Macro Economics

Contracting by 2.2% in Q1 2020 – the joint largest fall since 1979 – the UK economy took a severe hit to output in a period that contained just nine lockdown days. The data, however, was just a prelude with worse to come as economists are braced for a dire set of second quarter figures.

Following a further 6.9% fall in March, GDP fell by 20.4% in April. The monthly contraction in April was the largest drop in a single month since records began – three times greater than the decline seen during the whole of the 2008/2009 economic downturn. Even with growth of 1.8% in May the economy is now 24.5% smaller than in February. The impacts of coronavirus (COVID-19) were seen right across the economy but it was construction that saw the largest fall with output contracting by 18.2% in the period.

After falling to an all-time low of 8.2 in April, the pace of contraction of the UK construction PMI softened in May as business activity picked up and construction sites re-opened. With site activity pausing, reduced client spending and furloughed staff across the supply chain, companies saw their capacity leak away and the construction sector facing a challenging environment. Whilst June’s construction PMI figure of 55.3 indicated a return to growth, the increase in activity comes from a low level in the preceding month and does not indicate a recovery to normal levels of construction output.

Although respondents were cautiously optimistic about their near-term prospects, construction firms continued to face challenges in securing new work against an unfavourable economic backdrop and a lost period for tender opportunities.

Consumer price inflation (CPI) dropped to a near four-year low of 0.5% in May as inflationary pressures continued to abate during the lockdown.

Weak domestic price pressures as a result of the restrictions placed on the economy since the end of March have impacted inflation, prompting Samuel Tombs, the chief UK economist at consultancy Pantheon Economics, to say that headline inflation would fall even closer to zero in the coming months.

The Bank of England (BoE) has responded to the weakness of price pressure by increasing its bond-buying quantitative easing scheme. A £100bn of additional QE has been added to a total of £745bn as the bank seeks to underpin the nascent recovery. However, any speculation that the BoE was close to announcing negative interest rates was quashed by its monetary policy committee in June as interest rates were kept at 0.1%. Andy Haldane, the BoE’s chief economist, has since said that the UK economy is recovering faster from the lockdown than the central bank had expected, casting doubt on the need for further stimulus. He said although an unemployment spiral remains a threat the recovery is “so far, so V [shaped]”, noting that real-time data suggests the cumulative loss of annual GDP as a result of the pandemic will be 8%, rather than the 17% in the scenario modelled by the bank in May.

UK average weekly earnings declined at an annual pace of 1% in April 2020, but this paled in significance when compared to the 11% decline in average weekly earnings in the construction sector over the same period. ONS data shows that construction weekly earnings in April was £577 compared to £648 for the same month in 2019 - the biggest annual fall seen by any sector in Britain. April’s data captures the first full month when businesses placed workers on furlough under the coronavirus jobs retention scheme. Sectors where furloughing was more widely used inevitably saw larger falls in earnings, the construction industry has been the second largest user of the scheme.

Although the UK unemployment rate (3.9%) was better than expected in the three months to April, economists fear bigger rises are on their way as the Government winds down its job retention scheme and other poor labour market indicators feed through to the actual unemployment figures.

The summer statement announced several new measures to save jobs, with a job retention bonus and temporary cuts in VAT for the hospitality sector. Construction is likely to benefit from the Talent Retention Scheme to help redeploy displaced workers and also a £3bn boost to ‘green construction jobs’ (£2bn in grants for homeowners carrying out energy-efficient refits, £1bn to decarbonise public buildings such as schools and hospitals). A temporary rise to the Stamp Duty threshold has been implemented immediately which will help kick-start the housing market.

CONSTRUCTION OUTPUT

The most recent UK construction output data published by the ONS revealed a 40% (£5.1bn) drop in the value of ‘All Work’ output in April compared to the previous month. April’s output value was also 44% lower than the same month in 2019.

All sectors experienced a substantial month-on-month drop in output but new housing appeared to be the worst affected, falling by more than 60%. The least affected sector was public non-housing (-14%) primarily due to work on hospitals and schools. Infrastructure (-20%) was also less affected as social distancing is easier to maintain on large sites.

Whilst April’s poor output figures point to a potentially tough recovery period for the sector, they may also represent the nadir given that they cover a full month of lockdown. According to Build UK, by mid-May 86% of infrastructure and construction sites in England and Wales had re-opened and output on site had risen to 75% of pre-COVID levels. Despite the fact that the vast majority of construction firms have now resumed work, many will experience reduced order pipelines over the next few months. With reduced workloads firms are more likely to experience lower revenue and greater cashflow pressures, creating market conditions for competitive bidding.

Currently, with a reduced number of workers on-site, productivity levels are averaging around 80% of pre-COVID levels. Recent changes in regulations that have allowed for extended site opening hours and staggered working patterns have certainly helped to improve productivity levels, but site output will continue to remain subdued for so long as there are fewer people on site, social distancing requirements remain, and supply chain disruption persists.

The Construction Products Association (CPA) forecasts that UK construction output will fall by 25% during 2020. The 25% decline is the CPA’s most optimistic of three scenarios modelled and is based on a ‘V-shaped’ or ‘tick-shaped’ recession with a slow economic recovery from June. The CPA said that although the worst effects on activity were in late March, April and May, activity in each month in the second half of 2020 is likely to be lower than in the same month one year ago. It’s anticipated that the least affected sectors will be non-housing R&M (-4.7%), public non-housing (-6%) and infrastructure (-9%). Construction output is then anticipated to rise later in 2021 under its main scenario.

NEW ORDERS

Construction new order data in Q1 was largely positive, with the ‘All New Work’ value increasing by 11.8% compared to the previous quarter. The infrastructure sector performed particularly well, growing by nearly 78% in the quarter. At the other end of the spectrum private industrial new orders fell by over 40% quarter-on-quarter.

Strong new order growth came off the back of greater political certainty provided by the decisive UK general election result in December 2019, and provides a silver lining to the slew of more recent negative COVID-19 related data. Stronger new orders in Q1 will have helped strengthen contractors pipeline, acting as a buffer for cancelled projects as a result of the pandemic. However, new order values are likely to fall significantly in Q2 and Q3 2020 with firms anticipating a reduced pipeline of work in the short-term as developers/investors defer projects.

IHS Markit/CIPS construction PMI readings in March, April and May pointed to a rapid drop in new orders received by UK construction companies as a result of the pandemic. Survey respondents commented on a sharp decline in demand for new construction projects, with the pace of decline exceeding the equivalent measures seen in the manufacturing and service sectors. However, June’s construction PMI report recorded a return to growth, with the reopening of sites helping to alleviate the scale of the downturn in order books. New orders showed signs of stabilising in June with new work from infrastructure projects acting as a key source of growth. Flat new order levels reflect ongoing hesitancy among clients and also longer lead-times to secure new contracts.

Fewer new orders will be a key driver of tender prices the coming months. Competition for new opportunities is likely to increase as the primary focus for contractors will be to win work in order to maintain pipeline.

MARKET CONDITIONS

An atypical downturn cannot be expected to follow a typical recovery. There is a broad range of upside and downside risks and it is far from clear how prevalent these risks will be and how significantly they will affect pricing. Regardless, the pandemic is likely to create a new dynamic with firms bidding for a fewer number of projects in a more competitive market.

Initially, the focus will be on getting sites fully functional, ramping up productivity and ensuring that pipeline projects can maintain cashflow. As firms move out of ‘survival mode’ the focus will shift to winning work and increasing market share in a tighter tendering environment. With fewer new projects coming forwards contractors may be forced to start discounting in order to secure future pipeline work.

G&T’s experience has been that although enquiry levels have been better than initially expected, a number of projects have paused, holding back investment whilst undertaking diligence of viability in light of a changing market demand. Clients whose current assets aren’t currently performing as they’d like are experiencing liquidity issues and will inevitably be more focused on shoring up their balance sheets rather than commissioning new capital projects. Equally, new projects may struggle to get commissioned if clients feel that social distancing will increase project delivery times and costs. The Government will play a crucial role in supporting the recovery and stimulating growth. So far, the Government has brought forward £5bn of planned spending to accelerate key projects in the UK’s long-term infrastructure pipeline under Boris Johnson’s ‘new deal’.

Some opportunistic clients will use the pandemic to drive costs down or perhaps bring projects forward in anticipation of tendering becoming more competitive. Whilst lower productivity levels and additional preliminary items will apply upwards pressure on tender pricing, contractors’ concerns about securing turnover may more than balance out these additional costs, resulting in a net reduction in tender prices.

To manage the effects of the lockdown, main contractors have had to conduct consolidation exercises. The supply chain is currently having to resize to cater for anticipated lower levels of demand for projects and schemes. Builders’ merchants and suppliers have been operating at reduced capacities since March in attempt to match demand for materials. Whilst there has been a significant recovery in trading volumes in recent weeks, it is evident that the UK is facing an economic recession and this will have a corresponding impact on demand for materials in 2020 and 2021. This has prompted action from the likes of Travis Perkins to close 165 of its stores with its chief executive Nick Roberts stating, “While we have experienced improving trends more recently, we do not expect a return to pre-COVID trading conditions for some time.”