Two weeks is a very long time in economics: profit warnings continue to rise despite a growing economy

I thought you said things were going well?

Two weeks ago, EY’s Capital Confidence Barometer reported increased economic confidence amongst UK businesses. Last week, the EY ITEM Club forecast strong UK economic growth in 2015, especially post the election assuming business investment recovers after the end of political uncertainty. This week, EY’s latest analysis shows more companies issued profit warnings in Q1 2015 than the same period last year. How can we reconcile these conflicting results?

It is certainly the case that profit warnings are higher than we would expect given the level of GDP growth in the UK economy. A level of about half the current rate would be more usual for the stage in the cycle.  Given the improving economic outlook therefore, it’s tempting to make the oil price the chief culprit for this year-on-year rise – particularly as one in five warnings cited its dramatic fall. However, there’s more to this story and we need to dig into the details to understand what is happening.

It is true, there are some challenges out there.

UK quoted companies issued 77 profit warnings in Q1 2015, three more than the same period of 2014, but sixteen fewer than the previous quarter.  Overall, 5.5% of UK quoted companies issued profit warnings in Q1 2015 – the highest first quarter percentage since 2009.

Yes, the rapid fall in oil price at the end of 2014, contributed to 16 profit warnings in the first quarter. This includes a record eleven warnings from within oil & gas sectors and five from elsewhere, primarily the FTSE Industrial Engineering sector.But it’s not all about oil. The FTSE sectors leading profit warnings in Q1 2015 were Oil & Gas Producers (8), Support Services (8), Software & Computer Services (7) and General Retailers (6): a wide sector spread.

When we delve into the reasons cited for profit warnings, it becomes clearer that the problems businesses are encountering go beyond a falling oil price.

EY’s analysis found that:

  • Increasing competition and pressure on prices contributed to 22% of profit warnings in Q1 2015. This includes most retail profit warnings.Rising consumer spending power helped to keep retail profit warnings in single figures, despite deepening price deflation. But, the constant fight to keep prices low and meet rising consumer expectations continues to create a testing retail environment.
  • A quarter of profit warnings cited contract delays or cancellations in Q1 2015, highlighting the impact of rising market uncertainties and just how little room companies have for manoeuvre. The FTSE Support Services sector is geared to the economic cycle and contract cycles. This leaves it well placed to benefit from the upturn, but also open to election uncertainties. Over 50% of the sector’s profit warnings blamed contract delays or cancelations in Q1 2015.
  • Volatile exchange rates and the strong pound continued to complicate the forecasting environment, contributing to 10% of profit warnings in Q1 2015.  This is down on last year’s high, as companies adjust and sterling eases against most currencies, although not the Euro.

A fresh look

Profit warnings matter: the median share price fall on the day of warning was 10.8% last quarter. In  this maelstrom of change and volatility, it’s imperative that companies take a fresh look at their strategies, business models and portfolios. There are significant benefits for companies who can build a business that has the capital, market, operational and stakeholder resilience to can meet the challenges of this recovery and implement more effective planning and decision-making. Not least because companies can now expect a greater interest in how they perceive the future from activist stakeholders and regulators.

Accurate, scenario based forecasting is crucial. Let’s consider outsourcing as an example. The aftermath of the 2010, election created contract uncertainty and increased margin pressure to the sector, as the new Government reassessed existing contracts. We recorded 30 profit warnings citing election related delays or ‘austerity’ related issues in the year after May 2010 – 13 from FTSE Support Services companies. The chief concern in 2015 – for both the public and private sectors – is the potential for a drawn out process that stalls contracts and creates indecision in the wider economy. Now is the time to make sure plans are in place for alternative scenarios to avoid an unpleasant time 6 or 9 months down the road.

The “Phoney war” is nearly over, are you ready for life after May 7th?

Politics has had a limited impact on economic prospects to date…

Hard though it sometimes is to believe given the full on media coverage, the General Election campaign is drawing to a close. The EY ITEM Club UK Spring forecast suggests the UK economy will weather the Election storm and GDP will grow by 2.8% this year, in line with last year’s upwards-revised figure. CPI inflation will average 0.1%, this year, effectively taking base rate increases off the agenda until next spring.

EY ITEM Club UK Spring forecast 2015 April 3

As the forecast states,

“There is a wide gulf between the Conservatives and Labour on vital economic issues like fiscal consolidation and the EU …. Although there have been surprisingly few jitters in the financial markets, business investment growth has already fallen back from the strong figures we saw last summer. The housing market has also slowed and construction output has been falling as projects are put on hold. However, barring major upsets in the election, favourable developments in commodity and export markets should outweigh the effect of political uncertainty. “

Businesses now need to ensure they are fully prepared to make the appropriate decisions once the General Election result is known.

…and it will be back to business on May 8th

Whatever the result of the election, the rebalancing of the global economy is set to continue. As EY’s recently published Capital Confidence Barometer demonstrated, corporate confidence in the global economy is high, and actually running ahead of confidence in domestic economic prospects in most major economies. The shifting global outlook is most noticeable in the Eurozone with the combination of lower oil prices, the impact of QE on the exchange rate and financing costs, an easier fiscal regime and a more stable banking sector making economic prospects brighter than for some time.

It is not just the Eurozone economy that is in better health. Sentiment in India has improved and the USA continues to grow, albeit at a slower pace than some forecasters expected. The results from the CCB are consistent with developments in M&A and equity markets, all of which indicate a rebalancing in corporate investment priorities and a pivot back to the developed markets. Only India and China of the emerging markets feature in the top 10 investment priorities amongst the 1,600 companies surveyed for the CCB. Now is the time to review your geographic portfolio.

It also seems clear that the election is unlikely to curb the growth in UK consumer spending. EY ITEM Club forecast that household disposable Income will grow by 3.7% in 2015, the fastest growth for over 20 years. This seems sure to translate into increased consumer spending in the UK economy. With good retail sales data and strong car purchases so far in 2015, it does appear that the consumer recovery is becoming increasingly robust. Businesses need to make sure that their plans are such as to allow them to capitalise on this spending and avoid missing out on the consumer revival.

EY ITEM Club note that business investment has eased since the rapid growth in 2014. This probably reflects both a loss of confidence in the pace of UK economic growth in late 2014 and concerns over the election result. However the EY ITEM Club forecast is positive about UK economic growth all the way through to 2018, with growth averaging just under 3% per year for the period. This is healthy growth and ought to create opportunities for business but exploiting this growth will most likely require investment. UK business needs to ensure it has the capacity to invest to capture the available returns in the growing UK economy.

Once the election result is known and the identity of the future government known, business must work through the implications of likely policy for the economy. The different plans for fiscal policy are an obvious area as could be the UK’s relationship with the EU. Moreover, whatever the composition of the new government, immigration policy is likely to impact business. Appropriate analysis and contingency planning is required to ensure there are no nasty shocks in future.

Business confidence is improving but pragmatism means it is steady as we go with a pivot to developed markets.

Corporates increasingly confident in the global economy…

EY’s 12th Capital Confidence Barometer, a survey of around 1,600 decision makers globally, shows that 83% of respondents are confident that the global economy is improving, a significant increase from the 53% who felt this way in October 2014. This positive outlook extends beyond the economy with business having a positive view of global corporate earnings, credit availability and equity market conditions..

This is something of a surprising finding. In January the IMF downgraded its forecasts for global growth, while the problems faced by previously rapid growing markets such as Brazil and Russia are well known and the slowdown in China has cast a shadow over many emerging markets. Why is business so confident in the global economy?

…rather than their local markets…

The confidence that businesses have in the global economy is in marked contrast to their views on their own domestic economies. As the chart below shows, corporates are significantly more confident in the prospects of the global economy compared to their local economy. Spain is the only major economy with business executives having more confidence in the local than global economy.

The economy is improving

Graph 1. The economy is improving

…and the global risks are not being ignored.

Yes business is more confident in the prospects for the global economy but corporate leaders are still very aware of the risks that exist. Political instability and currency and commodity volatility are both prominent in the list of most significant economic risks identified by respondents. His is no surprise: the global political outlook has dominated the news in recent months and the challenge posed by major shifts in currency values has become clear through the recent earnings reporting season.

What do you believe

Graph 2. What do you believe to be the greatest economic risk to your business over the next 6 to 12 months?

Should we twist or stick?

The mixed picture of business confidence and risk makes decision-making for corporates very challenging. Is now the time to seek to exploit stronger global economic conditions or should the focus be on the domestic business or on risk avoidance? The answers in our survey suggest that the preferred way forward is a pragmatic approach seeking to manage across the various conflicting issues.

On one hand, despite increasing confidence in the global economy, 54% of respondents state that their primary focus is on cost management compared to 31% focussing on growth. This is a reversal of the relative positions in October 2014 when the respective figures were 37% and 40%. Consistent with this cautious approach, the intentions to hire staff have fallen from 52% to 29% of respondents since October 2014 although 65% of businesses plan to maintain staffing levels

On the other hand, despite the focus on costs, 56% of businesses plan to make an acquisition in the next 12 months, up from 40% six months ago. And, reflecting the strong confidence that corporates have in the global economy, 84% of those deals are expected to be outside of the company’s primary domestic market.

However, most M&A activity, 81% of it, is expected to be deals of under £250 million and only 5% of companies plan deals of over £1 Billion in the next 12 months. We can conclude that both cost management and acquisition strategy are actually very much carefully managed incremental programmes rather than ambitious transformation strategies. Business is confident but cautiously so and this translates into balanced strategies.

Back to the developed markets

However the most striking demonstration of how corporates are seeking to balance their conflicting views on confidence and risk is provided by the change in their geographic focus. Investment intentions in the next year are very much international: only 16% of M&A is expected to be domestic, 54% is regional and 30% further afield. Corporates do appear to believe the grass is greener outside of their home market and are searching for growth beyond their domestic borders.

Acquisition capital

Graph 3. What percentage of your acquisition capital are you going to allocate to the emerging markets in the next 12 months?

But this is still cautious international expansion with a significant reduction in the amount of capital allocated to emerging markets. 65% of companies expect less than 10% of their investment to be in emerging markets and another 15% expect to allocate less than 25% of their capital spend to these geographies.

There is a clear pivot back to the developed markets with only China and India of the emergers making the top 10 destinations identified by respondents to our survey. In an uncertain world, the upturn in the Eurozone and relatively good performance in the USA and UK has changed perceptions. Cautious corporates are looking internationally for growth but increasingly, and for the first time in a long while, to the developed markets.



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.


…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.


…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.


…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.


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.


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