Forecasting is an inherently difficult task, even at the best of times, but a constantly shifting economic landscape and enhanced market volatility in recent weeks has made predicting where the market will be next week, let alone in the years to come, a complex and problematic undertaking.
Having contended with an overheating market, rampant inflation and strong construction activity growth for much of 2022, the market may be on the verge of a turn. There are signs that the market has peaked and the post-pandemic recovery cycle is entering a new phase – a phase with slowing output and new order growth and a certain degree of demand-destruction.
The IMF predicts that one-third of the global economy will be in recession next year. Even more will feel like they are in a recession. This is in large part due to a combination of the ongoing cost-of-living crisis, Russia’s invasion of Ukraine and the slowdown of growth in China. In Europe, a severe energy crisis has hampered economic activity and fuelled levels of inflation not seen since the early 1980s. Governments have reacted to tame inflation but the risk of monetary, fiscal or financial policy mis-calibration has risen sharply at a time when the world economy remains historically fragile and financial markets are showing signs of stress.
The UK looks set to narrowly avoid recession, growing by 0.3% in 2023 according to the IMF, but it wouldn’t take much to swing the pendulum in the other direction. Most other key European economies look likely to fall into recession over the next two-three quarters. Any recessions experienced are likely to be relatively shallow. Banks are in better shape, governments are unlikely to implement austerity and household finances are also in a better position than they were in 2008/09, so recession won’t be as deep this time round. Weakening inflation, easing supply-chain pressures and supportive policy stimulus by governments should also ensure that any recessions will be relatively mild and short.
Any slowdown, however severe, will have second round effects that will impact UK construction activity, but the taming of inflation due to lower demand is likely to be one of the positive benefits that stem from lower growth.
Against this backdrop, we have raised our UK and London TPI forecasts from last quarter’s (Q3 2022) TPI report by 50 basis points, to 5.5% and 6% respectively for 2022. These figures, as always, represent an average inflationary increase across all project types, values and sub-sectors of the built environment. Some sectors, such as industrial warehousing and logistics, will have experienced levels of inflation significantly higher than this in 2022 while others, such as office fit-out, may have seen less construction cost inflation. With a slowdown on the horizon and an easing of certain price pressures expected in the coming months, the rate of inflation is likely to subside in 2023. G&T’s current expectation is that tender prices will rise by 3% in 2022 (UK average and London) as manufacturers feed through higher energy costs into their pricing strategies and increased labour costs as the tightening labour market plays catch-up with headline inflation amid cost-of-living pressures.
If current macro-economic forecasts play out as expected and UK growth slows to a crawl in 2023, competition to secure pipeline and win reduced volumes of new work coming to the market may encourage more competition with contractor margins. However, many contractors will be unwilling to surrender their higher post-pandemic margins and remain selective and risk averse in their bidding for as long as possible.
Longer-term inflationary movements are even more difficult to assess. For now, we have reverted towards our long-term inflationary average of c.2.5% for 2024 and 2.25% for 2025. The Bank of England currently expects headline inflation (or CPI) to fall back to its 2% target in around two years’ time. Construction tender price inflation is closely correlated with wider economic outlook, so as the BoE forecasts a return to more normal growth market across the whole economy by 2024, we would expect tender price inflation to ultimately follow suit (albeit with some potential lag effects).
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.
UK GDP grew by just 0.2% in the second quarter of this year, suggesting that Britain is not quite in recession...yet. However, the marginal rise in quarterly GDP means the UK is the only G7 country with an economy smaller than in early 2020, prior to the pandemic.
The UK’s Q2 GDP figure does not reflect the latest upsurge in inflation and leap in borrowing costs, which are expected to contribute towards the 0.1% contraction of GDP being factored in by the Bank of England in Q3. Unless growth can be spurred in Q4, there is a likelihood the UK will enter a recession (ie two consecutive quarters of economic contraction) by the end of the year.
Economists don’t hold much hope for an improvement next year either. Data from Consensus Economics – which provides an average of leading forecasts – point to an economic contraction of 0.3% in 2023. Despite annual headline inflation (or CPI) easing back from its recent peak of 10.1%, households face the prospect of stubbornly high inflation running at or near double digits over the winter period before starting to come down. This is likely to quash consumer confidence and lead to falling spending and demand in the coming quarters.
The complete and indefinite halting of Russian pipeline gas supplies to Europe, combined with the UK’s recent mini-Budget, were just two of the key inflationary events in Q3. The inflationary impact of these events will be somewhat blunted by the deployment of fiscal support measures that place an upper limit on typical household energy bills (a key driver of headline inflation). However, the mini-Budget was inflationary in other ways – not least of which was the subsequent plunging of the pound, driving up the cost of imported goods and energy while domestic price pressures remain elevated. This has made the prospect of stagflation and recession almost inevitable.
The Bank of England will likely respond to these additional inflationary pressures by raising interest rates to further cool the economy and attempt to rein in sky-high inflation. However, doing so may mean sacrificing a portion of the UK’s potential GDP growth over the next few years, producing tougher financing conditions when these higher rates feed through to the real economy. The markets believe that UK base interest rates of 5-6% by mid-2023 are a realistic prospect, but others argue this is excessive given the relatively small size of the packages announced in the mini-Budget.
After the pound’s strong sell-off in late September, sterling became significantly undervalued. The reason for the sell-off was simple. After the mini-Budget, international investors panicked that the sweeping tax cuts would need to be paid for with higher Government borrowing. Households would then spend the additional money as a result of the tax cuts, increasing demand for goods and services and driving inflation even higher. A later policy reversal regarding the 45% rate tax cut provided some relief to investors and saw the pound rally but bouts of volatility in the currency in the coming weeks are inevitable until a credible medium-term fiscal strategy is published to help restore the markets confidence. On the positive side, a weaker pound tends to increase net investment from abroad which acts as a shock absorber, providing a cushioning effect from the impact of a weaker pound.
Another lever the Government could pull to instil confidence in the markets is austerity and spending cuts. After announcing that the departmental spending envelope will remain the same in nominal terms (despite much higher-than-expected inflation), there are signs the Government might rein in some of its spending. Deep spending cuts, however, may not be politically viable given that the Conservative Party has an election to fight in around two years’ time and many public services are currently experiencing significant post-pandemic backlogs under existing spending allocations.
Meanwhile, the Bank of England is likely to use all levers at their disposal to tackle some of the current economic pressures. It’s not inconceivable the Bank of England will push interest rates higher than 75-basis points in November in order to head off any concerns the markets might have about any loosening of fiscal policy through tax cuts. Its £65bn intervention programme in the debt markets has already helped avoid a fire sale of gilts (ie UK Government bonds/debt). Without this intervention, pension funds would have been forced to quickly sell £50bn worth of long-term Government debt, but the Bank of England’s emergency bond-buying scheme helped stave off a financial meltdown and the risk of entering into a self-reinforcing spiral in the funding markets.
While this particular crisis may have been averted for the time being, 2022 has experienced one unforeseen supply shock after another. Higher borrowing costs in the short-medium term will impact all corners of the UK economy. Construction, like all sectors, is exposed to the second-round effects of higher intertest rates. The housing market has been used to mortgage interest rates of around 0-2% over the past decade and taking away this prop by potentially increasing rates to 4-6% or more could put considerable downward pressure on housing demand.
With inflation hovering around double digits, the risk of an imminent recession and rising interest rates, the economy is predicted to perform weakly in 2023. Despite the darkening economic outlook, construction continues to surprise. Positive activity growth indicators (in the form of recent Construction PMI readings) and strong momentum from the past year provide hope that the sector can weather any storms in 2023.
Construction Output and New Orders
July saw another month of declining construction output – the second consecutive decrease following seven months of growth. July’s 0.8% fall was ironically blamed on the weather being too good. Amber and red weather warnings across the country meant several working days were lost to extreme weather conditions and record-breaking temperatures.
Repair & maintenance was the driver behind the drop in output (-2.6%) while total new work saw a slight increase (0.3%) in the month. However, repair & maintenance output values remained nearly 10% higher than their pre-pandemic levels, and with financially constrained councils looking to switch resource away from new projects to basic repair and maintenance jobs, further declines in repair & maintenance output could be stemmed. Of all the sub-sectors the biggest decline was reserved for public new housing (-13.1%), but all sectors other than private new housing and private commercial experienced modest monthly declines in output values.
Of course, the weather isn’t solely to blame for July’s dip in output. The cumulative effect of falling demand in light of rising costs and uncertainty over the UK’s economic policy and growth prospects are weighing in on investor and developer confidence. Supply bottlenecks also continue to impact the sector (albeit to a lesser extent than a few months ago). Some of those that are contemplating major new projects are holding off on committing investment or progressing projects from design while they see how the current pressures and economic situation evolve.
Somewhat reassuringly, the level of construction output remained some 2.1% above the February 2020 pre-pandemic level, but an interesting trend has emerged in recent months. Price rises in the construction industry have seen the gap widen between the value and volume of construction output, suggesting higher project values are making up for less overall construction activity
With respect to new order growth, ONS data for Q2 2022 revealed a drop in new work below the five-year quarterly average. New orders have been on a downward trend for several quarters now and more recent indicators suggest this continued into Q3.
October’s S&P Global/CIPS UK Constriction PMI report pointed to the weakest trend for new orders since the sector’s recovery began in June 2020. A scarcity of incoming new orders has been pinned on slowing decision making among clients and greater risk aversion due to inflation concerns. Squeezed budgets and worries about the economic outlook are also reasons why the PMI new orders index has slipped in recent months.
Increasingly fragile business confidence and rising interest rates doesn’t bode well for a pick up in new order growth anytime soon. As contractors complete their delayed projects that have spilled over into Q3 and look to bolster their longer-term pipeline, we may see more competitive tendering conditions arise. Furthermore, if a sustained, global drop in demand for new construction work materialised, purchasing activity would likely put greater downward pressure on key construction material prices. Combined, both factors could bring about a drop in cost burdens in 2023.
The PMI survey’s forward-looking indicators weakened in September while output growth expectations for the year ahead were the lowest since July 2020. Although optimism is evidently subdued and growth projections have weakened, firms continue to comment on “forthcoming” projects, suggesting many clients are just waiting for an improvement in conditions before greenlighting planned projects.
In terms of the underlying value of UK construction work starting on site on site, Q3 figures from construction data provider Glenigan show a 27% decline compared to the previous month (and a 23% decline on the same quarter in 2021). Thanks to utilities work starting on site, civil engineering project starts provided one of the few bright spots (+1% Q-on-Q) while residential starts fell by a third against the preceding three months. Most non-residential building sectors also saw sharp declines in the third quarter of 2022.
Every region in England saw declines in project starts in Q3 2022 (NI and Wales bucked the trend), and with further headwinds ahead new starts on site look to remain sluggish for the short-term.