The UK recovery remains on course…
At first glance, the UK economic recovery is continuing unabated. Indeed, despite the consistent failure of exports to grow as expected, the recent revisions to the ONS’s figures suggest overall growth since 2008 has been stronger than we first thought. The EY ITEM Club Autumn forecast is very similar to the summer one with expected GDP growth of 3.1% in 2014 and growth of around 2.5% in the next few years.
Even more encouragingly, the new measure of GDP reveals that fixed investment has been stronger in the last few years than we realised. An initial analysis suggests that higher investment in IT one of the reasons for this improved view. For those of us looking for signs of a balanced recovery and an economic transformation, this is good news.
…but the global economy remains challenged.
But wherever you look in the world – and across all sectors – there are risks and potential shocks that have begun to prey on corporate confidence. And in the last few weeks, investors, politicians and business owners have started to acknowledge that the global economic still faces major challenges. China’s rebalancing is leading to slower growth and impacting both commodity and manufacturing exporters, the end of the taper by the USA has also hit emerging markets, and it is now clear just how much further the Eurozone still has to go to rebuild its economy. All of this poses real risks to the UK recovery.
UK businesses believes they can cope…
EY’s 11th Capital Confidence Barometer indicates that although UK businesses believe economic conditions are weakening and 37% of businesses cited political risk as their primary concern going forward, 93% of the UK companies surveyed are confident in their future corporate earnings, compared to 71% six months ago. How can these conflicting views on economic and financial performance be reconciled?
Drilling into the detail it appears that companies believe that the lessons learned in responding to the global financial crisis mean they will be able to manage their way through a difficult economic environment. The intention is clearly to increase the focus on operational efficiency and costs with a near 50% rise in the number of businesses intending to prioritise cost management in the 6 months since the last CCB. This more measured outlook is also reflected in the approach to M&A with all the signs pointing to cautious and limited M&A activity.
…but can they deliver?
However, as highlighted in our Q2 Profit warnings Report, profit warnings have been increasing. This seems at odds with the confidence corporates have in future earnings.
We found that in Q2 around a fifth of profit warnings were due to adverse currency movements and almost another fifth due to pricing pressures and tougher than expected competition. This suggests that corporates are either over-confident in their ability to manage, or have an unrealistic view of the environment or have inappropriate forecasting processes, or, of course, some combination of these possible explanations.
Time to revisit those contingency plans.
The priority therefore is for businesses to review their plans in the light of the current environment. In particular, there is an urgent need to evaluate the potential impact of both the Eurozone entering recession and a prolonged slowdown in the emerging markets. This should include the risk of a knock on effect in the UK, with a slowdown in investment being the most obvious risk to test.
A detailed review and analysis of the potential impact of an economic slowdown will provide the basis for identifying the nature and potential scale of major risks. It is vitally important that the review is based on a realistic view of the economic outlook around the world. Over the last 6 to 12 months, businesses appear to have slipped into a complacent view of the state of the global economy when in fact few of the fundamental indicators have improved from 12 to 24 months ago. Like the bond markets, businesses appear to have become too willing to rely on Mario Draghi and his central bank peers around the world.
This review will provide the basis for deciding on the need for contingency plans. As was the case two years ago when the Eurozone crisis first broke, plans should be developed in cases for which the potential costs of contingency planning are merited.
With appropriate contingency plans in place, businesses will then have the opportunity to consider the longer term strategic challenges posed by the economic environment. For all businesses in every sector, the question is this: is your business model appropriate for an environment of steady, unspectacular growth? With short term tactical plans in place, it is critical to consider the long term.
Good news or bad news first?
The good news is that the EY ITEM Club Special Report forecasts that UK consumer spending will continue to grow over the next few years. However, the bad news is that growth is likely to fall below the 2.5% expected in 2014, being closer to 2% in the following years. This is a much lower level of growth than we have become accustomed to: growth in the decade to 2008 averaged 3.7% a year, almost double the current forecast rate.
Slow as it may be, this rate of growth is higher than the expected outlook for the Eurozone as set out in EY’s Eurozone forecast published on September 25th. High unemployment, the threat of deflation, limited bank lending and high levels of debt are all acting to limit consumer confidence and hence spending in the Eurozone. With emerging markets also slowing there are no easy options for consumer products companies looking to grow revenues and earnings. For businesses, understanding the macro market drivers is a critical first step to maximising the available opportunities.
I thought the economy was improving?
The UK economic recovery continues but this is a recovery unlike any other. Consumer spending has been the key driver of the recovery, both on the high street and in the housing market. However this spending is being driven by an increase in the total numbers employed rather than by real wages. In 2014, the impact of increased employment on income growth is likely to be four times greater than the impact of higher real wages.
There will be no rapid increase in consumer spending until real wage growth accelerates. While EY ITEM Club expect real wage growth to strengthen in the coming years, the hangover from the shock of the downturn, continuing increases in the labour supply, higher employer pension costs and the relative weakness of trades unions compared to the past will all act to keep wage rises in check. Hence we are in for a period of little growth in consumer spending.
Well it is definitely changing.
The economy is recovering but it is not returning to its pre-crisis shape. The EY ITEM Club report sets out how the highest and lowest earners are likely to fare relatively better over the coming years, due to the war for talent on one side and the changes to taxes and minimum wage levels on the other. By contrast the middle of the income distribution will continue to be squeezed. In real terms, the median income will fall from £18,852 in 2008 to £17,827 in 2017 according to the EY ITEM Club forecast. Similarly, older people are likely to do better than the young, the latter group facing proportionately greater unemployment and being much more exposed to housing costs. Since 2008, the number of over 50s in work has increased by around 1.1 million while the number of 18 to 24 year olds employed has fallen by 200,000.
Creating winners and losers
Consumer behaviour changes due to a number of factors, one of which is the economic environment. As the recovery becomes entrenched but consumers recognise that growth in incomes will be low so their spending is adjusted. The first development is likely to be a slowing in the recent rate of growth in sales of high ticket items such as cars, furniture and large domestic appliances. This reflects some satisfying of pent up demand, the decline of the PPI effect, a slowing in the growth of housing transactions and the fact that consumers recognising that incomes will be relatively flat for some time, hence purchasing on credit needs to be carefully managed.
By contrast, EY ITEM Club expect the demand for more immediate satisfaction to increase. In this environment consumers will allocate their resources towards buying the latest technology and games and buying clothes and shoes. Gardening is also expected to do well as is spending on health. There will be a slowdown in alcohol and tobacco sales, reflecting taxation, regulatory and lifestyle factors as well as income changes, and education as people struggle to afford private options. There is no good news for the food industry with spending set to lag average growth in consumer spending as competition and price conscious consumers limit revenue growth.
A call to action
Consumer oriented businesses need no reminding of how challenging market conditions are. The last EY Profit Warnings identified increased competitive and pricing pressure as a major driver of profit warnings in 2014. Nevertheless there are some key steps to maximise the chances of success.
1. Ensure the business has the most detailed possible analysis of trends by segment and that all budgets and forecasts are up to date and accurately reflect the implications of the outlook for prices, competition, distribution and promotion strategies.
2. Assess the appropriateness of the business model for a low growth, low inflation environment in the light of economic outlook but other technological and social changes.
3. Be very clear on the future plans for the size and shape of the workforce. A low wage environment creates the temptation to hire labour rather than invest in technology and facilities however innovation remains critical to long-term success and investment should not be neglected. On the other hand, the labour market is fragmenting and highly skilled individuals will command a premium, talent development strategies need to reflect this.
I thought you said that things were getting better?
We all know that a week is a long time in politics, but what about economics? Only seven days after the EYITEM Club issued its upbeat Summer Forecast “The UK economy hits the sweet spot’, EY’s latest analysis shows that UK profit warnings reached their highest level for three years in the first half of 2014. Surely some mistake? How can business decision-makers reconcile such apparently conflicting messages?
Well, some things are…but it is a complicated story…
The EYITEM Club forecast set out the prospect of a balanced recovery in the UK with business investment surging and, in tandem with increased consumer spending, driving economic growth. With signs of moderation in the housing market, the UK economy is forecast to grow at over 3% in 2014 and prospects are strong for the following years.
However not everything is rosy: export performance, especially for goods, remains disappointing; real wages are not increasing in line with growth; and investment is still well below peak levels. The UK economy is moving forward but has not yet recovered.
The UK economy is not just recovering, as I discussed previously, it is also changing. The low growth in real wages has undoubtedly helped to boost the numbers in employment but it has also changed the way in which consumers, especially those on lower incomes, approach their spending decisions. On the corporate side, as Chris Giles of the Financial Times so clearly explained (in a great set of graphics highlighting all the major economic changes since 2008), there has been a significant shift between sectors since 2008. Oil and the Extraction industries are down nearly 40% in real terms and Finance has fallen by around 15% but Professional Services are up close to 10%, the Communications sector has grown by 10%, Health by 15% and Administrative Services are 20% higher than in 2008.
…which helps to explain the rise in profit warnings…
When we delve into the detail underlying the EY Profit Warnings, the impact of the challenges and changes in the economy becomes clear.
Companies used three main reasons were used to explain why profit warnings were necessary:
- currency movements were cited as accounting for 20% of all warnings in H1 2014;
- competitive and pricing pressures, were the cause for 18% of all warnings in H1 2014 versus 5% a year earlier; and
- increased expenditures on R&D and investment led to 10% of all warnings this year to date.
The key sectors making profit warnings were Consumer Goods and Services, Support Services and Industrials.
The UK economy’s strength has made life harder for exporters. Market expectations over a rise in interest rates, recognition of the improvements in the UK economy and the relative political stability of the UK have all combined to increase the rating of Sterling. The result has been a significant appreciation especially against many emerging market currencies such as those of Turkey, Thailand and India, and some gains against the US Dollar. The impact on the Consumer Sector and Support Services is clear as companies have found their competitiveness under pressure, and even when they have been successful in their chosen markets, the conversion of international earnings into Sterling has been on less favourable terms than originally forecast.
Increased competitive and pricing pressures provide the perfect illustration of how the changing nature of the economy can impact corporate performance.
- In the consumer market, a fall in real disposable incomes of something close to 10% since 2008 has partly been compensated for by more people in the workforce, reducing the impact on total consumer spending. However, lower real wages has been a significant factor in driving consumers to be more price conscious, which in turn has led to success for businesses targeting these segments.It is no surprise therefore to see 30 profit warnings from the Consumer sector overall in the first half of 2014.
- We have also seen a large number of profit warnings from the Business to Business sectors this year to date, With a changing sectoral mix, the UK economy is now more weighted towards sectors with relatively lower value add per unit of output, consider Administrative Services compared to Financial Services as an example. In this changing environment, as in the consumer market, prices are subject to ever greater scrutiny and challenge and hence margins come under pressure too.
Finally, when we note that UK business investment slumped in the period after the financial crisis and is still 12% below peak levels according to EYITEM, it is no surprise that corporates are starting to incur increased costs as they increase output to respond to growing demand. The fact that these costs have been cited as reasons for profit warnings suggests they are short-term patches rather than long-term investment commitments.
…and provide a longer-term lesson
We can therefore reconcile an optimistic macro-economic outlook for the UK with an increase in profit warnings. The success of the UK economy is part of the reason for a strengthening pound and the changing nature of the UK economy, which is supporting the recovery, is creating new pressures on prices and costs. Nevertheless, there is also a case for arguing that business forecasting may not yet be fully attuned to the challenges of a growing but changing economy. We have been through two distinct periods in recent economic history: up to 2008 when risk appears to have been underestimated; and 2009-2013 when risk aversion was the norm. As we move to growth mode, the challenge is to manage and price risk appropriately.
Companies require robust forecasts to support decision-making in the complex environment they are going to be operating in. This means:
- an assessment of the external economic environment to identify the key trends and the potential scenarios which could impact how these key trends play out;
- in-depth analysis of how the macro trends such as currency and real wage developments will impact their sector ;
- mapping of the macro view to their business and financial models, using their own data to tailor the high level view.
Much has been made of the potential of “Big Data’ but this may the moment when it really comes into its own. The companies with the best understanding of the complexities of the growing but changing economy stand to benefit most. The approach to forecasting and analytics will be a key building block of future success.
Could the “New Normal” become the “NICE Normal”? Time for an in-depth assessment of the opportunities in the UK economy.
Staying ahead in the global race: services exporters show the way
When the UK government talks about rebalancing the economy from consumption to exports, most people think of manufacturing. But exports of services are every bit as effective a way of rebalancing, as the EY ITEM Club special report on exports shows.
Late last year, in our special report on UK exports overall, we noted that successful exporters target the right markets with a product offer at the right quality and price. This applies in services as well, with the proviso that the trade-off between quality and price is tilted more heavily in favour of quality. While price matters, it is our consistently high quality that has established the UK as a pre-eminent global centre for services. As with German manufactured goods, people buying British services feel they know what they’re going to get. As the report makes clear in Financial and Business Services the UK has a truly world class offer and all the signs are that this situation will continue as the world economy recovers.
But this doesn’t mean our services exporters can rest on their laurels. Like their counterparts in manufacturing, they need to pick their battles and be clear on where to compete.
This involves four steps:
►Examine the potential markets for your services and identify those with the best growth prospects. China is an obvious example as it shifts towards a greater reliance on consumer spending for its future expansion.
►Assess the competitiveness of your services in these markets. Can you sustain quality at the right price?
►Examine the scope to differentiate your services in each market, including drawing on the strength of ‘Brand UK’ in services.
►Identify any structural issues that might hinder your exports, such as local trade barriers or shortage of skills, and take steps to address these, perhaps including working with government.
In the global race for services exports, the UK is making great headway. But now is no time to ease off: in a competitive world, our services exporters need to keep raising their game — and their sights.
Inward investment performance varies by region…
The coalition Government came to power determined to “Rebalance” the UK economy but EY’s 2013 UK Attractiveness Survey suggests that in terms of attracting inward investment to the English regions the policy has not been a success to date. Total Foreign Direct Investment (FDI) projects flowing to the UK increased by 10% between 2010 and 2013, with the number of projects going to London increasing by over 30% and projects in Scotland, Northern Ireland and Wales were up by over 60%, 50% and 25% respectively. But, by contrast, there were 20% less projects in the English regions in 2013 than in 2010.
The South East and East regions were the only two regions to increase projects in this 3 year period although the North West and West Midlands are on an upward curve and achieved close to their 2010 levels in 2013 and, along with the South East, remained in the top 3 English regions outside of London. However, the remainder of the English regions suffered a decline.
…with clear winners and losers…
The EY data on inward investment provides the basis to analyse long-term trends since 2004 in order to identify what factors drive the performance of inward investment into the UK regions. Over a ten-year period (2004-2013), four English regions, West Midlands, North West, South West, East Midlands, have seen their FDI project numbers increase and four, the South East, East, North East and Yorkshire, have seen project numbers fall. The South East seems to have suffered in comparison to London with a fall from 41 to 27 in the number of projects originated by investors from the USA, primarily as a result of a fall from 26 to 13 in the number of Software projects, many of which have gone to London. The other factor impacting the South East has been its loss of 11 of the 16 electronics and telecommunications projects it won in 2004.
The same appears to be true of the East: investments from the USA fell from 19 to 10 in the period, and software and electronics investments accounted for only 2 projects in 2013 compared to 21 in the peak year of 2005.The performance of the South East and East appears to be directly as a result of London’s emergence as a technology hub over the last decade. But what of the other regions?
The North West, South West and East Midlands are regions with a broad-based appeal to investors from different geographies across a range of sectors. All have a significant and reasonably stable base of projects from the USA and at least one European origin, usually France or Germany. Although the North West had a spike in Logistics investment in 2013, probably reflecting the contribution of good infrastructure and an international airport, this region and the South West have investment profiles that are similar to the profile of the UK as a whole and so are better able to cope with peaks and troughs in the market than less diversified regions. The East Midlands tends to attract a broad spread of manufacturing businesses which helps to smooth the peaks and troughs in individual sector investment.
By contrast, the North East and Yorkshire lack either a core investor or a strong set of core sectors. Both have seen investment from China and the USA collapse over the last decade and have suffered as their manufacturing base has weakened.The North East has benefitted from Japanese investment in the automotive sector but is now very dependent on this sector which accounted for 15 of its 23 projects in 2013.
The West Midlands has only grown its projects from 46 to 47 in the period, but is in many ways the region with the most interesting story. The relatively low overall growth masks a dramatic transformation with investment from the USA replaced by projects from Germany and India with an increase in automotive and food manufacturing replacing machinery and software as key sectors. The region appears to have real momentum and a solid base from which to move forward having effected a real transformation.
…which highlight the key drivers of success…
The performance of Scotland, Northern Ireland and the more successful regions in England indicates that a diversified local economy, good infrastructure, including an effective international airport, and the pulling power of a strong city are important drivers of success in attracting FDI. The poorer performing regions tend to have a limited core offer and no focal point, Yorkshire & Humber seems to suffer particularly from competition between a number of cities with no strong focus nor overall co-ordination. The examples of the West Midlands reshaping its offer around specific Manufacturing sectors, and the success of automotive in the North East hint at a way forward, potentially in sectors which were previously thought of as ones which the UK could not compete in.
…and a way forward with Manufacturing at the core.
Cutting through the messages, it is clear that the regions offer the opportunity to rebuild elements of the UK’s Manufacturing base. The good news is that there is currently an unprecedented opportunity in Manufacturing. There were 2,000 Manufacturing FDI projects in Europe last year and the UK captured a 12% share. Increasing the UK’s performance to its average share of FDI would attract an additional 80 projects a year and around 13,000 direct jobs and possibly half as many again indirectly supported positions, so a total of 20,000 a year.
Then there is the emerging Reshoring opportunity which is increasingly gaining attention. As China rebalances its economy and the world economy continues to change so Manufacturing is being reshaped. If the UK is to rebalance towards the regions then Manufacturing offers the best opportunity. Success will require:
- Developing a strategy to exploit the strengths of the regions for Manufacturing, which, according to investors, are primarily in areas such as labour supply and wage rates and real estate costs, by identifying the sectors and origins which the UK could build a competitive position in,
- Increasing the awareness of exactly what the UK regions offer – investors currently are largely unaware of the attributes of the UK regions according to the EY survey and tend to form their view of the UK, based on their perception of London;
- Improving the co-ordination of the offers, and prioritize skills development and promotion of the regions -
- Investing in infrastructure to make the regions accessible and better connected to the UK’s export markets; and
- Identifying ways to leverage London’s strengths through partnerships with the regions.
Success could create relatively well paid, secure jobs outside of London and go a significant way to address some of the major challenges currently facing the UK economy and especially the desire to rebalance between London and the rest of the country.
The UK leads the European race for inward investment but challenges remain. Is Manufacturing the way forward?
2013 was an outstanding year for the UK…
The UK Government’s attempts to make the UK attractive to foreign investors are bearing fruit: in 2013, the UK attracted 799 FDI projects, its highest ever total and 20% of the European market according to EY’s 2013 UK Attractiveness Survey. This represents a 15% increase over 2012, high growth indeed when viewed against only 4% growth in Europe overall.
Investor perceptions also improved significantly. The UK moved from 8th to 5th in the global investor ranking of attractive locations over the next three years, moving past Germany. Only China, the USA, India and Brazil are ahead of the UK – an outstanding result. The UK is the leading destination in Europe for investment from the USA, India and Japan.
…with performance built on solid foundations…
The UK and Germany pulled ahead of the European pack in 2013, increasing their share of the European market as investors demonstrated a clear preference for economic strength. In the EY survey, the UK scored over 80% approval in a range of features important to investors including stability of political climate, technology and telecommunications infrastructure and quality of life. Even in lower scoring areas such as labour costs and corporate taxation, the UK is regarded as significantly stronger than Germany.
And in London the UK has a jewel in the crown. If London was a country it would be fourth largest in Europe in terms of projects attracted. It is a hub for Software and Business Services investment and attracted 48% of all UK projects in 2013.
…facilitating a transformation of the economy’s sector mix…
This is not just a story of growth, it is also one of transformation: the UK is becoming a modern, knowledge based economy in the eyes of inward investors. Software projects in the UK surged by 55% in 2013 as the UK confirmed its dominance in this sector in Europe. London is seen as the only European city in the top 10 globally most likely to create the next Google. R&D was another success for the UK with 52 projects secured, a leading market share of 18% and representing 20% more projects than Germany.
…reflecting well on Government…
The UK Government deserves credit for enabling the improvement in the UK’s performance. 31% of investors feel the UK improved its financial flexibility and support for SMEs over the last year, 25% of investors identified improvements in taxation, 22% investment in industry initiatives and 21% support for trade missions over the last year. The success in R&D owes something to the “Patent Box” policy and the UK’s leading share of HQ relocations has been helped by the reductions in corporate taxation.
…but there is more to do…
It may seem churlish to highlight weaknesses in such a stellar performance but the UK cannot rest on its laurels. The market for inward investment is very competitive and so standing still is not an option. More importantly, there are several areas in which the UK can do better and must do better if it is to ensure the benefits of inward investment are felt by the whole country and can be used to address some of the UK’s most challenging economic problems. The critical areas are:
- The English regions have found it hard to maintain their performance in attracting inward investment and project numbers are down by 20% since 2010;
- The UK achieves a 20% of European FDI but only 12% of Manufacturing projects and 6% of “new” manufacturing projects; and
- The UK is overly reliant on investment from the USA and does need to broaden the geographic spread of origin of FDI.
To maintain and ideally improve the UK’s FDI performance a number of actions are essential:
- Continuing to work to preserve the UK’s existing strengths such as taxation and political stability:
- Confirming the UK’s status within Europe, leaving the EU will impact the UK’s ability to attract inward investment according to EY’s survey;
- Working to attract R&D and incentivising innovation;
- Increasing the awareness of the UK’s attributes especially amongst investors not currently in the UK; and
- Examining ways to use London’s strength to benefit the country as a whole through joint propositions.
…and Manufacturing appears to offer real opportunity.
Looking beyond the narrow lens of FDI, while the UK economy is recovering challenges remain: London is growing faster than the rest of the country; real wages remain flat at best; and youth unemployment is at high levels. Boosting the UK’s share of European and global manufacturing appears to offer the best scope to create a major impact on the specific challenges highlighted above. In 2013, more than 50% of all European FDI projects were Manufacturing originated, over 2,000 in total, creating 160 jobs per project on average compared to 18 for a typical Sales & Marketing project. Manufacturing offers the prospect of relatively well paid, skilled jobs, located outside of London and with the potential to train young workers. The UK should now raise its ambitions for FDI and put Manufacturing at the heart of its plans. More thoughts on this topic to follow in subsequent posts.