CYBG - SME Health Check Index Q4 2018 by Lesley Brydon

SME Health Check Index Q4 2018

MARCH 2019 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, March 2019

#SMEhealthcheck | Q4 2018 REPORT

CONTENTS Foreword 4 Infographic 6 Executive Summary 7 1 UK macroeconomic environment 8 2 SME business health weakens in Q4 2018

3 Cities Health Check Index

4 In focus: SME Business Cost Inflation

5 Conclusions 27 6 Methodology 28

#SMEhealthcheck | Q4 2018 REPORT

FOREWORD

GAVIN OPPERMAN

Group Customer Banking Director Business decisions have not got any easier for Britain’s Small and Medium-sized Enterprise (SME) sector. These important building blocks of the British economy were faced with a conundrum in Q4 2018. On the one hand, they felt the need to accelerate hiring thus taking the employment rate to an all-time high. While on the other hand economic headwinds, influenced strongly by Brexit, led to the lowest level of confidence since the SME Health Check began in 2014. And while increased employment is welcome, a 0.9% year-on-year decrease in investment demonstrates the lack of confidence shown in this quarter’s SME Index. It seems that firms are making full use of existing capacity rather than investing to expand capacity. The headline Index is up this quarter despite decelerating GDP growth. We will probably have to wait until

there is clarity on Brexit to drill down into what is really happening for the country’s SMEs. For now, they are hedging their bets. While there are understandable worries, the wary, but optimistic message is “keep calm and carry on”. SMEs are a crucial part of the UK economy and we are able to respond to the complex needs of this sector. A year-on-year increase in the value of loans to SMEs is certainly something to celebrate. While Brexit-related decisions of large manufacturing and service sector businesses have hit the headlines, the underreported actions of individual SMEs are very important indeed.

There are exciting developments in our fast-changing economy, and I am confident that the

drive to provide innovative new products and services, among newly-formed and existing SMEs, will help overcome any temporary uncertainty. This report is a valuable insight into the concerns of our current and future customers. We pride ourselves in knowing what matters in all sectors from farming to tech, and from manufacturing to services. I am pleased that the rate of net business creation has increased, albeit from a low base, and the number of businesses dissolved fell between Q3 and Q4. So we detect resilience and resolve against a wider backdrop of uncertainty.

This quarter we decided to shine a spotlight on SME performance in major cities, on top of our usual

#SMEhealthcheck | Q4 2018 REPORT

regional breakdown. The results give us a useful level of granular detail. Cambridge, with its high-tech sector and strong knowledge base, came out as the top performing city. Employment was the driver of Cambridge’s strength, but this indicator was very weak in nearby Norwich. In the Northern Powerhouse region, Liverpool is a stand out city for employment growth and Manchester performed even better, pointing to economic dynamism in the North West. And between the Yorkshire rivals, Leeds came out ahead of Sheffield.

Last quarter the results for Newcastle, Sunderland and Middlesbrough suggest a challenging environment for SMEs in the North East. There are, however, factors giving cause for optimism in the North East such as investment in infrastructure, so let’s hope we see an upturn in the coming months. And London, for so long the dynamic job-creating hub of the country, saw a decrease in jobs in the fourth quarter of last year in contrast to Birmingham which, before long, could be only a short HS2 train journey away.

The expanded set of figures for this quarterly report make very interesting reading. It is a nuanced picture, but one which gives me cause for optimism that the country’s SMEs are poised for greater growth and success when the Brexit fog clears. Until then, CYBG will help its customers weather the storms, and even prosper, in uncertain times.

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

Q4 2018

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

16.3 MILLION total employment in SMEs

Q3 2018

£2.0 TRILLION

private sector businesses

SMEs combined annual turnover

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%

50.0

10 0-

- 0.1%

82.6

79.8

81.1

77.0

74.3

83.0

74.1

87.5

58.9

57.5

64.1

63.1

60.6

57.6

50.4

44.0

47.1

50.9

50.0

54.9

2014

2015

SME Health Check Index

2015

2016

GDP

Business Costs 63 (3 )

Capacity 63 (17 )

Confidence 22 (12 )

Employment 74 (5 )

GDP 63 (13 )

Lending 95 (29 )

Net business creation 17 (10 )

Revenue 42 (-)

changes above are compared to Q3 2018.

Q4 2018

Change from Q3 2018

East Midlands

48.0

6.9

East of England

41.1

2.9

London

48.8

0.2

North East

53.9

5.3

North West

49.4

10.1

Scotland

42.9

1.2

South East

44.6

6.2

South West

48.1

1.5

Wales

52.4

0.4

West Midlands

44.6

1.7

Yorkshire and the Humber

48.9

1.5

2017

2018

- 0%

GDP (%)

Q4 2018

INDEX SCORE

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

5.7 MILLION

#SMEhealthcheck | Q4 2018 REPORT

EXECUTIVE SUMMARY The role of SMEs in the UK economy cannot be underestimated. Incredibly, they make up 99.9% of businesses so play a vital role in driving growth, creating employment and shining a light on our innovation and creativity. Across the country, SMEs are doing ground breaking work across a wide range of sectors, launching into new markets, opening up endless opportunities which will help future proof our economy. This quarterly report for CYBG, owner of Clydesdale and Yorkshire Bank, 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 businesses 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 Q4 2018 report finds that: ⊲ T he SME Health Check Index rose by 4.9 points to 54.9 in the final quarter of 2018 – the highest level in six quarters. Despite the increase, there was considerable variation in the performance of the individual indicators. ⊲ T he primary drivers of the improvement were the employment and lending indicators. The latter increased from 66 to 95 between Q3 and Q4, as the annual rate of growth in the value of SMEs’ outstanding loan balances entered positive territory for the first time since 2013. Meanwhile, the rate of employment growth continued to impress in Q4, despite the macroeconomic headwinds.

⊲ T he annual rate of business cost inflation fell by 0.2 percentage points to 2.8% in Q4 2018, which led to a three point uptick in the score for this indicator to 63. ⊲ T he quarterly rate of GDP growth declined to 0.2% in Q4 – the lowest it’s been since Q1 2018 when the economy was rocked by the Beast from the East. This brought down the indicator score from 76 to 63. Meanwhile, the confidence indicator fell to its lowest level since the SME Health Check Index began in 2014. ⊲ D espite the overall improvement in the Index, declines were registered in four of the UK’s regions. The falls were most severe in the East Midlands and the East of England, in both cases led by sharp falls in confidence among SMEs, as well as an increased share operating below capacity. There were smaller declines in the Index in Scotland and Yorkshire & the Humber, fuelled by a significant weakening of the GDP and confidence indicators in Q4. ⊲ T he Index score for the North West rose considerably for the second consecutive quarter, this time driven by a 31 point increase in the employment indicator. The South East and the North East also recorded strong gains, on the back of sizeable upticks in the employment and lending indicators. There were less sizeable increases in

the SME Health Check Index score for the West Midlands, the South West, Wales and London. ⊲ A s part of the Q4 2018 SME Health Check Index report, a Cities Index was developed, allowing for comparisons between the UK’s major urban centres. Cambridge was the highest ranked city, as its highskilled industries have fuelled strong employment and economic growth. Meanwhile cities with a more dominant industrial sector, such as Sunderland and Middlesbrough, placed at the lower end of the rankings, due to a declining population of SMEs and above average rates of business costs inflation. ⊲ S everal major car manufacturers have announced in recent weeks that they will be reining in their UK operations, with a variety of factors cited, ranging from Brexit related uncertainty to waning demand from Europe. The automotive industry is an integral part of the local economy for cities across the North East, West Midlands, South West and other regions, and these developments represent a significant challenge for the affected areas in the coming months and years.

#SMEhealthcheck | Q4 2018 REPORT

1 UK MACROECONOMIC ENVIRONMENT The spurt of economic activity that took place in the early summer months of 2018 proved fleeting, as uncertainty, a deterioration of sentiment and a pronounced slowdown in external conditions finally caught up with the UK economy in the fourth quarter. GDP expanded by 0.2% in Q4 2018, down from 0.6% the previous quarter. For 2018 as a whole, the UK economy grew by 1.4% – the joint weakest growth rate since the recession of 2009. Underpinning Q4’s weak performance was a 0.9% and 0.3% contraction in the manufacturing and construction sectors respectively. The former has been hit by disruptions to car production across Europe following new vehicle emissions tests, waning demand from key export markets, as well as continued domestic uncertainty, which has crippled confidence in the sector. Survey data suggest that stockpiling activity among the UK’s manufacturers is now at a 27-year high, as firms prepare themselves for the possibility of a no-deal Brexit. While this effect will pump up GDP statistics in the period leading up to Brexit day, this comes at the expense of growth post-Brexit, when firms will inevitably draw down their accumulated inventories. Despite the UK’s darkening economic outlook, the labour market remained strong in the final quarter of 2018. Indeed, in the three months to December, the UK’s employment rate was 75.8% – the highest level since comparable records began in 1971. Meanwhile, the number of vacancies rose to an average of 870,000 between October and December – 46,000 higher than during the same period in 2017 and the highest since estimates began in 2001. The remarkable consistency with which the labour market has tightened in recent years can be attributed to a variety of factors including increased female participation, the use of the internet to more efficiently match jobseekers and employers, as well as later retirement. These factors reflect longer term structural shifts in the labour market and are therefore more resilient to swings in the UK’s economic fortunes.

The annual growth rate of the Consumer Prices Index, including owner occupiers’ housing costs (CPIH) fell to 2.0% in December – the lowest rate of inflation since January 2017. This reflects sharp declines in energy prices, as well as heavy discounting by retailers ahead of the crucial Christmas period. Meanwhile, the tightness of the labour market has driven earnings growth to a more than 10-year high, meaning that the real value of households’ pay packets is on the rise. However, an analysis of the data suggests that household consumption has been tied more closely to the credit cycle than the income cycle over the past two years. Following the spike in inflation, which ate away at real incomes in 2017, households turned to borrowing to finance their expenditures, which in turn sustained consumer spending. However, many households have now reached the limit of how

much they are willing to extend themselves. Indeed, unsecured gross lending plateaued in the final half of 2018, placing a significant drag on consumer spending. The final quarter of 2018 saw a series of developments in the Brexit negotiations, as EU leaders approved a Withdrawal Agreement for the UK’s departure from the European Union. However, rather than providing clarity, it largely served to transfer the deadlock from Brussels to Westminster. The continued uncertainty has sunk business and consumer confidence to multi-year lows, weighing considerably on spending and investment

#SMEhealthcheck | Q4 2018 REPORT

2 S ME BUSINESS HEALTH REGAINS SOME STRENGTH IN Q4 2018 The UK economy would struggle to cope without our hard working SMEs. 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 final quarter of 2018, the SME Health Check Index rose by 4.9 points to 54.9. This result is somewhat surprising on the surface given the sharp deceleration of GDP growth between Q3 and Q4, as well as the deterioration of sentiment among SMEs – fuelled by continued uncertainty surrounding Brexit. The improvement was driven predominantly by increases in the

lending, capacity and employment indicators, and, to a lesser extent, by a decline in the annual rate of business cost inflation and an uptick in the rate of net business creation.

outstanding loan balances between Q2 and Q3 2017, which pushed up the annual growth rate in Q3 2018 (the latest period for which data is available). Without this effect, the improvement in the overall SME Health Check Index in Q4 would have been considerably more muted. The following section analyses the indicators of the SME Health Check Index in more detail.

It is worth noting that the most significant improvement was in the lending indicator, which rose from 66 to 95. However, much of this can be attributed to the fall in the value of

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

GDP

2017

2018

- 0%

GDP (%) quarter-on-quarter change

INDEX SCORE

Figure 1: SME Health Check Index

#SMEhealthcheck | Q4 2018 REPORT

Business Costs The annual rate of business cost inflation fell by 0.2 percentage points to 2.8% in Q4 2018. This is despite average earnings growth reaching the highest level since 2008, pushing up the annual rate of employment cost inflation to 3.4%. The decline in the overall rate of inflation was driven by a moderation in the rate of price growth for business services, physical inputs and commercial rent. Capacity Despite the slowdown in economic activity reflected by headline GDP figures for Q4, the share of SMEs operating below capacity fell for the third consecutive quarter, pushing up the score for this indicator to 63. In normal circumstances, improvements to this indicator would be associated with high levels of demand and activity in the economy. However, the recent declines in the share of SMEs operating below capacity have come during periods of weak economic growth. Business investment in 2018 was 0.9% lower than in 2017, which is symptomatic of the crippling uncertainty faced by UK firms in the build up to Brexit. The results for this indicator suggest that many firms have met demand by eating into their existing spare capacity rather than by investing to expand their capacity.

Confidence Federation of Small Businesses’ (FSB) Voice of Small Business Index1 shows that business confidence among SMEs in Q4 2018 fell to the lowest level since the SME Health Check Index began in 2014. This takes the confidence indicator below the depths observed in the immediate aftermath of the EU referendum in Q3 2016. The deterioration of sentiment can be attributed to emerging weaknesses in the UK economy, as well as the continued possibility of a no-deal Brexit, after the emphatic rejection of Theresa May’s Withdrawal Agreement by MPs. Employment The annual rate of employment growth increased from 1.1% in Q3 to 1.4% in Q4, bringing the score for this indicator up from 69 to 74. The number of people in employment averaged 32.6 million in the final quarter of the year – 444,000 more than during the same period in 2017. The employment rate and the number of vacancies are the highest since comparable records began, while the unemployment rate is the lowest it’s been since 1975. Based on these headline figures, the labour market has been seemingly impervious to various economic and political developments and headwinds over the past year. This is in part

because rising employment reflects structural shifts in the UK workforce, including higher female participation, later retirement and more flexible working hours. GDP The quarterly rate of GDP growth fell by 0.4 percentage points to 0.2% in Q4 2018. This dragged down the associated indicator score by 13 points to 63. Output contracted in both the manufacturing and construction sectors, while activity also slowed in the services sector. The monthly data paints an even more worrying picture, with a 0.4% monthly contraction in output across the economy recorded in December. While monthly data is volatile and subject to revisions, the size of this contraction is indicative of a pronounced slowdown in activity at the end of the year.

10 1

Federation of Small Businesses: Voice of Small Business Index – Q4 2018

#SMEhealthcheck | Q4 2018 REPORT

Lending to SMEs

Net Business Creation

The annual rate of growth of the value of outstanding loans to SMEs rose to 0.5% in Q3 2018 – the first time that this has entered positive territory since data collection began in 2014. However, this is largely attributable to the close to £2 billion drop in the value of outstanding loans between Q2 and Q3 2017, which lowered the base value for the annual growth rate calculation in Q3 2018. On a quarterly basis, the value of outstanding loans to SMEs declined by £300 million to £93.0 billion in Q3 2018. Lending to SMEs in the third quarter of 2018 will have been boosted by the resurgence in economic activity that took place in the summer, as well as the ramping up of stockpiling activities in certain sectors.

Revenue

The annual rate of net business creation rose to 4.2% in Q4 2018 – up from 3.8% the previous quarter. This pushed up the indicator score by 10 points, although at 17 it remains well below the long run average. The number of companies that were dissolved fell from over 130,000 in Q3 to 112,000 in Q4. This data provides some much needed encouragement for the UK economy, and suggests that many businesses are keeping their heads above water despite the mounting challenges faced.

Data on this indicator is provided bi-annually, and was not updated in Q4 2018. The indicator score therefore remains at 42. Retail sales disappointed during the crucial Christmas period, declining by 0.9% between November and December. Excluding automotive fuel, the monthly decline was an even more dire 1.3%. Although this partially reflects a shift of Christmas spending from December to November as a result of the growing popularity of Black Friday, the data points to a weakness in consumer spending that will have weighed on SMEs’ revenues last quarter.

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

100

0 Business Costs

Capacity

Confidence

Employment Q3 2018

Sources: FSB, ONS, BBA, Cebr analysis

GDP

Lending

Net Business Creation

Revenue

Q4 2018

#SMEhealthcheck | Q4 2018 REPORT

2.1 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 as Scotland and Wales. The deterioration of sentiment among SMEs, as well as the slowdown in the rate of GDP growth led to declines in the SME Health Check Index for four regions.

The largest falls were in the East Midlands and the East of England, where the share of SMEs operating below capacity rose considerably in Q4 – indicative of a moderation in demand in these areas. Significant improvements were recorded in the North East, the North West and the South East, led by substantial gains in the lending and employment indicators.

Figure 3: Regional SME Health Check Index

60 50 40 30 20 10 0 East Midlands

East of England

London

North East

North West South East Q3 2018

South West

West Midlands

Yorkshire & the Humber

Scotland

Wales

Q4 2018

Sources: FSB, ONS, BBA, Cebr analysis

East Midlands The East Midlands saw a 6.9 point decline in the SME Health Check Index in Q4 2018, bringing the score down from 54.9 to 48.0. This is the lowest it has been since the final quarter of 2017. The declines in the GDP and confidence indicators observed across the country in Q4 were also seen in the East Midlands. 12

Furthermore, the annual rate of employment growth fell between the third and fourth quarters of last year, while the improvement in the lending indicator was far more muted than elsewhere in the UK. The value of SMEs’ outstanding loan and overdraft balances fell by nearly nine per cent year-on-year in Q4 2018. This, together with

the significant decline in confidence suggests that many businesses in the region have become highly cautious. This is a likely reflection of the UK wide economic slowdown, as well as the ongoing risk of a disruptive Brexit. It is hoped that the East Midlands Development Corporation – which is in the process of being assembled – will stimulate activity in

#SMEhealthcheck | Q4 2018 REPORT

this region, by identifying strategically important projects such as the HS2 station and East Midlands Airport, and streamlining planning processes to accelerate progress. A similar framework has been successfully deployed in London’s docklands area. East of England The SME Health Check Index for the East of England fell by 2.9 points to 41.1 in the final quarter of 2018. Business confidence in this region plunged to the lowest level since the Index began in 2014, while the share of businesses operating below capacity rose considerably. This is indicative of a pronounced decline in demand in the East of England economy, as well as weak levels of investment among SMEs in the region. The Confederation of British Industry has recently estimated that a no-deal Brexit would cost the East of England around £17 billion in lost output by 2034. The East of England is vulnerable to the effects of Brexit on several different fronts. The high-skilled, knowledge intensive industries centred around Cambridge are at risk of facing reduced access to workers from Europe. Meanwhile, the region’s crucial homebuilding sector would be heavily impacted by the imposition of tariffs, given its reliance on imported inputs. London London’s SME Health Check Index score remained broadly stable in the final quarter of 2018, edging

up by 0.2 points to 48.8. It was one of only two parts of the UK to see a slight improvement in the confidence indicator in Q4, the other being Wales. It is important to note that the indicator score tracks the performance of this measure compared to London’s historical average. Therefore despite Q4’s improvement, confidence among SMEs in London still remains below that of SMEs in most other regions of the UK. At the start of 2018, London had a higher rate of employment growth than any other UK region. However, the number of people employed in the capital declined by more than 100,000 between the third and fourth quarter of 2018, bringing down the annual rate of employment growth to 0%. ONS data on internal migration suggest that Londoners are increasingly leaving the capital. The high cost of living and, in particular, house prices are likely to be major factors underlying this trend. The rapid rates of employment growth currently being observed in other major cities such as Manchester and Birmingham are a further sign that many workers are seeking employment in alternative centres outside of the capital. North East The North East’s SME Health Check Index score rose by 5.3 points to 53.9 in Q4 2018, despite declines in the confidence and GDP indicators. Although the confidence indicator

did fall last quarter, SME sentiment in this region remains more positive than elsewhere in the UK. This is reflected to some degree by the lending indicator, which rose by 20 points to 81. The employment indicator also registered a significant improvement, although the annual rate of employment growth in the region remains in negative territory. Due to the relatively high concentration of firms in the industrial sector, the North East has the highest rate of business cost inflation in the UK. However, a slowing rate of price growth for physical inputs, together with accelerating employment cost growth mean that overall cost inflation is converging between industries and regions. In the North East, the annual rate of business cost inflation fell from 3.2% in Q3 to 2.9% in Q4, which was one of the drivers of the improvement in the overall Index score. The car manufacturing sector is a major employer and economic driver in the North East. It is also an industry that is closely integrated with the EU and is therefore highly exposed to the disruptive impacts of Brexit, which could include higher import costs, export tariffs and lengthy checks at the border. The North East Local Enterprise Partnership has updated its plans to reflect the likely economic realities post-Brexit, and is seeking to promote diversification by building on existing strengths in the life sciences and energy sectors. 13

#SMEhealthcheck | Q4 2018 REPORT

2.2 R EGIONAL BREAKDOWN OF THE SME HEALTH CHECK INDEX North West For the second consecutive quarter, the North West recorded a larger increase in its SME Health Check Index score than any other region in the UK. Between Q3 and Q4, the score rose by 10.1 points to 49.4. The share of SMEs operating

to 42.9 in Q4 2018. This was driven primarily by the confidence indicator – which fell from 41 to zero between the third and fourth quarter of last year. The annual rate of net business creation in Scotland also fell by 0.3 percentage points to 3.7% in Q4 2018. More positively,

the number of people employed in the region and the value of SMEs’ outstanding loan balances was still lower in Q4 2018 than at the same time the previous year. While the UK-wide economic slowdown has been led by the industrial sector, there are signs that the moderation

below capacity fell drastically in the fourth quarter, while the number employed in the region has risen by more than 94,000 between Q4 2017 and Q4 2018. The North West is set to be one of the main beneficiaries of Transport for the North’s £70 billion Strategic Transport Plan. This would see the introduction of contactless payment cards on all forms of public transport, as well as a major expansion of existing local and national routes. At present, these ideas remain recommendations and have yet to be approved by the Department for Transport. However, there does appear to be considerable momentum and political will behind the idea of raising infrastructure standards towards the levels seen in London. If these ambitious plans are implemented, it would represent significant progress in narrowing the longstanding productivity gap between cities in the North West and the capital.

the annual rate of employment growth rebounded strongly to 2.0% - the first time it has been in positive territory since Q1 2018. Last month, the Scottish Parliament approved plans to freeze the threshold at which income is taxed at 41%, widening the gap in income taxation between Scotland and the UK. Proponents of the move argue that it will boost tax revenues while protecting vulnerable parts of society. However, there are concerns that further divergence from the rest of the UK could make it more challenging for Scottish firms to attract workers.

in growth is seeping into the services sector. The latest ONS data estimates that services output declined by 0.2% between November and December. While monthly data is highly volatile and subject to revisions, this nonetheless paints a worrying picture for the services sector – an area crucial for the economy of the South East – going into 2019.

Scotland The SME Health Check Index score for Scotland fell by 1.2 points 14

South East The South East of England recorded the second largest increase in the SME Health Check Index. Between Q3 and Q4, the score rose from 38.4 to 44.6 – the highest it has been since Q3 2017. While encouraging, the bulk of this improvement can be attributed to increases in the employment and lending indicators, which both came from a very low base. Indeed, both

South West The SME Health Check Index for the South West of England rose for the second consecutive quarter in Q4 2018. The score rose from 46.6 in Q3 to 48.1 in Q4. Declines in the annual rate of business cost inflation and the share of SMEs operating below capacity were driving the increase. The region received a major blow last month when Honda announced that it would be closing its Swindon factory – which currently employs around 3,500 people – in 2021. The company has stated that this move is not due to Brexit, and is more likely a reflection of the shifting centre of gravity of the global car

#SMEhealthcheck | Q4 2018 REPORT

industry, with emerging markets in Asia accounting for a growing share of demand. Meanwhile, leaders of the region’s crucial aerospace sector have become increasingly vocal about the impact that uncertainty is having on this industry and the risks associated with a no-deal Brexit. For instance, Airbus has stated that while its deep existing links mean that it will continue to have a presence in the UK after Brexit, a no-deal scenario would threaten its future investments into the country. Wales The SME Health Check Index score was stable for Wales in Q4, rising by 0.4 points to 52.4. Between the third and fourth quarter of 2018, the number of people employed in Wales increased by more than 90,000. This equates to an annual growth rate of 6.6% - by far the highest since data collection began in 2014. It is also a faster rate of employment growth than observed in any other of the UK’s regions. These figures suggest that Welsh businesses’ hiring plans have not been hindered by the economic and political uncertainty that continues to prevail in the UK. The results of the employment indicator also imply that many firms were expanding their capacity at the end of 2018. This could go some way to explaining the large increase in the share of Welsh SMEs operating below capacity, given that the expansion of capacity implied by the rapid rate of employment growth took place alongside a pronounced slowdown in

economic activity throughout the UK. West Midlands The SME Health Check Index score for the West Midlands increased from 42.9 in Q3 2018 to 44.6 in Q4 2018. The main drivers of this slight improvement were the net business creation and lending indicators. However, the value of SMEs’ outstanding loan and overdraft balances did still fall by £112 million between Q3 2017 and Q3 2018. The West Midlands has a higher share of SMEs operating in the manufacturing sector than any other UK region. The fall in the rate of inflation of key physical inputs such as metals and chemicals delivered a boost for manufacturers in the West Midlands in Q4. However, this will have been overshadowed by the array of challenges currently facing the sector, ranging from trade uncertainty to waning demand from key export markets such as Europe and China. The intensification of these challenges in the final months of 2018 is reflected in a decline of the confidence indicator between Q3 and Q4. A recent study by insolvency trade body R3 suggests that the proportion of businesses in the region that are at an elevated risk of insolvency was 41.4% in January 2019. This compares with a figure of 34% at the same time a year earlier. While these figures are concerning, it is interesting to note that in the manufacturing sector, the share of West Midlands’ firms at an elevated risk of insolvency is lower than the UK average.

Yorkshire & the Humber Yorkshire & the Humber witnessed a small decline in the SME Health Check Index between Q3 and Q4, from 50.4 to 48.9. This comes despite a more than 52,000 increase in the number of people employed in the region between Q4 2017 and Q4 2018. The score for the fourth quarter was dragged down by the confidence and GDP indicators, as well as an increased proportion of SMEs operating below capacity. According to data from the Start Up Loans Company, only small businesses in London and the South East have taken out more loans than those in Yorkshire via this Government scheme. This highlights that SMEs in the region are taking active steps to expand, despite the economic headwinds and uncertainty facing the UK economy. Yorkshire accounts for around 12% of England’s agricultural output and a third of England’s pigs are reared in this region. Leaving the EU’s common agricultural policy could have significant ramifications for the thousands of Yorkshire-based SMEs in this sector. Environment Secretary, Michael Gove, has recently suggested that the UK would charge tariffs on agricultural imports following a nodeal Brexit, in order to protect British farmers. However, this has been met with opposition from other members of the Government who would prefer to scrap tariffs to lower overall consumer prices. This debate will be watched closely by SMEs in the agricultural sector as the UK’s withdrawal date draws closer. 15

#SMEhealthcheck | Q4 2018 REPORT

3 CITIES HEALTH CHECK INDEX Cities represent a major component of regional economies throughout the UK. For this quarter’s SME Health Check Index report, the health of SMEs has been analysed at a city level, in order to establish the areas within each region that are flourishing or struggling, and to compare the performance of cities across the UK in Q4 2018. For this, a Cities Index has been developed, which combines indicators on business costs, GVA, employment and business creation to produce an overall Index score from 0 – 100 for each of the 25 cities covered.

City

Region

Cambridge (Ca)

East of England

76.6

Manchester (Ma)

North West

66.2

Reading (Re)

South East

65.5

Leeds (Le)

Yorkshire & the Humber

63.5

Edinburgh (Ed)

Scotland

63.1

Southampton (So)

South East

62.6

Liverpool (Li)

North West

61.7

Leicester (Le)

East Midlands

59.8

London (Lo)

London

58.1

In the Cities Index, a city’s score for a particular indicator is based on how it fares relative to the other cities covered by the index. Therefore, the index scores are comparable between cities. This is not the case for the regional SME Health Check Index, where a region’s score for each indicator is based on how that region fared in the latest quarter relative to that same region’s performance in previous quarters.

Sheffield (Sh)

Yorkshire & the Humber

56.7

The following table presents the Index scores for each of the 25 cities covered. The remainder of this section goes into the results for each city in greater detail, to identify the main drivers of the Index scores.

Index Score

Bournemouth (Bo) South West

56.4

Glasgow (Gl)

Scotland

54.4

Bristol (Br)

South West

54.3

Aberdeen (Ab)

Scotland

53.6

Preston (Pr)

North West

53.3

Swansea (Sw)

Wales

52.2

Coventry (Co)

West Midlands

51.3

Nottingham (No)

East Midlands

50.6

Birmingham (Bi)

West Midlands

48.4

Cardiff (Ca)

Wales

47.4

Norwich (Nw)

East of England

43.4

Newcastle (Ne)

North East

41.9

Portsmouth (Po)

South East

39.3

Middlesbrough (Mi) North East

30.6

Sunderland (Su)

21.2

North East

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Sw Ca

#SMEhealthcheck | Q4 2018 REPORT

3 CITIES HEALTH CHECK INDEX East Midlands Leicester emerges as the stand-out performer from the East Midlands, with an Index score of 60. This places it eighth out of 25 in the city rankings. The average number of people employed in Leicester in the 12 months to September 2018 was 2.7% higher than during the same period the previous year. This rate of growth is significantly higher than the UK average, and helped to propel Leicester up the rankings. Employment in the area could receive a further boost in 2019 from the construction of a major logistics park in north-west Leicestershire, which is expected to support close to 1,000 jobs. The manufacturing sector plays a larger role in the economy than in almost any of the other cities covered, with textiles and shoes among the established industries. As a result, the average rate of business cost inflation is above the UK average, due to high rates of price growth for physical inputs such as metals and chemicals. This factor weighed on Leicester’s overall score in the Cities Index. Nottingham – another major city in the East Midlands – recorded an Index score of 51. The score was limited by declining levels of employment in the city, higher than average business cost inflation and a tepid rate of business creation. Nottingham came in last position in the Learning and Work Institute’s Youth Opportunity Index, which points to a shortage of training and

employment prospects for young people in the city. Employment prospects in Nottingham received another blow recently when EDF Energy announced that it would be closing its Nottinghamshire power station, citing weak energy prices and a shift in demand towards cleaner sources of electricity. There are, however, sources of optimism as a study by Paymentsense has ranked Nottingham as the secondbest place in the UK to start a business, citing a five-year start-up survival rate of 43%, and affordable commercial rents, as well as the Nottingham Enterprise Zone, which provides support for businesses in the life sciences and IT sectors. East of England With an Index score of 77, Cambridge is the highest ranked city both in the East of the England and in the UK. The strong performance is driven by Cambridge’s fast growing economy and expanding employment base. However, the total number of SMEs in the city did decline marginally between 2017 and 2018. The rich pool of skilled workers and resources associated with Cambridge’s world-class university have provided a springboard for the city to become one of the UK’s leading centres for the science and technology sectors. Numerous reports have now highlighted that it’s among the cities that will be most impacted by immigration restrictions following the UK’s

withdrawal from the EU, given its relatively high reliance on skilled workers from abroad. This therefore represents a downside risk for SMEs in the coming months and years. By contrast, Norwich – the East of England’s largest city – ranks 21st out of the 25 cities covered by the Index, with a score of 43. The city’s poor performance is largely driven by the employment indicator. The number of people in employment in Norwich has fallen from an average of 137,000 in the 12 months to September 2017 to an average of 134,000 in the 12 months to September 2018. This 2.2% decline is the largest recorded in any of the cities covered by the Index. The large difference in the Index scores between Cambridge and Norwich highlights that geographical proximity does not always preclude the emergence of wide gaps in economic performance. In the case of the East of England, this divergence can be attributed to the differing sectoral composition of the region’s cities, as well as Cambridge’s superior connectivity to other major urban centres. London In the Cities Index, London ranks in ninth place with a score of 58. The service-oriented structure of London’s economy means that the annual rate of business cost inflation is among the lowest in the UK – behind only Cambridge and Edinburgh. However, the recent

#SMEhealthcheck | Q4 2018 REPORT

uptick in earnings growth means that SMEs in the capital are likely to see an intensification of cost pressures in the coming months. North East The North East’s major cities do not fare well in the Cities Index, occupying three of the bottom four places. Newcastle has an Index score of 42, driven largely by falling levels of employment. However, the city did recently receive a boost after securing the opening ceremony for the Rugby League World Cup. It is estimated that this will bring in £13 million to the local economy2.

International car companies have become increasingly vocal about the damaging effect that a nodeal Brexit would have on their operations in the UK – many of which are centred in Sunderland. The city received a major blow in February when Nissan announced that it would instead build its X-Trail vehicle in Japan. While Brexit uncertainty appears to have played a part in this decision, it is important to note that there were also significant business drivers, including an overall decline in the demand for diesel vehicles in Europe.

The number of SMEs in nearby Sunderland fell by 2.5% between

With an Index score of 31, Middlesbrough ranks second from last in the list of UK cities. This

2017 and 2018. This is the second sharpest decline among the cities covered, and contributes to Sunderland’s placement at the bottom of the city rankings, with a score of 21. Another major factor is the rate of business cost inflation, which is higher than in any other city covered by the Index. Sunderland is one of the UK’s leading manufacturing cities. While this industry has been a powerful driver of economic growth for Sunderland, it also means that the city is heavily exposed to some of the ramifications of Brexit.

is driven by a fall in the number of SMEs between 2017 and 2018, above average business cost inflation, and relatively weak employment growth. However, there are some causes for optimism looking ahead. Early this year, the £588 million Tees Valley investment plan was approved, which aims to reinvigorate the local economy through a series of infrastructure developments and schemes to support business growth. Prospective transport developments such as HS2 and Northern Powerhouse Rail also

https://www.chroniclelive.co.uk/business/business-news/newcastle-economy-benefit-13m-hosting-15748138

have the potential to improve Middlesbrough’s connectivity with other major economies in the UK in the medium term. North West The North West is home to some of the best performing cities in the UK, according to the Cities Index. Manchester – the North West’s largest city – ranks second with a score of 66. As has been the case in neighbouring Liverpool, the rates of employment growth and SME creation in Manchester have been well above the national average, indicative of a vibrant and expanding economy. An Independent Prosperity Review of the Greater Manchester economy recently concluded that despite its strengths in high-value added sectors, such as advanced materials and health, challenges still exist such as the high levels of existing employment in low-skilled and low-productivity jobs. The report also highlighted the link between health and productivity, and how expanding programmes to improve people’s health has the potential to deliver meaningful economic improvements in the medium to long term. With a score of 62, Liverpool places seventh in the city rankings. The population of SMEs has been expanding rapidly in recent years, and this has been matched by an equally impressive rate of employment growth. The economy received a boost last year when

#SMEhealthcheck | Q4 2018 REPORT

3 CITIES HEALTH CHECK INDEX over 2.2 million people visited the city for a series of events marking 10 years since Liverpool was designated the European Capital of Culture. Looking ahead, Transport for the North’s Northern Powerhouse Rail plan – which would include a high-speed rail line between Liverpool and Manchester – has the potential to unlock considerable economic gains, through enhanced connectivity both with regional cities and London. Manufacturing accounts for a larger share of economic activity in Liverpool than in the majority of cities covered by the Index, and this sector remains among the most vulnerable to a disruptive Brexit. Therefore, Liverpool’s SMEs in the manufacturing sector will be watching developments in Westminster closely over the coming weeks. Preston ranks 15th out of the 25 cities covered, with an Index score of 53. The average level of employment in the city in the 12 months to September 2018 was 5.6% higher than during the 12 months to September 2017. This is the fastest rate of employment growth among the cities covered by the Index. However, the fact that economic growth has not matched this rate of employment growth suggests that many of the new jobs that are being created are in relatively low-productivity fields or occupations – an issue experienced throughout the region.

Scotland Edinburgh ranks in fifth place in the Cities Index, with a score of 63. This makes it Scotland’s best performing city. The average number of people employed in Edinburgh in the 12 months to September 2018 was nearly 273,000 – more than two per cent higher than during the 12 months to September 2017. However, the city’s Index score is held back by a relatively slow rate of growth of its SME population. Edinburgh’s economy is one of the most service-dominated economies in the UK, with only a small percentage of output coming from primary or secondary industries. This means that it is less vulnerable to some of the overnight impacts of a disorderly Brexit, such as higher tariffs or increased checks at the border. However, the challenge of accessing required skills may well intensify in the months and years following Brexit. Edinburgh is the UK’s most visited city after London. Between 2016 and 2017, the number of visits rose from 1.7 million to over two million. Councillors in Edinburgh

have courted some controversy, given the increasingly important role that tourism plays in the economy and the potential for further visitor charges following the UK’s withdrawal from the EU.

have recently voted in favour of a tourist tax, which would charge overnight visitors £2 a night in any paid accommodation during the first week of their stay. These plans

growth of high skilled industries in Glasgow in the medium term.

https://www.glasgowist.com/500-million-glasgow-city-innovation-district-launched-to-create-jobs/

Glasgow has a score of 54 in the Cities Index, placing it in middle of the rankings. It’s not experienced the sizeable employment gains observed across the rest of the UK, with only a marginal increase in the average number employed in the 12 months to September 2018 compared to the same period the previous year. Glasgow’s economic strategy aims to revitalise the economy through the creation of 50,000 new jobs by 20233. Part of this is a £500 million Innovation District, which aims to boost the growth of high-tech industries and the local economy more broadly through investments in housing, commercial space and hotels. Glasgow has demonstrated its potential to attract skilled young workers, with 46% of students choosing to stay there after graduation – the fifth highest rate in the UK. This bodes well for the

Aberdeen ranks 14th in the city rankings with an Index score of 54,

#SMEhealthcheck | Q4 2018 REPORT

driven by tepid performance across the sub-indicators. Out of the cities covered by the Index, Aberdeen is the most reliant on the productive sector. Underpinning this is the crucial oil and gas sector, which despite having shrunk in real terms since 2013, remains a core part of the local economy. The precipitous falls in energy prices that took place towards the end of 2018 will have therefore been a major concern to those businesses both directly and indirectly supported by the sector. However, the recent discovery of an estimated 250 million barrels of oil in the North Sea to the east of Aberdeen may well lead to some recovery of exploration and extractive activities. South East With a score of 66, Reading is the third highest ranked city in the Index, behind only Cambridge and Manchester. Underpinning this performance are a high rate of GVA growth and a low rate of business cost inflation. This is due to the relatively low share of SMEs in the city operating in the manufacturing or construction sectors, which have seen significantly higher rates of input inflation in recent months. While SMEs in the services sector are typically less exposed to increases in physical input prices, they are usually more exposed to rising employment costs. In Q4, average weekly earnings rose by 3.4% year-on-year – the highest rate since 2008. While the boost to

households’ finances will promote spending and boost revenues for some SMEs, many others will also face difficulties keeping up with growing wage bills. This dynamic could threaten Reading’s position in the rankings over the coming year. Southampton is another city that performs well, with an Index score of 63. Driving this was a 3.3% increase in the number of SMEs operating in the city between 2017 and 2018. International trade is an integral part of the Southampton economy. The Port of Southampton is the UK’s main export port, and is crucial for the country’s automotive sector. It is also the second busiest import port after Felixstowe. 90% of the exports passing through the Port of Southampton are not bound for the EU, meaning that this sector should be more resilient in the coming months. Moreover, there is the opportunity for growth in this sector in the longer term if the UK does deepen its trading relationships with non-EU economies, as is often called for by leading proponents of Brexit. Relatively high business cost inflation, a declining population of SMEs and modest employment growth mean that Portsmouth places 23rd in the city rankings, with a score of 39. As with nearby Southampton, the maritime sector is a key part of the local economy in Portsmouth. The council is on course to approve around £18 million of investment in

https://www.built-environment-networking.com/bristols-global-gateway/

Portsmouth International Port, with the aim of attracting cruise liners to dock. If this scheme is successful in boosting tourism in Portsmouth, the positive spill over effect for SMEs throughout the city would be substantial. Representatives of the city are also in early talks with the Ministry of Defence regarding the construction of a dry dock to house the UK’s new aircraft carriers. Such a scheme would provide a considerable boost to the local economy both in the short to medium term during its construction and in the long term due to the increased military activities in the area. South West Bristol ranks 13th out of the 25 cities covered, with an Index score of 54. After several years of substantial increases, the number of SMEs in Bristol edged down slightly between 2017 and 2018, which weighed on the Index score. Trade and distribution is an important part of the local economy. Bristol Port employs 549 people directly and an estimated 9,000 indirectly in the local area4. Due to its geographical location, this port handles a smaller share of EU imports than other UK ports, and is therefore less exposed to the potential disruption caused by the UK’s withdrawal from the EU. Furthermore, it has put aside land for storage to assist with any backlog of freight that emerges following Brexit, which could provide a potential boost to Bristol’s economy in the short term.

#SMEhealthcheck | Q4 2018 REPORT

3 CITIES HEALTH CHECK INDEX

Bournemouth has an Index score of 56, placing it just ahead of Bristol in 11th place in the rankings. In the 12 months to September 2018, the average number of people employed in Bournemouth was just under 245,000 – 1.6% higher than the number in the 12 months to September 2017. Bournemouth has a reasonably diverse economy, with established tourism, finance and IT sectors. This diversity is an important asset, and will assist Bournemouth in weathering various potential economic shocks that could hit the UK in the coming months. Wales Both of the Welsh cities covered by the Cities Index place towards the lower end of the rankings. Cardiff

has an Index score of 47, weighed down by a GVA growth rate that is below the national average. The finance sector is a key part of the Cardiff economy, expanding by 30% in the five years to 2016 and now accounting for more than 10% of GVA5. The UK’s impending departure from the single market would restrict access to the large European market, throwing cold water on one of Cardiff’s primary drivers of growth.

Swansea fares slightly better with a score of 52 but there were mixed results among the sub-indicators. The number of SMEs in Swansea rose by 2.6% between 2017 and 2018. However, the average level of employment in the city in the 12 months to September 2018 was more than 2,000 lower than the average level in the 12 months to September 2017. This highlights that while the UK as a whole has seen a considerable strengthening of the labour market in recent years, this has not been observed in all parts of the country. Renewable energy has the potential to deliver large economic benefits to Swansea. Private investors have reportedly shown an interest in the proposed Swansea Tidal Lagoon scheme, after the Government chose

not to allocate subsidies to the project6. If this scheme was to go ahead it would represent a major source of employment during both its construction and operation, providing considerable spill over effects for the local economy. West Midlands The annual rate of employment growth in Coventry is 4.32% the third highest among the cities covered by the Index. However,

the number of SMEs operating in Coventry fell by more than two per cent between 2017 and 2018, which brought the overall Index score down to 51. The recent struggles of Jaguar Land Rover are a significant cause for concern given the positive spillover effects it brings to SMEs in the area. Another important sector for Coventry is further education. A recent study has estimated that 4,000 residents are employed full time by the city’s two universities, while student expenditures create a further 2,500 jobs. 15% and 20% of students at the University of Warwick and Coventry University respectively come from overseas, and it will be important that this flow of students is maintained in the years ahead.

Birmingham – the UK’s second largest city after London – has a score of 48 in the Cities Index, placing it 19th in the rankings. Both economic growth and employment growth have been well above the UK average. Indeed, the average number of people employed in the city in the 12 months to September 2018 was nearly 27,000 higher than during the 12 months to September 2017. However, there was a sharp fall in the number

https://www.ons.gov.uk/economy/grossvalueaddedgva/datasets/regionalgrossvalueaddedbalancedlocalauthoritiesbynuts1region 6 https://www.theguardian.com/environment/2019/feb/04/swansea-tidal-lagoon-plan-government

#SMEhealthcheck | Q4 2018 REPORT

of SMEs operating in the city in 2018. It is important to note that this decline followed four years of rapid growth of Birmingham’s SME population, so the latest data appears to be somewhat of an outlier. Manufacturing is a large part of Birmingham’s economy, meaning that a disruptive Brexit – and the effect of this on international competitiveness, input costs and frictions at the border – is a major risk for the local economy. Jaguar Land Rover has already announced that it will be pausing production at its Wolverhampton, Solihull and Castle Bromwich sites between April 8th and April 12th. Although such temporary closures are not unprecedented, the specific timing is attributable to Brexit. Despite performing well in recent years, Birmingham’s productivity still lags well behind London and is lower than one may expect for such a large city. One theory proposed by the Open Data Institute is that a shortage of transport infrastructure means that Birmingham has not been able to benefit from agglomeration effects – such as low transport costs, access to a large local labour supply and knowledge spill overs between firms – to the same extent as other larger urban centres. While HS2 will undoubtedly

deliver economic benefits through improved integration with London, as well as northern centres, investments in the internal transport network will also be key in closing the productivity gap. The Index scores for both Birmingham and Coventry are significantly weakened by their performance in the business creation indicator. Both cities saw a marked decline in the number of SMEs between 2017 and 2018. However in both cases, these declines followed several years of rapid growth, so should not be overstated. Yorkshire & the Humber Leeds ranks fourth in the Cities Index, with a score of 64. High skilled and high-value added sectors, such as professional services and IT, are an important part of Leeds’ economy and have been a key source of growth in recent years. HS2 and Northern Powerhouse Rail also have the potential to deliver significant economic benefits to Leeds, by increasing connectivity to other northern hubs as well as London. The ‘Leeds Key to the North’ initiative is aiming to build upon these gains by pushing for major investments to transform

Leeds station into a ‘world class transport hub’, utilising its geographical location in the core of the north of England. In the shorter term, SMEs in Leeds’ transportation sector will be impacted by the recent approval of a Clean Air Charging Zone, which will come into effect in 2020. This will lead to daily charges of £12.50 for taxis and private hire vehicles and £50 for heavy goods vehicles, buses and coaches. Sheffield – Yorkshire’s second largest economy – has an Index score of 57, placing it below Leeds in the city rankings. The number of SMEs in Sheffield actually contracted in 2018, although this is balanced by the fact that the rate of employment growth is second only to Preston among the cities covered in the Index. In the 12 months to September 2018, the average number of people employed in Sheffield was over 398,000 – nearly 18,000 higher than during the 12 months to September 2017. Despite this, economic growth in Sheffield has been below the UK average in recent years – a finding that many ascribe to relatively poor road, rail and air infrastructure, as well as challenges transitioning from heavy industry and manufacturing towards services.

#SMEhealthcheck | Q4 2018 REPORT

IN FOCUS: SME BUSINESS COSTS INFLATION

In this section, we explore the business costs indicator in greater detail in order to establish its contribution to the overall improvement in the business climate in the fourth quarter of 2018, and the degree to which it has affected SMEs in different regions. Figure 4: SME Inflation Q1 2014 â&#x20AC;&#x201C; Q4 2018

3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018 2018

The annual rate of business costs inflation fell to 2.8% in Q4 2018 â&#x20AC;&#x201C; 0.2 percentage points lower than the rate recorded in the third quarter. This is the first decline in the rate of business costs inflation since Q2 2017. Beneath the overall fall in the rate of business cost inflation, there were a number of opposing forces. Employment cost inflation continued to accelerate in Q4, driven by stronger earnings growth. However, this was more than offset by slowdowns in the rates of price growth for commercial rents and physical inputs. The price of chemicals in Q4 2018 was 7.1% higher than during the

same period the previous year. However in Q3 2018, the annual rate of price growth for this input category was 8.7%. Similarly, the annual rate of inflation for metals has fallen from 7.3% in the third quarter to 4.3% in the final quarter of 2018. The price of important base metals such as aluminium and copper actually fell slightly during Q4 2018. This is reflects at least partially the moderation of the global economy at the end of last year, which will have weighed on demand for these commodities. Metal prices are also impacted heavily by geopolitical developments. For instance, aluminium prices have edged up since the start of the

year after the US announced that it would be lifting sanctions on Russian aluminium firm Rusal. Another contributor to the decline in business costs inflation in Q4 is commercial rents. The annual rate of growth of commercial rent prices fell from 1.3% in Q3 to 0.8% in Q4. A large part of this is attributable to the retail sector, where demand for rental space will have been hit by the slew of insolvencies and store closures announced by major companies. Headline rent price data does not provide the full story when it comes to the true cost of commercial property. Landlords commonly offer incentives to tenants including rent-

#SMEhealthcheck | Q4 2018 REPORT

free periods, cash transfers at the start of a tenancy and shorter leases. These incentives typically become more generous during softer market spells and taking them into account, the cost of renting commercial space may well be falling more than is reflected in the rent data. For instance, high street retailer, Next, has estimated that in 2018-19, it will see a 27% decline in the cost of rents after taking into account capital contributions7. However, given the lack of available data on these contracts, it is difficult to say whether equally generous incentives are

being made available to smaller sized businesses. The decline in business cost inflation would have been even more pronounced last quarter were it not for the upward contribution coming from employment costs. Between October and December, the annual rate of employment cost inflation was 3.4%, compared to 3.0% in the third quarter of 2018. Average weekly earnings are now growing at the fastest rate since 2008 – a result widely attributed to the tightness of the UK’s labour

market. Labour market tightness can be measured in numerous ways. The record high number of vacancies and the lowest rate of unemployment since 1975 suggest that firms are finding it difficult to hire workers, forcing them to make more generous offers to attract the required skills. The UK’s underemployment rate – which considers the number of people currently in work who would like to work more hours but cannot do so – has also been falling steadily since 2013.

Figure 5: Breakdown of costs faced by SMEs

https://www.ft.com/content/6ba2aee8-68d5-11e8-aee1-39f3459514fd

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

#SMEhealthcheck | Q4 2018 REPORT

IN FOCUS: SME BUSINESS COSTS INFLATION

The rising cost of labour, together with a slowing of the rate of price growth for physical inputs, has led to some convergence in the rates of business cost inflation between industries. The annual rate of business cost inflation for SMEs in the manufacturing sector fell by 0.5 percentage points to 3.8% in the final quarter of 2018. This provides some much needed good news for a sector that has been buffeted by economic uncertainty and waning demand in the past months. However, the rate of inflation for this industry is still higher than for any other industry, despite last quarter’s slowdown.

A moderation in the rate of price growth for physical inputs such as metals and chemicals also led to a fall in the annual rate of business cost inflation for the construction sector from 3.3% in Q3 to 3.1% in Q4. Contrastingly, the high share of labour costs in total costs for SMEs in the business services sector meant that the annual rate of business cost inflation actually increased from 2.7% to 2.8% between the third and fourth quarters of 2018. Similarly, in the accommodation and food services sector the rate of business cost inflation rose from 2.3% to 2.4%. The annual rate of business cost

inflation declined in all of the UK’s regions in the final quarter of the year. The narrowing gap in the rate of inflation between the industrial and services sectors means that the gap between regions in cost inflation has also shrunk. In London and the South East, the annual rates of business costs inflation fell to 2.7% and 2.8% respectively. The annual rate of business costs inflation in all of the UK’s remaining regions was 2.9% – a reflection of the higher share of SMEs operating in the construction and manufacturing sectors outside of London and the South East.

T H E A N N U A L R AT E O F B U S I N E SS CO S T I N F L AT I O N D EC L I N E D I N A L L O F T H E U K’S R EG I O N S I N T H E F I N A L Q U A R T E R O F T H E Y E A R

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5 CONCLUSIONS There was considerable variation in the movements of the indicators that make up the SME Health Check Index in the fourth quarter of 2018. According to most data sources, the UK economy took a turn for the worse in the final months of 2018, as GDP growth contracted and confidence deteriorated, leading to negative movements in the corresponding indicators. This can be attributed to numerous factors including a slowing global economy, ongoing political and economic uncertainty surrounding Brexit and high levels of household debt, which has weighed on consumer spending despite increases in earnings growth. The labour market continued to strengthen in Q4, in a sign that businesses’ hiring activities have not yet been impeded by the UK’s gloomy economic outlook.

base effect of the sharp fall in the value of outstanding loan balances between Q2 2017 and Q3 2017, which drove up the annual growth rate in Q3 2018.

Meanwhile, a moderation of the rate of price growth for physical inputs and commercial rent led to a decrease in the annual rate of business cost inflation for the first time since Q2 2017. These factors contributed to the overall increase in the SME Health Check Index in Q4.

Overall, the results of the Q4 SME Health Check Index bring mixed news for the UK’s SMEs. The UK-wide economic slowdown will inevitably be weighing on SMEs’ revenues, although falling business cost inflation will provide much needed relief for many firms – particularly in the manufacturing sector.

However, the most significant factor behind the increase was the lending indicator, which rose from 66 to 95 between Q3 and Q4. It is important to note that this largely reflects the

The inclusion of the Cities Index this quarter has shed light on the considerable variation that exists across the country in terms of

the health of the local business environment and the overall performance of the economy. The strength of the knowledge intensive industries in Cambridge and Reading led to very high Index scores in these cities, while the rapidly expanding population of SMEs in Manchester drove the city to second in the rankings. Meanwhile, cities with a large industrial sector performed less well, consistent with the significant difficulties currently facing the UK’s manufacturing sector, and the automotive industry in particular.

#SMEhealthcheck | Q4 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. 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 longrun 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

#SMEhealthcheck | Q4 2018 REPORT

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 the 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

63 (Q4 2018)

Capacity

Federation of Small Businesses

Net balance of SMEs operating below capacity

63 (Q4 2018)

Confidence

Federation of Small Businesses

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

22 (Q4 2018)

Employment

Office for National Statistics

Annual percentage change in employment numbers

74 (Q4 2018)

GDP

Office for National Statistics

Quarterly percentage change 63 (Q4 2018) in gross domestic product

Lending

UK Finance

Annual percentage change in lending to SMEs

95 (Q3 2018)

Net Business Creation

UK Insolvency Service

Annual growth rate in the number of registered companies

17 (Q4 2018)

Revenue

Federation of Small Businesses

Net balance of SMEs reporting rise in revenue

42 (Q3 2018)

#SMEhealthcheck | Q4 2018 REPORT

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/ http://www.ybonline.co.uk/business/business-news/

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