E&Y - ITEM Club Autumn 2013: Outlook for financial services

Outlook for financial services

Issue 10 – Autumn 2013

EY ITEM Club

Contents

2 Macroeconomic overview 3 Executive summary 4 Banking forecast The banking sector continues to heal Viewpoint: Omar Ali Partner, UK Banking &

Capital Markets Sector Leader, UK Financial Services

6 Insurance forecast Life business hit by RDR this year... Viewpoint: Mark Robertson Partner, Head of

UK Insurance 8 Asset management forecast More resilitent financial markets embrace

risk assets Viewpoint: Gill Lofts Partner, Financial

Services – Asset Management 10 Appendix Charts and tables

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The ITEM Club outlook for financial services examines the implications of ITEM Club’s economic projections for the financial services sector.

EY is the sole sponsor of the ITEM Club, which is the only nongovernmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or business bias.

EY ITEM Club

1EY ITEM Club: outlook for financial services Autumn edition 2013

The resulting boost to consumer confidence should serve to encourage the UK's consumer led economic recovery.

It is also a reminder that while banks’ balance sheets have been extensively restructured over the past few years, the UK economy has not fundamentally changed its spots. It was probably naive to expect otherwise. Reshaping a large and complex economy takes decades, and it is doubtful whether any government can do so without the help of significant economic forces.

It is therefore critical to know whether a recovery supported by rising asset prices and increasing leverage can deliver sustainable growth, rather than re-inflating old bubbles. After all, it is widely accepted that these same factors contributed to the build-up and eruption of the financial crisis.

A pessimistic answer would be that we are destined to repeat the mistakes of the all-too-recent past. This view is backed up by the dispiriting fact that household savings rates are declining again after the briefest of increases. While political rhetoric may encourage people to repair roofs as the Sun begins to peek out from the clouds, regrettably we, the Great British public are still more likely to use the break in the weather to upgrade our television sets. A more optimistic assessment is that economic recovery (consumer led or otherwise) should finally encourage businesses to loosen the purse strings of investment, thereby accelerating or at least broadening any recovery. Policymakers will have to find more effective ways to

accelerate the business contribution to economic recovery going forward if we are ever going to convert a nation of consumers into a nation of savers and to break our reliance on them.

The importance of achieving a sustainable recovery means that tapering – the process of withdrawing exceptional monetary stimuli – is looming ever larger over the UK’s outlook. A key challenge for Bank of England Governor Mark Carney during his five-year term will be to wind down these ultra-loose policies without provoking a disorderly market reaction.

The temperature of debate may have cooled, but just as economic confidence remains fragile so is trust in the financial system and its participants.

A bump free road to recovery must be unlikely whilst business and investor confidence remains fragile. One would hope that the appointment of Janet Yellen as the next Fed Chairperson would help to calm fears around tapering. Then again, domestic US politics could become a greater source of unpredictability to the World's economic recovery. In any event both the UK and the US need to avoid a ‘confidence gap’ opening up between the end of QE and the start of an investment-led recovery.

These uncertainties only reinforce the continuing importance of reform in UK financial services, and banking in particular. Growth may be taking off, but the banking industry has a long way to go before fully recovering from the financial crisis. Banks’ regulatory landscape, although much altered, has not been strengthened in a globally coherent way. Balance sheet repairs continue. And it is certainly too soon for customers to have confidence that the culture of banking has changed.

Banks should resist the temptation to think that public opinion towards the sector has been mollified by the return of economic growth. The temperature of debate may have cooled, but just as economic confidence remains fragile so is trust in the financial system and its participants. Policymakers, taxpayers and customers remain wary and the industry cannot afford to test their nerves or patience anew. This is not just a case of "Bankers Beware." Other sectors of financial services should also avoid complacency. Just as the imbalances that led to the crisis have yet to be fully reversed, political and regulatory attitudes towards conduct in the insurance and asset management sectors have surely yet to run their full course.

Introduction

As the economic recovery gathers pace, the state of the UK’s housing market is retaking its place at the heart of national debate. Unlike quantitative easing (QE), which has supported the value of assets on banks’ balance sheets, the Help to Buy (HTB) scheme has the effect of supporting the value of many households’ largest asset – their home.

Managing Partner UK Financial ServicesContact detailsTel: +44 20 7951 2313 Email: [email protected]

Chris Price

2

UK recovery appears to be firmly entrenched...

The UK recovery now appears to be firmly entrenched. GDP growth is forecast to pick up from 1.4% this year to 2.4% in 2014 and 2.6% in 2015. So far, the acceleration has been fuelled by consumption growth, but as the recovery broadens we expect investment and exports to revive. A slow but steady return to growth in the UK should result in a gradual upward shift in the yield curve. We expect the Bank of England to start raising rates in late 2015 from the current 50bp, slightly later than financial markets currently forecast. By the end of 2016, the bank rate is forecast to reach 1.75%. This measured return to more normal interest rates should not threaten the recovery.

… providing more support for employment and household consumption

The labor market will improve as the wider recovery strengthens, generating sustained employment growth and higher wages. Employment growth so far this year has been more subdued than in 2012. Just 26,000 new jobs were created in the first six months of 2013, compared with 605,000 over the whole of 2012. Real disposable incomes in Q2 were 0.7% lower than a year earlier. Consumption growth picked up by 1.5%, though, as the saving ratio fell back to 5.9% from 7.4% a year earlier.

We expect real incomes to grow just 0.2% this year, but as the economic outlook improves and the worst of the deleveraging is completed, consumer confidence will increase over the next 12 months.

We expect real incomes to grow just 0.2% this year, but as the economic outlook improves and the worst of the deleveraging is completed, consumer confidence will increase over the next 12 months. Consumers are already reducing saving rates, and consumer spending growth is forecast to accelerate from 1.2% in 2012 to 1.6% this year. Spending should then gain momentum in 2014 and beyond. However, households are continuing to reduce debts and the saving ratio remains above historic norms, so the pace of recovery will be constrained. We expect consumer spending growth of 1.9% in 2014 and 2.2% a year during 2015–17, well below the 3.7% averaged in the decade before the financial crisis.

The housing market is also reviving …

The revival of the housing market is a key reason for the recovery in consumer confidence. Housing market activity was initially boosted by the Bank of England’s Funding for Lending Scheme (FLS) introduced last year, and is further supported by this year’s HTB scheme. Mortgage approvals in August 2013 were more than 30% higher than a year ago. They should accelerate steadily, translating into house price growth of 3.5% in 2013 and 6.6% in 2014. Some forecasts of house price inflation are well into double

figures, led by a strong London market, and some commentators have warned of a property bubble. We think these worries are misplaced; so far, the biggest price rises have been confined to London. Modest house price inflation would help to build confidence and equity at the lower end of the market and is a natural feature of a well-functioning market.

… but business investment has yet to pick up

Business investment fell 2.7% in Q2 and is now 27% lower than in early 2008. This is surprising given the strength of corporate finances. Non-financial corporations ran a surplus of 2.5% of GDP in 2012, well above historical norms. The ratio of company profits to GDP has risen steadily over the last three years and is close to pre-crisis levels. Some smaller firms continue to report problems accessing funding, but larger firms tend to dominate investment spending as they have both high levels of cash holdings and good access to bank finance. Lack of funding is therefore unlikely to be the decisive factor behind low levels of investment. Rather, companies’ expected returns on investment are still low, held back by the subdued global economic outlook.

The recovery of the UK economy and continued low interest rates should encourage more investment. Business investment is forecast to fall by 5.6% in 2013, but we expect it to rebound next year by more than 7% as confidence continues to strengthen and firms take advantage of low borrowing costs and strong liquidity.

Macroeconomic overview

EY ITEM Club: outlook for financial services Autumn edition 2013

3

Executive summary

Banking

We expect net mortgage lending to increase by 0.7% in 2013 before accelerating to 2.9% in 2014, reaching £1,116b.

After falling by 4.2% in 2013 to £4,362b, we expect deposits to be broadly flat in 2014.

Net lending to businesses has continued to fall this year and we expect it to decline by more than 4% in 2013.

Consumer lending growth should pick up from a little over 1% in 2013 to more than 3% in 2015.

Insurance

Life premium income will grow by an average 3.8% a year during 2014–17 to reach £176b by 2017, still 17% lower than its peak 10 years ago.

By 2017, almost 20% of the population will be at least 65 years old — an additional £1.6m people compared with that in 2000, creating new opportunities and challenges.

By 2017, we estimate that housing market turnover will be 41% higher than that in 2012. This should boost demand for products, such as life cover, and buildings and contents insurance.

After two years of declines, we expect a 2.8% increase in insurance profits in 2013. By 2015 profits are expected to have reached £7.5b, exceeding their pre-crisis peak of £7.3b.

Asset management

Total UK-focused assets under management (AUMs) are expected to rise by 12% this year to £780b, as investors are increasingly willing to hold risk assets again.

AUMs in bonds will expand just 1.2% a year on average during 2014–17, compared with almost 18% a year over 2009–12.

If AUMs increase in line with our forecast, the industry’s annual contribution to the UK economy will be about £20b in 2017.

Equity AUMs are forecast to rise by 17% this year and more than 7% in 2014.

EY ITEM Club: outlook for financial services Autumn edition 2013

Mortgages

We expect net mortgage lending to increase by 0.7% in 2013 before accelerating to 2.9% in 2014 reaching £1,116b.

2.9%

Life premiums

Life premium income will grow by an average 3.8% a year during 2014–17 to reach £176b by 2017 still 17% lower than its peak 10 years ago.

£176b

AUMs

Total UK-focused AUMs are expected to rise by 12% this year to £780b, as investors are increasingly willing to hold risk assets again.

12%

4 EY ITEM Club: outlook for financial services Autumn edition 2013

There is clear evidence that the banking sector is continuing to heal. Share prices are starting to recover and the UK Government has taken its first step toward reprivatizing nationalized banks.

Banks have made good progress in restructuring their balance sheets, with most either already compliant with the Basel III guidelines or with plans to achieve the desired level of capital by the end of 2013. Tier one capital is forecast to average 10.7% of assets this year across the sector, up from 10.4% in 2012. This goes hand-in-hand with a 4.6% reduction in total assets to £6,664b.

Despite growing economic confidence, most UK banks will remain constrained in their ability to increase net lending for the foreseeable future. As alternative funding solutions establish themselves in the UK, banks risk losing ground permanently.

Policy initiatives set to boost mortgage activity

The Bank of England’s FLS and the Government’s HTB scheme are bearing fruit, with mortgage approvals up 14% between April (when the scheme began) and August, a sharp increase on the 6% rise over the whole of last year. The early implementation of the second phase of HTB will further support mortgage availability. Better employment figures and household incomes will encourage households to take advantage of improved credit availability. Gross mortgage lending was up 30.8% in August compared with a year earlier, but

has been largely offset by repayments, as households continue to restructure their balance sheets. We expect net mortgage lending to increase by 0.7% in 2013, before accelerating to 2.9% in 2014. This should help boost banks’ profitability.

After shrinking for four years, consumer credit has also begun to pick up. The FLS has helped banks improve the availability of credit, but consumer demand for borrowing is also picking up as confidence in the economic recovery improves and the housing market accelerates. We expect this trend to continue, supported by higher consumption over the next few years. We forecast a consumption growth of 1.6% this year, rising to 1.9% by 2015. As a result, consumer lending growth should pick up from about 1.5% in 2013 to more than 3% in 2015.

Business lending will take longer to recover

While FLS has been successful in boosting mortgage lending, there is little evidence that it has helped to support corporate lending. Lending to businesses picked up in Q2 and Q3 2013 compared with that in 2012, but repayments have also increased. Net lending to businesses has therefore continued to fall this year and we now expect it to decline by more than 4% in 2013. The decision of the Financial Policy Committee (FPC) to relax liquidity requirements for banks holding sufficient capital is another attempt to encourage lending to businesses, but corporate investment is still very subdued. Business surveys, such as the CBI’s industrial trends survey, indicate that lack of demand appears to be the key reason for low lending levels in 2013. Confidence is improving, however, and we expect this to translate

Banking forecast

The banking sector continues to heal

Contact detailsTel: +44 20 7951 1789Email: [email protected]

The Parliamentary Commission on Banking Standards recommended a number of initiatives to stimulate increased competition. On paper the UK banking market is poised for a shake-up. TSB has returned to UK high streets, Williams & Glyn’s should follow soon and several non-traditional banks are planning to enter the current account market. Yet, the response to current account switching has been under- whelming and may actually see the bigger players take more share. We will not see real competition in the market until new entrants are able to effectively compete on price, proposition and offer radically differentiated services. The good news is that economic recovery is boosting confidence. Consumer lending is gathering pace, and HTB is giving additional support to mortgage demand. However, net business lending continues to contract, particularly to SMEs. Demand for SME credit remains weak, but we hope the economic recovery will end firms’ singular focus on reducing debts and conserving cash. It is harder to predict how the supply of SME credit will evolve. Banks have made continued efforts to lend over the past year, but they have not always been able to do so at rates — or on terms — that SMEs have found attractive. New high-street banks may have an impact at the smaller end of the SME spectrum, but SMEs are increasingly turning to alternative sources, such as peer-to-peer lending and crowdfunding for finance.Medium-sized firms, like their large corporate counterparts, continue to have more funding options. Banks unwilling or unable to increase their own lending are partnering with institutional investors to offer their clients alternative credit sources. Capital will continue to be constrained. While not subjected to the Asset Quality Reviews (AQR) of the Eurozone, the Bank of England’s evolving regime of stress testing is setting a clear tone for UK banks. Despite growing economic confidence, most UK banks will remain constrained in their ability to increase net lending for the foreseeable future. As alternative funding solutions establish themselves in the UK, banks risk losing ground permanently.

Viewpoint

Omar AliPartner UK Banking & Capital Markets


Banking highlights

The banking sector continues to heal

into stronger investment from 2014. Business lending is forecast to rise by 3.7% in 2014 and close to 5% in 2015. This puts the UK ahead of much of the rest of Europe, with the notable exception of Germany where lending to corporates is expected to rise this year.

FLS will continue to restrain deposits in 2014

Deposits have continued to fall, shrinking 3.8% between the end of 2012 and August 2013. This is partly due to slower household income growth, which fell 0.1% in H1 2013 compared with a 2% rise in H1 2012. Improving consumer confidence has also played a part by reducing the household savings rate from its post-financial crisis peak of 7.3% in 2010 to an expected 5.7% in 2013 and encouraging consumer spending, which is forecast to grow by 1.6% this year. FLS has also contributed by driving down interest rates. With household incomes set to strengthen next year and the savings ratio forecast to stabilize, there is likely to be more support for deposits from 2014. Holding money on deposit will continue to look relatively unattractive, however, as interest rates on savings are likely to remain at present levels until 2015. We expect deposits to be broadly flat in 2014, after falling by 4.2% in 2013 to £4,362b, and it is only when FLS ends in 2015 and interest rates begin to normalize that we expect to see any significant pickup in deposit growth.

Though the sector is healing, there remains a high degree of uncertainty

As the recovery strengthens and corporate profits revive, bad and doubtful debts should continue to fall as a proportion of outstanding loans. We expect consumer debt write-offs to average 2.2% in 2013 and

2.1% in 2014, well below the 2010 peak of 5.5%. Corporate loan write-offs have fallen back from the 2011 peak level of 1.7% and we expect them to average 1.4% of outstanding loans in 2013, before falling to just 1.1% in 2014.

There are some risks ahead, however. Although confidence in the sector is improving, the US Treasury yields have risen sharply this year as markets anticipated a slowdown in asset purchases. The Federal Reserve has not yet announced the start of QE tapering, but it is likely to become an issue later this year or early next year. If this results in higher yields in the UK than what we currently forecast, falling market values of bank assets could necessitate further capital raising. Our modeling suggests that if markets view the start of the taper as a signal that rate rises are imminent, UK 10-year yields could increase to about 400 basis points (bp) by the end of 2014, compared with our current 315bp forecast. There is also a high degree of regulatory uncertainty, especially following the short-notice demand of the Prudential Regulation Authority (PRA) for more capital in June. It is not yet known how the Government will complete the re-privatization of nationalized banks.

Deposits

After falling by 4.2% in 2013 to £4,362b, we expect deposits to be broadly flat in 2014.

£4.362b

Business lending

Net lending to businesses has continued to fall this year and we expect it to decline by more than 4% in 2013.

4%

Consumer lending

Consumer lending growth should pick up from a little over 1% in 2013 to more than 3% in 2015.

3%



Viewpoint

Mark RobertsonPartner UK Insurance

Insurance forecast

Life business hit by RDR this year

UK life insurers still face a challenging operating environment. Premium income is forecast to rise by little more than 1% this year as the effects of the RDR alters the shape of the industry. The number of financial advisors is likely to fall from approximately 28,000 in 2009 to just 21,000 by the end of this year, and most high-street banks have stopped providing retail advice. So, insurers will need to find new routes into the market.

Once these changes have been negotiated, an improving economic backdrop brings the prospect of faster life premium income growth. Real household disposable income is set to pick up by 1.6% in 2014, helped by strong employment growth and lower inflation. This will support higher premium growth, averaging 3.8% a year during 2014–17. Although this is an improvement compared to the last few years, even by 2017 premium income of £176b will still be 17% below its peak 10 years ago.

But housing market revival offers a new hope

Both life and general insurers should benefit from resurgence in the housing market. Property transactions are expected to be 12% higher this year than those in 2012, and are forecast to rise a further 8% in 2014. By 2017, we estimate that housing market turnover will be 41% higher than that in 2012. This should boost demand for products, such as life cover, and create new opportunities for general insurers to increase the levels of buildings and contents insurance. A near 2% rise in employment helped sales of critical illness and life insurance products to stabilize last year, but further progress is likely to be slower.

Employment growth is forecast to average just 1.1% between 2013 and 2017, so sales driven by higher housing market transactions will be particularly important for insurers.

Across the industry, the over-riding theme is the need for insurers to focus on their core underwriting, often by making it more tailored.

Increased competition will limit the pace of general insurance premium growth

General insurance premiums were up 2.5% last year and we expect growth to average 3.7% during 2013–17 as the economy improves. Nevertheless, this is slower than the nominal GDP growth, which we forecast to increase by 4.5% a year. Abundant capacity means that the price of insurance cover has remained fairly flat. Motor insurance prices are lower than a year earlier, and intense competition together with falling new business rates prevent providers from writing profitable business. Household contents insurance prices have fallen by 6.5%, and even in health insurance, where prices have risen by 9% in the past 12 months, rising costs have eroded most of the gains.

News of the UK economic recovery is music to the ears of insurers, but it is barely relieving the pressure on many players’ business models.General insurance is a case in point. Recovery should give a lift to premiums, but the FCA’s thematic reviews (e.g. dual pricing and ancillary sales) represent a direct challenge to many firms’ current business models. Many insurers and brokers will see an erosion of certain profit streams and need to focus harder on customer or risk specific value propositions, making full use of behavioural data for advice and underwriting. At the same time, they need to simplify their operating models and become more transparent to customers in order to secure long-term profitability.The picture is not so different in the life market. In the short term, recovery in the housing market will encourage policy renewals. Looking further ahead, protection providers need to move away from broad assumptions around morbidity and mortality to writing individual risks. Again, this means doing more to collect and understand personal and behavioural data and turn new sources of data (e.g. pharmaceutical life cycles and medical practitioner performance) to their advantage. Meanwhile, the effects of the Retail Distribution Regulation (RDR) are challenging life companies’ savings and pensions businesses. On one hand, firms need to improve their ability to provide wealthy groups and individuals with tailored services. On the other, they need to reconnect with mass market consumers that are increasingly cut off from affordable advice and are at risk of being given a false sense of security by auto-enrolment. We anticipate that continuing improvements in longevity and the concentration of wealth in the ‘later life’ segments will see insurers look to innovate in this space, leading to increased prevalence of equity release and long term care solutions. Specialty insurance markets face a different sort of challenge, with pricing under pressure from the sheer volume of capital entering the market. Cost reductions will only have a temporary effect on performance, especially given the prospect of increasing scrutiny from the PRA and the FCA. To deliver sustainable profitability, underwriters will need to focus expertise on their chosen risk segments; achieve complete management of aggregated risk portfolios and realise the benefits of more sophisticated predictive claim modelling.Across the industry, the over-riding theme is the need for insurers to focus on their core underwriting, often by making it more effectively tailored. This means that each firm needs to strike a balance between harnessing technology and developing vital human skills. Every firm is under pressure to invest further in digital channels to meet the increasing service expectations of the new consumer generation. Many face the difficult choice of layering new technologies on top of legacy infrastructure or starting afresh with entirely new business models.


Life business hit by RDR this year

Insurance highlightsAdd-ons to basic policies are still profitable, but this may not last as they are attracting increased regulatory and customer scrutiny. Dual pricing — offering new customers better rates than existing customers — is also under threat. We expect insurers to reassess their pricing models to balance regulatory conduct requirements with the need for profitable business. This applies particularly to direct sales distribution models.

Insurers will search for innovative ways to return to profitability

In an increasingly competitive environment, higher housing market turnover offers an opportunity to attract new customers and write more efficient business. Returning core businesses to profitability will be a challenge, given that the real GDP is forecast to grow just 2.5% a year during 2014–17, and household wealth is expected to rise less than 2% a year. M&A activity will continue, and investments by private equity organizations should provide further impetus for change, together with fresh ideas and approaches. In the absence of any other catalyst for market-wide rate increases, insurers are likely to focus on improving claims management by replacing costly systems or outsourcing the function.

Although the operating environment will remain challenging, we expect the insurance industry to see some profit growth after two years of declines, with 2.8% growth forecast for 2013. By 2015, profits are expected to have reached £7.5b, exceeding their pre-crisis peak of £7.3b.

Evolving customer demographics will create new opportunities and challenges

Demographic changes will also bring new prospects for growth. By 2017, almost 20% of the population will be at least 65 years old — an additional 1.6m people compared with 2000 levels. New technologies may enable more individually tailored products to be offered to this sector, including prefunded care and improved equity-release products. We also expect some insurers to expand the supply chain by providing their own residential and health care facilities. But, there will also be challenges in successfully implementing these changes, and in writing profitable business in what is likely to be a highly competitive market. As the generation who grew up with the internet approach their middle years, the market will become increasingly price-sensitive.

Aging population

By 2017, almost 20% of the population will be at least 65 years old — an additional 1.6m people compared with that in 2000 creating new opportunities and challenges.

1.6m

Housing market

By 2017 we estimate that housing market turnover will be 41% higher than that in 2012. This should boost demand for products such as life cover and buildings and contents insurance.

41%

Profit growth

£7.5bAfter two years of declines we expect a 2.8% increase in insurance profits in 2013. By 2015, profits are expected to have reached £7.5b, exceeding their pre-crisis peak of £7.3b.


Asset management forecast

More resilient financial markets embrace risk assets

Viewpoint

Gill LoftsPartner Asset Management

Total UK-focused AUMs are expected to rise by 12% this year, to £780b, as investors are increasingly willing to hold risk assets again. Financial markets have continued to suffer from a series of shocks, including proposed changes to the US's QE program, escalating conflict in the Middle East and fears that the US debt ceiling may not be raised. Nevertheless, as we expected, asset price volatility has been less pronounced this year. This indicates growing resilience, as market reactions are becoming more considered and determined by fundamentals. The more recent shocks have related less to systemic financial risks than to specific events, such as the US Fed’s surprise decision in September this year not to announce a start date for reducing the scale of its QE program.

AUMs in higher-risk assets, such as equities, are therefore forecast to rise by 17% this year, and more than 7% in 2014. With GDP growth accelerating, pan-European equity funds are well placed to benefit from any investor that shifts away from emerging markets as injections of liquidity from the US begin to slow. Among equity funds, we expect high-dividend yield funds to be less in demand as gilt yields steadily rise and investors shift their focus to growth stocks and undervalued assets. Investment managers are likely to place more confidence in stock-picking strategies rather than relying on asset allocations. In these market conditions, small and mid-cap funds have historically seen an increase in interest

Multi-asset funds should continue to grow rapidly in these conditions

We expect AUMs in multi-asset funds to grow even faster than equities. They are forecast to increase more than 22% this

year, and a further 16% in 2014. This will be the fifth year of rapid expansion. If the current pace of growth were to continue, multi-asset funds would manage a quarter of UK-focused assets by 2017. Even if growth slows as the industry matures, as our forecast suggests, multi-asset funds will overtake bond funds to become the most popular fund type after equities by the end of 2014. They will manage 15% of UK-focused assets by 2017, with a total value of £155b.

An increasingly complex operating environment for pension funds and insurance companies, created by regulatory changes, is driving some of the shift into multi-asset funds. As investors face a rapidly expanding choice of investment types, we expect increasing numbers to outsource their investment management decisions to multi-asset funds and fiduciary managers.

This is a relatively new sector with mixed investment performance and a shorter track record than is usual for other asset classes. Investors are likely to move quickly out of underperforming funds. As the risk environment moderates, funds with absolute return performance targets may see some outflows, with value and growth funds benefiting.

Wherever the road ahead may lead, asset managers still face a number of potential obstacles. A widespread expectation in the industry for flatter markets during 2014 is a reminder that many underlying weaknesses have yet to be addressed.

Buoyed by improving economic news, the solid performance of UK equities has made this a good year for UK asset managers so far. Firms enjoyed strong inflows during the first half of the year, although this tailed off during the third quarter. European equities, which have often lagged behind UK markets in recent years, are expected to continue benefitting from increasing risk appetite.The sector’s growing confidence also reflects its undoubted potential for long-term growth. Our forecasts suggest that asset management’s contribution to UK’s GDP could grow from the Government’s estimate of £12b in 2011 to as much as £20b by 2017. This prediction is purely based on economic and market fundamentals, and takes no account of the Government’s new focus on asset management. If the improvements in tax, regulation and marketing outlined in the Treasury’s Investment Management Strategy can be implemented, this forecast could prove to be conservative.Wherever the road ahead may lead, asset managers still face a number of potential obstacles. A widespread expectation in the industry for flatter markets during 2014 is a reminder that many underlying weaknesses have yet to be addressed. Loose monetary policy and other interim measures cannot alter the fact that the UK economy has barely reduced its dependence on leverage and property, or that financial structures in the Eurozone remain fundamentally unchanged.So, it is no surprise that financial markets continue to be disrupted by sudden reversals of sentiment. In fact “risk-on/risk-off” is arguably the new normal for asset managers. Although institutional investors are becoming more sanguine about market swings, turnover among retail investors remains very high. Asset managers need to do more to help investors separate long-term potential from short-term volatility. After all, the challenges posed by domestic US politics, European restructuring and the withdrawal of QE mean that unpredictability will remain a feature of financial markets for the foreseeable future.



More resilient financial markets embrace risk assets

Investments in safe haven funds will decline

AUMs in bond and money market funds will contract this year as investors adjust to "risk-on/risk-off" becoming the new norm and gradually shift away from safe havens. The shift is unlikely to be smooth, however, as swings between "risk-on" and "risk-off" will generate short-term flows in and out of bond and money market funds. Our forecast sees AUMs in bond funds shrinking by 3.5% in 2013 and in money market funds by about 5%. Money market AUMs are forecast to continue falling until they level off in 2016. We expect interest rates to start rising later than financial markets currently forecast; so bond funds may briefly see some benefit as the longer end of the yield curve adjusts downward in line with our expectations. Nevertheless, AUMs in bonds will expand just 1.2% a year on average during 2014–17. This is a reversal of the attractiveness of safer assets in the aftermath of the financial crisis when AUM growth of bond funds averaged almost 18% a year between 2009 and 2012.

However, some money market funds will fare better, particularly enhanced funds that offer higher yields associated with more credit risk. We expect enhanced funds to increase their share of the total money market fund sector.

Alternative investment opportunities will be developed in the search for higher returns

Not only will enhanced funds become more popular, other alternative investment opportunities will expand as investors search for higher returns. Commercial property funds are likely to benefit, especially from the introduction of HTB.

Asset management highlights

But, investments in corporate debt funds and collateralized loan obligations are also on the agenda. These trends are already being seen, especially among the larger fund management firms, and interest in private equity investments is reviving. As continuing retrenchment prevents banks from competing in these markets, investment management firms will take on the management of some of these risk assets. This should help compensate for pressure to cut fees on standard products, such as tracker funds.

Investors have traditionally focused on fund performance rather than costs, but over time regulations are likely to require a greater level of fee transparency. We expect to see a cultural shift in approach toward the US model of adjusting returns to take account of costs. The fund management industry is an important contributor to the UK economy, accounting for roughly 1% of GDP, so the impact of regulatory changes could be substantial. If AUMs increase in line with our forecast, the industry’s annual contribution will be about £20b in 2017 compared with £12b in 2011 (based on estimates made by the Government). Fund management would provide an additional quarter percent of GDP by 2017. Changes to regulation or taxation would affect this forecast, as would any shift in the macroeconomic environment. Increasing AUMs by an additional 5% in 2017, for example, could increase the industry’s GDP contribution by about £1b.

Bonds

AUMs in bonds will expand just 1.2% a year on average during 2014–17 compared with almost 18% a year over 2009–12.

1.2%

Annual contribution

If AUMs increase in line with our forecast, the industry's annual contribution will be about £20b in 2017.

20b

Equities

Equity AUM’s are forecast to rise by 17% this year and more than 7% in 2014.

17%


Appendix

Introduction

Banking

Chart 1: Business/Corporate loansSource: Bank of England/ITEM

Chart 3: DepositsSource: Bank of England/ITEM

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Source: Bank of England/ITEM

Forecast

Chart 2: Residential mortgage loansSource: Bank of England/ITEM

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2010

2011

2012

2013

2014

2015

2016

2017


4300

4400

4500

4600

4700

4800

4900

5000£b

Forecast

2012 2013 2014 2015 2016 2017

GDP 0.1 1.4 2.4 2.6 2.5 2.5

Consumer prices 2.8 2.7 2.1 2.2 2.4 2.5

Average earnings 1.2 1.7 2.6 3.4 4.0 4.1

Unemployment rate (%) 7.9 7.7 7.3 6.8 6.4 6.0

Government net borrowing (% of GDP) 6.0 5.5 5.6 4.6 3.1 1.9

3-month interbank rate rate (%) 0.8 0.5 0.5 0.6 1.3 2.3

Effective exchange rate 82.9 81.1 80.8 79.8 79.0 78.2

Source: ITEM Club

Table 1: Forecasts for the UK economy (Annual percentage changes unless specified)


Appendix Banking

Table 3: Forecast for the UK economy

Table 2: Banking

2012 2013 2014 2015 2016 2017

Total assets (£b) 6,986 6,664 6,859 7,103 7,398 7,742

Total loans (£b) 5,314 5,130 5,194 5,324 5,572 5,875

Consumer credit (£b) 157 159 164 169 176 185

Write-offs (% loans) 2.8 2.2 2.1 2.1 2.3 2.3

Business/Corporate loans (£b) 427 409 424 444 470 503

Write-offs (% loans) 1.5 1.4 1.1 0.8 1.0 1.0

Residential mortgage loans (£b) 1,076 1,084 1,116 1,155 1,205 1,258

Write-offs (% loans) 0.05 0.05 0.04 0.03 0.04 0.04

Deposits (% year) -5.9 -4.2 0.0 2.6 4.5 5.0

Loans/Deposits (%) 117 118 119 119 119 120

Total income (£b) 124 123 125 129 133 139


2012 2013 2014 2015 2016 2017

Macro variables

Nominal GDP growth (%) 1.8 3.6 4.4 4.6 4.9 5.2

Nominal consumption growth (%) 3.8 4.5 4.2 4.3 4.6 4.7

Nominal personal disposable income growth (%) 4.2 3.0 3.9 4.6 4.3 4.3

Nominal private business investment growth (%) 3.4 -5.9 6.8 10.4 9.1 9.1

Financial variables

3 month interbank rate (%) 0.8 0.5 0.5 0.6 1.3 2.3

10-year gilt yield (%) 1.9 2.4 3.0 3.6 4.2 4.4

Source: ITEM Club


Appendix Insurance

Insurance

Table 4: Insurance

Chart 4: Life Insurance premiumsSource: ITEM

Chart 6: Population aged 65Source: ITEM

9.5

10.0

10.5

11.0

11.5

12.0

12.5

1980

1985

1990

1995

2000

2005

2010

2015

Population aged 65 years+Million

Source : ITEM

Forecast

2012 2013 2014 2015 2016 2017

Life gross premium (£b) 149.6 151.5 155.1 160.9 168.0 175.9

% year -0.2 1.2 2.4 3.8 4.4 4.7

Life gross claims payments (£b) 143.1 137.4 133.6 131.2 130.2 134.4

Life claims ratio (%) 92 88 85 81 77 74

Non-life gross premium (£b) 59.6 61.5 63.5 65.7 68.3 71.5

% year 2.5 3.1 3.4 3.3 4.0 4.6

Non-life gross claims payments (£b) 36.8 35.5 34.2 32.8 31.4 30.1

Non-life claims ratio (%) 62 58 54 50 46 42

Net profit (£b) 5.0 5.1 6.4 7.5 8.2 8.8

Source: ITEM Club

0

50

100

150

200

250

1993

1996

1999

2002

2005

2008

2011

2014

2017

Life Insurance premiums

£b

Source: ITEM

Forecast

Chart 5: Property transactionsSource: ITEM

0.5

1.0

1.5

2.0

2.5

1980

1985

1990

1995

2000

2005

2010

2015

Property transactionsMillion

Source: ITEM

Forecast


Appendix Insurance


2012 2013 2014 2015 2016 2017

Macro variablesNominal GDP growth (%) 1.8 3.6 4.4 4.6 4.9 5.2

Real GDP growth (%) 0.1 1.4 2.4 2.6 2.5 2.5

CPI (% yoy) 2.8 2.7 2.1 2.2 2.4 2.5

Labour marketTotal employment (thousands) 29,519 29,849 30,219 30,547 30,883 31,258

Employment in manufacturing (thousands) 2,611 2,632 2,619 2,594 2,572 2,539

Employment in non-manufacturing (thousands) 24,212 24,769 25,119 25,506 25,893 26,269

Unemployment (thousands) 2,548 2,492 2,370 2,234 2,117 1,988

DemographicsPopulation (thousands) 63,937 64,391 64,820 65,231 65,637 66,037

Population of working age (thousands) 39,582 39,860 40,119 40,376 40,663 40,968

Population, 65 years+ (thousands) 12,320 12,383 12,425 12,440 12,404 12,340

ConsumersNominal personal disposable income (% yoy) 4.2 3.0 3.9 4.6 4.3 4.3

Gross household financial wealth (£b) 4,435 4,776 4,870 4,978 5,069 5,165

Personal loans outstanding (£b) 102 103 111 118 125 132

Credit card lending outstanding (£b) 55 58 59 60 61 62

Personal insolvencies (thousands) 131 120 113 97 81 74

MotoringCar registrations (thousands) 2,045 2,198 2,238 2,257 2,297 2,343

Housing marketHouse prices (% yoy) -0.9 3.5 6.6 6.7 5.6 5.5

Number of households (thousands) 26,244 26,447 26,640 26,826 27,010 27,192

Property transactions (thousands) 932 1043 1126 1169 1233 1312

Mortgage marketGross mortgage lending (£b) 143 172 201 228 274 300

Net mortgage advances (£b) 8 11 28 42 62 61

Number of mortgages approved 613,525 708,387 774,698 816,417 869,669 920,565

Total number of mortgages (thousands) 11,284 11,177 11,159 11,227 11,324 11,434

Corporate sectorNew companies (% active companies) 0.05 0.05 0.03 0.04 0.04 0.05

Insolvences (% active companies) 0.0018 0.0016 0.0017 0.0017 0.0018 0.0018

Total number of companies 2,531,773 2,629,372 2,621,623 2,644,390 2,732,066 2,865,385

Company profits (£b) 268 282 302 320 336 354

Financial variables3-month interbank rate (%) 0.8 0.5 0.5 0.6 1.3 2.3

10-year government bond yields (%) 1.9 2.4 3.0 3.6 4.2 4.4

FTSE All-Share (% yoy) 2.7 14.9 9.6 10.1 7.8 6.0

Source: ITEM Club


Appendix Asset management

Asset management

Chart 7: Total assets under managementSource: ITEM/Lipper FMI

Chart 9: Share of enhanced money market funds Source: Oxford Economics/Haver Analytics

Chart 8: Assets under management Source: ITEM/Lipper FMI

0

200

400

600

800

1000

1200

2001

2003

2005

2007

2009

2011

2013

2015

2017

Total assets under management

£b

Source: ITEM/Lipper FMI

Forecast

02468

10121416

2002

2004

2006

2008

2010

2012

Share of enhanced money market funds

% of money market

Source: Oxford Economics/Haver Analytics

0

20

40

60

80

100

120

140

160

2001

2003

2005

2007

2009

2011

2013

2015

2017

Assets under management

£b

Source: ITEM/Lipper FMI

Forecast

Multi-assetBonds


Appendix Asset management


Table 6: Asset management sector

2012 2013 2014 2015 2016 2017

Total Assets under management (£b)* 696 780 840 900 950 1,001

% year 14.2 12.0 7.7 7.2 5.5 5.3

Bonds (£b) 132 128 130 133 134 134

Equity (£b) 356 416 447 482 514 546

Fund of Funds (£b) 72 80 89 99 109 120

Hedge (£b) 1.6 1.2 1.3 1.4 1.5 1.6

Mixed (£b) 93 113 131 144 150 155

Money Market (£b) 28 27 26 25 26 26

Property (£b) 14 15 15 16 17 18

*UCITs and non-UCITS assetsSource: ITEM; Lipper FMI

2012 2013 2014 2015 2016 2017

Macro variables

Nominal GDP growth (%) 1.8 3.6 4.4 4.6 4.9 5.2

Real GDP growth (%) 0.1 1.4 2.4 2.6 2.5 2.5

CPI (%) 2.8 2.7 2.1 2.2 2.4 2.5

Financial variables 0.0 0.0 0.0 0.0 0.0 0.0

3-month interbank rate (%) 0.8 0.5 0.5 0.6 1.3 2.3

10-year government bond yield (%) 1.9 2.4 3.0 3.6 4.2 4.4

FTSE All-Share (% yoy) 2.7 14.9 9.6 10.1 7.8 6.0

Households

Wealth (£b) 4,435 4,776 4,870 4,978 5,069 5,165

Savings flow (£b) 75 65 66 73 73 73

Source: ITEM Club


More information

EY ITEM Club publications

EY ITEM Club Economic Forecast is a macro-economic report that uses the HM Treasury model to provide an outlook for the UK economy and key business implications.

Scotland Forecast is a bi-annual extension of the UK forecast and the Ireland Forecast, the bi-annual Economic Eye, is the only forecast that covers both north and south Ireland together.

ey.com/uk/economics

EY Eurozone Forecast

The quarterly forecast provides an overview of developments across the Eurozone and the 17 individual member states. It uses the ECB model and governmental statistics to offer insight into the issues that affect the region’s governments and businesses.

Outlook for financial services. A comprehensive quarterly forecast for the regions banks, asset managers, and insurers based on the ECB model and governmental statistics.

ey.com/eurozone

EY Rapid-Growth Markets Forecast

The quarterly forecast analyzes 25 rapid-growth markets, which have a global influence in the world economy.

ey.com/emergingmarkets

Global Capital Confidence Barometer

The Barometer is a regular survey of senior executives from large companies around the world, conducted by the Economist Intelligence Unit. Our findings gauge corporate confidence in the economic outlook, and identifies boardroom trends and practices in the way companies mange their capital agenda.

www.ey.com/ccb

@EY_ITEMClub ey.com/uk/economics

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