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 marginal rise in profitability in the first quarter does little to alleviate our concerns about the tough times facing the UK corporate sector. Firms are under intense pressure and even more challenging times lie ahead.
• Oil companies enjoyed the biggest rise in profitability as they cashed in on the rise in oil prices to over $55 a barrel in Q1. And the improvement in services sector profitability – to its highest since the end of 2002 – was in line with other evidence suggesting that this sector has remained fairly resilient in the face of the high street slowdown.
• However, this resilience is unlikely to last. Profits growth is clearly vulnerable to a further tightening of purse-strings by consumers. Just as households are coming to terms with a weakening housing market, they are likely to face a nasty rise in taxes in the 2006 Budget.
• In the face of a domestic slowdown, the economy would normally rely instead on its external sectors. But the global slowdown is gathering pace, prompting calls for interest rate cuts in the euro-zone, the destination for the majority of UK exports. Weaker external demand was no doubt a key factor behind the sharp drop in manufacturing profitability in Q1.
• As such, there is little scope for any near-term improvement in either of the two bedrocks of profits growth – sales volumes and mark-ups. Not only is economic growth slowing, but competitive pressures will limit the extent to which firms can pass on the recent build-up of cost pressures into higher prices, squeezing margins.
• We expect GDP growth to slow from last year’s 3.3% to 1.7% this year and 2.0% next year. Given that profits growth tends to fall by 4 times as much as GDP growth, we expect real profits to show barely any growth at all this year and next.
• As such, the share of profits in GDP is now set to decline – bad news, given that it is barely above the levels seen in the early 1990s recession as it is. (See Chart in attached press release.)
• Slower profits growth has key knock-on effects on other parts of the economy. Without profits, firms can’t afford to make the investment crucial to any future improvement in living standards. Indeed, business investment is already suffering, having fallen over the last two quarters as a whole.
• And the poor outlook for profits is certainly bad news for Mr. Brown. The Chancellor is relying heavily on strong company profits to generate the tax revenues needed to fill the black hole in his finances.
• Firms might enjoy some respite if the ICT investment boom in the late 1990s finally pays off, boosting productivity growth – it took the US around five years before it reaped any gains from its investment boom. Equally, though, competitive pressures are so strong that firms could be forced to pass these benefits on in lower prices. Meanwhile, although we expect interest rates to fall, this is unlikely to benefit the majority of firms who have fixed-rate debt. What’s more, the corporate sector as a whole is a net lender, meaning it will suffer falling variable rate income.
• The slowdown in profits growth will probably still be modest compared to that seen in the early 1990s recession or the aftermath of the stock market bubble in 2000, when profits fell by 8% between 2000 Q4 and 2001 Q2. But it comes at a time when the economy needs all the support from the corporate sector it can get.

About Deloitte
In this press release references to Deloitte are references to Deloitte & Touche LLP.

Deloitte & Touche LLP is the UK's fastest growing major professional services firm based in 21 UK locations, with over 10,000 staff nationwide and fee income of £1,246 million in 2003/2004. It is a member firm of Deloitte Touche Tohmatsu, a leading professional services organisation, delivering world class audit, tax, consulting and corporate finance services, with around 120,000 people in over 140 countries. Deloitte Touche Tohmatsu is a Swiss Verein, and each of its national practices is a separate and independent legal entity.

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.