In a low growth world, M&A is more sensitive to the economy: the race to get on the right side of the line

Values up, volumes flat…

Uk M&A activity in 2014 shows a wide divergence between value and volume. While M&A value has increased by 68% in 2014 to $260.7 Billion, volumes are relatively flat, only growing by 5.1%. Digging further  into the data it quickly becomes clear that the headline numbers hide even wider disparities between sectors in terms of both the level and the nature of M&A activity.

…and divergence increasing…

The increase in deal volume has been driven by Consumer Products and Retail (343 deals, a 31% increase on 2013), Media & Entertainment (221 deals, 39% increase on ‘13) and Technology (412 deals, 12% increase on ’13).

Woman Shopping at a Grocery Store

These three sectors were also amongst the top 6 generating the most value and so contributing to the $105.7bn year on year increase in value. Life Sciences ($31.2bn), Real Estate ($25.1bn) and Telecommunications ($21.1bn) were the other high spending sectors.

By contrast, low volumes and values were to be found in Aerospace & Defence, Government & Public Sector, Mining & Metals and Provider care. And while volumes were slightly higher, the deal value was also low for Oil & Gas and Power & Utilities.

…as business adjusts to the new UK economic paradigm…

The UK economy is clearly playing a part in shaping M&A activity. In the pre-crisis period, when growth was relatively high, all sectors were able to benefit. Today we are in a lower growth environment but crucially, one in which prospects and challenges vary significantly by sector.

The high value, high volume acquirers are in dynamic and relatively fast sectors that are going through significant change. Companies are using M&A as a part of their moves to reposition to make sure they are on the right side of the growth line. Technology and Media & Entertainment companies are looking to acquire new skills, content and capabilities and to capture the benefits of the revival in UK consumer spending. Activity in the Life Sciences sector has been partly driven by the inversion opportunity but also by companies looking to replenish and adjust their drug portfolios to reflect their views on the appropriate segment/product mix as economic prospects, demographics and the impact of fiscal austerity impact the market.

We can see the impact of austerity and changes in government spending reflected in low volumes and values of activity in Aerospace & Defence, Government & Public Sector oriented businesses and Provider Care. With an election looming in which the view of the two largest parties on public finances is as wide as it has been for several decades, so political uncertainty has been added to the challenges created by the austerity programme.

The changing nature of demand in the world economy, especially China’s moves to rebalance its economy have reduced the demand for commodities which is a factor in the low activity recorded for Mining & Metals. Limited progress on shale gas in the UK, increase uncertainty over energy policy with the referral of the sector to the Competition & Markets Authority, and the fall in the oil price all form part of the rationale for low activity in Oil & Gas and Power & Utilities sectors.

Offshore Oil Platform Under Construction

…as well as broadening their horizons.

Overseas deals completed by UK companies saw a 16% increase in the year to November (from 641 to 766), with values increasing by nearly 60% from $44.5bn to $105.5bn – catapulting the UK to second most active overseas acquirer ahead of Germany, Japan and China, second only to the US. A recovering domestic economy and increased corporate confidence together with a strong stock market and access to financing has enabled UK business to increase its international M&A activity

To thrive and survive transaction strategies must change

Considered overall, transaction levels have been too low in the UK given the need for businesses to sustain a healthy level of deal activity to remain competitive in this rapidly changing economic and technological world. Together will relatively weak capital investment levels, this means that business is now readjusting quickly enough. Certain sectors are pushing ahead but more action is required by businesses to position themselves effectively in the new economic environment in which we find ourselves.

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Eurozone outlook: growth edging up but the devil is in the detail

Some signs of life…

Forecast GDP growth of 1.2% for 2015 is the somewhat surprisingly upbeat message from the December EY Eurozone Forecast. This goes some way to offsetting the latest reduction in the 2014 outlook from 0.9% in September to 0.8% now. The new 2015 estimate incorporates the upside effect of the recent decline in the oil price, adding potentially 0.3% to the growth in consumer disposable incomes and mitigating the impact of slowing global growth and Russian sanctions.

Euro currency and coins

But it would be wise not to send out the party invitations just yet. There remain significant downside risks related to the external environment and it is far from certain that Eurozone policy will be able to launch stimulus measures of the scale required to head off the deflationary pressures that have been building.

…but can they be maintained?

Beyond the obvious risks though is a more fundamental question: does this forecast represent a realistic, achievable scenario for the Eurozone economy? An upturn in GDP to 1.2% in 2015 and then 1.6% annually to 2018 is very welcome but will this be sufficient to keep stakeholders behind the programme?

If this forecast is accurate, then by 2018 Unemployment in the Eurozone will have only fallen from 11.6% in 2014 to 10.5% in 2018 and Government debt as a share of GDP will have increased from 96.2% today to 97.1%. Unemployment will be over 20% in Spain, above 19% in Greece and almost unchanged in Italy from today’s 12.6%. Government debt will be just under 150%of GDP in , will be higher than today’s ratio in both France and Spain, and largely unchanged in Italy and Portugal.

A decade on from the financial crisis, after years of misery and significant reductions in the standard of living in the countries in the south of the Eurozone, it is questionable how much there will be to show for the efforts of each country. Even Germany will only grow by an average of 1.6% a year between 2014 and 2018, although this is higher than the equivalent figures for France of 1.1%, Italy 0.5% and Portugal 1.3%.

This is a recovery but only in a very marginal way and it is certainly unlike the recovery from any recession in living memory. There is a significant risk that a slow and small improvement will not prove acceptable to the populations in some countries.

And what about the long-term cost?

But there is a potentially more significant issue. The forecast growth in investment is very low given the scale of the slump: only 0.9% in 2015 and then averaging 2.6% a year to 2018. In the UK in 2014, an increase of up to 8% is likely. Low investment together with the high rate of unemployment, especially the high rate of youth unemployment, means that the risk that the Eurozone is permanently reducing its productive capacity is a real one. The Eurozone may be irreversibly damaging its potential but even it is not, the consensus forecasts for the UK and USA imply that the Eurozone will be falling further behind these two economies for the rest of the decade. The politics of envy could well become a factor shaping the public mood in the Eurozone.

Time to face facts

Globally, the slowing economy and the increased awareness of political risks have drawn the Eurozone back into the spotlight. The export led recovery has slowed and the focus has switched back to the challenging fundamentals. The reality is that the crisis never went away and a long process of reform still lies ahead with many potential bumps on the road.

For business, now is the time to take another long hard look at prospects within the Eurozone and the relative attractiveness of operating in the region compared to other capital deployment opportunities. Current policies are not going to restore the economy to rude health anytime soon and so business cannot rely on economic growth to drive improved performance. A few sectors may outperform, the communications sector which includes mobile phones, consumer technology and social media has strong prospects across the currency zone, and Manufacturing and Business Services are on an upward curve but generally sector growth is at best in line with GDP growth.

Nothing should be ruled out. The full range of options from exit to accelerated investment and using M&A to acquire capacity or to drive synergies should be evaluated. It may be that sitting tight is the way forward but this should be the result of a positive choice not through apathy.

It is also time for business to engage with policy-makers. The low growth estimates set out in our forecast imply consumer price inflation of 1.6% in 2018, still below the ECB’s target. It is reasonable for business to question why more stimulus is not being applied urgently to move the economy back on a stronger growth trajectory. When a key indicator lags so badly for 5 years, policy has to be challenged. The Eurozone is falling further and further behind its peers and needs to move faster.

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Read the report

 

 

Scotland’s economy moving in sync with the rest of the UK

A good year for Scotland…

The latest EY Scottish ITEM Club forecast confirms that Scotland has had a good year with expected growth of 2.8% in GDP in 2014, including a strong capital spending performance, better than in any year since 2007. This compares with EY ITEM Club’s forecast of 3.1% for UK GDP growth this year. Drilling down further, Scottish performance was very similar to the UK as a whole.

ey-scottish-item-club-forecast-2015-infographic

Growth across the UK helped push up Scottish non-oil exports to the rest of the UK, however the value of overseas exports suffered from continuing weakness in the Eurozone, slower growth in key emerging markets, the clampdown on luxury gifting in China and the strength of sterling through the middle of the year.

The data suggest that 2014 was the year when Scotland caught up with the UK as a whole in terms of jobs growth from the low point in mid-2009, with a higher overall employment rate. Scotland had been lagging the UK in terms of the rate of job creation but this gap has now closed. The availability of skilled workers is likely to become an increasing issue for Scottish employers.

The main differences between Scotland and the rest of the UK appear to be:

  • The consumer appears to have been more cautious in Scotland this year than in the rest of the UK. To some extent this is pay-back from 2013 when Scots were more ready than their counterparts south of the border to reduce saving to boost consumption.
  • Average house prices remain more affordable in Scotland than almost anywhere else in Britain. For example the average mortgage requires around 21% of average earnings to service, compared with 30% for the UK as a whole and highs of 38% and 44% in the South East and London respectively.

…but the signs point to a slowing outlook…

Just as for the UK as a whole, with at best a slow improvement in international markets in prospect in 2015, much now hinges on Scotland’s investment performance to drive growth. It is yet to be seen, as has been the case for the UK data, whether the new methodology for calculating GDP will show Scotland’s recent record for investment in an even better light.

Further investment by businesses in Scotland faces a number of headwinds. Only time will tell if Scotland will experience the same types of “uncertainty” effect that hit Quebec after its referendums; the possibility of a post-election EU-referendum opens up a new range of uncertainties; stumbling whisky exports could slow the investment boom in the sector; and, if the lower oil price is sustained, both North Sea and renewables investment may suffer.

Given the global backdrop and the slight cooling in the UK economy, GVA growth for Scotland in 2015 is now forecast to moderate to 2.0%. This compares with growth of 2.4% for the UK as a whole. With continued employment growth and real increases in pay consumers’ expenditure growth is expected to increase slightly to 2.1% in 2015.

…with the risks being more to the downside…

Average As well as the political risks, weakness in the Eurozone and emerging markets, missteps in monetary policy decisions on either side of the Atlantic and continued weak wage growth could undermine the recovery from here, however the plunge in the oil price, if sustained, would be good news for much of the Scottish economy and household budgets. Overall though the balance of risks is to the downside.

…so business must remain vigilant…

EY’s most recent Capital Confidence Barometer found that 86% of UK businesses were confident about future earnings, up from 50% a year earlier and this despite their optimism over future economic performance falling in the period. Deeper analysis suggests much of this confidence derived from a belief in their ability to manage costs as necessary, though it may also reflect a feeling that the central bankers would step in to help if a crisis emerged.

However, the 3rd Quarter of 2014 saw the highest number of profit warnings in this quarter since 2008, suggesting this confidence may be misplaced. This conflicting data perfectly illustrates the challenges of forecasting in the new economic environment in which we find ourselves. The past is not necessarily a good guide to the future and more vigilance is required.

Businesses operating in Scotland must pay close attention to the economic data as it emerges, and continue to monitor closely both their own performance and that of their customers and suppliers. Scenario analysis to ensure they are positioned for alternative outcomes will be useful and contingency planning around key risks is a sensible course of action.

 

UK business is putting expansion on hold – time for cool heads all round.

UK corporate optimism has fallen.

UK businesses are in “wait and see” mode according to the results of EY’s latest Capital Confidence Barometer, a survey of almost 1,600 corporates worldwide, 10% of which are based in the UK. The shift in sentiment since our last survey is dramatic: only 27% of UK businesses cite growth as their primary focus, down from 49% in only 6 months.

But the mood is not one of doom and gloom, far from it. Looking at the UK, 93% of respondents are confident about their UK earnings, 76% see good credit availability and 68% are positive about equity valuations. These levels of confidence would ordinarily translate into aggressive expansionary plans, we tend to see higher M&A activity and increased capital investment when earnings and equity values are high and credit is readily available, but this is not the case currently all the signs are of businesses adopting a cautious approach.

So why has UK sentiment moved so sharply, making the UK significantly less optimistic than the USA for example, despite the two economies growing at comparable rates?

It’s the global economy stupid…

Without doubt, a change in the expected global economic outlook has impacted UK corporate sentiment. Only 14% of UK respondents see the global economy improving in the next year, a massive fall from 57% with this view in April and the lowest response of all the major European economies.85% of UK businesses see the global economy as stable, but stable is no basis for rapid expansion given the relatively low growth rate by historic standards.  46% see the UK economy improving but this is also down  compared to 63% six months ago and adds to the move towards risk minimising activity.

…and it’s scary out there.

This lack of growth in the global economy is coming at a time when concern over risk is increasing. 37% cite increased global political instability, 31% worries over QE tapering and 18% slowing growth in emerging markets as their major worry. All of these risks reflect issues largely external to the UK and may go some way to explaining the UK’s lacklustre trade performance. UK plc is increasingly planning to rely on the domestic economy to support its performance which clearly sets limits to the scale and pace of any expansion plans.

But don’t worry, we can cope

Despite the challenging backdrop described about, which was also prominent in the recent EYITEM Club Autumn Forecast, business appears confident in its ability to manage through potentially difficult times. The confidence in earnings mentioned above confirms this: UK businesses are more confident in earnings than the global average. A closer analysis of the responses to our questions on planned actions gives some clear insight into how businesses are reacting to the slowing global economy by: balancing costs and growth strategies; sticking close to their core activities; and pursuing low risk M&A.

UK businesses are preparing to adopt relatively cautious strategies based around striking a balance between watching the bottom line and investing for growth. Cost management is the focus for 50% of UK businesses compared to 35% of global corporates. Having survived the recession, UK companies are in no mood to throw away the gains they have made and so a strong focus on efficiency will remain central to their plans,

Organic expansion will be similarly cautious with a rigorous focus on core products and markets and adding complimentary sales channels preferred to existing in new geographies or large-scale increases in R&D. The plan is clearly to seek out lower risk, incremental benefits rather than making big bets.

The cautious theme can also be seen in the proposed approach to M&A. Only 16% of UK companies expect to make an acquisition in the next year compared to 40% of the global total. And the corporates doing deals expect these to be relatively modest with 86% of expected deals under $500 million. Moreover 90% of deals will be in the core business. So deals will be cautious, relatively small and close to the existing business model.

The plans seem clear but the level of confidence is very high. The worry is that there is little slack and current plans are dependent on no major shocks and continuing support form central bankers.

The owners seem happy.

At times over the last couple of years we have sensed pressure from shareholders for more aggressive strategies. This does not seem the case today. When asked what shareholders want, 45% of companies cited share buybacks, 41% cost reduction, 37% divestments and 30% increased dividend payments. With only 1% mentioning pressure for acquisitions, we can be reasonably confident that shareholders are happy with cautious strategies that minimise the risks of incremental investment and prioritise returning income and capital to shareholders. This appears to be a time for caution rather than expansion.

No time for rash moves by business or government.

A weakening economic outlook and increased risks are driving UK businesses to adopt cautious strategies based around preserving capital and minimising exposure. Having learnt the lessons of survival during the recession, managements are not panicking and are confident in their ability to manage in a low growth economy. This is a time for cool heads and rigorous, emotion free decision-making. While keeping calm it nevertheless makes sense to be developing contingency plans based around scenarios of potential shocks to the economic outlook, especially from Europe and key emerging markets. Although businesses are confident in their ability to cope, the worry is that this assumes the willingness and ability of central bankers to step in remains unchanged and there is limited slack to absorb further shocks.

Our research also contains clear messages for policy makers.  Although businesses are confident in their ability to cope, the worry is that this assumes the willingness and ability of central bankers to step in remains unchanged and there is limited slack to absorb further shocks. In an uncertain environment it is important that confidence is maintained. With no signs of inflationary pressure in the UK, it seems sensible for the Bank of England to hold off on any interest rate rises for as long as possible. Any moves to tighten policy in the UK are unlikely to improve business confidence or incentivise greater risk-taking and do run the risk of increasing the slowdown.

Yet it is also clear that credit remains readily available. Indeed, anecdotally there is a feeling of increasing pressure to lend to meet targets and concerns that credit standards could become too relaxed. the worry is that the competition for business could either lead to asset bubbles or  to an increase in riskier lending. Continued macro-prudential vigilance is therefore essential in a low-interest rate, high liquidity environment.

Cool heads all round.

Just when you thought it was safe…time to dust off the contingency plans.

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.

UK consumer spending outlook: No easy wins on the High Street

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.

Profit warnings on the rise: forecasting is tough in a changing economy.

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.