The outlook for the uneven recovery

As part of our new programme, ‘The uneven recovery’, we look at the prospects for the UK economy in the post-pandemic recovery.

Key takeaways

• The twin forces of Brexit and Covid-19 exacerbated by the cost-of-living crisis are conspiring to create challenging trading conditions for most, but not all, SMEs.
• Corporate insolvencies increased 11% to just over 14,000 from 12,500 in 2020 despite extensive government support measures and will exceed pre-pandemic levels by 2023.
• Whilst levels of distress amongst SMEs appears broadly consistent across regions there are pockets of Growth and Financial Stability outperformance in the South-West and pockets of Growth underperformance in London.
• Over 500,000 UK employees face a risk of job loss that is between 4-25 times greater than the UK average.

When drilling down into sectors we can see ‘covid winners’ and ‘covid losers’ emerge, but will the same players retain their positions as recovery takes hold?

The road to recovery is potholed given Brexit, Covid-19, and Ukraine

Any discussion of a broad-based post-pandemic UK wide recovery ignores the often-divergent fortunes of different sectors and different regions. These differences have become more pronounced during the past two years, resulting in an inconsistent policy approach that seems to have inadvertently given a competitive advantage to those companies in and around London and the South-East. Whether the government’s flagship levelling-up agenda will realise its lofty ambitions only time will tell, but what we do know is that the 5.6 million. SMEs that collectively employ around 16 million people, will play a pivotal role in powering the UK through the post-pandemic recovery.

There is a very real and present risk to any recovery given the impact of Brexit, Covid-19 and the situation in Ukraine, on an acceleration of corporate insolvencies leading to elevated risk of job loss to over 500,000 SME employees – as modelled by Clarity.

Setting the scene: is talk of recovery premature?

The twin forces of Brexit and Covid-19 exacerbated by the cost-of-living crisis are conspiring to create challenging trading conditions for most, but not all, SMEs.

Headline data show rising inflation and tightening monetary policy, while expectations are that the recent modest decline in unemployment will soon go into reverse. This time last year, debt-fuelled stimulus was injected into the economy to prop up the ailing SMEs sector, and commentators were pointing to the need for a loosening of monetary and fiscal policy to support growth. However, global supply-chain constraints and the recent surge in wholesale energy prices has sent inflation well past the Bank of England’s 2.0% target; the Bank now expects inflation to peak at around 7% in April and to fall back only gradually, not returning to 2% until around 2024. 

Whilst the Chancellor has yet again extended financial support to those SMEs most affected by Covid-19, any discussion of a broad-based UK wide recovery ignores the wildly divergent impact the twin forces of Brexit and Covid-19 have had on different sectors and regions. Demand is clearly outstripping supply in some narrow aspects of the economy (professional services being one of the most often cited examples) but lagging in many others especially hospitality, tourism, and leisure sectors. The implications for this unequal impact are clear. There is no ‘one-size-fits all’ strategy for helping navigate SMEs through these troubled times. Instead, we strongly believe that each SME’s needs should be considered with respect to sectoral and regional specificities. Those SMEs reliant on extensive foreign supply chains will face working capital challenges as higher input prices feed into suppressed margins, whereas those SMEs where ‘human capital’ is the main ‘commodity,’ are likely to be faced with staff shortages acting as a constraint on growth.

As revealed in the most recent Bank of England Decision Makers Panel survey, respondents suggest that the negative effects of the pandemic are likely to have fully reversed during 2023, with investment sentiment having accelerated during Q4 2021 in response to the continued reopening of the economy and easing of lockdown restrictions. However, it remains to be seen whether, considering the Ukraine situation, the same optimism holds true given the likely effect on input prices and further upside pressure on wholesale energy prices leading to further inflationary pressure.

Individually, each of these forces would have left a marked but temporary impact on the shape and scale of the UK economy. However, taken together, the impact is more profound and will likely lead to a fundamental economic adjustment affecting some sectors and regions more profoundly than others.

Insolvency rates set to normalise

Corporate insolvencies increased 11% to 14,048 from 12,635 in 2020(*1) despite extensive Treasury support measures and they remain below pre-pandemic levels – but for how much longer?

The widely anticipated raft of corporate insolvencies did not materialise during 2021 and with good reason; the government injected over £80bn into UK businesses through various forms of business support including from lending schemes, business rates holidays, tax deferrals and VAT reductions. This support has allowed businesses to ‘tread water’ for the time being. But fundamental structural change in market conditions and supply chains, driven by Brexit and compounded by Covid-19, have meant many small businesses are simply no longer viable. We expect that in 2022 total insolvencies will reach 2019 levels with a 20% increase over 2021 and will reach around 19,000 by 2024. This will be driven in part by a sharp acceleration of insolvencies coming into Q3 and Q4 this year as inflationary pressures, the cost-of-living crisis, and fallout from the Ukraine situation weigh heavily on the micro-end of the market and particularly owner-managed businesses. 

Whilst there is an expected level of inertia amongst tightly held owner-managed businesses, where there is much stronger emotional connection to the business, owners are now much more receptive to exploring the ‘art of the possible’ when thinking about topics that previously had been ‘off the table’. They include succession planning, full and partial exits, and, introducing debt into the capital structure for instance. One trend we are observing is the increase in the use of employee ownership trusts (EOTs) as a vehicle for exit for owners. 

Winners and losers: a sector view

When drilling down into sectors a very different picture emerges, with both winners and losers – but will the same players retain their positions as recovery takes hold?

It is widely understood that Covid-19 and the consequent injection of stimulus from the Treasury had an uneven effect on regions and sectors. But will those that had a ‘good pandemic’ be well positioned to power through the recovery, or will those that had a ‘bad pandemic’ have their fortunes reversed? 

Unsurprisingly, SMEs in the utilities sector have the highest Growth Score in the UK and with a median score of 94, sit comfortably above the UK median of 52. Conversely, we can also see that several sectors are significantly trailing the UK median with a score of 43. Perhaps counter-intuitively given the demand for goods bought online and delivered due to the many months of lockdown restrictions, SMEs in the transport sector within SIC divisions 49, 50 , 51 , 52 , 53 also score 43. However, increased demand for goods transport has been offset by reductions in passenger numbers across rail and air channels. 

Utilities (established players not new to market players) will continue to enjoy relative outperformance during this year, along with other SMEs funded by the public purse including those that fall under the public administration sector, which has a Growth Score of 87.

However, we expect a gradual reversion to the mean as the effects of central government stimulus are fully phased in and as the private sector takes advantage of the full reopening of the economy and withdrawal of the last remaining Covid-19 measures during late February.

We do not expect to be ushering in a new era of growth champions in the utilities sector. Instead, we maintain a watchful eye on SMEs in the manufacturing and financial services/insurance sectors where Clarity is identifying an increasingly stronger pattern of growth signals which will intensify as the economy continues to ‘open up’ despite the challenging macro-economic backdrop. 

Winners and losers: a regional view

Whilst the level of distress appears broadly consistent across regions, we are seeing pockets of growth and financial stability outperformance in the South-West and pockets of growth underperformance in London. 

Since 2020, received wisdom is that regional location is not a key driver of the success or failure of an SME. However, our analysis reveals that differences do exist between regions and that some of these differences run counter to recently introduced policymeasures as part of the levelling-up agenda. When drilling into each of the regions, a stark picture emerges of the variance when looking at measures of distress (DWS), financial strength (FSS) and growth (GS) as captured by Clarity. 

London, with a score of 43, is lagging regional leaders Midlands, Scotland, South West, and Wales in terms of growth each scoring 51. Whilst the capital’s GS score performance may surprise some, it was entirely consistent with our expectations given the very dynamic nature of the London labour market and the high concentration of sectors that are very sensitive to the free movement of people and the consequent negative affect of Brexit leading to repatriation of many of the capital’s skilled workers employed in hospitality, leisure, food & beverage, and accommodation SMEs for example. Conversely, with respect to FSS, the South-West is leading the pack with a score of 51 closely followed by Eastern and South-East with scores of 49 each respectively followed by Scotland, London, Midlands, and Wales with a scores of 48 each respectively.

As introduced in our Foreword, a key component of Clarity is a proprietary insolvency propensity model that allows us to early identify the most severely challenged mid-market UK SMEs that have an insolvency risk that is between 4-25 times the national average of 1%. Using this model, we have identified a population of the UK labour force that faces a risk of job loss that is between 4-25 times greater than the UK average.

Almost 80% of this cohort is concentrated within the 4-8% insolvency risk bucket comprising roughly 4,000 SMEs, 20% is accounted for in the 8-15% bucket comprising roughly 1,500 SMEs and less than 1% in the 15-25% bucket comprising roughly 1,000 SMEs. We anticipate levels of distress to increase amongst UK SMEs throughout the year and this will feed into an increasing number of corporate insolvencies this year and next. However, having early identified the SMEs and their affected employees, preventative measures should be taken now, thereby ensuring the continued viability of these SMEs and the lifeline that they provide the 500,000 employees whose livelihoods can be preserved with acute and timely preventative strategic interventions.

Footnotes:

(*1) The Association of Business Recovery Professionals, “R3”