EY ITEM Club Autumn forecast

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Are businesses over-confident?

Confidence in corporate earnings seems very high

EY’s 10th Capital Confidence BarometerEY Capital Confidence Barometer indicates that businesses believe economic conditions are weakening. In addition, 37% of businesses cited political risk as their primary concern going forward. Yet despite this backdrop, 93% of the UK companies surveyed are confident in their future corporate earnings, compared to 71% six months ago. Can we reconcile these two sets of respondents?

Lessons from the crisis underpin confidence

Drilling into the detail it appears that that companies believe that the lessons learned in responding to the global financial crisis mean they will be able to manage their way through a difficult economic environment. The intention is to up the focus on operational efficiency and costs with a near 50% increase in the number of businesses intending to prioritise cost management in the 6 months since the last CCB.  This more measured outlook is also reflected in their approach to M&A with all the signs being of limited M&A activity.

But can they deliver?

However, as highlighted in our Q2 Profit warnings Report, profit warnings have been increasing. This seems at odds with the confidence corporates have in future earnings.
We found that in Q2 around a fifth of profit warnings were due to adverse currency movements and almost another fifth due to pricing pressures and tougher than expected competition. This suggests that corporates are either over-confident in their ability to manage, or have an unrealistic view of the environment or have inappropriate forecasting processes, or, of course, some combination of these possible explanations.

Integrated forecasting is required

In a complex, uncertain environment more effort is required to develop forecasts than in a world with steady state growth. It is truer than ever that the past is no guide to the future, long-standing historic relationships and correlations have broken down and so the drivers of performance require regular and detailed analysis.

The economic environment has become more uncertain and the range of potential outcomes has increased. In the pre-crisis decade the growth in emerging markets drove global growth but we are now in a world in which potential outcomes could be significantly different. For example, the Eurozone slipping into recession would have very different implications to a banking crisis in China. We do not have perfect foresight but companies can use scenario analysis to identify the potential impact of alternative outcomes and to develop appropriate plans to respond. Companies believe they can manage but good process is required to ensure they can.