Today’s Index of Production gave us a first sneak peek into activity levels in the post-referendum period. July saw manufacturing output contract by 0.9%, with the pharmaceuticals sector posting the largest negative contribution.
However, this monthly data point is hardly a meaningful indicator of the post-Referendum state of UK manufacturing, with output in the sector on a rollercoaster ride since the beginning of the year. Rather, the contraction is likely to reflect an unwinding of the spectacular gains in manufacturing output during the second quarter of 2016.
This release therefore does not change our view about the growth prospects for manufacturing in this year and the next. And one thing that it did confirm is that sectoral variation is very much still at play.
Sectoral variation to remain a key theme
Over the past few years’ sectoral variation has been a key theme when looking at the performance of UK manufacturing. Two key global economic trends have shaped the fortunes of UK manufacturing sectors over the past two years. Slowing global growth and the end of the commodity super-cycle.
While the former has been universally bad for the export-intensive manufacturing sector, the latter has generated significant variation within manufacturing. The drop in commodity prices including the prices of oil & steel, have been a boon to consumer-facing sectors such as food & drink and motor vehicles via lower inflation propping up household disposable incomes, but a bane for sectors like basic metals and mechanical equipment which supply pipes and capital equipment to the North Sea.
The beginning of this year saw these headwinds bottom out and sector performance somewhat converging to post spectacular output growth in Q2. Now the question post-Referendum is how the national trend of derailed recovery will play out across different sectors, so which sectors are the most or least vulnerable to the fresh economic challenges arising from the Brexit vote.
We see the emergence of two key drivers affecting the performance of manufacturing sectors over the 2nd half of the year and into 2017: relative demand uncertainty and the impact of exchange rate movements.
1. Relative demand uncertainty
While it’s still hard to discern the immediate impact of the referendum result on real demand prospects, one thing we are seeing for certain is rising levels of uncertainty. With the first casualty of business uncertainty usually being investment we see manufacturers of capital goods – like electronics, mechanical and electrical equipment – bearing the brunt of postponed or cancelled capital expenditure plans.
Another thing we know for certain is that uncertainty is weighing heavily on the construction sector which has been in the doldrums since the first quarter of the year. This spells bad news for manufacturing sectors in its supply chain like non-metallic minerals, rubber and plastics and the metals sectors.
On the other hand, sectors with strong fundamentals and long order books are likely to be shielded from these headwinds. The motor vehicles sector is still tied up into contracts for developing new models in the UK, while a long order book for aerospace manufacturers should ensure continued demand. The pharma sectors is also enjoying a bit of a renaissance with the end of the patent cliff signalling new drugs coming through the pipeline.
2. Exchange rate movements
The hefty depreciation in the pound since the Brexit vote is likely to create both winners and losers. While it should boost export competitiveness across all manufacturing sectors, it will also put upward pressure on input costs via more expensive imports.
This means that export-intensive sectors that import less of their intermediate inputs into production – like aerospace, chemicals and pharmaceuticals – are in a strong position to benefit from the pound depreciation. Conversely, domestic-focused sectors with a reliance in imported raw materials will fail to see this benefit.
In this category are sectors like food and drink, textiles and paper and printing. While still resilient consumer spending should help offset some of the hit on food & drink manufacturers’ profit margins, the textiles and paper & printing sectors are less well situated to absorb this shock and prospects for these industries look downbeat.
So what’s next for sectors?
All in all, incoming data over the next few months will help us put our finger on how these trends are playing out across manufacturing sectors. But all signals point to another couple of years of substantial sector variation within UK manufacturing, something we have factored in our sector forecasts for 2016 and 2017.