Q4 2020
Macro Economics
The UK economy took a battering in Q2 2020, suffering its largest quarterly fall on record. Revised data from the ONS showed that output in the UK dropped by 19.8% in the quarter, making it the worst contraction among major economies.
The record contraction was preceded by a quarterly fall in GDP of 2.5% in the January-March period. Taken together, the two quarters confirmed the largest UK recession in modern history as the economy shrank by almost a quarter in the first six months of 2020.
The ONS said that the services, production and construction sectors all suffered record falls in output between April and June, but the effects were most pronounced in those industries that were most exposed to public health restrictions and the effects of social distancing. Although the monthly GDP growth figures are more encouraging, with August marking the fourth consecutive month of growth, the economy is still 9.2% smaller than it was before the pandemic struck.
With output contracting by 35% in Q2 2020, construction was one of the most affected sectors in Q2 2020. Only a handful of other sectors were more badly affected. According to the IHS Markit/ CIPS UK PMI readings, construction experienced the steepest contraction in activity compared to the manufacturing and services sectors. It also experienced the steepest recovery between April and June as the UK Government gave the industry a free pass, allowing work to continue on site under new site operating procedures and other safety measures.
Since June, all UK construction PMI readings have shown a month-on-month expansion in activity. The latest construction PMI survey (covering September 2020) indicated the sharpest expansion in new order growth since before the pandemic-induced lockdown. Firms increased their purchasing activity at the quickest pace in nearly five years as builders stocked up for Brexit, and sentiment towards future activity was the strongest it has been for seven months. Work undertaken in the residential and commercial sectors rose strongly as demand conditions improved but respondents noted that employment numbers continued to fall. Still, construction managed to outperform both the manufacturing and service sectors in terms of output growth and purchasing activity in September.
Two of the UK’s main measures of inflation – the CPI and the RPI – fell to 0.2% and 0.5% respectively in August on an annual basis. The CPI annual rate is now at its lowest level in almost half a decade, primarily as a result of discounted meals through the Government’s Eat Out to Help Out scheme and the temporary VAT cut for the hospitality sector. Although deflationary forces intensified in Q3, CPI is likely to bounce back in Q4. A comparison of independent forecasts for the UK economy published by HM Treasury in September 2020 showed that UK CPI (on average) is expected to grow by just 0.6% in 2020 – well below the Bank of England’s 2% target. However, the same independent forecasters expect that CPI will grow by 1.9% in 2021[1].
Although the Bank of England has played down the idea of introducing negative base rates, it remains a potential ‘tool in the bag’ according to BoE Governor Andrew Bailey. The Bank said that the potential for more lockdowns could slow down or interrupt the UK’s economic recovery and if this happens we’re likely to see an interrupted or incomplete V-shape recovery. Whilst the Bank has held fire on further quantitative easing stimulus, some economists expect that the Monetary Policy Committee will expand its £745bn bond-buying target in November when more economic and labour market data becomes available.
Andy Haldane, chief economist at the BoE, pointed out that much of the good news over the UK economic recovery is being crowded-out by undue pessimism and fear. These worries are creating excess caution, fear and fatalism, Haldane argues. He said, “We now expect GDP to be around 3-4% below its pre-COVID level by the end of the third quarter. In other words, the economy has already recovered just under 90% of its earlier losses.” With millions of jobs saved and a strong recovery in lost output, he said that avoiding economic anxiety will be crucial in supporting the ongoing recovery and that now is not the time for the economics of “Chicken Licken”.
Despite a rise in the UK unemployment rate from 4.1% in the three months to July to 4.5% in the three months to August, up to 9.6 million job losses have arguably been averted as a result of the Government’s Job Retention Scheme. However, in the coming months the unemployment rate is expected to rise as the scheme unwinds and less viable jobs are ultimately terminated. The BoE has forecast that unemployment will hit 7.5% by the end of this year. For now though at least, redundancies (although rising sharply) are well below their peak during the 2008 financial crisis, the number of job vacancies continue to recover (albeit they are still 40% below pre-pandemic levels) and average weekly earnings are improving as more workers return from furlough leave.
Economists are expecting a rebound in economic growth in Q3, fuelled by stronger consumer spending. Although the UK is on the path to recovery, the threat of a second wave of COVID-19 cases, no-deal Brexit, and an anticipated sharp rise in unemployment could derail the recovery.
CONSTRUCTION OUTPUT
UK construction output (All Work) fell by a substantial 35% in Q2 2020 – the largest drop since quarterly records began. However, recent month-on-month data is more encouraging, which show that UK construction output rose by 17.6% in July 2020, with all sub-sectors experiencing output growth.
Output hasn’t fully recovered though, and in July it remained around 12.8% lower than in the same month in 2019. Since the all-time monthly low in April, when a substantial amount of work on site was paused, the residential housing sector has seen the strongest recovery in output value, rising by more than 123% to July. This is perhaps unsurprising as most residential contractors downed tools and halted their entire construction work during the early lockdown period.
In the commercial sector, although output has made a good recovery so far, it remains particularly vulnerable to delays and deferred investment. In line with Government guidelines, relatively few workers have returned to the office, and there is a clear lack of new work coming in to replace completed projects. Although the current uncertainty is prompting some developers to scale back in the short-term, once businesses have been able to fully assess their post-pandemic positions, we could see commercial output increase as firms opt to refurbish, alter or even re-purpose their existing space.
A significant chunk of output has been lost as a result of COVID-19 and output growth is expected to remain subdued for the remainder of 2020 as a number of projects are likely to be deferred to 2021. So far, in the 7 months to July 2021, output has been 18.5% lower than in the same period in 2019 so a recovery to pre-COVID-19 levels will take time. The Construction Products Association (CPA) expects that output will fall by 24.9% in 2020, followed by a25.5% increase in 2021. Even with such a sharp recovery, pre-pandemic levels of output growth are unlikely to be achieved until 2022 at the earliest.
Although productivity levels on UK construction sites are now generally at 80-90% of pre-pandemic levels and individual task productivity is close to normal, the impact has been variable by trade, sector and project size. Projects that require multiple trades working in close proximity have been most affected due to the steps taken to implement social distancing and reduce the risk of transmission. Concreting, core construction, steelwork and fit-out trades are reportedly working well below normal productivity levels whilst other trades (eg groundworks) have been largely unaffected.
The partial recovery in productivity levels since April has been impressive but output will continue to remain subdued whilst distancing measures remain. Many sites have reduced the number of trades and operatives on site at any given time, but extended site hours and flexible working shift patterns have helped to maintain activity levels. Guidance under the current Site Operating Procedures (SOP) will continue to be refined and improved which should bring some marginal productivity gains over the coming months. New innovations and greater collaboration will also help minimise the impact and cost of existing distancing restrictions.
NEW ORDERS
New orders hit their lowest level on record in the second quarter of 2020 and were around half the value they were in Q1 2020. The lack of new work coming forward indicates a potentially tough period ahead, placing a greater pressure on contractors to secure work at a lower cost.
All sub-sectors experienced heavy declines in Q2 with most seeing record quarter-on-quarter falls. New Public Industrial (eg roadworks, schools and hospitals) and Public Housing work were by far the least affected sectors falling by 10.9% and 15.2% respectively in the second quarter. New orders are likely to remain comparatively strong in these sectors as a result of the Government’s recent spending commitments. The Prime Minister’s ‘Build, Build, Build’ speech on 30th June 2020 promised £12bn over an eight-year period for the affordable homes programme, £760m to repair and upgrade schools, £900m on local growth and infrastructure projects and a further £100m on road projects.
Although new orders are expected to remain somewhat subdued in the second half of 2020, monthly contract award data from the likes of Builders’ Conference show that even amidst the growing COVID-19 and Brexit uncertainty, there is clearly still strong demand for projects – particularly from the house-building and infrastructure sectors which accounted for some 37.6% and 30.5% of contract awards in August 2020 according to Barbour ABI.
Both the value and number of new contract awards appear to have been steadily growing month-on-month since May, but Builders’ Conference said that contract awards in August were still 19% lower than they were in August 2019. The number of new tender opportunities were also nearly 70% lower than they were in the same month in 2019, with just 246 jobs up for tender. This was 63% below the monthly average of 672 projects that were available for tender between August 2019 and March 2020 - a clear sign that many investors/ developers remain hesitant, deferring projects and adopting a wait-and-see approach.
The September PMI construction survey noted that whilst new orders have now risen for the fourth time in as many months, there is still a lack of new work coming in to replace completed contracts. This is acting as a brake on the speed of expansion in activity in the sector. The lack of new work is expected to be a key driver in more competitive tender pricing in the over the coming months, distorting ‘real’ TPI movement.
MARKET CONDITIONS
Whilst there were a number of very clear themes and expectations that emerged from our most recent TPI survey, the current market is expected to affect tendering differently depending on the project size, location and sector. However, most markets are expected to contract in the short-term and supply chain capacity is expected to increase, which is likely to translate into a more competitive tender environment and lower tender pricing for the remainder of the year and into 2021.
A greater supply of construction workers in the market has pushed labour rates down, with average weekly earnings in July 2020 being 5.3% lower than the same month in 2019. Vacancies in the sector also remain relatively low so those looking for new work may find themselves having to accept lower rates of pay. Whilst this has provided contractors with scope to reduce tender pricing, shortages of certain construction materials have added upward inflationary pressure to input costs so far this year. The net result has been that input cost inflation has remained fairly static, with lower tender pricing coming largely from movements in margin adjustment and/or competitive pricing.
The pandemic has undoubtedly dented client confidence which has had a corresponding negative impact on new project commissions. Consequently, the supply chain has become more aggressive in seeking work, translating into a greater prevalence of price reductions and discounted rates. In light of this, we have seen evidence of contractors dropping OH&P in order to win work, fill order books and secure turnover, but this is a trend that, so far, has been more prevalent among smaller contractors and sub-contractors. Larger tier 1 main contractors, who are generally better capitalised, are less inclined to take a ‘work at any cost’ approach. Tier 1 contractors are better positioned to adopt a more selective business development approach, taking on only quality projects that have lower risk profiles.
A number of survey respondents noted that the current and anticipated shortage of new work will really start to bite in early 2021. However, some sectors (eg Public Sector and Infrastructure) are likely to see upwards price pressure next year as spending and investment in these sectors is anticipated to rise.
Although a lack of new work will put downward pressure on tender prices in the sort-term, there are some upward inflationary pressures countering against the softening market. These pressures include pricing in COVID-19 risk and lower levels of labour productivity, additional preliminaries costs for site set-up and also Brexit premiums. Indeed, a no-deal Brexit could potentially put a significant amount of upwards price pressure on construction projects. Under the new UK Global Tariff (UKGT) regime, the average import tariff for the most heavily imported building materials/ components from the EU is around 3.3%. There is also the added risk of a weaker pound pushing up construction material import costs from the EU which would increase project costs and tender pricing.