services Winter 2017-18 ey.com/fsitemclub
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 sectors. At EY Financial Services, we share a single focus to build a better financial services industry, not just for now, but for the future. Together let s build a better working world. ey.com/fsminds 2 EY ITEM Club Outlook Winter 2017-18
Contents 04 06 Macroeconomic overview Banking 08 10 Insurance Wealth & Asset Management EY ITEM Club Outlook Winter 2017-18 3
Macroeconomic overview The UK economy grew faster than expected in 2017, but a return to historic norms looks unlikely in 2018 or the years that follow. Financial services firms should benefit from higher interest rates, but a squeeze on consumer spending will keep demand subdued. Businesses will also need to navigate potential headwinds, including uncertainty over Brexit. GDP beat expectations in 2017 We started 2018 with some good news. The UK s Gross Domestic Product (GDP) grew by 1.7% during 2017, easily beating last January s forecast of 1.3%. This year, lower inflation should offer potential upside for GDP. Set against that, failure to achieve a Brexit transition deal would create downside risk. Overall, there is little sign of improvement in the UK s belowtrend growth. GDP is forecast to grow at 1.7% this year and next, and at 1.9% in 2020 noticeably lower than global and European averages. This unexciting performance is likely to leave many of the UK s financial services firms struggling to accelerate their own growth. The inflation squeeze should ease this year Inflation had a major cooling effect on consumer spending in 2017, as prices reacted to sterling s post-referendum fall. The Consumer Price Index (CPI) measure breached 3% towards the year end. Inflation will ease off during 2018, helped by the pound s recovery against the US dollar. We also expect pay growth to increase slightly and unemployment to stay close to its current low rate. This reflects a tighter jobs market and increases in the National Living and Minimum Wages. but consumer spending will stay subdued Nonetheless, real disposable income will climb by just 1.2% in 2018. This means that consumer spending will only accelerate to any great extent if households are willing to grow spending faster than income. That is exactly what happened in 2016 and 2017, but declining household saving ratios mean this is unlikely to be repeated. Consumer spending growth is expected to continue last year s soft performance, rising by 1.3%, compared to 1.7% in 2017 and 2.9% the year before, as consumers look to rein back their spending. 1.7% 2.5% 2.4% GDP GDP is forecast to grow at 1.7% this and next year, then at 1.9% in 2020. This is noticeably lower than global and European averages. Inflation Inflation is forecast to fall from 2.7% in 2017 to 2.5% in 2018 and 1.9% in 2019. Mortgage lending Housing market to remain sluggish with mortgage lending forecast to raise by a modest 2.4% this year. 4 EY ITEM Club Outlook Winter 2017-18
Business investment will recover up to a point Robust business investment was a good news story in 2017. Capital expenditure rose by 2.3%, reversing a decline of 0.5% in 2016. We expect investment to grow by 1.9% in 2018 and 2.7% in 2019. That is welcome, but it is far below the annual average of 4% since 2010. On the upside, investment will be supported by nonfinancial companies high profitability and strong cash balances, as well as low interest rates on corporate borrowing. On the downside, sluggish consumer spending will have a cooling effect. Interest rates should rise twice in 2018 We expect the Monetary Policy Committee (MPC) to raise interest rates further in 2018, building on its first rise in over a decade in November 2017. We anticipate hikes of 25 basis points in May and November, as the MPC reacts to an economy, declining risks and global tightening in monetary policies. helped by buoyant exports Exports were buoyed by the weak pound in 2017, and this year should see more of the same. The global economy and particularly the Eurozone is forecast to grow at a good pace. Sterling has regained much of its post-referendum loss against the US dollar, but it remains cheap against the Euro. Weak sterling may also encourage a shift towards domestic goods and services. Net trade is forecast to add half a percentage point to GDP growth in 2018 and 2019. 0.9% 3% Business lending Business lending is forecast to drop by 0.9% this year. This follows a 4.6% fall in 2017. Consumer credit Consumer credit still rising but growth rate likely to cool from high of 7.8% in 2016 and 6.9% in 2017. EY ITEM Club Outlook Winter 2017-18 5
Banking A fairly sluggish economy points to soft lending growth UK banks look set for a stable year in 2018. The forecast for modest GDP expansion will limit lending demand and this, together with regulatory pressures on the supply of consumer credit, should result in soft lending growth. Overall lending growth is forecast to slow from 3.6% in 2017 to just below 2% in 2018 and 2019, with 2017 s rate unlikely to be bettered until 2021. On the upside there are no obvious triggers for a downturn in credit quality. For example, household interest payments as a proportion of income reached a record low of 4% in the third quarter of 2017. However, it will be interesting to see how the introduction of IFRS 9 affects banks provisions and capital ratios. The new standard introduces a judgement-led expected credit loss impairment model and could increase some UK banks accounting provisions by more than 20%. That may impact investor perceptions and banks lending behaviour especially for higher risk credit. Household debt on the up, but interest burden is at a record low % 170 160 150 140 130 120 110 100 90 80 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 Interest payments as % of income (RHS) Source: EY ITEM Club Debt as % of income (LHS) The mortgage market remains steady but slow The mortgage market typifies the banks steady outlook, with lending forecast to grow by 2.4% in 2018 and 1.7% in 2019. Demand will be limited by the cooling housing market, and the fact that mortgage rates are beginning to creep up from their record lows. This rise is set to continue this year as rate hikes by the Bank of England feed through to market interest rates. Then again, rates remain very low by historical standards. The cut in first-time buyers Stamp Duty should also support demand, and so will lenders continuing tendency to offer longer-term mortgages. During 2017, at least 15% of new mortgages had terms of more than 35 years, compared with around 6% in 2008. % 14 12 10 8 6 4 2 0 and consumer lending faces a squeeze We expect consumer credit to grow by just 3% this year, down from 6.9% growth in 2017. A slowdown in annualised growth during the second half of 2017 suggests this process is well underway. This reflects a combination of factors. On one side, demand for consumer credit is softening. After two exceptional years in which consumer spending outstripped household income growth, we expect households to rein in expenditure in 2018. On the other side, pressures on supply are growing. The Bank of England s latest Credit Conditions Survey indicated a tightening in consumer lending standards, as banks respond to regulatory warnings. The average interest-free credit card transfer period has fallen by around three months since March 2017. The FCA is due to publish new guidance on creditworthiness assessments during the first half of 2018. However, the consequences for the consumer shouldn t be exaggerated in 2017, the net rise in the stock of unsecured debt was equivalent to only 1.1% of nominal consumer spending. Businesses are ready to borrow, but are turning to the markets The business lending picture is more mixed. Corporate borrowers are in a strong position, with UK corporate profitability at near-record levels. Interest burdens are also low. In fact, non-financial companies interest costs were just 8.5% of profits in late 2017, around half the 30 year average. But business lending is forecast to decline by 0.9% this year, following 2017 s 4.6% fall. This disconnect reflects the growing attractions of market finance. Net new issuance of bonds and commercial paper by UK companies in late 2017 was at its highest since October 2009. Growth in lending forecast to be modest % year 25 20 Forecast 15 10 5 0-5 -10-15 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Consumer credit Lending to companies Mortgage lending Source: EY ITEM Club/Haver Analytics 6 EY ITEM Club Outlook Winter 2017-18
Banks will benefit from higher margins and persistently low provisions Despite lacklustre lending growth, the prospect for banks income is far from gloomy. Net interest margins are already benefiting from the higher Bank Rate the end of 2017 saw spreads climb for mortgages and unsecured loans. The prospect of two more rate rises in 2018 should provide further margin support, even if fixed mortgage rates remain lower than two to three years ago. The provisioning outlook also gives banks reason to be cheerful. Employment keeps growing and joblessness is forecast to remain close to its current near-42-year low. Interest payments absorb an average of just 4% of household incomes the lowest ratio since 1987 and this will help to keep provisions low. But they also face some threats to profitability The immediate outlook may be benign, but there are threats to profitability on the horizon. The closure of the BoE s Term Funding Scheme (which as of Q3 2017 had provided banks with 85bn of cheap funding) in February is likely to push up funding costs. And although claims for PPI compensation will come to an end in August 2019, the deadline may be encouraging new claims. The six months to November 2017 saw compensation average 301m, higher than the same period in 2016 ( 247m). The Plevin ruling, which broadens the potential scope of PPI claims, could also push up costs as banks approach 2019. Looking further ahead, the introduction of Open Banking in January has also opened up the longer-term possibility of increasing competition from non-banks. These potential threats underline the importance of efficiency as a driver of bank profitability. But achieving long term cost savings is increasingly dependent on banks ability to develop a strategic approach to digitisation. and new capital requirements As so often in recent years, banks capital positions are under pressure. This may seem strange. After all, UK banks had an average common equity Tier 1 ratio of 14.5% in 2017, more than three times that in 2007. And for the first time since 2014, the Bank of England s September stress tests did not require any bank to strengthen its capital. Even so, the countercyclical capital buffer will rise from 0.5% to 1% in November 2018. The Financial Policy Committee s plan to reconsider the adequacy of the 1% figure during 2018 also means that a further increase might be on the cards. Banking sector recap 2016 2017 2018 2019 2020 2021 Total assets ( b) 7,044 7,287 7,368 7,405 7,567 7,810 Total loans ( b) 6,083 6,303 6,407 6,506 6,706 6,994 Business/corporate loans ( b) 407 388 385 390 396 411 Write-offs (% loans) 0.7 0.6 0.7 0.8 0.9 0.7 Consumer credit ( b) 193 207 213 219 226 235 Write-offs (% loans) 1.4 1.3 1.4 1.8 2.0 2.2 Residential mortgage loans ( b) 1,155 1,204 1,233 1,255 1,302 1,362 Write-offs (% loans) 0.01 0.01 0.02 0.03 0.03 0.04 Deposits (% year) 8.2-0.6 0.9 1.0 1.3 3.1 Loans/deposits (%) 134 140 141 142 144 146 Total income ( b) 134 145 145 148 152 158 Source: EY ITEM Club EY ITEM Club Outlook Winter 2017-18 7
Insurance Non-life income growth faces a potential squeeze The UK insurance sector faces a mixed outlook in 2018. This is particularly true in the non-life market, where we expect premium income to grow by around 3% in 2018 and 2019 little change from 2017 s 2.8%. The predicted 1.2% growth in real household incomes is better than 2017 and is one of the factors giving premiums some support. Even so, this is a tepid improvement by historic standards. It reflects a difficult outlook for vehicle and house sales. The end of PPI payments in 2019 could also weaken big ticket purchases, although that may be partly offset by retirees taking tax free cash lump sums and pension withdrawals. In a slow-growth environment, a focus on efficiency will be essential to protecting insurers slender margins. Growth in insurance prices have outstripped general inflation % year 40 35 30 25 20 15 10 5 0-5 -10-15 2010 2011 2012 2013 2014 2015 2016 2017 Home contents CPI inflation Motor insurance Source: EY ITEM Club/ONS The outlook looks mixed for motor insurance The motor market illustrates the challenges facing non-life insurance. Car registrations declined by 4.4% in 2017 and are forecast to fall by a further 6% and 2.3% in 2018 and 2019, reducing from 2.69m in 2016 to 2.36m in 2019. Headwinds include the exhaustion of pent-up demand, greater caution over auto finance and the growing unpopularity of diesel cars. Looking further ahead, insurers are keeping a wary eye on ride-sharing services and the development of self-driving cars. Fortunately, the picture is not all bad. Average premiums are at a record high. The price of car insurance also rose 10.6% in the three months to December 2017 from the same period in 2016 more than three times the rate of inflation. Some of this increase still reflects last June s rise in Insurance Premium Tax (IPT), as well as the February 2017 cut in the Ogden discount rate from 2.5% to -0.75%. But the upswing in rates remains evident, and September s partial reversal of the Ogden rate cut should reduce pay outs and support profitability. Reforms to reduce whiplash claims are also due to come into force this year. And having increased IPT three times in 2015 and 2016, the Chancellor held off on further rises in 2017 - which may help to ease pressure on premiums. and for home and commercial activity Home insurance also faces a difficult outlook. Housing transactions are cooling, with average annual growth forecast at 2.6% from 2018 to 2021 compared to 5.9% over the preceding five years. As a result, home insurance premiums rose by less than 2% during 2017, implying a real-terms fall. The rising cost of leak damage is contributing to higher repair claims, squeezing profitability. Commercial insurance faces headwinds of a different kind. The prospect of Brexit is more of a concern here than in retail lines, given the UK s share of cross-border business. Adapting to the new reality seems certain to push up costs. It is also likely to distract firms from making the most of what should otherwise be a fairly benign environment. Housing transactions are forecast to see only modest growth 000s 450 400 350 300 250 200 150 100 50 Forecast 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Source: EY ITEM Club/Haver Analytics 8 EY ITEM Club Outlook Winter 2017-18
Life insurers will benefit from global investment conditions On the life and pensions side, the signals look slightly more positive. Life premium income is forecast to rise by an annual average of 3.4% from 2018 to 2021, driven in part by stronger real household income growth. The gradual rise in term life protection should provide support, but investment returns will also play a key role. Buoyant equity prices favour life companies and, despite the market volatility of early February, strong global growth should continue to support equities during 2018. Fixed income yields should also gain ground during 2018, as the Bank of England takes further steps to tighten monetary policy. Rates will remain historically low; Bank Rate is forecast to end 2019 at just 1.25%. But we expect 10 year gilts to yield an average of 2.7% from 2018 to 2021 as global monetary policies tighten, supporting investment returns. but profitability could still face some headwinds The outlook for profitability is mixed. Insurance profits dropped 17.5% in 2017, though this owed much to 2016 s post-referendum boost to foreign currency earnings. We expect profit growth to recover to an average of around 5% over the next few years, but there are risks to this view. One comes from Brexit, given the likely cost of maintaining access to EU markets and the consequent distraction from pursuing efficiency. The possible phasing out of the RPI inflation measure for long-term government contracts, recently mooted by Mark Carney, could also affect insurers profitability, particularly if it resulted in payments on index-linked gilts being linked to the (lower) CPI measure of inflation. Pension freedoms are having complex effects The mixed effects of pension freedoms will also impact profits. The reforms should offer some upside, as money leaving defined benefit schemes shifts into personal pensions and drawdown products. If life expectancy among some older cohorts remains static, it could also reduce corporate scheme deficits and encourage buyouts by specialist insurers. Set against that, asset managers typically with lower costs than insurers are increasingly well placed to compete in the retirement space. And annuities are fast becoming a niche product. Sales dropped 75% between the April 2015 reforms and the end of 2016. Insurance sector recap 2016 2017 2018 2019 2020 2021 Life gross premium ( b) 168.9 176.1 181.7 186.4 192.7 200.9 % year 4.6 4.2 3.2 2.6 3.4 4.2 Life gross claims payments ( b) 164.1 170.1 172.1 172.9 175.1 178.7 Life claims ratio (%) 97 97 95 93 91 89 Non-life gross premium ( b) 60.5 62.2 64.1 66.0 68.2 70.9 % year 2.6 2.8 3.1 3.0 3.4 3.9 Non-life gross claims payments ( b) 29.2 31.3 31.8 32.2 32.8 33.6 Non-life claims ratio (%) 48 50 50 49 48 47 Net profit ( b) 7.4 6.1 6.3 6.6 7.0 7.4 Source: ITEM, OECD, Swiss Re EY ITEM Club Outlook Winter 2017-18 9
Wealth & Asset Management Despite currency shifts, global economic strength will boost AUM in 2018 Total UK assets under management (AUM) were worth 1.24t at the end of 2017, equivalent to 61% of GDP. That represented year-on-year growth of 14.6%, slightly lower than 2016 s figure of 16.5% but still very strong by historical standards. Growth in AUM over the past two years has been flattered by the post-referendum drop in sterling. In contrast, sterling s recovery against the dollar will constrain AUM growth in 2018. But this should be offset by gains for equities and other asset classes. Despite the market gyrations of early February, the outlook for global investments looks positive. We predict total AUM to reach almost 1.4t by 2020, up from our previous forecast of 1.3t. AUMs exceeded 60% of GBP for the first time in 2017 % of GDP 70 60 50 40 30 20 10 0 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Source: EY ITEM Club/Haver Analytics Pensions policy will also support inflows Forecast In the medium term, asset managers will benefit from the growth of auto enrolment, which has expanded since 2012 to cover over 8m people. April will see employers contributions rise from 1% to 2%, before reaching 3% in 2019. According to the Department for Work and Pensions, auto enrolment will account for additional savings of 17bn a year by 2019-20. Future opportunities for the sector should also be supported by the pension freedoms introduced in April 2015. The resulting drop in annuity sales means that asset managers have an opportunity to capture postretirement assets that would previously have been held by life insurers. This, and the fact that net household wealth reached a near-record 350% of income in 2017, should give further support to inflows. As the housing market cools, especially in London, some wealthy investors may also shift more capital into financial investments. We expect further rotation from bonds to equities Our forecast suggests that asset allocation will see a further rotation towards equities during 2018, even if equity prices are unlikely to match the 9.2% climb registered in 2017. We expect UK equity prices to rise 3.9% this year, with the recent recovery in sterling weighing on the valuations of international-facing companies. The market volatility of early February is also a sign of the potential headwinds from the gradual tightening of global monetary policy. We forecast equities under management to rise by around 5% a year between 2017 and 2021, with their share of total UK AUM ticking up from 50.8% to 51.9% over the same period. Conversely, bond prices are likely to be affected by further UK and US interest rate rises. We also expect the European Central Bank s asset purchase programme to close in September 2018, further reducing the attractiveness of this asset class. Overall, we expect bonds share of UK AUM to fall from 14.8% in 2017 to 12.5% in 2021, with weaker demand potentially exerting some upward effect on bond yields and market interest rates at the margin. AUMs forecast to rotate further towards equities b 1400 1200 1000 800 600 400 200 Money market Fund of funds Property Mixed Equities Bonds Forecast 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Source: EY ITEM Club/Broadridge 10 EY ITEM Club Outlook Winter 2017-18
while alternatives apart from property enjoy strong demand Meanwhile, the desire for yield and diversification will continue to drive appetite for alternative assets. These offer returns uncorrelated with bonds or equities, although sometimes at the cost of liquidity. Together with the UK s growing flexibility on retirement income, this will support demand for fund-of-funds and multiasset funds. Rising interest rates should also boost the attractiveness of money market products. However as we predicted - the share of UK AUM allocated to property declined in 2017, falling to 2.3% of total AUM from its 2015 peak of 3.3%. This reflected the expense of property assets, and reputational damage caused by the suspension of several property funds after the EU referendum. We expect this softness to continue, with property AUM rising at a below-par rate of around 2% each year until 2021. Brexit and regulation offer downside risks Looking beyond the UK-domiciled assets that are the focus of the ITEM forecast, Brexit risks are a potential wildcard for asset managers. In particular, exiting the EU in March 2019 poses a threat to delegation the ability of UK managers to advise funds domiciled in another EU country. Asset managers also face pressure to increase their capital reserves. This stems from action taken by the FCA in 2015, encouraging managers to hold cash against expected losses rather than relying on insurance. The introduction of MiFID II in January could also increase firms operational complexity and costs. Wealth & Asset Management sector recap 2016 2017 2018 2019 2020 2021 Total assets under management ( b)* 1,086 1,245 1,286 1,320 1,396 1,495 % year 16.5 14.6 3.3 2.6 5.8 7.1 Bonds ( b) 165 184 182 183 185 187 Equity ( b) 539 632 656 674 717 775 Fund of funds ( b) 133 155 164 171 184 203 Hedge ( b) 1.3 1.3 1.3 1.3 1.3 1.3 Mixed ( b) 159 178 187 194 211 230 Money Market ( b) 59 66 66 67 67 67 Property ( b) 28 29 29 29 31 32 *UCITS and non-ucits assets Source: EY ITEM Club, Broadridge EY ITEM Club Outlook Winter 2017-18 11
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