Securing a transitional agreement with the EU is critical for the UK’s business investment outlook

By Mark Gregory | EY Chief Economist

Report highlights

Business investment is vital for a successful Brexit

In 2016, business investment dipped for the first time since 2009, falling 0.4% amid heightened uncertainty in the run-up to the referendum on EU membership. However, despite the June 2016 Brexit vote contributing to a decline in business confidence, business investment grew 0.8% quarter-on-quarter in Q1 2017 and 0.5% in Q2.

Stronger business investment is key

Going forward, a healthy level of business investment is important. With consumers’ purchasing power under pressure, sustained weakness in business investment could contribute to a prolonged period of muted economic activity. And from a longer-term perspective, it’s desirable for business investment and exports to make greater contributions to UK GDP growth, helping to rebalance the economy away from its dependence on the consumer.

Business investment is also seen as key to improving the weak productivity that has been evident in the UK since the 2008/9 downturn. And it’s urgently needed to build new export capacity and support the domestic supply chain for the post-Brexit environment.

In this context, Brexit could reinforce a move towards less offshoring and more domestic sourcing of inputs. Businesses may be keener to secure domestic sources of supply, due to concerns about possible delays to cross-border supply chains and increased regulations once the UK is outside the EU’s Single Market – a particular worry for “just-in-time” supply chains.

Favourable factors supporting investment

On the positive side, several fundamentals for business investment are currently favourable. Companies’ net rates of return are relatively high overall and corporate balance sheets are largely healthy. Additionally, if companies want or need to borrow to invest, the cost of capital remains low and credit is readily available. Finally, sterling’s weakness means UK exporters and domestic firms competing with imports have an incentive to invest.

Business motivation diluted

However, businesses’ motivation to invest has been diluted by uncertainties over Brexit and domestic political uncertainties, following the outcome of the June 2017 general election. Businesses also face a struggling UK economy. Given these factors, we expect only limited growth in business investment in the near term, especially as the low cost of labour will make it more attractive for companies to meet extra demand by employing additional workers rather than investing in plant and machinery.

Brexit cliff-edge should be avoided

We also expect the UK to avoid a “cliff-edge” Brexit in March 2019 by agreeing a transitional period with the EU. For this to happen, the nature of the transitional agreement will need to be in place by late 2018 to allow enough time for ratification across the EU before the end of March 2019. While a transitional agreement still wouldn’t address the longer-term Brexit uncertainties, it should be sufficient to encourage businesses to take a more positive approach to investment from late 2018.

In addition to trade arrangements with both the EU and non-EU markets, a further important factor determining the strength of business investment after Brexit is likely to be the UK’s regulatory environment and immigration regime. There are concerns that a lack of skilled workers able to operate complex machinery and processes could constrain future business investment—especially if the post-Brexit immigration regime fuels a shortage of workers in high-tech sectors.

Government support required to boost investment

This underlines the pressing need for UK Government policies to boost investment in education, skills and training. Investment in robots and other labour-saving machinery could also help—as would tax incentives for business investment and training in these areas, together with increased public funding of R&D and grants for pilot schemes in robotics and artificial intelligence.

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