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Flagstone Weekly Update - 19 February 2018

19th February 2018

UK Economic Headlines

UK retail sales for January held back by higher prices The latest figures from the Office for National Statistics (ONS) indicate that UK retail sales have had their worst start to a year since 2013 and appear to be in a continued slowdown mode. The figures suggest that higher prices are having an effect on shopping habits with retail sales volumes rising by only 0.1% between December and January. This was below economists’ forecasts of a monthly rise of 0.5%. Also, compared with the same month last year, there was less of an increase than economists had expected with a rise of 1.6% representing the weakest January performance since 2013 and at the bottom end of forecasts. Retail spending makes up around 20% of the UK economy and is considered a key indicator of how comfortable consumers are feeling about their personal finances. This is considered by economists to be of importance because households are considered to be the growth engine of the UK economy. However inflation has steadily risen to a near-six-year high as a result of a fall in the value of the pound while wages have been falling in real terms. January’s disappointing performance follows a sharp month-on-month decline of 1.4% in December which was partly attributable to consumers having brought forward some Christmas shopping to November to take advantage of sales during the “Black Friday” weekend. However the three month period to January, which balances out the monthly volatility of the data, shows that sales rose by only 0.1% which marks the weakest three-month period since April 2017.

UK inflation still at 3.0% despite fall in food prices The latest official figures from the Office for National Statistics (ONS) indicate that UK consumer price inflation (CPI) remained at 3.0% in January, the same level as in December. However the inflation rate remains just below November's six-year high of 3.1%. Most economists had expected a small fall in the CPI to 2.9%. Earlier this month, the Bank of England (BoE) indicated that interest rates might rise sooner than expected as it wants to get the inflation rate closer to 2.0% within two years rather than three years. Markets are pricing in the likelihood that UK interest rates will rise in May, with a second rise expected in November. If the BoE were to raise interest rates in line with market expectations, they would reach 1.0% by the end of this year. The ONS reports that petrol prices have risen by less than this time last year while food price inflation appears to be slowing down.

City steps-up lobbying for ‘mutual access’ deal after Brexit Senior figures from the City of London have announced that they intend to visit many European Union (EU) countries soon to lobby for an innovative agreement for financial services after Brexit. Executives from the UK’s banks, insurers and professional services firms hope to visit most of the EU’s 27 other member states as well as European regulators before the end of March. They will lobby for a deal that would give “mutual access” to markets for EU and UK firms. The City lobbying group’s increased effort comes ahead of the key moment in a few weeks’ time when terms will be set for talks about the future relationship between the UK and the EU. The City lobbying group want to persuade European countries to instruct the European Commission to move away from its hard-line rhetoric about the UK not being allowed a free-trade deal in services towards thinking about an agreement that would allow frictionless access for both sides. Their proposals are underpinned by a series of reports compiled by the International Regulatory Strategy Group (IRSG), an industry body whose members include European as well as UK institutions and which has gained traction among UK politicians, with ministers expected to endorse the proposals in speeches over the next few weeks. The City lobbying group believes that mutual access is possible because UK and EU laws will be exactly the same at the point of departure and because the UK is home to one of the world’s biggest financial markets on which EU companies depend. To overcome objections, it has suggested a mechanism to resolve future disputes that would not infringe either side’s ‘red lines’ about the role of the European Court of Justice. Analysts believe there are signs that officials and politicians from the EU side have shown an increasing interest in hearing more detail.

Analyst spotlight on Virgin Money due to central bank funding concerns Virgin Money has come under the spotlight amid analyst concerns about its reliance on UK central bank funding schemes that are about to come to an end. As a result, shares in the banking group fell by 5% over the week to a six month low of 261p. RBC Capital Markets has downgraded the lender and has applied an “underperform” rating on expectations that growth and margin could come under pressure this year as Virgin Money’s digital offering gathers pace. Figures from the Bank of England (BoE) indicate that the bank’s aggregate usage of the BoE’s Term Funding Scheme (TFS) and Funding for Lending Scheme (FLS) totalled £6.2 billion as at 30th September 2017. As a percentage of assets, this equates to 18% which is the third highest total among UK banks on that date. Access to these funding schemes will end this month and RBC expects lower profitability in the short-term as the bank looks to replace the cheap loans with more-expensive customer-based term deposits and savings accounts. Last year Virgin announced a move into mainstream current accounts as well as a step into the business banking market that is aimed at small and medium-sized enterprises (SME’s). RBC acknowledges that Virgin Money has been very successfully in growing the asset side of its balance sheet which has resulted in the loan-to-deposit ratio rising from 108% in 2015 to a more aggressive 118% at the 2017 year-end. However, while they accept that the launch of the SME deposits initiative in the first half of 2018 and the business current account initiative in the second half of 2018 to be followed by the digital bank initiative in 2019 will reduce the loan-to-deposit ratio and change the mix of deposits towards current accounts, they have concerns that these initiatives will take time to make a meaningful difference. Having started last year at 302p, shares in Virgin Money have fallen by 14% to date while share prices in the banking sector as a whole have risen over the period.

RBS expected to report a profit for the first time in a decade This week sees the start of the UK bank annual results reporting season. For the first time in 10 years, analysts expect the Royal Bank of Scotland group on Friday to report a profit for the 2017 full-year. Analysts predict that the bank, which is still 71% owned by the taxpayer, will reveal a pre-tax profit of £1.6bn, compared with a -£7.0bn loss last year. However, RBS has yet to settle a claim brought by the U.S. Justice Department over its role in the mis-selling of mortgage-backed securities that fuelled the financial crisis and which could cost the bank between £5.0bn and £12.0bn in misconduct charge costs. The bank has previously agreed to pay $5.5bn (£4.2bn) to settle a separate claim brought by the Federal Housing Finance Agency last July. RBS has also been embroiled in a UK domestic scandal over the alleged systematic mistreatment of small businesses by its Global Restructuring Group division. This week, members of the Treasury Select Committee are expected to decide whether to publish a report criticising the bank’s actions that was compiled by the Financial Conduct Authority.

Other Headlines

U.S. Consumer price rise signals firming inflation The Commerce Department has reported that U.S. consumer prices rose faster than expected in January which economists interpret as a sign of firming inflation that has bolstered expectations of higher U.S. interest rates. The Consumer Price Index grew by 0.5% against forecasts of a rise of 0.3%. This follows earlier data showing accelerating US wage growth which had raised concerns that the U.S. Federal Reserve (Fed) might raise interest rates faster than previously thought, triggering days of volatility on the financial markets. The Consumer Price Index is a different measure of inflation from the one the Fed typically emphasises. The Commerce Department also reported that U.S. retail sales declined by 0.3% in January, an unexpected drop that analysts said made it more difficult to draw a clear picture of the U.S. economy. Economists have consistently stated that they expect higher inflation in the U.S. due to stronger economic growth and low unemployment, but these expectations were unfounded last year as relatively soft inflation lagged the 2.0% target set by the Fed. However, economists interpret the latest data as pointing to price and wage increases at levels that suggest the dynamics could be changing. Over the 12 months to January, inflation remained at 2.1%. Investors are concerned that the Fed could move too aggressively, triggering higher borrowing costs for companies and consumers that choke economic growth. New policies, including the U.S. tax reforms approved last year and increased U.S. government spending further complicate the situation by adding to the inflationary pressures.

European Union grows at its fastest economic pace for 10 years Figures from the European Union’s statistics office, Eurostat, have confirmed that the EU economy grew at its fastest pace in a decade last year. The 28-strong EU expanded by 2.5% in 2017 which was its strongest performance since 2007 when it grew by 2.7%. In the final three months both the EU and the 19-nation eurozone grew by 0.6% compared with the previous quarter, which mirrored the growth levels in France and Germany, while Spanish growth was a notch stronger at 0.7%. These latest figures confirm the flash estimates published by Eurostat at the end of January which were based on more limited data. Economists attribute the strength of the eurozone economy to the European Central Bank's (ECB) stimulus policies which have brought down the cost of borrowing in recent years. In addition, economists believe that confidence had been steadily hitting record levels since the crisis years while unemployment is down to pre-crisis levels with activity supported by strong global growth which is helping European exporters.

FTSE European 350 Bank Index rose by +3.3% over the last week The FTSE European 350 Bank Index recovered from its fall of the previous week, rising by +3.3% over the week to 4,598 from 4,449. The recovery mirrored that of global stock markets that had experienced significant downward volatility over the previous week, caused by concerns that strong global economic growth will lead to higher inflation and result in further interest rate rises sooner than expected.

ITRAXX Europe Senior Financials 5-year CDS Index improves by -8.8% over the last week The ITRAXX Europe Senior Financials 5-year CDS Index partly recovered from its sharp rise of +27.5% over the previous week when it was adversely impacted by the same underlying concerns as affected the global stock markets. The improvement in the Index over the latest week by -8.8% to 51.3bps from 56.2bps was due in part to analyst expectations that the European full-year reporting season will confirm the strengthening capital position of most European banks. In addition, Deutsche Bank AG recovered part of its adverse rise of the previous week, in reaction to its disappointing 2017 financial results, by improving -16.5% to 89bps from 106bps.

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