EY Scottish ITEM Club - Building a better working world - EY - · PDF file · 2017-06-06as many of the big ticket public sector funded infrastructure projects near ... needs to rebalance

EY Scottish ITEM Club Scotland’s stagnating growth

Summer update 2017

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Dougie Adams

Senior Economic Adviser, EY Scottish ITEM Club

Dougie, the author of this report, is a respected economics adviser with over 40 years’ experience in the public and private sectors.

Mark Gregory

Chief Economist, EY, UK and Ireland

Mark is a business economist with over 25 years’ experience in more than 40 countries as an advisor to Governments and industry on economics, policy and regulation.

This report is based on data and information available before 16 May 2017.

EY Scottish ITEM Club report is part of the EY Economics for Business programme which provides knowledge, analysis and insight to help business understand the economic environments in which they operate, both in the UK and globally. Find out more:

ey.com/uk/economics

[email protected]

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markgregoryeconomics.ey.com linkedin.com/in/markgregoryuk @MarkGregoryEY

Contents

Foreword 2

Highlights 4

Global and UK background 5

Scotland 8

Forecast 12

Risks 14

Forecast tables 15

EY is the sole sponsor of the ITEM Club, which is the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or business bias.

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Fore

wor

d Searching for solutions to Scotland’s stagnating growth

Since 1988, EY has been the sole sponsor of the ITEM Club, one of the UK’s best-known independent economic forecasting groups. During this time we have seen various levels of economic growth, from the boom times to the lower growth world we now find ourselves in. Today, Scotland’s economic prospects face many headwinds with the latest EY ITEM analysis bearing witness to a year of near stagnation in the economy.

Economy stalledWith 0.4% non-oil GDP growth over the year in 2016, Scotland trailed well behind the UK which saw growth of 1.8%. 2017 is set to be another year of below par growth in Scotland with a forecast growth of 0.9% - half the UK rate.

The challenge is well and truly set as Scotland’s employment rate continues to fall, wages growth remains subdued, inflation bites further into spending power and the household saving ratio continues to sink. The resulting slowdown in consumer spending is set to continue into 2017, which EY ITEM report anticipates will have a marked effect on the Scottish economy if other sources of demand do not fill the gap.

The report highlights an extremely challenging backdrop but there are grounds for optimism with professional, scientific, administrative and support services set to grow relatively fast. However, the forecast decline in the significant contribution to GDP growth in recent years from construction as many of the big ticket public sector funded infrastructure projects near completion, together with consumer spending under pressure, means that growth will have to be driven by improved trade performance or increased business investment.

Mark Harvey Senior Partner, EY, Scotland

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Refuelling strategies requiredA buoyant world economy is anticipated over the next few years which provides a positive backdrop to the current adjustment processes. Seeking out opportunities to benefit from this global growth is an imperative as the Brexit trade negotiations offer potential upsides where favourable new trading arrangements can be secured. At a time such as this, focusing on constructive dialog and policies which maximise Scotland’s position will define the country’s position on the world stage for many years to come.

At home, the findings of the report highlight that the Scottish economy needs to rebalance and shift away from over-reliance on public funded major infrastructure projects, oil & gas and financial services.

Business investment cannot be underestimated as an important driver of sustained growth. Although business confidence has picked up over the last few months, business investment remains weak and is being constrained by the weaker consumer outlook and uncertainty about the UK’s future trading relationship with the EU and remains vulnerable to shocks.

Stimulating business investment in Scotland both in terms of physical assets and skills would deliver extensive, long-term economic benefits. This presents an opportunity for public and private sectors to define a new way of working together in order to drive further economic growth.

Government can help de-risk investment by supporting the development of skills and infrastructure that businesses need so that companies can feel confident they can maximise their investment.

Collaborative roadmap will dictate future directionA collaborative approach between public and private sectors will ensure projects, proposals and investments are prioritised to deliver the biggest return in terms of skills, jobs, economic benefits, productivity, innovation and competitiveness.

Areas which will help deliver this are the production of a Scottish industrial strategy in order to align with the wider UK strategy and the proposed establishment of a Scottish Investment Bank to get the economy moving.

Against this backdrop let’s not forget that Scotland has a strong offering for the global marketplace as highlighted in our EY Scotland Attractiveness Survey 2017. It also has world-class universities and an Economic Strategy which embodies the need for inclusive growth supported by competitiveness.

But more must be done to improve business confidence and incentivise business investment at home, especially during this period of unprecedented geo-political uncertainty.

The challenge ahead for Scotland is evident and requires government and business to pull together to ensure Scotland can restart its stalling economy.

4EY Scottish ITEM Club Summer update 2017

Highlights

2016 ► The Scottish economy ended 2016 on a downbeat note.

Onshore GDP contracted by 0.2% in the final quarter after lacklustre growth earlier in the year. As a result, growth within Scotland’s economy has been downgraded to 0.4%. This was in contrast to growth of 1.8% across the UK.

► The weak GDP figure was caused by contractions in the production and construction sectors. The fall was most notable in construction as a number of major projects that supported very strong growth in 2014 and 2015 began to complete. Manufacturing activity in Scotland also contracted through the year, in contrast to an upturn in activity across the UK. Manufactured exports have suffered too, particularly in the second half of 2016, despite stronger global demand and a more competitive exchange rate.

► Some respite was provided by Scotland’s service sector, which continued to grow through 2016 on the back of resilient domestic demand. But the pace of growth was well behind the UK average and there was a loss of momentum at the end of the year. This was particularly noticeable in sectors most reliant on consumer spending. Indeed, the volume of retail sales has fallen since the middle of the year.

► Recent labour market developments are consistent with weakening economic activity. The number of people employed in Scotland has fallen over the past year. Yet unemployment continues to fall. This apparent contradiction is explained by a sharp and worrying increase in economic inactivity and lower labour market participation.

2017 ► The household sector is expected to come under increasing

pressure this year as higher inflation and a deterioration of the labour market restrict the growth in real incomes. Businesses and consumers also report a lack of optimism regarding growth prospects. We therefore expect another weak year of growth in 2017. Scottish non-oil GDP is forecast to grow by 0.9%, and whilst this represents a modest upgrade on the forecast 0.4% released last December, it is still just half the UK rate. Scottish growth is expected to slow a little in 2018 to 0.7% before gradually accelerating to around 1.4% per year by the end of this decade. Throughout this period, the Scottish economy is forecast to grow more slowly than the UK.

► Scotland’s economy will show a degree of rebalancing this year. Growth will be less reliant on domestic demand as consumer spending slows and businesses remain reluctant to invest whilst Brexit related uncertainty persists. At the same time, weaker sterling and a pick-up in global demand should ultimately provide a boost to manufacturing and exports.

► Weak economic growth will impact the labour market. Employment in Scotland is forecast to fall by 24,000 over the period to 2019. Job losses are likely across most sectors, including from wholesale and retail trade, a sector that has been an important source of new jobs in recent years. Manufacturing and the public sector are also forecast to reduce headcounts over the medium term. Some offset will be provided by rising employment in business services. Lower employment will feed through to higher unemployment. The Scottish ILO unemployment rate is forecast to rise from 5.2% in 2016 to 6.2% in 2019.

► Longer term prospects for the Scottish economy will be heavily influenced by the outcome of the UK’s negotiations over its exit from the EU, especially regarding trade, and on the way the Government uses any additional powers that it gains in areas such as immigration policy. Our forecast assumes exporters will be trading under WTO rules in two years’ time, although it is possible the UK will be able to negotiate more favourable transition arrangements, perhaps followed by free trade agreements.


World GDP growth% change on previous year

Real GDP 2015 2016 2017 2018 2019 2020

North America

United States 2.6 1.6 2.1 2.7 1.8 1.6

Canada 0.9 1.4 2.5 1.8 1.8 1.7

Europe

Eurozone 1.9 1.7 1.9 1.6 1.4 1.3

Germany 1.5 1.8 2.0 1.5 1.1 0.9

France 1.2 1.1 1.4 1.6 1.5 1.4

Italy 0.7 1.0 0.9 1.0 1.0 1.0

UK 2.2 1.8 1.8 1.2 1.5 1.8

EU27 2.2 1.9 1.9 1.7 1.5 1.5

Asia

Japan 1.2 1.0 1.4 1.3 0.9 0.0

Emerging Asia, excl Japan 6.0 6.0 5.9 5.7 5.5 5.3

China 6.9 6.7 6.6 6.1 5.8 5.6

India 7.5 7.5 7.2 7.5 7.1 6.8

World 2.7 2.3 2.7 3.0 2.8 2.7

World 2005* Purchasing Power Parity 3.2 3.0 3.5 3.7 3.5 3.4

World trade 1.7 1.8 5.0 3.5 3.7 3.8

Global and UK background

Global growth improving …World trade and industrial output are growing faster than at any time since 2010 when they bounced back from the recession, and economic data have surprised on the upside for a change, including in the US and the Eurozone. This revival is partly a lagged

response to the collapse in commodity prices in 2015, while their recent recovery has pushed inflation back close to target almost everywhere, easing worries about deflation, especially in the Eurozone. As a result, the global economy is expected to grow by 2.7% in 2017, up from 2.3% in 2016.

Table 1: World GDP and world trade growth

Source: ITEM*2005 is the base year for the calculation of PPP rates

ForecastActual


In the US, GDP growth is forecast to accelerate to 2.1% this year, compared with 1.6% in 2016, as stronger business and residential investment more than offset a moderation in consumer spending. However, President Trump is facing political challenges in delivering on some of his key campaign promises so the outlook remains at risk to political developments. There is upside potential through significant tax cuts and deregulation, but also downside risks, where the big concern is over US trade policy and the impact on international trade.

Meanwhile, economic activity has picked up in the Eurozone and recent forward looking indicators are positive — in 2017 the bloc could record its strongest GDP growth since the Eurozone crisis. Strengthening export conditions are an important support to growth as inflation is likely to limit the recovery in consumer spending, and we remain cautious about the investment outlook given political uncertainty in the region and further afield. Overall, we expect GDP growth of 1.9% this year, followed by 1.6% in 2018. The slowdown in Eurozone growth from 2017 to 2018 (1.6% from 1.9%) and reflects slightly slower growth in domestic demand, most notably from consumer spending and investment. But the slowdown is relatively modest.

Back in 2015, China was at the centre of global concerns, with worries that a financial crisis would spill over into the other emerging market economies and hit the main engine of world trade growth. Although worries about China persist, the authorities seem to have got a grip on the situation and the commodity markets and emerging market economies have been recovering. We forecast China GDP growth to be 6.6% in 2017 as we expect the external background to remain broadly helpful through the rest of the year, and compensate easing domestic demand.

… but UK growth slows as the economy rebalancesWe expect the UK economy to grow by 1.8% in 2017, in line with last year’s outturn. However, this disguises a shift in the balance of demand associated with the fall in the exchange rate and revival in global growth. Last year, consumption provided almost all of the growth in demand, with overseas trade subtracting 0.4% from growth. This year sees a major slowdown in consumption as inflation bites into spending power, while net trade makes a

positive contribution to growth. Growth is also forecast to slow during the course of this year, leaving 2018 and 2019 weaker at 1.2% and 1.5% respectively. And with wage inflation remaining subdued, we think the MPC will hold base rates at the current level of 0.25% until the autumn of 2018.

The key drivers of the UK forecast are:

Consumers under mounting pressure:

► After displaying a surprising degree of resilience last year, consumers now appear to be retrenching in the face of higher inflation — retail sales volumes contracted in Q1 2017, the first quarterly contraction since Q4 2013

► Household spending power will also come under pressure from the government’s welfare reforms hitting those on low incomes, and from deterioration in the labour market — employment growth is expected to slow sharply in 2017 and remain broadly flat in 2018 and 2019

► With savings ratios already very low, we see little scope for households to offset these pressures by borrowing more. As a result, we expect the growth in consumer spending to slow from 2.8% last year to 2.0% this year and just 0.6% in 2018

Uncertainty subduing business investment:

► Business confidence has picked up over the last few months

► However, business investment remains very weak and is held back by the weaker consumer outlook, uncertainty about the UK’s future trading relationship with the EU and is vulnerable to disappointing news on the Brexit front

–5–4–3–2–1012345

1990 1995 2000 2005 2010 2015 2020

(%)

Source: ITEM

Chart 1: GDP growth, UK


ForecastActual


Chart 2: Expenditure components contribution to GDP growth, UK

–1.5–1.0–0.5

0.00.51.01.52.02.53.03.54.0

1997–2007 2014 2015 2016 2017 2018 2019

InventoriesNet tradeGovt. consumption

InvestmentConsumer spending

Source: EY ITEM Club

% pts

► Business investment fell by 1.5% in 2016, and we forecast another fall of 2.2% this year and a decline of 1.5% in 2018

An improvement in net trade:

► Recent data suggest that the combination of Sterling’s devaluation since the Referendum and the revival in world markets may at last have begun to boost UK manufacturing and exports

► The monthly trade figures have been flattered by movements in gold and other erratic items, but excluding these, the balance of trade in goods and services improved modestly from a deficit of £9.4 billion in Q3 2016 to £8.2 billion in Q4. Looking forward, survey evidence from CIPS and the CBI are consistent with exports continuing to grow at a robust rate

► Net trade is forecast to add 0.2% to GDP this year, adding another 0.6% in 2018. This would be a marked turnaround from previous years but not sufficient to fully offset drags on growth from the domestic economy

In summary, the global economy is shaping up nicely, helping the UK rebalance post-devaluation and paving the way to Brexit. But political developments could cause upset and seriously complicate Britain’s exit from the EU. Trade performance and output growth in 2019 and beyond will also depend critically upon the exit terms that can be agreed with the EU27 and other countries. As in previous forecasts, our central case is based on the assumption that UK-EU trade will be conducted under WTO rules come April 2019. However, there is the potential for an upside surprise if transitional arrangements can be put in place, perhaps followed by a Free Trade Agreement later.


ForecastActual


Scotland

Scottish economy shrinks at the end of 2016 …The latest data for Scotland showed the economy ended 2016 on a downbeat note. Onshore GDP — which excludes North Sea oil and gas extraction — contracted by 0.2% in the final quarter of the year. This followed lacklustre growth throughout 2016, meaning the Scottish economy ended the year no larger than it was at the end of 2015. This outcome was in stark contrast to the wider UK experience, where non-oil GDP grew by 1.9% in the year to Q4 2016. Longer term growth comparisons paint an equally disappointing picture — Scotland’s economy was 5.9% larger in Q4 2016 than a decade earlier, just half the expansion seen across the UK.

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Weak Scottish GDP has largely been underpinned by disappointing outturns in the production and construction sectors — both have seen consistent falls in activity in real terms over the past year. Construction posted the most significant contraction with output down by 6% in the year to Q4 2016. To some extent, this performance needs to be viewed in the context of the unsustainable rapid pace of growth seen in 2014 and 2015, on which we have commented on in previous editions of this report. Nonetheless, lower activity from the sector was sufficient to knock around 0.5pp off GDP growth over the past year.

Scotland’s production sector also made a significant negative contribution to growth. The sector contracted by almost 5% over the past year, mainly because of a 7.3% fall in manufacturing activity. This extended losses recorded through much of 2015

and was in contrast to growth across the UK. Each of the major sub-components of Scotland’s manufacturing sector have declined over the past year, with the most notable contractions in textiles (–11.6%), transport equipment (–8.8%) and chemicals (–8.3%).

Some respite was provided by Scotland’s dominant service sector. Here, output rose by 1.6% in the year to Q4 2016. Even so, Scottish service sector growth was significantly below the UK average of 2.9%, and there was a significant loss of momentum as the year progressed. Indeed, service sector activity was flat in the final quarter of 2016.

Chart 4: Sector contributions to growth in the year to Q4 2016, UK and Scotland

–0.8% –0.6% –0.4% –0.2% 0.0% 0.2% 0.4% 0.6% 0.8% 1.0%

Manufacturing

Construction

Transport and comms

Mining and quarrying

Govt and other services

Distribution and hotels

Business services andfinance

Scotland UKSource:ITEM/Scottish

Chart 3: GDP growth, UK and Scotland

An important driver of Scotland’s service sector has been professional, scientific, administrative and support services. Output across these activities rose by 2.5% over the past twelve months, therefore outpacing the service sector as a whole. But a note of caution is required as growth came to a halt in Q4 2016 compared with a rise across the UK. Scotland’s finance sector also stalled at the end of 2016, taking the gloss off of robust growth earlier in the year.

Scotland’s large retail sector began 2016 on a strong note. But since then, activity has remained flat and supporting evidence of this weakening trend is provided by the latest snapshot of Scottish retail sales. This shows the volume of sales has been falling since the middle of 2016, with the decline both preceding and exceeding the Great Britain average. As a result, retail sales in Scotland in Q1 2017 were just 0.2% higher than a year earlier — the comparable figure for Great Britain was 2.1%.


Three factors are likely to be contributing to the slowdown in consumer activity. Firstly, the household savings ratio has been trending down in Scotland, reaching just 2.6% in Q4 2016. This is the lowest it has been at any time over the last two decades for which data exists, and is well below the UK rate of 3.3%. With Scottish households saving so little, there is little scope for them to fund consumption by cutting savings further. Secondly, Scotland’s labour market is entering 2017 on a weak footing, and alongside rising inflation, this is placing further pressure on household incomes. Finally, the Scottish Consumer Sentiment Survey shows that households, on balance, expect that the economy will weaken over the next year. Therefore, households are likely to be cautious about future expenditure.

Chart 5: Savings ratio, UK and Scotland

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Scotland UKSource: Scottish Government/ONS

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Notwithstanding the loss of momentum through the year, the latest National Accounts data, which do not adjust figures for price changes, show that the value of Scotland’s onshore GDP grew by 2.1% in the year to Q4 2016. The comparable figure for the UK was 4.8%. As there was no expansion in the volume of Scottish GDP, this increase reflects a rise of 2.1% in the economy-wide measure of inflation.

Nominal Scottish GDP on the wider measure that takes account of Scotland’s geographic share of oil and gas grew by 1.7% in the year to Q4 2016. On this basis, the value of Scottish GDP per capita grew by 1.5% over the same period, significantly less than the UK average of 4%.

The expansion in onshore nominal GDP over the year to Q4 2016 was driven by an increase in domestic demand — net trade made a negative contribution as export growth of 0.7% was more than offset by a 1.6% increase in imports. Growth in domestic demand was largely driven by household spending — which was up by

3.0% on a year earlier — with other positive contributions made by government spending, and to a lesser extent, investment. This provides further evidence that a slowdown in consumer spending in 2017 will have a marked effect on the Scottish economy if other sources of demand fail to fill the gap.

Chart 6: Nominal expenditure components contribution to growth, Scotland

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Govt. spending Investment Net trade

%

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… as manufactured exports struggle The latest data illustrate the recent challenges faced by exporters. The overall volume of manufactured exports from Scotland fell consistently through 2016, and most markedly in the second half of the year. As such, exports in Q4 2016 were almost 7% lower than a year earlier in volume terms. The most significant contractions were reported in engineering and allied industries (–18.6%) and textiles, leather and clothing (–15.6%). Some offset was provided by food, beverages and tobacco, one of Scotland’s largest trading sectors, where export volumes increased by 6.3% during 2016. But even here, the quarterly data shows a weaker performance in the second half of the year. The relatively small wood, paper and printing sector was the only other area of manufacturing to post positive export growth in 2016.

The value of Scottish exports of goods and services to the rest of the UK was 1.6% lower in Q4 2016 than a year earlier, reflecting a particularly weak quarterly reading at the end of the year. Scottish exports to the rest of the world also fell modestly in the final quarter of 2016, but strong growth earlier in the year was sufficient to ensure overall annual growth of 5%. Despite a fall in the final quarter of 2016, imports to Scotland from both the rest of the UK and rest of the world have increased over the past year. As a result, Scotland’s on-shore net trade deficit grew in 2016, and is now at its widest since 2007.

Scotland


Chart 7: Net trade deficit, Scotland

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2,500

3,000

3,500

2010 2011 2012 2013 2014 2015 2016

Goods and services deficit (rest of UK & overseas)

£m

Source: Scottish Government

Employment is falling …The number of people employed in Scotland has been trending down over the past year reflecting the wider slowdown in the Scottish economy. Comparable figures for the UK have, on the whole, remained largely positive, albeit with the pace of job creation slower after the referendum than before it. Employment growth in Scotland has now been lagging the UK average since the start of 2015.

The headline employment figures mask divergent trends across Scotland sectors. Job losses have largely been concentrated in manufacturing, extractive industries and parts of the public sector. The ONS also report lower employment in administrative and support business services than a year ago, a sector that has generally grown across the UK. Losses in these sectors have been partially offset by gains in other parts of the Scottish economy. Most notable has been rising employment in professional services, information and communications and sectors supported by rising consumer spending, such as retail and leisure services.

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Scotland UKSource: ITEM/LFS

Chart 8: Employment, UK and Scotland

With fewer people in work, the Scottish employment rate has edged down over the past year. In January 2017, 73.4% of those aged between 16 and 64 were in employment. This is more than one percentage point below the UK average, as it has been for most of the last six months, and represents a marked turnaround from the relatively high employment rates seen in Scotland between 2013 and 2015.

An emerging feature of the past year has been the steady rise in economic inactivity in Scotland. This trend has continued in recent months with the proportion of Scottish residents aged between 16 and 64 neither in employment nor seeking work rising to 23% in January 2017, an increase from 21.3% a year earlier. Furthermore, the inactivity rate in Scotland is now significantly above, and moving away from, the UK average. This helps to explain why the unemployment rate in Scotland has fallen over the past year despite lower employment.

Chart 9: Inactivity rate, UK and Scotland

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Scotland UKSource: LFS

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Economic inactivity rate (Aged 16–64): Scotland vs. UK

… and business surveys report further pressures aheadThe Purchasing Managers’ Index (PMI)1 provides further evidence that the Scottish economy has lacked dynamism recently. In the last three months (February to April), the composite output measure averaged 50.8 and continues to trend well below the UK average. The latest data suggests rising manufacturing output has been compensating for weakness from services, and whilst companies across both sectors remain positive about future growth prospects, the survey reports expectations have eased in light of economic and political uncertainty.

Scotland

1 Markit Economics Bank of Scotland Purchasing Managers’ Index


Chart 10: Purchasing Managers Index, UK and Scotland

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The Scottish Chambers of Commerce Survey provides an indication of recent business trends for individual sectors. Given the weakness in the latest retail sales data and the pressures facing household budgets, it is not surprising that optimism amongst retail and wholesale businesses dropped sharply in the first quarter of 2017. The survey shows a negative balance of 8% for business optimism, compared with a positive balance of 10% a year ago. And almost twice as many businesses reported a fall in revenue than those who saw a rise. The net balance of –20% is the lowest recorded since Q4 2015. Retail and wholesale businesses are relatively optimistic that revenues will grow over the next quarter, but more than two thirds of businesses expect to increase their prices over the next three months in the face of increased cost pressures.

Optimism amongst tourism businesses also dropped into negative territory in the first quarter of 2017. This may well reflect the weakness in consumer spending — revenue from domestic sales was reported to have fallen — alongside drop a in overseas customers compared with a year ago. Forward looking expectations are more encouraging, as a positive balance of firms expect sales revenue and employment to increase over the next quarter, reversing the falls reported in Q1 2017.

Financial and business services firms reported both the highest and biggest improvement in optimism in the first quarter. A net balance of +9% reported an increase in revenues and further growth is expected over the coming quarter. The Scottish Chamber of Commerce suggest the overall improvement in sentiment is because more than a third of oil and gas businesses, important uses of financial and business services, are now more positive about the future.

The manufacturing sector is also reporting rising optimism and this measure is now at its highest level for more than a year. This is likely to reflect the fact that the depreciation of Sterling and stronger global demand should support growth in the short term.

Optimism amongst construction businesses has been weakening and is now at its lowest since Q3 2014. This fall is consistent with GDP data which has shown falling activity through 2016. Whilst Scottish construction companies expect revenue and employment to increase over the next quarter, their expectations are markedly weaker than a year ago.

Scotland


Forecast

Consumer slowdown restricts growth in 2017 …A combination of slowing UK economic growth and weak business and consumer surveys point to another challenging year for the Scottish economy in 2017. Non-oil GDP is forecast to grow by 0.9% this year, and whilst this is a modest upgrade from our December forecast, it represents just half the rate of growth expected for the UK. Scottish growth is expected to slow a little in 2018 to 0.7% before gradually accelerating to around 1.4% by the end of this decade. Throughout this period, the Scottish economy is forecast to grow more slowly than the UK.

Chart 11: Non-oil GDP growth, UK and Scotland

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2020–5

–4–3–2–101234

Scotland UKSource: ITEM

Forecast

(%)

past the past five years and therefore reflects a significant loss of momentum from a key driver of the Scottish economy.

The sharp slowdown in consumer spending will be felt most keenly by Scotland’s retail sector. Growth here is expected to slow to 1.1% in 2017 from 2.4% in 2016, and remaining below 2% over the next five years. Scotland’s hospitality sector will not be immune to weaker consumer spending. But it should benefit from the weaker pound which will encourage both domestic and international tourists to the country, helping to support above average growth in the sector in the short term.

Table 2: The ITEM Club forecast for the Scottish Economy

The ITEM Club forecast for the Scottish Economy, May 2017% change on previous year

Real GDP 2015 2016 2017 2018 2019 2020

Non-oil GDP 2.1 0.4 0.9 0.7 1.1 1.4

Personal disposable income

2.2 –0.1 –0.4 0 0.7 0.7

Consumers' expenditure

1.6 1.3 1 0.2 0.6 0.9

Population (000s)

5,373 5,396 5,411 5,424 5,431 5,440

Employment (000s)

2,736 2,752 2,749 2,735 2,728 2,730

Unemployment rate % (ILO defintion)

5.8 5.2 5.1 5.8 6.2 6.2

Working-age migration (000s)

26.8 19.3 12.6 10.6 4.4 6.1

Source: ITEM

Lacklustre growth in Scotland is underpinned by mounting pressure in the consumer sector. Scottish households are likely to endure a fall in real incomes this year due to rising inflation, weak labour market conditions and the government’s welfare reforms hitting those on low incomes. Alongside weak consumer confidence and with little scope to fund spending through additional borrowing, we expect consumer spending to rise by just 1% in 2017, and by less than 1% per year between 2018 and 2020. This compares to an average annual rate 2.3% over the


Weaker Sterling is also a key factor that is supporting stronger confidence amongst Scotland’s manufacturing companies. This timely boost to the competitiveness of Scottish manufacturers, alongside a pickup in global demand, should mean manufacturing output grows in line with the total economy in 2017. This will be the first time this has been achieved since 2013. Transport equipment and food and drink are forecast to perform best, and all manufacturing subsectors are expected to grow following a difficult 2016. Together, these trends reflect a modest rebalancing in economic activity from consumer spending led domestic demand to manufacturing and exports.

We are less optimistic about the short term prospects for construction. As noted previously, the sector is adjusting from a period of very strong growth in 2013 and 2014 as major projects come to an end. And with Brexit related uncertainty hitting business confidence and therefore spending plans, we see activity remaining flat in 2017 before growing modestly in 2018 and over the medium term.

Private services least exposed to sluggish consumer demand are forecast to be the strongest performing sectors in Scotland this year. Professional and administrative services, which include a broad range of business activities, is forecast to grow by 3% in 2017, twice that achieved last year and close to the UK average. Transport, storage and communications are also expected to grow significantly faster than overall GDP, with the digital and IT elements of this sector likely to show the strongest momentum. Financial services are also expected to make a positive contribution to growth in Scotland this year, albeit to a smaller extent than in 2016.

… leading to a period of falling employmentSluggish economic growth will be accompanied by a sustained period of job losses in Scotland. Overall employment is forecast to fall by 0.1% in 2017, followed by further contractions of 0.5% and 0.3% in 2018 and 2019 respectively. This is equivalent to 24,000 job losses over this three year period and is in contrast to relatively flat employment across the UK as a whole. As a consequence of this, the ILO unemployment rate is expected to increase from 5.2% in 2016 to 6.2% in 2019.

There are likely to be few employment bright spots amongst the sectors over the next few years. Significant job creation is likely to be restricted to Professional and administrative services, which together, are forecast to create around 10,000 additional jobs in Scotland by 2019. More modest growth is likely from information and communications companies, which tend to need fewer additional workers to accommodate output growth, and leisure

businesses which gain from stronger tourism activity. We also expect some uplift in construction employment over the medium term once business investment and economic growth pick up. But in all these sectors, employment growth in Scotland is forecast to fall short of the UK average.

Chart 12: Employment change by sector, Scotland

–15 –10 –5 0 5 10

Public administration and defenceWholesale and retail

ManufacturingEducation

Human health and social workMining and quarrying

Financial and insuranceElectricity, gas, steam and air

Water, sewerage, and waste managementReal estate

Transportation and storageAccommodation and food

Agriculture, forestry and fishingOther service

Information and communicationArts, entertainment and recreation

ConstructionProfessional services

Administrative and support

Change in total employment, 2016–2019 (000s)

Source: ITEM

Furthermore, gains in these sectors will be more than offset by job losses in other sectors. The most significant of these are likely to come from manufacturing, despite the pick-up in output in the sector. This represents a long run trend where the adoption of new technologies and shift towards higher value activities has allowed manufacturers to support rising activity with fewer jobs. We also expect the public sector to continue shedding jobs.

The most significant change in fortunes is for wholesale and retail trade. This sector has been a catalyst for job creation in Scotland in recent years. But the sharp slowdown in consumer spending in our latest forecast sees a reversal in this trend — by 2019 we forecast almost 7,400 fewer jobs in this sector than in 2016.

Weak short term employment prospects and the likelihood of more stringent policy around migration in the longer term are likely to lead to lower, whilst still positive, net migration into Scotland. We estimate the working age net figure will fall from around 19,300 in 2016 to between 6,000–7,000 per year from 2020. This will help to support population growth of around 0.2% per year over the next decade, which will see the number of people living in Scotland rise to 5,503,000 in 2027, an increase of 92,000 compared with current levels.

Forecast


Risks

Political uncertainty prevailsScotland’s economic slowdown has occurred at a time of heightened economic uncertainty, both domestically and globally. Whilst we expect the Scottish economy to grow in 2017, there are a number of downside risks that could derail what is ultimately a modest and fragile outlook.

Political uncertainty continues to dominate the global economic landscape. Since the turn of the year, concerns have heightened over the impact of major shifts in US policy on the global economy. Whilst we have seen an increase in consumer and business confidence in the US, President Trump is facing political challenges in delivering on some of his campaign promises, which makes US policy initiatives and their timing very uncertain. Depending on the outcome, particularly with regard to trade policy, both the upside and downside risk to the global economy could be very significant, either helping or hindering the UK and Scottish economies as they adjust to Brexit.

Back in 2015, China was at the centre of global concerns, with worries that a financial crisis could spill over into the other emerging markets and hit the main engine of world trade. The authorities seem to have a grip on the situation and the commodity markets and emerging market economies have been recovering. But global growth would be negatively impacted should China’s policymakers decide to lower their ambitious growth targets and rein in the expansion of credit. The result would be to delay the anticipated pickup in the pace of global expansion.

Assuming there is no change of UK government in June, domestic risks will continue to be dominated by Brexit for some time to come. Now that Article 50 has been triggered, the phoney war is over and the clock has started on the two-year period of exit negotiations. Our central case is based on the assumption that UK-

EU trade will be conducted under WTO rules come April 2019 as that provides the UK greatest control over immigration. There is an upside risk that a more favourable free trade agreement is agreed after a transitional period, and that would be supportive of growth over the longer term. But there is also downside risk associated with Brexit. As we have noted previously, in the short term the main concern is centred on a more significant retrenchment in consumer and business confidence, leading to a sharper slowdown in domestic demand and pushing Scotland closer to economic stagnation.

The Scottish and rest of UK income tax regimes have begun to diverge. While the difference currently only affects the threshold above which the 40% rate applies, it means there is a band of income from £43,500 to £45,000 on which Scottish workers face a marginal rate of tax on income of 52% when national insurance is taken into account. While the absolute additional burden of taxation is modest for more highly paid workers, it remains to be seen if the signalling effect of the Scottish Government’s willingness to impose a higher rate of income tax will make it more difficult to attract highly skilled labour to Scotland, to the long-term detriment of the economy’s supply potential.

The productivity performance of the Scottish economy since the financial crisis has been disappointing — as it has across the UK generally. Until recently, there had been some tentative signs of improvement and our forecast assumes that this continues. But there is a risk productivity growth regresses again, particularly if Brexit results in less openness and lower inflows of FDI.

Finally, the prospect of a second referendum on Scotland’s constitutional position hangs in the air, adding an additional and potentially corrosive layer of uncertainty for many Scottish businesses.


Economic and demographic indicators for Scotland2016 2017 2018 2019 2020 2021 2023 2025 2027

Population (000s) 5396 5411 5424 5431 5440 5449 5465 5484 5503

(% pa) 0.4 0.3 0.2 0.1 0.2 0.2 0.2 0.2 0.2

Migration1 3.9 2.6 2.2 0.9 1.2 1.2 1.1 1.3 1.4

Employment rate2(%) 58.6 58.5 58.1 57.9 57.8 57.9 58.4 58.4 58.3

Unemployment rate 2.2 2.2 2.5 2.7 2.7 2.6 2.3 2.2 2.3

Personal disp. Income (% pa)

–0.1 –0.4 0.0 0.7 0.7 0.9 1.8 1.6 1.6

Per capita (UK=100) 93.0 93.0 93.1 93.2 93.3 93.3 93.3 93.4 93.4

Consumers’ expend. (% pa)

2.2 1.0 0.2 0.6 0.9 1.0 1.8 1.4 1.5

Per capita (UK=100) 98.6 97.6 97.1 97.2 97.4 97.5 97.5 97.2 97.4

Self-employed (000s)

284 284 281 280 279 279 281 282 282

(% pa) 0.6 0.0 –1.0 –0.6 –0.3 0.0 0.5 0.1 0.1

Employment3

total employment (000s)

2752 2749 2735 2728 2730 2739 2770 2788 2798

(% pa) 0.6 –0.1 –0.5 –0.3 0.1 0.3 0.6 0.2 0.2

Manufacturing (000s)

195 194 192 188 185 182 178 173 168

Location quotient4 93.5 94.0 94.3 94.5 94.7 94.9 95.2 95.5 95.7

Private serv. (000s) 1307 1307 1306 1310 1316 1324 1345 1360 1372

Location quotient 90.6 90.5 90.6 90.7 90.8 90.9 91.0 91.1 91.2

Government serv. (000s)

793 788 779 771 770 773 781 785 786

Location quotient 113.8 113.8 113.7 113.5 113.4 113.3 113.1 113.0 112.9

Notes: 1 Per 1000 of the population of working-age.2 Residence employment as a percentage of the working-age population.3 Employees plus self-employed, Government Supported Trainees and HMF Forces4 Sector’s share of total regional employment divided by sector’s share in total UK

Source: ITEM

Forecast tables


Sectoral outlook in Scotland: GVA2016 2017 2018 2019 2020 2021 2023 2025 2027

Agriculture, forestry and fishing

0.9 0.3 0.0 0.2 0.4 0.7 0.8 0.5 0.5

Mining and quarrying –0.3 –0.7 0.4 0.5 0.6 0.4 0.8 0.3 0.1

Manufacturing –6.3 0.9 0.1 0.5 1.0 1.1 1.6 1.0 0.9

Food, beverages and tobacco

–0.2 1.6 0.8 1.3 1.7 1.8 2.3 1.7 1.6

Textiles, clothing and leather products

–3.7 0.6 –0.3 0.2 0.7 0.8 1.2 0.7 0.6

Refined petroleum, chemical and pharmaceutical products

–8.3 0.5 –0.3 0.2 0.6 0.7 1.2 0.6 0.5

Metals, metal products and machinery n.e.c.

–12.7 0.5 –0.2 0.3 0.7 0.8 1.3 0.7 0.6

Other manufacturing industries including repair

–9.0 0.7 0.0 0.4 0.9 1.0 1.4 0.9 0.8

Electrical and instrument engineering

–3.7 0.3 –0.5 0.0 0.4 0.5 1.0 0.4 0.3

Transport equipment –5.4 1.7 0.4 0.5 0.9 1.3 1.7 1.2 1.1

Electricity and gas supply –6.4 1.1 1.4 1.6 1.5 1.4 2.0 1.7 1.6

Water supply and waste management

7.0 1.6 0.7 0.9 1.3 1.5 2.1 1.6 1.5

Construction –3.3 0.0 0.7 1.5 2.2 1.9 1.9 1.3 1.2

Retail and wholesale 2.4 1.1 1.2 1.4 1.6 1.4 2.1 1.7 1.6

Transport, storage and communication

–0.3 2.3 1.3 1.7 2.2 2.3 2.5 2.0 1.9

Accommodation and food services

1.5 2.7 1.0 1.5 2.0 2.0 2.2 1.8 1.7

Financial and insurance 9.4 0.9 0.9 1.1 1.0 1.0 2.3 2.0 1.9

Real estate 1.6 0.3 1.1 1.7 1.6 1.7 2.3 2.0 1.9

Professional and administrative services

1.6 3.0 2.1 2.6 3.0 3.1 3.5 2.8 2.7

Public administration and defence

–0.5 –1.8 –1.5 –1.3 –0.8 –0.6 0.0 –0.3 –0.4

Education 0.0 0.1 0.1 0.0 0.1 0.1 0.2 0.0 0.3

Human health and social work

0.9 0.9 0.5 0.5 1.1 1.4 2.1 1.8 1.8

Other service activities 2.1 0.5 0.1 0.3 0.9 1.4 1.5 1.1 1.0

Total GVA 0.4 0.9 0.7 1.1 1.4 1.5 2.0 1.5 1.5

Source: ITEM

Forecast tables


Sectoral outlook in Scotland: total employment2016 2017 2018 2019 2020 2021 2023 2025 2027

Agriculture, forestry and fishing

60 62 61 61 60 60 60 59 58

Mining and quarrying 32 31 30 29 28 27 26 24 23

Manufacturing 195 194 192 188 185 182 178 173 168

Food, beverages and tobacco

46 47 46 46 45 45 44 44 43

Textiles, clothing and leather products

13 13 13 13 12 12 12 11 11

Refined petroleum, chemical and pharmaceutical products

11 11 11 10 10 10 10 9 9

Metals and metal products 23 22 22 21 21 21 20 19 19

Other manufacturing industries including repair

58 58 57 56 55 54 52 51 49

Mechanical engineering 16 16 15 15 15 14 14 14 13

Electrical and instrument engineering

15 15 15 14 14 14 13 13 12

Transport equipment 13 13 13 13 13 12 12 12 12

Electricity and gas supply 21 21 20 20 20 19 19 18 18

Water supply and waste management

19 19 19 19 19 18 18 18 18

Construction 177 176 177 178 180 182 187 192 196

Retail and wholesale 388 384 382 381 382 384 388 390 391

Transport, storage and communication

188 188 189 189 189 189 191 192 193

Accommodation and food services

199 199 199 199 199 200 203 205 207

Financial and insurance 85 85 84 84 83 83 83 83 82

Real estate and business services

446 450 452 457 462 467 479 490 499

Public administration and defence

161 157 152 148 147 146 146 145 143

Education 202 201 199 197 197 197 199 199 199

Human health and social work

430 430 428 426 427 430 437 441 443

Other service activities 149 150 150 151 152 153 156 159 161

Total employment 2752 2749 2735 2728 2730 2739 2770 2788 2798

Source: ITEM

Forecast tables

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Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive nor sufficient for making decisions, nor should it be used in place of professional advice. Ernst & Young LLP accepts no responsibility for any loss arising from any action taken or not taken by anyone using this material.

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All views expressed in the EY Scottish ITEM Club summer update 2017 forecast are those of ITEM Club Limited and may or may not be those of Ernst & Young LLP. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive or sufficient for making decisions, nor should it be used in place of professional advice. Neither the ITEM Club Limited, Ernst & Young LLP nor the Ernst & Young ITEM Club accepts any responsibility for any loss arising from any action taken or not taken by anyone using this material. If you wish to discuss any aspect of the content of this newsletter, please talk to your usual Ernst & Young contact.

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