UK manufacturing: the shape of things to come

Posted on 16 Dec 2011 by Tim Brown

Trevor Williams, chief economist at Lloyds Bank Corporate Markets, provides expert analysis of the economic outlook for the UK with specific focus on the manufacturing sector.

The UK manufacturing sector has had a difficult autumn. Despite having grown considerably more quickly than the economy as a whole, rising more rapidly than GDP in every quarter since the trough in activity in late 2009 (see Chart A), that run came to an end in the second quarter of this year when manufacturing output fell by 0.5%.

While explanations such as the Japanese earthquake and an extra bank holiday have been amply discussed, more fundamental concerns have emerged in the second half of the year.  Weaker global growth prospects have resulted in a cut to our output growth forecasts for both this year and next and international developments including negative news from of the euro area have served to chill business sentiment almost everywhere.

There is no need to over-exaggerate the situation however. Overall the sector remains well positioned for growth, an ease in the pace of the manufacturing upturn was entirely predictable, particularly as a considerable part of the initial rebound was due to a turnaround in the inventory cycle.  The stimulus from this inevitably faded once inventories were once again close to desired levels.

The export-related nature ofUKmanufacturing also provides some insulation to the woes and domestic constraints that limit spending growth by theUKgovernment and households.  This means that exports are the most likely source of economic growth at present.

As such the overall outlook for manufacturing remains relatively positive. The sector is still expected to grow more quickly than the economy as a whole on the basis that international developments and those in the eurozone are managed sensibly to avoid a disorderly default on debt repayments.

Indeed, despite manufacturing’s contribution to UK GDP being considerably smaller than it was 20 years ago – accounting for 10% of the UK’s economic output – it still amounts to around 55% of UK exports.  To improve this further, Lloyds has joined forces with the Government body, UKTI (UK Trade and Investment), to launch a pilot which will help mentor businesses that want to export. This will focus initially on helping manufacturing businesses and is in alliance with the Manufacturing Technologies Association (MTA). So, although weaker than hoped, our export growth forecasts for next year remain positive with manufacturing output looking to do relatively well and profit margins in the sector continuing to expand.

Further insight

Chris Chambers and Stuart Apperley, relationship directors within Lloyds’ Global Diversified Industrials Team, give their perspective on UK manufacturing challenges with particular regard to market volatility, investment priorities and skills availability.

Although the negative sentiment emanating from the eurozone is a cause for uncertainty, and therefore a key challenge for the export-linked manufacturing sector, UK manufacturers are themselves in good shape.  Having taken action to de-leverage their balance sheets from 2008 levels, close underperforming operations and invest to improve efficiency, many are well positioned to take advantage of long-term opportunities and navigate adverse market conditions in the meantime.

The immediate and ongoing challenges facing UK manufacturing include potential market volatility in the form of fluctuating foreign exchange rates and commodity prices. Oil prices, still $30 a barrel higher than a year ago, remain keenly watched. Hedging and risk management are quite rightly priorities which we have been helping customers to traverse.

In terms of other priorities, investment in R&D and skills remain integral to the long term performance of the industry. The Government’s Make it in Great Britain campaign launched last month to champion the industry, combined with other policy work to promote careers in manufacturing, act to support the future of the industry and rebalance the economy away from the financial sector.

We know from our conversations with clients that there is a struggle to find candidates with the right skills. Indeed a shortage of skills is seen as the biggest barrier to foreign investment in theUK. The automotive industry has been proactive in tackling some of the challenges facing the manufacturing sector. It has demonstrated a firm commitment to R&D, investing £1.5bn annually and translated innovation into commercial success.  It has shown great strength and resilience and been rewarded by new commitments to UK facilities from global vehicle manufacturers such as TATA.

Automotives have also benefited from targeted tax incentives and support programmes to help trigger private sector investment in ultra-low carbon technologies helping to position the UK at the forefront of new developments in the sector. As a vital part of the UK economy with over £40 billion turnover and £8.5 billion value added, automotives comprise an important part of total UK exports and acts as a useful case study demonstrating British expertise in delivering high-value, low volume skills.

These high value skills are also keenly sought for export. Emerging markets like China are well known to crave the expertise held in the UK’s manufacturing sector, enabling the UK to export its products, world-leading technologies and know-how. In addition to this and making sought after, high-end products, some of theUK’s most successful manufacturers have also become adept at offering slick servicing and maintenance of the goods which they supply.  This has enabled them to open up new revenue streams and win new clients.  Rolls Royce, for example, now earns more than half of its revenues from regularly servicing the engines it has manufactured at a state of the art facility in the UK.

That said, the continued weakness seen in surveys, notably the manufacturing PMI and the CBI industrial trends suggest that the outlook for the sector continues to remain challenging.  This bolsters the view that the implied numbers of an increase in production of 0.7% in September may be too optimistic. As such we have pencilled in a flat reading for manufacturing output growth in September, with overall production posting a modest 0.3% rise. A weaker outcome would raise the risk of a potential downward revision to the 0.5% print for Q3 GDP.

Taken together, this means that despite the uncertainty emanating from the eurozone – and the potential contagion associated with it – the UK manufacturing industry stands in a strong relative position. The hard work the sector has invested since 2008 combined with a backdrop of government commitment to support and strengthen it, should serve to help limit fallout if for any reason there is not a clean outcome from current events.