Severe drop in service sector confidence spells danger for UK economy

Private sector unprepared to fill the hole left by public sector cuts 

 

Negative sentiment in the service sector has prompted a steep drop in business confidence that could spell danger for the UK economy, according to the latest Business Trends report by accountants and business advisors BDO LLP.

BDO’s Optimism Index – which measures growth expectations two quarters ahead – slipped to 92.0 in January from 94.8 in December, falling further below the crucial 95.0 mark that signals growth in UK output. 

The fall in confidence is attributed to a sharp drop in the BDO services index of 3.7 points, to 88.4 in January from 92.1 in December - the second largest fall on record. The marked decline in optimism within the sector is attributed to elevated inflation, weak earnings growth and the erosion of households’ real disposable income.  This is set against the backdrop of public sector cutbacks, which will also take effect this year. Added to this, as predicted in August’s Business Trends, the contraction in GDP experienced in Q4 2010 exposes the UK economy’s fragility. 

With services accounting for approximately 55% of UK GDP, the fall in confidence poses a significant challenge for the Government, which has set out its intention to rely on the private sector to drive growth and employment when public sector cuts come into full swing. 

While the BDO Output Index rose from 94.9 in December to 95.5 in January, indicating that re-entering recession is unlikely, growth prospects remain delicate at best – calling into question the economy’s ability to withstand a future rise in interest rates.

Peter Hemington, Partner, BDO LLP commented: “The significant fall in service sector confidence deals a blow to the Government, especially given the sector’s importance to the economy as a whole. If the Government is to rely on the private sector to drive the economy, more must be done to create an environment that facilitates growth. 

“In the short term, the Bank of England should continue to keep monetary policy loose. Low interest rates provide a fillip to businesses and consumers by making credit more accessible. This combined with increased consumer spending are vital to drive economic growth in the UK. 

“We do hope that 2011 is set to be a year of two halves. While sluggish growth is expected in the first half of the year, there are signs of an improvement in business investment which should help the economy to pick up from the summer onwards.  However, with Project Merlin failing to produce the magic some had hoped for, it may be that the Bank of England has to consider putting QE back on the table as we go through the year.”   

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Methodological Notes

The BDO Monthly Business Trends Indices are prepared on behalf of BDO LLP by the centre for economics and business research ltd., a leading independent economics consultancy. cebr has particular strengths in all forms of macroeconomic and market forecasting for the UK and European economies and in the use of business survey techniques.

The indices are calculated by taking a weighted average of the results of the UK’s main business surveys. It incorporates the results of the quarterly CBI Industrial Trends Survey (and the CBI Monthly Trends Enquiry which is carried out in the intervening months); the Bank of England Agents’ summary of business conditions; and the Chartered Institute of Purchasing and Supply’s Surveys of Manufacturing and of Services.

Taken together the surveys cover over 11,000 different respondents from companies employing approximately five million employees. The respondents cover a range of different industries and a range of different business functions. Together they make up the most representative measure of business trends available.

The surveys are weighted together by a three-stage process. First, the results of each individual survey are correlated against the relevant economic cycles for manufacturing and services. This determines the extent of the correlations between each set of survey results and the relevant timing relationships. Then the surveys are weighted together based on their scaling, on the extent of these correlations and the timing of their relationships with the relevant reference cycles. Finally, the weighted total is scaled into an index with 100 as the mean, the average of the past two cyclical peaks as 110 and the average of the past two cyclical troughs as 90.

The results can not only be used as indicators of turning points in the economy but also, because of their method of construction, be seen as leading indicators of the rates of inflation and growth.