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 strong corporate profitability seen at the end of last year is set to continue this year on the back of falling energy prices and the recent increase in firms’ pricing power. And crucially, last year’s pick-up in investment shows that firms have become more willing to spend these extra profits.
• The net rate of return (profits relative to the capital stock) in the non-oil sector rose from 14.2% in Q3 to 14.7% in Q4. Profitability in 2006 overall was therefore its highest since 1998.
• Part of the rise in profitability in 2006 reflected the capital stock growing at a slower rate than in 2005. But by far the bigger factor was the pick-up in profits growth. (See Chart.) Gross trading profits rose at an annual rate of some 11.3% in Q4, thanks to both a surge in Q4 and some favourable revisions to the past data.
• The economic environment has recently become more conducive to strong profits growth over the rest of this year as well. For a start, the domestic economy has continued to gather momentum, despite the three rises in interest rates since last August. I expect UK GDP growth of around 2.5% this year, only a touch slower than the 2.8% seen last year.
• And looking abroad, the euro-zone economy – the most important destination for UK exports – is looking healthier by the day. 
• Firms have also had more success in the last few months in pushing up their prices, particularly in the manufacturing and retail sectors. Both factory gate and high street inflation have been accelerating, with most surveys suggesting that firms expect to boost their pricing power further.
• Meanwhile, the recently announced cuts in utility prices mean that it will not be long before profits are receiving a boost from the cost side too. Indeed, the manufacturing sector already appears to be benefiting from easing energy costs, with manufacturing profitability leaping from 6.9% in Q3 to 10.0% in Q4.
• Admittedly, firms are likely to concede at least some pick-up in pay growth. But higher immigration should keep a lid on the extent of these rises. And non-wage labour costs should ease, given that pension fund contributions are levelling off, now that the bulk of pension deficits has been plugged.
• That said, some factors will still drag on profits growth, particularly in the manufacturing sector. The exchange rate has come off only slightly from its recent 14 year high. And I expect US growth to slow sharply this year, as consumers react to the recent falls in house prices. Indeed, developments in the US sub-prime market suggest that the current stabilisation in the housing market may be only temporary.
• The upshot is that weaker global demand and a high exchange rate are likely to offset some of the boost to profits from falling energy costs. Indeed, given that profits as a share of GDP are now above their long-run average, profits look more likely to fall relative to GDP, than to rise further.
  Accordingly, I still expect profits to grow by slightly less than overall GDP this year and next. Nonetheless, I now expect annual growth of around 3.5%, rather than the more sluggish 2% or so which was previously looking most likely.
• A pick-up in profits growth increases the chances of a more broad-based investment recovery in the coming months.

Download our press release for supporting table and graphs. (PDF, 202 KB)

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.

About Deloitte
In this press release references to Deloitte are references to Deloitte & Touche LLP which is among the country’s leading professional services firms, providing audit, tax, consulting and corporate finance services. Deloitte & Touche LLP is the United Kingdom member firm of Deloitte Touche Tohmatsu (‘DTT’), a Swiss Verein whose member firms are separate and independent legal entities.  Neither DTT nor any of its member firms has any liability for each other’s omissions.  Services are provided by member firms or their subsidiaries and not by DTT.  Deloitte & Touche LLP is authorised and regulated by the Financial Services Authority.  The information contained in this press release is correct at the time of going to press.