Our regular assessment of the current state of the profitability of British business and the economic factors influencing its prospects for the future, prepared by Roger Bootle, Economic Adviser to Deloitte.

• Profitability already appears to be levelling off. Give it another quarter and I expect profitability to be falling more sharply. Give it a year and it will be in freefall. Following the deterioration in the economic outlook and the relentless rise in energy prices, I think that non-financial profits will plunge by around 12% by the end of 2009. 
• While profitability of the overall non-financial sector has hovered at just under 15.5% for three quarters now, the sectoral breakdown is more telling. With the oil price rising by 10% in Q1, it was of little surprise to see profitability of the oil sector shoot up from 51.3% to 57.6%. But higher energy prices seem to be taking their toll on non-oil companies. Their profitability fell from 14% to 13.6%, pulled down by a sharp drop in the manufacturing sector, even though it is probably too early to see the effects on profits of the slowdown in the overall economy.
• And with the oil price having risen by another 30% since the end of March, the blow to profits of non-oil firms from rising energy prices is only set to worsen.
• Whilst manufacturers are the heaviest users of energy, they have so far been successful at passing their rises in costs further down the pipeline. But retailers will have trouble doing the same. After all, another effect of rising energy prices will be to squeeze household real incomes further, dampening consumer demand.
• Of course, workers could bargain for higher wages as compensation, but with unemployment already rising and set to rise further, I think the chances of their succeeding are slim. Consumer spending will struggle to rise at all in real terms next year, leaving retailers in pretty dire straits. 
• The trouble caused by rising energy prices doesn’t stop there, with the Monetary Policy Committee facing its toughest test yet. While, for now, I don’t think that an interest rate hike is on the cards, a near-term rate cut is certainly off the agenda. Accordingly, the economic slowdown is likely to be even deeper and more prolonged than it would otherwise have been.
• Indeed, I now expect the economy to grow by just 0.5% next year. There is certainly a good chance of a technical UK recession (i.e. two consecutive quarters of falling output). Indeed, a serious recession like that in the early 1990s is not out of the question if the labour market crumbles or if interest rates end up rising.
• Profits in the construction and consumer-related sectors are most vulnerable. But manufacturers could for once come out on top, given the recent fall in sterling. The chart shows that sterling’s exit from the Exchange Rate Mechanism in 1992 drove a whopping rise in manufacturing profits in the early 1990s.
• But the drop in sterling took some time to work its magic. The strongest annual rise in profits didn’t come until 1994. Indeed, manufacturers might only derive the full benefit of the potential increase in their competitiveness once the global economy has got back on its feet. And that might not be until 2010.
• What’s more, the manufacturing sector accounts for just 12% of all non-financial profits. The drop in the pound won’t stop overall profits from falling sharply.
• Admittedly, profits as a share of GDP aren’t as high as in the late 1980s, when they subsequently dropped by 21% in real terms. Back then, profits peaked at 19.4% of GDP; at the end of 2007 they were 16.3%. Nonetheless, I expect profits to fall by around 4% this year and a further 8% or so next year.
• Falling profits will have crucial implications for investment. So far, few firms have cited problems accessing external finance as limiting capital spending. But that may be because they have retained earnings to use instead. Once profits start to plummet, the credit crunch will become a much bigger constraint on investment.
  

Download the full Profitability Monitor report Q1 2008 (with supporting charts) (PDF,87 KB)

This assessment contains general information only and is not intended to be comprehensive nor to provide professional advice.  It is not a substitute for such professional advice and should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business.  Deloitte & Touche LLP accepts no duty of care or liability for any loss occasioned to any person acting or refraining from acting as a result of any material in this assessment.