Will businesses pick up the Chancellor’s gauntlet?

EY ITEM Club says businesses must increase investment and exports for the Chancellor’s summer Budget to succeed.

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Forecast in summary

by Peter Spencer, Chief Economic Advisor, EY ITEM Club

The UK economy continues to be buffeted by world events, with the developments in Greece and the Chinese stock markets being of most concern recently. However, domestic demand remains buoyant and the pace of activity has picked up nicely since the slowdown apparent over the winter months. We see GDP growth of 2.7% both this year and next, with CPI inflation remaining well below target.

The latest data show consumers racing away in the fast lane of the economy, fuelled by a strong labour market and low inflation. This pace looks set to continue into next year as the strong pound and weak commodity prices keep inflation subdued. However, with manufacturers well and truly stuck in the slow lane, the economy is becoming increasingly unbalanced.

The recovery in our European markets seems to be well-established, although so far, the benefits to UK exporters have been offset by the weakness of the Euro. The US economy has revived after its winter freeze and the Fed is preparing to increase interest rates, perhaps as soon as September. Recent UK labour market data look similar to those in the US, but we do not think the MPC will be in a hurry to follow, largely because the move to a much tighter fiscal framework in the UK suggests an accommodative monetary stance. On this view, interest rates are unlikely to move above 3% until 2019.

The path to prudence in the Summer Budget is more gradual than the rollercoaster we saw last March, but the new surplus target is very challenging. It means a major increase in taxes on households as well as a massive squeeze on welfare payments. The Chancellor has effectively passed the prime responsibility for supporting low income working people over to employers and this poses a clear risk to hours and employment.

Moreover, if the public sector is to move from heavy deficit into surplus, the private and overseas sectors must move in the opposite direction. Despite the squeeze, households will be reluctant to move further into deficit, so realistically it is now up to companies to increase investment and exports to make the Budget strategy work. Otherwise growth and imports will have to slow down to swing the balance of payments and government accounts back into surplus.

Ultimately the success or otherwise of the Budget strategy hangs critically on the way that the business community responds to the challenge. We believe that companies will respond positively and that spending on investment and training will both enhance efficiency and ease the difficult path towards a government surplus. We expect the continued success of UK service exports and the prospective recovery in overseas investment to lead to a substantial improvement in the balance of payments. This will also support the Budget strategy and help to rebalance the economy away from its dependence on consumer spending.

Business implications

by Mark Gregory, EY Chief Economist

The UK consumer continues to drive the economy. A buoyant labour market and rock-bottom inflation have led to growth in real incomes of 4.5% in the year to the first quarter of 2015 and consumption has risen by 3.4%.

However, the wider slowdown in the world economy and the pound’s strength against the euro are holding back demand for the UK’s exports. So the recovery – while continuing – is increasingly domestic in nature

The net result is a relatively positive economic backdrop, but also an increasingly unbalanced recovery that the Chancellor’s post-election Budget risks disrupting. While the Government’s spending squeeze is now slower than set out in the Spring Budget, the public sector cutbacks remain dramatic – and the introduction of £6.5bn of tax rises by 2020 will have the effect of reducing growth.

Consumers will also be squeezed by the Summer Budget through a combination of tax rises, loss of welfare payments and reduced housing benefits, potentially offset to an extent by the ‘national living wage’, if employers pay it. And while the reduced tax on businesses’ profit and increased investment allowances should boost business investment, taxes and the costs of paying the living wage will act to mitigate their effects.

Looking forward, EY ITEM Club expect UK GDP growth of 2.7% for 2015 and 2016, slowing to 2.4% in 2017. However, the uncertainties around the impacts of the Summer Budget – and not least over how businesses respond to its implicit call to boost investment, skills and exports – make forecasting especially difficult at the moment.

In the background is the Chancellor’s ‘productivity plan’, including new measures to boost apprenticeship numbers and implement the living wage for over-25s. However these measures are clearly at an early stage, with the productivity plan being a collection of initiatives rather than a detailed plan.

What does all this mean for business? 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. A 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 these characteristics, the factors affecting the business might include government spending cuts, investments in infrastructure, and further devolution and decentralisation of decision-making and tax-raising.

With the new government’s overall majority making it likely to serve its full five-year term, it would seem that business should have greater certainty against which to plan than for several years. But the questions surrounding so many aspects of the UK and global economy mean sound planning must still be accompanied by agility – and an ability to respond at pace to new shifts in the business environment.

Retail viewpoint

by Julie Carlyle, Head of Retail , EY

As this latest EY ITEM Club Forecast underlines, the caffeine shot of rising real wages and employment combined with low inflation has sent consumers into what looks – by recent standards – like a shopping frenzy. The result is set to be a 3.2% rise in consumer spending for 2015 as a whole, followed by another 2.5% next year.

The buoyant mood is underlined by recent figures, with the ONS’s latest retail sales statistics showing year-on-year volume growth of 4.6% in May. This was the 26th consecutive month of year-on-year increases – the longest period of sustained growth since May 2008.

Clearly, consumers’ storming comeback from the dark days of the downturn represents great news for retailers. But, as ever, all good things come to an end – especially strong retail environments. And it’s time to raise some warning flags.

Why? If you look further out, a number of the factors that are currently sustaining consumer confidence and spending – such as historically low interest rates and inflation – will start to turn round at some point, certainly by the second half of next year. There’ll also be a dampening effect from the tax rises and welfare cuts announced in the summer Budget. And in some areas of the industry, notably supermarkets, consumers’ quest for value that has driven the dramatic rise of the discounters will continue to bear down on prices.

Given such factors, EY ITEM is forecasting that overall annual growth in UK consumer spending will slow to 1.9% in 2018. And as past experience has shown, this slowdown will be spread unevenly across different sectors of retail – with some maybe even seeing declines.

This tightening is in prospect at a time when retailers are already under heavy pressure to raise their game. In today’s increasingly digital world, consumers are becoming accustomed to seamless, instant and personalised service in more and more areas of their lives. As a result, their expectations of what retailers can deliver – integrated omni-channel buying experiences, same-hour click-and collect, and more – are rising relentlessly.

The problem is that few retailers’ existing infrastructure was ever designed to fulfil these kinds of expectations. So to meet and stay ahead of them, retailers need to invest in upgrading their systems and processes – or see consumers move on to competitors who’ve already done so.

So, while consumers’ current buoyant mood is great news for retailers, this ‘expectation-versus-infrastructure’ pressure means there are tough times and difficult decisions ahead. And, significantly, this was the case even before the announcement of the new ‘national living wage’ in the summer Budget. Much media comment has focused on the potential impact of the living wage on retailers’ costs, given that they employ so many people on the existing minimum wage. But, in fact, the living wage will be just one more factor ratcheting up the pressure on retailers’ costs and margins over the next couple of years.


EY - Mark Gregory

Mark Gregory

EY Chief Economist