We are now four months into the Russia/Ukraine conflict and the world has a far better understanding of the disruptive impacts and costs that have stemmed from the war.
Global supply chains have become far more resilient and proficient at adapting to supply chain disruptions in recent years, but models are not equipped for continued uncertainty. There are still unknowns regarding the length and severity of disruptions and reinventing supply chains to accommodate for this is no easy task. Historically, Europe has been dependent on a number of Ukrainian and Russian-made materials and products and so the disruptive impact of the conflict has forced companies to seek alternative sources of supply. Trade sanctions and embargos applied against Russia has resulted in a global loss of supply for several key commodities, putting a strain on production capacity elsewhere and resulting in additional costs.
Elevated inflation across the globe has impacted every sector and UK construction is no exception. The post-pandemic rebound that was building prior to the conflict has come to a halt following broad-based inflationary pressures and the risk of stagflation or recession. Elevated costs are a threat to the forward pipeline but for the time being, the UK construction sector has strong positive momentum that has carried over into this year from 2021. Construction activity is still in growth territory, but some early indicators suggest a loss of confidence in recent months as pressure on input costs build.
Independent growth forecasts across the western world have been cut due to the anticipated effects of inflation on demand. A combination of factors, including higher interest rates, higher taxes, reduced trade and more expensive energy, have hit the UK. Many of these factors are a result of global pressures which are difficult to fully insulate against, but as we explore in this report, domestic or home-grown pressures have also been building, becoming more embedded in pricing decisions.
There is still a steady stream of tendering opportunities coming through as post-COVID projects obtain planning permission, but a slight drop-off in tendering activity is being reported by the supply chain. This could create gaps in contractors’ workloads and order books further down the line, but for now, with positive growth dynamics from unleashed pent-up, post-pandemic demand, one of the key challenges is to keep projects on track in terms of lead times and cost. With high inflation, contractors are finding it increasingly difficult to agree terms and are understandably nervous about committing to long-term fixed prices. Input costs are unlikely to fall significantly in the immediate future, therefore the affordability and viability of projects are being closely appraised by clients which is leading to some delays on contractor appointment and project starts.
So, what does this mean for our tender price inflation forecasts? For now, our forecasts remain largely unchanged from our previous (Q2 2022) TPI report with our UK weighted average staying at 5% for 2022. We acknowledge that there are a number of risk factors that could push construction costs and tender price inflation even higher, for now these are largely potential risks and have to be considered against the deteriorating macroeconomic conditions and any negative impact these might have on demand for construction. Because inflation has a project, region and sector-specific element which a single index cannot account for, a number of projects will experience inflationary uplifts greater than our weighted UK average forecast of 5% this year.
We envision that some inflationary pressures will start to ease back in the second quarter of 2023, but this is partly contingent on any further escalation of the Russia-Ukraine conflict and whether Russia continues to squeeze or shut off pipeline gas supply to Europe. Once the rate of inflation plateaus, we do not expect a large correction or reduction in construction costs. External factors and pressures acting on material prices may ease but we anticipate production costs will remain elevated and supply constrained for several key construction materials. The current labour market dynamics, with widespread shortages of skilled labour supply and near-record vacancy levels, will ensure upward pressures on labour rates for some time to come unless cooled by a significant drop off in demand.
A hard landing scenario would likely dent confidence and development would consequently slow, but this in turn could increase tendering competition as contractors become more competitive with preliminaries costs and overheads and profits. In short, while the immediate trend for inflation is up it is increasingly difficult to predict into 2023 and beyond. A levelling off in tender price inflation is on the horizon, but to what extent inflationary forces subside has become a progressively more difficult question to answer due to the uncertain economic outlook and a range of underlying risk factors.
Because of the level of uncertainty, we continue to use our TPI fan chart that was first published in our report on the impact of the Russia-Ukraine conflict on construction. This chart shows the potential range of inflationary increases to tender pricing depending on how the conflict (and subsequent macro-economic conditions) might develop and evolve from this point.
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.
After contractions in both March and April, UK economic activity returned to growth in May. To the surprise of economists GDP output grew by 0.5% between April and May. A flat performance had been expected as surging prices hit household spending and business activity, but all main sectors of the economy grew, likely due to the recovery in supply chain disruptions enabling manufacturers to fulfil a backlog of orders, as well as greater spending on travel. Consumer-facing services performed less well, with the cost-of-living crisis taking a toll on consumer spending. Household disposable income is set to come under even greater strain in the Autumn as the energy price cap increases, adding to the risk of recession.
Inflation is undesirably high and is expected to stay this way for some time to come. Inflationary metrics show pressures are broadening and intensifying leaving the Bank of England (BoE) with a difficult balancing act of reversing nearly a decade of ultra-loose monetary policy to tackle inflation while avoiding significant falls in spending and output growth.
According to BoE Governor Andrew Bailey, 80% of price rises come from abroad (ie ‘imported inflation’) and the UK central bank has little control over these pressures. However recent incoming data shows there is a growing element of domestic inflation being embedded in companies’ domestic pricing decisions, supported by excessive domestic demand.
With domestic inflationary pressures building and compounding the pressure of imported inflation on the economy, more robust policy moves could be needed. Ending this period of unanticipated and entrenched inflation is likely to require further interest rate hikes, with money markets pricing in a year end interest rate of 3%. While the BoE could adopt a more gradual and limited uplift in interest rates, rises to date have already started to negatively impact output growth.
The UK economy slowed to a crawl according to the latest set of PMI surveys, with forward looking indicators hinting that worse is to come. Headwinds of soaring prices, supply delays and labour shortages have pared back growth prospects, prompting some forecasting bodies, such as the OECD, to project looming stagnation next year. The economic authority says the UK is poised for the weakest growth in the developed world due to global pressures and the UK’s current fiscal stance (ie the combined impact of all Government decisions on taxing and spending).
According to KPMG – which is forecasting a significant risk of mild recession next year – recently said that likely policy actions to combat inflation, if combined with further fallouts from geopolitical tensions, could see annual GDP growth shrink to just 0.7% in 2023. KPMG also notes three developments which could push the UK into recession:
- A potential US recession arising from a significant monetary tightening by the US Fed
- A potential Eurozone recession due to interruptions of gas supplies from Russia, as well as a significant additional shock to global wholesale gas and oil prices
- An ongoing and worsening squeeze on UK household incomes leading to a sharp decline in household consumption
The overall economic outlook is contingent on any further deterioration in Russian energy supply and further lockdowns in China as a result of its zero COVID policy. These supply issues could significantly worsen the outlook.
On the positive side, the rate of inflation could soon peak. While a lot hinges on energy price cap announcements and whether increased labour earnings rise enough to create a wage-price spiral, there is broad consensus among economists and forecasting bodies that the headline rate of inflation (CPI) has either peaked or will do so soon. Supply issues are expected to gradually ease during the course of this year and certain goods categories begin to contribute less and less to the overall rate of inflation. However, the tight UK labour market may put some pressure on pay in the short-term, which will likely be passed onto consumers through higher prices. Even so, a number of economists expect that from Q2 2023 onwards, the headline rate of inflation will fall as quickly and dramatically as it rose with the BoE forecasting CPI to be close to 2% in around two years.
Regardless of the timeline, as with all inflationary bursts, the rate of inflation will eventually cool. Rising interest rates and the growing cost-of-living crisis will help see to that. The questions is what type of landing we have during any inflationary descent - ‘Hard’ (ie a sudden, sharp economic slowdown) or ‘soft’ (a cyclical or gradual slowdown that avoids recession, with interest rates raised just enough to stop an economy from overheating without causing a severe downturn). While the jury is still out on this, many suspect that a soft landing is becoming a distant dream, but something in between – a ‘bumpy landing’ – is still very possible.
Construction Output and New Orders
ONS data shows UK construction output defied expectations and grew by 1.5% in May 2022. May marked the seventh consecutive month of growth, culminating in a record-high quarterly output figure of £15.05bn.
May’s increase came solely from a strong (2.8%) rise in new work while repair and maintenance output growth contracted by 0.4%, month-on-month. Output in the month was nearly 7% higher than the five-year monthly average and more than 4.1% higher than its pre-coronavirus level.
At the sector level, the main contributors to the May increase were private commercial new work and private new housing, which jumped by 12.1% and 7.2% respectively. Since the falls at the start of the pandemic, the recovery to date has been mixed at the sector level. The private industrial and infrastructure sectors have been the stand-out performers for new work output growth, having grown by 18.1% and 19% respectively compared to their February 2020 levels. Monthly output in the commercial sector, however, is more than 21% lower than it was just before the pandemic.
These recent output figures are reassuring given the amount of supply chain disruption, demonstrating the robustness of the sector to weather volatile and uncertain market conditions. The industry faces a turbulent period of rising input costs but effective scenario planning and building in flexibility to project specifications has helped to maintain its strong momentum in recent months. A continuation of this momentum, however, is far from certain. Despite seeing strong growth in May, private commercial output remained well below pre-pandemic levels – a sign of subdued confidence amongst some developers. With the likelihood of further interest rate rises and uncertainty over the direction the new Prime Minister will take over policy in areas such as housing and infrastructure, this may potentially translate into a pause on investment before committing to longer-term projects.
Turning to new orders, the latest S&P Global/CIPS UK Construction PMI surveys give us the most up-to-date snapshot of new work growth. New orders expanded again in June, increasing for the 25th successive month in the construction sector. However, the rate of growth eased further from March’s recent peak, hitting its lowest level since October 2021. The survey’s New Orders Index adding to signs that heightened economic uncertainty and inflation concerns is starting to impact client spending and leading to greater hesitancy among clients.
Concerns about the business outlook were signalled by a fall in construction sector growth projections to the lowest for more than one-and-a-half years in May. Around 19% of construction firms predict an outright decline in business activity during the year ahead, up from just 5% at the start of 2022. While this does not bode well for new order growth, subsiding supplier delays and an easing of the rate of inflation to a three-month low in May according to purchasing managers, will hopefully mean that any curbing in appetite as a result of these specific concerns will be relatively short-lived.
Higher borrowing costs, economic uncertainty and the war in Ukraine were all cited as reasons for an expected slowing of overall construction activity in the short-term. That said, the publication’s Future Activity Index was still well above the neutral threshold, and purchasing managers indicated that extra recruitment was linked to rising workloads and the anticipation of new project starts.
Furthermore, recent figures from construction data provider Glenigan show a 9% increase in the number of sub-£100m UK project starts in the three months to May 2022 compared to the previous three months – a promising sign of recovery following the fallout from the Russia-Ukraine war. This comes on the back of a strong development pipeline of detailed planning approvals and contract awards, which rose by 1% and 13% respectively compared to the previous three months. However, while underlying project starts were up, the overall value of work commencing fell 5% to £6.54bn compared to the previous quarter, with major project starts (ie those costing more than £100m) falling by 32% over the same period. This is an indication that project sizes are growing smaller.
While activity still remains buoyant overall, forecasters are downgrading their growth forecasts. The Construction Products Association (CPA) is predicting a 2.8% growth in construction output for 2022 – a figure that would typically be viewed as very healthy – but this represents a sharp revision from the 4.3% growth in output that was forecast three months earlier. With an even lower (2.2%) growth in output forecast for 2023, there has been a net loss of c.£3bn from the pipeline for this year and the next.
The CPA noted some sectors such as private housing repair and maintenance are particularly exposed to the combination of price inflation, falls in consumer confidence and pressures on household spending. More generally, high near-term inflation will make it increasingly difficult to reach acceptable terms and will lead to a number of projects being delayed. Over time, these delays will lower demand and feed into slower output growth until a more normal, competitive tendering market can be established.