EY Eurozone forecast: Spring 2015
EY Eurozone forecast: outlook for financial services
Welcome to the Spring 2015 edition of the EY Eurozone forecast: outlook for financial services.
“Over and above the standard macroeconomic drivers, there are two recent developments that will have a significant impact on Eurozone financial services. The first is the commencement of the Quantitative Easing (QE) program. The second longer term consideration is the EU’s progress toward Capital Markets Union (CMU) and the long-term change in how Europe funds its businesses.”Andy Baldwin
EMEIA Financial Services Leader
Read Andy's Forecast Overview here
Our Spring 2015 outlook for financial services sees cheaper energy and quantitative easing (QE) aiding the Eurozone recovery this year. However, for financial services the medium term outlook is less positive for some.
As the effects of QE and the economic boost from cheaper energy filter through, we expect modest rises in consumer credit and mortgage loans. Business lending should also see a rise after three years of contraction. However the question remains as to whether this is enough to support banks in the longer term and offset ongoing Eurozone confidence concerns around unemployment and pensions. Read the full banking viewpoint from Marie-Laure Delarue, EMEIA Banking and Capital Markets Leader.
Life insurers in particular are facing a period of limited profitability as a result of declining bond yields and the rising cost of regulatory compliance. Insurers are re-risking portfolios to try and mitigate the impact of low yields, shifting toward corporate credit, commercial real estate and infrastructure investment. Read the full insurance viewpoint from Andreas Freiling, EMEIA Insurance Leader.
Wealth and asset management outlook
Wealth and asset managers stand to gain from QE, with significant increases in assets under management expected in 2015. However, against a backdrop of an aging population with inadequate retirement provision the pension crisis still looms. A strong and sustainable wealth and asset management industry will be vital, but will the EU also be bold enough to legislate and make saving for retirement compulsory? Read the full wealth and asset management viewpoint viewpoint from Roy Stockell, EMEIA Wealth and Asset Management Leader.
EMEIA Financial Services Leader
Looking at the usual drivers of the forecast, our latest outlook for the Eurozone gives more grounds for optimism than we have had for some time. Falling fuel costs are contributing to “good” deflation, GDP growth is picking up and real household incomes are rising at their fastest since 2001. While divergences in economic performance will continue at a country level, signs are emerging that governments are pushing through much needed supply side reforms; albeit not at the pace the EU commission would like.
To a large extent, the same applies for the financial services-specific outlook. Post-AQR restructuring and reshaping is beginning in the banking sector, and Eurozone banks look better placed to meet rising demand for credit. Insurers are set to experience higher demand as the economy picks up – and assets under management (AUM) in wealth and asset management are rising strongly.
Granted, there are some clouds on the horizon that can’t be ignored. As we go to press, negotiations between the EU and Syriza have once again become fraught raising the possibility of a “Grexit.” Perhaps most worrying is the rhetoric from both sides appears to suggest that neither feels this is the doomsday scenario it once was – driven either by negotiating strategy or a comprehensive contingency and break-up plan being in place. One suspects it's the former not the latter. It remains vital that an orderly way forward is agreed before the bailout terms expire in June. The situation in Ukraine also remains a nagging concern should there be any further military or economic escalation. And, depending on its outcome, the UK general election in May could trigger a destabilizing referendum on UK membership.
Over and above the standard macroeconomic drivers, there are two recent developments that will have a significant impact on Eurozone financial services. The first is the commencement of the Quantitative Easing (QE) program. The second longer term consideration is the EU’s progress toward Capital Markets Union (CMU) and the long-term change in how Europe funds its businesses.
With QE, there are some interesting insights learnt from the US and UK’s experience in recent years. Monetary expansion alongside interest rate reduction led to currency depreciation and a rise in investment in other asset classes – and equities in particular. We are seeing something similar now across the Eurozone. With Government borrowing costs falling and yields on shorter-maturity German bonds recently turning negative, there are growing signs of liquidity returning to the system.
However, further parallels are perhaps harder to draw. In the UK, QE and low interest rates drove saving lower and brought annuity rates down – triggering a dramatic liberalization of the country’s pensions system and a shift in insurer operating models. Such impacts may be more muted in the Eurozone because of the higher degree of state involvement in pensions. The UK also saw a search for yield which triggered significant growth in alternative assets such as property and alternative finance. Again, it is too early to tell whether this could happen in the Eurozone and the ECB will be watching the developments of any asset bubbles closely.
As QE ramps up over the next few years, the date set for CMU, 2019, may look a long way off. However, if Lord Hill can deliver the foundations of reform in that timeframe, the Eurozone and broader EU might benefit from a more integrated CMU just as the ECB’s QE program winds down.
At present, regulatory differences coupled with different market practices and behaviors combine to fragment what could and should be a major single capital market across the EU. The initial focus on creating more diversity in credit supply is to be welcomed. Promoting securitization markets, raising equity and debt should increase access to finance alongside traditional bank lending to support jobs and growth; the key focus for the current EU commission. The recent law creating European Long-Term Investment Funds (ELTIFs) is a step in the right direction. The CMU should also present new, additional revenue opportunities for the broader banking sector alongside greater investment opportunities for institutional investors.
In parallel to the creation of the CMU we also see alternative funding options expanding across Europe, demonstrating investor and SME appetite for new models. Recent research by Cambridge University and EY showed that the European online alterative finance market – including equity-based crowdfunding and peer-to-peer lending – grew by 144% last year. Peer-to-peer business lending in particular grew at pace, by more than 250% across all the main markets. Based on the average growth rates between 2012 and 2014, the European online alternative finance market outside of the UK is likely to exceed €1,300m in 2015.
So as spring arrives, the economic conditions in the Eurozone appear to be improving. The hope is that this year Europe, driven by QE and export growth, will reach the sunny uplands of sustainable economic recovery. However, achieving that will depend on how “Grexit”, Ukraine and “Brexit” ultimately play out.×
EMEIA Banking & Capital
As the forecast points out, the Eurozone’s macroeconomic prospects look to have improved since the last quarter of 2014, as the effects of QE and the economic boost from cheaper energy filter through.
Thanks to the work done ahead of the AQR and Comprehensive Assessment, the Eurozone’s banks are now better capitalized, and should be able to meet the rising demand for both consumer and business lending that seems likely to come on the back of this higher economic growth. As a result, modest rises in consumer credit and mortgage loans are expected this year, and business lending should see a rise after three years of contraction.
Recovery in lending activity and confidence in the Eurozone banking system may be a breath of fresh air but the question remains; is it enough to support banks in the longer term and offset ongoing Eurozone confidence concerns around unemployment and pensions? We should also remember that the escalation in QE could affect different parts of the industry in very different ways.
Retail and commercial banks are now in better shape to lend, but the flipside of QE will be a squeeze on net interest margins (NIMs). So rising lending volumes will not necessarily translate into higher revenues. Similarly, banks that have not solved their structural problems may not feel any real benefit. Whereas, investment banks will benefit from higher levels of business as more Eurozone corporates turn to the capital markets for funding, and from increased trading volumes as investors seek higher yields by buying corporate rather than sovereign bonds. And European banks with wealth management arms should also feel the benefit from the strong stock market rises this year which may help to mitigate the potential downside that we expect to see in this equation.
Overall, while demand for lending might finally be increasing, it’s too early to claim that the good times have returned. It will also be interesting to watch how the early adoption of the EU’s Bank Resolution and Recovery Directive (BRRD) by Austria to unwind “bad bank” Heta Asset Resolution plays out. German and Italian banks in particular have exposure to Heta, and the reaction of the market and these banks to BRRD in practice could set the tone for future cross-border resolution.×
EMEIA Insurance Leader
Time to adapt
With Eurozone bond yields declining in the wake of the ECB’s dramatic escalation of QE, the pressures on life insurers’ profitability that we noted in our last forecast are set to continue. The effect on insurers is greatest in those countries with high levels of classical guarantee-based life insurance, such as Germany, the Netherlands, Italy and France.
Without QE, the expectation was that the upturn in euro interest rates would happen around 2018. With QE, the anticipated time frame for an uptick in rates has been pushed back to 2019-2020 — by which time many insurers will have adapted their investment approaches and product offerings to the new environment.
Indeed, this adaptation is already under way. Most Eurozone insurers have limited exposure to equities, meaning they have reaped relatively little benefit to date from the recent strong development of Europe’s equity markets. In Germany, for example, major insurers only have 7%–8% of their investments in equities, despite being able to hold up to 35%.
Life insurers currently have substantial funds available for investment, and given their need for higher yields to fund policyholders’ bonuses and new business acquisition, their share of investments into equities is set to keep rising. A further aspect of this search for yields to drive better performance is higher investment in “riskier” areas like infrastructure and private equity. However, the long-term profitability of life insurers is worrying low. Slow increases in rates and inflation would be good news in the medium and long term, but a major risk is a sharp rise of inflation and short-term interest rates which could create a “life insurance run” that would be highly detrimental for the industry.
Meanwhile, general insurers are continuing to benefit from the overall decline in the frequency and severity of natural disasters in Europe in the past couple of years. The dampening effect on claims is being sustained, at least for the time being.
Looking across the insurance industry as a whole, the focus in the regulatory domain has remained very much on Solvency II ahead of its January 2016 start date. Also coming up on the horizon are IFRS 4 and IFRS 9, which will be large and costly undertakings for the industry with significant impacts on profitability between now and 2020. There is also an ongoing shift in in both regulatory and marketing terms, toward greater focus on customer conduct and interactions with clients.
Given these trends, both life and non-life companies are looking closely at how they go to market with their customers, and examining how they can meet regulatory requirements while also using behavioral insights to increase sales and manage pricing more effectively. All of this is leading to a growing focus on customer data management and analytics as potential sources of better compliance, control and competitive advantage.×
EMEIA and Asia Pacific Wealth
and Asset Management Leader
Education, legislation — or both?
The EU needs to take the lead by legislating to tackle Europe’s pension crisis
The ECB’s QE program has accelerated the rise in Eurozone AUM, driven especially by growth in bond and equity funds. However, this short-term boost of 25% growth by 2016 masks some longer-term concerns, as Europe’s time bomb of inadequate pension provision continues to tick away.
The fact is that AUM is rising not because Europe is attracting new money, but because its markets and asset values — fuelled by QE — are rising. This is happening against the background of an aging population whose overall retirement provision is woefully inadequate.
And QE is potentially making this situation worse. By driving up short-term returns, it’s helping the wealth industry make already wealthy people even richer. But it’s simultaneously widening the gap between the haves and have-nots — increasing the risk that a huge swathe of the population will become disenfranchised, and too costly for asset managers to service with long-term savings products.
Widespread take-up of such products is urgently needed. In countries such as the Netherlands, Germany and the UK, the switch from defined benefit to defined contribution pension schemes has caught out tail-end baby-boomers, giving them insufficient time to shift savings. In more socialist-minded societies such as Greece, Italy and Spain, the fond expectation that the state will provide is coming up against the harsh reality of empty government coffers.
As Europe ponders how to close its yawning pension gap, a strong and sustainable wealth and asset management industry will be vital. But here too there are some nagging worries. True, the AQR caused barely a ripple, and regulators’ concerns over systemic risk seem overstated. However, as investment continues to diversify in search of yields, one clear area of risk is around liquidity — particularly where supposedly liquid ETFs are investing in illiquid funds.
Given all this, how can Europe forestall a long-term pension crisis? Looking at territories that have legislated for compulsory superannuation, such as Chile and Australia, it’s clear that — while education is certainly a key component — without legislation, the levels of savings required would never have been achieved. In Europe, the EU has a significant role to play in supporting national governments with implementation of compulsory pension savings initiatives.
So the question is: will the EU risk making an unpopular choice and take the plunge to legislate to make saving for retirement compulsory?×