The gloomier picture painted by recent UK economic surveys chimes with the latest results from EY’s 14th UK Capital Confidence Barometer (UK CCB14). UK companies see this year as economically tougher than they expected six months ago, with volatility and political instability dampening the outlook. But our survey also shows that UK companies are still on the front foot, thinking even more about deals and alliances and by no means in retreat. Indeed, whilst UK executives are less positive than their global peers about the economic outlook, they are more interested in M&A. How do we square that circle?
It’s not been a great few months for the UK economy. Yesterday’s below-expectations industrial production figures showed growth of just 0.3% in March. Manufacturing output rose by just 0.1% and fell 1.9% year-on-year, the biggest annual fall since May 2013. Monthly construction output contracted by 3.6 % in March – the worst month since December 2012.Recent PMI surveys highlight weaker conditions across the board – both domestically and in terms of new export orders –and suggest the UK economy is heading for a weak second quarter.
The shift in mood is clearly reflected in UK CCB14, taken in February and March this year. It’s a shift from a highly positive position six months ago to something more stable, but it is a palpable and significant downward shift nonetheless. The Barometer shows that 27% of UK executives expect a modest or strong improvement in the global economy, down from 94% six months ago. Domestic expectations also have fallen significantly, with 8% expecting a modest or strong UK economic improvement, compared with 69% in our last survey. The vast majority of UK executives now think that the UK economy will remain stable (81%) and more than half (56%) signal the same for the same global economy.
The primary reasons for the fall in confidence are what you’d expect: concerns about economic and political stability – particularly in the EU – and volatility in currencies and commodities. As a result, UK executives have lowered their expectations for equity valuations, they anticipate more market instability, and are seeing greater pressure on earnings. This is a more hostile global environment in which to do business – as we noted last week – and the UK is no exception.
..and UK companies shake it up!
This is a shift from optimism to stability – not pessimism – with UK companies appearing to be taking a more pragmatic approach. And pragmatic doesn’t necessarily mean passive. The UK represents the epitome of the themes we discussed last week in a global context, where companies are creating their own tailwinds and using deals to traverse an uncertain landscape. In fact, despite their greater concern about the state of the global and local economy, UK executives in our survey have a greater desire to shake things up than their global peers. Contrary to the global trend, they intend to focus less on the core; they are placing an even greater focus on digital technology; and they expect to do more deals than six months ago.
How do we explain this?
- The UK is at the vanguard of disruption
The impact of digital technology on business models has risen up the UK corporate agenda, according to 43% of executives – compared with 33% on a global basis. It makes sense that if UK companies’ business models are under greater threat that they act to counter this threat, either by investing more organically or by adapting through acquisition or alliance. In Consumer Products & Retail, 73% of executives intend to pursue acquisitions as slow growth, margin pressure and changing consumer behaviour continue to disrupt the sector.
- Expensive labour vs capital
Regulatory changes could be encouraging UK companies to reconsider the balance between capital and labour. The cost of capital remains exceptionally cheap, but changes to minimum wage, pension regulations and the apprentice-levy are making labour more expensive. Cost cutting is one way forward and UK companies’ hiring intensions have fallen. But there is only so much fat left to trim before execution starts to suffer. Investment in digital technology is one way that companies can use their employees more efficiently in areas such as customer engagement. Companies are also consolidating and reviewing their portfolios to improve efficiency. Construction is a sector we’ve highlighted as being under more intense margin pressure and all of our UK Construction sector respondents said that they intend to transact in the next 12 months.
- Resources bias
The UK is significantly exposed to the resources sector and the currently uncertainties around pricing. Portfolio adjustments and alliances are an obvious means to adapt to new price realities and to build a stronger business. In our survey. 80% of Oil & Gas respondents intended to transact in the next 12 months. Oil & gas prices are stabilising, but at a level that should still encourage consolidation to cut costs and rationalise portfolios. More than a third of UK executives (36%) expect distressed sales to be more prominent in the next six months and resources companies should feature heavily.
- Looking beyond
UK executives could just be looking beyond current uncertainties. The rise of Germany and Sweden up the desired destination charts – replacing Australia and Canada – suggests that UK executives aren’t adverse to buying EU companies if the right deal comes along. Investment to adapt to new business models continues regardless – or even because of – uncertainty. Companies need to build greater resilience in a more uncertain world.
There is an growing body of thought that the world is becoming increasingly binary and polarized – in economics and politics. It does feel – as Matt King from Citigroup recently commented – that we’re in an increasing increasingly like a winner-takes-all environment, where brands can fall out of favour in instant. In this fast moving world, companies cannot afford to stand still – even if they can’t quite see the horizon. Deal activity may well stall ahead of the referendum if lenders and markets pause, but the imperative is still there for UK companies to do deals
Valuations, Valuations, Valuations…
Valuations remain a potential blot on the deal landscape. When outcomes are so uncertain and markets seem prone to extremes, it can be tougher to fix on values and the valuation gap is a rising concern for UK executives, even though most expect prices to remain constant in the next 12 months. In our survey, 64% expected the valuation gap to increase – compared to 34% six months ago.
The valuation outlook is likely to be complicated by market dislocation. At the moment, equity and credit markets appear to be building a Goldilocks scenario, where the Fed holds off from interest rate rises due to an oil price that stays just high enough to hold off sector disaster, but just low enough to keep inflation in check. Markets have been somewhat becalmed by the comforting thought, but this ‘just right’ level is surely too delicate a balance to hold for long in this world of greater extremes and we expect markets will blow hot and cold again in 2016.