Find out what Brexit could mean for the markets and how a hard or a soft exit from the EU could affect traders.
As the Brexit deadline draws nearer we have a look at how the impact to the UK economy could affect UK banks like Royal Bank of Scotland, Lloyds Banking Group and Barclays.
The governor of the Bank of England (BoE), Mark Carney, had a stark warning for the prime minister and her cabinet in September: if there is a ‘no deal’ Brexit, whereby the UK falls back onto World Trade Organisation (WTO) rules having failed to strike a trade deal with the EU, then the fallout 'could be as catastrophic as the financial crisis.'
The banks, still wounded from the last crash ten years ago, are tasked with supporting businesses and consumers whatever the outcome. Brexit has presented both challenge and opportunity to UK business and the banks will be the ones to absorb any hits to the economy or reap any rewards from any potential prosperity spawning from the nation’s departure from the bloc. Every industry faces its own unique challenges in preparing for Brexit, resulting in highly uncertain times for the country to make it even harder for banks to do their job.
The economic drivers that banks must respond to are all going to be impacted one way or another however the UK shapes up post-Brexit. Prospects for everything from jobs to investment and lending to property prices lies in the hands of negotiators on each side of the Channel. In the UK, both the BoE and the Treasury have acted to help accommodate immediate changes following the vote such as the drop in the pound, which has experienced more volatile fluctuations during the past two years of negotiations.
We have a look at how Brexit could potentially change the UK economy and what impact it could have on the country’s banks that currently lie at the heart of the European financial system.
There is clear evidence the UK economy has been weakened since the referendum was held in mid-2016 and a firm consensus that growth will be slower outside than EU than within it. The UK was the fastest-growing economy in the G7 in 2015 and toward the upper end of the league table when Brits went to the polls to vote, but the UK’s gross domestic product (GDP) growth has been the lowest among the group since the middle of 2017. Considering the UK has gone from top of the table to below countries like Italy, where the next euro-crisis could take place, there is clear evidence that the UK economy has not grown as fast following the ‘Leave’ vote compared to what the status-quo would have delivered under ‘Remain’.
The state of the UK economy is obviously hugely important to banks as it is one of, if not the biggest driver of their business. For example, the financial crash that began to unravel in 2008 resulted in the country losing over 6% of GDP to mark the deepest recession for 80 years, causing wages to fall, jobs to be lost and access to credit tightened. The crash brought banks to their knees, with both Royal Bank of Scotland and Lloyds Banking Group having to be bailed out by taxpayers and virtually all banks needing help from a government-led package of rescue measures.
Read more: Is it time to look at UK banks?
Therefore, Brexit is seen as a severe threat to UK banks. GDP is the primary metric used to measure the health of an economy and, generally, there is a strong correlation to the performance of the economy and that of its banks. If the UK’s exit fails to boost wages, starts to push up unemployment from current record levels, or results in conditions that make it harder for people and businesses to utilise and service debt then the banks could, as Carney believes, be in for another rough ride before recovering from the last one.
There is clear consensus that the UK economy will grow at a slower rate over the immediate future outside of the EU. The Centre for European Reform has predicted the UK economy was 2.5% smaller at the end of June than it would have been if the referendum result went the other way, while the London School of Economics believes the UK is 2% smaller with expectations for that to rise to 3.4% by the end of 2019.
But it is important to highlight that this doesn’t necessarily mean a recession is on the cards like Carney and some others have warned. In fact, many of the bleaker forecasts surrounding Brexit have been proven wrong: The Treasury’s prediction before the referendum that the vote to Leave would plunge the UK into an immediate recession was untrue and claims that an emergency budget would have to be introduced by the last Chancellor of the Exchequer George Osborne have been unfounded.
However, the UK has not yet formally left the EU and the current transition deal on the table means it will largely be business as usual for the next couple of years, during which banks and other industries will be hoping to gain further insight over future relations to plan more effectively. With little known about trade conditions after the transition deal ends there are still real fears that the UK economy could plunge into a recession, particularly under a no-deal scenario that would cripple businesses and the cross-border trading that they have enjoyed for over 40 years.
The performance of a currency reflects how confident the rest of the world feels about the future of a country and its economy. Although the UK has defied expectations since the referendum result the pound has plunged against its counterparts and fluctuations have become more volatile as investors respond to the ups and downs of negotiations and the changes sweeping the economy.
Sterling had dropped by over 17% from its pre-referendum levels when it hit new lows against the euro in August 2018 before recovering somewhat to trade nearly 14% lower than before the vote in June 2016.
The drop against the dollar has been dramatic but not as a severe as the euro, with the pound currently trading over 6% lower after falling by as much as 11% by March 2018.
There has been both benefits and drawbacks to a weaker pound. On the upside, British exports have seen demand rise as their goods and services become more affordable to other countries. Total UK exports of goods and services has risen over 20% since the referendum result to an all-time high of £163.5 billion in the third quarter of 2018. The growth seen over the nine quarters leading up to the referendum result was just 3.7%. One of the biggest exports out of the UK is the financial services provided by UK banks.
This boom in exports has been welcomed but many fear that once the UK formally leaves the picture could be very different. For example, the rise in demand for lower-priced British goods and services could wane if trade tariffs are introduced under a no deal scenario. For the banks, not only are their £60 billion worth of financial services exports under threat but any benefits they are seeing from financing a growing export sector could prove to be temporary.
The downside of a weaker pound falls on both consumers and businesses that import from abroad as both have less purchasing power when buying foreign goods or services, which drives inflation to push-up the cost of living or doing business. The introduction of any trade tariffs would only exacerbate this problem. For the banks this would likely mean that their customers would tighten their belts and reign in spending unless wages grow at a faster pace, which in turn means lower revenue for their business customers.
To date there has been a clear divide in confidence and spending between UK businesses and consumers. While business investment has plunged over the last two years household spending has remained resilient.
For businesses, the uncertainty over Brexit has prompted them to delay making major investments and wait for more progress to be made. Still, business investment in the UK has continued to grow since the referendum, up 2%, but it has started to fall this year. That is an evident slowdown considering investment had climbed over 11% between the start of 2013 and the referendum, and the fact the BoE’s pre-referendum forecasts suggested investment would grow 13% over the two-years following the vote. Less investment in the likes of property, plant and equipment means fewer financing opportunities for banks and, again, less custom for its business customers.
UK households, on the other hand, have continued spending since the referendum result, which some argue is unsurprising considering 48% of the nation voted in favour of Leave and are therefore more optimistic about the country’s prospects. The average UK household spent £531.30 per week in the 2014/15 financial year, rising just 0.3% in the following year that ended in March 2016. But, in the last financial year during which the referendum was held household spending jumped 4% year-on-year according to the Office of National Statistics (ONS). This has been partly driven by the UK’s record low unemployment rate and the return of wage growth that, for now, is surpassing inflation.
One of the reasons the UK defied expectations following the vote is because many didn’t take intervention from the likes of the BoE into account. The central bank reacted immediately to the referendum result and the plunge in the pound by cutting interest rates, increasing liquidity by purchasing both government and corporate debt and beefing-up the amount of cheaper financing available to businesses and consumers, helping boost economic growth by 0.5% to 1% over the two years after the vote, according to Carney.
However, after the BoE raised interest rates from the 0.5% ‘emergency’ level that had been introduced way back in 2009 to the current level of 0.75% in August, the governor warned it was time to concentrate on controlling inflation. Interest rates are one of the bank’s key tools in assisting the economy and are often raised to offset rising inflation, but Carney has warned that a weaker pound and the higher cost of living means the bank could lose its optionality and be forced into hiking rates.
Read more: What happened at the last BoE meeting?
This all has a detrimental impact on banks. If interest rates climb higher then debt - credit cards, loans and mortgages – becomes more expensive, making it harder for businesses and people to service their repayments. In turn, higher borrowing rates would lower the demand for new debt and see those who are struggling the most potentially cut-off from accessing new finance that they could no longer afford.
Consumer Price Inflation (CPI) was running at 2.4% in October – above the BoE’s target of 2% - and the central bank has said its current plan is to continue increasing interest rates over the coming years while inflation starts to ease back toward its target level. However, its current forecasts are based on a Brexit with a ‘smooth transition’ – a vague description that makes it highly likely that its policy will have to adapt in the future. Currently, rates are expected to start rising again in the middle of 2019 (after the UK formally leaves the EU) before climbing toward 1.4% by the end of 2021. At the bottom line, monetary policy and the future direction of interest rates over the next 12 months is unpredictable.
The UK unemployment rate is running at just 4.1%, its lowest for almost four decades, and has remained resilient since the vote to leave. However, the primary focus in the UK when it comes down to employment is not creating jobs but on growing wages and improving productivity – both of which Brexit threatens.
The UK job market and Brexit boils down to one topic: immigration. The debate, however, is broader. On one hand there is an argument that more restrictive immigration rules post-Brexit will make it harder for businesses to attract and retain staff due to loss of EU migrants, making them increase wages to entice the talent they need. On the other is fear that the UK will be starved of the talent it needs and that businesses could be crippled and fall into financial distress that falls onto the banks. The ability to continue exporting and finding a balance between keeping the UK open to the talent it needs and stimulating wage growth are both important to the future of the UK job market.
The UK reached a turning point in the three months to February 2018 when average wages finally started to grow at a faster pace than inflation following almost a year of deteriorating living standards. This trend has been maintained since, but average annual earnings are still some £800 lower than before the financial crisis.
Although employment was running strong before the referendum was held some have argued that the improvement in wage growth has been partly down to lower levels of immigration into the UK since the vote, increasing competition for talent. For banks, this all presents a delicate mix of results: higher wages help boost household spending but adds costs to businesses, which in turn feeds inflation that can start to erode that wage growth.
However, with business investment in the UK already stagnating some fear that any loss of access to the single market (which is highly likely) will redirect foreign investment out of the UK into countries with better access to the EU, lowering the amount of jobs being created as well as the quality of those jobs.
In addition, the UK economy has evolved over recent decades to centre on the services sector, which accounts for 80% of British exports. Unlike goods, exporting services relies on the ability of sending workers to carry out services for customers abroad, a much more difficult task if the UK loses access to the single market. While there is an argument a new, more-controlled immigration policy could help the UK gain better control over the likes of wage growth and open-up the doors to non-EU migrants, the harmonisation of UK and EU markets plus basic geography means the flow of people over the Channel will remain integral to the performance of the UK job market post-Brexit.
According to a report by The Times, Carney has warned that UK house prices plummet by 25% to 35% over the first three years under a no deal scenario. When this is coupled with the possibilities like higher rates being slapped on debt and increased costs of living then there is a distinct fear that people will no longer be able to afford their mortgages. This would mean the banks would start to have a growing number of customers defaulting on their repayments and, while these loans are held against the property, the houses the bank could end up accumulating could be worth less than the value of the loans it dished out for them.
If, as Carney has warned, Brexit causes the BoE to lose control of inflation and forces interest rates to rise as a counter measure then one major casualty could be a property sector that has become comfortable with rising valuations over the past ten years. Statistics already show the growth in house prices has slowed this year and even started to decline in some regions.
Regardless of how the UK economy has performed since the vote it is still impossible to know how it will respond once it has formally detached itself from the EU and banks are therefore struggling to prepare for all the possible scenarios on the table.
No deal is the worst possible outcome for UK banks. It would undoubtedly cause further deterioration in the pound and provide an immediate shock to the economy, forcing the BoE to wield interest rates in a way that could cause businesses and households, already facing higher costs from inflation and trade tariffs, to service their debts. This would ultimately fall onto the banks that underpin all this credit and the financial system. While banks have had to strengthen their balance sheet and improve their ability to handle a future crash since 2008, no-one is eager to test them.
Plus, Brexit poses more direct threats to UK banks, which face losing the likes of ‘passporting rights’ that have allowed them to freely sell their services in the EU. Many in the sector have already started to move staff and operations out of the UK and into cities like Dublin, Frankfurt, Paris and Amsterdam to ensure they have an EU-based subsidiary with access to the market post-Brexit.
Read more: How will Brexit impact UK financial services?
Any loss of access to the EU compared to what the UK currently enjoys will be detrimental to UK banks and will feed into higher costs that will in turn make it more difficult for them to compete with their European counterparts. Whether it be through trade tariffs, a lack of access to talent, or having to cope with a weaker domestic market relative to its peers, the UK banking industry is likely to see the cost of business rise higher over the coming years to possibly knock its historic competitive edge over its neighbour.
This information has been prepared by IG, a trading name of IG Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.
CFDs are a leveraged products. CFD trading may not be suitable for everyone and can result in losses that exceed your initial deposit, so please ensure that you fully understand the risks involved.
All trading involves risk and losses can exceed deposits. Trading CFDs may not be suitable for everyone so please ensure that you fully understand the risks involved. All trading involves risk and losses can exceed deposits.