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.
Economic confidence remains resilient…
The 10th EY Capital Confidence Barometer published on April 7th, based on a survey of over 1,600 executives worldwide, clearly demonstrates that business economic confidence is both strong and resilient, and has not been impacted significantly by economic and political shocks in the 6 months since the last survey. Fully 90% of respondents felt that the global economy was either improving or stable, compared to 89% in October 2013. There was a slight fall in those choosing Improving, down from 65% to 60%, but given recent shocks to the world economy, these results indicate that confidence is now well established and resilient to short-term shocks – certainly the mood is very different to the one at the height of the Eurozone crisis.
…and financial confidence has improved…
Even more strikingly, business confidence on key financial indicators has improved significantly over the last 6 months: 64% of businesses are confident about future earnings compared to 43% six months ago and there has been an increase of 21% in the number of businesses confident about valuations, now up to 50%. The results for financial indicators are the highest for several years and suggest that businesses now perceive the recovery to be broadening out and sustainable.
…but attitudes to growth remain cautious…
But global business leaders are not planning a major push for growth despite these high levels of confidence. When probed on their growth ambitions, the picture that emerges is of a cautious approach to expansion:
- The same number of businesses (39%) are prioritising growth as those with a focus on cost reduction and operational improvement, the lowest share for growth since April 2012;
- Only 29% expect to undertake M&A activity in the next 12 months, down from 35% in October; and
- Only 30% expect to create jobs compared to 48% in October.
However, there are some positive signs with a clear shift towards more ambitious forms of organic growth: we estimate that 66% of organic activity is likely to be higher risk, a significant increase from 43% in October. Companies are more ambitious about their plan to enter new geographies and 15% identified R&D spending as a priority compared to 6% only 6 months ago. The sense is of businesses recognising the need to take risks to grow but with a desire to ensure this is measured, balanced and appropriate.
…with external influences playing a role…
It is unsurprising given the depth and length of the global financial crisis that business confidence is not translating into a push for rapid expansion but other factors are at play. The CCB identifies that shareholder activism is impacting the boardroom agenda. When asked how shareholder activism had impacted the boardroom agenda, 49% said it had pushed cost reduction higher and 24% identified higher dividend payments and 23% divestments as other areas that had been prioritised as a result. By contrast only 11% suggested it had led to a greater focus on acquisitions. There does appear to be evidence that increased pressure on boards and management has led to a shift towards lower risk activities further dampening the momentum for growth.
…and the risk-reward equation is attracting more attention…
The survey also suggests that business leaders have changed their perspective on the relative attractiveness and riskiness of different regions of the world. Political risk is cited by 32% of respondents as the most significant risk to global growth, just ahead of a slowdown in emerging markets at 29%. Only 12% cite the Eurozone and 7% inflation. Business is more confident that the world is going to grow but also more aware that growth will not be at the rates seen before the financial crisis and that there are risks associated with chasing higher growth.
…so its steady as it goes with a shift to quality and impact.
Business leaders globally are confident about the economic outlook but this is a different economic outlook than the one that formed the basis of accepted wisdom before the financial crisis. Today’s business leaders are basing their plans around a global economy that is expected to grow more slowly than the pre-crisis trend, with growth more balanced between developed and developing markets and with greater volatility. They also have a greater awareness of risk and recognise the need to balance risk and return. The result is a more measured and conservative approach to expansion than the high levels of confidence would suggest: capital will be allocated between various uses based on a more considered analysis of the benefits and risks.
The CCB suggests a greater allocation of resources to organic growth and margin improvement than in the boom period, and a more balanced geographic portfolio with an increased allocation of capital to developed markets. Most strikingly as identified by EY’s Global Transactions leader, Pip McCrostie, deal making will be concentrated on larger, high quality strategic deals with the capability to transform business prospects. We are entering a new era.
The UK economy is set to grow at 2.9% in 2014 according to the EY ITEM Club Spring forecast: the strongest rate of growth since the financial crisis. The drivers of the recovery to date, consumer spending and the housing market, will increasingly be supported by an increase in business investment, forecast to grow at 8 to 9% a year over the next 4 years.
…and low inflation…
But this is not a typical UK recovery. With increased labour supply as a result of delayed retirement and welfare to work, lower import costs due to the strong pound and reduced commodity costs as a result of weaker global demand, the UK is set for a low inflation expansion, with CPI forecast to remain below the 2% Bank of England target until 2017. Growing investment will drive higher productivity and create further downward pressure on inflation.
…creating a positive environment for business.
The EY ITEM Club forecast cites a number of business surveys on expected profitability, investment intentions and recruitment, all of which support the view that the recovery is gathering momentum. The key elements of the forecast that businesses should focus on are:
- Strong and sustained growth;
- Increased investment;
- A recovering world market, including several UK target markets;
- Low inflation and interest rates; and
- A booming labour market.
Make sure your business model is aligned for growth…
The EY ITEM Club forecast predicts growing demand in the UK and internationally. This upturn will create opportunities but also raise challenges that businesses will need to respond to. An integrated strategy will be required to ensure the opportunity for profitable growth can be exploited successfully.
In recent years, companies have concentrated on doing what it takes to survive in a very difficult economy. With economic growth but subdued inflation, survival centric business models will need to change. In particular:
- A low inflationary environment is likely to make it difficult to raise end-user prices in a number of sectors, as an example, the February UK Retail Sales data revealed the pressure on retailers with clothing prices falling 11%;
- The labour market appears to be heating up and EY ITEM Club expect pay settlements to accelerate and for average earnings to run ahead of inflation; and
- A buoyant labour market may also mean there will be a war for talent and possible shortages across a range of skill sets.
Now is the time to undertake a review of the business model to ensure that the business is able to grow and generate returns in future. The 10th EY Capital Confidence Barometer released on April 7th shows how leading companies are reviewing their geographic portfolios and adjusting the balance of effort between cost reduction, organic growth and inorganic expansion.
…as there are opportunities…
The EY ITEM Club forecast identifies a number of opportunities for business:
- Exporters can expect continuing growth in China, a boost from the strong performance of the USA and even a return to positive GDP movements in the Eurozone;
- Business to business suppliers should ensure they are positioned to exploit the opportunities that the expected acceleration in business investment will create;
- Companies selling to consumers should benefit from rising disposable income and while consumer spending is not forecast to race away, steady growth of around 2% per year is too good to miss;
- Although Government spending will remain under pressure, the targets that have been set to increase employment and to continue to improve the quality and efficiency of the delivery of public services, mean that there will be opportunities for innovative businesses to benefit.
…that require attention now.
Companies have generally focused on survival and good housekeeping in recent years and have been rewarded for this. With confidence rising, growth prospects more positive, cash on the balance sheet and increased availability of finance, all the conditions are in place for sustained and low inflationary, if unspectacular, growth. There remain risks and close monitoring is required especially of key indicators such as business investment, exports and house prices and mortgage to income ratios. However, this outlook is as good as it is likely to get and delaying too long may mean either that opportunities are lost to others or become more expensive to pursue in future.
Back in positive territory…
Eurozone GDP will grow by around 1% this year according to EY’s Spring Euro zone Forecast. After several tough years, this is welcome news with an upturn in consumer spending, investment and exports. It is also the case that bond yields in the periphery have fallen sharply and financial investors have begun to look again at the Eurozone in search of potential bargains. In part this change in financial market sentiment reflects a slowing of growth in many other markets: the Eurozone is performing better in relative terms as other countries falter.
…but the crisis is not over…
The detailed estimates in the EY forecast illustrate the scale of the challenge still facing the Eurozone:
- GDP will grow at around 1.5% between 2015 and 2018, too slow to make a significant impact on unemployment which wills till be at over 11% in 2018;
- Exports will grow at 3% in 2014 and then at around 4% for the next 4 years, again insufficient for the Eurozone to catch up the income since 2010;
- Consumer spending will grow at around 1.2% per annum between 2014 and 2018, very slow given the fall in spending in the last couple of years;
- Investment will grow at around 2.5%, a very slow rate given the fall in investment since the financial crisis, suggesting there will be a lack of momentum behind the recovery; and
- By 2018, Government debt to GDP will be almost 98% across the Eurozone.
…and risks remain …
So growth is returning but it is very weak and certainly lower than we would normally expect following a recession of the severity the Eurozone has experienced and significant risks exist. In particular:
- Deflation is now a potential concern with inflation at 0.8% currently and real concerns that the lack of growth in the money supply and credit , the output gap and labour market conditions could drive prices lower;
- Divergence continues to increase across the currency union, Germany’s economy is performing strongly and indicators point to continued growth, some of the peripheral countries are making progress but core states such as France, Belgium and the Netherlands are slipping behind Germany;
- The high levels of unemployment both place a significant burden on welfare systems and could be a source of social unrest .
In this environment the Euro remains a surprisingly robust currency. Germany’s strong surplus is undoubtedly a factor but the EY forecast projects a €:$ rate of 1.2 in 2018, too high to support the much-needed acceleration in exports and potentially adding to the deflationary pressures by reducing import prices.
There are also concerns about the possible impact of the results of the Asset Quality Review of the major European banks. An adverse set of findings could further hamper attempts to stimulate lending and credit growth.
…so business should be cautious…
Confidence has improved and there is no doubt that the economic situation in the Eurozone is the best it has been for over 2 years. However, this remains a troubled economic region and the outlook is still weak and fragile. The EY Forecast identifies only 2 sectors that are likely to achieve growth rates of over 2% a year int he coming 5 years: Manufacturing and Communications. Construction will be close to this level but many other sectors will grow at historically low rates. The low rates of consumer spending growth and investment show both how hard it will be for businesses to improve their performance in the coming years, and how challenging the longer term outlook is. If investment remains low and unemployment high, there is real risk that the productive capacity of the Eurozone and ultimately the value of its market will decline over time.
With the situation more stable than in recent times, now is the perfect opportunity for businesses to evaluate the long-term potential of the Eurozone and to develop the appropriate strategies and operating models without the complexity that crisis mode brings. There are clear pockets of opportunity and signs of improvement but an objective analysis is required to inform medium to long-term decision-making.
..and remind policy makers of their responsibilities.
In my view, the Eurozone policy makers have become a little too relaxed in recent months as we have seen signs of improvement. As discussed above, the Eurozone remains challenged and is facing a long period of difficult conditions and significantly below trend growth. There is more than can be done by policy makers including:
- Using monetary policy to provide more stimulus and to encourage growth in credit and to adjust the exchange rate;
- Considering relaxing the speed of the austerity programmes to provide a short-term stimulus to demand;
- With the above, specific initiatives to get people, especially young people, into work to avoid a loss of capability over the medium to long-term; and
- Identifying ways of stimulating investment, including public infrastructure schemes potentially in collaboration with the private sector.
The crisis is not over and business needs to make clear to policy makers that there is a gap that needs to be filled working in partnership with business.