Global economic and geopolitical overview
Riding on economic tailwinds
Despite the seismic changes in the geopolitical environment in 2016, the global economic outlook turned out to be rosier than expected since mid‑2016. The growth of nominal GDP – growth plus inflation – is now higher across major developed economies. We are seeing signs of reflation, with stronger economic growth and rising inflation across a host of countries. Labour market conditions are also strengthening, as employment has risen significantly in recent years across the major economies. Prospects across emerging economies, led by China, have improved too.
There are, however, three issues that raise questions over the sustainability of this favourable outlook. First, productivity and wage growth in key developed economies are still relatively subdued, reinforcing concerns over future living standards and the distribution of economic growth. Second, debt levels in key developed markets remain high, despite an improving fiscal position facilitated by low rates and yields. Third, even though the US and the UK are growing solidly, there may yet be a potential slowdown in both in the near‑term. Compared with Eurozone economies, the US and the UK are at a much latter stage of their economic cycles, indicating limited upside potential in the near term, even though their long‑term outlook remains favourable.
‘Banking’ on monetary policy
A big economic and financial challenge relates to monetary policy. Since the 2008 financial crisis, monetary policy has been the shock absorber across western economies. Interest rates were cut and many other measures were adopted, including the printing of money through quantitative easing (QE) here in the UK. This helped limit the economic downside and boosted the upside for asset markets, including housing and equity.
But we are seeing the beginning of the end of expansionary monetary policies. In the US, the Fed is embarking on a gradual and well‑announced round of tightening. Here in the UK, despite the Bank of England keeping policy on hold at the latest Monetary Policy Committee (MPC) meeting, the question is whether the lone hawk at that meeting may soon be joined by more MPC members. The concern is whether the long cycle of low rates and accommodative monetary policies have put Western economies and financial markets in a false comfort position. To prepare for tighter monetary policy ahead, banks need to reconsider whether they have been pricing in risks sufficiently in a low‑rate environment, and indeed whether what they consider as ‘risk-free’ assets, such as government bonds and housing, are indeed ‘safe’ from higher interest rates. More profoundly, there is a need for a much broader debate as to the drivers of monetary policy and whether it can play an even more effective role.
Sting in the long tail of geopolitical risks
There are geopolitical risks that need to be factored in, as they define the contour of opportunities and risks facing economies, markets and businesses. Globally, the key relationship will be that between the US and China under President Trump, and the key region to watch for will be the Indo-Pacific. Both face ongoing tensions and wild cards in the long tail of geopolitical risks: notably an increasingly bellicose North Korea, the danger of deteriorating trade relations between the US and China, and possible tensions in the South and East China seas. Increasingly, the portfolio of geopolitical risks are expanding and moving to behind the ‘Silicon Curtain’. Systematically significant banks are particularly vulnerable. Indeed, expectations are that the Bank of England’s will include failure of IT infrastructure caused by cyber attack in its 2017 biennial stress test scenarios.
Here in the City of London, one key question for business leaders is how well positioned is the banking sector for future growth and how resilient will it be in the face of any setbacks? The stress tests by the Bank of England and by the European Central Bank in recent years point to a more resilient sector. And the City is trying to retain its global appeal and actively exploring growth frontiers such as the trading of the Chinese currency, the growth of ‘green bonds’ and Islamic finance. But as the Prime Minister pointed out in her Lancaster House speech in January, ‘a vote to leave the EU would be a vote to leave the Single Market’. Brexit negotiations matter for the City’s appeal as a place to do business in, and a place to do business from. We remain positive about the City’s future, but what are some of the challenges ahead?
Spotlight: can the City withstand aftershock tremors?
The City’s Brexit-proof appeal
We expect the City to remain the financial capital of Europe and remain confident about its ability to adapt, innovate and succeed. That being said, the big issue now for the City is the impact of the Brexit negotiations. There are many important aspects to this, including how sentiment on the Continent over losing control of its financial capital could play into the negotiation dynamics. Indeed, as Andreas Dombret of the Bundesbank recently pointed out, ‘economic rationality would not necessarily guide policy-making during a politically fraught period’.
The economic case for the City to maintain unfettered access to the EU’s banking and capital markets is strong. Many factors that contribute to London’s appeal are Brexit-proof: language, lifestyle, time zone, and importantly, a mature ecosystem of professional services encompassing legal, accounting and consulting. In the UK, of every £100 of economic value created by the financial services sector as a whole, £29 of that comes from legal, accounting, consultancy, information, IT and business support services. This deep linkage between financial services and the wider professional infrastructure is a key reason behind London’s crown position on the Global Financial Centres Index (GFCI) ranking of financial centres. Frankfurt, by contrast, is in 19th place in 2016.
Ties between financial markets in the EU and the UK are deep. Over a third of the UK’s surplus in financial services comes from trade with the EU, and UK banks have made £1.1trn of loans to European companies.
The regulatory infrastructure is also in place to support equivalence. The UK is well under way in transposing key EU directives and regulations into UK law, notably in areas governing market infrastructure, implementing the Basel III agreement, the sale of capital market products, and access to European payments markets.
There will be vulnerabilities. Leaving the EU has raised concerns as to whether London will be able to retain Euro clearing and whether this will play to the hands of international financial centres such as New York (rather than the Continent). Financial centres compete globally – it is imperative for London to remain attractive to international capital and skilled labour globally. And this requires certainty in the broader policy context.
Currently, one in eight people in the City are EU workers from outside the UK. The UK will develop its own migration policy, with a focus on low migration and attracting the workers that the UK needs. Given the time period over which many firms take decisions, the sooner uncertainty is reduced the better, particularly over issues such as migration and market access.
Brexit served with a twist
While there are reasons to be positive about the City’s future, there are broader geopolitical risks that need to be kept in perspective. A major exogenous shock here arises from impending elections in France and Germany. Marine LePen, the National Front candidate, who has vowed to hold a referendum on France’s EU membership and take France out of the Euro, is now the front-runner in the first round of the presidential election. Polls suggest that Mme LePen’s chance in the second round run-off vote is slimmer, where Emmanuel Macron is the current favourite. But even so, the forces of nationalism behind the popularity of Mme LePen could alter the dynamics of Brexit negotiations.
Mme LePen may be a ‘known-unknown’; the election in Germany may prove a bigger wildcard for Brexit negotiations and the future of the City. Mr Martin Schulz, Chancellor Merkel’s main rival, has been a keen federalist and a harsh critic of Brexit and Eurosceptic overall. Even though his Social Democratic party is currently polling behind Merkel’s conservatives, Schulz’s chance cannot be dismissed, nor would his influence on Germany in following a hardline approach during Brexit talks.
Taken together, these may spell a heightened risk of a ‘no-deal’ scenario. The European Commission has indicated its desire to have an ‘upper hand’ in defining and policing equivalence and proposed the right to revoke equivalence at any point. This signals the Commission’s willingness to trigger a ‘lose-lose’ scenario as a credible threat to maintaining European integration.
Between a rock and a hard place
The City’s real competition comes from New York. In this sense, President Trump’s ‘America First’ agenda across the Atlantic could also have profound implications at home. On February 3rd we saw the unveiling of President Trump’s Executive Order on reviewing financial regulation in the US. In what could signal a major change in the post-crisis regulatory landscape, the President declared that ‘we expect to be cutting a lot out of Dodd-Frank’ and set out his administration’s new ‘core principles’ for regulating the financial system.
The Financial Times suggested that 11 out of 16 titles in Dodd‑Frank Act are at risk of rollback. And in February, Parker Fitzgerald identified the reclassification of systemically important financial institutions (SIFIs) that are subject to more stringent regulations, the watering down of the Federal Reserve’s stress tests, and the removal of the Volcker rule as some of the likely changes.
The deregulation agenda in the US is likely to open regulatory arbitrage opportunities and boost New York’s appeal to international capital. The City has an incentive to follow suit, and potentially the leeway to do so. But any regulatory fragmentation between the US and Europe will pose the City a particular dilemma, between maintaining equivalence with the EU and retaining competitiveness with New York.
Withstanding aftershock tremors
Ultimately, regulatory fragmentation globally – and less prudent financial regulation in the US – could undermine financial stability, to the detriment of financial services everywhere, but the City in particular. Since the 2008 crisis, the financial sector’s approach to regain its footing has been a global concerted effort, guided by the Basel Committee and Financial Stability Board (FSB) and interpreted by national agencies in a consistent (and often gold‑plated) manner. Any deregulation that peels the US away from international consensus could heighten risks to financial stability.
The potential change at the helm of the US Federal Reserve next year could also add new dynamic and debate regarding monetary policy.
Indeed, in a recent letter to G20 leadership, The Systemic Risk Council warned that the combination of stalling of Basel banking reforms, repealing parts of the Dodd‑Frank Act, and divergence between EU and UK financial policy for the first time since the collapse of the post‑WWII Bretton Woods risks trigger a financial crisis more severe than that experienced 2008–10. That is a very dire warning, but at the very least there will be a divergence in some important policy areas between the major economies.
The reality may well be less melodramatic. The financial market has been resilient in 2016, as seismic changes in the geopolitical environment prevailed. But the full ramifications of these have yet to fully unravel and can be exacerbated if the market is not pricing in risks properly in a low‑rate environment and ‘risk-free’ assets become vulnerable to macroeconomic and geopolitical shocks. We will examine these and the banking sector’s weak spots in our next Point of View.
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