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What is behind the cost of business crisis hitting UK plc?

Even with Prime Minister Liz Truss’ move to stem the rise in energy bills, the economic pain is only just beginning.

British households are still under pressure on their finances that has not happened since the Second World War. The same goes for companies. Caught by both rising costs and falling consumer spending, this pincer move is worrying businesses of all sizes.

So far, with strong spending still in the economy, many companies have been able to raise prices to correct the problem. They will also receive help this winter with a limit on the non-household energy bill. Even with the underlying strengths and government support, the big question is what happens next.

This is a drama that is likely to unfold in three companies, culminating in corporate distress and a recession.

Act 1: Never Ending Accounts

In the first quarter of 2022, average company electricity bills were about 30 percent higher than a year earlier. Rising bills haven’t stopped in business executives’ inboxes since then.

When a crisis point was reached in early September, the government promised to act almost immediately to prevent companies from having to pay up to five times their old rates in gas and electricity rates.

It has pledged to cut energy bills for the next six months, with help for some smaller businesses well into next year.

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However, at the new controlled price, many companies will still face much higher energy costs than they were a year ago.

Among the hardest hit are energy-intensive industries, often at the bottom of the supply chain, that produce metals, plastics and other parts critical to manufacturing and construction. These now feel the pinch. Small business confidence fell this year in both the manufacturing and construction sectors.

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While oil prices have taken a hit in recent months, manufacturing companies using crude oil or other fuels, including gas, saw the largest cost increase over the course of the year to August. Gas prices have risen by about 50 percent.

For the manufacturing sector, input costs have increased by 20.5 percent over the past year, adding to the challenges. Now that food inputs have also increased by about 20 percent, the prices of many supermarket items have of course risen sharply.

Bar chart of change in costs in August (year over year, %) showing companies experiencing extreme increases in raw material costs

At the other end of the supply chain, leisure industries that rely on heating large spaces, such as shops, swimming pools or nurseries, need to lower thermostats and raise prices. Small businesses feel like they’re on the cutting edge.

The shortage is not limited to raw material costs. In much of the service sector, companies are more affected by wage increases than by higher costs.

Regular wages grew 6.2 percent year-on-year in the private sector in July, the most recent month available. That was the highest rate of increase this century, except for a period during the pandemic when the figures were distorted.

Still, wages are growing more slowly than prices, which were 9.9 percent higher in August than a year earlier, putting pressure on companies to pay more. This will be hard to resist if there are currently as many vacancies as there are people classified as unemployed, twice the normal labor market tightness.

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For jobs in wholesale, construction and hospitality, advertised rates have risen sharply since early 2022, recruitment website Indeed.com reports. In contrast, the advertised pay for nurses is barely rising, even after their services have been so sought after due to the pandemic.

Act 2: Rising borrowing costs

Companies have more on their mind than raw material and labor costs. The cost of debt is also rising.

After the Bank of England kept official interest rates close to zero for more than a decade, the Bank of England raised borrowing costs by 0.1 percent last November and signaled further increases to help lower inflation. The Monetary Policy Committee set the interest rate at 1.75 percent in August and financial markets expect it to rise above 3 percent by the end of the year.

Large UK companies often have fixed borrowing costs, limiting their exposure. The BoE expects the proportion of large companies at material risk of repayment problems to rise from 30 percent to 46 percent by the end of this year. Interest rates would need to rise to 4.5 percent for this exposure to reach historic highs and capture just over 60 percent of companies. However, this is no longer above market expectations.

Market expectations for Bank of England interest rates have risen significantly.  Chart with future interest rate (%) on March budget 2022 and latest forecast.  According to the latest data, interest rates are now expected to peak at 4.5% in mid-2023, compared to a peak of 2.3% in mid-2023, as forecast in March

Smaller companies are not nearly as well protected. While the new debt these companies took on during the pandemic was generally fixed interest rates, BoE estimates that 70 percent of their existing credit stock will be exposed to interest rate hikes within a year. Many of these companies will be exposed to a nasty borrowing cost shock in the coming months.

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At the same time, companies need to look at sales. These fall in the high streets and stress is clearly visible in the consumer confidence figures. This fell to a nearly 50-year low in August as households worried about their own financial situation and the economy in general.

Act 3: Expenditure under pressure

Consumer spending is likely to fall further. The prices of food, rents, mortgages, gasoline and energy, which make up more than 40 percent of the household budget, are all rising rapidly. Many consumers will be cutting back on discretionary spending this winter and focusing on the basics. Poorer households will have to make even more difficult choices.

A survey of 3,000 people by SellCell, a price comparison website, found that a majority of households plan to cut back on entertainment spending and eat out. Only 24 percent of respondents said they would not cut back on discretionary spending at all this winter.

Bar chart of expected movements, percentage of households (%) showing Households plan to cut discretionary spending this winter

Intentions to austere do not always lead to actual savings, but early signs from high streets point to greater spending constraints in non-food stores than in supermarkets, suggesting that discretionary spending is likely to be affected.

With food producer costs up about 20 percent, food price inflation is likely to rise further from its 13.4 percent level in August. That will put great pressure on cafes, restaurants and eateries to cut costs at a time when consumers are becoming much more price conscious.

Line chart of the unemployment rate (%) showing that unemployment is expected to rise as the recession hits

And the BoE still wants to deliver a shock to make sure inflation falls. For the central bank, higher unemployment and lower wage growth are the necessary ills needed to restore price stability. The BoE thinks the recession will be shallow but will last much of next year, with unemployment rising to more than 6 percent.

The data suggests that the process is already underway. Households are cutting back while corporate profits are falling. Signs of business distress, such as the 42 percent increase in bankruptcies since last year, are likely to increase further.

This is how the recession starts.

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