July 25, 2012

U.K. Recession Deepens

Q2 figures far worse than expected; bank earnings expected to disappoint

The Office for National Statistics blamed Queen Elizabeth II's diamond jubilee for some of the GDP fall. (Photo: AP) The Office for National Statistics blamed Queen Elizabeth II's diamond jubilee for some of the GDP fall. (Photo: AP)

As the world counts down to the opening of the Olympic Games in London on Friday, Londoners—and others in Britain—are dealing with an economy that in Q2 of this year slowed considerably more than expected. Also, with British banks being pressured to estimate the effects of the LIBOR rigging scandal on their balance sheets ahead of earnings reports expected later this week for the first half of the year, the numbers are expected to be “underwhelming.”

Bloomberg reported Wednesday that the Office for National Statistics in London announced Q2 numbers indicating a deepening recession. GDP fell for the third straight quarter, but it was the amount that surprised: a 0.7% plunge after Q1’s numbers dropped 0.3%. Economists surveyed earlier had expected a median fall of 0.2%.

The U.K. economy was also down 0.8% from a year ago; when economists had predicted a 0.3% year-on-year drop. It had not fallen so much since Q3 of 2009. While unemployment was a slight bright spot, down to 8.1% in the three months through April from 8.2%, thanks in part to the coming Olympics, the rest of the numbers were not so bright.

Reuters reported that the service sector, making up more than 75% of Britain’s GDP, fell by 0.1%, after rising 0.2% in Q1. Industrial output fell by 1.3%. Construction followed suit, plunging by 5.2%—the most since Q1 of 2009.

The statistics office said some fall in GDP was expected because of the extra holiday for the queen’s diamond jubilee. The wettest second quarter on record was also cited, with both events creating “additional uncertainty.” The office also said the GDP report included estimates for June based on the effects of previous jubilee holidays in 1977 and 1992.

"This is terrible data. Frankly there's nothing good that comes out of these numbers at all," said Peter Dixon in the report. Dixon, an economist at Commerzbank, added, "The economy looks to be badly holed below the water line at this stage. It's a far worse period of activity than we'd expected."

The report puts additional pressure on both Prime Minister David Cameron and Chancellor of the Exchequer George Osborne to rethink their commitment to austerity measures in an effort to eliminate the country’s structural budget deficit over the next five years, as the Labour Party turns on the heat over such measures trying to do too much too soon.

However, both continue to resist a change in strategy. Osborne and Bank of England (BoE) Governor Mervyn King worry that a change could trigger a loss of confidence in Britain's commitment to long-term deficit reduction.

In a statement, Osborne said, "We're dealing with our debts at home and the debt crisis abroad. We've made progress over the last two years in cutting the deficit by 25% and businesses have created over 800,000 new jobs."

He added, "But given what's happening in the world we need a relentless focus on the economy, and recent announcements on infrastructure and lending show that's exactly what we're doing."

King may find himself boosting BoE efforts to promote growth nonetheless. Ross Walker, an economist at Royal Bank of Scotland Group, said in the report, “This isn’t easy for policy makers to interpret, but it increases the likelihood of further easing.”

The banking sector in Britain has its own woes. Investors are calling for the U.K.’s largest banks to provide estimates of how much the scandal over the rigging of the London interbank offered rate (LIBOR) could cost them as they report first-half earnings later in the week.

Although the big U.K. banks are expected to have done better than the top five U.S. banks, which this year posted the lowest first-half revenue since 2008, the shadow of four major banking scandals in the past 14 months will no doubt extract a price.

With the four largest-by-assets banks having already reserved 6.9 billion pounds ($10.69 billion) to compensate customers over improperly sold insurance, they still face probes over misselling interest rate swaps to small businesses. In addition, HSBC could face fines for failing to enforce money-laundering regulations that the U.S. Senate has said gave drug rings and terrorists entree to the U.S. financial system.

Morgan Stanley analyst Betsy Graseck estimated such tolls in an investor note on July 12. She put possible numbers at another 626 million pounds from civil lawsuits for Barclays, which has already been fined a record 290 million pounds over the LIBOR debacle. In addition, she estimated fines and legal costs of as much as 2.2 billion pounds for Royal Bank of Scotland Group, Lloyds Banking Group and HSBC Holdings.

The banks themselves have remained quiet on the subject and are likely to continue to keep mum, four unidentified individuals who have knowledge of the banks’ reasoning told Bloomberg. RBS, Lloyds, HSBC and Barclays could cite international financial reporting standards used by U.K. firms, which only require banks to set aside funds for such expenses if the amount can be “estimated reliably.”

However, Prem Sikka, an accounting professor at the University of Essex, England, said in the report, “They’ll say it’s a contingency, the amounts are unknown, therefore we can’t deal with anything with certainty. I would say they should provision. They know it’s coming.”

Richard Hunter, head of equities at Hargreaves Lansdown, a British stockbroker with 26 billion pounds of assets under management, expressed the views of many when he said, “We hope for some form of guidance on what the banks are looking to provide for on LIBOR. Where the U.S. is concerned, you have the potential for litigation which can take considerable time to get to the other side of.”

Ian Gordon, an analyst at Investec in London, summed it up in the report, saying, “With limited scope for negative surprise on impairments and with a predictable weak outlook for revenues, expect a broadly underwhelming picture.”

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