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UK firms vulnerable to slowdown

Joseph Mariathasan finds that the UK economy has fared quite well since the Brexit vote, but smaller companies are vulnerable to any potential domestic slowdown 

At a glance

• Although the UK economy performed reasonably well in the six months after the Brexit referendum, some economists expect the next two years to be difficult.
• A fall in the demand for credit and the sharp depreciation of sterling are indicators of future problems.
• Smaller companies are in a weaker position than large ones to weather an economic slowdown in the UK.
• It is unclear how much scope the government has to give extra support to small businesses.

What is the likely long-term impact of Brexit for the UK’s small and mid-cap companies? Such companies tend to be more domestically focused. Whether they will be better or worse off over the long-term is more an article of faith and the subject of heated debate between pro and anti-Brexit factions than it is amenable to rational analysis. 

However, the view of most mainstream economists is clearer. As David Page, European economist at AXA Investment Management argues, the outlook for the UK domestic sector for the next few years is that it will be hit badly by Brexit. 

Many Brexit supporters are dismissive of fears of a negative economic impact. Page accepts there was no evidence of one in the economic data released in the second half of 2016 following the Brexit vote. However, he expects a couple of negative waves to hit the UK economic environment over the next two years. First, there is the uncertainty over Brexit, and second the reaction of the financial markets. 

While capital spending did not fall in the second half of 2016, Page points out that decisions to increase investment in that period were probably taken before the vote. 

“Once we look at investments based on decisions made after the vote, we are likely to see declines over the next couple of quarters,” says Page. He points to evidence for that being seen in the demand for credit which has fallen in the UK in the corporate sector across all size categories at the fastest pace since the 2008 crisis. That fall in demand for credit is indicative of a drop in investment spending. 

The other substantial impact is currency weakness. Sterling fell by 17% year-on-year on a trade-weighted basis to December 2016. Page sees this as exacerbating what was already a pick-up in inflation. Real incomes look set to fall substantially in 2017, so consumer spending will probably drop too. 

As a result, the UK economy could flirt with recession this year. That creates a short-term hit for small businesses. Larger businesses, which have better access to international markets, are likely to do better, with some even benefiting from sterling depreciation.

What all businesses face for a few years is the transition to the brave new post-Brexit world. No one in Europe has a big interest in creating disruption, says Marcus Ratz, a partner at European small-cap specialist Lupus Alpha. “Even with the UK, with its own currency, there are huge trading links that no one wishes to destroy,” he adds. “My feeling is that what is required is to negotiate a post-Brexit settlement that would cause the least disruption in terms of execution.” 

But that may not be easy. As Page points out, at the very least there are practical problems. Trade deals that the EU either has negotiated or is in the process of doing so account for close to 80% of the UK’s current export composition. The UK has not written a trade deal for the past 40 years, so that experience is lost. Many of the ministries that would have been responsible for negotiating trade deals, such as the Treasury and the Foreign Office, have been under significant cost-cutting pressures over the past six or seven years, shrinking the work force. So although the government is bolstering available resources, there is a significant question as to how quickly trade deals can be done. 

The UK is a large net importer of goods with the EU so, as Page suggests, it is likely that the EU will have some vested interest in trying to guarantee that tariffs and other trade barriers remain relatively low. What is not obvious is that such a deal will be mirrored in the service sector where the UK is a large exporter, particularly in the financial sector, to the EU. 

London’s pre-eminent role as the UK’s financial hub has created huge opportunities for many small and mid-sized companies, as well the behemoths. 

“One has to ask, is it still realistic for the UK to remain the hub for the financial community in Europe?” says Ratz. Clearly many European financial centres are vying with one another to take over London’s role in a post-Brexit world. 

“Even with the UK, with its own currency, there are huge trading links that no one wishes to destroy. My feeling is that what is required is to negotiate a post-Brexit settlement that would cause the least disruption in terms of execution” 
Marcus Ratz

But Ratz questions whether anyone should realistically expect either Paris or Frankfurt to become the new European financial hub after Brexit. “I think London is the financial hub of Europe and all the other contenders are secondary players,” he says. For that to change post-Brexit the rest of Europe would need to agree on where the future financial hub for Europe should be. It could be Amsterdam as well as Paris or Frankfurt, but Ratz does not see a decentralised structure as viable.

“Just saying that London should no longer be the financial hub of Europe will not be enough to shift business away from London,” he says. “There needs to be a consensus view of where a new hub should be and then the huge financial community in London needs to be persuaded to move to a new European financial hub with all the consequences that it entails. That raises a lot of question marks.”

Given the uncertainties and the high risk of disruption, particularly to the smaller company sector, what can the UK government do? As Page points out, it certainly managed to do something to encourage Nissan to increase its production and commit to future production in the UK. What it said appears to be a secret. State aid to a large, high-profile manufacturer may be done for all sorts of reasons, but it is not clear that such a model could be rolled out across the rest of the UK economy and potentially not to small businesses either.

“There are just too many small companies to be able to individually lobby the government for support,” says Page. Moreover, he adds, given that it is subject to EU law, the UK government may not be able to give smaller companies what they want. 

Longer term there will inevitably be a shift in trade away from Europe post Brexit. Page points out that this has already occurred to some extent because of the different growth patterns between the EU and the rest of the world over the past 15 years. 

UK exports shrank from 60% to the EU in the mid-1990s to 50% now. But part of the reason that the UK exports more to Spain than Australia – countries that are broadly similar in GDP – is not because it is in the EU, but because it is closer. It is significantly more expensive to export goods halfway round the world than just few hundred miles south of us. That may not be the case for financial services, but how scaleable they are will be an issue, says Page. “So there are significant questions as to how successful the UK can be in creating this über international trade framework in a post-Brexit world,” he says. 

For the UK’s smaller companies that may not be great news.

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