How vulnerable is the UK corporate sector to a slowdown?

The combination of tighter credit conditions in Q2, as shown in the Bank of England’s latest report on lenders and a fall in the services, manufacturing and construction
Purchasing Managers’ Indices (PMI) further below 50 – the level below which output is generally declining – has intensified concern about the likelihood of recession in the UK.

Signs of slower corporate activity increase…

The combination of tighter credit conditions in Q2, as shown in the Bank of England’s latest report on lenders and a fall in the services, manufacturing and construction
Purchasing Managers’ Indices (PMI) further below 50 – the level below which output is generally declining – has intensified concern about the likelihood of recession in the UK. Of course, this debate is not new, ever since the credit crisis broke in mid 2007 there has been worry that it could lead to recession. But, driven by commodity prices, rising price inflation has added another danger because it has removed
the ability of the Bank of England to respond to economic weakness with further rate cuts. Hence, any evidence that the pace of activity in the corporate sector has slowed and that credit is hard to come by warrants greater scrutiny. 


Our analysis in the following brief suggests that corporate conditions have deteriorated in the last three months but not yet to the sort of levels that imply recession, though entirely consistent with sub trend economic growth – i.e. below 2.3% or so a year. Of course, it must be remembered that sub trend growth is
necessary to help to bring consumer price inflation back to the 2% target and, if economic growth were not below trend, the Bank of England would probably have to raise interest rates to engineer such an outcome.


…as credit conditions tighten and PMIs fall further below 50…

Credit conditions are certainly tighter for UK companies than a year ago, with chart a illustrating this point quite clearly. Conditions, though, are not expected by lenders to deteriorate in the next three months as much as they did in the preceding three month period. In short, the availability of credit to companies by lenders in the quarter to September is planned to be tightened but by less than in the last quarter. The reason why this is so important is the effect that tighter credit conditions could have on company investment spending decisions and thence the impact on the wider economy. Chart b shows that UK recessions are heavily influenced by the investment spending cycle. Although investment is a relatively small share of the expenditure
measure of gdp, 11.5% in 2007, compared with private consumption, which was 62% last year, its volatility means it has more impact on the cyclicality of economic growth. Therefore, a recession is highly unlikely if investment spending growth is positive or does not drop too sharply. This may seem obvious but the question is whether there are any signs that investment spending is about to collapse, either through the unavailability of credit, stressed corporate finances, demand conditions etc. These sorts of questions – what factors are limiting investment – are asked by the CBI in its regular survey of company opinion in the UK.


…but the credit crisis is not yet causing severe economic problems for companies

The latest results from these surveys are shown in chart c. They suggests that, as yet, the credit crisis, in the form of the cost of finance and credit availability, is less limiting to investment intentions than the outlook for demand, rate of return on capital and labour shortages. The latter is reflecting that, although there has been some modest rise in unemployment in the last four months, the rate is still at a 30 year low and employment is at a record high, with job vacancies standing at 678,600 in the three months to May. With sub trend economic growth one would expect there to be some rise in unemployment and a fall in employment growth, but for these to be modest. And so far the trends have been modest. This may change, of course, but
as yet there appears no intent by companies in business surveys to slash employment dramatically.


However, demand conditions are deteriorating


Insofar as the PMI is a measure of activity, its trajectory should be a good proxy for demand conditions from a corporate perspective and as such the recent fall is worrying. Chart d illustrates that a composite of the services and manufacturing PMI’s suggests that annual UK economic growth is likely to fall to around 1.5% later in the year, if sustained. But its current level is not consistent with recession. The last time the composite index was at these levels, sub-50 in 2001, the economy grew by 2.4% and then expanded by 2.1% in the following year.


What about companies net rate of return and internal finances?


Chart e shows that the net rate of return of UK firms is still very high, albeit partly reflecting the profits of oil companies and services firms. However, if this net rate of return is compared with investment spending, it shows little sign of an imminent sharp cutback occurring. And chart f may partly explain why that is: UK firms
have been generating a financial surplus – i.e. are net lenders to other UK sectors – since 2001, amounting to a cumulative £83bn. However, the net position has narrowed in the last six months. Another aspect of the current corporate position is that stock levels in the run up to the current unfolding economic slowdown are
much lower than in the recessions of the 1970s, 1980s or 1990s. This means there is much less need for companies to cut back on current production in order to save money through carrying less stock on their books by slashing inventories. This does not mean that stocks may not be cut further or that output will not weaken, but that the wrenching economic effect of this will likely be smaller than in previous downturns. Our overall view is therefore, significant risks not withstanding, that the UK corporate sector is in better shape to weather an economic slowdown than many suppose and certainly better than in the 1990s. However, demand conditions are worsening and the risk is that companies overreact and cut output.


Bank of England to hold base rate at 5.0%


The Bank of England meets on interest rates this week. A deterioration in forward-looking indicators of activity, worries about the housing market and the reduced availability of credit will have to be balanced with continued increases in inflation. We expect an MPC majority to vote on Thursday in favour of no rate change. In the US, Fed chairman Bernanke will testify on Thursday on financial market regulation and bank lending. We may also hear from the Fed chairman on what he makes of the latest economic data as the Fed prepares its latest forecasts for growth and inflation. A fairly quiet week in the euro zone features the release of final Q1 gdp data on Wednesday.


The economic backdrop in the UK took a turn for the worse last week after it emerged that credit availability is set to remain tight in Q3, whilst the forward-looking reports of activity in the manufacturing and services industries fell to the lowest level since 2001. The Q2 credit conditions survey published by the BoE showed that both demand and supply of household credit decreased last quarter and are expected to fall further for a fourth successive quarter. The sharp rise in unsecured household lending and a higher projected default rate on credit card loans suggest that the financial position of households could become more fragile. With inflation taking a toll on purchasing power and the labour market showing signs of stress, we appear to be headed for a more challenging consumer environment in the months ahead. The decline in the availability of corporate lending equally demonstrates that the credit crisis is not over, though the expected decline is less than in the three previous months. But higher funding costs could push up defaults – we note that 3-month Libor fell last week to 5.89%, a one-month low. This is especially true for the
most leveraged sectors like retail and construction where most of the economic downturn is being felt. However, we would argue that a sustained period of sub-trend economic growth is desirable to help the BoE succeed in bringing inflation back to the 2.0% target in 2010 without having to raise interest rates. With the threat of inflation not over and annual CPI set to hit new peaks over the summer, we believe the BoE is likely to stick to its view that keeping base rate on hold is the best solution right now to bring down inflation over the medium term. The hawkish rhetoric by some MPC members since the June meeting may give the impression that a rate hike is more likely than not (see chart below), but we are not so sure they can deliver on this and believe that this may be an attempt by the Bank to try and keep a lid on inflation expectations, without having to actually increase the cost of borrowing.
Industrial production figures released this morning showed manufacturing output fell to an eight month low. The NIESR will publish its gdp estimate for June on Tuesday, and may not report much change from the 0.2% q/q growth rate covering the
three months to May. Foreign trade data is released on Wednesday and is expected to show a widening of the deficit.


Fed chairman Bernanke may on Thursday decide to elaborate on the state of the economy during a testimony that will be dedicated to the topic of bank lending and financial market regulation. Comments about inflation and growth may influence
how markets perceive the likelihood of higher interest rates this year. However, the report last Thursday of a spike in initial claims to 404,000, the highest since March, begs the question whether US companies are starting to cut jobs and costs more
aggressively in the face of record oil prices. Weekly claims data are due on Thursday and another number above 400,000 would intensify worries of a rise in the unemployment rate above 5.5%. Foreign trade data for May is due on Friday. We expect higher fuel prices and rising import prices to have widened the deficit to $62bn, a 14-month high. The University of Michigan survey for June is also due on Friday and may show that households are turning increasingly pessimistic, as record petrol prices eat into their disposable income.


The ECB last Thursday raised interest rates to 4.25% and stated that it had ‘no bias’ with regard to future policy changes. The nature of this week’s data means there should be no change to the Bank’s intentions. French and German industrial output
may show the toll from high oil prices, whilst final Q1 gdp is forecast to be confirmed at 0.8% q/q and 2.2% y/y. The ECB will publish its monthly bulletin on Thursday and Ecofin may discuss the impact of oil prices on the economy.