Capital allocation post Brexit: Into the unknown

A blog by Mark Gregory and Michel Driessen, Partner & Markets Leader, Transaction Advisory Services, EY

There is no precedent to guide capital allocation post Brexit, so don’t rely on the standard macro response, look beneath the surface for the long-term opportunity.

Brexit is unique…

There is no previous event for us to compare Brexit to. No developed country has chosen to inflict a shock of the nature of Brexit on itself.  While there is currently a great deal of noise about what the UK can and can’t do and what the impact of Brexit might be, the reality is that no-one can be sure.

…so don’t rely on the markets’ reaction…

The financial markets appear to have stabilised after the initial shock of the referendum result. But don’t be fooled. There is currently very little post-vote information on which to develop an accurate view of the future. The markets are guessing just like everyone else.  As we saw, after stabilising post-vote, sterling soon came under pressure when the first release of PMI data after the referendum painted a negative picture.

It will be the end of the summer before we have sufficient economic and financial data to develop a clear view on the state of the economy and our prospects. Now is as good a time to have a holiday, sudden decisions based on little information are as likely to destroy value as they are to create it.

…as their initial response was not very sophisticated…

The early market reaction was exactly what we would expect: a traditional response to a forecast economic slowdown:

  • Sectors and companies reliant on domestic growth were marked down;
  • By contrast, companies with exposure to export markets, especially emerging markets, were seen as benefitting from the falling pound;
  • Large cap stocks were favoured relative to smaller companies.

Chart 1

Chart 2

Things have moved a little as shown below but the market continues to favour defensive sectors and companies likely to benefit from a lower exchange rate. There has been some adjustment as demonstrated with the relative repositioning of healthcare and telecoms, possibly reflecting the potential risks of lower migration on staffing from the former and possible regulatory pressure on the latter. Deeper analysis is still required.

Chart 3

…failing to reflect the specifics of Brexit…

At first sight this appears rational, it is certainly conventional. However, Brexit could well be different as the changes in trade, migration and regulation that will come as a result will impact sectors in different ways and these may not be the same as the traditional impact that results from a general economic slowdown.

… And other potential major shifts in policy.

Brexit is a political rather than economic shock and the political shock may turn out to be more significant for capital allocation than Brexit itself. The change in UK Government policy post the referendum vote may turn out to be at least as dramatic as the move to leave the EU, if not more so.

Reflecting on the nature of the vote, the new Prime Minister has signalled her intention to make the UK economy work for everyone. In so doing, she explicitly acknowledged that more intervention in the economy than has been the case in recent years may be needed to achieve this. The new Chancellor of the Exchequer has also indicated that he would be willing to adjust the UK’s fiscal strategy to support the economy if required, another significant departure from the past.

It is possible therefore that fiscal policy will be able to mitigate other forces that are slowing UK growth. While a more ambitious industrial policy will stimulate growth in selected sectors and regions. Brexit may be an economic shock but Government policy may mitigate this and help the UK adjust more effectively to a changing world. The key implications for investment are:

  • Government spending and intervention may have a differential impact on sectors; and
  • It is not yet clear there will be a full scale economic slowdown, consumer spending may hold up better than business investment anyway, especially if public spending mitigates any slowdown in business investment.

…and Brexit is not the only change in the global economy…

The UK leaving the EU is not the only source of change and uncertainty in the world today:

  • Overall global growth has slowed driven by a significant slowdown in the emerging markets;
  • China is embarking on a major reshaping of its economy and its growth has slowed, although it remains relatively high;
  • The BRICs are no more, Russia and Brazil are both facing difficult economic conditions but India is growing strongly;
  • Capital has started to move back to the developed world as investors rebalance their portfolios.
  • The UK referendum result is just one example of an increasing challenge to globalisation and its perceived consequences.
  • Digital technology is increasingly being used to disrupt traditional business models

Focus on the future.

The future opportunities for UK based businesses will be determined by the interplay between the Brexit negotiations, Government policy and the UK economy against a backdrop of change in the global environment. A traditional macro view of M&A based on the key macro drivers alone and failing to take policy shifts into account may provide the wrong guidance.

Key investment themes

There are a number of themes for investors to explore in this complex UK landscape:

  • Infrastructure: existing assets may benefit from higher inflation which will support increased end user charges under price cap regimes, as well as lower financing costs. There is, however, a risk of higher staff costs if immigration controls restrict labour supply.
  • Government & new infrastructure: In an era of low inflation and relatively cheap finance, if the public sector does become more interventionist and commissions new projects and infrastructure schemes, there could be significant opportunity. A new runway in the South East, more road and rail schemes are possible and offer investment potential. Businesses with a presence in the sectors supplying these infrastructure projects could offer interesting opportunities.
  • Longer term exports: Global growth is slower than in the past but the recovery in the USA remains robust and India and China are both posting healthy GDP growth figures relative to other countries. It is likely that the UK will be able to secure trade deals with at least some of these countries on leaving the EU and hence the potential trade benefits go beyond the short-run gain from a fall in sterling already factored in to market valuations – there is potential upside. Now might be the time to consider acquisitions or joint ventures to create or increase exposure to these export markets ready for life after Brexit.
  • Industrial policy: The UK Government has indicated it will be pursuing a more active industrial policy. That policy is likely to favour capital intensive, knowledge based sectors that have the potential to use technology to enhance the UK’s competitiveness relative to labour intensive countries. Sectors that offer the potential to create employment opportunities outside of London could find public support is available because of the desire to rebalance economic activity geographically. Our regional economic analysis has identified Electronic and Optical products, Motor Vehicles, Machinery, Clothes, Paper and possibly Food as sectors which could provide the best regional growth opportunities.
  • Industrial supply chain: With the new lower level of the pound likely to be the norm for a significant period of time, favourable financing, and additional support, such as incentives or changes to business rates, reshoring and import substitution could become attractive propositions. If this can be allied to export growth to new markets there could be a win-win for certain sectors. Our previous work on Reshoring suggests Electronic and Optical products, Aerospace, Paints and Varnishes, Pharmaceuticals, Chemicals, Motor Vehicles and Paper were all interesting sectors worthy of consideration.
  • Digital enabler: Digital is not a new theme but there is potential for a new focus post-Brexit. If policy does move to a greater focus on industrial development then digital technology will become very important as an enabler. While there is a major focus on “the internet of things”, digital businesses that offer the potential to transform industrial processes and help address potential labour shortages if immigration is reduced would be potentially very attractive.
  • The new consumer: The outlook for consumers is uncertain. Some of the early post-referendum confidence data suggested a slowdown in consumer spending is imminent. On the other hand, Ipsos Mori reported that consumers were less negative about the short-term impact of Brexit and more positive about the long-term than before the referendum. Policy may soften the slowdown in spending, welfare reform appears to have been pushed back and more support may be forthcoming in the Autumn Statement. If the government is able to mitigate the impact of the initial Brexit shock then consumer and retail sector valuations may have fallen too far.

Look to the long-term for Brexit opportunities

Brexit is a major shock and there is significant uncertainty about the immediate outlook for the UK economy. However, the picture is becoming clearer as the new administration finds its feet and senior level meetings with other European leaders take place.  Despite the short-term uncertainty, we can begin to paint a picture of some of the likely long-term developments around trade, industrial policy and other policy initiatives. These do lead to potential opportunities which look different to the short-term market signs. There is clearly risk attached to any long-term strategy but moving now to create future options is worthy of consideration.

Brexit means Brexit…but what does Brexit mean for the TMT sector?

The markets were gentle on TMT (Technology, Media and Telecommunications) in the immediate post-referendum adjustment.

The immediate market reaction in the first week after the referendum on the UK’s membership of the EU led to little change in TMT stocks. This suggests the view was that the TMT sectors were neither significantly exposed to a domestic slowdown nor likely to benefit from higher exports to emerging markets as a result of the falling pound.

Chart1

Four weeks on and the story has not changed significantly. The Technology and Media sectors have strengthened slightly and Telecoms has slipped a little but all are very minor moves. The impression is that it appears the general view is that the TMT sectors are not overly exposed to the risks of Brexit.

Chart 2

We need to look longer-term to understand the true potential impact.

Brexit is unique: no developed economy has imposed a shock on itself of this potential scale. Brexit is a political rather than an economic shock and as such the long-term impact will depend on the interplay of political and economic factors. Three areas will be critical in shaping the long-term outcome:

  • The development of the UK economy over the next few years as the country moves towards Brexit;
  • The negotiations between the UK and the EU, and between the UK and other countries, which together will shape the future international relations of the UK; and
  • Government policy to support and develop the UK economy over the next few years.

The economy will be challenging…

The EY ITEM Club Summer 2016 forecast confirms that the domestic economy faces a challenging period going forward. EY ITEM Club is more positive about 2016 but more negative about 2017 than consensus. Broadly speaking, consensus is that aggregate GDP growth for 2016 and 2017 will be about 40% down on the level forecasters expected in the spring.

…but it is too early to call…

On the economy, despite a fall in confidence, consumer spending seems to be under less pressure than business spending. Investment and exports should be stronger supported by a lower pound. The likely developments in the key economic indicators which are most significant for TMT are:

  • Nominal interest rates will be at or close to zero for the next 2 years and real rates will be negative;

Chart 3

 

  • The pound is likely to weaken further and we should assume this lower level will become the norm, the UK’s current account deficit and the shock to trade from leaving the EU are likely to weigh heavily on the currency;

 

Chart 4

  • Inflation will return and could be running at around 2% by the end of the year or in early 2017. This could accelerate if labour market pressures caused by a fall in immigration lead to wage rises.

 

Chart 5

 

Brexit means Brexit…but what does Brexit mean?

Changes in three areas will drive the impact of Brexit on the UK and hence on the TMT businesses in the medium to long-term:

  • Trade policy;
  • Immigration; and
  • Regulation

The appointment of trade ministers has given us a first set of clues as to the future trade strategy. With a clear commitment to reduce immigration by all Ministers who have spoken about it, it seems highly unlikely that the UK could join the EEA. This leads to a future based on a bilateral deal, or a series of, with the EU.

Logic would suggest that a deal on goods should be achievable – the balance of trade between the UK and EU in aggregate and at a country level should make this attractive to most players. Goods trade is also the area easiest to fix in trade deals generally. By contrast, services and especially financial services will be tougher. The UK runs a huge surplus with the EU, averaging more than £10 billion annually in financial services, and it seems likely that EU countries will try to capture some of this activity.

We might see a bilateral deal by 2019 or possibly a default to WTO rules at that time followed by a bilateral deal in future. We can also expect the UK will start unofficial trade talks with the USA and India plus other Commonwealth and Middle East countries, with the aim of having deals in place in 2019 or as soon as possible afterwards. It is possible that the UK as a one country bloc will be able to secure competitive deals with non-EU countries faster than the EU has been able to.

Migration remains the key challenge and we are already hearing anecdotal reports of recruitment challenges and staff unease. The UK’s future labour and skills strategy is the area we know least about currently although it is possibly the most urgent area to resolve.

Regulatory change will be driven in the first instance by the trade negotiations. Other than a few possible head line grabbing moves, most of the action is likely to be post 2019 giving companies a chance to plan and position. The more urgent need is to position for and actively lobby to shape UK Government policy given the signals for change that we have witnessed in recent weeks.

What does this all mean for TMT?

The immediate impact is likely to be via the economy. Business investment may slow and consumer spending too, both of which may impact the customer base of TMT companies. Advertising spend may well be under pressure hitting media companies in particular. The weaker pound may benefit exports but the UK’s imports of technology equipment both phones and devices for consumers and technology for businesses and networks will become more expensive – margins may come under pressure.

Longer-term, the signs that the UK Government will be more interventionist may mean that the regulatory regime is subject to change. Broadband provision and mobile coverage tend to come and go on the political radar, it is possible that they will be very much back in the spotlight. On the other hand, the desire to use public spending to invest in productivity enhancing technologies could create opportunities for TMT companies. Schemes which boost economic potential and create opportunities in regions outside of London may well be eligible for public support via grants, tax incentives or investment funding.

The labour market, especially for skilled staff could be challenging if the UK moves to restrict immigration. At the same time, the development of skills and improving educational attainment is likely to be a priority and TMT sector companies should consider how they can contribute to this aim.

Phew, that was the week that was!

Retail was in the immediate post-Brexit firing line…

The immediate stock market reaction to the result of the referendum on the UK’s membership of the EU saw retail stocks heavily marked down. This was consistent with the treatment of sectors deemed to be most exposed to a domestic slowdown such as housing and the banks. By contrast, sectors with more exposure to exports to emerging markets, such as Life Sciences and certain sub-sectors of Consumer Goods fared well, boosted by the falling pound.

Retailblogchart1.JPG

…and the outlook appears challenging…

The EY ITEM Club summer forecast confirms that the domestic economy faces a challenging period going forward. EY ITEM Club is more positive about 2016 but more negative about 2017 than consensus. Broadly speaking, consensus is that aggregate GDP growth for 2016 and 2017 will be about 40% down on the level forecasters expected in the spring.

In addition, although the economic activity was slower and the Bank of England chose to hold off on any loosening of monetary policy last week, the members of the MPC have signalled a significant monetary boost is likely to be announced at their August meeting. This is likely to add to the challenges facing sterling.

…but it is too early to call…

On the economy, despite a fall in confidence, consumer spending seems to be under less pressure than business spending and investment. Retail sales have slowed but the impact so far seems less than in sectors such as to commercial property, recruitment and business investment which anecdotally appear softer. Moreover, Ipsos MORI ‘s latest survey suggests that compared to before the vote, consumers are more optimistic about Brexit having a positive impact on the economy over the long-term and less pessimistic about the short-term hit. As well as these positive nuggets, retailers with an export business should be evaluating the potential opportunity to boost overseas sales as a result of a falling pound.

…although the key parameters of the outlook are becoming clearer…

The likely developments in the key economic indicators are:

  • Nominal interest rates will be at or close to zero for the next two years and real rates will be negative;
  • The pound is likely to weaken further and we should assume this lower level will become the norm, the UK’s current account deficit and the shock to trade from leaving the EU are likely to weigh heavily on the currency;
  • Inflation will return and could be running at around 2% by the end of the year or in early 2017. This could accelerate if labour market pressures caused by a fall in immigration lead to wage rises.

Retailblogchart2

Retailblogchart3

Against this backdrop, the potential risks to consumer spending are becoming clearer. Employment growth is likely to slow as employers react to increased uncertainty and the housing market is forecast to go through a difficult period with a knock on effect on consumer spending plans.

Retailblogchart4

Retailblogchart5

Retailers will need to be agile, monitoring the market and their own customer data and ready to respond to both threats and opportunities. If domestic demand slows, could a shift of focus to export markets help to minimise the potential impact? At what point will falling import prices mean supply chain reconfiguration makes sense?

Brexit means Brexit…but what does Brexit mean?

Changes in three areas will drive the impact of Brexit on the UK and hence on retail business in the medium to long-term:

  • Trade policy;
  • Immigration; and
  • Regulation.

The appointment of trade ministers has given us a first set of clues as to future trade strategy. With a clear commitment to reduce immigration by all the Ministers who have spoken about it, it seems highly unlikely that the UK could join the EEA. This leads to a future based on a bilateral deal, or a series of, with the EU.

Logic would suggest that a deal on goods should be achievable – the balance of trade between the UK and EU in aggregate and at a country level should make this attractive to most players. Goods trade is also the area easiest to fix in trade deals generally. By contrast, services and especially financial services will be tougher. The UK runs a huge surplus with the EU, averaging more than £10 bn annually in FS, and it seems likely that EU countries will try to capture some of this activity.

We might see a bilateral deal by 2019 or possibly a default to WTO rules at that time followed by a bilateral deal in future. We can also expect the UK will start unofficial trade talks with the USA and India plus other Commonwealth and Middle East countries, with the aim of having deals in place in 2019 or as soon as possible afterwards. It is quite possible the UK as a one country bloc will be able to secure competitive deals with non-EU countries faster than the EU has been able to. There is the issue of a lack of trade negotiators but this may be a bonus it is possible to argue a new approach to trade negotiations might benefit everyone.

Migration remains the key challenge and we are already hearing anecdotal reports of recruitment challenges and staff unease. The UK’s future labour and skills strategy is the area we know least about currently although it is possibly the most urgent area to resolve. As the UK has signalled it wants to restrict migration, it may well be the first area in which decisions are announced, particularly given the urgent need to make both UK and EU nationals aware of their future rights.

Regulatory change will be driven in the first instance by the trade negotiations. Other than a few possible head line grabbing moves, most of the action is likely to be post 2019 giving companies a chance to plan and position. The more urgent need is to position for and actively lobby to shape UK Government policy given the signals for change that we have witnessed in recent weeks.

You thought Brexit was a big change

The pace of change in politics accelerated unexpectedly in the last 10 days and we now have more insight into the UK’s preferred policy direction. The early statements from the new Prime Minister and her senior team suggest that the future direction of UK Government policy may be an even more significant change than the act of the UK leaving the EU. In particular, the signs are that economic policy will be significantly more interventionist and that the previous government’s fiscal framework has been abandoned.

These changes will become clearer in the next few months especially with the Autumn Statement which will set out spending plans in detail. The issues of relevance for retailers are likely to include:

  • Infrastructure investments in rail, road, airports, ports, energy, housing, potentially with favourable Government support especially after the UK is free of EU state aid rules in 2019;
  • Spend and investment in the UK regions outside London is likely to appeal to a government keen to position prior to a 2020 election;
  • A strategy for skills and education to support greater inclusiveness will be essential;
  • Intervention in targeted areas such as executive pay, minimum pay etc.

Not as uncertain as we feared

The post-referendum debate has centred on uncertainty and of course there are huge issues still to address but we have moved forward in the last couple of weeks. For retailers, the risk and extent of a consumer slowdown is still hard to gauge but exports offer some potential respite for some parts of the market.

As well as tracking the economy it will be important to follow the Brexit negotiations and see how changes in the UK’s relationship with the EU will impact the sector. Labour market conditions could change quickly but longer term shifts in trade and policy may have the greatest impact on the shape of future portfolios and the design of business s models.

Can Brexit be the catalyst for UK economic reform?

An uncertain outlook….

The EY ITEM Club Summer forecast sets out how challenging and uncertain the economic outlook is with a significant downgrade in expected GDP growth compared to April’s forecast. Given the likely shock to the economy from the decision by the people of the UK to leave the European Union, this change in outlook is unsurprising.

Business investment and GDP

However, all the current forecasts are highly uncertain – we arguably know no more, and possibly less, than we did before the referendum. The result is clear but the UK political landscape is being rebuilt after an earthquake and discussions with the other members of the European Union have not yet started.

…unlikely to change soon…

Businesses should organise their planning and analysis in this uncertain environment around 3 time periods:

  • The short-term, probably until after the Autumn Statement, when we will have more clarity on UK Government policy and sufficient post-referendum economic and corporate data to enable us to develop a clearer view on the likely future path of the economy;
  • The negotiation period: two years seems a sensible working assumption for the process. The hope is that the options will be narrowed down as time progresses and hence uncertainty will be reduced; and
  • The longer-term: post exit when the UK will be pursuing its individual economic course. It is of course possible that a new trade deal may take longer than 2 years but the longer-term should nevertheless be significantly clearer in 2 years than it is today.

…so take the time to prepare.

In the short-term, businesses should avoid knee-jerk reactions. Absent good data, decisions made in this period are as likely to be good as they are bad. The focus should be on shoring up the business and initiating the research and analysis to enable strategic and operational decisions as we learn more.

There are obvious challenges moving forward: the EY ITEM Club expects both business investment and consumer spending to slow for the rest of 2016 and companies will need to adjust to this.

Real household income and spending

However, there will also be opportunities, especially for exporters, as the pound is likely to remain low for some time. Moreover, as the UK develops its new trade strategy, new markets may open up and existing markets could become more attractive under improved trading arrangements.

Contributions to GDP growth

Monitoring developments will be critical…

The move from the current arrangements to the long-term post-EU position will be driven by four factors:

  • Agreement on arrangements for post-Brexit, UK-EU and UK-rest of the world trade which will impact both exports and imports, the latter critical for many supply chains;
  • Approach to movement of labour between UK and EU and UK and the rest of the world with clear implications for the recruitment and retention of skilled and unskilled workers and also potentially for investment in labour saving technology
  • UK regulation in areas where EU rules no longer apply, offering the scope to “free up” British businesses; and
  • UK Government policy across a range of areas, using the potential freedom from EU “State Aid” rules to forge a new role for the public sector in UK economic activity.

Each of these four areas has clear implications for business but their impacts could vary significantly depending on negotiations. Some effects are likely to be felt sooner than others. Beyond the exchange rate effect already mentioned, shifts in trade are likely to take some time to become clear. But just the potential for changes in the current arrangements for the free movement of labour might start to impact current workforces and upcoming recruitment activity very quickly.

Close attention to the developments in each of these areas in the UK’s exit negotiations will be critical in shaping strategy over the next two years and for the longer-term. Signs of clarity are emerging, the new prime Minister has made clear the approach to the free movement of labour needs to change, and more details in other areas will hopefully emerge in the not too distant future.

…and especially not ignoring opportunity.

Some of the likely opportunities arising from the UK leaving the EU are relatively easy to identify: a reduced regulatory burden and greater trade freedom most obviously. But there are others.

With the likely slowdown in both consumer spending and business investment identified by the EY ITEM Club, the public sector may need to take up some of the slack. The referendum campaign identified concerns over immigration, inequality and geographic differences in economic opportunity amongst others, policy is also likely to evolve to address these concerns.

I expect that there will be a greater focus on infrastructure, education and skills going forward and that this will create business opportunities. It also seems likely that these initiatives will have to be delivered locally meaning an acceleration of the devolution of powers and responsibility to bodies such as the Northern Powerhouse and Midlands Engine.

The outlook is challenging and things may well be rocky in the short-term but the die has been cast and now is the time to begin to shape the future.

 

 

Political and social uncertainty has economic costs too, time to move forward

Let’s not have a “Neverendum”…

In the immediate aftermath of the UK’s vote to leave the European Union (EU), there have been a significant number of calls for a second vote. The press have runs stories about people who either apparently tried to change their votes, as they either didn’t expect the UK to vote to leave, or claimed they didn’t know what they were voting for, or felt they had made a mistake. Alongside this, some commentators have stated that Parliament is sovereign and the vote could be over-turned. Others have outlined scenarios where Article 50 is never activated and the UK moves to either a general election or second referendum before deciding to stay in the EU.

There seems little if any evidence to support the claims of the widespread voter angst that have been made based on individual statements. Opinion polls conducted after the result was announced have shown that the public generally still stand by their decision and there is roughly a 2 to 1 majority against another referendum.

…it is time to move on…

The reality is that, given the choice of “the best of both worlds” as the Prime Minister put it being in the EU but also outside by virtue of the UK’s various opt outs and the additional guarantees secured by the PM in the run up to the campaign – a majority of people voted to leave the EU.

The issue of EU membership has been a feature of British politics for more than four decades.  Several politicians in the EU have observed in the last week that the UK has spent a great deal of time criticising the EU, blaming EU policy for some of the many problems that exist in the UK today, and a positive case for Remain was not a major feature of the referendum campaign. As our work with the CBI[1] indicated, the UK has perhaps not taken all the positions available within Brussels, weakening the UK’s ability to shape policy and hence increasing the likelihood of EU proposals then not meeting the UK’s objectives – a vicious circle.

…and avoid creating further doubt for investors and businesses.

The die is now cast and the UK’s attitude to the EU is there for all to see. Many businesses made their positions clear before the vote and are now starting to work through what the implications of the vote may be. It is very hard to go backwards and so even if there was a move to change the UK’s position, it would most likely require a major swing towards favouring EU membership in order for investors to believe that the situation was stable. Further campaigning and uncertainty may well unsettle investors more than the current uncertainty as a new Prime Minister is selected and more details emerge on the UK’s approach to exiting the EU. Some delay in activating Article 50 is sensible to ensure the UK is prepared, but indefinite delay is likely to have economic costs.

Foreign investors have consistently told us that the UK’s diversity, culture and language, the stability and transparency of the political, legal and regulatory environment in the UK and the stability of the UK’s social climate are three of the UK’s most attractive attributes. In 2015[2], these three qualities were ranked in the top six of the UK’s attractiveness attributes with even the lowest ranked rated as equally attractive as access to the European Single Market. It is clear therefore that continuing to create an environment of uncertainty, which might well lead to increased social tension, is not going to have a positive impact on investor perceptions of the UK.

The Attractiveness of the UK on selected attributes.

Image 1

A positive reform agenda is urgently needed…

It would seem there is a realistic chance that access to the European market will be on less favourable terms in the future. If there are reductions in the level of immigration into the UK, then the availability of skilled labour in the UK may fall, at least in the short-term. It is important therefore that alongside working to minimise any potential negative impact in these areas, the UK does what it can to protect and even strengthen our position on other attributes.

From the list above, delivering world class education, improving labour skills and boosting both telecommunications and transport infrastructures would seem important areas. This view is confirmed when we look at what investors tell us are the priorities driving investment. Skills and infrastructure stand out as the areas for policy makers to focus on to boost productivity and increase the UK’s attractiveness.

Image 2

…and we need to start talking about it now.

Businesses, investors and the EU have got the message: the UK is a reluctant member of the EU and this is unlikely to change. Continuing to look backwards and trying to unpick the referendum result will just add to short-term uncertainty. The UK’s new status will provide opportunities to do things differently and we need to embrace this and to begin working to strengthen the UK’s competitive position. The trade and domestic agendas need to be developed in parallel, with skills and infrastructure at the heart of them.  Detailed thoughts on the required future activity will follow in subsequent blogs.

[1] Our Global Future, CBI
[2] UK Attractiveness Survey 2016, “Positive Rebalancing?”, EY

Moving forward will require a focus on domestic policy as much as a focus on our relationship with the EU

The UK has woken up a little bleary eyed to find that her people have spoken and the majority of voters have chosen to leave the European Union (EU) – a victory for the Leave campaign. So, what now? After months of campaigning, it is vital that we all accept the result, look forward and focus on the UK’s future.

The EU Referendum campaign will have consequences

A campaign as intense as this was will have consequences. I have been in 11 UK cities in the last 3 weeks and have spoken with local campaigners on both sides about the mood on the ground. Without doubt there are issues which have been bubbling beneath the surface that the campaign has brought to the boil.

The campaign has exposed divisions across the UK. The pre-vote polls strongly suggested there are clear differences by age, social class and geography on key issues such as immigration, sovereignty and the economy. During the campaign we heard concerns over access to education, the NHS and housing as well as frustration over the nature and value of opportunities in the labour market.

What are the priorities for action?

Moving forward it is vital that the issues raised in the referendum campaign are addressed. A sustainable long-term solution will look to ensure the benefits from changes in the UK’s relationship with the EU and the rest of the world and will be directed to improving the situation in the whole of the UK. Clearly the UK needs to negotiate the terms of its separation from the EU and to start to engage with other trading partners to make clear that Britain is open for business. At the same time it is at least as important to consider the domestic political agenda. This two-pronged approach is essential to get the UK moving forward together as one nation.

Europe is one key area…

As far as relations with the EU go, the priorities should be to begin the process of defining the future terms of trade and the UK’s approach to the movement of labour. This is likely to require trade-offs at some point, although the strong concerns voters raised over immigration may tie the negotiators’ hands somewhat.

…but the referendum has shone a light on many domestic challenges.

It would be wrong to interpret the vote as solely a comment on the UK’s relationship with the EU. The country is divided and any future settlement must be designed with the aim of improving the economic and social circumstances of people across the whole country. The drive to devolve economic decision-making power has already started and this now needs to be bolstered. Key components of making this a success will be the development of a manufacturing strategy and a concerted approach to build up the UK’s digital skills capability. These efforts should be integrated to the UK’s trade negotiations to ensure we are working to maximise the new opportunities available to us.

The future has to be one of inclusive growth

There is a need to think about the economy more strategically as part of the process of preparing and then running negotiations with the EU and other trading partners. How might we do this? Is there an opportunity to create a special commission or a group that can really focus on future UK inclusive growth? Many businesses will be looking to the Government to set out a five year vision for the UK that can be marketed to the rest of the world, and many citizens want to be reassured their lives will be improved. A tri-partite initiative with a national remit which involves all groups and geographies seems like a new way of thinking. It may herald the start of a new era in UK economic policy-making to sit alongside the new era in external relationships we are embarking on.

For further EY analysis click here.

 

 

Do we need a digital revolution outside of London to rebalance the UK economy?

Digital is driving economic growth…

We have to close the digital skills divide – we need a digital revolution outside of London if we want to rebalance the UK economy. 

EY’s UK region and cities forecast clearly shows the importance of the digital economy in driving economic performance. We expect the ‘information & communication’ sector to grow at an average rate of 4.8% a year to 2018, way in excess of the average growth rate of 2.3% for the economy as a whole according to the EY ITEM Club UK Spring forecast.

It is not just the core ICT sectors that are being impacted by digital’s surge. ‘Professional, scientific and technical activities’ is expected to be the second fastest growing sector at an average of 3.9% a year over the next three years, closely followed by ‘administrative and support services’ at 3.8%. The adoption of digital increases the demand for the skills in these two sectors as they are needed to implement the changes to operations and technology that will make digital a reality.

Chart 1

Source: EY ITEM Club, EY analysis

By contrast, manufacturing is expected to grow more slowly than the economy overall. I have previously discussed the importance of manufacturing to the UK and especially its role in helping rebalance the economy geographically, but there is also a close link between digital and manufacturing. Modern manufacturing is a technology based sector in which digital skills are as important as they are for the ‘information & communication’ sector.

…albeit the impact varies across the country.

The expected growth rates of regions and cities in the UK vary significantly and existing economic structure is the key driver of the differences in the short to medium outlook for individual geographies across the UK. Reading is expected to be the fastest growing city and this is as a result of its strength in the ‘information and communication’ sector which accounts for 25% of their GVA in 2015.

Chart 2

Source: EY ITEM Club, EY analysis

By contrast, Hull is expected to grow at below the national average rate and the structure of its local economy is also a major explanatory factor for this forecast: 25% of Hull’s GVA is made up of manufacturing and information & communication accounts for only 2%. Having limited exposure to the fastest growing sectors will limit Hull’s potential growth in the next few years.

Birmingham, Leeds, Manchester, Glasgow and Edinburgh all have digital sectors that are currently smaller than we might expect for the dynamism and scale of their local economies. For example, Leeds has just over 19,000 people working in the information & communication sector out of a city workforce of 372,000. This compares to Reading with 14,300 people in the sector out of a total workforce of only 84,000. There appears to be a significant potential to boost the digital sector in the North and Midlands which will act both as a source of growth in its own right but even more so as an enabler of wider economic growth in all sectors.

 Information & communication sector % of GVA % of Employment
London 11 8
Cambridge 14 9
Reading 25 13
Leeds 7 4
Manchester 6 4
Birmingham 4 3
Bristol 6 5
Hull 2 2
Edinburgh 5 4
Glasgow 5 4
Newcastle 6 4
Northern Ireland 3 2

Source: EY ITEM Club, EY analysis

The potential is clear…

EY’s UK Attractiveness survey 2016 provides further insight on the situation with respect to digital and also scientific research, another vital sector for future growth. London’s overwhelming dominance is clear, attracting as it does the majority of software FDI projects into the UK. Beyond London, the data clearly illustrates the UK’s digital divide with the majority of projects concentrated in a few regions.

2015 FDI projects

Digital Research
London 132 11
Scotland 24 23
South East 22 15
North West 18 5
Wales 6 10
W. Midlands 6 10
South West 8 6
Yorkshire and Humberside 7 5
North East 8 4
East Midlands 4 7
East of England 2 7
N. Ireland 4 2

Source: EY’s Global Investment Monitor 2016

Although the South East appears to do well, the 2015 performance lags some of the region’s better years and there are signs in the performance of Scotland and the North West that there is more to play for in the digital world.

There does appear to be a shift in the digital FDI projects towards city based establishments. The South East has been the go to destination for the technology sector in the UK for several decades but the modern software based sector may be drawn to city centre locations by the need to offer the work and life experience its potential workforce requires. A business park on the M4 corridor may struggle to compete with the appeal of city centre living in Edinburgh or Manchester, the cities driving the strong digital figures for Scotland and the North West respectively.

..with Scotland leading the way.

Outside of London, Scotland’s strength provides an interesting insight on what is needed to succeed in the rapidly changing knowledge based economy. Scotland appears to be leading the way in leveraging the power of its universities and bringing this together with business to create interesting propositions for foreign investors.

It is all about the skills.

Skills are crucial to success in the digital and knowledge economies. How good the UK and its cities/regions are in attracting, developing and retaining talent will determine overall economic growth not just the development of the digital industries. Universities are very important in this process but success requires a tripartite approach between educators, business and the public sector. This should not start at university education but needs to begin in schools, making children aware of the opportunities presented and the skills required to succeed.

We rightly celebrate London’s success in developing Tech City but we also need to ensure the North and Midlands are not merely providers of resources for the capital’s businesses. Applying the skills of our best and brightest to problems in manufacturing and research is likely to generate significant economic benefits given the potential of these sectors to stimulate wider economic activity. It is important the UK uses its scarce resources for maximum benefit.