Scattergun approach to UK industry won’t be enough to deliver on reshoring opportunity

Rather than picking industry winners, the Chancellor has taken a ‘scattergun’ approach to supporting UK business. From the investment in the new Energy Research Accelerator and the Croxley rail link, to the expanded support for postgraduate research and plans to extend the Oxford Science Vale Enterprise Zone.

As we demonstrated in our Reshoring report, the UK has a once in a generation opportunity to grow its manufacturing base. Changes in global economic conditions, corporate strategies and consumer tastes have put future manufacturing investment in play. The UK will not regain the 700,000 plus jobs it offshored between 1995 and 2011, but a sector focussed strategy could capture 300,000 jobs over the next decade.

Our analysis suggests that sectors such as Life Sciences, Chemicals, Advanced Engineering, Aerospace and Automotive offer real opportunities for the UK. However, success requires a joined up long-term plan over two Parliaments with investment in skills, changes to tax, and investment in infrastructure all required.

The plans announced today address several of the sectors identified but not on the scale required to drive real growth as the OBR’s forecasts appear to confirm. In 2019, there is a planned increase in Government investment of £5 billion but this is too little too late: the opportunity is large scale and immediate, and the UK risks missing out.

Look beyond the “caretaker” Budget, business needs to pay close attention to the future shape of fiscal policy

EY ITEM Club expect a “caretaker” Budget

With the General Election looming, the EY ITEM Club believes that a “caretaker” Budget is the most likely scenario on March 18th. Nevertheless, the Chancellor’s statement should continue some positive news. With expected Tax receipts rising and interest rates on Government debt falling – even since the Autumn Statement – EY ITEM Club expect that the Chancellor will be able to announce a reduction in the Office for Budget Responsibility’s (OBR) forecast of borrowing for the current year of just over £2 billion and a possibility of a £6 billion reduction for the following year. It is hard to imagine any Chancellor not wanting to play up these positive developments.

Budget infographic

Beyond this though, it is unlikely that there will be a significant number of major policy initiatives announced in the Budget. The Chancellor may well pull one or two rabbits out of his hat but the politics of a Coalition close to an election are likely to limit his scope for broad-based change. This Budget is more likely to mark the start of the fiscal policy debate for the next Parliament and this is what business should be focusing on understanding.

…but the medium-term is much harder to predict…

Paul Johnson of The Institute for Fiscal Studies recently commented that the gap between the fiscal plans of the two largest UK political policies is as wide as it has been since 1992. The Conservative Party has stated it wants to eliminate the entire government deficit and run a small surplus during the next Parliament. Duncan Weldon estimates this would require spending cuts or tax rises worth between 4.3% and 5.3% of GDP (national income), depending on how large a surplus was desired.

Labour, by contrast, only wants to balance the current budget (current government spending excluding capital investment). That means that, under their plans, the government would still be borrowing in the next Parliament to make investments. Labour’s plans imply spending cuts or tax rises of 3.0% according to Duncan Weldon’s analysis.

…although business seems to have a clear position…

Chris Giles of the Financial Times has surveyed the attitudes of business leaders to government spending. Support for deficit reduction before the end of the next Parliament was very strong with 39% wanting this achieved wholly through spending cuts rather than tax rises.

In terms of where the cuts should fall, 84% of the business leaders interviewed want to see welfare spending reduced compared to only 4% who wanted an increase. A majority of 54% to 46% wanted the NHS ring fence ended and 71% wanted the ring fence on international aid removed. And 85% saw more private provision of public services as one way to help achieve these aims.

However, 90% wanted an increase in the capital spending budget of more than the planned 2% and there was a majority of more than 2 to 1 in favour of maintaining the protection of the school’s budget.

…but may need to be careful what it wishes for…

The position of corporate leaders on public spending seems clear: overall they would like less except in selected areas, which presumably have a clear benefit to business. However the position may be more complicated than they realise: the benefits to business may flow in ways that are not obvious from the headline numbers.

Kevin Farnsworth of the University of York has calculated that “socio-corproate welfare” and “corporate welfare” as he describes them, could have delivered something of the order of £85 billion of taxpayers’ money in benefits to the corporate sector in 2012. This estimate includes wage support, training assistance and pensions in the first category and subsidised lending, export insurance, marketing by the Department for Business Innovation & Skills and other departments and public purchases from the private sector amongst the second. The approach used is a very specific one and may not be accepted by all business leaders as valid, but it does show the challenges of understanding how fiscal policy changes may impact the economy.

For example, there is research available to support the view that public sector funding of Research & Development can have major benefits for the private sector. Grants and other support may also be important to certain companies. Businesses need to be clear on the specifics of policy if they are to be in a position to make informed decisions.

Even the potential impact of welfare spending is not that straightforward to analyse. Something of the order of 47% of benefits accrue to pensioners. Cutting this could well reduce consumer spending and disproportionately impact businesses exposed to this segment. If this spending is protected then policy might mean schemes that benefit lower income workers are targeted. This could have significant implications for labour intensive sectors such as the hospitality industry.

…and now is the time to do the numbers.

Government finances are a complex are. When listening to politicians, it’s easy to believe the choices are straightforward. The reality is different especially when policy differs between the parties to the extent it currently does. Business must get to grips with the detail and plan accordingly.

The Eurozone is in play: are you ready

Has a declining oil price saved the Eurozone?

After a year of tentative recovery in 2014, the latest EY Eurozone forecast expects growth in  the Eurozone to accelerate in 2015 With GDP growth increasing from 0.9% in 2014 to 1.5% this year and then to 1.8% in 2016. The movement in oil prices since the previous EY forecast in December 2014 has undoubtedly had a major impact and is likely to boost real household income by 1.5%, enabling consumer spending growth to accelerate from 0.9% in 2014 to 1.6%. A very healthy rate when set against recent experience.

E2

…to an extent, but policy is also playing a role…

The ECB’s recent announcement of substantial sovereign bond purchases is expected to prevent a deflationary spiral and underpin medium-term inflation expectations at 2%.  The impact of QE is already been seen in the falling value of the Euro which will boost exports. But experience in the USA suggest the impact of QE will go beyond the exchange rate and is likely to impact asset prices positively and keep interest rates lower than would otherwise be the case.

E3

…even in unexpected areas.

Stronger domestic and external demand, plus improving access to finance, should underpin business confidence and spur faster capital spending. Alongside a tentative recovery in housing markets and stabilizing public investment. Rising growth and lower borrowing costs will have a positive impact on public finances in next few years. But with public debt above 90% of GDP in eight countries (and 96% for the Eurozone overall), room for fiscal easing is limited. Nevertheless the period of emergency austerity is over, and EY expect government spending to contribute modestly to  growth.

 

However there are still risks to the outlook…

Threats to stability remain – principally from the prospect of difficult negotiations over Greece’s situation.  But at least these discussions are taking place in an improving macroeconomic and financial environment in much of the rest of the Eurozone. The conflict in Ukraine will also continue to pose a risk to confidence but, with much lower global energy prices, one of the key transmission mechanisms of a spiralling conflict to the Eurozone looks to be less potent.

E5

…and longer-term challenges.

The EY forecast sees growth slowing to 1.6% between 2017 to 2019 as the boost from lower oil prices and QE tapers off and productivity limits the pace of future growth. The improvement expected over the next two years provides policy-makers with some breathing space but reform is still required. Policy-makers in the Eurozone now have an opportunity to push ahead in more favourable circumstances. With an improvement in growth some of the pain of restructuring may be eased: it is vital they seize the moment.

E6

Now is the time for business to re-assess their position in the Eurozone

Business has adopted a cautious approach to the Eurozone in recent years, shoring up operations and limiting investment. We can see this clearly by comparing capital investment and M&A values and volumes between the USA and the Eurozone. Over the last few years and especially since 2012, the rate of activity by US companies has been significantly higher than their Eurozone peers. More capital has been invested in the USA and more deals have been done and the gap has widened.

This is not an unexpected observation as economic growth has been stronger in the USA and corporate profitability has been higher. Valuations and earnings multiples are now significantly higher in the USA but with growth returning, a weaker Euro and QE likely to impact European valuations in a positive fashion: the relative attractiveness of investing in the Eurozone is increasing. Moreover, QE and the work of the ECB to rebuild trust in the banking sector mean that there is likely to be more finance available and at competitive rates. We are already seeing US companies look to raise finance in Europe, taking advantage of the favourable combination of lower interest rates and a weaker Euro.

Our experience suggests M&A activity and capital investment tend to increase when growth is good, valuations are increasing and profits are improving. The Eurozone could well move positively in all of these areas in the coming months, especially for investors that benefit from a weaker Euro. the early signs are promising, the first two months of 2015 have seen the highest non-European M&A values since records began, with 40% coming from companies based in the USA.

The Eurozone is in play. Companies that want to buy for growth or to consolidate their positions are likely to see more opportunities emerging, while potential sellers should start preparing their assets now. Financing will increasingly be available to support capital investment and early movers could establish a first-mover advantage given the low levels of modern capacity added in recent years.

E7

The longer-term remains challenging and a careful analysis of potential returns is still required. But now is the time to re-visit the strategy for the Eurozone and set out a long-term vision and short-term plan. As emphasised many times in the recent past, this should reflect the differences by geography, sector and segment very clearly.

 

 

The UK labour market has transformed

The labour market has changed dramatically…

The EY ITEM Club special report on the UK labour market sets out in detail the scale of the transformation since the onset of the financial crisis. The number of people looking for work has increased by over 1mn since the start of 2010, there is a record of 30.8mm people in employment and yet real wages fell by 8% between 2008 and 2014. This is a very different market from the one that prevailed for the last two decades when rises in employment typically translated into rises in real wages.

EY ITEM Club expect these broad trends to continue in the medium-term. The labour supply is forecast to grow by 1.2mn over the next 4 years, at a 0.9% faster annual rate than between 2010 and 2014, and although real wages will rise, the rate will be moderate for the level of employment, averaging only around 1.5% per year.

…with wide-ranging implications for business…

The new labour market will clearly have a significant impact on the way that companies seek to manage their human capital but the changes in the UK labour market are so significant that they will have implications beyond the strategic and operational issues in the human capital domain. Businesses now need to incorporate this new labour market outlook into their strategy and planning.

…impacting both demand…

Although EY ITEM Club believe that much of the change in the labour market is due to the changes in the level and structure of the labour supply, there will be a major impact on the level and structure of demand that businesses face. This is because not only has the labour market changed in aggregate over the last few years, but it has also transformed at a disaggregate level with shifts between segments and sectors. It is the combined effect that will impact the demand for goods and services. One of the most striking changes is the fact that the growth in aggregate consumption has been driven more by changes in total employment and hence total income than by real wage rises for the existing workforce. When we also take into account distributional effects – the growth in real wages has been concentrated amongst workers earning £25,000 or less and the number of workers earning over £45, 000 has fallen by around one seventh, the picture becomes clearer. Businesses selling in the consumer market will have to continue to ensure their offers are value based and priced appropriately for a market in which there is less real income growth than before the financial crisis. Life for sellers of luxury and high end goods is likely to remain challenging even as the economy recovers.

Another likely consequence of the developments in the labour market that EY ITEM Club predicts is for an increasing share of labour income to go to older workers. By contrast, younger workers may find it harder to replicate the acceleration in incomes that previous generations achieved. The analysis of income distributions suggests that the value of qualifications is being squeezed in this labour market. For businesses, it will be important to review the balance of their sales and marketing efforts across age groups. The consumers of the immediate future are likely to be older and with lower income growth prospects on average than would have been the norm in previous periods.

The increase in the number and share of self-employed workers in the labour force will also impact the consumer market. These workers are likely to be less secure in their employment and may well find it harder to raise debt and especially mortgages. This lack of security may well translate into different purchasing patterns and a demand for new product and service offers, particularly for financial services. Businesses need to begin to work through how the changing labour market may impact their product and service portfolios and propositions.

..and operating models…

The dynamics in the market serve as further reinforcement of how much the labour market has changed and how significant this could be for businesses. It is likely that corporates have deployed relatively cheap labour to help maintain margins and to minimise capital investment in what has been a difficult economic environment. With the expected developments in the labour market, is now the time to consider a new approach? It is true that the broad trends in the labour market that have supported significant hiring are going to continue. However EY ITEM Club do envisage real wage growth and although this is in an economy that is expected to grow faster, margins could come under more pressure. In addition, there is the risk of skill shortages and battles for talent in certain parts of the labour market. There are clear areas for analysis in the operating model:

  • When we look across occupations we can see an increase in professional and managerial roles but a decline in the number of back office roles and almost no growth in sales and customer service employment. It does appear that technology may be impacting certain roles and companies need to make sure they are operating at the optimal mix of labour and capital, especially as labour becomes more expensive.
  • IT continues to grow in importance and the increase in the number of people employed in professional and IT services supports this view. There is clearly a risk of skill shortages which could in turn lead into higher wage demands. Now is the time to review the IT strategy and especially assumptions on the level and mix of labour required to deliver the plan successfully.
  • The labour market analysis provides a direct insight into how dynamic the economy is. The decline in the numbers employed in the Retail sector is almost matched by the increase in Warehousing &. Transport roles. It seems reasonable to assume this may reflect the shift to online shopping. Certain retailers have clearly been caught out by this trend, it is important businesses look at their business model and how it might change to avoid being similarly caught. These are interesting times. The transformation of the UK labour market has been a key factor in the UK’s recovery to date. While the broad trends are expected to continue, developments at both the macro and micro level mean that now is the time to ensure that the dynamics of the labour market are fully reflected in business and operating strategies and plans.

Key labour market forecasts table

Could Greece save the Eurozone? Don’t look away, we are at a crucial point.

Athens

A fresh perspective from Greece, …

Watching Yanis Varoufakis on the BBC’s Newsnight programme last Friday was fascinating. We saw someone willing to challenge the basis of the economic policy currently being applied  in the Eurozone. Mr Varoufakis was clear: Greek Government debt cannot be repaid and hence Greece is insolvent. He went on to say that this means that a bailout extension makes no sense. A bailout is the solution to illiquidity not insolvency. With Greek Government debt at 175% of GDP, the facts seem to support his view. and

…with ideas for change…

Addressing the insolvency issue is only one element of the Greek plan. Mr Varoufakis wants to have an open discussion on both austerity and the current model of structural reform with the objective being to develop an approach that has a chance of working for the Eurozone not just Greece. We should not forget how challenged the Eurozone economy remains, the December EY Eurozone forecast does not envisage growth reaching 2% anytime in this decade and unemployment in Greece and other countries is still at unbearably high levels. Surely Mr Varoufakis cannot be alone in thinking now is the time to consider alternative ways forward?

I have to confess to a personal interest here. I have worked extensively in Greece over the years with both public and private sector clients. In the course of these engagements, I had some of the most fun and rewarding experiences of my career and made some lasting friendships as well as learning about the “Greek reality”. As a result, I have spent a great deal of time observing and participating in projects to implement EU policies for industry reform that were initially developed elsewhere, usually in the UK, into Greece. If nothing else, I became convinced that “top down” solutions developed outside of a country rarely work. Yet much of the structural reform is exactly this and it is for this reason I believe we should be willing to listen to alternatives developed by people familiar with the specifics of the Greek situation. Re-hiring public sector workers may conflict with conventional wisdom but it may be a better option for Greece with policy changes made elsewhere to balance out these moves. We should at least be willing to listen to the rationale.

…but could the plan work?

I am not alone in thinking the outline Greek proposals deserve consideration. An excellent analysis can be found in Frances Coppola’s article and speaking last week, Mark Carney, the Governor of the Bank of England suggested fiscal policy in the Eurozone needed to be more supportive than it currently is. Moreover, The Economist newspaper appears to be in agreement with the ideas on debt restructuring  and reframing austerity although it is unwilling to embrace change to the ongoing structural reform process, describing proposals to change as “crazy socialism”.

Is it really crazy? I firmly believe that policy makes in Europe have failed to grasp the seriousness of their situation. Over the last three years I have presented and discussed the Eurozone situation with over 100 businesses, many of which are based outside of  the Eurozone. The overwhelming majority are extremely worried about the economic situation and are very reluctant to commit resources to expand their operations in the Eurozone. It is no surprise that investment has been so low in recent years, business leaders cannot see the growth story in either the short, medium or long-term. Quite the opposite, I have heard leaders speak at length about how they despair of watching the Eurozone economy continue to decline and lose its productive capacity. In the face of such high levels of youth unemployment with investment insufficient to create the basis for future growth, one CFO said to me, “Where are the European consumers of the future going to come from?”.

A more reasonable question might be, why would policy-makers not consider alternative courses of action?

What does it mean for business and investors?

It is difficult to predict what the outcome of the current activity. Detailed discussions have yet to take place and negotiations are currently only taking place in the media. In high-level terms, there are three outcomes, either:

  • Negotiations do not reach an agreed conclusion and lacking financial support, Greece leaves the Eurozone; or
  • A ‘muddle through” position is agreed with minor changes to the current outlook; or
  • There is a significant change in policy agreed impacting Greece and other countries in the Eurozone.

The first option is one businesses should now have plans in place to address. The scale of the impact remains uncertain but this scenario has been around for some time.

The second case would mean little change to current circumstances and outlook.

It is the third option that is most interesting and does merit further consideration by businesses. This is particularly so because the Greek initiated negotiations come at a very interesting time for the Eurozone. After months of discussions, the ECB has finally launched quantitative easing and the € has continued to weaken, offering benefits to European exporters. In addition, the oil price has fallen significantly which will boost economic growth primarily via increased consumer spending. if QE now also acts to boost asset prices and increase bank lending then the Eurozone might find itself benefitting from a reasonable tailwind for the first time in several years.

If the Greek Government was to be successful in obtaining some relief from its debt burden and also managed to initiate a change in the nature of austerity and structural reform in other countries, the combined effect with the tailwinds described above could be reasonably significant. For the first time since 2010, growth in the Eurozone could start to accelerate at levels that would be noticeable.

The Eurozone is not suddenly going to bounce back to pre-crisis levels of activity. Improving the outlook is a long-term game requiring further hard work and sacrifice but the short-term outlook could look better relatively quickly, providing an envelope in which to continue reform with more positive support. In this environment, opportunities for businesses to make moves to improve their position in respect of their European assets. With higher asset values both buying and selling of assets might become more realistic giving companies the opportunity to either tidy up their portfolios or to acquire assets to help them consolidate markets. There might be enough growth to support business cases that have been put on hold.

Things could suddenly become much more interesting. So while the mood is of worry and concern it is important to stay balanced with a close eye on developments. We are at a critical point in the Eurozone’s journey. What a turn-up if Greece were to be the catalyst for securing the Eurozone’s future.

The impact of the Greek Election for UK businesses

Profit warnings surge – forecasting is difficult in a divergent world

Highest number of profit warnings for 6 years – what happened to “Silver linings turning gold”?

A week is a long time in economics…

Profit warnings reached their highest fourth quarter total since 2008 in Q4 2014, with 93 warnings also taking the annual total for 2014 to a six-year high. But this news comes only a week after the EY ITEM Club forecast which set out a very positive prognosis for  UK growth. How can we explain these seemingly contradictory views of the economy?

       

This is a level of profit warnings more consistent with a period of low growth or global shock than an improving macro outlook. There were signs that the UK and global economies were slowing as 2014 came to an end but the level of profit warnings still appears out of line with underlying economic conditions. What this latest analysis shows us is how difficult it is to forecast in the current economic environment.

Graph for blog 1

…and it has been a long year for profit forecasts… 

The key features of profit warnings in 2014 set out below illustrate some of the key factors making forecasting so challenging :

  • More FTSE 100 companies warned in 2014 than at the height of the credit crunch, whilst total profit warnings from FTSE 350 companies were just three shy of the record 90 issued in 2008.
  • Adverse exchange rates, in particular a strong pound and weakening emerging market currencies, were especially troubling for the internationally exposed FTSE 350. In 2014, 17% of profit warnings cited exchange rates – including 27% of warnings from FTSE 350 companies.
  •  In 2014, 20% of warnings cited contract delays or cancellations, rising to 27% in Q4 2014. The FTSE sectors that are vulnerable to contract disruption led profit warnings in 2014, including Support Services (47), Software & Computer Services (28) and Media (16).
  • The pressure from the squeeze on real incomes is evident from the sharp rise in profit warnings from Consumer Goods companies in 2014 – up by over 70% from 2013. Pricing and competitive pressures triggered 21% of all profit warnings in 2013, compared with 7% in 2013.
  • Unsurprisingly, profit warnings in FTSE Oil & Gas segments rose from seven in 2013 to 11 in 2014. The rapid fall in oil – and other commodity prices – has compounded existing capex pressures, increasing stress for contractors and suppliers, with warnings coming thick and fast in 2015.

 …especially in a complex, volatile economic environment…

The economy has changed from the pre-crisis environment. No longer is strong growth helping all sectors to grow. What we see today is much more divergent performance but in a very interconnected world. As an example, the moves by the Swiss National Bank to stop its policy of intervention in the foreign exchange market were most likely driven by the expectation of capital flows increasing as the ECB moved to Quantitative Easing and Russian investors continued to respond to the fall in oil prices and the impact of sanctions.

The three most important drivers of profit warnings can be attributed to changes in economic conditions:

  • Exchange rates were a standout theme in 2014, peaking at 26% of warnings in Q1. The contrast between the strong pound and weaker Euro and emerging market currencies – together with weakness in these economies – help to push profit warnings from the internationally-exposed FTSE 100 to a record high. Healthcare, finance and support services sectors were particularly affected.
  • Competitive pressures were a constant throughout 2014. Low insolvency rates, new entrants and technological changes have brought seismic changes to previous market norms. The pressure to invest, and yet cut costs and prices, is transmitting strain along supply chains
  • Warnings citing delayed or discontinued contracts peaked in the final quarter as uncertainties upset contract cycles.  In the final quarter, 44% of warnings from the contract-dependent FTSE Support Services cited delays or cancellations.

Business must be prepared

There are clear advantages in these uncertain times for companies who can take the initiative and demonstrate resilience in the face of economic and market volatility. Companies will need to demonstrate clear vision and the ability to adapt their forecasting and planning capabilities to the dynamics of the post-crisis economy.

Many of these pressures represent new realities, rather than a passing phase. An improving macro outlook is no longer a guarantee of a smoother ride for UK plc. Undoubtedly, many companies have faced increasing challenges to their forecasts in recent months from rising geopolitical concerns and falling oil prices.

Forecasting and planning approaches must be adapted to allow for scenario analysis especially around key assumptions such as currencies and also for disruptive events. While it will not be possible to avoid shocks, careful up-front analysis will at least build an understanding and allow companies to have contingency operational and communication plans in place. This will provide the opportunity to mitigate adverse impacts on both results and market sentiment. This is the “new normal” approach to planning: many futures have to be considered; no longer can the past be used as the guide to the future.