Happy New Year…or is it? Welcome back to risk and return

EY ITEM Club comes into its own…

EY ITEM Club was created over 25 years ago by companies wanting a business view of the economy. EY’s sponsorship ensures the two-way interchange between economics and business continues and the Winter 2014-15 forecast illustrates how important and powerful this relationship is.

The forecast is for increased GDP growth in the UK but against a backdrop of increased risk and uncertainty. This creates a very decision environment  for business: opportunity exists but things could change very quickly. While the economic forecast implies businesses should accelerate their ambitions, the pragmatic business view leans towards a more cautious view in the light of potential risks. The EY ITEM Club model attempts to calibrate for the range of likely responses but ultimately the aim of EY’s sponsorship is to facilitate the debate and analysis around the risk and return trade offs: exactly the situation we now find ourselves in. I explore the specific issues for business to take into account below, this is based on the content of our pre-launch discussions with our clients on the outlook and implications.

Cheaper oil driving growth and potential returns..

The dramatic decline in the oil price in recent weeks means that the UK economy, driven by much higher consumer spending,  is expected to grow by 0.5% more than was likely only 3 months ago, according to the EY ITEM Club Winter forecast. GDP growth in 2015 of 2.9% is a significant shift from the previous view of 2.4% and points to a dramatic change of gear for a UK economy that appeared to have been slowing in the last quarter of 2014.

EY ITEM Club UK Winter Forecast 2014-15
EY ITEM Club UK Winter Forecast 2014-15

The good news does not stop there. EY ITEM Club have upgraded their forecasts for 2016 through 2018 as well and we are looking at annual growth of almost 3% for the four-year period. Inflation in 2015 is forecast at zero, yes..ZERO and does not reach the Bank of England’s target until 2017 at the earliest, which means interest rates are likely to remain unchanged in 2015.

EY ITEM Club UK Winter Forecast 2014-15
EY ITEM Club UK Winter Forecast 2014-15

…but risk is back as well…

While the UK economy appears in rude health, the risks are increasing. The oil price is the most obvious risk: a rapid rise could remove many of the recent benefits. But there are other economic and political risks on the horizon.

The Eurozone crisis has returned and the upcoming election in Greece is the most immediate problem, but beyond this the signs are that the Eurozone economy continues to struggle. The ECB appears to be moving towards Quantitative Easing but although a boost to the European economy should be good for UK exports, the immediate effect of QE would most likely be to weaken the Euro and hence damage UK competitiveness.

The UK General Election in May is a looming political risk with the differences between the two largest parties greater than in recent memory, meaning uncertainty is that much higher. Beyond the immediate economic policy differences is the threat of a referendum on EU membership – several EY clients have already asked for our view on what this might mean.

There are political risks in all regions, Russia, the Middle East and Korea for example but the greatest economic risk is policy uncertainty. With lower global growth than before the financial crisis, there is huge pressure for structural reform nearly everywhere, not just in the Eurozone. Major economies such as China, India, Brazil and Japan are all working to reform their economies as are many other countries such as Mexico and Indonesia. There are few sure bets in the global economy.

The key question…is it time to be brave?

A 0.5% revision upwards in the EY ITEM Club forecast in 3 months and the unexpected move by the Swiss National Bank int he last week, show how difficult this economy is to call.  The EY Analysis of UK profit warnings for Q3 2014 confirms this: the Uk saw the highest Q3 warnings since 2008 with pricing, competitive intensity and currency movements all cited as reasons for earnings missing expectations despite 2014 being a good year for the economy. But with strong GDP growth forecast for several years ahead, is this now the time to take a risk?

It is certainly time to get ready…

There is sufficient uncertainty to make companies nervous about pushing ahead aggressively even though the potential returns appear attractive. The consumer is expected to lead growth with business investment set to follow, but it is the corporate sector that is most sensitive to the economic and political risks.

It will be a brave company that would go out all guns blazing. However, with significant returns potentially available, it would also be remiss of leaders not to explore the opportunities and to make plans. Several of the risks identified, Greek election, UK General Election, QE and the ECB are likely to play out in the next 3 to 6 months so preparing now and monitoring the situation would seem to  be the sensible option.

…revisit those forecasts and develop options…

Almost certainly, given the rapid change in outlook, business forecasts for 2015 are conservative, at least for consumer facing companies. The starting point for planning therefore is a review of these forecasts and the supporting economic assumptions to ensure there is a robust “base case” forward view.

Once the base is established, the plan should be tested for the likely variability in the major potential assumptions (eg oil price, consumer spending growth, business investment) and shocks such as the Eurozone, UK General Election and business specific risks such as changes in China if this is a major destination for sales. The aim of this process is to size the up and downsides and identify potential actions, such as investment if conditions improve, cost management if there is a decline, and create contingency plans.

“it is “business as normal”

After a period of growth on all fronts, the world moved into safety first mode. In both cases, decision-making was relatively straightforward. We are now heading back to more uncertain times with potential higher rates of growth and hence return, but with more risk.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s