The capex conundrum
14 February 2017
Investment in the UK economy is lower than it was on the eve of the financial crisis. In part this reflects the precipitous 25% peak-to-trough fall in the type of activity seen during the crash. It also reflects a disappointingly slow recovery in headline investment since. Indeed, while the investment share of GDP has edged steadily higher from a low of 15.6% in 2009 to 17% at present, it remains well below pre-crisis rates. This somewhat reflects weaker spending on dwellings compared to when the property market was booming before the crisis. Government cuts have also hurt, with public investment down on average by 2.3% per annum over the past five years as austerity takes its toll. In spite of these headwinds, business investment has been a brighter spot, growing by 4.6% on average over the same period (see Chart 4). However, there have been signs more recently that the impetus from business spending was starting to fade even before the EU referendum. Capex was down by 2.2% in the 12 months up to Q3 last year and leading indicators at present are weak. Has the business investment recovery run its course?
Let’s think about this from a firm’s perspective. On a positive note the UK corporate sector looks to be in a relatively healthy position from a balance sheet perspective. Debt at private non-financial corporations has fallen significantly to 86% of GDP from a record 107% in 2009. Moreover, low interest rates mean that the debt-service ratio for the sector (interest payments and amortisation as a share of income) is at 34% – down some 10 percentage points from its peak. Credit is not just cheap – it also looks to be readily available. The Bank of England’s credit conditions survey shows only a very small tightening in credit standards since June, while corporate credit spreads remain close to multi-year lows. Alongside the favourable financial backdrop, growth has been better than expected since the referendum. Household spending has remained robust, while an acceleration in global growth is encouraging for the industrial sector, especially given sterling’s recent depreciation.
However, uncertainty clouds the investment case. First, it remains to be seen how well the economy holds up in 2017. A weaker sterling is likely to push inflation higher, weighing on the all-important consumers’ real purchasing power. Firms can limit this effect by passing less of the rise in import costs through to consumers, but they would do so at the expense of their own margins. Second, managers planning longer-term investment projects will have to contemplate life outside of the EU. The current signals from the government are that it is prepared to exit the single market and customs union. Firms may have to build in at least some risk of tariffs or, perhaps more importantly, non-tariff barriers to trade with its largest trading partner. Until there is more clarity around these issues managers might consider it best to be cautious. Indeed, these factors do seem to be weighing on investment intentions, if survey data are to be believed. The Bank of England agents’ survey shows weak investment intentions in both manufacturing and services, with the BCC and CBI polls telling a similar story (see Chart 5). We continue to expect aggregate investment to fall this year, unless consumers are able to shrug off rising inflation. Going forward, firms will monitor the negotiations between the UK and EU to try and understand how the new relationship might evolve.
James McCann, UK/Europe Economist