Download EY ITEM Club Special Report on Business Investment

EY ITEM Club
Special Report
on Business
Investment
Contents
EY is the sole sponsor of
the ITEM Club, which is
the only nongovernmental economic
forecasting group to use
the HM Treasury model
of the UK economy. Its
forecasts are
independent of any
political, economic or
business bias.
Foreword
2
EY ITEM Club special report on business investment 5
Highlights
6
EY ITEM Club special report on business investment
7
1.
The recent performance of business investment
7
2.
Tailwinds to investment
10
3.
Challenges to investment-led growth
13
4.
Conclusions
17
EY  1
Foreword
EY  2
Foreword
Foreword
Mark Gregory
EY Chief Economist UKI
@MarkGregoryEY
►
Are you investing enough? Over the past few years, there has
been a widespread perception that the UK economy has been
performing relatively poorly in terms of business investment.
This view has fuelled fears that the UK could slip into ‘secular
stagnation’ – a scenario where a combination of high savings and
low investment acts as a brake on growth. Earlier this year, the
IMF raised the prospect that the entire global economy could
suffer such a fate.
►
The good news is that this latest special report on UK business
investment from EY ITEM Club suggests that – for the UK at least
– such worries are not just overdone, but actually misplaced. The
report finds that UK business investment has been outpacing
other economic indicators since 2010 to reach its highest level
as a share of GDP since 2000. The report reveals a much more
optimistic picture than many, including myself, had expected.
►
Especially encouraging is that the outlook for business
investment in the UK remains positive. EY ITEM Club believe the
UK is set to remain a relatively conducive environment for
business investment in the coming years, encouraged by factors
such as falling corporation tax rates, plentiful corporate liquidity,
and greater certainty around issues such as market demand and
the availability and costs of finance.
►
Encouragingly, EY ITEM Club’s projections show investment by
UK business rising by an average of 6.4% a year between 2015
and 2019, to reach a high in real terms of 12.9% of GDP, a level
not seen in the UK for over 3 decades. This is broadly in line with
the OBR’s July 2015 forecast, which saw the investment/GDP
ratio rising to 13.1% of GDP in 2019.
►
It is also possible that the forecasts understate investment. One
of the most striking developments identified in the report is the
dramatic changes in working practices in recent years and the
implications for investment. The growing ranks of the selfemployed and home-workers apparently means that some
investment in technology, such as smartphones, tablets and
home printers, to support work is now classified as consumer
spending rather than business investment. As a result, the
official figures may be missing some of the expenditure. The
gathering momentum behind the ‘sharing economy’ suggests
this effect may increase in the years ahead.
►
However, while there’s cause for greater optimism around
business investment, the UK’s record still lags some way behind
its international competitors – with only Italy among the G7
seeing it account for a smaller share of GDP. That said, the
continued growth over the next few years will narrow the gap,
and see the UK rise at least part way up the global rankings.
EY  3
Foreword
Foreword
Nevertheless there is a risk UK business is still underinvesting
when judged on a global basis.
►
So, what are the implications of all this for UK business? The
first question businesses should ask themselves is whether they
have been investing enough to ensure their on-going success.
Given the general view that investment has been low in the UK,
it is possible that businesses have been assuming there was less
investment going on than has actually been the case. This has
typically applied most obviously to international peers, whose
investment levels have been higher on average – but based on
EY ITEM Club’s analysis, it might also now apply to UK focussed
businesses as well.
►
In analysing the adequacy of their investment, businesses should
start by assessing if the historic level of investment revealed in
this special report been sufficient to lay down a platform for
sustained growth in the UK. This will provide them with the
insight into the extent that their current business forecasts
reflect the potential of the UK economy to grow over the coming
years.
►
It is also important for businesses to reassess their investment
plans in the context of the changed environment identified in
this report. Examples include the increasing role played by
consumer technology in sales processes and the rising incidence
of sharing in appropriate areas of the value chain, enabling
businesses to share investment and effectively boost returns. It
may well be that the level of investment and hence potential
demand is higher than might be reflected in current plans.
►
The impact of investment in technology has at least two
dimensions. Yes it might mean that there is more demand than
previously assumed but it may also mean that businesses need
to invest now to head off the disruptive threat from
technological change. For example, have sales channels been
optimised to reflect the impact of the smartphone on customer
behaviour?
►
Finally there is a need to consider the potential impact of the
introduction of the National Living wage from 2016. As this EY
ITEM Club report highlights, the relative costs of capital versus
labour have changed in recent years as labour has become
relatively more competitive. For some sectors, the NLW will
reverse this trend and business investment may therefore
become both more attractive and necessary to offset increased
labour costs.
►
Overall, the brighter picture for business investment revealed by
this special report is good news for the UK economy. But it raises
challenges and questions and businesses do need to move
quickly to reassess their asset base and investment intentions to
ensure they are not left behind.
EY  4
EY ITEM Club
special report
on business
investment
EY  5
Highlights
Highlights
►
Contrary to common perceptions and fears of ‘secular stagnation’, UK business investment has
performed impressively in recent years, substantially outgrowing other components of GDP since
2010 and, as a share of output, currently standing at the highest level since 2000.
►
Changes in working practices, notably the rise of self-employment and home working, mean that
the official numbers probably understate what already appears a robust performance. And the
emergence of the ‘sharing economy’ points to that understatement growing over time.
►
Internationally, the appetite of UK firms to invest looks less impressive, with business investment
currently accounting for a smaller share of GDP than any other G7 economy, bar Italy. But the link
between capital spending by firms and economic performance is not clear-cut. Japanese companies
have consistently invested more than those in most other advanced economies over the last 20
years, but the Japanese economy has consistently grown more slowly in GDP terms.
►
A consideration of factors which drive business investment, including rates of return, taxes, the cost
and availability of finance, the level of economic uncertainty and the relative price of capital goods
all point to plenty of support for this area of spending over the next few years. The return on capital
is at a historically high level and will be supported by future cuts in corporation tax, corporate
liquidity is plentiful and traditional constraints on investment faced by firms - such as uncertainty
around future demand and the cost of external finance - have eased significantly.
►
Since 2008, the price of capital relative to labour has moved heavily in favour of the latter,
reflecting historically weak pay growth. But the ongoing recovery in pay combined with the
introduction of the ‘living wage’ next year should spur firms to invest more in labour-saving
technology and improving efficiency.
►
However, the outlook for business investment is not uniformly bright. The shrinking North Sea
sector, which accounts for a disproportionate share of capital spending, will drag on growth.
Corporate pension deficits represent a competing claim on firms’ cash piles. And a referendum on
EU membership poses risks to the UK’s attractiveness as an investment location.
►
We are sceptical about some supposed structural, longer-term threats to business investment. In
particular, the argument of ‘techno-pessimists’ that modern innovations are generating fewer
profitable investment opportunities compared to previous waves of technological advances strikes
us as short-sighted. However, other risks may be more real. Moves towards greater corporate
transparency and disclosure risk exacerbating short-termism, a threat to investment that may be a
particular issue in the UK because of the importance of equity financing and the role of share-based
bonuses in executive pay
►
But criticisms around short-termism come up against relatively high level of business investment in
the culturally-similar US and the fact that UK corporate investment is currently running at a
historically high level, but without the overheating economy or ‘irrational exuberance’ that past
historical episodes of high investment have typically required.
►
Overall, the balance of forces working for and against continued strong growth in business
investment strike us as firmly erring towards the former. We expect business investment to continue
rising well in excess of overall GDP growth, implying that secular stagnation is an affliction that the
UK should happily avoid.
►
As higher investment stimulates activity and tax receipts and pushes the corporate sector further
into deficit, it should also give the Government scope to ease what looks to be an unnecessary
degree of fiscal tightening. And a higher level of potential output will push down on inflation and so
allow the Bank of England to keep borrowing costs lower than would otherwise be the case.
EY  6
EY ITEM Club special report on business investment
EY ITEM Club special report on business
investment
The Government’s oft-proclaimed goal of a better-balanced economy has focused on exports and
investment playing a bigger role in driving growth compared to the consumer and government spendingfuelled expansion of the 2000s. We explored prospects for exports, specifically exports of services, in a
Special Report published last year.1 This Special looks at an important element of the other side of the
rebalancing coin - business investment – which consists of spending on machinery and plant, transport
equipment, commercial property, software and R&D.
The appetite among firms to invest has assumed added importance in light of the latest buzz-phrase in
economics - ‘secular stagnation’. This is the idea that a surfeit of savings and a dearth of demand,
particularly investment demand, will condemn economies to a continuation of the relatively slow growth
that has blighted much of the advanced world since 2008. This Special Report begins by examining the
contribution that business investment has made to the UK economy in recent years. It then assesses
what the future might hold for this component of GDP and whether a diagnosis of secular stagnation is
an appropriate one for the UK.
1. The recent performance of business investment
Spending by firms has punched well above its weight in driving the recovery
Following a sharp decline during the financial crisis, business investment has performed relatively
strongly since the economy emerged from recession at the end of 2009. In real terms, investment by
firms dropped by almost 20% in 2008 and 2009, declining from 10.2% of GDP in Q2 2008 to 8.7% in Q4
2009. But since 2010, business investment has more than made up the loss seen during the recession,
reaching 11% of GDP in Q2 2015, the highest ratio (allowing for classification changes) since the end of
2000.2 Business investment has also substantially outperformed other expenditure components of GDP,
ending Q2 2015 14.8% higher in real terms than the level at the beginning of 2008. In comparison,
consumer spending grew by 4% over the same period and overall GDP by 5.2%. And recent growth rates
for investment (along with GDP) may well be revised up when the ONS publishes the latest National
Accounts ‘Blue Book’ at the end of September. So the national accounts tell a very different story from
the perception in some quarters of an unbalanced recovery overly-reliant on consumers and underweight on investment.
UK: Business investment
12.0
UK: GDP & expenditure components
50
11.5
% of real GDP (LHS)
11.0
£b, real terms (RHS)
45
40
10.5
Q1 2008 = 100
115
Business investment
Government consumption
110
GDP
105
Consumer spending
10.0
35
9.5
30
9.0
25
95
20
90
7.5
15
85
7.0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
10
8.5
8.0
Source : EY ITEM Club/Haver Analytics & OBR
100
80
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source : EY ITEM Club/Haver Analytics
1
‘EY ITEM Club: Special report on services exports’, September 2014. http://www.ey.com/UK/en/Issues/Businessenvironment/Financial-markets-and-economy/EY-ITEM-Club-special-report-on-services-exports---Summary
2
Classification changes relate primarily to the transfer of British Nuclear Fuels from the public to the private sector in 2005.
EY  7
EY ITEM Club special report on business investment
The resurgence in business investment that has occurred since early 2010 likely reflects the recovery in
demand over the same period. Predictably, growth in investment lagged the early stages of the revival in
GDP, as firms adopted a ‘make do and mend’ approach, waiting to see if growth in activity, particularly
consumer spending, was sustained before committing to spend. Since 2010, investment growth has
been strongest in the services sector where output has also risen at the fastest rate.
Growth in business investment since 2008 also compares well with the pre-financial crisis era. In the ten
years to Q4 2007, business investment rose at an average annual rate of 2.3%. 3 Average annual growth
of 2.5% since Q1 2008 has run ahead of this, despite the decline seen in 2008 and 2009. Stripping out
the effect of the recession, capex has risen by 5.5% since the start of 2010, more than double the precrisis average. Meanwhile, firms have chosen to devote an increasingly large share of retained profits to
investment. The ratio reached 104% in the first quarter of 2015, up from 2010’s low of 62% and well
above the average of 85% recorded since records began in 1997.
UK: Business investment
UK: Business investment
% year
15
% of retained profits
130
10
120
5
110
0
100
-5
90
Services
Electricity, gas & water
Mining & quarrying
Manufacturing
Other
Total
-10
-15
80
70
-20
2007
2008
2009
2010
2011
Source : EY ITEM Club/Haver Analytics
2012
2013
2014
2015
60
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source : EY ITEM Club/Haver Analytics
Admittedly, a strong performance from business investment appears somewhat at odds with the marked
lack of productivity growth since 2008. In reconciling the contrasting performance of productivity and
investment, sizeable growth in the workforce over the last few years provides one explanation. As of the
middle of 2015 there were an additional 2m people in work compared to the beginning of 2010, the
largest absolute rise in employment over any equivalent period since records began. This means that the
amount of capital per worker has not risen as rapidly as the investment numbers might imply.
Meanwhile, the UK’s poor productivity performance has reflected a decline in what is termed total factor
productivity growth – the efficiency with which capital and labour is used. So on the face of it, firms have
not put their extra investment to particularly productive use. But it takes time for capital spending to
feed through to higher productivity. And the latest data, which suggests that output per hour is now
growing well in excess of its long-run rate, may be tentatively indicating that such feed-through is now
happening.
Picture for business investment may have been even brighter than headline numbers
suggest…
In practice, there are reasons to think that the already strong headline numbers may actually understate
the true level of business investment. One is the effect that growth in self-employment alongside
advances in personal technology may have had in depressing official investment numbers. In 2000,
3.2m people worked for themselves (11.8% of the workforce). In 2014, this number was 4.6m, or 14.8%
of the workforce. Why might this push down measured investment? Consider an item bought by a selfemployed person for personal reasons but which is also used for business purposes (for example, a
laptop computer). In the national accounts, this will boost retail sales and not investment, even though
its purpose is for production rather than consumption. Indeed, a crude comparison of investment
3
Excluding the distortion in mid-2005 arising from the transfer of British Nuclear Fuels from the public to the private sector.
EY  8
EY ITEM Club special report on business investment
spending by the information and communication sector with consumer spending on technology shows a
sharp rise in the latter relative to the former over the last 10 years.
Moreover, traditional spending on capex may have been partly superseded by employers encouraging
workers to draw on their own personal capital. One way this could occur is via home-working. In 2014,
4.2m people, or 13.9% of those in employment, worked from home. This corresponded to a 1m rise in
home workers compared to ten years earlier. Consequently, the need for traditional spending on things
like office facilities and company cars is lessened. The growth of ‘hot-desking’ and the potential of
personal technology like smartphones to cross the leisure-work boundary may have had the same effect.
If workers’ personal devices allow them to access work-related emails, why bother buying staff
Blackberries? The growing scope for firms to make better use of non-business assets suggests that the
common claim that UK firms ‘underinvest’ may be failing to capture an increasingly important trend.
UK: Change in employment since 2008
UK: Consumer & corporate spending on tech
'000s
800
Q1 2008 = 100, real terms
350
Self-employed
Household spending on information processing equipment
600
300
Investment by information & communications sector
Part-time employees
400
250
200
0
200
-200
150
-400
100
-600
-800
-1000
2008
50
Full-time employees
2009
2010
2011
2012
2013
2014
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
2015
Source : EY Item Club/Haver Analytics
Source : EY ITEM Club/Haver Analytics
The advance of the ‘sharing economy’, exploiting the internet to share human and physical resources, is
another reason to think that the published business investment numbers may not present a full picture.
For example, Uber and Airbnb offer services which make use of billions of pounds worth of vehicles and
property respectively. But none of this equipment officially counts as capital spending. The extension of
the sharing economy to areas beyond transport and accommodation, along with further advances in
technology which make the need to work in an office environment superfluous for more and more
people, suggest that the difference between measured capital spending and the ‘true’ level of business
investment is likely to grow.
….but a global comparison is less reassuring
So in terms of investment demand (if not the
performance of productivity, at least until very
recently), the UK has looked a long way from
suffering the malaise of secular stagnation. Where
spending by UK firms appears less impressive is on
an international basis. The UK has consistently
fallen short of its G7 peers in terms of the share of
GDP devoted to business investment. In 2014, that
ratio (10.6%) was lower than that of any other G7
economy with the exception of Italy (10.2% of GDP)
and well below the G7’s leaders (Japan on 13.7% of
GDP and the US on 13.5%). Moreover, in the
decade to 2014, the UK was bottom of the G7
rankings, with businesses investing an average of
9.5% of GDP. In contrast, US firms invested an
average of 12.4% of national income and Japanese
G7: Business investment
% of real GDP
15
Japan
US
France
Germany
UK
Italy
Canada
14
13
12
11
10
9
8
1997
1999
2001
2003
2005
2007
2009
2011
2013
Source : EY Item Club/Haver Analytics
EY  9
EY ITEM Club special report on business investment
companies 13.6%.
But whether this comparison shows that investment by UK firms has been, and is, too low is not clearcut. Composition effects represent one reason for this. The share of GDP accounted for by services is
larger in the UK than any other G7 economy.4 Since service activity is less capital intensive than other
sectors, a lower ratio of business investment to GDP in the UK is unsurprising. Having said that, the US
and French economies are only slightly less services-orientated than the UK, but investment is
noticeably higher as a share of GDP. Another reason to be cautious is the extent to which business
investment delivers “bang for the buck” in the form of GDP growth. Over the last 20 years, Japanese
companies have consistently invested a larger share of GDP than those of any other advanced economy.
But that has not prevented the Japanese economy from putting in a mediocre GDP performance – in
2014 real output was only 6% higher than the level in 2004, compared to the 13% rise seen in the UK.
On the other hand, both Germany and the US, bigger investors than the UK on the business side, saw
larger gains in GDP.
It follows that it is not easy to get a grasp on what constitutes the ‘right’ level of business investment.
But there is certainly a strong case for saying that more spending in this category is better than less.
Spending by firms on investment has the dual advantage of boosting activity and, if directed wisely,
expanding the potential of the economy to grow before inflation takes off. So growth in business
investment is a prerequisite for sustained growth in the wider economy. Moreover, by raising capital per
worker and labour productivity, investment should also feed into higher wages and profits. And even
irrational surges in investment by firms can deliver benefits. For example, the ‘railway mania’ of the
1840s left the UK with an extensive rail network with all the associated supply-side benefits flowing
from that. More recently, the ‘dot-com’ boom of the late 1990s provided a national broadband
infrastructure that may not have been created in the absence of what, with hindsight, was a clear
episode of investor over-exuberance.5
2. Tailwinds to investment
Plenty of reasons to think investment growth will remain strong…
The relatively healthy performance of business investment in recent years suggests that there may not
be the same scope for catch-up growth that other components of GDP enjoy. But countering that,
investment growth arguably has, up to a point, more of a self-reinforcing nature than rises in consumer
spending and exports, a point highlighted in a speech last year by Ian McCafferty, an external member of
the Monetary Policy Committee.6 And a consideration of the factors which influence investment,
including rates of return, taxes, the cost and availability of finance, the relative price of capital goods
and the prevalence or otherwise of economic uncertainty all point to plenty of tailwinds supporting
investment spending over the next few years.
Taking these forces in turn, contrary to the predictions of the secular stagnation school of a weak rate of
return on investment, the net rate of return on capital enjoyed by UK services firms reached a record
high of 18.9% in Q2 2015. Granted, the 11.9% rate of return for private non-financial companies
(PNFCs) as a whole was not as strong, with the number dragged down by the manufacturing and North
Sea sectors. But this was still above the average of 11.1% recorded since records began in 1997. And
investment by manufacturers only accounts for 15% of total business investment. On another positive
note for returns, EY’s latest analysis showed profit warnings among UK companies falling to a near two
year low in Q2 2015, 26% down on the previous quarter.7
What’s more, corporate liquidity is plentiful, with currency and deposits held by non-financial companies
equalling 29% of GDP in Q1, close to the record high of 29.4% seen in mid-2014. With around 60% of UK
4
Comparison from World Bank: http://data.worldbank.org/indicator/NV.SRV.TETC.ZS
See Daniel Gross (2007) ‘Pop: Why bubbles are great for the economy’, HarperCollins.
6
“As the recovery becomes more entrenched, finance directors will naturally become more watchful of their rivals’ investment
plans and market-share strategies, engaging in a virtuous circle of matching their investment plans with that of competing firms”.
See ‘Achieving a sustainable recovery: where next for business investment?’ Speech given by Ian McCafferty, Nottingham Business
School, 22 January 2014. http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech703.pdf
7
‘On the rebound?: Analysis of profit warnings’, EY, Q2 2015. http://www.ey.com/Publication/vwLUAssets/EY-profit-warnings-Q22015/$FILE/EY-Profit-Warnings-Q2-2015.pdf
5
EY  10
EY ITEM Club special report on business investment
business investment financed from internal funds, a more plentiful supply of such funds (which
shareholders seem unlikely to tolerate sitting idle from too long) should disproportionately boost
investment.8 And both post-tax rates of return and cash holdings are set to benefit from a more
favourable tax regime. The rate of corporation tax paid by firms is due to fall from the current 20% to
19% in April 2017 and 18% in April 2020, giving firms more incentive and more resources to invest.
UK: Net rate of return
%
20
UK: PNFC deposits to GDP ratio
% of GDP
31
Services
18
All non-financial companies
Manufacturing
16
30
29
28
14
27
12
26
10
25
8
24
6
23
4
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
22
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source : EY ITEM Club/Haver Analytics
Source : EY Item Club/Haver Analytics
…with the corporate sector moving into deficit…
Meanwhile, the financial balance of the corporate
sector appears to have finally moved into a
sustained deficit. The ONS estimates that firms ran
a financial deficit in each of the four quarters from
Q2 2014 onwards, reaching £5.7bn or 1.2% of GDP
in the first three months of 2015. This followed 46
consecutive quarters of corporate surpluses,
stretching back to the beginning of 2003. So after
11 years of saving, companies are finally showing a
growing appetite for borrowing, with spending on
inventories and capital equipment exceeding their
retained profits.
UK: Sectoral balances
% of GDP
8
Net saving
6
4
2
0
-2
-4
-6
Overseas
Households
Companies
Government
-8
-10
Net borrowing
Along with the benefits of investment highlighted
-12
2007
2008
2009
2010
2011
2012 2013 2014 2015
earlier, a continuation of this trend will be good
Source : OBR
news from the point of view of the Government’s
deficit reduction ambitions. If one sector of the economy is a net saver, another must be a net borrower.
In recent years, that latter sector has been the government, with the fiscal deficit partly mirrored by the
corporate sector’s surplus. But as companies invest more and the corporate balance moves further into
deficit, the resulting boost to activity and tax receipts will reduce government borrowing and may soften
the perceived need for austerity.
…and traditional constraints on investment easing
Meanwhile, traditional constraints on investment have continued to fall back. July 2015’s quarterly CBI
Industrial Trends Survey found that only 3% of manufacturers said that investment over the coming year
would be constrained by a lack of external finance, the lowest share since 2007 and below the long-run
average. Corporate credit conditions also look very favourable. According to the latest Bank of England
Credit Conditions Survey, the availability of credit to companies, particularly small firms, is expected to
8
See footnote 5
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EY ITEM Club special report on business investment
continue expanding.9 The almost one-percentage point fall in the effective interest rate on businesses’
time deposits since the start of 2013 will encourage firms to invest rather than leaving cash idle. And
the lower cost of external finance, both for banks loans and alternatives such as bonds, should also
boost capital spending. Indeed, PNFCs raised net external finance of over £11b in the first half of 2015,
the largest amount over an equivalent period since the first half of 2009. With the Bank of England set
to keep Bank Rate unchanged until well into 2016, firms’ appetite to invest should continue to be
buttressed by low borrowing costs.
UK: Factors holding back investment
UK: PNFC interest rates
% of firms, deviation from long-run average
20
Uncertainty about demand
%
15
Unable to raise external finance
Cost of finance
10
8
7
6
5
5
Loans of £1m-£20m
Loans in excess of £20m
Time deposits
4
0
3
-5
2
-10
1
-15
1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
0
2007 2008 2009 2010 2011 2012 2013 2014 2015
Source : CBI/Haver Analytics
Source : EY Item Club/Haver Analytics
Admittedly, while cheap money will boost firms’ means to invest, it will not necessarily provide the
motive. For the latter, companies’ confidence in the stability of the economic outlook is crucial.
Investment is costly to reverse, so when a firm decides to undertake a project, it gives up the option of
waiting to gather more information. That option has a value which increases with the level of
uncertainty. A high level of uncertainty means that a firm will require a higher rate of return to
compensate for giving up the “option to wait”. Hence, the incentive to invest is reduced. 10
The good news is that notwithstanding recent
UK: Business investment & policy uncertainty
troubles in the world economy, economic
Index
% year
Real business investment (LHS)
uncertainty is currently at a fairly low level.
15
450
Policy uncertainty index (RHS)
According to the CBI survey quoted earlier, the
400
10
percentage of firms citing uncertainty over demand
350
as a factor holding back investment is currently
5
300
well below the norm. And a reassuring picture is
0
250
also painted by an ‘Economic Policy Uncertainty
Index’ developed by academics at the University of
200
-5
Stanford. This assesses economic uncertainty by
150
-10
measuring the frequency with which newspaper
100
articles contain the terms uncertain or uncertainty,
-15
50
economic or economy, as well as policy relevant
-20
0
terms such as ‘tax’, ‘regulation’ and ‘central
1998 2000 2002 2004 2006 2008 2010 2012 2014
11
bank’. On this measure, economic uncertainty in
Source : EY Item Club & policyuncertainty.com
the UK has been on a sharp downward path since
the 2012 and is presently running at its lowest level since early 2009.
In light of these positives, it is unsurprising that corporate confidence is presently running at a high
level. Both the latest Bank of England’s Agents survey and the quarterly survey conducted by the British
Chambers of Commerce show investment intentions above the norm. And according to EY’s Capital
9
Bank of England (2015), ‘Credit Conditions Survey, Q2 2015’.
http://www.bankofengland.co.uk/publications/Documents/other/monetary/ccs/2015/q2.pdf
10
See Avinash Dixit and Robert Pindyck (1994) ‘Investment under Uncertainty’, Princeton University Press.
11
For more details, see http://www.policyuncertainty.com/
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EY ITEM Club special report on business investment
Confidence Barometer, 58% of UK companies intend to buy assets over the next 12 months – the highest
proportion in the Barometer’s six-year history.12
The balance between cost of capital and labour is shifting in favour of the latter
We have long argued that one of the forces driving
very strong employment growth in recent years has
been the erosion of real pay. As well as supporting
labour-intensive activities, cheaper workers may
have encouraged firms to substitute labour for
capital. Indeed, thanks to depressed pay growth,
the period since 2008 has seen relative price of
capital goods versus UK workers move significantly
in favour of the latter. The cost of capital goods
(measured by the difference between real and
nominal business investment) increased by just
over 9% in real terms between Q1 2008 and Q2
2015. But the real weekly pay of the average UK
worker dropped by 8%. In contrast, the five years to
2008 saw real wages rise by 14% but the real cost
of capital goods increase by a much more modest
3.4%.
UK: Real cost of capital goods and labour
Q1 2008 = 100
115
Capital goods
110
Labour
105
100
95
90
85
80
2001
2003
2005
2007
2009
2011
2013
2015
Source : EY ITEM Club/Haver Analytics
But just as the post-2008 weakness in pay growth likely held back investment, current and future trends
in pay may promote it. Granted, we are not expecting growth in the typical worker’s cash pay to return to
the pre-financial crisis norm anytime soon. But a likely acceleration in pay growth stemming from an
increasingly tight labour market and the uplift to pay levels arising from next April’s introduction of the
‘living wage’ may encourage firms to invest more in improving efficiency and automating jobs previously
done by people.13 Such a shift will also be supported by cheaper energy, if low oil prices are sustained.
Energy and capital are often complements in production for the simple reason that many capital assets
require power. 14 This suggests that the spike in the price of oil in 2007 and 2008 may have been a
factor in the fall in investment during the financial crisis. Equally, the collapse in the price of crude over
the last year should deliver a spur to investment spending by on-shore firms.
That said, we would not want to overplay the importance of relative prices. The impetus to investment
from more expensive workers is likely to take some time to materialise in light of the large gap that has
opened up between the relative price of capital and labour. And the latter is not always easily
substitutable for the former, although advances in technology should make this process easier.
3. Challenges to investment-led growth
So there are plenty of reasons to think that business investment is set to continue making a substantial
contribution to economic growth. But these positive forces will have to battle potential headwinds, both
short-term and more structural.
North Sea investment likely to drop sharply…
One drag that already appears to be making its presence felt comes from the oil and gas sector, where
ageing fields and the collapse in the price of oil is hitting production and investment. In Q1, investment
by extraction companies fell by 7.9% on an annual basis, the largest drop for two years. Although
production of oil and gas in the North Sea accounts for little more than 1% of GDP, investment by the
extraction sector represents 7% of total business investment. So a drop in investment by oil and gas
12
‘EY Capital Confidence Barometer’, April 2015. http://www.ey.com/UK/en/Services/Transactions/EY-capital-confidencebarometer
13
The living wage will be paid to workers aged 25 and above, initially set at £7.20 an hour (compared to the current National
Minimum Wage of £6.50) with a target to reach more than £9 an hour by 2020. The Office for Budget Responsibility estimates
that allowing for spillovers to individuals higher up the pay scale, a total of 6m people will be affected.
14
See Lester C. Hunt (1984) ‘Energy and capital: substitutes or complements? Some results for the UK industrial sector’, Applied
Economics, Volume 16, Issue 5, 1984.
EY  13
EY ITEM Club special report on business investment
companies will have a disproportionate effect on overall business investment. And that drop could be
significant. A recent report by Oil and Gas UK, the industry trade body, suggested that capital
investment by the sector could halve by 2017 compared to the level in 2014.15 In mitigation and as
highlighted earlier, the boost from cheaper oil should encourage more investment in other sectors of the
economy, although this positive influence is likely to take some time to make its presence felt.
…while firms will need to use some of their cash to plug pension deficits…
Another current pressure potentially hitting investment comes from the sizeable pension deficits faced
by many firms. The aggregate deficit for FTSE 350 companies was estimated to have increased from
£53.3bn in 2013 to £64.7bn in 2014.16 Pension deficits can undermine investment in two ways. First,
uncertainty is generated around how much and when a firm will have to pay to fill the gap. Second, filling
a deficit means that a company may have less retained earnings to finance capital expenditure. Granted,
the closing down of many defined benefit pension schemes to new members means that any drag on
capital spending from this source should gradually abate. But with major UK companies taking
advantage of more flexible regulations from the Pensions Regulator to cut pension contributions over
the last few years, the current size of deficits may create pressure from trustees to reverse that trend.17
…and ’Brexit’ possibility presents risks
Stability and political predictability feature prominently in the list of desirable attributes cited by
investors in surveys like EY’s UK Attractiveness Survey, and the UK has traditionally scored well in these
areas. The UK Government is committed to a referendum on the future of the UK’s membership of the
European Union by the end of 2017 at the latest. It is difficult to judge how this might impact on
business investment in advance of the Government’s renegotiation. But the referendum has the
potential to change perceptions of the UK in a negative fashion. However, ‘Brexit’ fears certainly do not
appear to be having a noticeable effect on investment levels at the moment, despite speculation that a
EU vote could occur as early as the autumn of 2016.
The end of growth (and investment)?
There are also more speculative, longer-term
UK: Output per hour
threats to investment-led growth. Some
Quarterly, % point difference from 1972-2015 average
commentators, notably Professor Robert Gordon,
4
argue that modern computer-based innovations are
3
delivering much less in the way of productivity
growth (and hence opportunities for profit) than
2
advances seen during the first two industrial
1
revolutions (which encompassed the harnessing of
energy, clean water and urbanisation). 18
0
Consequently, investment in new developments
-1
becomes less attractive. The very weak
performance of productivity in the UK and other
-2
advanced economies since the financial crisis
-3
certainly offers some reason to support this view.
1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012
But we think that the techno-pessimists are
Source : EY ITEM Club/Haver Analytics
overplaying the gloom, not least because of the
potential offered by the computer-internet economy.19 Moreover, productivity growth is very volatile –
the UK has experienced a period of very weak productivity growth since 2008, but there have also been
15
‘Plunge in North Sea investment predicted’, Financial Times, 9 September 2015. http://www.ft.com/cms/s/0/e3a754e8-557811e5-9846-de406ccb37f2.html#axzz3l2KqtPUG
16
‘UK pension deficits widen as contributions drop’, Financial Times, 10 August 2015. http://www.ft.com/cms/s/0/7f284e263e9b-11e5-9abe-5b335da3a90e.html#axzz3l2KqtPUG
17
Ibid
18
Robert Gordon (2012) ‘Is US Economic growth over? Faltering innovation confronts the six headwinds’, NBER, August 2012.
http://www.nber.org/papers/w18315.pdf
19
For a comprehensive rebuttal of Gordon’s claims, see Justin Hicks ‘No More Growth? Let’s not be so Hasty: An Assessment of
Robert J. Gordon’s Recent Working Paper’, November 2012. http://www.innovationfiles.org/no-more-growth-lets-not-be-so-hastyan-assessment-of-robert-j-gordons-recent-working-paper/
EY  14
EY ITEM Club special report on business investment
prolonged periods of above-trend growth. So it would seem unwise to extrapolate the recent
performance of productivity into the future.
Conversely, a more optimistic perspective, with the future delivering a continued rapid stream of
innovations, poses its own risk to the appetite of companies to invest. The possibility of better
technology in the future always raises the danger of making current processes and products
unprofitable. Pioneer companies in the mobile phone sector provide a classic example, benefiting
enormously from the first wave of investment in mobile technology, but then battered by subsequent
advances in smartphones made by other companies. And it is not difficult to spot where rapid ‘creative
destruction’ could occur in the future. For example, driverless cars could make investment in
conventional vehicle production increasingly obsolete. If firms fear that the value of current investments
will be undermined by better opportunities in the future, they may be deterred from investing even if it is
currently profitable to do so.
That said, whether managers are as far-sighted or lacking in ‘animal spirits’ as this argument suggests is
debatable. Certainly, the fear of taking a first step in investing in new technology because the second
step may bite back hasn’t stopped numerous technological innovations from getting off the ground. And
if some investment is held back by a desire to ‘future-proof’, this may not necessarily be a bad thing,
since it should reduce the chances of investment spending being wasted.
Low rates – low investment?
The potentially favourable environment for investment from continued low interest rates was noted
earlier as a positive. But a low-rate environment may not necessarily provide much of a boost. Recent
academic work in the US, using data stretching back to the 1950s, concluded that movements in
interest rates play only a small role in explaining how much firms invest. Other factors – most notably
how profitable a firm is and the performance of its share price – were found to be far more important.20
A more counter-intuitive argument is that a long
Japan: Business investment
period of low interest rates may be positively
% year
harmful for business investment. If firms have
15
become more risk averse, they will want to
10
maintain a higher cushion of safe assets such as
cash. High interest rates mean that firms can build
5
up those assets simply by letting interest
0
accumulate on cash balances. But ultra-low rates
mean that accumulation requires actively adding to
-5
cash balances via cutting outgoings, including
-10
spending on investment.21 Granted, recent strong
growth in investment does not point to this being a
-15
particular problem among UK firms. But a look at
-20
the performance of business investment in Japan,
1994 1996 1998 2000 2002 2004 2006 2008 2010
an economy that has arguably been afflicted more
Source : EY ITEM Club/Haver Analytics
than any other over the last two decades by a riskaverse culture, saw periods when investment grew very strongly, only to slow just as rapidly.
2012 2014
More transparency may mean less investment
Meanwhile, a potentially structural threat to investment is posed by the move towards greater corporate
transparency and disclosure. It has been argued that these moves increasingly focus managers’
attention on disclosing what is termed ‘hard’ information (like quarterly earnings, which can be
quantified and verified). But this is at the expense of ‘soft’, less quantifiable and verifiable, information,
such as the value of a firm’s intangible assets (human capital and customer satisfaction being good
20
S.P. Kothari, Jonathan Lewellen and Jerold Warner (2014),’The behaviour of aggregate corporate investment’, April 2015.
http://faculty.tuck.dartmouth.edu/images/uploads/faculty/jonathan-lewellen/AggregateInvestment.pdf
21
Kenza Benhimay and Baptiste Massenot (2012), ‘Safety traps’. Journal of Economic Literature, May 2012.
http://www.hec.unil.ch/deep/textes/12.04.pdf
EY  15
EY ITEM Club special report on business investment
examples). Hence, more transparency and disclosure may mean that managers are incentivised to boost
short-term earnings by cutting longer-term investment projects or spending on staff.22
This argument posits an external pressure encouraging firms to invest less. But long-running internal
forces may also have the same effect. Namely, it is argued that the relative dominance in the UK of
quoted companies and a culture (shared with the US) of paying executives large share-based bonuses to
reward short-term success discourages long-term thinking and hence investment. In the short-term view,
cutting investment might damage a firm’s prospects. But that damage may take a long time to become
apparent. However, the boost to share prices from using money saved to pay higher dividends or engage
in share buybacks is immediate.
This is an issue which has long preoccupied some commentators and appears to be making inroads into
the thoughts of policymakers. The potential costs of shareholder short-termism were raised in a speech
earlier this year by Andrew Haldane, the Bank of England’s Chief Economist. 23 Mr Haldane cited striking
evidence that investment in the UK (and the US) is consistently and significantly higher among private
than public companies with otherwise identical characteristics, relative to profits or turnover. Moreover,
survey evidence, also quoted by Mr Haldane, shows that a much larger share of UK and US executives
place shareholder dividends as a higher priority than employee job security compared to their peers in
Japan, Germany and France.
UK: Stocks of fixed assets of private and quoted
firms scaled by profits and sales
Ratio
140
Survey results: senior executives at large
companies
Whose company is it?
Quoted
Job security or dividends?
Private
All stakeholders
Shareholders
Job security
Dividends
UK
120
100
US
80
Germany
60
40
France
20
Japan
0
Fixed assets by profits
Fixed assets by sales turnover
Source : Haldane quoting Davies et al (2014)
0
20
40
60
80
100
Source: Haldane quoting Yoshimori (1995)
Given how ingrained the UK’s equity culture is, a move towards a more German-style private ownership
economy seems unlikely. And that such a change would boost investment runs into a number of
problems. For one, UK corporate investment is currently running at a historically high level and appears
to be reversing the downward trend that began around 2000, despite the supposed ‘short-termism’ of
UK executives. Moreover, unlike previous episodes where the ratio of business investment to GDP
reached a relatively high level in the late 1980s and late 1990s, investment growth now is not being
spurred by an overheating economy or irrational hopes in a small number of sectors. And it is difficult to
square the supposed investment-depressing effects of an equity culture with the relatively high level of
business investment in the US, or the huge valuations of some prominent US companies which devote
significant resources to investment but, so far, have made relatively tiny profits.24
22
Alex Edmans (2015) ‘The real costs of financial efficiency when some information is soft’, Centre for Economic Policy Research,
June 2015. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2316194
23
‘Who owns a company?’ Speech by Andrew Haldane at the University of Edinburgh Corporate Finance Conference, 22 May 2015.
http://www.bankofengland.co.uk/publications/Pages/speeches/2015/833.aspx
24
See James Surowiecki, ‘The short-termism myth’, The New Yorker, 25 August 2015.
http://www.newyorker.com/magazine/2015/08/24/the-short-termism-myth
EY  16
EY ITEM Club special report on business investment
4. Conclusions
Overall, the balance of forces working for and against continued strong growth in business investment
strike us as firmly erring towards the former. In that respect, we are in fairly close agreement with the
Office for Budget Responsibility (OBR). Our forecast shows investment by firms rising by an average of
6.4% per year from 2015 to 2019, reaching, in real terms, a record high of 12.9% of GDP in that latter
year. In its July 2015 forecast, the OBR predicted annual average growth of 6.6% over the five years
from 2015, with the investment/GDP ratio rising to 13.1% of GDP in 2019.
If we (and the OBR) are correct, there are strong reasons to be optimistic about prospects for the UK
economy over the next few years. A continued robust appetite among firms to invest will be good news
in a variety of respects, not least for productivity growth, the economy’s potential to grow and the
sustainability of the expansion. Evidence from the CBI’s Industrial Trends Survey has been promising in
this respect, suggesting that companies that have been investing over the last year or two have done so
to expand capacity to a much greater extent than usual.
UK: Business investment
UK: Reasons for investment
% of real GDP
13.5
Difference from average, four-quarter moving average
20
Expand capacity
15
Replacement
10
Increase efficiency
OBR
ITEM Club
13.0
12.5
5
12.0
0
11.5
-5
11.0
-10
10.5
-15
10.0
2014
2015
2016
Source : EY ITEM Club & OBR
2017
2018
2019
-20
2000
2002
2004
2006
2008
2010
2012
2014
Source : EY ITEM Club/CBI
As higher investment stimulates activity and tax receipts and pushes the corporate sector further into
deficit, it should also give the Government scope to ease what we consider to be an unnecessary degree
of fiscal tightening. And a higher level of potential output will push down on inflation and so allow the
Bank of England to keep borrowing costs lower than would otherwise be the case.
That said, interpreting the evolution of investment over the next few years won’t be easy. The changing
nature of economic activity, including the increasing importance of intangibles and the rise of the
‘sharing economy’, will make defining and measuring the true level of ‘investment’ an ever trickier task.
Indeed, this challenge has already been evident from data revisions over the past few years which
transformed the measured performance of business investment from fairly dismal to impressively
strong. So it will continue to be necessary to take at least early estimates of investment spending with a
pinch of salt. But we are confident that time will prove that secular stagnation is an affliction that the UK
should happily avoid.
EY  17
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