SME Health Check Index Q1 2018

SME Health Check Index Q1 2018 #SMEhealth JUNE 2018 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, June 2018

CONTENTS Foreword 4 Infographic 6 Executive Summary 7 1 UK macroeconomic environment 8 2 SME business health improves for the first time since Q3 2016 9 3 In focus: SME Business Cost Inflation 16 4 Special Report: The impact of SME hiring on the UK economy 18 5 Conclusions 26 6 Methodology 28 3

FOREWORD GAVIN OPPERMAN Group Customer Banking Director It pays to be optimistic in business. The UK s army of small firms thrive on seizing opportunities and the belief they can compete with companies that are many times larger than them. Signs of such optimism can be found in our latest SME Health Check Index. After five consecutive quarters of decline, the headline reading rose in the first quarter of 2018. SMEs are hiring and business confidence has improved in most UK regions, despite the slowest quarterly GDP growth in more than five years. This is vitally important. Small and medium-sized enterprises might not captivate the national conversation, but they operate in the engine room of the UK economy, accounting for 99.9% of all private sector businesses in 2017 and generating 51% of business revenue in the UK. Small business leaders would be nothing without realism. Our Index contains plenty of that too. We blend measures directly linked to SME performance with components that relate to the wider economy, as well as taking the temperature of 500 small firms around the UK, making it one of the largest ongoing SME research exercises of its kind. The detailed picture is mixed. The Index remains well below levels seen in past years. While indicators such as lending, confidence and employment are on the up, net business creation is at the lowest rate since we began tracking it in 2014. I am particularly pleased that the lending indicator has rebounded. At CYBG, we are proud to be playing our part. Our Bank s core lending to SMEs rose 5% on an annualised basis in the first half of the financial year, with 1bn of gross lending in the period. We are on track to fulfil our 6bn, threeyear lending commitment to SMEs by the end of next year. A tangible sign that a small business is growing is when it recruits. A new member of staff is a sign of confidence because they bring with them added cost, complexity and they change the dynamic in the workplace. But they also embody opportunity. At the end of a sevenyear period that saw corporate and public-sector downsizing, SMEs can be justifiably proud for hiring close to two-thirds of all workers that joined the private sector. This activity accounted for more than 30% of gross value added growth during this period. Given the UK employment rate stands at the highest on record, it is not surprising that this effort will not be repeated going forward. But it should stand as testament to SMEs appetite to grow. Optimistically, I hope it sparks a serious debate about the access to talent our small firms need post-brexit, plus how they can be incentivised to invest in skills and boost productivity. 4

TAKING THE TEMPERATURE OF THE UK S SME PERFORMANCE Small and medium sized enterprises are the engine room of the UK economy. SME HEALTH CHECK INDEX SCORE Q1 2018 16.1 MILLION people employed by SMEs 51% of total business revenue 60% of private sector employment OVERALL INDEX SCORE 100-90 - - 1.0 % - 0.9 % 80 - - 0.8 % 70 - - 0.7 % Q1 2018 47.4 INDEX SCORE 60-50 - 40-30 - - 0.6 % - 0.5 % - 0.4 % - 0.3 % GDP (%) 20 - - 0.2 % Q4 2017 44.0 10-0 - 81.5 79.3 80.9 77.6 74.4 83.1 74.0 87.3 58.9 58.5 64.4 63.3 60.0 58.0 50.3 44.0 47.4-0.1 % - 0 % Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 SME Health Check Index GDP Business Costs 65 (-) Capacity 36 (9 ) Confidence 46 (13 ) Employment 71 (5 ) GDP 62 (8 ) Lending 56 (31 ) Net business creation 0 (17 ) Revenue 43 (12 ) Changes above are compared to Q4 2017. Q1 2018 Change from Q4 2017 East Midlands 50.1 10.6 East of England 38.6 10.0 London 50.6 6.0 North East 46.9 1.6 North West 28.9 3.3 Scotland 36.3 7.4 South East 45.5 1.1 South West 48.1 8.3 Wales 50.6 0.9 West Midlands 43.9 10.1 Yorkshire and the Humber 43.3 4.1

EXECUTIVE SUMMARY The importance of small and medium sized enterprises (SMEs) to the economy cannot be over emphasised and their number has been growing every year. There are now 5.7 million SMEs across the UK and their combined annual turnover was 1.9 trillion in 2017. 1 In addition, SMEs account for at least 99.5% of the businesses in every main industry sector. With such a strong influence on the economy, SMEs are also an important employer - it is estimated that around 16.1 million people work for an SME, equating to 60% of the UK s total private sector employment. This quarterly report for CYBG, owner of Clydesdale and Yorkshire Banks and digital brand B, 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 the business and macroeconomic environment within which SMEs operate. The SME Health Check Index takes on values between 0 and 100. A score of 100 would indicate maximum improvements across the SME Health Check Index s eight indicators 2 while a score of 0 would point to major declines in the sub-components. The Q1 2018 report finds that: The SME Health Check Index rose from 44.0 in the fourth quarter of 2017 to 47.4 in Q1 2018. This is the first increase in the reading since the third quarter of 2016, although the Index remains well below the levels seen in past years. There were mixed results across the indicators in Q1 2018, with four out of the eight indicators seeing an improvement and three seeing a worsening (the business costs indicator was unchanged between Q4 2017 and Q1 2018). The improvements were in lending, confidence, revenue and employment, while poor GDP growth in Q1 2018 and a fall in the rate of net business creation - as insolvencies in the construction and retail sectors rose significantly - weighed on the SME Health Check Index. There were also mixed results across the UK s different regions. Most regions scores were boosted by a recovery in confidence and a stabilisation in lending to SMEs, while the slowdown in GDP growth and falls in the annual rate of net business creation weighed on the regional SME Health Check Index scores. The East Midlands and the West Midlands enjoyed the largest improvements to the SME Health Check Index, with both scores rising by 10 points between Q4 2017 and Q1 2018. London also performed well, with the SME Health Check Index rising by six points to 51. Smaller improvements were recorded in Yorkshire and the Humber, the North East and the South East. The East of England experienced a 10 point fall in the SME Health Check Index in Q1 2018, driven by falls in the revenue, capacity and employment indicators. A worsening of the health of SMEs was also recorded in Scotland, Wales and the South West. All three of these regions experienced a fall in the employment indicator, while the uptick in business confidence in Scotland and the South West was notably less pronounced than elsewhere in the UK. 1 Federation of Small Businesses: Business Population Estimates for the UK and Regions in 2017 2 The eight sub-components are: business costs, capacity, confidence, employment, GDP, lending, net business creation and revenue. 7

1 UK MACROECONOMIC ENVIRONMENT The first quarter of 2018 has brought with it mixed news for the UK economy. The Office for National Statistics (ONS) released its preliminary estimate of GDP in April, which showed that the UK economy grew by 0.1% in Q1 2018, compared to 0.4% in Q4 2017. This is the slowest quarterly growth rate recorded since Q4 2012. In per capita terms, GDP actually declined by 0.1% quarter-on-quarter. The adverse weather conditions in February and March were a significant impediment to growth, with the construction sector particularly impacted. In more positive news, the yearlong squeeze on real incomes finally came to an end early in 2018, which should help to bolster consumer spending in the coming months. Over the first quarter of 2018, regular pay (excluding bonuses) increased at an annual rate of 2.9%, 0.6 percentage points above the annual rate of CPIH inflation recorded in March. Data on total pay (including bonuses) was somewhat less encouraging, with a 2.6% annual growth rate recorded in the first quarter of 2018. While wage growth has picked up in recent months, the latest productivity data showed that output per hour the ONS main measure of productivity fell by 0.5% in Q1 2018. This represents the largest quarterly fall since Q4 2015. The willingness of firms to pay higher wages without a corresponding increase in their employees output suggests a very tight labour market, with firms having to offer higher salaries to attract employees from the shrinking pool of available workers. In spite of the slowdown in GDP growth, the labour market continued to tighten in the three months to March. In the first quarter of 2018, the share of working age individuals in employment rose to 75.6%, the highest rate since records began in 1971. The total number of people in work rose to 32.34 million, 197,000 more than in the final quarter of 2017. Much of the rise in employment in the UK in recent years can be attributed to small and medium sized businesses, with the collective size of the SME workforce increasing by 2.8 million between 2010 and 2017. The Bank of England s (BoE) hawkish comments following the Monetary Policy Committee s meeting in February led to a widespread expectation of an interest rate rise in May. However, the weaker than expected growth figures and the coincident fall in inflation did not strengthen the case for a rate rise, and the central bank voted to hold rates at 0.5% in its May meeting. The Bank s Governor Mark Carney made it clear that the BoE judges the weak performance of the UK economy during Q1 2018 to have been a weather-related soft patch rather than a more persistent slowdown in momentum. Accelerating real wage growth, record low unemployment and lower productivity show there are signs of underlying inflationary pressure building, which will likely keep price growth above the BoE s 2% target. Taken together these factors mean a rate rise remains on the cards for later in the year. The value of outstanding consumer credit remained constant between February and March at 209.2 billion, bringing the annual growth rate of consumer credit in March to 8.6% - the lowest it has been since November 2015. Furthermore, in the BoE s credit conditions survey for Q1 2018, banks reported a significant contraction in the demand from consumers for unsecured credit. This can be attributed to the return to growth of real wages, the already elevated levels of debt many households are burdened with, and the probable interest rate rises on the horizon. 8

2 SME BUSINESS HEALTH IMPROVES FOR THE FIRST TIME SINCE Q3 2016 Accounting for over 99% of all UK businesses, SMEs are crucial to the UK economy. This section seeks to explore the health of SMEs across the country. We are not only analysing different variables that can be directly linked to the performance of SMEs, such as confidence and revenue, we are also investigating the business and macroeconomic environment in which SMEs are operating. The following section begins by presenting the overall results of the SME Health Check Index and its indicators, before turning to regional data. In Q1 2018, the SME Health Check Index rose for the first time since the third quarter of 2016, increasing from 44.0 in Q4 2017 to 47.4 in Q1 2018. A partial recovery in business confidence, a continued tightening of the labour market and a stabilisation of lending to SMEs were the key drivers of this improvement. Despite the modest gains made last quarter, the SME Health Check Index remains suppressed by historical standards, and a fall in the rate of net business creation, together with the first quarter s disappointing GDP figures inhibited any more significant improvements in the Index. In most of the past quarters covered by the SME Health Check Index, improvements in the Index have been mirrored by an acceleration in GDP growth and vice versa. The first quarter of 2018 was a notable exception to this trend, with the sharp deceleration in GDP growth coupled with a small improvement in the Health Check Index. Since a significant portion of the slowdown in economic growth can be attributed to one-off factors in particular the adverse winter weather the deterioration in the GDP indicator was not mirrored by other components of the Index such as the business confidence and employment indicators. The following section analyses the indicators of the SME Health Check Index in more detail. Figure 1: SME Health Check Index 100-90 - - 1.0 % - 0.9 % INDEX SCORE 80-70 - 60-50 - 40-30 - 20 - - 0.8 % - 0.7 % - 0.6 % - 0.5 % - 0.4 % - 0.3 % - 0.2 % GDP (%) quarter-on-quarter change 10 - - 0.1 % 0 - Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018-0 % SME Health Check Index GDP Sources: FSB, ONS, UK Finance, Cebr analysis 9

2.1 INDEX INDICATORS Business Costs The annual rate of business cost inflation rose marginally to 2.7% in the first quarter of 2018. Given the small change compared to the last quarter, the Index score for this indicator remained at 65 in Q1 2018. A strengthening of the pound, together with a fall in some key commodity prices drove down the rate of inflation of physical inputs, while an acceleration in earnings growth offset these effects. The results for this indicator highlight that, although the UK s consumers are experiencing a fall in the rate of price growth, the decline in costs is not yet being felt by SMEs. Capacity The net balance of SMEs operating below capacity ticked up further in Q1 2018, bringing down the score for this indicator to 36. The overall slowdown in the economy in the first quarter of 2018 will mean that many SMEs will have reduced their activity rates in response to a fall in demand for the goods and / or services they provide. Confidence Business confidence among SMEs - as measured by the Federation of Small Businesses (FSB) Voice of Small Business Index 3 - recovered somewhat in the first quarter of 2018, taking the score for this indicator to 46. Encouragingly, this uptick in business confidence was seen across all of the UK s regions with the exception of London. Businesses will have been heartened by the stronger than expected performance of the wider economy in the latter half of 2017, as well as the agreement of a transitional deal between the UK and the EU, which may signal a lower risk of a cliffedge Brexit. The return to growth of real wages will also make SMEs who are dependent on consumer spending more optimistic about the future, although at the same time the corresponding increase in employee costs will be a concern to SMEs in some sectors. Employment Despite the slowdown in GDP growth in the first quarter of 2018, the prolonged tightening of the labour market showed no signs of abating. In the three months to March, the rate of unemployment was 4.2%, the joint lowest rate since 1975. Meanwhile, the employment rate rose to 75.6% - the highest rate since records began in 1971. In total there were 32.34 million people in work in Q1 2018, 197,000 more than for Q4 2017 and 396,000 more than at the same point the previous year. This equates to a 1.2% annual growth rate in the number of people in employment, the highest rate recorded since Q3 2016. This brought the Index score for this indicator up to 71. The consistent growth in employment the UK has seen in recent years can be attributed to a number of factors including a steady increase in the labour force participation rate, a shift towards later retirement, slow rates of wage growth compared to historical standards and the increased prominence of temporary contracts. GDP A reduction in growth was anticipated for the UK economy in 2018, however in the first quarter of 2018, the slowdown was even more pronounced than expected. The second estimate of GDP released by the ONS in May showed that quarterly GDP growth fell to 0.1% in Q1 2018, the lowest since Q4 2012. By far the worst performing sector was construction, which shrunk by 2.7% over the quarter, as the adverse weather conditions in February and March led to the loss of around 30 construction days. Manufacturing which had performed well in the latter half of 2017 also slowed significantly, due to a softening of external demand, weather-related disruption and a strengthening of the pound. The quarterly growth rate of the UK s crucial services sector which accounts for nearly 80% of GDP also fell by 0.1 percentage points to 0.3%, as consumers began to cut back following an extended period of rapid credit growth. The poor economic growth recorded in Q1 2018 dragged down the Index 10 3 Federation of Small Businesses: Voice of Small Business Index Q1 2018

score for this indicator by eight points to 62. Lending to SMEs UK Finance s lending data was more positive in the final quarter of 2017. Between the third and fourth quarter of 2017, the value of outstanding balances increased by 174 million to 92.7 billion. Although the value of SMEs loan and overdrawn balances remained below the level recorded at the same point in 2016, the annual rate of contraction fell to 1.8% compared to 3.7% in Q3 2017. The first interest rate rise in a decade, with the prospect of more to come in the medium term, may have made SMEs more cautious about increasing their borrowing. The appetite for borrowing among the UK s SMEs in Q4 2017 may also have been dampened by the prevailing political and economic uncertainty during that period, particularly relating to the nature of the UK s future relationship with the EU. Net Business Creation The annual rate of net business creation in the UK fell from 4.2% in Q4 2017 to 3.5% in the first quarter of 2018, the lowest rate recorded since the SME Health Check Index began in 2014. However, this fall can be attributed partially to the large jump in the number of registered companies between Q4 2016 and Q1 2017, which weighed on the annual growth rate figure for Q1 2018. The number of new companies incorporated rose from 146,852 to 167,717, but the number of company dissolutions also rose from 117,545 in Q4 2017 to 129,688 in Q1 2018. Revenue A higher share of SMEs reported an increase in revenues in Q1 2018, bringing the Index score for this indicator up to 43 from 31 the previous quarter. However, it is worth noting that with the exception of the previous two quarters scores, this indicator remains at the lowest level since the SME Health Check Index began tracking in 2014. In addition, for this indicator SMEs were surveyed in February, before much of the adverse weather and ensuing disruption. ONS data show that retail sales volumes fell by 1.2% between February and March, while the volume of sales in Q1 2018 as a whole was 0.5% lower than in Q4 2017. SMEs will be hopeful that the end of the year-long squeeze on real incomes will generate some increase in consumer spending over the remainder of the year. Figure 2: Sub-components of the SME Health Check Index 80 60 40 20 0 Business Costs Capacity Confidence Employment GDP Lending Net Business Creation 0 Revenue Q4 2017 Q1 2018 Sources: FSB, ONS, UK Finance, Cebr analysis 11

2.2 REGIONAL 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 have an improving 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 and the Humber), as well Scotland and Wales. The first quarter of 2018 had mixed results for different parts of the UK. The health of SMEs improved in six of the 11 regions, with the Midlands and London exhibiting the strongest gains. The largest falls in the SME Health Check Index were recorded in the East of England, the South West and Scotland. Figure 3: Regional SME Health Check Index 60 50 40 30 20 10 0 East Midlands East of England London North East North West Scotland South East South West Wales West Midlands Yorkshire & the Humber Q4 2017 Q1 2018 Sources: FSB, ONS, UK Finance, Cebr analysis East Midlands The SME Health Check Index score for the East Midlands bounced back by 10 points to 50 in the first quarter of 2018 following a 12 point fall the previous quarter. The key drivers of this were a decrease in the share of companies operating below capacity, a stabilisation of lending to SMEs and an uptick in business confidence. In Q1 2018, the Midlands Engine Investment Fund was launched, which aims to provide 250 million in equity finance to boost the growth of smaller businesses in the region. Schemes that improve SMEs access to finance will be increasingly important in the short to medium term as borrowing costs return to more normal levels and the UK s economic uncertainty continues to deter investment. A recent study has found that firms in the Midlands have a particularly large proportion of their revenues tied up in inventories and unpaid invoices 4. This represents an opportunity for businesses in this region to free up cash for investment, which could provide a welcome boost to productivity. 4 Lloyds Banking Group: Working Capital Index - Spring 2018 12

East of England The environment for SMEs in the East of England deteriorated more than in other regions in the UK in Q1 2018, as the SME Health Check Index fell by 10 points to 39. The share of SMEs reporting an increase in revenues over the past three months fell to the lowest level since data collection began in 2014. Meanwhile, the recovery in business sentiment was somewhat more muted in the East of England than elsewhere in the UK. London An increase in employment of over 71,000 brought the annual rate of employment growth in London to 3.8% in the first quarter of 2018 - the highest it s been since Q3 2014. The share of SMEs reporting an increase in revenues over the previous three months was greater than at any point since Q4 2015, while the value of outstanding loans and overdrafts rose by 171 million between the third and fourth quarters of 2017. North East The health of SMEs in the North East remained fairly stable in Q1 2018, with the SME Health Check Index edging up two points to 47. The revenue and business confidence indicators both rebounded strongly following sharp declines in Q4 2017. A fall in the annual rate of employment growth from 2.1% in Q4 2017 to 1.1% in the first quarter of 2018 tempered the increase in the Index for the North East. The annual rate of employment growth also fell from 1.2% to 1.0% between Q4 2017 and Q1 2018, taking it below the UK average of 1.2%. The adverse weather in the early months of 2018 will have exacerbated the challenges faced by the construction sector in the region, while the collapse of Carillion will have had ripple effects throughout the industry. Over one in five SMEs in the East of England are in the construction sector the second highest share of construction firms in the UK behind Wales. The importance of the embattled construction sector is likely a key contributor to the deterioration of the health of SMEs in the East of England. The strong improvements in the aforementioned indicators suggest that the capital s SMEs have been performing well in the first quarter of 2018, and this is reflected in the six point uptick in the SME Health Check Index to 51. However, London is the only one of the UK s regions to have seen a decline in SME confidence in Q1 2018. London is the region with the highest share of SMEs in the professional, scientific and technical activities sectors. These industries are heavily reliant on skilled workers, and with the number of vacancies remaining at near record highs and net migration on the decline, many firms will have concerns about their ability to access the necessary skills in the future. Furthermore, increasing wage growth will be associated with rising input costs, particularly for firms in London s crucial services sector. The uptick in earnings growth at the start of 2018 increased the rate of business cost inflation for this region to 2.6%, which may have contributed to the decline in business confidence. With the terms of the transition deal largely agreed, the focus of the Brexit negotiations has shifted to trade. Since trade with the EU accounts for 60% of total trade in the North East, SMEs in this region are heavily invested in the outcome of these negotiations. The two options outlined by the UK Government a customs partnership that would see the UK collect tariffs on the EU s behalf for goods destined for the EU, and a maximum facilitation (max fac) customs arrangement that would create a customs border between the UK and the EU would both inevitably generate some economic disruption and trade frictions. The customs partnership would require goods to be tracked to ascertain their final destination, while the head of the HMRC has recently claimed that the max fac option could cost up to 20 billion per year. 13

2.2 REGIONAL BREAKDOWN OF THE SME HEALTH CHECK INDEX North West The SME Health Check Index for the North West crept down three points to 29 in Q1 2018, despite a stabilisation of lending to SMEs following seven quarters of decline. The revenue indicator fell to the lowest level since data collection began in 2014, while the North West is one of just two regions that has seen a contraction in employment over the last 12 months (the other being Wales). The business confidence indicator for the North West did partially recover following the dramatic 36 point fall in Q4 2017, although sentiment does remain lower than in most other regions in the UK. Subdued business sentiment is a likely contributor to the North West s weak employment figures. Despite being home to many large and dynamic cities, the North West still requires large amounts of investment if it is to compete with regions such as London. However, there are a number of positive developments on this front which will benefit SMEs in the region. The Northern Powerhouse agenda is bringing investment across the North of England, including in the North West, through initiatives such as the Northern Powerhouse Investment Fund and the Transforming Cities Fund. Devolution through the election of metro mayors in Greater Manchester and Merseyside is also bringing increased local focus to creating an environment within which SMEs in the region can succeed. Scotland The SME Health Check Index for Scotland fell by seven points to 36 in the first quarter of 2018, as the share of businesses reporting an increase in revenues over the previous three months fell to the lowest level since data collection began in 2014. The annual rate of net business creation also declined by one percentage point to 3.6% between Q4 2017 and Q1 2018, and while employment continues to expand in Scotland, the annual growth rate remains significantly below the national average. Recent data shows that productivity in Scotland as measured by output per hour worked declined by 1.9% in real terms over 2017, the second consecutive yearly fall. Productivity growth in Scotland is constrained by low levels of business investment and research and development spending compared to the rest of the UK. In recent years, increases in employment have counter-balanced declining productivity. However, the tightening of the labour market cannot continue indefinitely and as employment growth begins to slow, Scotland - as well as the UK as a whole - may well struggle to generate substantial economic growth given the weak productivity figures. South East Employment in the South East fell by over 88,000 over the first quarter of 2018, which brought down the annual rate of employment growth to 0.4% from 2.5% in Q4 2017. This mostly offset the effects on the SME Health Check Index of improvements to business confidence, a fall in the share of SMEs operating below capacity and a higher share of SMEs reporting an increase in revenues over the last three months. The SME Health Check Index remained fairly stable in Q1 2018, rising by one point to 46. Four cities in the South East - Portsmouth, Southampton, Oxford and Salisbury are among 10 cities identified by Tech Nation as having a wellestablished technology sector. The digital technology sector is one of the fastest growing areas in the economy, and this therefore represents an opportunity for the region to accelerate growth in the future. 14

South West The SME Health Check Index for the South West fell by eight points to 48 in Q1 2018. The primary driver of the fall in the Index was the revenue indicator, with the share of SMEs reporting an increase in revenues in the previous three months falling to the lowest level since the Index began in 2014. Perhaps as a result of this, the uptick in confidence reported by SMEs in Q1 2018 was somewhat more muted than in the UK s other regions. The annual rate of employment growth also fell from 2.1% in Q4 2017 to 1.2% in Q1 2018. In more positive news, the South West remains the only region that has seen an increase in lending to SMEs in the last 12 months, with a 92 million rise in the value of outstanding loans and overdrafts in Q4 2017 taking the annual growth rate of lending to 2.3%. Wales The SME Health Check Index for Wales remained fairly stable in the first quarter of 2018, with the score edging down from 52 in Q4 2017 to 51 in Q1 2018. Confidence recovered slightly following the fall at the end of 2017, although the revenue indicator dropped off significantly. While most of the rest of the UK has enjoyed a considerable surge in employment over the last year, Wales has been excluded from this trend, with the number of people in employment in Q1 2018 slightly below the number at the same point last year. The weakening of the SME Health Check Index in Q1 2018 can also be attributed to the importance of the construction sector, which accounts for 22% of Welsh SMEs. This industry contracted by 3.3% in Q1 2018, in the face of an array of issues in recent months, from adverse weather to the collapse of Carillion. West Midlands The West Midlands saw a notable improvement in the SME Health Check Index in Q1 2018, with the score rising from 34 in Q4 2017 to 44. There were significant upticks in the revenue, lending and confidence indicators. However, the largest driver of the increase in the SME Health Check Index was the employment indicator. The number of people employed in the West Midlands increased by 57,000 over the first quarter of 2018, taking the annual growth rate of employment to 3.8% - the second fastest growth rate in the UK behind London. Furthermore, the economically active population (which includes those not currently in work, but who are actively seeking a job) also rose considerably last quarter. Employment in this region will have been boosted by the strong performance of the crucial manufacturing sector in the latter half of 2017. While these strong labour market figures point toward solid economic performance, the quality of jobs is a concern in some parts of this region. In particular, the number of workers on a temporary contract has risen steeply to 8% in Birmingham, compared to a national average of around 5%. Another challenge faced by the West Midlands going forward is a manufacturing sector that appears to have come off the boil amid a softening of external demand and a strengthening of the pound. Yorkshire & the Humber An increase of close to 57,000 people in employment twinned with a strong improvement in the revenue indicator helped to boost Yorkshire and the Humber s SME Health Check Index score by four points to 43 in Q1 2018. Confidence among SMEs also rose considerably, with firms in Yorkshire now more optimistic about the future than in any other UK region apart from the East Midlands. Among the UK s regions, Yorkshire has the highest share of SMEs operating in the wholesale and retail sector. The improvement in business sentiment is therefore likely to reflect the return to positive real wage growth early in 2018 which should help to prop up consumer spending. 15

3 IN FOCUS: SME BUSINESS COST INFLATION In this section, we explore the business costs indicator in greater detail in order to establish its contribution to the overall SME Health Check Index in the first quarter of 2018, and the degree to which it has affected SMEs in different regions. Figure 4: SME Inflation Q1 2014 Q1 2018 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 The overall annual rate of business cost inflation rose to 2.7% in the first quarter of 2018. This shows that while much has been made of the slowdown in consumer price inflation, SMEs are still very much burdened with rising costs, particularly in the manufacturing and construction sectors. For the first time since 2016, employment costs made an upward contribution to the overall measure, as the annual rate of wage growth finally picked up at the beginning of the year, averaging 2.8% in Q1 2018 compared to 2.5% in Q4 2017. The acceleration of earnings growth means that real incomes are now growing again following a prolonged period of contraction. The annual rate of inflation of metals and chemicals - both of which are key physical inputs for sectors such as manufacturing and construction - averaged 5.7% and 6.9% respectively over the first quarter of 2018. These rates of inflation are significantly lower than the rates recorded in Q4 2017, although they remain well above those of other inputs. This was driven by a strengthening of the pound, which lowered import costs, together with a decline in the price of major commodities such as copper and aluminium over the first quarter of 2018. Other notable changes between Q4 2017 and Q1 2018 include an uptick in the rate of price growth of electricity and gas, as well as a decrease in the annual rate of inflation of commercial rents from 2.0% to 1.9% as the UK s property market continued to soften. 16

Figure 5: Breakdown of costs faced by SMEs 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 The manufacturing sector, which relies relatively heavily on physical inputs, while still high, enjoyed a fall in the annual rate of business cost inflation from an average of 3.7% in Q4 2017 to an average of 3.5% in the first quarter of 2018. This remains well above the economywide average rate of business cost inflation. The fall in inflation was driven largely by a slowdown in the rate of price growth of physical inputs such as metals and chemicals. Although the fall in cost inflation will be welcomed by manufacturers, this has been brought about in part by the strengthening of the pound, which in turn has reduced the competitiveness of UK exports. Similar to the manufacturing sector, the rate of business cost inflation for SMEs in the construction sector was above the national average at 3.0%, due to the relatively large share of physical inputs in the overall input basket. Business cost inflation continued to escalate for SMEs in the services sector in Q1 2018. In the business services industry where labour costs make up the majority of total costs the annual rate of cost inflation rose by 0.2 percentage points to 2.4%. For the retail, accommodation and food services sectors, where food accounts for a relatively large share of total input costs, a reduction in the rate of inflation for the food and tobacco category helped to push overall cost inflation down to 2.5% and 2.6% respectively in the first quarter of 2018. In London and the South East, where SME activity is more dominated by the labour intensive services sector, the annual rate of cost inflation stood at 2.6% and 2.7% respectively. Although the annual rate of inflation is lowest in these regions, they actually saw the largest increases in the rate of price growth between Q4 2017 and Q1 2018, which reflects the escalation of employment costs. Business cost inflation remained relatively stable for the UK s remaining regions between Q4 2017 and Q1 2018. In the East of England, the annual rate of business cost inflation was 2.7% in Q1 2018 - in line with the national average while all other regions recorded an annual rate of cost inflation of 2.8%. 17

SPECIAL REPORT 18

4 THE IMPACT OF SME HIRING ON THE UK ECONOMY Since the 2008 global financial crisis and the ensuing recession in 2009, the UK s rate of productivity growth as measured by output per hour worked - has slowed considerably. Between 2000 and 2007, output per hour worked grew at an average annual rate of 2.1%. By contrast, between 2010 and 2017 output per hour has grown at an average annual rate of less than 0.5%. There are a number of possible explanations for this slowdown, including low levels of business investment and an increased prominence of less productive sectors. Sluggish productivity growth has been the key cause of the tepid economic growth that the UK has experienced in recent years. Figure 6: UK output per hour worked 103 101 99 97 95 93 91 89 87 85 Q1 2000 Q3 2000 Q1 2001 Q3 2001 Q1 2002 Q3 2002 Q1 2003 Q3 2003 Q1 2004 Q3 2004 Q1 2005 Q3 2005 Q1 2006 Q3 2006 Q1 2007 Q3 2007 Q1 2008 Q3 2008 Q1 2009 Q3 2009 Q1 2010 Q3 2010 Q1 2011 Q3 2011 Q1 2012 Q3 2012 Q1 2013 Q3 2013 Q1 2014 Q3 2014 Q1 2015 Q3 2015 Q1 2016 Q3 2016 Q1 2017 Q3 2017 4.1 SME HIRING 2010-2017 With productivity growth remaining stubbornly below pre-2008 crisis levels, the UK s economy has increasingly been powered by rising levels of employment. Over the last six years, the UK s labour market has experienced a sustained tightening, with the unemployment rate falling from 8.4% in the fourth quarter of 2011 to 4.2% in Q1 2018. Meanwhile, the number of people employed in the UK has reached a record level of 32.3 million, compared to 29.3 million in Q4 2010. This surge in employment 19

4.1 SME HIRING 2010-2017 is all the more striking given that it occurred during a period in which the size of the public sector workforce fell significantly. Between 2010 and 2017, the number of people employed in the private sector rose by 4.2 million, and only around 1.4 million of this increase was accounted for by businesses with a workforce size above 249. Over the same period, SMEs (defined here as companies with fewer than 250 employees) have expanded their workforces by over 2.8 million people. 5 London has seen by far the most rapid expansion in the size of the SME workforce: between 2010 and 2017 SMEs in the capital increased the size of their collective workforce by 813,000 a 41% increase. For the UK s other regions, the percentage change in the size of the SME workforce ranges from 12% in Wales to 20% in the West Midlands and South East. Figure 7: Change in SME employment by UK region between 2010 and 2017 900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0 London South East East of North West South West West Yorkshire & East Scotland Wales North East England Midlands the Humber Midlands SME hiring pattern research To supplement our research into hiring patterns among SMEs, we commissioned YouGov plc to survey 500 small and medium sized businesses across the UK. 6 This survey has provided a deeper insight into the factors that have driven the expansion of SME employment in recent months. 58% of businesses in our survey have increased the size of their workforce over the last six months, while just 14% decreased the size of their workforce over the same period. 29% of SMEs increased their workforce by between one and five workers, while 18% added between six and 20 employees over the last six months. In the East of England, the share of SMEs in our survey who have increased the size of their workforce over the last six months was just 47%, which is consistent with the decline in the employment indicator which that region experienced in Q1 2018. Half of the SMEs in our survey who had recently expanded their workforce listed a higher demand for output from clients / customers as a reason for doing so. This was by far the most commonly cited rationale for increasing workforce size. 17% of SMEs who have increased the size of their workforce over the last six months said that a greater degree of optimism regarding their business future prospects was a contributing factor. 20 5 Some of the increase in SME employment could also be attributed to large companies reducing the size of their workforce so that they now fall into the category of SME. 6 All figures, unless otherwise stated, are from YouGov Plc. The total sample is 501. The data has been weighted and are representative of SMEs in the UK. Fieldwork was undertaken between 14/05/18 19/05/18. The survey was carried out online.

This highlights the link between business sentiment and employment. The widespread improvement in SME confidence in Q1 2018 is therefore a likely factor driving the uptick in the employment indicator in the SME Health Check Index last quarter. Meanwhile, 16% of SMEs in our survey cited the expansion of operations to a new geographical area as a reason for them expanding their workforce. The share of SMEs who have increased the size of their workforce due to expansion into new geographical areas or fields that require a different skill set was highest in London, which indicates a highly dynamic population of SMEs in the country s capital city. For the 14% of respondents who shrank their workforce, the primary reasons SMEs gave were a decline in demand from clients /customers (34%), a less optimistic view of their future prospects (21%), an inability to find suitable replacements for staff who have left (20%), falling prices of their goods or services (17%) and the ability to produce the same output with fewer staff (16%). The latter factor is set to intensify in the future, as rapid technological developments allow firms in some sectors to produce their required output with increasingly few employees. The UK s unemployment rate in the three months to March 2018 was 4.2% - the joint lowest rate on record. Meanwhile, the economic activity rate (the share of working age adults who are either employed or actively seeking work) rose to 79% in February, compared to 78.5% at the same point the previous year. The results of our survey suggest that SMEs have played a considerable role both in lowering the UK s unemployment rate and in lifting the UK s economic activity rate through the hiring of individuals who were previously unemployed or out of the workforce altogether. 21% of SMEs have hired recent university graduates within the last six months, 19% have hired workers who were previously unemployed and 14% have hired mothers or fathers who had previously withdrawn from the workforce due to their family commitments. Medium sized companies (with workforce sizes ranging from 50 to 249) have been the most active in taking on workers from these groups, with 27% hiring recent university graduates over the last six months and over one in five taking on individuals who were previously unemployed. In London, nearly a third (32%) of SMEs have hired a recent graduate over the last six months, emphasising the capital s ability to attract young, skilled workers. Unsurprisingly, university graduate hiring is highest in professional services sectors such as the legal, accountancy, financial services and education sectors. Meanwhile SMEs in the construction sector have been particularly active in hiring workers who were previously unemployed, as well as recent school / college leavers: 35% of construction SMEs have hired someone who was previously unemployed over the last six months, while a quarter have hired recent school / college leavers. Figure 8: Share of SMEs who have hired specific groups of workers in the last six months 25% 20% 15% 10% 5% 0% Workers who have recently graduated from university Workers who were previously unemployed Workers who have recently left school/college Mothers who had previously withdrawn from the workforce due to family commitments Fathers who had previously withdrawn from the workforce due to family commitments 21

4.2 CONTRIBUTION OF SME HIRING TO GVA GROWTH The growth in SME employment has been crucial in sustaining the UK s economy in a climate of low confidence and weak productivity growth. As a result of the 2.8 million person increase in SME employment since 2010, we estimate that in 2017, the UK s gross value added (GVA) was 5% higher than it would otherwise have been had SME employment remained at its 2010 level. In other words, the expansion of the SME workforce between 2010 and 2017 generated around 76 billion of the UK s total GVA of 1.75 trillion in 2017. This means that each year between 2010 and 2017, net hiring by SMEs added on average 10.9 billion to the UK s GVA. Our analysis indicates that SME hiring contributed to over 30% of total GVA growth between 2010 and 2017. Again, the significance of SME hiring varies considerably between regions: in Yorkshire it accounted for 38% of total GVA growth between 2010 and 2017, while in London, the South West and the North East, it accounted for 35%. In Wales, SME hiring accounted for just 17% of total GVA growth between 2010 and 2017. Figure 9: Contribution of SME hiring to regional GVA growth between 2010 and 2017 40% 35% 30% 25% 20% 15% 10% 5% 0% Yorkshire & the Humber South West London North East North West South East East of England East Midlands West Midlands Scotland Wales 22

4.3 SME EMPLOYMENT FORECASTS 2018 2022 Our SME survey also delved into how businesses expect the size of their workforce to change over the next six months. 52% of SMEs expect to expand their workforce in the coming months, while just 9% are expecting to reduce the size of their workforce. Although these results show that SMEs intend to continue hiring over the remainder of 2018, they also suggest that the rate at which small and medium sized businesses hire could slow somewhat. This is because the share of SMEs who plan on expanding their workforce over the next six months is slightly lower (52%) than the share who increased the size of their workforce over the last six months (58%). SMEs in London and the South were the most optimistic about how the size of their workforce would evolve over the next six months, with 56% and 59% respectively expecting to expand their workforce. In Wales and the East of England, this share was just 39% and 40%, which may feed into these regions SME Health Check Index scores in the coming quarters. There was also significant variation in hiring expectations across the UK s key industries. Among SMEs in the struggling retail and construction sectors, just 34% and 45% respectively expected to increase the size of their workforce over the next six months. This is in line with weak retail sales and consumer spending figures, and the array of challenges facing the construction sector. Meanwhile, firms in the financial services and IT sectors are more optimistic, with 66% and 65% of SMEs surveyed expecting to expand their workforce over the coming six months. About one in two (51%) of SMEs stated that an increase in demand for the goods and / or services they provide would encourage them to hire more in the future, while 28% answered that an improvement in the outlook for the overall economy would have an effect. This again highlights that trends in SME employment are set to be closely coupled with the level of demand in the economy. A rise in the availability of skilled workers would also incentivise SMEs to increase their hiring, which emphasises the importance of ensuring a pool of appropriately skilled workers is available following the UK s withdrawal from the single market. The factors that would most discourage SMEs from hiring in the future are a fall in demand (50%), a worsening outlook for the UK economy (37%), an increase in employee costs (28%), an increase in other outgoings (24%) and a reduced availability of skilled workers (23%). A lower share of SMEs (18%) reported that an increase in the rate of corporation tax or VAT would inhibit their ability to expand their workforce going forward. This suggests that while modifications to tax policy are a significant consideration for a large number of SMEs, the predominant factors that will drive SME employment in the coming years are the health of the company s specific market, the state of the overall economy and the availability of skilled workers. According to our survey, the sectors that would be most affected by a shortage of skilled workers are the medical and health; construction; accountancy and financial services sectors, where 34%, 26%, 25% and 25% of SMEs respectively stated that a reduced availability of skilled workers would prevent them from hiring more in the future. SMEs in the Midlands region in particular feel that a skills shortage could affect their hiring, with 31% responding that a fall in the availability of skilled workers would prevent them from expanding their workforce. In the first quarter of 2018, the quarterly rate of GDP growth fell to 0.1% compared to 0.4% in Q4 2017. Although a portion of this slowdown can be attributed to the adverse weather in February and March, the UK economy looks likely to grow at a relatively low rate for the remainder of the year, as productivity remains stagnant, financial conditions tighten, external demand softens and consumers begin to rein in their spending 23