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

• The slight increase in profitability in the first quarter suggests that businesses might be starting to feel the benefits of the recent pick-up in activity both in the UK and abroad. But costs remain under upward pressure from higher energy costs and rising pension fund contributions. As such, 2006 is still likely to be another weak year for profits growth.
• The oil sector continued to benefit from high oil prices, which remained at close to $60pb over Q1. The net rate of return in the North Sea sector rose from 34.1% in Q4 to 35.4%, its highest level since 2000. But more importantly, the non-oil sector saw profitability pick up too, from 13.3% to 13.4%.
• Firms across a broad range of sectors are likely to be feeling the benefits of slightly stronger demand. Retailers will have been relieved to see the improvement in retail sales growth over the last few months, although some of this strength is likely to have been the result of a temporary pre-World Cup boost.
• Meanwhile, UK exports finally seem to be responding to the improvement in euro-zone activity, with euro-zone GDP set to rise by 2.3% this year after the 1.4% growth seen last year.
• That said, my forecast is for overall UK GDP growth this year to remain slightly below its long-run average of 2.7%, at around 2.5%. What’s more, a number of factors are likely to continue to put upward pressure on firms’ costs.
• The wholesale gas price could yet rise again later this year, given that it responds to oil prices with a lag of around a year. The manufacturing sector has been largely successful in passing on the rises in energy prices over the last year by raising its output prices. However, this has just left the distribution sector bearing the strain, with retailers already suffering from a pick-up in import price inflation.
• Meanwhile, firms still have vast pension fund deficits to plug. The recent rise in bond yields – which are used to discount future pension liabilities – has helped to narrow the deficit a little. But the recent fall in equity prices – and therefore the value of pension fund assets – will have offset some of this benefit. Indeed, the deficit of the FTSE 350 as a whole is still estimated to stand at around £60bn.
• Firms have recently been raising their pension fund contributions by an average of £5bn per annum (see chart.) If employers’ contributions continue to rise at this rate, they are set to reach the equivalent of around 17.5% of profits this year, compared to 16% in 2005 and just 8% in the late 1990s.
• Of course, firms can offset part of the rise in energy and pension costs by keeping a closer check on other costs. In particular, the threat of employing cheaper labour from Eastern Europe should help to keep a lid on pay demands and therefore employers’ wage bills. Higher immigration from the new European Union countries has left the UK workforce rising at its fastest rate in 20 years.
• The overall effect, however, is likely to be a further squeeze on profits growth. We continue to expect nominal profits to rise by around 0.5% this year, leaving profits falling by 1.5% in real terms.
• This would clearly not be good news for Gordon Brown. His borrowing forecasts bank on non-oil corporation tax receipts rising by a hefty 16% in 2005/6, although he expects the financial sector to account for a large part of this.
• But more importantly, lower profits mean less money available to invest. As such, another year of sluggish profits growth could undermine the re-balancing of the economy away from the consumer sector that finally appears to be underway. 

Ends

Notes to editors
This press release has been prepared by Roger Bootle, Economic Adviser to Deloitte.  If you have any questions regarding the views in it, please contact Roger Bootle directly on 020 7823 5000 or via email on business@capitaleconomics.com.

This press release 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 publication.

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The information contained in this press release is correct at the time of going to press.