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Economics Weekly

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How vulnerable is the UK corporate sector to a slowdown?

Tue, Jul 8 2008, 07:17 GMT
by Trevor Williams

Lloyds TSB Financial Markets

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.

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Published on  Tue, Jul 8 2008, 09:46 GMT