Business after Brexit: Investing under uncertainty

Change to the UK economy is inevitable …

I suspect that one of the few things that both supporters and opponents of Brexit can agree on is that the UK economy will change after the UK leaves the European Union (EU). Reshaping a very deep economic and political relationship that has been developing for over 40 years will clearly have an impact – the challenge is to understand the likely nature and scale of any change.

Forecasting the future is never easy but the uncertainty about the terms on which we will leave the EU means that making predictions is currently even more difficult than normal. Indeed, even understanding the current situation is challenging with views on Brexit tending to influence how individual commentators view the health of the economy. While it is true that the UK economy performed much better in the aftermath of the EU referendum than some forecasters expected, I agree with the view that the UK has grown more slowly since the EU referendum than we could reasonably have expected given conditions in the global economy.

… corporates are already acting …

Looking beyond the top line numbers, whatever the growth rate, there are signs that businesses are already moving to reposition their businesses in response to expected future changes, both due to Brexit and the other forces for change I have previously identified (demographics, technology and climate change for example). Capital deployment decisions are by their nature, long-term in outlook and so it will take some time before the full implications of Brexit on investment are clear, but they do provide insight into how business sees the UK economy developing in the future.

The top-level indications are worrying: UK business investment fell by 3.7% year-on-year in the final quarter of 2018, a much weaker outcome than we would expect for a growing economy with technology driven investment opportunities, and a significantly lower rate of growth than several of the UK’s international peers. It appears businesses are concerned about the UK’s future growth prospects and there is a risk that low investment today will hamper growth in future, meaning the UK risks missing out on new opportunities.

However not all the data on investment is as concerning. While business capital investment fell in 2018 - and I expect, based on my discussions around the country in recent weeks, that foreign direct investment (FDI) also fell compared to 2017 (we will know for sure when EY publishes its 2018 analysis in June) - the value of UK M&A rose in 2018 and was close to the pre-referendum level of 2015, while volumes of activity were in line with recent averages. It appears businesses are willing to invest resources in M&A even if they are more reluctant to commit to capital expenditure for new activities. I believe this reflects the confidence corporates have in their ability to execute M&A compared to the more uncertain environment for new capital investment with potentially longer payback periods.

UK M&A Announced Deals Value & Volume 1996-20188

Source: EY & Dealogic analysis

… but in a selective manner …

Sector growth, measured by Gross Value Added (GVA) can provide us with additional insight into how businesses are positioning for the future. Over the last decade, the fastest growing sectors in the UK economy in GVA terms have been professional and business services and the digital industries, with average annual growth of 4% or more. By contrast, financial services, one of the traditional pillars of the UK economy has hardly grown in this period, reflecting the impact of the financial crisis. We would expect these growth trends to be reflected in the mix of activity across the various types of investment.

The key trends in recent UK investment activity are:

• Despite slow overall growth, financial services has remained one of the four fastest growing sectors for FDI over the last decade together with digital, business services and automotive;
• The highest value sectors in recent M&A activity have been digital, life sciences and financial services; and
• Domestic capital expenditure in 2016 and 2017 (we are waiting for 2018 data) was dominated by capital intensive sectors such as energy and real estate with digital the next largest area of spend.

It is harder to identify spend on intangible investment such as software, brand and processes, but it is likely to reflect the sector growth trends mentioned above as the expenditure will be incurred on a current basis and will most probably track growth in employment which was significant in the digital and services sectors.

… with clear trends …

Overall, the approach to investment since the referendum vote has been relatively conservative. Both UK and international investors have continued to pursue opportunities in the fast-growing digital sector, including deploying technology into financial services, and investing in sectors in which the UK has competitive capabilities such as life sciences. By contrast, as the economy slows, investment in the consumer sector appears to have slowed in 2018 while infrastructure investors seem to be less sure of their commitment to energy and utilities based on the 2018 M&A data – capex remains relatively high due to the needs of these sectors. Discussions with investors suggest political uncertainty is a factor influencing infrastructure investment.

The strong M&A data is not necessarily inconsistent with reduced capital investment. Some of the M&A activity relates to chasing fast-growth opportunities as mentioned above but a significant element is domestic activity reflecting consolidation in the UK market – classic defensive activity in a slowing economy. .

We can also identify the impact of greater uncertainty together with a weaker pound than before the referendum on the value of outbound UK activity. Despite strong global growth, UK investors have spent less on foreign deals in both 2017 and 2018 than in the preceding four years. This suggests the UK will not be where it needs to be in terms of being able to exploit new global opportunities after Brexit.

… but time to look forward.

Even though business capital investment has slowed overall, the strength of investment in the digital sector across M&A, FDI and capital investment shows that UK businesses are not blind to future opportunities and it does appear the knowledge sectors will be the major sources of future opportunity. However, short-term activity is being negatively impacted by uncertainty and a slowing economy. To develop our view of Business after Brexit further, we need to lift our heads out of the current fog and consider the megatrends that could drive the future shape of the UK economy. This will be the topic of the next post in this series.

@MarkGregoryEY