EEF blog

Today’s inflation report brings a more positive tone to the future outlook than has been seen for a while, with both the output and inflation forecasts having been revised in a positive direction. The improvement was driven by signs of early momentum picking up in the wider economy. We look at some of the reasons behind each of the revisions in turn.

Output forecast revised up

The upside surprise of 0.3% growth in the first quarter of this year underpins a number of other indicators that give rise to the expectation of stronger GDP growth over the course of this year. Demand and supply are expected to pick up gradually with a number of factors contributing to this change in view. While employment has fallen back somewhat, it is expected to pick up more than previous estimates, household real incomes have led to some up-tick in consumption and the extension to the Funding for Lending Scheme is expected to ease credit conditions and boost demand.

Risks do remain, however, and the recovery, though slow, will depend on how households and businesses respond. The international environment will continue to weigh on sentiment, particularly those risks pertaining to the Eurozone.

Inflation forecast revised down

In the past couple of months inflation remained sustained but for the first time in a while the forecast has been revised down though it will still take the best part of two years to return to target. The slow return to target is expected as administered and registered prices are to remain elevated.

The improvement in the overall forecast was driven by expectations of external price pressure being lower and higher labour market participation dampening down domestic pay pressures.

All in all, the picture is somewhat more positive but the overall trends are not much changed. Inflation will continue to remain above target for some time and, while the economy will remain subdued, it will be growing. As we have mentioned in an earlier blog we want to see the government doing everything possible to support growth, by providing more certainty to business that they have a plan get the economy growing again and ensuring decisions, such as the upcoming spending review, do everything possible to support growth.

In recent weeks sterling has been falling.

One pound will now buy you about €1.17. On January 1st this number was €1.23; you could have had an additional six Euro cents for every pound you traded as little as a month ago.

The reasons are better sentiment about Europe, and weak UK GDP data.

This has been brought about largely by better sentiment with regards to the Eurozone. As exits from the currency region have looked less likely, so the Euro has become stronger. However, the pound has also fallen more recently following poor GDP numbers announced on the 25th January.

These GDP numbers suggest that the UK economy shrank again in the fourth quarter of 2012, and a fabled ‘triple dip recession’ is looming. Although we expect some growth in every quarter this year, a weaker 2012 hits our forecasts for 2013, and the impact of last week’s data – taken in isolation – would imply that the UK economy will now grow a meagre 0.8% this year. 

But nothing ever happens in isolation, and as sterling falls, there is the inevitable question as to whether this will benefit the economy.

There are some benefits associated with a weaker currency.

The good news is that a weaker pound should be good for exports. We forecast that if the pound were to remain at its current level throughout 2013, then exports would be about 1% higher than in our baseline forecast.

This would be positive for the economy, and GDP growth would be around 0.2 percentage points higher than in our baseline scenario.

But the benefits of depreciation don’t always play out in reality.

As we saw earlier in the recession, when sterling fell markedly, exports did not perform anything like as strongly as expected (see this blog from 2010 where we’ve discussed this issue)

Andrew Sentence explained this pretty neatly in an article for City AM last week.

“Exporters in a mature industrialised economy like the UK do not respond to short-term currency movements... British exports are… not highly price-sensitive. Within manufacturing, our main exports are high value-added products which sell on the basis of quality and technology.”

And there are losers from a weaker currency too.

In addition, even if a weaker sterling is good for exporters, it’s not great news for companies that import a large proportion of their inputs, and it’s not good news for consumers. Because weaker sterling increases the prices of imports, a depreciation of the exchange rate will boost inflation.

Under our depreciation scenario, CPI would average 2.8% over 2013, compared with our current forecast of 2.2% this would further increase the squeeze on households (knocking 0.2 percentage points off growth in consumption in 2013) and this may lead to increased wage pressure.

Nonetheless, weaker household spending offset by stronger exports would be positive, in the sense that this is part of the rebalancing our economy needs to see, but this can’t be guaranteed. In particular, if trouble erupts in Europe again, there may be further swings in exchange rate, that more than negate the advantages of a depreciation. 

Exchange rate volatility poses challenges for companies.

Unstable currencies can be hugely problematic for companies who are engaged with international markets. A volatile exchange rate can make it difficult to set prices and erode margins within a matter of weeks.

In our recent Executive Survey, 37% of manufacturers told us that they saw significant movements in exchange rates as a key risk to their business in 2013, with medium and large sized companies – those more likely to be exposed to multiple export markets – particularly concerned about this risk.

While there are reasons to think sterling’s recent depreciation might benefit the UK economy, things are rarely as straightforward.

Further reading: Sterling depreciation... a side note

Last week I had a look at what we are expecting to happen to manufacturing sectors in the UK in 2013. Today I look at some international and global indicators.

Overall 2013 is looking brighter than 2012 with global growth, world trade and stock market prices picking up. Inflation and real commodity prices are expected to fall. Yet challenges and risks remain including on-going issues in the Eurozone and the stability of the middle-east so we do not expect the year to be plain sailing. Our own Executive survey shows that UK manufacturers are expecting things to pick up in 2013 but they also recognise both the risks they will face and the opportunities that exist in the coming year.

On Monday Andrew outlined our recommendations for improving access to finance for SMEs. Over time access to finance has been becoming more and more difficult for SMEs. We have seen changes in a number of finance conditions that are adversely affecting SMES, the main ones being:

• The availability of bank finance has tightened: The Bank of England’s Credit Conditions survey shows fewer lenders are reporting increasing the availability of finance for small companies and EEF’s own Credit Conditions Survey shows some declines in the availability of borrowing for both new and existing lines of credit.
• The cost of finance has been rising: Spreads and fees on small business lending are increasing according to BoE’s Credit Conditions survey.
• The terms and conditions of finance have changed: anecdotal evidence suggests personal guarantees are becoming more common and the covenants in lending agreements are being applied more rigorously.

SME access to finance issues are one of a number of factors holding back investment and ultimately growth

The OBR has successively downgraded forecasts for business investment in 2012 and 2013 and cumulatively, actual investment is down by more than £20 billion when compared to initial forecasts in 2010. Not all of this can be attributed to access to finance but there is enough evidence that shows us that this is a material issue:

• A recent EEF survey found that 37% of manufacturers have viable investments going unfunded due to problems accessing the finance they need. The equivalent figure was higher for SMEs, with almost half of saying they were unable to fund viable investment because finance was not available at the right cost, with the right terms and conditions or investors lacked knowledge of manufacturing businesses.
• Official data also shows a close correlation between business investment in the UK and total outstanding loans to businesses.

As Andrew pointed out in his earlier blog, we need to see SMEs investing and growing. Lowering the cost and increasing availability of finance for SMEs will go a long way helping them do just that.

We need more competition in SME banking

Access to finance challenges have been debated and discussed a lot in recent times. The Government has also acknowledged the issues and has introduced a number of interventions such as Funding for Lending, the Enterprise Finance Guarantee and Project Verde and more work is underway looking at an aggregation institution and the role of a business bank in grouping all government’s finance interventions. We support these interventions and believe they will have an impact in the short term and at the margin but further action needs to address the underlying structural problems in SME banking.

Structurally, the UK SME market is very concentrated: 85% of the UK SME market is concentrated in four providers (and has become more concentrated over time). Studies have shown that markets with higher concentration in the banking sector have higher average lending rates than less concentrated sectors. Lowering concentration through increasing competition in SME banking would therefore be one way of reducing the cost of finance for SMEs.

There are other benefits of greater competition, particularly from the entrance of a new player into the market: A new bank would be able to provide an additional source of credit to SMEs, increasing the amount of finance available on the market. Not only this, a new bank would be able to take advantage of a healthy balance sheet to access cheaper lines of credit which could then be passed onto customers.

We believe there is a clear case for increasing competition in the banking sector and, with some fast action, improvements in the availability and cost of finance for SMEs could be visible within five to ten years. On Friday we will outline our specific recommendations for increasing competition in SME banking.

Lord Heseltine today published his review No stone unturned in pursuit of Growth. The review is a welcome recognition of some of the key issues that are holding the UK economy back from the growth that the UK needs.

• The need to improve the competitiveness of the UK as a place to do business, and
  
• The need to have a more joined-up government placing a greater focus on growth.

Lee outlined some of the aspects we thought this review needed to address in her blog yesterday, in particular the need for changes that lead to a reduction in the hurdles that companies face in successfully investing and innovating across our economy.

So what do we think?

Lord Heseltine’s review has provided some much-needed thinking on how we can create a more competitive and stronger economy.

Now the proverbial baton has now been passed to the government. The government needs to consider the proposals carefully to ensure that they offer value for money, that the proposals will not lead to unintended consequences that could adversely affect industry and how they can be made to work in practice.

Some of the review's recommendations in brief 

The review is very wide-ranging and makes 89 recommendations focusing on how the government interacts and impacts industry. Recommendations cover issues ranging from the structure of the private sector to the structure of government, the link and relationship between central and local government, as well as specific policy areas such as skills and innovation. There is too much to cover effectively in one blog so I have summarised some of the key areas.

Improving the structure of government

The review recognises the lack of ownership of the growth problem across government, with many departments not placing a sufficient focus on the extent to which their policy impacts growth. The review recommends

• Setting a clear economic strategy;
  
• Establishing a growth council chaired by the PM with the aim of driving the government's growth agenda;
  
• Establishing sector councils; and
  
• A range of recommendations aimed at strengthening the civil service.

Establishing a central group to focus on and drive growth is a positive move and in line with the recommendations we set out in EEF’s A route to Growth. Making sure the group has the teeth it needs to make a difference is important – it should focus not only on strategy but also on implementation, and how it interacts with and works across government and with other areas of government (i.e. sector councils if established) needs to be clear so that it doesn’t become just another bureaucratic step in the policy process.

Increasing control at the local level

Lord Heseltine identifies a lot of the key issues at the local government level – the need to rationalise local government and simplify its funding, the need to get better value for money from expenditure and to improve the way it engages with business. Recommendations include

• Giving LEPs the resources and authority to drive local growth and act as an effective ‘business voice’ on key issues;
  
• Consolidating ‘growth-related’ local funding (e.g. business services, houses, infrastructure, skills) into a single pot and allocating on a competitive basis over a longer time horizon; and
  
• Encouraging a local government landscape with fewer, single-tiered, authorities.

Heseltine rightly points to the need for simplification of local government. Dealing with one authority rather than several is easier for businesses. Giving LEPs the tools and funds to make a real impact on issues such as planning and transport, and the power to cut through the obstacles to growth at the local level makes sense and may well drive efficiency across areas like procurement.

Simplifying local funding and driving efficiencies by making it more competitive are good ideas. However, government needs to make sure that LEPs and local authorities are up to the task before giving them control of large pots of public money and there are areas where it should be cautious about giving them additional powers. Plus the government must not underestimate the administrative task of running and assessing a five-yearly competition for a £50bn fund.

Boosting science and innovation

Broadly speaking, the review correctly identified the problems with innovation and science: the UK spends less on R&D and innovation than many competitor nations and there are issues with the procurement of innovative goods, namely that public sector procurement can too often tend towards ‘best price’ and ‘off the shelf’ solutions rather than looking at long term value, and the impact of decisions on industry. Recommendations include

• Committing to long-term stability of science funding;
  
• Greater use of public procurement standards across government;
  
• A role for LEPs in delivering innovation policy; and
  
• Expanding the TSB’s area of responsibility.

While many of these are in line with current policy, the role of LEPs and an expanded role for TSB need to be carefully thought through to ensure the right level of resources are provided and incentives are aligned.

Improving support for businesses, including advice and support for exporting

The review identified problems with the provision of advice and support to UK businesses. It suggested access to and knowledge of the right advice and support are not helping UK performance, including the UKs export performance. The review suggests some solutions to address this issue including

• Using the Chambers of Commerce to be one-stop shop for business with easy access to business services including advice and support on exporting.
  
• Strengthen international chambers, especially in key growth markets.

The Review’s focus on support for improving access, advice and support for business services is positive. Industry will welcome the Review’s focus on support for exports which needs to be better resourced, better marketed and more accessible.

As Felicity pointed out in her blog yesterday, we face a substantial challenge getting the economy back on the path to growth. Without an explicit growth strategy, policy pulls in different directions making the task even harder.

The fiscal mandate provides a clear path towards reducing the deficit – all parts of government are committed to achieving, the OBR measures progress towards it, the chancellor is accountable for it and it can be explained in less than two minutes.

We need something equivalent for growth, we need an industrial strategy.

Key components of our industrial strategy:

1. A vision for the economy

2. Coherence across government

3. Accountability

The vision (in two minutes)

The vision should provide a clear, simple and bold statement that gives businesses a compelling reason to invest here.  Like the fiscal mandate, our vision for the economy can be set out in two minutes.

_______________________________________________

The UK needs to generate better balanced growth and maintain its position as a leading economy. Four ambitions, set out below, spell out the vision for the economy and can be used as a compass to make sure we are on the right track.

Ambition 1: More companies bringing new products and services to market

Ambition 2: More globally focused companies expanding in the UK

Ambition 3: A lower cost of doing business

Ambition 4: A more productive and flexible labour force

_______________________________________________

Why these ambitions?

Ambition 1 

The UK must be a leading destination for all aspects of innovation to anchor production and compete with rising R&D intensity across the world. We know that UK manufacturers are planning for growth and they are innovating.

» If we have More companies bringing new products and services to market companies will be investing and innovating which is central to supporting their ambitions to grow.

Ambition 2 

The UK must be global in its outlook and create a dynamic business environment that supports high-value investment and job creation. Manufacturers have an appetite to invest, we need to give companies every reason to do it here in the UK.

» If we have More globally focused companies expanding in the UK we will know that the UK business environment is competitive and companies have good reasons to invest in the UK.

Ambition 3 

A competitive business environment is important but the job is not done in some areas, such as energy costs. The UK must provide a stable, predictable and competitive regulatory environment and cost base. 

» If we have A lower cost of doing business companies will be supported to grow with more cash available for innovating and investing and the UK will remain a major destination for foreign investment.

Ambition 4 

Skills needs are increasing and companies are struggling to attract the people they need. The UK must have the talent that a diverse and agile industrial base requires to be competitive in 21st century global markets.

» If we have A more productive and flexible labour force firms will have the right skills to respond to shifts in demand, changing customer needs and economic factors.

As recess draws to a close, policymakers need to start to tackle the thorny issues that still face our economy.   

Apart from the weather, summer has been a time to celebrate some of the successes of Britain – not just in sport but also as an industrial economy. However, today's statistics show the events of summer have not raised consumer confidence as expected and this could be risky as a pick up in consumption is expected provide some moderate support for growth in the second half of this year. 

Our summer reading list has discussed some of important issues that will contribute to a resurgence in growth in the short, medium and long term.

• We have discussed the need to stimulate innovation and continue to address the credit constraints businesses face. 
• A new model of growth needs to see investment and trade as key drivers – while the trade balance has not been improving, manufacturing investment has picked up in recent quarters and for some time now has been stronger than investment in the wider economy.
• We can also look to other countries that have seen some success in stimulating growth and supporting their productive sectors.

In the upcoming party conferences we want to see a big focus on getting the UK economy growing again with all parties having a clear and concrete commitment to raise growth akin to that of the fiscal mandate.

The coalition has made good inroads into getting the public finances back on track but in the absence of growth will they be able to achieve this goal?

Last week the public finance statistics showed public sector net borrowing, the key measure of the fiscal mandate, had increased in the year to July 2012 to £0.6 billion.

Clearly there is a tension between managing public finances and stimulating growth. But if conditions continue to worsen the government may be in a position where growth continues to lag and as a result are unable to meet the fiscal target.

The debate on our economy needs to change.  Keeping our fingers crossed that Europe will sort itself out and economic rebalancing will get back on track isn’t a plan for growth.  We need to start talking about what is most important for our economy – for us that’s the private sector investing, exporting and innovating – and how all parts of government can help companies do it.

The Inflation report points to lower inflation and slower economic growth.  Mervyn King sums it up:
 
“The economy will continue to face headwinds over the forecast period…  The recession in the euro area is damaging demand for our exports; a black cloud of uncertainty is hanging over investment; and the weakening euro is a further obstacle to the adjustment we need to make in our net trade position. Our efforts to bring about a rebalancing of the UK economy will require patience.”

Key points

Inflation is now expected to fall from its current level to be around or a little below target for much of the forecast period as external price pressures ease and domestic cost pressures stay muted.

Growth forecasts have been lowered across the forecast period.  Growth in 2012 is now expected to be close to zero, down from 0.8% expected in May.  The medium term outlook for growth has also been revised down from the May report to just over 2% for the rest of the forecast period.

Output has been volatile over the last couple of months but much of that is due to factors such as the jubilee which do not give a good indication of the underlying picture of the economy.  Despite these though, output has been broadly flat over the past two years.

Household spending has been held back by weak real income growth but pressure should start to ease.  Consumption is now expected to recover gently over the next year to provide moderate support for growth.

Business investment may pick up on the back of a gentle recovery in consumer spending.  Further information on corporate cash balances shows that there is probably some scope for businesses to increase investment but, as we have previously suspected, whether this eventuates is difficult to anticipate and depends on how companies respond to the environment.  Some interesting points:

- Two measures show that cash holdings have been increasing steadily over the past decade but it is difficult to know how much of this is held by non-financial corporations and so is available for investment. 

- There are alternative uses for cash that companies may be more inclined to go with, particularly in an uncertain environment. These could include dividends, paying down debt and equity buy backs.

- A continuing of the uncertain environment may lead companies choosing to hold on to their cash to either shore up their balance sheet so they are in good position for further shocks, or to wait until the investment environment becomes more favourable.

Trade and external demand have been somewhat weak. Euro area developments are likely
to have a pervasive impact on the UKs economic prospects but a modest recovery in global demand will lead to a pickup in export growth.

Productivity growth has been surprisingly weak and is expected to recover gradually but may stay below the long-run average for much of the forecast period.

Rising bank funding costs which are feeding through to higher rates for domestic borrower on the back of the Eurozone crisis have been concerning.  However, the bank expects the funding for lending scheme to reduce funding costs which could then feed through into lower lending rates.  Assessment by the bank, although very uncertain, indicates that the reduction in funding costs relative to current market conditions for the major UK banks could range between around 100 to 200 basis points if these banks used the scheme to borrow and also maintained their stock of net lending.

All up, the picture suggests a lengthening of the recovery period.  Mervyn King said the process of rebalancing will require patience - but it also requires action.  The Government needs to have a clear plan for how it will seek to support growth and provide the right environment for businesses to grow.

Yesterday, Rachel highlighted the disappointing UK manufacturing PMI release for July. While it's difficult to put a positive spin on a 38-month low, it is worth having regard for what's happening in the rest of the world.

Looking across some of our key markets shows that, with the exception of Ireland, all manufacturing PMIs are in contraction territory. The USA and China are the most positive but are still below the neutral red line.

So is manufacturing in 'crisis globally' as City AM has said today? Or is the performance of the sector more closely connected to the general depression in confidence being generated primarily by the ongoing eurozone crisis?

I think the generalised downturn across many countries and regions in the world sugggests this is not a manufacturing problem per se but a more generalised period of slower world demand. That slowdown in world demand is undoubtedly driven by the buffeting consumer and investor confidence is taking.

While the biggest force pushing down on confidence is what's happening in Europe, the weakness in China and particularly the U.S. is not solely down to this.

The slowdown in U.S. job creation and expiry of investment incentives at the end of last year are clearly playing a role there and China's internal demand has yet to pick up as hoped - though may be helped by monetary policy easing that is in the pipeline already.

So this is the demand context the government is faced with. Our summer reading list is highlighting the need for a renewed focus on growth when the Coalition returns from recess.

Our first look at the UKs vital signs in August unfortunately does not provide much positive news.  Today’s Markit economics release shows the UK manufacturing PMI has hit a 38-month low of 45.4.

Below the headline figure, UK output and orders fell sharply as did input prices.  Selling prices continued to rise and employment rose slightly.  The employment story is somewhat interesting; despite poor indicators manufacturers continue to increase employment, leaving us with a question to ponder – does this suggest manufacturers are planning for things to pick up later on this year?  Or is this a temporary adjustment to complete existing order?

The big worry is that UK demand is being hammered by persistent weakening in key Eurozone markets and slower growth in the US and emerging economies.  On our blog tomorrow we will look at how the UK PMI compares internationally.

Last week we saw that the recent falls in official data can in a large part be attributed to the one-off Jubilee celebrations.  Falls of the extent experienced should not have been unanticipated and were, in fact, better than previous Jubilee celebrations. 

However, the weak PMI for the UK places a significant question mark over whether we will see the bounce back we need in the second half of the year.  Getting growth back on track needs to be a priority for the government. 

The recess comes at a good time.  It offers the perfect opportunity for the government to crystallise and be ready to provide more clarity on how it plans to get the economy growing again.