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Flagstone Weekly Update - 6 February 2018

6th February 2018

UK Economic Headlines

Adverse impact of rising prices on UK manufacturing production The latest survey results from the IHS Markit UK manufacturers purchasing managers’ index (PMI) for January indicate that the sector has started the year on a sluggish manner with production dropping to its lowest level since June and prices rising at one of the fastest paces in 25 years. Economists believe that the index shows that the recent surge in growth in the sector had been checked due to a combination of slower growth and rising prices. Manufacturing had enjoyed a buoyant end to last year with factory output growing at the fastest pace in almost seven years. However, the index showed that activity in the sector had dropped to a balance of 55.3, down from 56.2 in December, which was contrary to economists’ expectations of a small rise. Although a disappointing reduction, the level was still considerably above the long-run average for manufacturing of 51.7. A spokesperson for IHS Markit stated that, if growth was sustained at this level for the next two months, it would point to a quarterly growth rate of 0.6% for the sector which would be better than the broader economy but half the rate achieved in the final three months of last year. The survey also showed that the recent easing in prices for raw materials and other input costs has caused a sudden sharp reversal for UK manufacturers. The rise in manufacturing costs is likely to concern policymakers at the Bank of England, who are reassessing how fast inflation will fall this year. In November inflation was the highest it has been for more than five years, when the central bank raised interest rates for the first time in more than a decade. A minority of economists think the Bank will increase interest rates as soon as May, although the consensus still points to November.

Fresh interest rate rise possible as economic growth picks up Analysts believe that the Bank of England (BoE) is set to upgrade its growth forecasts this week in preparation for another rise in interest rates. No immediate change is expected at the Bank’s monthly policy meeting on Thursday but the quarterly inflation report is expected to acknowledge that the economic outlook has brightened since November. The Bank is currently forecasting growth of 1.6% this year. Futures markets are reflecting a 50-50 chance that the BoE will follow November’s rate increase with a further rise in May. BoE Governor, Mark Carney, has previously stated that the pace of rises in 2018 will depend heavily on the tone of Brexit negotiations. The outlook for inflation is less clear as stronger growth and an increase in oil prices since the last inflation report could be offset by the recent rise in the pound which will reduce import prices. Analysts expect little overall change to the BoE’s inflation projections over its three-year forecast horizon but the majority expect a more hawkish tone from the Monetary Policy Committee (MPC). The latest BoE projections come after the influential EY Item Club, which uses the Treasury’s forecasting model, announced that it now expects growth of 1.7% for this year compared with 1.4% previously. While the Item Club believes that the economy is over the worst of its recent slowdown, it cautions that the UK is likely to remain “stuck in the middle lane” over the medium term, growing by just 1.7% next year and by 1.9% in 2020. With a Brexit transition deal likely to be agreed in the first half of this year, the Item Club expects business investment to increase by 1.9% in 2018 as companies receive reassurance that there will be no change to their trading arrangements until at least December 2020.

EU appears to reject City plan for a free-trade deal that includes financial services Member states of the European Union appear to have all but ruled out including financial services in a wide-ranging free-trade deal with the UK. In a rebuff to Philip Hammond, the UK Chancellor, who has called for financial services to be at the heart of a trade deal with the bloc, it is understood that an internal meeting of EU27 officials this week concluded that future arrangements should be based only on “equivalence”. Those present at the meeting are said to have argued that a smaller City of London could help to develop capital markets on the Continent and that the risks of cutting off EU businesses to City funding had been overstated. The decision increases the likelihood that the City will trade with Europe under less favourable terms and could accelerate corporate contingency plans to move more operations out of London. Under equivalence, the UK would be required to mirror all present and future European financial regulation to have access to EU markets and such access could be revoked with only 30 days’ notice. Officials from the EU’s executive have consistently said that they will not agree to a deal that would allow finance companies to operate barrier-free because the UK has said that it will leave the single market. The City’s plan proposed that the UK and the EU would allow cross-border trade in financial services on condition that each side preserves regulatory standards in line with the best international standards. This model would be maintained by close co-operation between regulators and financial policymakers. The UK’s vast financial services sector looks set to be one of the most divisive areas in the Brexit negotiations, with the UK demanding a generous deal while the EU refuses to shift from its insistence that the UK’s red lines, such as ending the free movement of workers from the EU, make that impossible. At the recent meeting in Davos, Mr Hammond warned that the UK would refuse to sign a trade deal with the EU unless it included financial services. Despite the hard-line EU position, Jean-Claude Junker, the European Commission President, suggested yesterday that stage two of the Brexit talks would lead to compromise.

European banks to face their toughest stress test yet Banks across the European Union (EU) will face their toughest stress test yet to ensure that they can withstand huge potential shocks, including the impact of Brexit. The European Banking Authority (EBA), the watchdog for banks operating in the EU, unveiled the scenarios last week against which 48 of the largest banks across the current 28-member bloc will be tested. The results are due to be published by November. The regulator, which replaced the Committee of European Banking Supervisors in 2011, monitors and assesses market developments as well as identifying trends, potential risks and vulnerabilities that banks may face. Stress tests, which are also conducted separately by the Bank of England, are seen as crucial to global financial stability. They were introduced in the EU, UK and the U.S. after the 2008 credit crunch exposed serious shortcomings in the ability of banks to withstand shocks. As well as the impact of Brexit, the EU regulator has set a worst-case stress test that involves a recession that would leave EU economic growth 8.3% lower by 2020 than the latest European Central Bank (ECB) forecasts. In 2019, the year when the UK is due to leave the EU, the EBA’s model implies a contraction of 2.2% followed by a weak recovery with growth of 0.7% in 2020. The stress test is designed to give participants in finance markets a common analytical framework to consistently compare and assess the resilience of EU banks to economic shocks.

Santander announces a £200 million write-off of Carillion bad debts Bad debts at Santander UK have risen by more than £200 million after the bank was hit by the cost of having to write off loans made to Carillion, the failed construction company. The bank announced that it would book an impairment charge of £203 million for 2017 after the Carillion debt caused the ratio of non-performing loans in its corporate banking portfolio to rise. Santander reported that the overall proportion of its lending book that was not expected to be repaid had fallen year-on-year to 1.42%, a drop of only 0.08%. However, in its corporate banking division that proportion rose from 1.11% to 5.67%. Details of Santander UK’s exposure to Carillion came alongside the bank’s full-year results which showed pre-tax profits down 5% year-on-year at £1.81 billion even as net interest income rose to £3.8 billion. Leading lenders have been widely hit by Carillion’s failure, with Barclays, HSBC, Lloyds and Royal Bank of Scotland having provided the company with £140 million of emergency funding in September on top of a near-£800 million credit facility. Estimates of bank losses from the collapse of Carillion have been put at more than £900 million as lenders believe that much of the money they loaned will not be recovered.

TSB Bank makes £100 million available for small businesses TSB Bank plc has announced plans to boost its business banking operation with a £100 million investment in small UK-based companies. The move represents the start of TSB’s plan to add competition in the small business lending market and will provide equity funding to UK businesses and start-ups in their early stages. TSB, which was bought by Sabadell in 2015, said that real competition is needed in this market to break the shackles the big banks have had on the UK’s small businesses for far too long. At present, Barclays, Lloyds Banking Group, HSBC and Royal Bank of Scotland control 85% of small business banking. The bank believes that it is ideally placed to make use of some of the money that RBS is providing to make the market more competitive, a condition that RBS must meet after its £46.0 billion bailout during the financial crisis. The £425 million Capability and Innovation Fund will grant funding to a range of competitors. TSB’s equity finance offering, known as Bluewaves, will begin with an initial tranche of £30 million.

Eurozone economic growth turnaround gathers momentum The latest IHS Markit Eurozone purchasing managers’ index (PMI) for European manufacturing indicates that the boom in economic growth in the eurozone has shown no signs of abating in January although the PMI balance of 59.6 was a slight slowdown from December’s record high of 60.6. In 2017, the eurozone stunned stock markets and economists by becoming one of the fastest growing blocs in the developed world, with unemployment at a nine-year low and economic growth hitting 2.5%, a 10 year high. The Netherlands led the 19-nation bloc, with factory activity rising to 62.5, its highest level on record. Italy also enjoyed a rise in growth to a seven-year high of 59.0. The survey also showed factory activity in Greece rising at its fastest pace since late 2007 to a mark of 55.2. However, while the Greek economy seems to be recovering, the reforms demanded by the EU bailout continue to anger workers. Last week, farmers blocked roads in protest at austerity measures as lenders began to assess if the country had made enough progress to unlock further aid.

Deutsche Bank unveils third annual after-tax loss Deutsche Bank has made its third annual loss in a row as the German lender reported its lowest revenues in seven years. Despite the latest annual loss of nearly €500 million, Deutsche announced that it would still give staff in its investment banking division pay and bonuses worth more than €1.2 billion, a rise of 45% year-on-year, even as the business slumped €700 million into the red. The after-tax loss was mainly due to the one-off cost of US tax reforms. On a pre-tax basis, Deutsche reported a profit of €1.29 billion against a €810 million loss for the year before. Over the last 3 years the bank has been hit by regulatory investigations, financial penalties and lawsuits. Shares in Deutsche fell by over 11% over the last week. The bank is preparing a float of its wealth management business in an effort to boost returns, but plans to reduce costs have stalled, prompting new questions about the success of the bank’s strategy.

FTSE European 350 Bank Index fell by -3.5% over the last week The FTSE European 350 Bank Index fell by -3.5% to 4,570 from 4,736 over the week. While European market sentiment on the whole remains positive, on the back of recent bullish economic growth forecasts for the global and eurozone economies, markets fell on the back of a correction in the U.S. stock market caused by fears of higher inflation that would result in further interest rate rises.

ITRAXX Europe Senior Financials 5-year CDS Index rises by +7.5% over the last week The ITRAXX Europe Senior Financials 5-year CDS Index reversed some of its recent improving trend, rising by +7.5% to 44.1bps over the last week, as financial markets react to the Deutsche Bank after-tax loss and the announcement of a stricter European Banking Authority (EBA) stress test for this year. However spreads are expected to remain low as the European banks’ reporting season unfolds which is expected to confirm the strengthening capital position of most European banks.

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