Have you rebalanced back to the Eurozone?

The Eurozone recovery continues…

The Eurozone remains in a “sweet spot”, benefiting from lower energy prices, expansionary monetary policy by the ECB, a more competitive exchange rate and a softening of austerity. It seems likely GDP will have grown by 0.5% in Q3 2015, up from 0.3% in Q2, and we expect 1.5% expansion for 2015 as a whole. With business confidence improving, investment spending will pick up in 2016, lifting growth to 1.8%.

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Are UK businesses investing enough? The latest EY ITEM Club report shows UK business investment is strong and growing.

UK businesses are investing…

Over the past few years, there has been a widespread perception that the UK economy has been performing relatively poorly in terms of business investment. This view has fuelled fears that the UK could slip into ‘secular stagnation’ – a scenario where a combination of high savings and low investment acts as a brake in growth. Earlier this year, the IMF raised the prospect that the entire global economy could suffer such a fate.Chart1

The good news is that the latest EY ITEM Club special on Business Investment suggests that – for the UK at least – such worries are not just overdone, but actually misplaced. The report finds that UK business investment has been outpacing other economic indicators since 2010 to reach its highest level as a share of GDP since 2000. The report reveals a much more optimistic picture than many, including myself had expected.

…and will continue to do so…

Especially encouraging is that the outlook for business investment in the UK remains positive. EY ITEM Club believe the UK is set to remain a relatively conducive environment for business investment in the coming years, encouraged by factors such as falling corporation tax rates, plentiful corporate liquidity, and greater certainty around issues such as market demand and the availability and costs of finance.Chart2

Encouragingly, EY ITEM Club’s projections show investment by UK business rising by an average of 6.4% a year between 2015 and 2019, to reach a high in real terms of 12.9% of GDP, a level not seen in the UK for over 3 decades. This is broadly in line with the OBR’s July 2015 forecast, which saw the investment/GDP ratio rising to 13.1% of GDP in 2019.


…and it may even be better than the data suggests…

It is also possible that the forecasts understate investment. One of the most striking developments identified in the report is the dramatic changes in working practices in recent years and the implications for investment.Chart 3

The growing ranks of the self-employed and home-workers apparently means that some investment in technology, such as smartphones, tablets, home printers, to support work is now classified as consumer spending rather than business investment. As a result, the official figures may be missing some of the expenditure. The gathering momentum behind the ‘sharing economy’ suggests this effect may increase in the years ahead.

…although still not at best practice levels…

However, while there’s cause for greater optimism around business investment, the UK’s record still lags some way behind its international competitors – with only Italy among the G7 seeing it account for a smaller share of GDP.

Chart 4

That said, the continued growth over the next few years will narrow the gap, and see the UK rise at least part way up the global rankings. Nevertheless there is a risk UK business is still underinvesting when judged on a global basis.

Are you investing enough? 

So, what are the implications of all this for UK business? The first question businesses should ask themselves is whether they have been investing enough to ensure their on-going success. Given the general view that investment has been low in the UK, it is possible that businesses have been assuming there was less investment going on than has actually been the case. This has typically applied most obviously to international peers, whose investment levels have been higher on average – but based on the EY ITEM Club’s analysis, it might also now apply to UK focussed businesses as well.

In analysing the adequacy of their investment, businesses should start by assessing if the historic level of investment revealed in this special report been sufficient to lay down a platform for sustained growth in the UK. This will provide them with the insight into the extent that their current business forecasts reflect the potential of the UK economy to grow over the coming years.

It is also important for businesses to reassess their investment plans in the context of the changed environment identified in this report. Examples include the increasing role played by consumer technology in sales processes and the rising incidence of sharing in appropriate areas of the value chain, enabling businesses to share investment and effectively boost returns. It may well be that the level of investment and hence potential demand is higher than might be reflected in current plans.

The impact of investment in technology has at least two dimensions. Yes it might mean that there is more demand than previously assumed but it may also mean that businesses need to invest now to head off the disruptive threat from technological change. For example, have sales channels being optimised to reflect the impact of the smartphone on customer behaviour?

Finally there is a need to consider the potential impact of the introduction of the National Living wage from 2016. As the EY ITEM Club report highlights, the relative costs of capital versus labour have changed in recent years as labour has become relatively more competitive. For some sectors, the NLW will reverse this trend and business investment may therefore become both more attractive and necessary to offset increased labour cosChart 5ts.

Overall, the brighter picture for business investment revealed by this special report is good news for the UK economy. But it  raises challenges and questions and businesses do need to move quickly to reassess their asset base and investment intentions to ensure they are not left behind.


Time to go back to the Eurozone?

Increasing discretionary spend by consumers

Outside of Greece things are looking up as consumers start spending…

All of the recent economic commentary in the Eurozone has centred on Greece, but elsewhere in the Eurozone, a positive start to 2015 suggests that consumers are responding to lower energy prices according to the latest EY Eurozone Economic Forecast. Unlike consumers in the UK and USA, consumers are spending a major share of their energy windfall; this is despite stubbornly high unemployment and weak wage growth.

As a result, we now expect an increase in forecast consumer spending growth in 2015 from 1.6% to 1.7% compared to our Winter estimate. As firms step up recruitment and labour market slack falls, wage growth will start to gather pace. As such, consumer spending will be able to sustain growth of a little over 1.3% a year through 2017–19.

…exports respond to a falling currency…

Depreciation has left the euro 7% weaker than at the start of 2015, despite recent appreciation, and weaker still against the sterling. This has reinforced Eurozone competitiveness in key export markets as the dollar soars. We expect the euro to weaken to US$1.10 by the end of this year and about US$1.05 by the end of 2016.

As a result, Eurozone exports should grow by 3.7% in 2015, while imports remain strong despite becoming more expensive.A domestic Eurozone recovery

…and business investment returns…

As uncertainty fades, so total investment should begin to grow as corporate confidence strengthens. We expect investment growth of 1.1% in 2015, before accelerating to almost 3% in 2016-17, before easing to 2.5% in 2018-19. M&A is also picking up as the weak currency, relatively low multiples and nascent economic growth make European assets look more attractive.

…creating a more positive outlook for government finances…

The nascent recovery in consumer spending is welcome news for governments, as sales tax receipts will rise too. And as consumer demand drives firms to hire more staff, employment tax revenues and national insurance receipts should be starting to rise while unemployment benefits fall. Together, these factors should help improve public finances.

…and the economy overall.

There is still a long way to go until unemployment falls to more acceptable levels and risks to stability remain. But at midway through 2015, prospects for the Eurozone economy seem brighter than for quite some time. As a result, we have raised our forecast for growth in 2015 to 1.6% from the 1.5% seen in March with 1.9% now forecast for 2016.

But is the consumer recovery real?

After several false starts, is this a real consumer recovery in the Eurozone? The early signs are positive. Household energy bills fell by around 5% in the second half of 2014 and this has translated into a 0.6% increase in consumer spending in the first quarter of 2015, a significant rise given how slow spending has been growing in recent times.

Even more encouraging is the breakdown of spending with an increase in discretionary spending. Fuel and food sales did grow in the first quarter of 2015 but expenditure on discretionary categories such as clothing, household goods and recreational equipment have grown at their fastest annual rate since 2007.

Households are also increasingly willing to purchase “big ticket” items. New car registrations rose 4.7% in Q1 2015 from Q4 2014 and 9.5% on a year earlier. Car sales remain 20% below 2006 levels, but the improvement in demand is welcome both from a spending perspective and a production/investment one – 12.7m Europeans work in the automotive sector, so recovering demand will aid the recovery in Eurozone investment and employment.

The improvement in “big ticket” demand is encouraging, as it suggests households are not only feeling the benefit from lower energy bills, but are also more positive about underlying financial prospects. Labour market conditions are key in this respect. It is perhaps surprising therefore that such a recovery in underlying consumer confidence has occurred with the headline unemployment rate having fallen by just 0.4 percentage points over the year to Q1 2015.

But this would be too simplified an assessment of the Eurozone labour market. Firstly, unemployment data refer to the stock of people seeking work. This might remain higher than it otherwise would if previously inactive people start to look for work again. This is indeed occurring in the Eurozone, with the working-age labour participation rate rising by 0.2 percentage points in both Q3 and Q4 2014. So the headline unemployment rate partly disguises the strength of job creation in the Eurozone.

Secondly, the headline unemployment rate disguises a more impressive fall in the youth unemployment rate, 1.4 percentage points in the year to Q1 2015. Youth unemployment remains high – 22.8% at the Eurozone level – but nevertheless the improvement in access to employment for the most badly-hit cohort of the workforce is a real cause for optimism.

Still a long way to go, but it is time to reassess the Eurozone opportunity.

It is good news and a balanced recovery is beginning. There are still clear risks especially longer-term around the willingness and ability of all countries to deliver structural reform. Nevertheless, businesses do need to look alone at the Eurozone and ensure they are taking the appropriate steps to respond to an improving economy.

Rebalancing at last?

After the General Election and the Budget, what is the economic outlook for business? A business friendly government…

A decisive General Election victory for the Conservative Party should mean that the economic policy framework for the next five years is both clear and predictable. And based on the sentiment expressed pre-Election with the fiscal policy contained in the Conservative Party Manifesto, the mood amongst businesses should be positive: they have a predictable and desirable policy environment.

…and a solid economic backdrop…

The UK economic recovery is continuing. Consumer spending continues to drive the economy. A buoyant labour market and rock-bottom inflation have lead to growth in real incomes of 4.5% in the year to the first quarter of 2015 and consumption has risen by 3.4%. This solid base means that, despite the continuing slowing of the outlook for the world economy and the pound’s strength against the euro holding back demand for the UK’s exports, the EY ITEM Club UK Summer forecast predicts GDP growth of 2.7% for 2015 and 2016.

…but wait a minute.

So everything is looking rosy? Well…not quite. The recovery – while continuing – is increasingly domestic in nature The net result is that the relatively positive economic outlook is based upon an increasingly unbalanced recovery with neither exports nor business investment contributing to the extent that the Chancellor’s believes is necessary to propel the UK to the position of the world’s richest economy by 2030. The post-election Budget differed significantly from the one that was expected based on the Conservative manifesto. The Chancellor has decided to gamble on potentially disrupting the economy in order to shock into moving to a higher level of productivity and ultimately a higher income level. The Government’s spending squeeze is now slower than set out in the Spring Budget, although the public sector cutbacks remain dramatic, but the slower pace of expenditure reduction has been compensated for by and the introduction of tax rises that will be worth £6.5 billion annually by 2020. Revised policy it may be, but it will still have the effect of reducing growth. Consumers will also be squeezed by the Summer Budget through a combination of the tax rises, loss of welfare payments  and reduced housing benefits. There is some compensating adjustments in the income tax system but the impact on consumers, and businesses, hinges on the impact of the ‘national living wage’ on economic activity.The Chancellor expects the national living wage to cost business £4 billion and lead to a loss of 60,000 jobs. The reduced tax on businesses’ profit is expected to deliver £3 billion of benefit to businesses and increased investment allowances should boost business investment.

…how should I interpret the productivity plan?

The key driver of the UK economic outlook is now how businesses respond to the call implicit in the Budget for business to boost investment, skills and exports. This is very uncertain and makes forecasting especially difficult, certainly more so than we expected given such a decisive poll victory. The Chancellor’s ‘productivity plan’, includes new measures to boost apprenticeship numbers and a range of other initiatives. These measures are clearly at an early stage and the productivity plan is more a collection of themes rather than a detailed plan. But at the core is the proposal for the national living wage which will change the labour market environment. The UK recovery has been built on the flexible labour market and the remarkable rate of job creation alongside a fall in real wages. We are now moving into uncharted territory compared to recent economic history.

Time to test the 5 year plan.

The economic landscape has changed significantly since the General Election with the Budget containing a number of unexpected twists. The Chancellor is gambling on business responding to the productivity challenge his national living wage creates, so that exports and investment will compensate for the fiscal squeeze and consumer slowdown. Now is the time for all companies to reassess the outlook, and formulate a five-year plan to run alongside this majority Conservative administration. This plan should involve three elements:

– First, a strategy and financial plan. This should take account of likely changes in revenues, as growth in the UK and global macro-economies slows down, and the cost base shifts under the impact of factors such as the living wage and fluctuations in currency exchange rates.

– Second, an assessment of the scope to make investments to improve labour economics, given the new wage paradigm.The key question to address is whether now is the time to accelerate the deployment of technology to improve productivity, as the relative costs of human capital rise.

– Third, a review by sector of the opportunities and threats facing the company, given its areas of activity, customer mix and business model. Depending on the focus, the factors affecting the business might include government spending cuts, investments in infrastructure, and further devolution and decentralisation of decision-making and tax-raising.

What George gives, George takes away. How will the Budget impact business?

A surprising Budget…

A crackdown on non-doms, a significant increase in the tax take and the introduction of a national living wage, it is entirely justifiable to ask if this really was the first Conservative Budget since 1992? With a wide range of policy initiatives, the Chancellor has moved quickly to set the economic agenda for the next 5 years but many of his proposals were from a new playbook.

…with slower spending cuts and higher taxes…

As promised the reduction of the Government’s deficit continues to take centre stage but spending is to be cut at a slower rate than promised in either the March Budget or the Conservative Party Manifesto. At the same time, the range and scale of tax rises over the life of the Parliament including taxes on insurance premiums, a new vehicle excise duty regime, a bank profit tax, removal of renewable energy tax breaks and further squeezes on pension tax relief was unexpected. In total, the tax take is likely to rise by £6.5 Billion in 2020. The result is a smoother profile for spending reductions allowing the achievement of surplus in 2019, a year later than previously signalled.

…though some things were as expected…

Despite the surprises in some areas, the widely expected squeeze on welfare was a key feature of the Budget with reductions in housing benefits, tax credits and a range of in work benefits. The IFS characterises these policies as being regressive and likely to impact the poorest third of households disproportionately hard.

…but the Chancellor pulled a few rabbits pulled out of the hat in his latest “rebalancing”…

The most significant surprise was the announcement of a national living wage of £7.20 an hour in 2016 and increasing to at least £9 by 2020. The OBR estimates this might cost 60,000 jobs and will cost employers around £4 Billion. The Chancellor positioned this as balancing the reduction in welfare as a way to ensure work pays…making Britain a “high wage, low welfare” economy. However, the IFS suggest that there are significant differences between the groups being impacted by welfare cuts and those likely to gain from the national minimum wage with low earners the biggest losers.

The Chancellor also plans to balance the impact of higher wage costs on business through a reduction in the rate of corporation tax to 18% by 2020 down from today’s rate of 20%, which is already the lowest in the G20. There will also be an increase in the Enterprise Allowance to reduce the impact on employment costs. Nevertheless this is a major shift in policy that will impact wage levels and may, based on early reaction, prove very challenging for small businesses to absorb without an impact on employee numbers.

…though the productivity story has yet to be told…

The introduction of the national minimum wage appears to be the first move in the Chancellor’s plan to improve productivity. More details of this plan will be provided in due course, but the Budget also contained moves to boost spending on roads, an apprenticeship levy, the devolution of further powers to the regions and the creation of a permanent annual investment allowance of £200,000.

It is difficult to comment on these initial proposals without seeing the full plan. The pressure on margins created by the national minimum wage may cause businesses to seek productivity gains but it may not. The other measures are helpful but do not appear of the scale likely to drive a rapid transformation in performance. Business certainly needs to see a more detailed plan to be able to judge its likely effectiveness.

…which is a major concern as it is the key to success.

The OBR’s forecast illustrates just how important productivity is. The base case forecast to 2020 sees GDP growing at around 2.4% a year through the period. This is hardly runaway growth and yet it is based on productivity improvement of just under 2% per annum on average. If however productivity stays stuck at the levels achieved in recent years, GDP growth will be closer to 1.6% per annum, a reduction of a third form the base case.

When we consider that the OBR forecasts the UK will fall over £300 Billion short of the £1 Trillion of exports in 2002 and that the growth of 2.4% will come about in part due to an increase in household debt to income to over 170% – higher than at the time of the financial crisis – it is clear both how important productivity is and how vulnerable the UK remains to shocks.

Not the Budget business expected or wanted.

This is a difficult Budget for business to analyse as there are some major policy initiatives but these are designed to a large extent to balance out. However, over £12 Billion of welfare cuts and £6.5 Billion of tax rises by 2002 will take demand out of the economy and slow the pace of growth according to the OBR. There are some incentives for business in the budget but prior to seeing the details of the productivity plan, it would seem as though the Budget has not created the environment in which we can expect a surge in business confidence or investment.

UK M&A activity confirms UK corporate confidence remains fragile

Our research suggests UK businesses are more confident in the global economy than in their domestic economy.

Our 12th Global Capital Confidence Barometer found a consistent pattern in business sentiment: corporates across the globe were much more confident in the outlook for the global economy than they were for their own domestic economy. This was true for all of the major economies we surveyed with the exception of Spain, where the recovering domestic economy was reflected in a positive surge in local business sentiment and India, where corporate sentiment was almost balanced between local and global views, reflecting the increased confidence in the Indian economy that we have seen in recent months. But these 2 countries were the exceptions.

Reported UK business confidence was very much in line with the observed global trends: 91% of UK businesses reported confidence in the global economy improving over the next year but only 45% saw the UK economy improving over the same period. This was also reflected in relative confidence in future earnings: 99% of UK businesses were confident in global earnings but only 62% were confident in UK earnings.

Based on the research, we forecast that UK business were increasingly likely to turn to international acquisitions as the major part of their acquisition led growth strategies. UK businesses would move to acquire companies with strong earnings in markets expected to grow, rather than in a UK economy that they were somewhat more uncertain about. The ONS has now published first quarter data for UK M&A and we can now explore how our findings and predictions sit alongside actual results.

Still no sign of a significant upturn in UK M&A…

The ONS M&A data for Q1 reveals little sign of an increase in UK M&A activity with the results confirming that UK transaction volumes remain very low by historic standards. There were 90 transactions in total involving UK companies in the first quarter of 2015, compared with a quarterly average of 289 between 2002 and 2006 and 255 over the longer period of 1997 to 2014. M&A activity has yet to recover from the impact of the financial crisis.

…either by domestic oriented businesses …

In the first quarter there were only 28 transactions between UK companies which is the lowest figure since records began in 1969. The average volume of deals between 1997 and 2014 was 193 a quarter which illustrates just how low this figure really is in historic terms. The same story holds for average deal value which at £1.1 million is around one sixth of the £6.4 million average value between 1997 and 2014.

…or by foreign investors…

It is the same story for investment into the UK by foreign companies with only 21 transactions completed, the lowest first quarter volume since 1988 and some way off the long run average since 1997 of 49 transactions per quarter.  There was a better story on average values with the Q1 performance about half the average value of deals since 1997.

…but the story is more positive on outbound transactions.

The one positive note was the increase in the volume of outbound transactions: UK businesses acquiring foreign companies. In Q1 2015 there were 41 acquisitions, an increase of 71% on the average number between 2012 and 2014 and about half the long-term average volume of activity. On values, performance was much stronger with the average deal value of £8.5 million being higher than the running average since 2001.

So should we worry? Does the UK have a confidence problem?

It is clear that the financial crisis has cast a long shadow and any stumbles or increased uncertainty surrounding the UK economy quickly transmit to business confidence and activity levels.  As the EY ITEM Club Spring forecast noted, UK business confidence has fallen since the end of Q3 2014.

The CCB results also suggest that the true level of confidence in the UK economy is almost certainly lower than the headline figures. UK business confidence is a mix of higher confidence in the global economy and lower confidence in the UK, so it is likely that the average overstates actual confidence in the domestic outlook and points to a more fragile environment than we have been assuming.

The hope is that the decline in confidence was due to increased political uncertainty at the end of 2014 and that with the General Election now over, businesses will start to move forward. However, as shown by our UK Attractiveness Survey, the looming EU Referendum is likely to impact foreign investor confidence. The M&A performance in the first quarter suggests that confidence remains fragile and there is likely to be a rocky road ahead.

Way out in front but where next? Can UK inward investment success drive productivity improvement?

Another strong year, the UK pulls away from the pack…
Once again, the UK turned in an outstanding performance in attracting FDI in 2014. The numbers speak for themselves: a record number of 887 projects, up 11% on 2103; increased European market share; and a market leading 31,198 jobs created.

…with strength across a range of sectors and geographies…
The UK’s success was broad based.  Despite a second year of decline in Business Services projects across Europe, the UK grew its Software and Financial Services sector projects, captured 35% of all European HQ moves and led Europe in R&D projects . The UK achieved a leading market share of 29% of US projects in Europe and was the top destination for investment in Europe from France, Japan, Australia, Canada, India and Ireland.

…winning more Manufacturing projects than Germany.
The UK secured 164 Manufacturing projects in 2014 beating the 131 projects secured by Germany. This was based on strong growth in the Automotive, Food and Machinery & Equipment sectors. We have become used to being told that the UK cannot compete in manufacturing but the results suggest that there is untapped potential and more attention should be given to the makers.

With resurgent regional investment…
2014 saw significantly improved performance across the English regions, Northern Ireland and Wales. Yorkshire with a 140% increase in projects, the South East up 49% and the West Midlands with a 38% rise led the way. In total, the English regions secured 344 projects, the highest total since 1998 and a sign that UKTI’s attempts to support economic rebalancing are bearing fruit.
The upcoming referendum on European Union membership is a major risk to FDI…
Stability and political predictability feature prominently in the list of desirable attributes mentioned by investors and the UK has traditionally scored very well in this respect. The UK Government is committed to a referendum on the future of the UK’s membership of the European Union. With 72% of investors citing access to the European Single Market as important to the UK’s attractiveness the referendum has the potential to change perceptions of the UK dramatically, posing a major risk to FDI .  31% of investors told us they will either freeze or reduce investment until the outcome is known.

…but the good news is that investors view devolution very positively.
The EU Referendum risk comes at a time when FDI values are falling worldwide and a reviving Eurozone is likely to mean more competition to the UK for FDI in future years. One piece of good news is that proposals to devolve more economic decision-making power to the UK regions are seen as positive for UK attractiveness by 48% of investors.

Where next? No time to rest, the UK must maximise the economic contribution of FDI.
The UK’s performance in attracting FDI is a huge success story: rising numbers of projects, higher market share and large numbers of jobs created. Yet since the financial crisis, FDI projects have increased by 29%, a much faster rate of growth than both the UK economy as a whole and GDP per head. Even more strikingly, FDI volumes have grown much faster than productivity in the UK. This does raise a question as to the potential contribution of FDI to UK economic performance. Why do we appear to see very little impact on productivity from ever rising levels of FDI? What does this tell us about the desired future strategy for attracting FDI?

The priority for action: understand if the UK attracts the “right” FDI projects?
Since 2008, annual FDI project numbers secured by the UK have grown from 686 to 887 in 2014.  Unsurprisingly, there have been significant shifts in the mix of projects during this period. Sales & Marketing investments, typically when a foreign company sets up an office in the UK, have been the main driver of growth increasing from 314 to 466 projects over the 6 year period, a growth of 48%. After a dip in 2011, R&D projects have recovered and are about 10% up over the period. Recent success in attracting HQs to the UK has seen a doubling of projects since 2011 but volumes are still over 25% below the 2008 figure. Since 2012, and especially in the last 12 months, the real UK story has been the growth in Manufacturing and Logistics projects, led by the Automotive sector, up 34% on a combined basis. Does this offer an alternative way forward for the UK?

On a first review, there does appear to be a question about how significant an economic impact the dominant growth of Sales & Marketing investments has delivered to the UK. Any investment will stimulate economic activity but if the primary driver is to sell goods and services in the UK then the economic benefit may be less than from investments that bring capital investment and knowhow and potentially create a platform for export growth. The investments in the Automotive sector are a good example of productivity and export enhancing activity. Using our data, we plan to dig deeper into the relationship between FDI and productivity and to understand if changes in the mix of FDI could help boost productivity.