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Flagstone Weekly Update - 05 March 2018

5th March 2018

UK Economic Headlines

Surge in new orders expected to boost manufacturing industry output The February UK manufacturing survey figures from the IHS Markit purchasing managers’ index (PMI) indicate that UK factory activity slowed last month but remains on track for future robust expansion as a surge in orders continued to drive the country’s manufacturing revival. Although manufacturing activity in February was strong compared with historic averages, the pace of expansion fell to an eight-month low and was the second slowest since the Brexit referendum in June 2016. The headline activity index inched down to 55.2 for February from 55.3 in January. The sector, which accounts for a tenth of UK gross domestic product (GDP), expanded by 1.3% in the final quarter of last year which helping underpin overall growth. It has now expanded for eight consecutive months for the first time since 1988. The recent strength of manufacturing, particularly in overseas sales, is helping to offset a slowdown since the Brexit vote in both consumer spending and services which have traditionally been the engines of growth. Economists believe that the latest PMI data points to a slower quarterly growth rate for the sector in the first quarter of 0.4%. This represents a marked reduction from the 1.3% increase signalled for the final quarter of 2017 and is likely to provide a further drag on the rate of expansion in the wider economy. However on a brighter note, new export business rose for the 22nd successive month in February with improved sales to clients in the US, China, Europe, Brazil and East Asia. While export orders slowed a little from 55.9 in January to 54.8 in February, the overall new orders index increased from 56.2 to 57.5 which was the best performance since November.

UK “structural” budget falls below the Government’s 2.0% target earlier than forecast The UK Government has balanced the books on day-to-day spending for the first time since 2002 as public borrowing rapidly comes under control. The current budget, which excludes capital investment, moved into surplus in November last year on an annualised basis and stood at £2.8 billion over the 12 months to January. Balancing the current budget is a watershed moment as it underpinned the UK Government’s austerity programme of tax rises and spending cuts after the financial crisis. In June 2010, the former Chancellor, George Osborne, pledged to balance the cyclically-adjusted current budget which measures day-to-day borrowing and assumes the economy is running at its full potential. The original target was to try to achieve this by 2015 which means that this goal has been met two years later than planned. Net borrowing for the same period, including capital investment in roads and hospitals, was £38.6 billion. In November, net borrowing for the year to March was forecast by the Office for Budget Responsibility (OBR) to be £49.9 billion but is now on track to come in at about £40.0 billion, all of which will have been spent in public-sector net investment. At that level the Chancellor, Philip Hammond, will have met his fiscal rule of reducing “structural” borrowing to below 2.0% of GDP a year earlier than forecast and three years ahead of target. The OBR has signalled that it will make a significant revision to its economic forecasts when the Chancellor makes his spring statement on the 13th of March. The public finances appear to have held up better than expected because self-assessed income tax raised more than predicted. Revenues from national insurance contributions and corporation tax were also better than expected.

Nine years since the Bank of England slashed interest rates to historic lows This week will mark nine years since the Bank of England (BoE) slashed interest rates to a historic low of 0.5% and undertook its first round of quantitative easing, an unprecedented measure designed to counteract a deep recession triggered by the global financial crisis. Ever since, the members of the Bank of England’s Monetary Policy Committee (MPC) have had to consider when would be the right time to normalise monetary policy and lift interest rates to more historically-normal levels. Analysts point out that, until now, the MPC has favoured a loose monetary stance even when inflation has exceeded the Bank's 2.0% target for most of the last year. MPC members have regarded price pressures, caused mainly by the drop in the value of sterling post-Brexit, as transitory and as such would not pose a medium or long term threat. Most economists acknowledge that the dovish sentiment of MPC members has by in large been correct as inflation remains under control. However economists have detected a change in mood among MPC members since the last policy meeting in February. Since then, a string of MPC members have made hawkish sounds that has pushed the value of sterling higher. Most economists believe that the era of ultra-low interest rates is now over with at least one interest rate rise predicted for this year, with interest rates rising to 1.25% by the end of 2019.

Bank of England snubs bitcoin technology for now Mark Carney, the Governor of the Bank of England (BoE) has said that for now the BoE does not plan to use the technology underpinning bitcoin and other cryptocurrencies and has cautioned that in his view virtual currencies are unlikely to be the future of money. Mr Carney said that he saw little chance of bitcoin displacing traditional currencies and that the Bank had concluded that blockchain technology was not sufficiently mature or reliable to replace existing payment systems. Mr Carney indicated that virtual currencies, based on nothing more than computer code, would have to adhere soon to the same standards as the rest of the financial system as he believes that being part of the financial system brings enormous privileges but with them great responsibilities. However, adopting a more moderate approach than some senior regulators, the Governor also said that authorities should not stifle innovations and that the BoE would keep an open mind on the development of cryptocurrencies with a view to their potential benefits. The surge in the value of bitcoin and other cryptocurrencies means that the market today is worth more than $200 billion which is up from around $20 billion twelve months ago. The Bank is in the process of upgrading its real-time gross settlement system, which processes more than £600 billion of transactions each day. Mr Carney said that the Bank had looked at using the blockchain “distributed ledger” technology, whereby transactions are processed across a network of users without the involvement of a central institution, but had concluded that it was not yet sufficiently proven to undertake the task.

Metro Bank reports its first annual profit UK lender, Metro Bank plc, has reported its first annual profit driven by strong growth in residential mortgages and commercial lending. The bank’s underlying profit before tax figure was £20.8 million in the year ended 31 December 2017. This compares with a loss before tax of -£11.7 million for the previous year. The bank, which listed on the London Stock Exchange in 2016, also raised its 2020 targets and said it would open 12 branches this year that will create 900 jobs. The lender increased its 2020 loan-to-deposit ratio target to a range of 85% to 90% from its previous target of about 85% as the UK Governments various funding schemes are now closed for new lending. The share price has risen by over 10% since the news was released.

Holmesdale Building Society to merge with Skipton Holmesdale Building Society is planning to merge with the far larger Skipton Building Society, pending the approval of its 7,300 members. Founded in 1855, the Holmesdale has just one branch in Reigate Surrey. Skipton is the fourth largest building society in the UK, with a network of 87 branches. It has £21 billion of assets under management compared to the Holmesdale’s £185 million of assets. As part of the deal, Skipton has agreed to keep the Reigate branch open for a minimum of two years. Despite the difference size of the two building societies, Skipton regards it as a merger situation rather than a takeover. Holmesdale said a merger with a stronger partner would enable it to offer greater choice and value to members, adding that the tough mortgage market and operating environment had continued to drive up costs for the society. However it said this merger wasn’t sought as a result of financial difficulties, pointing out that the Holmesdale made an operating profit of £1.5 million for the financial year ended 31 March 2017. If Holmesdale members approve the merger, it will become effective on the 1st October 2018. There will be no windfall payments payable to members.

Other Headlines

Trump escalates trade war rhetoric with threat to tax Europe-made cars The U.S. president, Donald Trump, made a surprise announcement last week that he intends to impose a 25% tariff on steel and a 10% tariff on aluminium in an attempt to protect U.S. industry. In response, the European Commission President, Jean-Claude Juncker, said the European Union (EU) was prepared to respond forcefully by targeting U.S. imports such as Harley-Davidson motorbikes, Levi jeans and Kentucky bourbon whiskey. In retaliation, President Trump has tweeted “If the EU wants to further increase their already massive tariffs and barriers on U.S. companies doing business there, we will simply apply a tax on their cars which freely pour into the U.S. They make it impossible for our cars (and more) to sell there. Big trade imbalance!” This action is consistent with previous verbal comments by President Trump attacking car manufacturers in Europe, especially in Germany with whom the U.S. has a huge trade deficit. Last year, he criticised companies such as BMW, Daimler and Volkswagen for failing to produce more cars on U.S. soil and threatened a border tax of 35% on vehicles imported to the US market. These companies operate some of their biggest factories in southern, Republican-leaning U.S. states, employing about 33,000 workers in the U.S. Analysts note that the U.S. Administration has not yet indicated which types of steel and aluminium the proposed tariffs will cover or whether there will be any exemptions or carve-outs for certain types of steel/aluminium imports for certain countries. Analysts also point out that if these tariffs are imposed across the board, the detrimental impact on Europe will come not so much from the direct tariffs on steel imported to the U.S. from EU countries (which is a small fraction of U.S. steel imports) but rather it will come from the destabilising effects on the European market caused by the flooding of steel into the EU from countries that would have otherwise exported to the U.S.

FTSE European 350 Bank Index fell by -2.6% over the last week The FTSE European 350 Bank Index has fallen for the second week in a row, falling by -2.6% over the week to 4,393 from 4,511. The downward trend reflects global market concerns that a retaliatory trade war will result from the decision by the Trump Administration to impose hefty tariffs on steel and aluminium imports.

ITRAXX Europe Senior Financials 5-year CDS Index improves by -5.4% over the last week The ITRAXX Europe Senior Financials 5-year CDS Index improved by -5.4% over the week, to 55.5bps from 58.7bps. This reflects positive market sentiment resulting from most European banks reporting stronger capital positions and profits for the 2017 full-year.

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