The economic outlook for the manufacturing sector - can manufacturers invest with confidence?

Despite its increasing digital capabilities, the manufacturing industry remains a capital-intensive and its growth relies on continual investment. It’s therefore encouraging that our latest survey, run in partnership with Make UK, found that 6 in 10 manufacturers plan on investing more in their plant and machinery over the next two years. 

That said, it’s the economic conditions that manufacturers face which will play a large part in determining whether these investment intentions come to fruition in the years ahead. 

Manufacturing has been in a recession for over a year

Manufacturing investment grew at an average yearly rate of 4% in the five years leading up to the financial crisis between 2007 and 2009. It then declined at a rate of 2% annually for the five years afterwards. While we believe that this current recession will be less profound, there is no doubt it will take time for the manufacturing industry to recover.

The manufacturing sector rebounded strongly from the pandemic, and was outperforming the rest of the economy. However, it has now fallen behind. The sector has effectively been in a recession since May 2021 – monthly output has declined in12 out of 18months since then, and is now 2.1% below its pre-pandemic level.

Unfortunately, the outlook over the next year suggests that the manufacturing sector’s health will continue to deteriorate. The future output index has taken a sharp fall demonstrating that orders are now declining steeply and the low backlog of work suggests manufacturers have now largely worked their way through the backlog created by the pandemic, and with the UK retail sector also in decline demand is now beginning to dry up. 

Energy costs hitting the sector hard

Manufacturers are more intensive users of energy than most other businesses, so the surge in energy prices this year has hit them harder. The government’s energy price guarantee (EPG) scheme has fixed energy prices for businesses until April, but the financial markets are braced for energy prices to be significantly higher than the current EPG level. 

This creates a potential cliff edge in firms’ costs. While energy prices have fallen significantly over the past month, it seems unlikely that they will return to pre-pandemic levels until 2026 at the earliest. 

Along with soaring energy prices, the cost of many raw materials also rose sharply during the recovery from the pandemic and in the aftermath of the Russian invasion of Ukraine. This pushed input price inflation to a peak of 24.2% year-over-year (y/y) in June. 

However, output price inflation has not risen as quickly. The implication is that manufacturing margins are being squeezed. Now that global commodity prices have fallen back and input price inflation seems to have peaked, output price inflation is now also falling. Despite this, weak demand means that manufacturing firms will find it difficult to rebuild their margins. 

Much depends on how the government reworks the EPG in April. One thing is clear, however – if manufacturing firms have to bear the full brunt of the energy price shock, the sector will fall into a much deeper recession than the rest of the economy, and is likely to shrink permanently.

Labour supply will remain a problem

As if soaring input costs weren’t enough, the manufacturing sector is also dealing with a shortage of labour. This is a problem across the UK economy and the developed world, but there is evidence that the manufacturing sector has it tougher than most.

Vacancies in the sector are about 65% higher than before the pandemic, compared to about 50% higher across the economy as a whole. This has prevented the sector from expanding its output to take advantage of high demand for goods over the last year.

It is possible that the huge increase in non-labour costs, such as energy and raw materials, has limited manufacturers’ ability to attract and retain talent with increased wages. Wage growth in the sector has been consistently below the average increase in private sector wages over the last three years.

Wage increases won’t deal with the main reason for labour shortages, which is the increase of about 420,000 people on sick leave across the whole economy. What’s more, there has been an estimated decline of around 100,000 EU workers since before the pandemic. It seems unlikely that these factors will go into reverse anytime soon.

So, even though the recession will increase the unemployment rate, the labour market will remain relatively tight by historical standards.

Supply chain pressures have eased…

The good news is that the supply chain pressures that dogged the manufacturing sector throughout the recovery from the pandemic appear to have eased recently.

The suppliers’ delivery balance of the S&P Global/CIPS manufacturing PMI, which measures how long firms are waiting to receive supplies, has recovered to its pre-pandemic level. Admittedly, this has been helped by demand falling across the sector, but it’s also because firms around the world have got better at managing supply disruptions, and they’re holding more stock to protect against longer delivery times.

…but the outlook is grim

Interest rate expectations have fallen from their peaks during the recent political turmoil, but they are still significantly higher than before. Markets went from expecting interest rates to peak at about 4.5% on 22nd September, the day before the infamous mini budget, to expecting them to peak at almost 5.5% a few weeks later. The installation of Jeremy Hunt as Chancellor and the u turns on most of the measures helped to bring down expectations, but they are still almost 5%. This is just one example of the cost of the recent political instability.

Soaring interest rates will make it difficult to refinance debt, and to borrow to invest in productive equipment. Capital intensive industries such as manufacturing tend to have higher debt levels than other businesses and, because most corporate debt is floating, increases in interest rates will quickly feed through into higher costs for firms.

Our survey findings provide some insight into the extent that these conditions might impact the sector’s costs and its future investment plans. 25% of manufacturers confirm they tend to borrow from banks to fund their investments in onsite machinery, and 39% confirm they do the same when funding new investments in new factories and warehouses.

Financial markets expect interest rates to peak at around 5% early next year. We think that is probably an overestimate, and that rates will peak at closer to 4% than 5%. Either way, it’s very clear that interest rates are rising and will stay high for the next few years.

The drop in the manufacturing PMI to 46.2 in October, its lowest since July 2012 excluding the pandemic months, suggests that the manufacturing sector has continued to contract heading into the last quarter of the year. We expect a 0.5% q/q drop in GDP in Q3 to be followed by a similar sized fall in Q4 as consumers reduce spending in the face of soaring inflation and mortgage bills.

Economies across the world are weakening at the same time, so it seems unlikely that firms will be able to rely on external demand to supplement a weaker domestic economy. Indeed, the new export orders index fell to 40.3 in October, its lowest level since the pandemic. The one silver lining in all this is that the weaker pound will boost the profit margins of manufacturers who export as firms don’t tend to dramatically alter pricing in response to currency fluctuations. In addition, imported goods will become relatively more expensive, giving a boost to domestic firms.

Overall, we expect the recession to last until Q3 2023 and result in a drop in GDP of around 2%. Our survey findings do indicate that the industry is concerned about future economic conditions with business leaders confirming these conditions will impact investment decisions profoundly.

But what happens if all of these demotivating factors come to pass at once? The industry is set for a turbulent time.