The sharp fall in sterling since the EU referendum has aided the international competitiveness of UK manufacturers and improved business confidence. But how long can it last?
Few thought June’s vote to leave the European Union (EU) would kick-start UK manufacturing. However, the 15.1 per cent depreciation in sterling against the US dollar since the referendum has helped restore business confidence quicker than many expected.
In the wake of the surprisingly sharp bounce in sentiment, forward-indicators of UK manufacturing and services output are encouraging for the final three months of 2016, with gross domestic product (GDP) appearing to have expanded by 0.6 per cent in the final quarter.
With businesses calling out for guidance on what ‘Brexit’ actually means, Prime Minister Theresa May unveiled the UK industrial strategy on 23 January. The proposals aim to boost the sectors of the economy in which the UK excels, while closing the gap between the most productive areas of the country and the rest. This followed a 12-point plan for opening negotiations on leaving the European Union unveiled on 16 January.
In this Q&A, Senior Economist Stewart Robertson and Equities Fund Managers James Balfour and Giles Parkinson consider whether a weaker sterling and proposed government business initiatives can really deliver the long-awaited revival of domestic manufacturing in the face of Brexit.
Can UK manufacturing stage a long-awaited revival?
Stewart Robertson: Stories of a UK manufacturing revival stretch back 20 years or more. History shows there tends to be a natural evolution of the economy away from agriculture to manufacturing and then to high-value services. There is an inevitable march of progress which means manufacturing will tend to shrink as part of the overall the economy.
Manufacturing contributes around 10 per cent of output in UK, compared to 12 per cent in the US, 23 per cent in Germany and 16 per cent in Italy. In a world where capital is internationally mobile, if you can make things cheaper somewhere else, companies probably will.
Giles Parkinson: The secular trend of manufacturing accounting for a shrinking proportion of economic output and employment spans all post-industrial countries. It's share of global GDP has shrunk from 21 per cent to 15 per cent over the last two decades. Capitalism is the process of organising resources more efficiently, which means fewer people making less ‘stuff’.
SR: We have seen government ideas in recent years such as George Osborne’s so-called northern powerhouse and Theresa May’s industrial strategy. But, if you look at the median wages for regions against the proportion of people employed in manufacturing, there is a negative relationship: the more manufacturers that are located in a region, the lower the median wage, while the more services that are found in a region the higher the median pay.
So, if you really want to revive the north, then you should be making it more like the south. That said, you can still promote manufacturing, but more of the high-value variety that the UK can be very good at. For instance, engineer Rolls-Royce produces world class aerospace engines and the cluster of technology businesses in so-called Silicon Glen in Scotland. If it was all about metal-bashing, building widgets or some other low-skilled activity then domestic companies would not be able to compete with similar manufacturers in low-wage economies.
How much can politicians do to rebalance the economy?
SR: UK industry needs to move with the times and where profitable business opportunities lie. And some areas will suffer because of that.
Politicians can do two things. They can support those areas that have a long-term future in a more competitive world to the extent that the northern powerhouse is concentrating on the right industrial sectors. But politicians should also develop initiatives to help retrain workforces hit by the change. Theresa May’s industrial strategy proposals and the northern powerhouse initiative are to be applauded in terms of trying to create the conditions to encourage business growth. But, it can’t be a misguided effort to continue making things people do not want.
Silicon Glen and ‘Silicon Fen’ around Cambridge are two examples where we have specific types of high-value manufacturing expertise. This sort of industry development should be encouraged.
Nissan’s car-making factory in Sunderland illustrates how mobile industries have become. If you don’t have a specific expertise, cost advantage or access to markets, international businesses have a larger incentive to move operations elsewhere.
James Balfour: Theresa May’s 12-point plan provides some clarity for business on the direction the government is heading in key areas such as trade with the bloc and the single market. May has clearly stated that science and innovation are critical and signalled increased investment in both areas. Such investment will be vital. The UK was a net receiver of EU funding for health and biosciences between 2007 and 2013, despite being a net contributor to the overall EU budget.
The industrial strategy proposals unveiled this month add more detail to efforts aimed at supporting UK businesses and the regions. That said, uncertainty will persist on business policy.
The car industry is a case in point. Whatever assurances the government provided to Nissan in October on retaining car production at Sunderland, it will likely need to make similar assurances with other car manufacturers or they are more likely to relocate abroad. The government will need to choose carefully which sectors of the economy it chooses to support most if it is to get real value for money from investment.
SR: Robotics and developments in technology such as artificial intelligence will be an increasing influence on whether businesses succeed or not. If you can employ robotics, and so fewer people, then you can have a competitive manufacturing base. For example, looking at car manufacturers, Germany has relatively expensive wages but a thriving car industry. At the high-value end, Germans are very productive. The UK can have pockets like that. Indeed, while German wages have risen, manufacturing’s share of total output was the same in 2015 as it was in 2000, while in the UK manufacturing’s share of the economy fell by a third over the same period.
Were you surprised by the speed of the bounce in sentiment after June’s vote?
SR: Yes. I thought the decision was a negative and it will be in the long term. It is not surprising manufacturers’ confidence has recovered given the boost to competitiveness from a weaker currency. But, this is not going to help rebuild the country’s manufacturing base.
The fall in sterling will not make a poor manufacturer a good one. Indeed, at the margins, you may see struggling manufacturers that may have gone out of business have been given a lifeline and go out of business over a longer period.
GP: The depreciation of sterling since June has helped everything from tourism to manufacturing and even higher-end jobs such as software design become more competitive globally. UK workers have all essentially taken a pay cut, which makes goods and services produced in the UK relatively cheaper. The impact will be greater where labour accounts for a high proportion of overall costs and margins are low. High-end software design is cheaper to conduct in the UK, but what matters more is whether the engineers have the right skills in the first place.
JB: Given the global supply chains that have become common across manufacturing, sterling’s devaluation means businesses may increase production of some materials in the UK as opposed to elsewhere if this will increase profit without compromising quality. For instance, engineering group Weir has stated that it will consider manufacturing more goods in the UK as the weaker pound makes it beneficial to do so.
SR: Indeed, there is some evidence that international supply chains are limiting the effect of currency depreciations on boosting exports. The more integrated the chain, the lower the potential benefit to exports of a weaker currency.
What about productivity?
SR: As the economy becomes more services driven, productivity growth typically falls. That’s a natural change. Productivity depends on output and the number of people needed to produce it. Increased use of automation will increase productivity. Over the last twenty years, productivity growth in manufacturing has probably been around three per cent, in services one per cent and overall 1.25 per cent. The problem with services is that you need more people.
There has been a secular decline in productivity growth in developed markets. One of the reasons is the greater proportion of retirees in the population; another is the transition to services from manufacturing.
Meanwhile, productivity growth is rising in emerging markets, aided by demographics and also technology catch-up with the rich economies.
Do you expect the manufacturing sector to benefit more from the sterling depreciation than services?
SR: Yes. So much of services is based on the domestic economy. Software and financial services are two services where exports are stronger.
While some industries are likely to benefit more from sterling’s weakness than others, it depends more on the level of exports within industries. Furthermore, the industries where price inelasticity is highest should benefit most. Those that prosper least from the weaker pound will be those where demand for their products is not price sensitive.
What about business investment?
SR: Business investment surveys are almost universally weaker. Both the Bank of England and the Office of Budget Responsibility project a marked investment-driven slowdown in 2017.
Investment typically makes up 15 per cent to 20 per cent of GDP, and business investment about half of that. A five per cent to ten per cent annual decline in investment is far from unprecedented. That alone would make a significant dent on overall output growth this year.
This fall in sentiment doesn’t mean profitable opportunities do not exist; it is the increased level of uncertainty around Brexit that is largely to blame. With at least two years of negotiations with other European Union states around the terms of the exit, this period of uncertainty will persist. Indeed, investment falling by five to ten per cent is plausible.
The slowdown in the UK economy I expect to see in 2017 will be driven by first weaker business investment and later by poorer consumer spending as higher inflation starts to bite.
My bias remains that Brexit will be a long-term negative for the UK economy, but there will be a short-term boon from the exchange rate.
 Source: Thomson Reuters EIKON, 25 January 2017
 Source: World Bank, Manufacturing, value added as percentage of GDP, 25 January 2017
 Source: The Centre for Economic Policy Research, Depreciations without exports, 27 August 2015
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 26 January 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.