David Wighton is a Financial News columnist
What’s the atmosphere like in town when everyone comes back from the beach? After my small and very unscientific survey, it’s remarkably relaxed – so relaxed that you wonder if some townsfolk have had a little too much sun.
After all, the challenges facing the economy are enormous. Consumer sentiment has fallen even before the true impact of the cost of living crisis and inflation forecasts rising towards 20% are fully realised. In the City, the end of the deal bonanza has raised the threat of job cuts, and there is widespread nervousness about what changes the new prime minister is likely to bring.
Sentiment has been helped by the rise in share prices since June, particularly in the US, which gave hope that the deal drought may soon break and the pressure on asset managers’ profits is beginning to reverse. But equity and bond markets have pulled back again since the US Federal Reserve’s chairman spoke tough on interest rates at the Jackson Hole Symposium on August 26.
Many financial firms have yet to feel much pain. Bank profits have recently been strong, both on the end user side and in the capital markets, where good trading gains largely offset the decline in contract work.
Even for those old enough to have been around, the previous metropolitan downturn of the financial crisis is a distant memory. Since then, Brexit and Covid have come and gone with the reality far less worse than first feared.
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This may have encouraged some complacency. The government is expected to pump in tens of billions of pounds to ease the gas bills facing households and businesses. But it will not be as generous as Rishi Sunak was with leave payments. Not even the Bank of England comes to the rescue this time. Interest rates are on the rise, with no peak yet in sight.
Judging by current share prices, investors seem to expect banks to suffer large loan losses over the next few years. But most top bankers and analysts seem more relaxed and point anyway to the banks’ very strong capital position.
On the corporate and investment banking side, write-offs are likely to be much more modest. A potential hit comes from loans made by banks such as Bank of America, Goldman Sachs and Credit Suisse to finance private equity deals. Banks face billions of dollars in losses if they sold those loans to investors at current rates, taking another blow from the Fed comments. Banks are expected to begin marketing loans from the $15 billion acquisition of US software company Citrix Systems on September 6, according to Bloomberg. But even if the market worsened further, the total loss potential is small in relation to the banks’ balance sheets.
On the income side, if markets stabilize, the strong pipeline of deals should start flowing again, and while higher interest rates will choke loan demand, they improve bank margins and should continue to support rising interest income.
What about the costs? As for US banks, Wells Fargo analyst Mike Mayo reckons that the huge investments in technology made in recent years mean banks are much better positioned than in previous periods of high inflation and that margins should benefit.
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Yet in the UK, Edward Firth at Keefe, Bruyette & Woods believes that banks expect inflation to drive interest rates and margins higher “while assuming that any impact on costs or credit is minimal”. It looks optimistic to say the least.
For established financial firms, one benefit of drying up funding for startups is that some fintech challengers will find themselves short of cash. Even those that are well funded are being told by investors to focus more on making money than gaining market share, which should reduce pressure on established firms.
Still, Firth believes the big banks are too relaxed about the threat posed by digital insurgents who “offer a terrifying combination of lower unit costs and higher levels of customer satisfaction”. The big banks face years of higher investment costs and will probably still give up a large part of their market share, he predicts.
The changes in Downing Street add another layer of uncertainty to the outlook. Liz Truss is set to move into Number 10, meaning the government will be led by someone portraying herself as a champion of the City with an unusual interest in reforming MiFID II trading rules. Her deregulatory zeal will encourage some, as will her promise to shelve the planned rise in corporation tax. However, how much of this survives contact with reality remains to be seen. And one thing is clear – those hoping for a more constructive dialogue with Brussels on market access to the EU are likely to be disappointed.
To contact the author of this story with feedback or news, email David Wighton
