Atradius Country Report

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1 Atradius Country Report United Kingdom September 2011 Belfast Cardiff Glasgow Manchester Liverpool Birmingham London

Summary Main economic developments UK GDP forecast revised downwards to 1.2 % in 2011 and 1.8 % in 2012 Inflation continues to climb (4.5 % in August 2011) Private consumption will contract by 0.

2 Summary Main economic developments UK GDP forecast revised downwards to 1.2 % in 2011 and 1.8 % in 2012 Inflation continues to climb (4.5 % in August 2011) Private consumption will contract by 0.4 % in 2011 Manufacturing growth to slow down as foreign demand is decreasing Industry performance Troubles in the construction sector persist, with fewer new orders Increasing insolvencies in the consumer durables retail sector Insolvency environment No insolvency decrease in 2011 as expected earlier this year Default risk for UK listed companies increased again in August 2011 Main economic developments The sluggish performance continues downward revision of growth forecasts According to the second estimate by the Office of National Statistics (ONS), in Q2 of 2011 GDP grew by only 0.2 % on the previous quarter and 0.7 % year-on-year. While construction output increased 0.5 %, following its 3.4 % decrease in Q1, the contraction of production industries accelerated to 1.6 % after a 0.1 % decrease in the previous quarter. Services maintained 0.5 % output growth. Economic performance has barely shown growth since Q3 of 2010, and remains depressed by massive budget cuts and lower household consumption. Real GDP growth (Quarter-on-Quarter percentage change) Sources: Global Insight; OECD (MEI). Atradius 2

Consequently, Consensus Economics has revised its monthly GDP forecasts downwards to 1.2 % in 2011 and 1.8 % in 2012, from its May forecasts of 1.6 % for this year and 2.2 % in 2012.

3 Consequently, Consensus Economics has revised its monthly GDP forecasts downwards to 1.2 % in 2011 and 1.8 % in 2012, from its May forecasts of 1.6 % for this year and 2.2 % in GDP growth (% change on previous year) f 2012f Source: Consensus Forecasts (Survey date September 12, 2011) No relaxation of austerity measures As a consequence of the credit crisis and governmental investment in stimulus measures, the fiscal deficit rose to 10.1 % of GDP in 2010 and will stand at 8.5 % for 2011, with public debt increasing sharply since 2009: to 65 % of GDP (see chart below). The government s aim is to cut the fiscal deficit to 1.9 % of GDP by 2015 to avoid adverse sentiment by international financial markets. Comprehensive austerity measures and tax rises are designed to save 80 billion and to bring in an additional 30 billion by In the process, more than 300,000 jobs in the public sector will be lost, but the government believes that a revival in the private sector will create job opportunities to compensate for this. While there is evidence of job creation in the private sector, there is no doubt that the average salary will not be comparable with that of the public sector, and this needs to be taken into consideration when looking at future consumer expenditure trends. Public debt and budget balance: United Kingdom (Government debt and budget balance in percent of GDP) Sources: Global Insight; Office for National Statistics. There has been mounting pressure on the government to soften its fiscal tightening, to avoid another recession. Some prominent economists warned that cutting spending may exacerbate the already tense situation by further dampening demand, and that what is needed is a strategy for growth that will reduce the budget deficit while boosting demand. So far, the government has ignored these alternative views and the expectation is that there will be no major change to the current strategy. Atradius 3

Inflation continues to climb Throughout 2010, consumer price inflation was above 3 %, and rose above 4 % in 2011, exacerbated by January s VAT rise from 17.

4 Inflation continues to climb Throughout 2010, consumer price inflation was above 3 %, and rose above 4 % in 2011, exacerbated by January s VAT rise from 17.5 % to 20 %, which was introduced to help tackle the budget deficit. In August 2011 the consumer price index stood at 4.5 %, up from 4.4 % in July and 4.2 % in June, and remains far above the Bank of England s target rate of 2 %. According to ONS, in August main upward pressures came from clothing, fuels and lubricants, furniture /household goods and domestic heating. Consumer price inflation (Annual percentage change in CPI all items) Source: Global Insight. That said, the Bank of England is maintaining its benchmark interest rate at 0.5 %, keeping in place its monetary policy of low interest rates to help mitigate the effects of fiscal tightening and to avoid stalling the already weak growth. However, with global commodity prices continuing to have an impact, it is difficult for the Bank of England and the government to regain control, and there is the danger that higher price expectations become entrenched. Overall it is expected that inflation will peak at around 5 % as early as November, due in part to rising energy costs, but then drop fairly quickly throughout the first half of Consensus Economics forecasts consumer inflation of 4.4 % for the whole of 2011 and 2.7 % in Consumer confidence deteriorates further After a short-lived recovery in mid-2011, consumer confidence has again declined. In August it fell for a third month in a row, reflecting uncertainty over the UK economic outlook, worries about the comprehensive budget cuts, rising inflation, and personal incomes. Consumer confidence (Index 100 = Neutral) Sources: Global Insight; ICON Atradius 4

Private consumption: contraction in 2011 Growing pessimism among consumers and low wage growth have subdued private consumption, which decreased 0.

5 Private consumption: contraction in 2011 Growing pessimism among consumers and low wage growth have subdued private consumption, which decreased 0.6 % in Q2 of 2011: the largest drop since Q2 of 2009, when the UK economy was in the midst of recession. Growth in real private consumption (Quarter-on-Quarter percentage change) Source: Global Insight. While in May Consensus Economics forecast that household consumption would increase by 0.5 % in 2011 and 1.5 % in 2012, forecasts have been revised steeply downwards as far as a 0.4 % decline this year, followed by 1.2 % growth in 2012 (see chart below). Household consumption (% change on previous year) f 2012f Source: Consensus Forecasts (Survey date September 12, 2011) Atradius 5

Business confidence on a downward trend Business confidence in manufacturing recovered comprehensively between mid-2009 and early 2011.

6 Business confidence on a downward trend Business confidence in manufacturing recovered comprehensively between mid-2009 and early However, confidence has begun to weaken again due to concerns about slowing domestic growth and weaker economic prospects, the continuing troubles in the Eurozone and uncertainty about the US economy. Business confidence (Manifacturing industry index) Sources: Global Insight; OECD (MEI). Manufacturing growth to slow down in 2011 After falling 10.7 % in 2009, manufacturing production grew 3.6 % year-on-year in However, industrial production has begun to decrease again: by 0.3 % year-on-year in June 2011 and 0.7 % in July. Manufacturing played a pivotal role in the economic rebound in British manufacturers have profited from a weakening sterling exchange rate and, according to the ONS, the volume of exports of goods (excluding oil and erratic items such as aircraft that may skew the figures) rose 12.0 % year-on-year in 2010, while imports increased 12.2 %. However, falling exports - down 1.1 % in Q2 on the previous quarter - and export orders are a worry for British manufacturers due to dampened domestic demand. In particular, exports to the US fell by 1.2 billion and the level of trade with China also fell. This is disappointing as a stronger relationship with China could play a pivotal role in the UK s economic revival. In fact, with the slowdown of growth in the Eurozone and the US, it is even more important that the 7 % of UK trade currently channelled towards the leading emerging markets (China, India, Brazil, Russia, Mexico, Indonesia, and Turkey) is significantly increased. Manufacturing production is expected to slow down: to 2.7 % in 2011 and 2.4 % in 2012 (see chart below). Manifacturing production (% change on previous year) f 2012f Source: Consensus Forecasts (Survey date September 12, 2011) Atradius 6

7 Industry performance Construction/building materials: high level of business failures will continue UK construction continues to be a difficult sector in which to operate. While construction output rose 0.5 % on the previous quarter in Q2 of 2011, it fell 1.6 % year-on-year. Orders in particular shows a worrying trend: according to ONS, new orders in the construction industry decreased by 16.3 % on the previous quarter in Q2 and by as much as 23.2 % year-on-year, meaning that the total volume of all new orders is now at its lowest level since This significant decline is due mainly to government cuts, as public sector housing and non-housing orders decreased 30 % and infrastructure spending dropped 25 % from the previous quarter. The impact of the austerity measures has been noticeable since the second half of 2010, as these led to a fall in expected projects and income for contractors who had previously focused their business on the more resilient public sector. The construction sector remains extremely competitive, but public sector spending cuts, deferred private sector capital expenditure and a lack of bank financing have all hampered projects from even getting off the ground. The result has been falling orders and low tenders: often priced no higher than break-even. Margins have been squeezed by powerful lead contractors demanding across-the-board discounts and extended payment terms from their supply chains, and by the cancellation of high profile framework agreements, to be replaced by competitive tendering. The situation is exacerbated by the risk of upstream insolvencies, difficulty in collecting retentions and reduced access to working capital. With these unstable market conditions, the effect on construction projects of the price of commodities like steel is of particular concern. We saw a deterioration of payment patterns throughout the sector in 2010 and early Moreover, insolvencies in the construction sector are above the industrial average: according to the Insolvency Service, the number of construction and property companies in administration accounted for 21 % of all UK administrations in With more impending government spending cuts and overall economic woes, we expect the number of insolvencies to remain high. Our underwriting approach remains cautious across all construction subsectors. As with other industries, we seek the very latest financial information to ensure that we can accurately assess each buyer s viability. That entails regular meetings with buyers and a close scrutiny of both forward order books and exposure to sectors that are known or forecast to have declining workloads, to ensure that we can continue to offer cover on viable business. Consumer durables retail feels the pinch of adverse consumer sentiment In view of adverse consumer sentiment and rising consumer prices (see economic section above), the already difficult trading conditions for the consumer durables retail sector are about to deteriorate even further. There were a number of high profile retail insolvencies during the recession and, while default rates declined noticeably in 2010, we expect an increase in There have been close to twenty significant consumer durables failures already this year, suggesting that 2011 s total will exceed that of The challenge for retailers is to ensure that whatever money is currently spent within their sector is spent in their own stores. This however will lead to unprecedented levels of competition. With input cost inflation continuing to be an issue, competing on price is tough and therefore a retailer s ability to differentiate its offering in some other way is vital to maintaining market share. Those that can are likely to flourish, while those that can t are in danger of failing. On a positive note, many businesses in the sector are now placing greater emphasis on their working capital management and in particular keeping a tighter rein on stocks. This has reduced companies exposure to short-term cash crunches which can often be fatal. Atradius 7

8 On average, payments in the consumer durables retail industry take around 60 days. We have received an increased number of notifications of non-payment from this sector since Q4 of clear evidence that trading is currently difficult - with the largest rise in payment delays seen in the furniture retail subsector, and indeed the subsectors of particular concern at present are those offering big-ticket purchases such as furniture and domestic appliances. With continuing fragility in the job market and restricted lending availability, both the willingness and wherewithal to go out and buy a 1,000 sofa or television have receded. Businesses in the furniture and domestic appliance/ consumer electrics subsectors have a relatively high fixed cost base and therefore lower revenues can very quickly cause difficulties. The increase in the number of insolvencies in these subsectors is therefore not surprising. The consumer durables underwriting team in the UK foresaw that 2011 would be a very difficult trading period for the sector. As with all sectors, cash flow is our key area of analysis but, within that, we focus particularly on the business s stock management and the financial structure of buyers. The consumer durables retail sector is one where private equity has a higher than average presence, and so understanding how the retailer services its financing obligations is essential to accurately analysing the risk. High commodity prices put clothing retailers under pressure We always monitor the retail sector closely, for trends in consumer behaviour etc, and particularly the clothing retail subsector, as it accounts for 12 % of all retailing. Added to the generally subdued retail climate, with consumer spending falling victim to the austere economic environment, clothing retail is under pressure from the higher commodity costs that are eating into its already strained margins. The insolvency environment Insolvencies expected to increase again in and 2009 saw spectacular year-on-year increases in corporate insolvencies: of 24.2 % and 22.8 % respectively. While in 2010 insolvencies decreased by 15.9 %, this improving trend has not continued. In Q2 of 2011 the number of insolvencies (compulsory liquidations/creditors voluntary liquidations) in England and Wales increased 4.4 % year-on-year and 2.7 % on the previous quarter: to 4,233 cases. Insolvency trends: United Kingdom (1-year trailing sum of insolvency counts based on quaterly data) Sources: Global Insight; The Insolvency Service. Due to the worsening economic environment, we have revised our UK corporate insolvency forecast for 2011: from the 5 % decrease estimated early this year to a further increase. Atradius 8

In the domestic market, the government s austerity measures continue to have a negative impact, as is highlighted by the forward order books of many construction companies.

9 In the domestic market, the government s austerity measures continue to have a negative impact, as is highlighted by the forward order books of many construction companies. Add to this the minimal pay increases and high levels of inflation and it is clear that the UK market is currently a difficult one to be focusing on. Moreover, for those businesses reliant on a buoyant export market there is little good news from either the Eurozone or the US. Latest forecasts for the Eurozone now anticipate minimal if any growth in the second half of This is clearly bad news for UK businesses that focus on export as a way to achieve growth while sterling remains weak. Against this backdrop, it is our belief that UK business insolvencies are likely to increase by up to 5 % year-on-year in This increase also takes into consideration the unknown impact of the HMRC (Her Majesty s Revenue & Customs) Time to Pay scheme which could potentially lead to a number of insolvencies, as HMRC take a tougher line on those businesses that default on their rearranged tax payments. With the continuing very difficult trading environment and so many unknowns (e.g. proposals to reform the banks, which could lead to a significant increase in the cost of funding) we believe that 2012 UK business insolvencies will remain at 2011 levels, i.e. stabilising at around 5,000 business failures per quarter. Default risk for UK listed firms is still high compared to pre-crisis years In the first seven months of 2011 the monthly median expected default frequency (EDF) figure for UK listed companies was around 50 basis points (51 basis points in July 2011) meaning that the overall decreasing trend recorded in H2 of 2009 and in due mainly to a rise in equity prices and a simultaneous reduction in market volatility - did not continue. Due to the extreme level of volatility across equity markets during last month, together with the accompanying large drop in valuations, the August 2011 EDF for the UK increased by 12 basis points, to 63 basis points (see chart below). Despite the overall improvement seen in the last two years, British listed companies still face significantly higher default risks than five years ago, and we cannot exclude a reversal in the previously benign trend in default expectations due to the current economic uncertainties. Median EDF evolution by country* Source: KMV Credit Monitor and Atradius Economic Research *The Expected Default Frequency (EDF) chart above is based on listed companies in the markets referred to, and the likelihood of default across all sectors within the next year. In this context, default is defined as a failure to make a scheduled payment, or the initiation of bankruptcy proceedings. Probability of default is calculated from three factors: market value of a company s assets, its volatility and its current capital structure. As a guide, the probability of one firm in a hundred defaulting on payment is shown as 1 %. Atradius Copyright 2011 This report is provided for information purposes only and is not intended as a recommendation as to particular transactions, investments or strategies in any way to any reader. Readers must make their own independent decisions, commercial or otherwise, regarding the information provided. While we have made every attempt to ensure that the information contained in this report has been obtained from reliable sources, Atradius is not responsible for any errors or omissions, or for the results obtained from the use of this information. All information in this report is provided as is, with no guarantee of completeness, accuracy, timeliness or of the results obtained from its use, and without warranty of any kind, express or implied. In no event will Atradius, its related partnerships or corporations, or the partners, agents or employees thereof, be liable to you or anyone else for any decision made or action taken in reliance on the information in this report or for any consequential, special or similar damages, even if advised of the possibility of such damages. Atradius 9

Atradius Country Report

Atradius Country Report France May 2011 Paris Strasbourg Lyon Toulouse Marseille Summary We estimate that corporate insolvencies will decrease by 5% year-on-year in 2011: to 49,000 cases. However, this