Russia's invasion of Ukraine has dramatically altered the outlook for the global economy. After glimmers of hope that the worst of the supply chain disruptions were easing and that the world was moving towards the final phases of the global pandemic and some longed-for normality, we face another broad-based supply shock that will mean inflation remaining higher for a longer period than previously expected.
The conflict and the ensuing roll-out of sanctions and retaliatory measures have ushered in a new era of economic difficulties and inflation. The swings in commodity prices have been dramatic and the record rises in fuel and energy prices alarming. War brings significant volatility, and this is set to be a feature of economic outlook for the foreseeable future.
So far, the greatest impact to UK construction has come from higher oil and gas prices. High energy costs are feeding through to the production of energy-intensive construction products and materials, and we have already seen several surcharges and price increase notifications as a result. Although down from their recent peaks, energy prices have yet to settle and are in a state of flux. Many producers use forward energy contracts/price hedging so there is typically a lag between wholesale energy cost rises and the impact on the cost of manufacturing products and materials, so even if the situation improves and prices fall in the short-term, the input cost of manufacturing these energy-intensive products and factory gate prices may not.
Construction has returned to normal levels of activity and output growth, and while the latest wave of inflation may slow this growth, the industry is now better equipped to deal with these supply chain disruptions and price increases. It may be that we have already seen the worst of material price inflation for 2022 and labour costs will be the real driver of further inflation from Q2 2022 onwards, but material prices are expected to remain elevated throughout the rest of the year. Strong inflation will prompt project viability assessments and may lead to some schemes temporarily being put on ice until market conditions settle. However, with correct planning, management and scrutiny of commercial contract provisions, as well as diversifying the markets in which some key materials are procured from, some of the price risk can be mitigated.
Higher prices are being passed on by contractors and their supply chains and so we are forecasting higher tender price inflation. Construction is not alone in having to do this. The headline-grabbing annual UK consumer price inflation hit a 30-year high of 7% in March, indicating that price rises are wide-ranging and businesses are passing on rising costs. These headwinds will likely be with us throughout 2022 and potentially beyond. High inflation has started to impact consumer confidence and if these macro conditions persist, we may have to brace ourselves for a stagflation-like episode for the UK economy.
In light of these additional cost drivers, G&T has upwardly revised its latest set of TPI forecasts compared to our previous quarter. We now expect tender prices to rise on average by 5% across the UK in 2022, followed by 3.5% in 2023. Thereafter, annual inflation should fall back towards long-term average of around 2.5% in 2024 and then 2.25% in 2025. Inflation in London is expected to be 50 basis points higher for 2022 and 2023 due to the expectation of greater labour price inflation.
Because of the level of uncertainty, we have updated our TPI fan chart that was first published in our report on the impact of the Russia-Ukraine conflict on construction. This shows the potential range of inflationary scenarios depending on how the conflict (and subsequent macro-economic conditions) might develop and evolve.
All forecasts in this report take account of all sectors and project sizes as a statistical average, indicating an overall trend in pricing levels. It should be remembered that individual projects may experience tender pricing above or below the published average rate, reflecting the project specific components and conditions.
Russia’s invasion of Ukraine has created a domino effect by amplifying global inflationary forces. Layering the impact of the war in Ukraine on top of everything else (namely the pandemic and Brexit) could prove to be quite damaging to the UK economy.
The Bank of England (BoE) faces a dilemma in trying to cool inflation. Raising interest rates too hard and too fast could result in stagflation (ie a drop in output alongside a prolonged period of inflation) or even an economic contraction in 2Q 2022. Consumer prices have surged (with annual CPI hitting 7% in March) while economic growth has slowed to a crawl (0.1% in February, month-on-month) and this is putting pressure on consumers and businesses. Higher fuel and energy costs have increased input prices and production costs for businesses and produced waning demand for many goods and services. Due to these pressures, the BoE has said that a double-digit inflation rate is not off the cards in the second half of the year
Inflation is a long way north of the Government’s official 2% target, but the speed of inflation has caught many by surprise. Just a year ago, the annual inflation rate was just 0.7% and the increase in magnitude in the following 12 months is unprecedented. These inflationary pressures are also broad-based, affecting all sectors and countries, not just the UK and the construction industry. Inflation is unlikely to cool significantly anytime soon either. The IMF forecasts core inflation will average 7.4% this year – slightly less than the US but higher than the euro zone – and then 5.3% in 2023.
Consumption is expected to be weaker as inflation erodes real disposable income and tighter financial conditions are expected to cool investment. The net effect is that GDP will likely fall, with the IMF almost halving its growth forecast from 2.3% to 1.2% in 2023 – lower than for any other major advanced economy in the G7. The reason why the UK is being more affected is that the BoE and UK Government face balancing a starker trade-off between flagging growth and soaring prices than its peers. It is also an open economy so is highly exposed to global energy market prices.
Although the UK economy is now 1.5% bigger than its pre-pandemic level (in February 2020), these figures predate Russia’s invasion of Ukraine. Resultant increases in raw material and commodity prices, and higher energy costs, will be met by a petering out of consumer spending and output growth. Given the weak near-term outlook for GDP growth, some economists expect the BoE might stop raising interest rates after increasing it to 1% in May, as is currently forecast.
In tandem with the above, the UK workforce is experiencing what is known as an adverse supply shock – a shrinking, economically active workforce. Just as with oil and gas, a lower supply should lead to higher costs. However, wage growth (at 5.4%) is lagging the rise in consumer prices and the overall picture is that the labour market is not yet so tight as to push up real wages (ie wages adjusted for inflation). One reason for this is that while labour supply is lower than it was before the pandemic, so too is demand. The OBR forecasts that inflation will fall sharply next year, as the current high prices become the baseline for future calculations, but this outcome largely depends on its belief that nominal wage growth will lag well behind inflation. With such a strong labour market and low unemployment levels, this is a big assumption.
ONS data shows UK construction output decreasing by 0.1% in February 2022 compared to the previous month – the first month-on-month fall since October 2021. Anecdotal evidence suggests storms Eunice, Dudley and Franklin in February had an impact as more working days were lost on sites than normal for this time of year. Energy prices, disruption due to the Ukraine crisis and rising inflation were also underlying factors, triggering nervousness from investors and construction suppliers.
Despite the drop, output remained nearly 4% above the five-year monthly average and 1.1% above the February 2020 pre-coronavirus level. However, repair and maintenance output (+13.7%) has outperformed new work (+2.4%) over the last two years. Some have suggested that February’s output data was a wobble rather than a worry, coming after a particularly strong performance in January, but the figure was just a snapshot of growth on the eve of war. However, it served as a reminder that continued positive momentum of output growth is not inevitable. The sector is highly reliant on global supply chains for materials and sanctions on Russia is disrupting key materials. The issues with sourcing materials will weigh on output growth, even if demand remains strong.
New orders grew by 9.2% in Q4 2021 compared to Q3 with all sectors recovering above their pre-COVID levels. The private industrial sector was the stand-out performer over the past year with new orders increasing by 62% (or £751m). Commercial new orders have also recovered strongly (+58%).
More recent data from recent S&P Global/CIPS UK Construction PMI surveys indicate that trend of positive new order growth will continue into Q1 2022. March’s PMI survey showed a sustained rise in new work – the fastest increase for seven months, in fact. The New Orders Index accelerated for the fifth consecutive month, hitting 58.9 in March 2022.
Construction firms cited improving tender opportunities and resilient customer demand, despite some reports that economic uncertainty and rising costs are limiting new business growth. However, the survey did pick up a drop in optimism in light of the war in Ukraine, dropping to its weakest since October 2020. There were concerns that clients will cut back spending in response to rising prices and the heightened economic uncertainty. The ongoing skills shortage and a lack of builders could also act as a roadblock to future new order growth.
Although new order growth has been positive and there is a strong pipeline of planning approvals and main contract awards, data from Glenigan shows that actual construction project starts continued their year-long downward trend in Q1 2022. The value of work starting on site in Q1 2022 fell 7% against the preceding quarter to stand 22% lower than Q1 2021. This has been driven by persistent material price inflation, and with recent events in Ukraine only exacerbating inflationary factors, this is likely to delay a recovery in project-starts. Starts on site have not fallen across all sectors though. Construction-starts in both the office and industrial sectors performed strongly in Q1 2022 but starts in most other sectors fell compared to the previous quarter.
Despite some difficulty converting new orders into new starts on site, contractors remain upbeat about their relatively strong pipelines and the current level of tendering activity. While mindful of the ongoing effects of Russia’s invasion in Ukraine (ie input cost inflation and disruption to raw material supplies), these are generally being managed well by contractors. Alternative avenues for materials supply are starting to emerge and a number of Main Contractors have suggested that most material inflation for the year has already happened and that the upward inflation curve will start to soften. Accordingly, new starts on site should pick up in the second half of 2022 and against this backdrop we have increased our tender price forecasts.