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Passing the stress test

market snapshot

14 July 2023 |
Results from the Bank of England’s (BoE) annual stress test indicate the UK’s largest banks should be resilient in the event of a severe stress scenario.

Fast reading:

  • The stress test assesses the resilience of the UK’s largest banks. The results suggest that major lenders should continue to have the capacity to support UK households and businesses, despite rising rates.
  • In the US, meanwhile, the rate of inflation slowed to its lowest level in two years, with June’s reading of 3% fuelling expectations the US Federal Reserve may be nearing the end of its aggressive rate hiking campaign.

The annual stress test, carried out by the Bank of England, was introduced in the wake of the 2008-2009 global financial crisis to identify potential vulnerabilities in the UK banking system, and accompanies a financial stability report.

“In aggregate the stress test has shown a lower CET1 drawdown than in previous tests undertaken in 2019 at -350bp vs -520bp in 2019,” says Filippo Maria Alloatti, Head of Financials (Credit) at Federated Hermes Limited, adding that there has been a structural shift in funding sources within commercial real estate (CRE), with the share of outstanding debt sinking from 60% to 30% since 2008. “This is partly driven by stricter capital requirements in relation to such loans, with losses on UK and non-UK CRE exposures at less than 7% of their total impairments in 2022/23,” he says.

“While supportive of the capital return plans of the listed UK, the dwindling wealth buffer by households (resulting from mortgage shocks) tilts the risk to the Bank of England overtightening, which could have second round effects on the lender’s asset quality.”

Elsewhere this week, the latest UK Gross Domestic Product (GDP) data showed a smaller contraction than expected in May, shrinking by just 0.1%1 despite ongoing strikes and an additional bank holiday for the coronation of King Charles. This follows 0.2% growth in April.

Figure 1: UK GDP fell by 0.1% between April and May

US inflation

A sharper-than-anticipated drop in US inflation triggered a dollar sell-off and pushed European stocks higher on Thursday, with investors responding to June’s encouraging 3% CPI reading. The pound rallied to reach a 15-month high, up 0.5% against the US dollar for the first time since April last year.2

The Euro STOXX 600 Index, representing large-, mid- and small-cap companies across the European region, added 0.3% in early trading3 , and logged its largest percentage gain (1.5%) since early June in the session prior.

The latest data indicates the slowest rate of inflation in more than two years, suggesting the Fed is succeeding in its bid to tame inflation and fuelling hopes that the US central bank might be close to ending its aggressive rate hiking campaign. The picture across the Atlantic, however, remains bleak, with UK inflation remaining high at 8.7%, despite efforts by the Bank of England (BoE) to bring inflation under control.

The data also brings the current rate of inflation in the US within touching distance of the Fed’s 2% inflation target. However, despite a move in the right direction, the US central bank cannot rest on its laurels yet, says Geir Lode, Head of Global Equities at Federated Hermes Limited.

While these figures are a positive step forward, there is still more work to be done.

« Wednesday’s CPI figures suggest we are beginning to see the light at the end of what has felt like an endless tunnel for the US. The Fed is looking for a softening labour market and low inflation before it begins to cut interest rates. So, while these figures are a positive step forward, there is still more work to be done”, he says.

The latest jobs report reflects further positivity in the region, with a lower-than-expected US jobs report spelling good news for the Fed’s price stability goal, but the unemployment rate remains at a historical low.

“Fed officials have often touted the need for two rate hikes this year, and yet a buoyant growth rally suggests that the market is seeing a faster exit out of this elevated rate environment. Wednesday’s softer figures plays into the market’s view, but it is difficult to see the Fed changing tactic in the short term, so we expect a 0.25% increase in July”, Lode says.

“The Fed will want to make sure they stave off further inflation rises in the near future, and, as such, we do not anticipate easing before the middle of next year,” he says.

Figure 2: US annual inflation falls to lowest level in two years

For more insights on the Fed, please watch our latest video insight: A tale of two indices | Federated Hermes Limited (hermes-investment.com)

1 Office for National Statistics, as at July 13 2023.

2 The Financial Times, as at 13 July 2023.

3 Bloomberg, as at 13 July 2023.

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