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Flagstone Weekly Update - 26 February 2018

26th February 2018

UK Economic Headlines

UK Q4-2017 economic growth revised downwards The second estimate from the Office for National Statistics (ONS) for gross domestic product (GDP) in the last three months of 2017 indicates that the UK economy expanded by less than previously thought. GDP grew by 0.4% in the October-to-December period which was down from the initial estimate of 0.5%. The ONS stated that the revision was due to slower growth in production industries. In 2017 as a whole, the UK economy grew by 1.7% which was also slightly lower than the previous estimate of 1.8% and the weakest growth rate since 2012. The ONS said that consumer spending grew by 1.8% last year which was also the slowest annual rate since 2012 as shoppers face higher prices. One drag on the UK economy at the end of last year was the shutdown of the Forties pipeline system for a large part of December 2017 which cost about £20 million a day in lost activity according to Oil and Gas UK. The ONS data also appears to suggest that the construction industry is in recession, business investment is stagnant and household income is growing by only a modest amount with the latter squeezed by rising inflation which has coincided with weak wage growth. Analysts believe that this could hold back growth this year to 1.5% which would place us towards the bottom of the G7 growth league table together with Italy and Japan rather than at the top with Germany and the U.S. The UK's year-on-year growth rate in the fourth quarter of 2017 was 1.4%, making it the slowest growth rate of the world's wealthy nations as well as lower than the eurozone. This appears to be at odds with the recent Bank of England growth forecast for this year of 1.8%.

UK jobless rate rises unexpectedly while wage growth remains modest The latest figures from the Office for National Statistics (ONS) indicate that the UK unemployment rate rose for the first time in almost two years at the end of 2017 while pay growth remained modest. This is likely to keep the Bank of England (BoE) waiting for an acceleration in wages that would justify a new interest rate hike. The ONS reported that the unemployment rate rose slightly to 4.4% from 4.3% in the three months to December. This is the first increase in the unemployment rate since the three months to February 2016. The ONS attributed the rise in unemployment to a fall in the number of people who are neither working nor looking for a job. However, the number of people in work also grew by less than expected, rising by 88,000 which is about half the consensus forecast in a recent Reuters’ poll of economists. Growth in employment has been one of the bright spots in the UK economy since the financial crisis but, as in many other countries, pay growth has been anaemic. Workers’ total earnings (including bonuses) rose by an annual 2.5% in the three months to December, as expected by economists, which was unchanged from the three months to November. BoE officials are likely to note that pay jumped by 2.8% in December alone but this was still weaker than the 3.0% CPI inflation rate for December. Excluding bonuses, earnings rose by 2.5% year-on-year against expectations for a 2.4% rise. The ONS also reported that the number of European Union (EU) nationals working in the UK rose by an annual 4.5 % over the fourth quarter which is the smallest increase since the third quarter of 2013.

UK public sector borrowing at lowest level since the financial crisis The latest figures from the Office for National Statistics (ONS) indicate that UK public sector accumulated net borrowing for the fiscal year-to-date is at its lowest level since the financial crisis. Excluding state-owned banks, net borrowing fell to £37.7 billion between April and January, down by £7.2 billion on the comparable period in the previous fiscal year. The ONS reported that this is the lowest figure for the period since January 2008. It cautions that the net borrowing figure for the rest of the fiscal year may be adversely impacted by the collapse of Carillion but is still expected to be below the projected figure for the full year. At the time of the UK Budget in November, the Office for Budget Responsibility (OBR) forecast that public sector net borrowing would rise by £4.1bn to £49.9bn in the financial year to March 2018.

UK productivity boosted in last quarter of 2017 A flash estimate from the Office for National Statistics (ONS) indicates that UK productivity saw a substantial improvement for a second successive quarter. Output per hour in the fourth quarter of 2017 rose by 0.8% quarter-on-quarter. This followed a gain of 0.9% quarter-on-quarter in the third quarter of 2017. The EY Item Club believes that the improvement in productivity suggests that some of the weakness over the first half of 2017 may have been cyclical with businesses keen to maintain employment levels given concerns over potential labour shortages in some sectors and taking into account the relatively low cost of labour. However, the Item Club warns that further sustained improvement in productivity will be needed to ease concerns over the UK’s overall poor productivity record since the deep 2008/2009 recession. With the final Brexit outcome still unknown, any prolonged uncertainty and concerns over the UK’s economic outlook could end up weighing down on business investment and damaging productivity. While recent analysis by the ONS has concluded that much of the slowdown in UK productivity over the last decade was due to the changing composition of the UK economy, with workers moving from more efficient sectors (such as mining) to less efficient sectors (food & catering), the ONS also observed that there had been a slowdown in productivity growth in a number of sectors, including financial services, telecommunications and manufacturing.

Bank of England deputy governor believes swifter rate rises are needed Sir Dave Ramsden, a deputy governor of the Bank of England (BoE) believes that swifter rises in UK interest rates are needed amid signs of accelerating wage growth. Until now he has been considered as one of the doves on the BoE’s Monetary Policy Committee (MPC) and his change of heart will add to a growing conviction among economists that a further increase to 0.75% is coming in May. The former Treasury mandarin was one of only two members to vote against the first rise in more than a decade last November. His views bring him into line with the majority of members on the MPC which includes the BoE Governor, Mark Carney. The BoE’s quarterly inflation report published earlier this month hinted that interest rates may need to rise faster than was previously expected to reduce inflation, which at 3.0% remains well above the MPC’s 2.0% target. Most economists now expect interest rates to rise again in May with many predicting a further increase in August or November. The BoE’s current forecast is for economic growth of between 1.5% and 2.0% over each of the next five years which is a remarkably slow and steady performance by historical standards. However Sir David cautions that the economy’s lower potential capacity means even this modest expansion will be sufficient to use up its spare capacity and fuel inflation.

Barclays’ shares rise on the back of pre-tax profit growth and restoration of the full dividend Shares in Barclays plc (Barclays) rose in reaction to the banking group restoring its full dividend after reporting a 10% rise in pre-tax profit to £3.5 billion and announcing that share buybacks would be considered at some point. Barclays made considerable progress in its restructuring last year, including selling off most of its African business albeit at a loss of £2.5 billion. Restructuring costs together with litigation and conduct costs of £1.2 billion - as well as a one-off charge of £0.9 billion relating to the U.S. tax reforms - resulted in a £1.9 billion attributable loss in the year compared with a £1.6 billion profit in 2016. The Group’s Chief Executive Officer, Jes Staley, said that some benefits of the restructuring were already being felt with the investment banking arm having a better end to the year compared with some of its rivals. However Barclays still faces a number of significant issues. Earlier this month it suffered a setback when the Serious Fraud Office (SFO) levelled a further charge over its £12.0 billion fund-raising in the Middle East at the height of the financial crisis. The SFO has now included in the charges its operating company, Barclays Bank plc - which holds its banking licence and regulatory approvals - in relation to the fundraising. The criminal case against the group, the bank and four of its former directors is due in court in January 2019. Mr Staley and the bank are also being investigated by the Financial Conduct Authority (FCA) over whether Mr Staley violated rules on whistle-blowers when he tried to uncover the identity of an individual. Barclays is also in dispute with the U.S. Department of Justice over its alleged mis-selling of mortgage-backed securities before the 2008 global financial crisis. Barclays wants to settle the case but rejected an offer last year because it believes it was more punitive than sums that U.S. banks had been forced to pay. Included in the litigation and conduct costs of £1.2 billion was a further £700 million charge for payment protection insurance (PPI) mis-selling that takes its total PPI bill to £9.2 billion as well as a new £240 million charge relating to foreign exchange.

RBS expected to resume dividend once agreement reached on U.S. sub-prime settlement Analysts believe that the Royal Bank of Scotland (RBS) group is working on plans to reinstate its dividend in the second half of this year, provided it can reach a settlement with the U.S. Department of Justice over mortgage-backed securities mis-selling claims. RBS returned to profit for the first time in a decade last week when it reported a 2017 full-year profit of £752 million and a pre-tax profit of £2.3 billion compared with a £4.1 billion loss in 2016. Analysts believe that RBS would like to be able to announce a small dividend with its interim results in June which would support the Chancellor’s plans to start selling down the UK Government’s remaining 71% stake in the bank. However the plan hinges on reaching agreement with the U.S. Department of Justice. RBS is one of only a handful of global banks that has yet to reach agreement over legal claims related to allegations of mis-selling toxic mortgage-backed securities in the run-up to the 2008 financial crisis. While the bank has already set aside £3.1 billion, there remains uncertainty over the expected size of the settlement with analysts pencilling in a shortfall for the bank of up to $9.0 billion (£6.4 billion). The timing of the settlement of the case rests with the U.S. Department of Justice. Before making any dividend payment, RBS will also require to receive the green light from the Prudential Regulation Authority (PRA). The size of the dividend will be driven by the size of the U.S. Department of Justice settlement as well as the level of additional restructuring charges which it unveiled in its full-year results and which are expected to reach £2.5 billion over the next 2 years.

HSBC’s sharp rise in profits fails to impress analysts at Moody’s HSBC Banking Group (HSBC) disappointed investors and analysts with a smaller than expected rise in annual profit and with plans to raise up to $7.0 billion to bolster its capital cushion. The banking group reported a 141% rise in reported pre-tax profits to $17.2 billion but after stripping out one-off items, such as the sale of its Brazilian business, the lender said that it made an adjusted profit of $21.0 billion in 2017, a rise of 11% year-on-year. HSBC said it was planning to undertake additional tier 1 capital issuance of between $5.0 billion and $7.0 billion during the first half of 2018 and that it would undertake share buybacks as and when appropriate. Analysts remain concerned about HSBC’s increased dependence on its Asian business - which now accounts for more than three-quarters of profits - pointing out that while there may be long-term appeal, the approach comes with associated risks. Meanwhile Moody’s has placed the long-term ratings of HSBC Bank plc on review for downgrade to reflect their view of the likely impact on the bank of the UK's ‘ring-fencing’ legislation. As HSBC Bank plc will become the non-‘ring-fenced’ bank, this will further increase its reliance on wholesale and capital markets, activities which Moody's view as riskier and more volatile than other activities.

Lloyds Banking Group announces its best annual results since the financial crisis Lloyds Banking Group has reported its best annual results since its takeover of HBOS in the depths of the global financial meltdown nearly a decade ago. Statutory pre-tax profits rose by 24% to £5.3 billion in 2017, which has allowed the bank to raise its dividend by a fifth and to announce a £1.0 billion share buyback programme. The UK’s largest retail lender said that, after stripping out restructuring costs and items such as losses on the redemption of its debt, its core underlying profit was £8.5 billion last year which was up by 8% from the previous year. The rise in profits was driven by a widening net interest margin which stood at 2.86%, helped by rising interest rates. The bank also announced a £3.0 billion digital investment programme over the next three years with the aim of ensuring that more than 70% of its services are automated by the end of 2020. Despite the encouraging results, familiar issues remain to be fully resolved. The bank said that it had taken a new £600 million payment protection insurance provision in the final quarter of the year, taking its accumulated compensation costs to £18.7 billion. In addition, the bank was hit by a further £865 million of other conduct-related costs.

Other Headlines

Confidence in the U.S. economy rises among some Federal Reserve policymakers The US Federal Reserve (Fed) is believed to be preparing for stronger-than-expected economic growth this year which is likely to boost the case for higher interest rates. However, some policymakers remain doubtful that the gains will appear in the form of rapid inflation and higher wages. Those members have urged their colleagues to be patient as they weigh up the pros and cons of future interest rate rises. The conflicting views were revealed in minutes published from the Fed's January meeting which was the final gathering led by former Fed Chair, Janet Yellen. However, it preceded the turmoil in the global stock markets that was partly due to investor concerns that the Fed might raise interest rates more rapidly than anticipated. Investors were reacting to data, including wage increases, that suggested inflation might be stronger than in recent years and which might prompt the Fed to raise interest rates more quickly. The Fed has been steadily shifting away from the policies aimed at economic stimulus that it enacted during the recession, including ultra-low interest rates. It took no action to raise interest rates at its January meeting, but markets expect at least three interest rate rises this year and expect the next rate action in March. Investors are also watching carefully to see if new Fed Chair, Jerome Powell, adopts a more aggressive stance than Ms Yellen who was viewed as moving relatively slowly to raise interest rates.

FTSE European 350 Bank Index fell by -1.9% over the last week The FTSE European 350 Bank Index reversed much of the previous week’s gain, falling by -1.9% over the week to 4,511 from 4,598. The reversal reflects underlying global market concerns that the U.S. Federal Reserve is likely to raise interest rates sooner rather than later as global growth continues which is likely to be followed by other countries apart from possibly the eurozone.

ITRAXX Europe Senior Financials 5-year CDS Index up by +14.6% over the last week The ITRAXX Europe Senior Financials 5-year CDS Index more than reversed last week’s improvement, rising by +14.6% over the week to 58.7bps from 51.3bps despite analyst expectations that the European full-year reporting season will confirm the strengthening capital position of most European banks. The higher spreads reflected in the Index are partly caused by concerns about the adverse impact of the UK leaving the European Union on remaining members’ budgets.

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