Read Omar Ali's comments on the latest ITEM Club for financial services forecast
The latest EY ITEM Club forecast won’t fill financial services companies with joy.
The UK’s economic outlook for this year has weakened, and the GDP forecast has been downgraded from the 1.7% predicted six months ago to 1.4%, well below historic trends and current global averages. Although there are no signs of a recession, the UK faces several years of subpar growth.
This is a challenging environment for the financial services industry. The limited opportunities to grow, to increase profitability and to strengthen balance sheets, make it hard for firms to provide as much support as they would like to the economy. That, in turn, impacts households, making it harder to generate consumer-led growth. In fact, the gap between income and spending is the biggest we have seen since the late ’80s.
Unfortunately, this is based on a best-case Brexit scenario. The forecast assumes an agreement over the UK’s withdrawal from the EU and transition period but, given the backdrop of political uncertainty and stalled negotiations, and that fact that the Government’s white paper on a future UK-EU relationship did not provide much reassurance for financial services, this looks increasingly like a best-case assumption. A “no-deal Brexit,” with potentially severe economic consequences, cannot be ruled out and would limit the international reach of the UK’s financial services industry.
Financial services firms need to invest in the transformative changes that would allow them to develop innovative new sources of growth, but the demands of contingency planning mean that many are struggling to invest in the capabilities they need.Instead of capitalising on trends such as aging and digitisation, access to a highly skilled workforce, strong links with growing markets overseas and continuity of service have become their main focus. For banks particularly, this means it will be harder to make the most of Open Banking, on which the UK is leading the way.
Even if we assume the UK will get a transition period, the low-growth environment is bad news for banks. 2017 saw household savings fall to a record low and household finances will continue to be squeezed this year. This is driven by renewed inflation, caused by rising oil and utility prices, weak wage growth and the need for people to rebuild their savings. Although the UK’s wider corporate sector enjoys fairly strong profitability, the uncertain economic outlook is weighing on their investment plans.
The upshot is that demand for credit remains weak. The scale of the challenge is illustrated by the mortgage market, which will experience its weakest growth since 2013 next year. Mortgage lending is growing at one-third the rate of 1997 to 2007, and further reductions are expected over the next two years.
Even consumer credit is expected to cool from the peak of over 10% in late 2017 down to 4.4% in 2018, and then slow sharply in 2019, running at around 1%, as households rein in their spending.
Added to this, the Plevin ruling is putting banking profitability under pressure from renewed growth in PPI costs. Weaker growth and the end of the Bank of England’s Term Funding Scheme will also increase competition for savings, adding to the squeeze on net interest margins.
The slowing economy is not just a problem for banks. It casts a shadow over insurers and asset managers too. The fact that only one 25 basis point base rate rise is now expected for 2018 suggests that the years to come will remain tough for savers.
There is no reason to expect a sustained fall in equity prices as price-earnings ratios do not look strained by historical standards, but the weakening global outlook – typified by slowing Eurozone growth and rising protectionism – also means that equity markets will not bolster life insurance and asset management revenues as much as they did in 2016 and 2017.
Tight household finances will make it hard for consumers to increase big-ticket spending or savings contributions, however much they wish to do so.
In these circumstances, insurers and asset managers need to keep their focus on developing new investment solutions. Auto-enrollment and the “pension freedoms” of 2015 give both sectors an opportunity to innovate in the markets for pre-retirement saving and post-retirement drawdown. But in the short term, the challenges brought by Brexit are pushing up costs.
A “no-deal Brexit” would hurt commercial insurers, given the importance of cross-border business to the UK’s unique specialty market. Such a scenario would also threaten UK asset managers’ ability to advise EU-domiciled assets – something that could put the sector at a lasting disadvantage.
So, the forecast is not very encouraging. Brexit uncertainty is now having an impact on both consumers’ and businesses’ appetite to spend, with many firms putting their investment plans on hold until more detail is known, resulting in lacklustre growth and little room for manoeuvre. But, it’s important we keep these challenges in perspective. The UK remains an unquestioned leader in financial services. This uncertain outlook calls for cooperation between industry and the Government to ensure we maintain the UK’s global position and that financial services can help the UK economy weather the changes that are coming.