Key inflationary and deflationary pressures
The latest independently produced raw input cost inflation metrics from the BCIS, show inputs of materials and plant have been biggest drivers of inflation in 2022.
Higher fuel and energy costs led to the BCIS’ Plant Cost Index rising by nearly 32% in 2022 while supply pressures and rising manufacturing costs saw the BCIS’ Material Cost Index rise by 12% overall in the period. However, with materials accounting for c.57% on a typical commercial office project, this has been the real driver of 2022 construction cost inflation in weighted terms.
At an estimated 4.8% for the year, the labour inflation index has lagged both the BCIS’ materials and plant inflationary indices but is forecast to see a significant step change in the second half of 2023 as earnings growth attempts to partly catch up with broader inflationary trends and higher costs of living. Construction’s skill shortage issues and tight labour market will likely mean less downward pressures on wages in 2023 compared to previous economic downturns.
Construction cost inflation for the first half of 2023 is in stark contrast to that of 2022. The BCIS Materials Cost index is set to continue its downward trend that started in mid-2022, dropping a further 2.2% in six months to June 2023 (on top of a 2.1% fall in the second half of 2022). This compares to a 14.2% increase to the materials index in the first six months of 2022. Meanwhile, BCIS’ Labour Cost Index is forecast to increase by just 0.3% in the six months to June 2023 (compared to a 1.4% increase over the same period in 2022).
As we likely enter recession, some key sources of construction cost inflation are set to ease or fall back in the coming months. Based on our observations of the market in tender returns, survey feedback and our extensive discussions with the supply chain, we have established that a number of inflationary and deflationary pressures are likely to impact tender pricing this year. Several factors from our previous TPI report continue to impact tender pricing, but economic headwinds and anticipated reductions in workload may act to partly offset these prevailing inflationary pressures.
Key to our lower inflationary expectations for 2023 is peaking materials prices. Since the summer, several key materials (such as structural steel and rebar) have fallen in price while other items (such as insulating materials) have risen due to high demand.
While the BEIS All-Work Index (a basket of goods that tracks price movements for construction materials) shows material prices in October 2022 were 14.7% higher than they were one year ago (and 44% higher than they were pre-pandemic), materials prices appear to have turned a corner. August and October saw two monthly contractions to the Index – the first time prices have contracted in over two years. The recent easing in general material price inflation reflects a stabilization of energy and commodity price inflation.
The risk of a global recession has had a part to play in easing demand (and hence, price) for many construction materials, but with manufacturers of several key materials such as bricks and plasterboard set to increase prices again in January, we’re unlikely to see an unbroken downward trend when it comes to materials costs.
Wholesale energy prices will remain a significant upside risk in 2023 for materials manufacturing costs. Recent falls in gas and oil prices are reassuring but prices remain historically elevated and the underlying/fundamental causes of these higher fuel and energy remain stubbornly in place. According to the Dutch TTF (a Europe-wide natural gas price benchmark), European natural gas prices fell back to pre-Ukraine war levels of €70/MWh in mid-January 2023. Milder European temperatures this winter reduced consumption, while record LNG imports, a rise in renewable capacity and high gas storage levels across Europe all helped bring wholesale energy prices down from their 2022 peaks. Regardless, the energy market will remain volatile through 2023 and beyond – especially now that gas demand from China and other Asian countries could increase competition in the LNG market.
Additionally, there is a risk that prices paid for gas and electricity will rise once the UK Government’s energy support packages end on 31st March. Support from April is likely to be less generous so energy prices for businesses in the short-medium term will rise, even if wholesale energy prices continue to fall. The lag effect from energy hedging will also feed into to elevated energy prices, with lower wholesale prices not passed on to consumers/end-users immediately.
Lower Brent crude oil prices also bode well for plant and machinery operational costs. At less than $80/bbl, oil prices in early January 2023 were on par with January 2022 levels. Prices have been slashed due to concerns over the impact a global economic slowdown will have on short-term crude demand. However, the recent UK/EU ban on Russian oil (which will add to demand), China’s COVID policy change and chronic underinvestment in upstream capacity mean the outlook for oil is bullish and prices may once again increase.
So, with energy-led materials price increases confirmed for January, prices for a number of key construction items will invariably increase. Fortunately, several materials that saw rapid price increases have subsided resulting in a net stabilisation of prices overall. While natural resources from Ukraine and Russia (eg neon, copper, aluminium, nickel, platinum etc) will remain in short supply and maintain higher pricing levels and longer lead times, most material resources have become more available as supply chain issues have eased and global demand subsided. Falling raw commodity prices have helped apply downward pressure on materials-related input costs of late, with basket of goods indices such as the ‘S&P GCSI’ showing broad downward trends since June of last year.
Amid a clouded global backdrop of slowing economic growth and monetary policy tightening by central banks worldwide, physical as well as speculative demand for commodities began to decline in the second half of 2022. Supply chain issues also began to ease significantly, alleviating stock shortages, while the cost of shipping freight (which exploded in 2021) is now roughly one-tenth of the levels reached in August 2021. These big declines in commodity prices began to feed through to the price of finished construction material prices, as evidenced by the BCIS’ price indices of key construction materials.
BEIS data shows that in October 2022 (the latest figures available at the time of writing), fabricated structural steel prices were just 6.1% higher than they were one year ago. Rebar prices have been more stubborn and are still 21% higher on an annual basis but a handful of materials cost less in October that they did one year ago (eg imported timber which dropped nearly 20% year-on-year).
Interestingly, both aggregates and insulating materials have outstripped until what were recently the most inflated materials in 2022 – structural steel and rebar. Insulating materials were more than 51% higher in October 2022 than they were one year ago, while some aggregates were nearly 57% higher. Both materials have been affected by a combination of ongoing shortages, strong demand and higher energy costs. These have forced manufacturers to add significant surcharges and make multiple unscheduled price increases.
The elevated costs of fuel and energy will continue to impact manufacturers in 2023 due to the lag effects noted previously. Builders merchant chain Jewson warned that the price of bricks and drainage pipes would rise 20% in January 2022 while block paving will increase by up to 19.5%. Aerated blocks, plaster and roofing materials are all increasing by up to 18%, and plasterboard and specialist board by up to 17% in January. There are also double-digit price prices for aggregates, PIR insulation and for heating and plumbing materials. Evidently, material price inflation is not yet over. Volatile energy price movements will continue to play a significant role in terms of input cost inflation in 2023, but the situation has improved significantly compared to 2022. Falling commodity prices are playing a part, applying some much-needed downward pressure on construction costs, but higher prices are likely here to stay for at least the short to medium-term.
The construction labour market remains tight. Structural supply issues with skilled labour and cost-of-living pressures helped push average weekly earnings (AWE) across the industry up by 6.1% (on a year-on-year, three-month average basis) in October 2022. It’s difficult to see the construction employment market being anything other than constrained in the near term. As such, pressure on wages will remain until either the pool of skilled labour expands or falling construction output starts to reduce workloads and demand for workers.
AWE growth in UK construction (again, on a year-on-year, three-month average basis) is typically 3% according to the ONS, but the construction sector is not alone in seeing such high levels of wage growth. The average weekly earnings figure for the economy as a whole (at 6%) is also nearly double the typical annual growth rate. Despite this doubling of typically annual wage growth, labour was the least inflated construction input cost in 2022.
However, many forecasters anticipate that labour will take over as the biggest driver of tender price inflation in 2023, pushing up installation costs on site and adding upward pressure to preliminaries. The UK unemployment rate recently reached its lowest level since the mid-1970s and many firms continue to struggle with recruitment difficulties. Difficulties in recruiting continue to support underlying wage growth. In fact, vacancy rates in construction reached an historical high of c.50,000 in the Aug-Oct period last year given the strong levels of demand for labour. However, high vacancy rates have also been associated with high hiring rates – with the labour market exhibiting significant ‘churn’ as many workers decided to move jobs in 2022. This may partly be a reflection of the inflexibility to move from one job to another during parts of the pandemic when many were initially furloughed.
Another key factor behind the current tightness in the labour market is a fall in participation rates among the working age population. The reasons behind the decline are varied but the Bank of England suggests that the impact of the pandemic on early retirement and long-term health, as well as underlying demographic developments, all seem to have played a role in reducing participating rates of those in the 50-65 age group. These rising levels of inactivity among the working age population contributed to an adverse labour supply shock and have played a role in preventing total construction employment numbers from returning to pre-pandemic levels. Following the winding down of the furlough scheme, policy makers expected that releasing furloughed workers back into the labour market would ease some of the recent tightness, however this did not materialise owing to the adverse developments in participation rates.
Brexit has undoubtedly been another factor that has weighed on labour supply. Although aggregate levels of immigration into the UK remain elevated (1.1 million in the year ended June 2022 – up 435,000 compared to YE June 2021), the loss of flexibility associated with the end to free movement of EU workers into the UK has not helped address labour market mismatches and is now more costly for employers. However, with the economy now slowing, ongoing resource pressures may partly be offset as current projects reach completion and demand for new construction projects recedes, releasing labour back into the market.
Indeed, a number of labour market indicators are starting to turn. Vacancies appear to have stabilised, according to the latest ONS data. In fact, in December’s UK Construction PMI survey purchasing managers noted that pessimistic expectations over the near-term economic outlook and construction activity in the year ahead were reflected in the first round of job shedding since January 2021. The PMI employment index fell below the no-change level (indicating a contraction in staffing levels at construction firms), ending a 22-month sequence of jobs growth. Further anecdotal evidence suggests some firms were also not replacing leavers due to weaker levels of new work.
Furthermore, several economic forecasters (including the OBR and the Bank of England’s Monetary Policy Committee) suggest unemployment rates have likely bottomed out and will start to rise as the economic downturn impacts trade and investment. Should economic slack emerge and unemployment rises as expected, this will weigh on domestic inflationary pressure and ease the threat of inflation persistence and the prospect of wage-price spirals. While these emerging pressures haven’t had much impact on wage inflation yet, they are likely to place increasing constraint on potential earnings growth.
For now, though, the current scarcity of available staff and labour resource across several trades (eg plumbers, joiners, painters and bricklayers) and dampened candidate availability due to increased caution in seeking new roles in the current economic climate continues to drive construction labour costs higher.