CYBG SME HEALTH CHECK INDEX Q2 2018 by Lesley Brydon

SME Health Check Index Q2 2018

#SMEhealth

SEPTEMBER 2018 Compiled by Cebr, in association with CYBG

DISCLAIMER Whilst every effort has been made to ensure the accuracy of the material in this document, none of Centre for Economics and Business Research Ltd (“Cebr”), CYBG PLC (“CYBG”), or any of their group companies, directors or employees will be liable for any loss or damages incurred through the reliance on or use of this report. This report does not constitute an investment or research recommendation, or any form of investment advice. This report may contain forward looking statements, based on assumptions and/or targets. Actual results may differ.

Authorship and acknowledgements This report has been compiled by Cebr, an independent economics and business research consultancy established in 1992. The views expressed herein are those of the Cebr only and are based upon independent research by it. The report does not necessarily reflect the views, financial position, business strategy or intentions of CYBG, its group companies, or its directors or employees. All lending decisions are subject to status. London, September 2018

#SMEhealth | Q2 2018 REPORT

CONTENTS Foreword 5 Infographic 6 Executive Summary 7 1 UK macroeconomic environment 8 2 SME business health nudges down in Q2 2018

3 In focus: SME Business cost inflation

4 Special Report: SME investment plans

5 Conclusions 27 6 Methodology 28

#SMEhealth | Q2 2018 REPORT

FOREWORD GAVIN OPPERMAN

Group Customer Banking Director The importance of SMEs to UK PLC needs no explanation. 99.9% of British businesses are in the SME bracket, and every one of those 5.7 million enterprises makes a unique contribution. CYBG has a unique insight into this diverse group of businesses and the backdrop against which they operate. Every three months we take the temperature of this critical sector and, regrettably, we report another quarter of mixed news.

between the last three months of 2017 and Q1 2018, as outstanding loan and overdraft balances decreased. Interest rate increases in November and August added to the pressure on business investment indicated by those trends.

The SME Health Check Index fell by 0.5 points in Q2 to 47.1 - its second lowest level since we began tracking this data in 2014 – but the individual indicators tell a much less sombre story. The capacity indicator is improving, as is general confidence (which is at its highest level since the second quarter of last year). Contracting lending and rising inflation put the squeeze on businesses across the country.

There have been some muchneeded boosts, the Royal Wedding, World Cup and warm summer weather all contributing to a pickup in output growth. Retail and construction businesses saw some of the greatest improvements over the second quarter. That being said, general business confidence is likely to be suppressed by the uncertainty surrounding the arduous Brexit discussions, which continue to arrogate a disproportionate share of the airtime.

These top-line pressures are material, but both capacity and GDP grew in most regions, with an encouraging balance evident across the country, In addition the East of England and Yorkshire & the Humber regions saw positive employment growth figures. Those are the headlines, but businesses of course deal with the reality on the ground. The lending indicator fell by 18 points to 38

We are hopeful that the timetable on Brexit will impose some clarity on this discussion and that British businesses will have the insight they need to plan for life outside the EU. However, it seems more likely that business will need to manage at least some level of continued uncertainty for the foreseeable future.

We worked with YouGov who polled 504 UK SMEs as part of this quarter’s SME Health Check Index. The findings of this survey portray low levels of confidence when it comes to investing in business, with around half of SMEs choosing to not increase the levels of investment in their businesses over the past 12 months. Strong levels of investment are crucial in achieving sustained improvements to the productive capacity of an economy and we have historically been below the levels seen in other advanced western economies. Our critical task is to ensure that the operating environment for SMEs – exporters, importers and entirely domestically focused businesses alike – is as uninterrupted as possible. As a lender, we are doing our bit, especially with our ongoing lending commitment to SMEs across all regions in the UK. We hope to have better news to share in three months’ time.

S M E H E A LT H C H E C K I N D E X S C O R E

TA K I N G T H E T E M P E R AT U R E OF THE UK’S SME PERFORMANCE

Q2 2018

Small and medium sized enterprises are the engine room of the UK economy.

5.7 MILLION

60%

private sector businesses

Q1 2018

47 47

100 -

- 1.0%

90 -

- 0.9%

80 -

- 0.8%

70 -

- 0.7%

60 -

- 0.6%

50 -

- 0.5%

40 -

- 0.4%

30 -

- 0.3%

20 -

- 0.2%

10 -

- 0.1%

82.5

80.1

2014

81.6

2014

77.4

74.6

2014

2015

83.0

2015

SME Health Check Index

74.0

2015

87.4

2015

59.1

2016

57.5

2016

64.1

2016

GDP

Business Costs 62 (2 )

Capacity 41 (5 )

Confidence 57 (11 )

Employment 66 (5 )

GDP 69 (4 )

Lending 38 (18 )

Net business creation 1 (1 )

Revenue 43 (-)

changes above are compared to Q1 2018.

Q2 2018

Change from Q1 2018

East Midlands

53.5

2.9

East of England

49.6

10.9

London

44.9

4.4

North East

48.3

1.8

4.9

Scotland

39.8

4.4

South East

39.6

7.3

3.6

Wales

58.6

8.8

West Midlands

43.5

0.8

Yorkshire and the Humber

58.8

11.3

North West

South West

SMEs combined annual turnover

62.9

2016

60.1

2017

57.8

2017

49.8

2017

43.9

2017

47.6

2018

47.1

2018

- 0%

GDP (%)

Q2 2018

INDEX SCORE

OV E R A L L I N D E X S CO R E

£1.9 TRILLION

of private sector employment

#SMEhealth | Q2 2018 REPORT

EXECUTIVE SUMMARY Small businesses are the backbone of the UK economy. Accounting for almost all businesses in the UK, the contribution SMEs make to the economy cannot be underestimated. As well as driving growth, opening new markets, and encouraging innovation and creativity, the UK’s 5.7m SMEs also create jobs - employing a record number in the private sector, equating to almost half the UK population. This quarterly report for CYBG, owner of Clydesdale and Yorkshire Banks and its digital brand B, analyses the health of SMEs in the UK. The result of the analysis is the SME Health Check Index, which combines various statistics and indicators to evaluate the health of the business and the macroeconomic environment within which SMEs operate. The SME Health Check Index takes on values between 0 and 100. A score of 100 would indicate that all of the SME Health Check Index’s eight indicators are at their highest level since data collection began in 2014. A score of 0 would show that all of the eight indicators are at their lowest level since 2014. The Q2 2018 report finds that: ⊲ T he SME Health Check Index fell by 0.5 points to 47.1 in the second quarter of 2018. This means the Index is now at the second lowest level since data collection began in 2014. ⊲ T he GDP and capacity indicators improved in Q2, as the UK economy rebounded following a stuttering start to the year. This uptick in activity was also reflected in the confidence indicator, which rose to its highest

level since Q2 2017. While the annual rate of business creation increased marginally, it remains very low by historical standards. ⊲ A lthough the labour market continued to tighten over the second quarter of the year, the annual rate of employment growth slowed somewhat, bringing down the employment indicator. The value of SMEs’ outstanding loans and overdrafts also fell between Q4 2017 and Q1 2018, which dragged down the lending indicator. Borrowing in the early months of 2018 will have been suppressed by the slowdown in economic activity and expectations of future interest rate rises over the remainder of the year. Meanwhile, steep increases in the price of physical inputs contributed to a two point decline in the business costs indicator. ⊲ S ix out of the 11 regions experienced an improvement in the SME Health Check Index between the first and second quarters of the year. Most regions saw significant improvements in the capacity and GDP indicators, while confidence also continued to increase in many areas. The largest gains

were seen in Yorkshire & the Humber and the East of England, which both bucked the trend of a slowdown in employment growth observed elsewhere in the UK. Scotland also experienced a notable increase in the SME Health Check Index, driven by a significant recovery in the confidence indicator. ⊲ T he number of people employed in the South East and the North West was lower in Q2 2018 than at the same point last year. This, together with significant falls in the capacity and lending indicators, contributed to these regions seeing the largest declines in the SME Health Check Index in Q2 2018. ⊲ T he SME Health Check Index score for the North East remained relatively stable, rising by one point to 48 in Q2 2018, as a large fall in the employment indicator was offset by improvements in the capacity and confidence indicators.

#SMEhealth | Q2 2018 REPORT

1 UK MACROECONOMIC ENVIRONMENT The second quarter of 2018 has seen the UK economy regain some momentum following a hesitant start to the year. According to the Office for National Statistics’ (ONS) first estimate, the annual rate of GDP growth rose from 0.2% in Q1 to 0.4% in Q2 of 2018. The most significant improvements were recorded in the construction and retail sectors, which both received a boost from the good weather - the former through fewer interruptions to work, and the latter through increased footfall on the high streets. These positive developments were balanced somewhat by a second consecutive quarterly contraction of the manufacturing sector, meaning that it has now entered a technical recession. In August, the Bank of England’s (BoE) Monetary Policy Committee voted unanimously to raise its base rate by 25 basis points to 0.75% - the highest level in over nine years. This reflects the Bank’s view that the UK economy currently has a “very limited degree of slack”, and a series of gradual rate rises is required in order to contain inflation, which has now exceeded the BoE’s 2% target for 18 months. Over the second quarter, the unemployment rate averaged 4.0% - the lowest level since 1975, and the number of vacancies in the three months to July was the highest since records began in 2001. While on one hand these figures do point to an extremely tight labour market, underwhelming earnings growth suggests that there remains some spare capacity, since firms are not yet being forced to raise wages significantly in order to attract workers. At the beginning of the year, it appeared that households were poised to enjoy a period of stronger real income growth following the prolonged squeeze in 2017.

However, the rate of earnings growth has since retracted while inflation has remained relatively stable, meaning real earnings growth for the average household has all but vanished. Throughout Q2, the annual rate of consumer credit growth stood at 8.8% below the level seen over the previous two years, but still high by historical standards. Flatlining incomes, together with the BoE’s delay in raising interest rates, will have bolstered household borrowing in recent months. A substantial improvement to wage growth is needed in the short to medium term to avoid either an unsustainable build-up of household debt or a slowdown in consumer spending, both of which would have potentially major ramifications for the UK economy. Over the summer the likelihood of a ‘no-deal’ Brexit has increased significantly, as the UK and the EU remain locked in negotiations on a number of key issues relating to trade and the Irish border. Any agreement will need to be finalised some months before the

UK’s withdrawal from the EU on March 29th 2019, in order to provide sufficient time for House of Commons approval and ratification by EU leaders. While both sides maintain that a no-deal outcome would be highly damaging for either party, the slow rate of progress in the negotiations thus far has meant that businesses will increasingly have to plan for what the UK’s foreign secretary has dubbed a “no-deal by accident”. This could act as a significant drag on investment in the coming months as the March 2019 deadline approaches. Alternatively, a large surge in imports prior to the UK’s withdrawal of the EU could occur if businesses fear that their access to European goods will be severely restricted post-Brexit.

#SMEhealth | Q2 2018 REPORT

2 S ME BUSINESS HEALTH NUDGES DOWN IN Q2 2018 SMEs are a key component to the success of the UK economy. Making up more than 99% of all UK businesses, SMEs’ commitment to achieving their goals helps drive the country’s growth. We are not only analysing different variables that can be directly linked to the performance of SMEs, such as confidence and revenue, but also the business and macroeconomic environment in which SMEs operate. The following section begins by presenting the overall results of the SME Health Check Index and its indicators, before turning to regional comparisons. In the second quarter of 2018, the SME Health Check Index dipped by 0.5 points to 47.1 – the second lowest level since data collection began in 2014. An improvement in business confidence and the rate of GDP growth in Q2 were negated by a rise in business cost inflation, a slowdown in the rate of employment growth and a fall in the lending indicator.

Similar to the results revealed last quarter, the movements of the Index in Q2 are slightly at odds with the historical trend, which has generally seen the SME Health Check Index move in tandem with the rate of GDP growth. This can be attributed to the fact that the adverse weather in Q1, followed by benign conditions in Q2 meant that a lot of activity was back-

loaded to the second quarter. This suppressed first quarter output, while elevating output in the second quarter, without significantly altering the economy’s long-term capacity. The following section analyses the indicators of the SME Health Check Index in more detail.

100 -

- 1.0%

90 -

- 0.9%

80 -

- 0.8%

70 -

- 0.7%

60 -

- 0.6%

50 -

- 0.5%

40 -

- 0.4%

30 -

- 0.3%

20 -

- 0.2%

10 -

- 0.1%

2014

2015

2016

SME Health Check Index

2016

2017

2018

GDP

Sources: FSB, ONS, UK Finance, Cebr analysis

- 0%

GDP (%) quarter-on-quarter change

INDEX SCORE

Figure 1: SME Health Check Index

#SMEhealth | Q2 2018 REPORT

2.1 INDEX INDICATORS Business Costs The annual rate of business cost inflation rose by 0.1 percentage points to 2.9% in the second quarter of 2018. This was driven by an acceleration in the rate of price growth for physical inputs. Another factor was an uptick in the rate of inflation for construction output, which is likely to reflect the spike in demand following the widespread disruption that took place in the first quarter with the collapse of Carillion and the adverse weather conditions. The rise in business cost inflation has not been matched by an increase in consumer price inflation, suggesting that for now, many businesses are not passing through rising costs to their customers. Capacity A lower share of SMEs reported that they had operated below capacity over the second quarter, which drove up the score for this indicator by five points to 41. This is the first time that this indicator has improved since Q2 2017. The disruption brought about by the bad weather in early 2018 will mean that a lot of activity has been pushed back to Q2, lowering the share of SMEs operating below full capacity.

Confidence

GDP

Business confidence among SMEs - as measured by the Federation of Small Businesses’ (FSB) Voice of Small Business Index1 - continued to climb over the second quarter, reaching a one year high. This is likely to reflect the rebound in activity that took place in Q2. However, it is worth noting that the SMEs were surveyed in May. Since then, the possibility of a ‘no-deal’ Brexit appears to have risen notably, which is likely to be a significant concern for many SMEs. . Employment The annual rate of employment growth edged down to 1.0% in Q2, bringing down the Index score for this indicator to 66. Despite the negative movement of this indicator, the continued rises in employment are encouraging given the existing tightness of the labour market. The unemployment rate is now at its lowest level since 1975 (4.0%), while the number of vacancies is at record high. Given the ever shrinking pool of available workers, a gradual slowdown in the rate of employment growth is likely in the coming quarters.

The UK economy has recovered from a slow start to the year, expanding by 0.4% over the second quarter of 2018. This pushed up the relevant indicator by four points to 69. The most notable improvements were registered in the retail and construction sectors, which grew by 1.6% and 0.9% respectively over Q2. The rebound in construction activity suggests that significant portions of work were delayed until the second quarter due to weather related factors. In less positive news, total exports in Q2 2018 were 1.8% down on the level recorded during the same period in 2017. This reflects a cooling of external demand from many of the UK’s key trading partners. One of the major victims of this has been the manufacturing sector, which contracted for the second quarter in a row in Q2 2018, meaning that it has now entered a technical recession.

Federation of Small Businesses: Voice of Small Business Index – Q2 2018

#SMEhealth | Q2 2018 REPORT

Lending to SMEs

Net Business Creation

The lending indicator fell by 18 points to 38 between Q4 2017 and Q1 2018, as the level of SMEs’ outstanding loan and overdraft balances fell by £842 million according to UK Finance’s lending data. SME borrowing in the first quarter of 2018 will have been constrained by the interest rate rise in November the previous year, the overall slowdown in economic activity, and the expectation of future rate rises over the course of the year. In the Bank of England’s Credit Conditions Survey, lenders reported a significant increase in the demand for corporate lending from small businesses in Q2.2 This suggests that SMEs’ borrowing habits were impacted to some degree by the economic slowdown in Q1 and the subsequent bounceback in Q2.

Revenue

The annual rate of net business creation in the UK remained at 3.5% in Q2 2018, the lowest rate since the SME Health Check Index began tracking data in 2014. At 256,000, the number of companies dissolved over the first half of this year is the highest since data collection began in 2014. The number of new companies incorporated over the same period is also higher than in any other year with the exception of 2016. This suggests that while technological developments have made it easier than ever to start a business, the challenging economic conditions prevailing in the UK also mean that more businesses are being forced to close.

The revenue indicator is based on data that are released only twice a year therefore the indicator remains at 43 in Q2 – the second lowest level since data collection for the SME Health Check Index began in Q1 2014. The Q2 pick-up in output growth observed in – among others – the construction, transport, storage, and restaurant sectors suggests solid revenues for SMEs in these industries. Furthermore, retail sales growth has accelerated since April, supported by solid consumer credit growth as well as a number of one-off events such as the Royal Wedding and the World Cup. This points towards strong revenues for consumer facing businesses, particularly in the food industry, which has seen sales rise during the warm weather the UK has enjoyed in recent months.

Bank of England, July 2018: https://www.bankofengland.co.uk/credit-conditions-survey/2018/2018-q2

Figure 2: Sub-components of the SME Health Check Index

0 Business Costs

Capacity

Confidence

Employment Q1 2018

Sources: FSB, ONS, UK Finance, Cebr analysis

GDP

Lending

Net Business Creation

Revenue

Q2 2018

#SMEhealth | Q2 2018 REPORT

2.2 R EGIONAL BREAKDOWN OF THE SME HEALTH CHECK INDEX While the previous section of the report analysed the indicators of the SME Health Check Index across the UK as a whole, this section investigates regional differences in order to understand which parts of the UK currently present a more favourable business and macroeconomic environment for SMEs. We divide the UK into the nine English government office regions (East Midlands, East of

England, London, North East, North West, South East, South West, West Midlands and Yorkshire & the Humber), as well Scotland and Wales. Six of the UK’s regions experienced an improvement in the SME Health Check Index over the second quarter of 2018, while five saw a decline. The largest improvements were seen in Yorkshire & the

Humber – which continued its momentum from the start of the year – and the East of England, which bounced back following a large fall in the Index score in Q1 2018. Meanwhile, the South East and the North West recorded the largest declines in the Index, the latter likely a reflection of the troubles that its crucial manufacturing sector has faced so far this year

Figure 3: Regional SME Health Check Index

60 50 40 30 20 10 0 East Midlands

East of England

London

North East

North West Q1 2018

Scotland

South East South West

Wales

West Midlands

Yorkshire & the Humber

Q2 2018

Sources: FSB, ONS, UK Finance, Cebr analysis

East Midlands The SME Health Check Index score for the East Midlands continued to climb in the second quarter of 2018, rising by three points to 54. This improvement was powered by an uptick in the annual rate of employment growth. The region 12

received a further boost this month when East Midlands Airport announced its intention to add an additional 8,000 jobs over the next five years. Confidence among the regions’ SMEs also increased to its highest level since Q1 2017. Despite the recent increases in the

SME Health Check Index, it is worth noting that the score remains lower than at any time prior to Q2 2017. One concern for businesses in the region is the retention of the young skilled workers produced by the region’s top universities. According to a study by Grant Thornton UK LLP,

#SMEhealth | Q2 2018 REPORT

less than a fifth of the East Midlands’ university students plan to stay in the region after graduation.3 East of England One of the largest gains in the SME Health Check Index was recorded by the East of England, where the score rose by 11 points to 50. This follows the seven point fall between Q4 2017 and Q1 2018. The improvement last quarter was driven mostly by a substantial decline in the share of SMEs operating below capacity. This is likely to reflect the rebound in economic activity that took place in Q2 following the slowdown in the early months of the year. The East of England will have been particularly exposed to this effect due to its large construction sector, which saw a marked acceleration in output as work delayed due to the adverse weather in Q1 was carried over into Q2. A recent report by the Centre for Cities has found that cities in the East of England are set to see significant labour shortages following Brexit. Cambridge – the region’s largest city – will be affected more than any other city in the UK, while two other Eastern cities (Peterborough and Luton) also enter the top 10.4 Maintaining access to skills will be crucial in powering the future growth of many of these cities’ high tech industries.

London The SME Health Check Index score for London dipped to 45 in Q2 2018, down from 49 in the first quarter of 2018. The number of people employed in the capital fell by 29,000 between the first and second quarter, dragging the annual rate of employment growth to the lowest level since the start of 2017. It is worth noting that London’s labour market has been booming in recent years, and while the annual rate of employment growth in Q2 was low by London’s standards, it remained well above the national average. The share of SMEs operating below capacity actually edged up in the second quarter, suggesting that the bounce-back in activity was felt less strongly in the capital than elsewhere in the country. While confidence did improve in Q2, the uptick in sentiment among SMEs was also less pronounced than in other regions. Concerns surrounding Brexit will have intensified in recent months, as the chances of a ‘no-deal’ scenario appear to have risen, while limited progress has been made on agreeing the financial services sector’s access to the EU market post-Brexit. With formal plans reportedly in place for many employees in this sector to relocate in the aftermath of a disorderly Brexit, many firms will be concerned about their access to labour in the medium to long term.

Grant Thornton, July 2018: https://www.grantthornton.co.uk/news-centre/uk-regions-struggling-to-retain-young-talent/

Centre for Cities, August 2018: http://www.centreforcities.org/publication/withorwithouteu/

North East The North East’s SME Health Check Index score edged up by one point to 48 in Q2 2018, driven by strong improvements to the confidence, capacity and GDP indicators. Further increases to the Index score were inhibited by very weak labour market figures emerging from the region – the number of people employed in the North East was 2.3% (or 28,000) lower in Q2 than at the same time last year. This is the sharpest rate of contraction since data collection began in 2014. Last month, Prime Minister Theresa May announced during a visit to the North East that plans for the North of Tyne devolution deal would be formally approved “as soon as our parliamentary timetable allows”, with local leaders hopeful that a May 2019 mayoral election could still go ahead. The deal would be the latest in a string of devolution agreements that have been implemented in recent years, which aim to transfer more decision-making and spending power to local regions.

#SMEhealth | Q2 2018 REPORT

2.2 R EGIONAL BREAKDOWN OF THE SME HEALTH CHECK INDEX North West The proportion of SMEs operating below capacity in the North West rose to the highest level since data collection began in 2014. This, together with a decline in the lending indicator, dragged down the SME Health Check Index score to 25. Employment in the North West also fell by nearly 20,000 between the first and second quarters of 2018. This region has recently faced severe disruption through delays and cancellations on its rail network. Indeed, an analysis by the Northern Powerhouse Partnership has estimated that the six weeks of major disruption in early summer cost businesses £38 million. These events will intensify calls to address the transport gap in the North, which is seen by many as a key factor holding back the area’s economic convergence with London.

Scotland The health of SMEs in Scotland improved over the second quarter of the year, with the SME Health Check Index score rising by four points to 40. The confidence indicator was the primary factor underlying this shift, rising to its highest level in three years. Official figures recently showed that the Scottish economy outperformed the UK in the first quarter of the year, driven by strong manufacturing exports. They also showed some early signs that productivity growth is beginning to pick up, which will be key in sustaining growth in the medium to long term. Less positively, the share of SMEs operating below capacity increased over the second quarter. This suggests that the rebound in activity in Q2 was less pronounced in Scotland than elsewhere in the UK. South East The South East was one of the worst performing regions in Q2 2018, with the SME Health Check Index score falling by seven points to 40. The region was one of the few to experience a decline in confidence over the second quarter, while the annual rate of employment growth fell into negative territory for the first time since 2015. There are signs that the UK’s services sector could be slowing slightly at the start of the third quarter, with IHS Markit’s purchasing managers’ index for the sector falling to the lowest level since March.5 Service businesses

gave mixed messages regarding the effects of the hot weather – some reported a boost in tourist related activity while others said that the weather had reduced demand for their output. This trend will be a concern for the high proportion of service sector SMEs in the South East. South West Falls in the lending, capacity and confidence indicators were behind a four-point decline in the SME Health Check Index score for the South West in Q2 2018. It is worth noting that the annual rate of lending growth in the South West is the highest in the UK, despite the fall in the indicator last quarter. More worrying for the region is the significant deterioration in business confidence, with sentiment now weaker in the South West than anywhere else in the UK. This, together with a higher share of SMEs operating below capacity suggests that the Q2 rebound in activity was not felt so strongly in the South West. The region did receive a boost this month, when the Chancellor announced an additional £65 million in funding for the region’s burgeoning technology sector.

5 HS Markit, August 2018: https://news.ihsmarkit.com/press-release/economics-media/ihs-markit-cips-uk-services-pmi-0

#SMEhealth | Q2 2018 REPORT

Wales Wales showed one of the largest improvements in Q2 2018, with the SME Health Check Index score increasing by nine points to 59. Business confidence soared to the highest level since data collection began in 2014 and the share of SMEs operating below capacity fell substantially. The share of SMEs in the agricultural or construction sector is higher in Wales than in any other UK region. These industries were heavily impacted by the weather-related disruption in Q1, and will therefore have enjoyed a notable spike in activity in Q2. By contrast to the rest of the UK, the annual rate of employment growth accelerated in Wales to 2.2%, as over 13,000 jobs were added over the second quarter of the year. Aided by its skilled workforce, enterprise zone and low rents relative to London, Cardiff has been successful in developing a thriving financial services sector. Indeed, a recent Centre for Cities report has found that Cardiff has a higher proportion of exports coming from finance than any other city in the UK.6 This highlights the fact that it is not just London that is exposed to the consequences of a loss of access to the EU’s financial market.

6 7

West Midlands The SME Health Check Index for the West Midlands remained stable at 44 in Q2 2018. A 57,000 increase in employment between Q1 and Q2 brought the annual rate of employment growth to 4.7% - the highest in the UK. The corresponding gains in the employment indicator were largely offset by a decline in the lending indicator. The rise in economic activity in the West Midlands implied by the positive movements of the employment and capacity indicators is somewhat surprising given the struggles that UK manufacturers have faced in recent months. This suggests that the local economy has been buoyed by other sectors. For instance, recent Government figures have shown that the creative, gambling and sports industries contribute to nearly 7% of the West Midlands economy, while the number of tourists visiting the region has also continued to grow according to the ONS’ International Passenger Survey. 7

Yorkshire & the Humber Yorkshire & the Humber saw the greatest improvement to the SME Health Check Index in the second quarter of 2018, with the score rising by 11 points to 59. Significant improvements to the capacity, confidence and employment indicators were behind this increase. Yorkshire and the Humber has been successful in attracting a number of major investments in recent months, which are likely to generate substantial spill over effects for the local economy. These include Siemens’ plans to develop a new rail factory in Goole, and Sirius Minerals’ major potash mine near Whitby. The latter development in particular has the potential to deliver a significant boost to exports in the region, following the Government’s recent report which found that Yorkshire is the largest exporter of manufactured goods in the UK after London. Yorkshire & the Humber has a well-developed financial services sector. Indeed, a recent Centre for Cities study has found that finance accounts for roughly 70% of total service sector exports from Leeds and York. While this relative strength in finance is very much a positive for the region, it does leave many firms and workers exposed to a possible restriction of access to the crucial European market if the Brexit negotiations yield an unfavourable outcome.

Centre for Cities, July 2018: http://www.centreforcities.org/publication/london-links/ NS, August 2018: https://www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/internationalmigration/bulletins/migrationstatisticsquarterlyreport/august2018 O

#SMEhealth | Q2 2018 REPORT

3 IN FOCUS: SME BUSINESS COST INFLATION In this section, we explore the business costs indicator in greater detail in order to establish its contribution to the overall worsening of the business climate in the second quarter of 2018, and the degree to which it has affected SMEs in different regions. Figure 4: SME Inflation Q1 2014 – Q2 2018

3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% Q1 2014

Q2 Q3 Q4 Q1 2014 2014 2014 2015

Q2 2015

The annual rate of business cost inflation continues to climb and rose to 2.9% in Q2 2018. This increase was driven by a variety of factors. The price of basic metals, which account for nearly 5% of total SME inputs, rose at an average annual rate of 7.7% in the second quarter, compared to 5.6% in Q1. The persistent strengthening of the US dollar in Q2 will have driven up the price faced by UK producers for many imported products, including metals. Similarly, the annual rate of inflation of chemical inputs increased from 7.0% to 7.7% between the first and second quarters of the year. The escalation of global trade tensions in recent months has led to fears that businesses could be hit 16

Q3 2015

Q4 Q1 2015 2016

Q2 Q3 2016 2016

Q4 2016

Q1 Q2 2017 2017

by a double whammy of reduced competitiveness in external markets and higher costs for imported inputs if further tariffs are implemented. While hostilities appear to have simmered down between the US and the EU following last month’s meeting between US President Donald Trump and European Commission President Jean-Claude Juncker, the trade war between China and the US has continued to escalate. Given the highly integrated nature of global supply chains, the consequences of this will extend far beyond the directly impacted countries. Higher oil prices are likely to have fed into transport prices. Indeed,

Q1 Q2 Q3 Q4 2017 2017 2018 2018

the annual rate of inflation of this category of input rose in Q2, but remains below the overall average rate of business cost inflation. Meanwhile, the resurgence in demand for construction output in the second quarter, following the disruption in Q1, appears to have had an impact on prices – the annual rate of inflation of construction output rose by 0.5 percentage points to 3.4% between Q1 and Q2 2018. This acceleration is a key driver of the increase in the overall rate of business cost inflation. The UK’s housing market has been cooling for several months, and there are signs of a similar pattern in the commercial property market.

#SMEhealth | Q2 2018 REPORT

Figure 5: Breakdown of costs faced by SMEs

Indeed, the annual rate of price growth of commercial rents fell by 0.3 percentage points to 1.6% in Q2. This component weighed down on overall inflation last quarter. Meanwhile, employment cost increases continued to push up business cost inflation, despite recent declines in the overall rate of earnings growth. Wages in the construction sector rose at an annual rate of 4.7% in Q2, again highlighting the resurgence of activity in this sector, as well as a shortage of skilled labour – a longstanding issue for the industry. The soaring prices of physical inputs drove up the annual rate of cost inflation for the manufacturing sector to an average of 4.1% in Q2. This is likely to be a contributing factor to the sector’s weak performance last quarter. Conversely, the annual rate of cost inflation for the retail sector edged

22.4%

Physical inputs

29.7%

Employment costs

5.0%

Rent and utilities

15.7%

Construction

3.6%

Transport and storage

20.5%

IT, business and financial services

3.1%

Other

down marginally to 2.5% in Q2, driven by declines in the rate of wholesale price growth for food, tobacco and alcohol products. The slowdown in wholesale food price growth also benefited the accommodation and food services sector, where the annual rate of cost inflation fell by 0.4 percentage points to 2.2%. The rate of business cost inflation increased in all regions with the exception of London, where it remained broadly stable at 2.6%. The relatively low share of manufacturing and construction SMEs in the South East contributed to a lower than average rate of cost inflation in this region in Q2. All other regions recorded an annual rate of business cost inflation of 2.9%. Interestingly, the increase in the annual rate of business cost inflation between Q1 and Q2 occurred

alongside a 0.3 percentage point fall in the annual growth rate of consumer prices. This shows that businesses are not fully passing through their rising costs to consumers, indicative of a decline in margins for many firms. We expect earnings growth to tick up slightly over the next year given the tightness of the labour market, which would exert further upward pressure on business cost inflation. If the EU and the UK fail to reach an agreement on trade and other matters prior to the UK’s withdrawal on March 29th 2019, there is the possibility that importers could face significant tariffs on EU products. The depreciation of the pound that would likely accompany any such outcome would lead to further import cost rises. Therefore, a ‘nodeal’ Brexit represents a significant downside risk for the business costs indicator. 17

#SMEhealth | Q2 2018 REPORT

SPECIAL REPORT

#SMEhealth | Q2 2018 REPORT

4 SPECIAL REPORT: SME INVESTMENT PLANS Business investment is a significant part of the economy, accounting for around 9.5% of the UKâ&#x20AC;&#x2122;s GDP. The volatility of business investment relative to other components of GDP such as household or government expenditures means that it is often a key driver of fluctuations in economic performance. Business investment refers to spending on goods that are not consumed today, but are instead used to generate output in the future. This includes expenditures on physical assets, for example building structures, transport equipment, machinery and IT equipment, as well as intangible assets such as research and development and software.

Spending on these types of goods is also referred to as Gross Fixed Capital Formation (GFCF). 8 Strong levels of investment are crucial in achieving sustained improvements to the productive capacity of an economy. In the UK, GFCF as a proportion of GDP has historically been below

the levels seen in other advanced western economies. The collapse in confidence following the 2008 financial crisis led to a sharp decline in investment levels in developed countries, which most have yet to fully recover from. This is likely to have contributed to the anaemic productivity growth that the UK has seen in recent years.

Figure 6: Gross fixed capital formation as a % of GDP

24% 23% 22% 21% 20% 19% 18% 17% 16% 15%

Italy

France

USA

Germany

2017

2016

2015

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

14%

Euro Area

https://www.ons.gov.uk/economy/grossdomesticproductgdp/articles/ashortguidetogrossfixedcapitalformationandbusinessinvestment/2017-05-25

#SMEhealth | Q2 2018 REPORT

Levels of business investment are related to several of the indicators in the SME Health Check Index. Many SMEs rely, to some extent, on borrowing to finance investment projects, therefore business investment will be influenced by movements in the lending indicator. Another source of funding for investment comes from firms’ own profits, hence the revenue indicator is also likely to feed into

business investment. Business confidence is another key factor underpinning investment spending. Finally, as discussed above, business investment has a significant impact on the overall economy and will therefore be related to the Health Check Index’s GDP indicator. Analysing the historical data shows that the annual rate of business investment growth has moved

closely with the confidence indicator and to a lesser extent with the revenue indicator, as shown below. There are few signs of any consistent relationship between the lending indicator and business investment growth, which emphasises that borrowing is just one possible avenue through which SMEs can finance investment.

Figure 7: Relationship between business investment growth and confidence and revenue indicators

100 -

90 -

7% 6%

80 -

5% 70 4% 60 -

50 -

40 -

1% 0%

30 -

- 1% 20 -

- 2%

10 0-

- 3%

Q1 2015

Q2 2015

Q3 2015

Q4 2015

Q1 2016

Confidence indicator

Q2 2016

Q3 2016

Q4 2016

Revenue indicator

Q1 2017

Q2 2017

Q3 2017

Q4 2017

Q1 2018

Q2 2018

- 4%

Business investment annual growth rate

Source: ONS, FSB, Cebr analysis

Steadily increasing borrowing costs and the uncertainty generated by the continued lack of progress in the Brexit negotiations, as well as escalating trade tensions emanating from the US have led to fears of 20

a significant slowdown in business investment in the coming quarters. In order to gain an insight into SMEs’ investment plans and the key factors that will shape these, CYBG commissioned YouGov plc

to survey 504 small and medium sized businesses across the UK.9 The remainder of this section presents the findings of this survey.

9 Total sample size was 504 SMEs. Fieldwork was undertaken between 15th August and 21st August 2018. The survey was carried out online. The figures have been weighted and are representative of SMEs in the UK.

#SMEhealth | Q2 2018 REPORT

4.1 SME INVESTMENT IN PAST YEARS According to ONS data, business investment growth in the UK has remained positive in recent quarters, albeit at a rate below that observed in the years prior to the EU Referendum. Our survey also suggests that collectively, SMEs have continued to increase their investment levels over the past 12 months. Over a quarter (26%) said that their investment spending over

the last three months was higher than the level during the same period last year, compared to 16% who have reduced their investment expenditures over the past 12 months. Another interesting finding is that a majority (51%) of SMEs in our survey stated that their level of investment spending has remained

about the same over the past year. This highlights that a considerable number of small businesses are not feeling confident enough to expand their investment. The most commonly listed categories of investment spending over the past year were ICT equipment, machinery and building structures.

Figure 8 Change in the level of SMEsâ&#x20AC;&#x2122; investment spending over the last three months compared to a year ago

60% 50% 40% 30% 20% 10% 0%

Significantly Higher

Higher

About the same

Lower

Significantly Lower

Source: YouGov / Cebr analysis

The survey then goes on to examine the factors that have driven SMEs to increase their investment over the past 12 months. 46% of SMEs who increased their investment spending over the past year stated that this was driven by a greater demand for

the products they provide, while a quarter (25%) said that more profits available for investment were a factor. Both of these factors are closely related to a companyâ&#x20AC;&#x2122;s revenue, which highlights that this is a key determinant of investment. Meanwhile, just 19% cited a more

optimistic outlook for the overall UK economy as a motivating factor. This suggests that the investment decisions of those SMEs that increased their investment spending were shaped primarily by firmspecific factors, as opposed to the wider macroeconomic environment.

#SMEhealth | Q2 2018 REPORT

4.1 SME INVESTMENT IN PAST YEARS Figure 9. Factors driving an increase in investment spending over the past year

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Greater demand for the goods and/ or services that my business provides

More profits available for investment

Turning to SMEs who decreased their level of investment spending over the past year, uncertainty appears to have been a major contributing factor. Two in five (41%) answered that uncertainty surrounding the UK’s future relationship with the EU and the overall economic outlook for the UK has contributed to them reducing their investment spending over the last 12 months. This provides evidence that the prevailing

A greater number of viable investment opportunities

Greater optimism regarding the outlook for the UK economy as a whole

Higher available returns on investment

economic uncertainty in the UK has indeed caused a significant number of firms to rein in their investments. Only one in ten (10%) SMEs in our survey who have decreased their investment spending over the last year said that this was due to a lack of viable investment opportunities. This highlights that most SMEs do see opportunities to grow, but the uncertainty that they now face on multiple fronts is casting doubt

Lower borrowing costs

Increased availability of credit

Source: YouGov / Cebr analysis

on the long term viability of these potential investments. While much has been made of the Bank of England’s recent rate rises, the results of our survey suggest that this is yet to have had a major impact on firms’ investment decisions. Indeed, just 3% of SMEs who decreased their investment spending over the past 12 months cited higher borrowing costs as a contributing factor.

#SMEhealth | Q2 2018 REPORT

Figure 10. Factors driving a decrease in investment spending over the past year

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Uncertainty surrounding the UK’s future relationship with the EU

Uncertainty Less optimism Fewer profits surrounding regarding the available for the UK’s outlook for the investment overall UK economy economic outlook

Since 2016, political and economic uncertainty in the UK has risen due to a number of events including the vote to leave the EU, a heightening of global trade tensions and the loss of the ruling Conservative Party’s majority. A key theme of the UK’s economic discourse in recent months has been the possibility that many firms are postponing their investment plans as a result of this uncertainty. To examine this, our

Lower demand for the goods and/or services that my business provides

A lower number of viable investment opportunities

survey asked all SMEs (regardless of whether they increased, decreased or held stable their investment spending over the past year) about the degree to which they have delayed their investments. We found that 43% of SMEs are indeed postponing their plans to some extent. Among these, 14% have postponed all of their investment plans and 26% have postponed most of their plans. Meanwhile, 43%

Increased risk of trade restricitions

Lower available returns on investment

Reduced availability of credit

Higher borrowing costs

Source: YouGov / Cebr analysis

said that their investment plans have not been affected. While this postponement will have inevitably suppressed growth in recent quarters, it also suggests that there could be a spike in investment if a favourable outcome is reached in the Brexit negotiations, as businesses implement investment projects that had previously been put on hold.

#SMEhealth | Q2 2018 REPORT

4.2 SME INVESTMENT IN FUTURE YEARS 30% of SMEs in our survey expect the level of their business’ investment spending to increase over the next year, compared to 15% who think that it will decrease. Meanwhile, nearly half of SMEs (46%) said that they expect their level of investment spending to remain stable over the next year. ICT equipment is the most commonly listed category for

expected expenditure over the next year. This points towards the evergrowing role of technology in the UK’s SMEs. 44% of SMEs stated that a greater demand for the products that they provide would encourage them to increase their investment spending over the next year.

Meanwhile, just under a third (31%) said that less uncertainty regarding the UK’s economic outlook would incentivise them to invest. This again highlights that investment plans are formed primarily by firm-specific conditions, although macroeconomic factors do play a significant role.

Figure 11. Factors that would encourage SMEs to increase investment spending in the coming year

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Greater demand for the goods and/or services that my business provides

Less Less More profits uncertainty uncertainty available for surrounding surrounding investment the UK’s the UK’s future overall relationship economic with the EU outlook

When examining the factors that would most discourage investment over the coming year, the most common response was a lower

Greater optimism regarding the outlook for the UK economy as a whole

Higher available returns on investment

demand for the products provided by the SME. Following this was increased uncertainty surrounding the UK’s future relationship with

A greater number of viable investment opportunities

Reduced risk of trade resrtrictions

Lower borrowing costs

Increased availability of credit

Source: YouGov / Cebr analysis

the EU: a third (33%) of SMEs in our survey said that this would discourage them from investing over the next year.

#SMEhealth | Q2 2018 REPORT

Figure 12. Factors that would discourage SMEs to increase investment spending over the coming year

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Lower demand for the goods and/or services that my business provides

Increasing Less optimism Fewer profits uncertainty regarding the available for surrounding outlook for the investment the UK’s UK economy future relationship with the EU

Increased uncertainty surrounding the UK’s overall economic outlook

Higher borrowing costs

Lower available returns on investment

Increased risk of trade resrtrictions

Reduced availability of credit

A lower number of viable investment opportunities

Source: YouGov / Cebr analysis

4.3 SME BORROWING FOR INVESTMENT A majority (59%) of SMEs in our survey rely to some extent on borrowing to finance their investment spending. However, only 9% of SMEs said that most of their investment spending was financed by borrowing. This finding could account for the limited association between the lending indicator and business investment growth, since many SMEs are able to tap into alternative sources of funding. That being said, it is conceivable that an increase in borrowing costs could have an impact on the level of investment spending for a significant share of small and medium sized businesses.

Indeed, 59% of SMEs in our survey stated that a one percentage point increase in the annual interest rate on business loans would have some impact on their level of investment spending. While this size of increase in borrowing costs is not likely to be realised within the next year given the BoE’s anticipated path of rate rises, it does highlight that the normalisation of interest rates will enter firms’ thinking as they form their investment plans. 31% of SMEs in our survey have successfully applied for some form of finance over the last year. The

most frequently cited motivations for this were to invest in fixed capital assets, with 31%, 25% and 17% of relevant SMEs saying that they obtained finance in order to invest in machinery, building structures and ICT equipment respectively. Just 7% of SMEs who successfully applied for finance over the last 12 months did so to cover existing employee costs, while 11% did so in part to service existing debts. This shows that most SME borrowing is directed towards productive investments designed to increase their capacity, as opposed to more defensive manoeuvres such as covering existing costs. 25

#SMEhealth | Q2 2018 REPORT

CONCLUSIONS & METHODOLOGY

#SMEhealth | Q2 2018 REPORT

5 CONCLUSIONS There was no major movement in the overall SME Health Check Index for the UK between Q1 and Q2, although the score fell by 0.5 points to 47.1. Economic activity rebounded in the second quarter of the year, as firms made up for lost ground following the weather-related disruptions that occurred at the start of the year. This resurgence in activity is reflected by the GDP and capacity indicator, the latter showing a notable fall in the share of SMEs operating below their full capacity. These gains were undermined by a deterioration in the employment and lending indicators. The first of these can be explained by the existing tightness of the labour market, which means that some slowdown in the annual rate of employment growth is to be expected. The slowdown in the rate of lending growth in Q1 suggests that firms’ demand for finance was impacted by the economic slowdown that quarter, as well as the prevailing expectation at the time of a more rapid escalation of interest rates than has taken place. Looking ahead, employment growth is likely to continue to slow, weighing on the employment indicator. Meanwhile, the increased likelihood of a no-deal Brexit may well impact upon SME sentiment as the Brexit negotiations approach their denouement. These trends suggest that the SME Health Check Index may experience some further declines in the coming quarters.

The relative stability of the UK wide Index score in Q2 2018 belies a number of significant shifts at a regional level. The East of England and Yorkshire & the Humber both recorded 11 point gains in the SME Health Check Index, both driven by marked improvements in the confidence, capacity and employment indicators. Meanwhile, the regions that struggled most last quarter – namely the North West and the South East – have actually registered falls in the level of employment over the past year. Business investment is related to a number of factors including SME confidence, revenues, access to credit and overall levels of demand. As such, it is an excellent bellwether of the health of SMEs and the wider economy. Our survey finds that a greater share of SMEs have increased their investment spending over the past year than have decreased it. However, a majority reported that the level

of their investment spending remained stable over the past year. Economic and political uncertainty is currently acting as a significant drag on investment, with 43% of SMEs postponing at least some of their investments as a result. The Bank of England’s interest rate rises appear to have had a limited impact on investment levels so far, although 59% of SMEs indicated that a one percentage point rise in the annual rate of interest on business loans would have at least some impact on their investment plans. The overriding finding of the survey is that demand for the specific products that an SME provides is the primary determinant of investment decisions, although the wider macroeconomic environment remains an important consideration.

#SMEhealth | Q2 2018 REPORT

6 METHODOLOGY The SME Health Check Index is designed to measure small business performance and the business and macroeconomic environment within which SMEs operate. The Index includes measures that can be directly linked to SME performance as well as components that relate to the wider economy. Specifically, the following measures are included: Business Costs The Index measures the annual change in costs faced by a typical SME and the main data source for this measure is the Office for National Statistics. Higher costs are associated with a deteriorating business environment as companies will either have to pass these on to their clients in order to protect profit margins or accept lower profit margins in order to secure market share. Capacity The data for capacity comes from the Federation of Small Businesses (FSB) and measures the proportion of SMEs operating below capacity. If firms operate below capacity, this could have negative implications for hiring and investments intentions. Therefore, a higher proportion of SMEs reporting to operate below capacity will have a negative impact on the overall SME Health Check Index.

Confidence SME business confidence data also come from the FSB. The Index indicates how confident businesses are about their shortterm prospects over the next three months. Higher business confidence has a positive effect on the SME Health Check Index. Employment Data for this sub-component is taken from the ONS and measure the quarterly change in absolute employment figures. Higher employment figures are associated with an improving macroeconomic environment and may signal improved confidence about future workloads. Gross domestic product Gross domestic product figures are taken from the ONS and measure the quarterly percentage change in economic growth. For the regional breakdown, we estimated the quarterly figures based on the previous relationships between a regionâ&#x20AC;&#x2122;s GVA and overall UK GDP growth.

Lending For the lending indicator, we used data from UK Finance to calculate the annual change in lending balances. The following measures are included: Value of overdrawn balances and value of loan balances. Net Business Creation The data come from the Insolvency Service Statistics and measure the annual growth rate in the number of registered companies. The higher the growth rate in the number of registered companies, the higher the score. Revenue Data come from the FSB and measure the net percentage balance of SMEs reporting an increase in revenues.

#SMEhealth | Q2 2018 REPORT

Following the data collection, we calculate the average of each individual series (such as employment, GDP etc.). In a second step, we calculate how many standard deviations a single data point (for example the employment data point for Q1 2017) deviates from its long-run mean. We then apply a scoring system ranging

from 0 to 100. A score of zero is assigned to the lowest observed value while the highest observation receives a value of 100. This means, the more standard deviations a data point is below the mean, the lower its score and the more standard deviations is above the mean, the higher its score.

This exercise is repeated for each of the eight indicators. The eight individual scores are then combined with an equal weight to the SME Health Check Index. A summary table of the sub-components can be found below. :

Indicator

Source

Measure

Latest score

Business Costs

Various, including Office for National Statistics

Annual change in business costs faced by SMEs

62 (Q2 2018)

Capacity

Federation of Small Businesses

Net balance of SMEs operating below capacity

41 (Q2 2018)

Confidence

Federation of Small Businesses

FSB Small Business â&#x20AC;&#x201C; Small Business Index

57 (Q2 2018)

Employment

Office for National Statistics

Annual percentage change in employment numbers

66 (Q2 2018)

GDP

Office for National Statistics

Quarterly percentage change 69 (Q2 2018) in gross domestic product

Lending

UK Finance

Annual percentage change in lending to SMEs

38 (Q1 2018)

Net Business Creation

UK Insolvency Service

Annual growth rate in the number of registered companies

1 (Q2 2018)

Revenue

Federation of Small Businesses

Net balance of SMEs reporting rise in revenue

43 (Q1 2018)

CONTACT DETAILS Corporate Affairs Christina Kelly christina.kelly@cybg.com 0141 242 3215 07484 905 358 Jennifer Devlin jennifer.devlin@cybg.com 0141 242 3314 07484 908 519 Jamie Maxton jamie.maxton@cybg.com 0141 242 3988 07867 537 033 @cybgplc #SMEhealth CYBG Plc Website: http://www.cbonline.co.uk/business/business-news

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Head Office: 30 St. Vincent Place Glasgow G1 2HL Registered Office: 20 Merrion Way Leeds, West Yorkshire LS2 8NZ