The UK economy has held up well…
The UK economy performed much better in the aftermath of the EU referendum than many expected. It is now clear, as the EY ITEM Club recently noted, that the primary driver of this stronger performance was consumer spending which grew at over 3% in 2016, the highest rate for over a decade.
..but it is too early to celebrate the success of Brexit…
Nevertheless, even this positive short-term experience raised some concerns. Most notably, business investment fell by 1% in the final quarter, a much weaker outcome than we would expect for a growing economy with strong consumer demand, increased export opportunities (due to a weaker pound and an improving international outlook), technology driven investment opportunities, and an on-going need for catch up expenditure after the slowdown following the financial crisis.
The reality is that the short-term performance does not tell us much about the impact of Brexit, in either the medium or long-term. The UK is at the very early stage of the process of leaving the EU and businesses have focused on avoiding panic reactions and working to understand the potential implications of the UK’s changing status.
…as this is a long game.
Capital deployment decisions are, by their nature, long-term in outlook and so it will take some time before the full implications of Brexit on investment are clear. When we surveyed foreign investors in late 2016, their responses suggested no significant decline in investment over the coming 12 months but significantly increased concern about the UK’s attractiveness from 2019 onwards, i.e. after Brexit. It is clear that Brexit will be the key driver of investment into the UK over the medium to long-term. The questions this raises are: when will the impact be felt? And, what will the impact be?
What clues do we have as to how might Brexit impact the UK economy?
For business, Brexit is really a question about geography, specifically the shape of their geographic portfolio. Inward investors come to the UK for three main reasons: to sell to UK customers; to use the UK as a base to export, primarily to the EU; and to access specific features of the UK such as research skills and UK financial services’ capability. If businesses become concerned about the UK’s prospects in one or more of these areas then the result is likely to be lower levels of investment than would otherwise have been the case.
UK businesses have to decide on where to allocate their resources. How much to devote to export activity and for which markets? Domestically the key decision is between make or buy their inputs, covering both capital and labour.
Financial markets suggest some concern about growth in the domestic economy…
Financial markets have been strong since the referendum vote and the indices are above their pre-referendum levels. However, more detailed analysis of multiples suggests that investors have concerns about investing in companies exposed to the UK domestic market. By contrast, their view of UK export oriented companies appears relatively more positive.
…which is feeding through to corporates…
My information at this time is largely anecdotal but may partly explain the fall in business investment in the fourth quarter. Capital decisions are being put under more scrutiny and sometimes delayed. For groups with opportunities to deploy capital internationally certain marginal allocations are now being deployed to locations other than the UK, especially into markets where growth is strengthening. I have been in several discussions in which, for the first time since 2010, potentially improved prospects for growth in Europe are influencing corporate thinking.
…even those with trade opportunities…
Although the stock market performance of export oriented companies has been relatively strong and there have been a number of high profile commitments to the UK, we are also seeing signs of moves to adjust to a future in which the UK is less attractive as a base for exporting. Concerns raised in discussions include the challenges that would be caused by tariffs on exports and for many manufacturers. an even greater concern is the potential disruption to supply chains through the emergence of non-tariff barriers, especially delays at customs. Other worries include the difficulty in competing for public sector contracts in the EU from a UK base and the risk of separate product standards emerging between the UK and the EU over time, risking increases in manufacturing costs due to losses of economies of scale.
…putting the focus on the UK as a base…
Noise in the market suggests that the UK may also find it harder to maintain its attractiveness in other areas in future. In regulated sectors such as life sciences and financial services, being outside of the EU regulatory regime is causing concern while the UK’s appeal as a HQ destination (over 50% of all HQ investments in Europe in 2015 were in the UK) is coming under review. This is partly because of concerns over the ability to influence policy from a UK base, but also because of potential problems that will be caused if people are not able to move as freely as is the case currently.
It is clear that, while there is no mass exodus underway, companies are now working to create options around their future structures. This includes looking at the tax implications of different organisational models and setting up skeleton structures, as well as subtle moves of people and the investigation of real estate options for future moves. Some investment is on hold and a smaller amount has been redirected, marginal at this stage, but nevertheless concerning.
…although opportunities as well.
The activity is not all one-way. Although EY’s recent European survey identified 14% of UK based businesses are considering moving some activity elsewhere, 2% of businesses not established in the UK were also considering moves, some of which might be to the UK. Just as UK companies may require an EU base to sell to the EU market, EU based companies might decide to locate in the UK, if the UK market is important to them.
Moreover, if the pound stays weak, the opportunities to sell to the rest of the world will increase. This opportunity could be further advanced as the UK signs new trade deals after Brexit, opening up new market opportunities. We’re also seeing companies reviewing their supply chains and considering investment in more UK capacity to adjust for higher import costs and the possibility of more cumbersome customs processes. This may create new jobs, but could also accelerate the adoption of new technology to create highly efficient operations.
Risks to the downside suggest a case for more Government action
The stronger than expected performance of the economy risks creating complacency. While growth has been positive, there is a degree of activity by corporates to create options for their future business that on balance is likely to mean less investment in the UK in future than would have been the case without Brexit.
The risk is that current moves mean that the UK loses out on investment in skills and productive capacity to an extent that will make it difficult to catch up in the future. Businesses may move to reshape their UK operations into sales offices, meaning the UK risks losing investment in more strategic activity. The economy does not look likely to fall off a cliff, but we can expect to see a slow but gradual decline in investment while uncertainty about the UK’s future relationship with the EU hangs over the economy.
In this uncertain environment, Government needs to do more to reassure investors and corporates. The starting point should be to add more ambition and detail to the industrial strategy. For example, more strongly identifying sectors and activities that will be prioritised and provide increased resources and support for economic development in the UK’s regions. Waiting is not an option, the UK needs to be investing more than in the past to position for life after Brexit, maintaining our existing strengths and adding new ones.