The 2021 consumer-led recovery is well underway, but UK corporate investment holds the key that will ultimately unlock more sustainable economic growth in the months ahead. After a year of caution amidst an unprecedented global crisis, UK corporates finally appear ready to start investing again – but medium-term risks still appear on the horizon.
- Corporates intend to spend more: still, the pandemic has inflicted significant distortions – including a huge fall in business investment in Q1 2021.
- Insolvency risks are to be watched: corporates took a hit to profitability, but bankruptcies are lower than many had feared.
- Corporates have piled on debt: we don’t see a full-blown credit crisis on the horizon – but elevated debt levels could weigh on expansionary corporate spending.
- The near-term economic outlook remains bright: medium term economic risks, like the impact of Brexit and back-dated tax rises, pose challenges.
Spring is in the air – and that quintessential sense of rebirth and rejuvenation felt in the UK’s many green spaces seems mirrored by most economic indicators of late. Indeed, the UK economy showed greater-than-expected resilience during the Q1 2021 lockdown. Gross domestic product (GDP) dropped just 1.5% throughout the period and by March, monthly GDP growth recovered to end-2020 levels, driven by a strong rebound in consumption as lockdowns eased.
Our confidence in stronger near-term output – we estimate 4.2% GDP growth in Q2 – is reinforced by recent surveys and high-frequency data. The UK Office for National Statistics (ONS) ‘faster indicators’ April 2021 survey, which asks UK firms how the pandemic has affected business turnover compared to what is normally expected around that time, showed the best reading since the survey became available (May 2020). At the same time, the UK purchasing manager’s index (PMI), a broad measure of economic sentiment & activity, reported sizeable gains in April, with the composite PMI reaching 60.7, its highest levels since late 2013 (a score above 50 typically implies expansion, with the opposite holding true for scores below 50).
Yet this superficially strong economic rebound masks very real challenges – not least for businesses. Corporates have suffered a hit to profitability and piled on debt while households, whose long overdue holidays and shopping trips drive the current rebound, tended to benefit from government transfers. Near-term Brexit trade frictions and longer-term structural challenges will be testing – recent UK trade data vis-à-vis the EU are a cause for concern. Ultimately, a sustainable economic recovery in 2022 and beyond will hinge on a larger contribution from corporates in the form of capex and investment. How healthy are UK corporates and how well-positioned are they to boost investment?
Capex: good intentions suggest a recovery on the horizon with caution in the near-term
The disruption caused by the pandemic makes it quite difficult to use past data as a reliable lens for viewing a future capex trend. Business investment actually fell some 11.9% during the first quarter of this year, much more than rates seen during previous lockdowns – and it remains unclear why (we do think it’s likely the data will be revised). Still, the latest investment intentions survey data show a sharp rebound despite remaining some way below pre-pandemic levels (see below).
Good intentions: UK corporate capex intentions (standard deviation from the mean)
Sources: Bank of England (BOE), BCC Group, Confederation of British Industry (CBI), NatWest Markets.
The latest Bank of England (BOE) Credit Conditions Survey, which helps paint a picture of why corporates are borrowing, lends some weight to the view that a rise in capex waits in the wings. The latest reading shows a pick-up in funding for acquisition purposes, already at multi-decade highs, alongside a very sharp rise in borrowing to fund capex – the highest levels seen since 2014.
The BOE Credit Conditions Survey: M&A vs. capex as a driver for funding
Sources: Bank of England, NatWest Markets.
We do expect to see some recovery in capex in the months ahead, but with a degree of caution persisting in the near-term. The CBI’s latest industrial trends survey, which seeks to measure factors limiting corporate investment, shows still elevated levels of demand uncertainty. But that same survey also showed concerns over labour shortages edging higher, which at the margin may justify future investment.
Insolvency risks are to be watched – but less severe than you may think
Usurpingly, the pandemic inflicted a sizeable hit on the UK corporate sector. Profitability across all sectors fell 2.6% through 2020 – versus an average annual rise of 2.6% in the preceding five years, the worst annual outturn in decades. We would expect this to improve as the pandemic recedes, but the rate at which this happens will vary widely across sectors.
Still, while bankruptcy data typically lag, they have yet to show any significant deterioration; in fact, the official UK Insolvency Service data show a marked decline in corporate bankruptcies (see chart below).
Corporate insolvencies: actual vs. expected
Sources: Bank of England, UK Insolvency Service, NatWest Markets.
Some caution is warranted here. Falling insolvencies are likely a reflection of pandemic-related factors like law courts being closed for extended periods, new legislation to allow companies greater breathing space from their creditors, and substantial government support (grants, loan guarantees, tax relief and the furlough scheme). It’s reasonable to expect corporate insolvencies to rise over the next year or two as support is withdrawn.
But what’s impressive is the starting point – one of far less damage than was feared, and a much lower level of corporate bankruptcies compared to before the pandemic. Banks’ concerns about insolvencies (as captured by the BOE’s Credit Conditions Survey) have also fallen sharply, and particularly for larger firms, which is significant as they account for a disproportionately large share of capex.
Higher levels of corporate debt won’t lead to crisis but could weigh on expansion
The policy response to the pandemic was clearly one aimed at ensuring an uninterrupted flow of affordable credit to the real economy – and corporates tapped ample quantities across bank lending and the capital markets throughout 2020.
But a flood of cheap funding has also meant corporates’ debt stock has jumped by nearly 11% (or £45 billion) since the end of 2019, reaching £462 billion, and as percentage of GDP, rose from 18.6% to 21.3% during the same period.
We don’t see a corporate debt crisis on the horizon. Debt levels, while elevated, remain some way below where they were during the global financial crisis, and interest rates are likely to remain low for some time. But large debt stocks do seem likely to weigh on capex & investment. We may already be seeing early signs of this: the latest corporate credit data show a net £2.4 billion in repayments, which could signal a lack of appetite to boost spending (but is more likely a sign that corporates are drawing down excess liquidity accumulated during the pandemic as a precaution).
The economic outlook is brighter, but challenges remain in the medium-term
Overall, the economic outlook is looking brighter, with GDP expected to grow 6.5% in 2021 and 6.4% in 2022 (versus a 9.8% contraction in 2020), and high-frequency business activity & survey data are reaching historic heights. But there are some signs of stress that UK corporates should be prepared for.
As I’ve written elsewhere, the latest trade data show significant frictions vis-à-vis the EU as smaller UK exporters step back from European markets in response to higher administrative and transportation costs. For larger firms, ‘rules of origin’ (RoO) requirements might conceivably pose greater risks over time if supply chains increasingly circumvent the UK. This underscores the growing importance of active supply chain management in the post-Brexit era.
Finally, the UK government’s support for corporates will remain generous in the months ahead, with many expected to benefit from continued pandemic support measures and capital allowances introduced in the March 2021 Budget. But from 2023, those capital allowances will give way to sharp tax rises. We don’t see this dampening investment too much over the long-term – the long-dated corporate tax rises are roughly equal in size to the near-term tax allowances – but it’s a risk worth watching nevertheless.