EY ITEM Club UK Spring forecast

Businesses to pick up the baton from UK consumers.

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Forecast in summary

by Peter Spencer, Chief Economic Advisor, EY ITEM Club

The forecast shows growth of 2.3% in GDP this year. This is in line with the latest estimate for 2015, which was heavily dependent upon the consumer, supported by the strong labour market and low inflation.

Although these tailwinds remain in place this year, households are unlikely to be able to sustain this drive for much longer as inflation and austerity progressively undermine the growth in real disposable income. Household spending has also been growing faster than income, cutting their saving ratio to an all-time low of 3.8%.

The household financial deficit also reached a record £43 billion in 2015. However, that reflects the high level of spending on housing rather than consumption. Households invested a record £95 billion in housing last year, 7.8% of their disposable income. In contrast, their investment in financial assets, net of sales, was just £28 billion, lower than at any time since this series began in 1987.

It seems clear that the low interest rates and high equity prices engineered by central banks in response to the financial crisis have encouraged households to invest in housing rather than low-yielding financial assets. This is the main reason why their move into heavy financial deficit has not been accompanied by the surge in bank borrowing that we saw in the run up to the crisis in 2007.

On this analysis, the economy is less prone to a banking crisis than it was then. Nevertheless, in our view the high level of house prices relative to income does pose a risk to financial stability. Affordability also poses a risk to social cohesion, threatening to lock younger generations out of the housing market.

Companies have been reluctant to follow consumers in switching from financial to real investment. They continue to run huge financial surpluses, amounting to £32 billion in 2015. Companies hit the pause button last summer as risk appetite was undermined by uncertainty about the global economy and this year’s referendum on EU membership.

The forecast is constructed on the assumption that the UK remains a member of the EU following the referendum. On this view, we should see a rebound in investment following the vote, as spending held back by the associated uncertainty comes through. Profitability in most sectors is moving up to progressively higher levels, while the return on financial investments is progressively depressed. The cost of labour is also rising as the Living Wage is introduced and levies on businesses are increased.

On this view, investment adds 1.2% to GDP next year, making up for the expected slowdown in the consumer sectors and pushing the growth rate up to 2.6%. However, that looks like the high point in this cycle as inflation progressively saps consumer spending power and austerity tightens its grip on consumers and companies alike.

Business implications

by Mark Gregory, EY Chief Economist

It is time to think longer-term…

It would be easy for UK businesses to get caught up in the economic gloom and embark on very defensive strategies. However, there a broader set of economic challenges facing UK businesses which require attention. The most important of these are:

  • A slowing in the rate of the increase of consumer spending as a result of a fall in the rate of growth of real disposable incomes and a likely reduction in the high rate of job creation seen in recent years, as the higher costs of employment start to bite;
  • An increase in operating costs due to the combination of a declining pound which means import costs will increase, the return of inflation and, once again, the higher costs of employing people due to the introduction of the National Living Wage, the Apprenticeship Levy and the Single Tier Pension.

In parallel, technology continues to develop meaning there is an increasing potential to use it to disrupt current business models. At EY, we continue to see technology deals as the largest category of M&A activity in both the UK and the global economy.

With the consumer still likely to provide reasonable support to economic growth in 2016, now is the time to look beyond short-term concerns and focus on positioning the business as effectively as possible for the long-term.

…about the business model.

The UK recovery has been characterised by extremely high levels of job creation facilitated by increased labour supply and relatively restrained wage increases. With output growth increasing at a slower rate than the workforce, productivity has fallen, leading to a view that labour may have been used to substitute for capital. With labour becoming relatively more expensive, it is time to evaluate the relative balance between capital and labour in the business model and work through the implications for capital investment.

Enhancing operating efficiency is not the only way that investment can drive productivity. In a challenging economic environment, there is a need to look to new sources of revenue and here digital technology may have a positive contribution to make either in facilitating new forms of customer engagement or enabling the creation of new products and services. Looking to get more from the existing workforce by growing the top line rather than a focus on cost reduction could be a winning strategy.

But be prepared for June 24th.

The EY ITEM Club forecast, like that of the Office for Budget Responsibility, is constructed on the basis of ‘unchanged government policies’. It is therefore based on the assumption that the UK will remain part of the EU. This assumption sees business investment bouncing back after the EU referendum and therefore underpins growth of 2.6% in GDP in 2017. Business investment alone is expected to add 1.2% to GDP in 2017.

The UK could choose to leave the EU on June 23rd at which point the economic outlook would be uncertain during the period of transition. I was struck by the wide range of outcomes for the key drivers of the UK economy outside of the EU and hence the large number of possible scenarios. Against this uncertain backdrop, it seems to make little sense for companies to undertake detailed planning now. It is better to wait for the vote and respond as the details of the future environment become clear. However, a sensible approach would be to have a short-term plan on how to manage through the initial period of a leave scenario. The focus should be on stabilising relationships with customers, partners, suppliers, employees and shareholders, buying time to develop more detailed plans over time.

Financial Services viewpoint

by Gillian Lofts, Partner at EY. Leader of UK Wealth & Asset Management Business

The British love affair with property remains undimmed. Investing in homes was by far the most popular investment choice last year – perhaps unsurprising given the continuing low interest rate environment we’re living in. The financial services industry will be watching this flight to bricks and mortar with alarm given the negative knock on effect this has on their assets. Some investors have used pension cash to fund investment property, and it remains to be seen whether auto-enrolment and Lifetime ISAs will entice a new generation of savers into more traditional investments.


EY - Mark Gregory

Mark Gregory

EY Chief Economist