With an economy that continues to flatline amid a stubborn inflationary backdrop, the bigger picture is one of a recovery that is likely to remain stuck in low gear as it battles a range of headwinds to growth.
Tight monetary policy, sticky inflation and restrictive credit and financial conditions will act as significant drags on growth in the months ahead, but despite all this, construction remains upbeat about its growth prospects. Although concerned about the UK economic outlook and the impact of rising interest rates, there are plenty of reasons to be positive.
Materials supply conditions continue to normalise, helping to moderate construction cost inflation pressures, while output and workloads on site remaining robust. Strong order books have also helped support recruitment activity and job creation, while fewer logistics bottlenecks and an improved balance between supply and demand has helped shorten lead times. Specialist labour supply remains tight with limited capacity driving higher wage rates.
Despite weaker demand in most construction sectors compared to 2022, contractors remain busy. Main contractors have secured a high proportion of their workloads for 2023 and 2024, suggesting pipelines will remain strong in the short to medium-term. The expected slowdown that many, including G&T, expected to come sooner in the year has been pushed back to 4Q 2023. Busy, risk-averse contractors with capacity issues meant that many contractors could pick and choose which tenders to pursue. However, the prospective impact of ‘higher for longer’ interest rates on demand will take some of the heat out of the tendering market as some projects pause to reassess.
While many will take a longer-term view of the recent economic developments and push ahead through the shorter-term issues, demand in certain sectors (ie residential) will undoubtedly be hit hard over the coming months. G&T has therefore adjusted its view on tender price inflation to factor in the weaker demand conditions caused by persistent inflationary pressures, and higher project financing costs.
The dip in input cost pressures and lower demand not hitting the market as we previously anticipated has had the effect of holding a higher level of inflation for a greater portion of the year. We have therefore readjusted our regional tender price inflation forecasts, which has pushed our UK weighted annual average TPI figure for 2023 from 2.75% to 3%. However, the anticipated fall in construction activity and its influence on overall tender price inflation, which we initially predicted 1H 2023, is now more likely to manifest towards the latter part of the year. Indeed, June’s UK Construction PMI survey indicates that construction activity has begun to contract, correlating with our view that a fall in activity is coming, but with a time lag.
With the reduced demand likely to take a greater hold in early 2024, G&T has lowered its 2024 UK average forecast from 2.5% to 2.25%. While inflationary views beyond this are more speculative in nature, we anticipate that from 2024 the sector will return to a more typical inflationary environment, with annual tender price inflation levels of 2.25% - broadly in line with our long-term average forecasts.
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.
The UK economy has returned to slender growth (with GDP rising 0.2% in April, month-on-month), but the inflationary backdrop remains troubling. Fuelled by positive wage growth and resilient consumer spending, inflation has remained stubbornly high. The Bank of England’s (BofE) decision to raise interest rates for the 13th time in a row in June was therefore unsurprising.
The headline CPI inflation rate of 8.7% in May was unchanged from the previous month, confounding the BoE's expectations of a fall to 8.3%. Heated pay growth and a tight jobs market, combined with core inflation continuing to head in the wrong direction, swung the MPC into acting unusually aggressively. A 7-2 majority voted for a 50bps rise in the bank rate, lifting the official interest rate to 5%, a level last reached in September 2008.
Core inflation rose to a 31-year high of 7.1% from 6.8% and services inflation (which the MPC often cites as an indicator of domestically generated price pressures) increased to 7.4% from 6.8%, also above the BoE's prediction. Some erratic categories such as recreation, food and air fares played a key role in keeping inflation high. However, there was one silver lining. Inflationary pressures further down the pricing pipeline (ie producer input costs and factory gate prices) continue to ease. While there is now less clarity on where rates will head next, evidence of inflation persistence will require further monetary tightening.
Activity growth across the key sectors of the economy generally show that growth is being driven by resilient spending, but this is being tempered by weaker consumer demand. Falling energy prices present a big positive for activity but on balance, the economy faces a further period of weakness and a growing risk of recession. To curb inflation, some economists believe the BofE will have to tip the economy into a shallow recession by the end of this year.
There is also a risk that the Bank overtightens policy in its efforts to do “what is necessary” to bring inflation back down to 2% - especially given that the full impact of previous rate increases has yet to be felt and that there are still good reasons to expect inflation will fall sharply over the remainder of the year. As such, the BoE may even opt to follow the US Federal Reserve and press pause on further rate hikes while it accesses the impact of previous rises in the economic data.
Regardless of what approach is taken, the key concern has moved away from energy prices to the labour market in recent months. April’s jump in private sector regular pay growth (+7.6% in the three-month average of the annual rate for the whole economy) points to a tight labour market. With core inflation still high, unemployment relatively low, and evident domestic wage pressures, the situation risks a wage-price spiral. As such, BoE Governor Andrew Bailey has admitted the UK faces a longer crisis than expected in the battle to tame inflation.
Construction Output and New Orders
While contracting 0.6% in value terms in April, UK construction output remains 8.8% above the five-year monthly average figure and 6.7% higher than before the pandemic in February 2020.
April’s drop follows two months of consecutive growth. Caused by a fall in new work (-1%) but with a small offset from an increase in repair and maintenance output (+0.1%) on the month, output was dragged lower by the continued slow-down in private housing. With falling house prices and low mortgage approval rates, it’ll take time before volume house-building shows signs of a turnaround. More generally, economic worries and high borrowing costs dented confidence among many big investors to request work.
Construction output saw an increase of 1.6% in the three months to April 2023; the increase came solely from a rise in repair and maintenance works (5.7%), which again prompts debate around the rate and scale of new construction projects getting underway, with new work experiencing a decrease of 0.9%.
However, more recent sentiment-based data from June’s construction Purchasing Manager’s Index (PMI) signalled a downturn in overall construction output, but this masked divergent trends across the three major categories of construction activity. As reflected in the ONS data, the residential sector was by far the weakest performing category of activity, with output declining at the steepest pace in three years. Concerns about a subdued housing market, the domestic economic outlook, and the impact of rising interest rates have dented business expectations, prompting a downturn in business confidence for the third month running in June’s PMI survey. Despite this, solid rates of output growth in the commercial and civil engineering segments are helping to offset weakness in the residential sector. Growth in these sectors helped keep June’s PMI’s future activity index in positive territory overall.
On an annual basis, the CPA forecasts that total UK construction output will fall by 6.4% in 2023, according to its latest (Spring 2023) forecasts. Again, the expected contraction will be driven by sharp falls in activity in the two largest construction sectors – private new housing and private housing repair and maintenance. Total output is then forecast to recover in 2024, rising by 1.1%, as wider economic growth boosts demand for both housing activity.
Meanwhile, new order growth – a measure of the value and volume of new orders received by main contractors – dropped significantly in Q1, contracting by 12.4% and falling below the five-year quarterly average. All sectors other than public new work (+11.7%) contracted Q-on-Q, led by private commercial (-22.3%) and new housing (-18.5%). An uncertain outlook carried over from last year, denting client confidence in Q1. However, as we moved further into the year the economic outlook began to improve, with bottlenecks, cost pressures on site, and materials shortages all experiencing a degree of alleviation. While the overall economic and inflationary outlook has darkened in recent weeks, creating pockets of uncertainty, client confidence has improved overall since Q1. Accordingly, new orders may make a partial recovery in Q2 2023.