For UBS, the New Normal Is the New Painful

(Bloomberg Opinion) -- After a horrid start to the year, UBS Group AG Chief Executive Officer Sergio Ermotti finally got some relief. Switzerland’s biggest bank posted its best second quarter results under his watch on Tuesday. Unfortunately, the likelihood that the stars will remain aligned is remote.

At $1.4 billion, net income in the three months through June was the highest since 2010, comfortably beating analyst estimates. While revenue dropped from the year-earlier period amid a severe contraction in net interest income, so did expenses. Profitability is improving and all divisions, except the firm’s biggest – wealth management – surprised the market on the upside.

There lies the challenge for the world’s largest manager of money for the rich: It won’t be able to count on exceptional swings, such as a surge in fees from advising companies on mergers, to offset the likely pain from the new normal. Interest rates will be staying lower for longer, squeezing margins.

In an interview with Bloomberg Television, Ermotti described the shift in rate expectations as a “complete u-turn” and “a huge change.” As a result, he declined to be drawn on the full-year outlook, telling analysts to expect UBS to make strategic adjustments to adapt. In short, the firm will need to do more to lower costs and the pace of expansion in Asia may have to slow.

When UBS shrunk its investment bank and pivoted toward wealth management, part of the objective was to diversify earnings so that they would be more resilient. But as Ermotti put it on Tuesday: “When market conditions are normal, our cash generation, our business, our diversification is able to deliver very strong results.” In the real world, the environment isn’t often normal.

Take the wealth business. Clients unexpectedly pulled almost $2 billion in the second quarter. Recurring fees and interest income fell compared with the same period last year. Looking ahead, a 25 basis-point reduction in U.S. interest rates would lead to yet lower lending income in the third quarter.

The outlook for lower rates has already affected behavior among wealthy clients in the U.S., its biggest market. Customers are refinancing their borrowings to lock in lower rates, and when they do, they open up the business to competition.

In Asia, clients have been cutting back on borrowings as they become less confident about the economic outlook. Though sentiment there can turn quickly, Chief Financial Officer Kirt Gardner said he doesn’t see a catalyst for change and investors should expect hiring plans for the region to be delayed.

At the investment bank, UBS countered a decline in trading revenue with a surge in income from advising companies on deals. Income from the M&A business soared by 67%, in sharp contrast to U.S. peers whose advisory businesses mostly posted declines. Much like its Wall Street competitors, though, the Swiss firm’s pipeline of deals going into the third quarter has weakened. It is hard to see how it could replicate such out-performance.

All this suggests Ermotti will have to revisit the firm’s financial objectives. The $300 million of cost savings planned for this year may not be enough if he is to meet his target of a cost-income ratio of 77% for 2019. The measure stood at 76.5% at the end of the second quarter, but regulatory costs will put it under pressure in the second half.

UBS’s preferred measure of profitability, return on common equity Tier 1, stood at 14.6% for the first half, up from 14.2% for 2018 and closer to Ermotti’s 15% target for this year. But, when asked, he couldn’t promise that the benchmark won’t fall back in the second half.

The CEO was keen to suggest that evolution, rather than revolution, is on the way as the bank seek ways to drive growth. He may have to do more than tweak around the edges.

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.

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