Macro Economics

Despite there being only a limited amount of economic data to show the impact that COVID-19 is having on the UK economy, it is clear that the country is set to experience an unprecedented shock.

Global business leaders are preparing for a prolonged and drawn out U-shaped recession due to the impact of the virus, meaning that economic hardship is likely to persist until at least late 2020. Whilst economists are in agreement that the next few months will bring economic pain, there is little consensus regarding how deep and protracted the economic slump will be.

An ONS poll of 5,300 businesses found that one quarter of UK companies have temporarily closed because of the COVID-19 lockdown. The majority (55%) of those still operating have reported lower turnover than normal. Whilst the standard economic indicators showing the extent of the damage caused by the lockdown will not be available for another month, both the IMF and the OBR forecast that the UK faces the deepest recession since the 1920s as a result of lockdown measures.

Bank of England governors have said that a 35% contraction in Britain’s economy in Q2 2020 predicted by the Office for Budget Responsibility (OBR) did not look unrealistic and warned that escaping the downturn might not be easy. The OBR’s scenario also suggests that the deficit would rise to £273bn in 2020-21, 14% of national income, almost half as high again as at the depth of the 2008 financial crisis. Unemployment would soar close to 1980s levels.

Early indicators are not encouraging. Business activity across all sectors plummeted in March according to the IHS Markit/CIPS PMI indexes. Services and construction were the worst hit, dropping to 35.5 and 39.3 respectively as many service providers reported a total halt in activity and construction projects suspended work on site. At the time of writing the preliminary Flash UK Composite PMI shows that activity is expected to contract even further in April and fall to a record low of 12.9 (from 36.0 in March) - consistent with a quarterly fall in GDP of 7%. The poor survey readings will inevitably have many questioning how long the current containment measures will last.

The lockdown is costing the UK economy approximately £2.4bn per day according to the Centre for Economics and Business Research. Although Matt Hancock said that the UK has reached the peak of coronavirus outbreak, current restrictions will continue until early May, and even then we are only likely to see a phased relaxation of the lockdown restrictions and social distancing rules.

Despite Government support packages, the UK is not likely to survive many more months of a lockdown. Bill Michael, chairman of KPMG, recently told staff that at some point, we run the risk that economic disaster will transcend the human one. Striking the right balance is going to be a difficult judgement call and cabinet ministers appear to be divided over when and how to lift lockdown restrictions.

Low demand and consumer caution has contributed to falling inflation rates. Consumer price inflation fell to 1.5% year-on-year in March from 1.7% in February. However the most recent inflationary data was collected before the Government imposed lockdown measures. Inflation is expected to fall further in April, possibly to 0.5%, as commodity and wholesale energy prices fall further.



DEMAND

The pandemic has led to a historic collapse in demand across many sectors. Construction, being no exception, is also experiencing weaker demand as clients wait for the pandemic to pass.

Lower demand will undoubtedly apply downward pressure on tender pricing. Typically in recessionary periods, strong deflationary pressures are created as a result of lower demand. There is less demand for skilled labour due to fewer projects getting on site. Demand for products and materials also falls which exerts downwards pressure on raw commodity prices. Input cost deflation can create good buying windows as pure economics dictates that it is better to have some work at a lower price than no work at all.

At this point a UK pandemic-induced recession appears to be highly likely. However, there are key differences between this and previous recessions. In the last recession, the UK economy experienced six consecutive quarters of negative growth (Q2 2008 – Q3 2009). During this time the BCIS All-in TPI index fell by 12.6%. In fact, tender price inflation fell for another two subsequent quarters after the recession ended. Factoring in these two additional quarters means that tender prices fell by a total of 15.4% as a result of the last recession. The current pandemic is highly unlikely to create such a prolonged recession but it could be much deeper over the short term. For example, the worst quarter at the height of the previous recession saw UK GDP fall by -2.6% (Q1 2009). This seems relatively insignificant when compared to the 35% drop in GDP that both the OBR and BoE are suggesting is possible in Q2 2020. However, as per our poor scenario above, should we be inflicted with a second wave of CV19, demand will be further reduced leading to a prolonged recession. This, like the whole CV19 outbreak is unprecedented.

Although it won’t be instant, demand is likely to return relatively quickly compared to previous recessions once the lockdown ends and social distancing restrictions begin to ease. There will be a release of pent up demand and one of the challenges will be ensuring that supply can keep up with demand in a recovery.

Pipeline

Although work has stopped at 29% of all UK construction sites (accounting for 64% of the value of work currently under construction), Glenigan reported a significant increase in detailed UK planning approvals in March compared to any of the previous 12 months. This is positive for the long-term project pipeline, but the short-term project pipeline is faring less well.

Data from Barbour ABI shows that contract awards in March were weak, falling to £3.8bn from £7.6bn in February. Furthermore, many of the contracts awarded in March have now been put on hold. However, in the first quarter of the year the total value of contract awards were 26% higher than the previous quarter and 17% higher than Q1 2019. Before the pandemic hit the UK was clearly experiencing improving demand conditions in the wake of the General Election result and a positive March 2020 Budget.

However, the lockdown measures, which came into effect on 23rd March, prompted sites to take a variety of approaches in response, from temporarily closing all sites to continuing work after conducting internal reviews and putting new protocols in place. It has since been confirmed by the Government that work on site in England is permitted providing the Construction Leadership Councils (CLC’s) Site Operating Procedures and Public Health England guidance on social distancing is followed.

Lockdown restrictions have certainly had an immediate and severe impact on projects currently on site but the long-term development pipeline looks encouraging. The current uncertainty has inevitably led to a fall in new enquiries which will hit the project pipeline in the short term, but projects at the design stage are proceeding. Most work in pre-construction also appears to be proceeding as planned but is often pausing or stopping at the end of a work phase.

Government Gives Construction the Green Light

Keeping sites open has become an economic imperative for both the Government and construction firms. However, for this guidance to have the greatest effect, the whole construction supply chain needs to be operational and working collaboratively. Most builders’ merchants have responded to lower demand for materials by reducing production capacity and offering only a partial service. To help keep supply chains moving and ensure that parts and raw materials are available, the Department for Business, Energy & Industrial Strategy (BEIS) issued a letter to those working in manufacturing and industry in the UK, asking for the industry to keep supply chains moving. Building material manufacturers such as Michelmarch are beginning to restart production at their plants, partly because of such encouragement from the Government. New BMF ‘Branch Operating Guidelines’ will also provide some reassurance to builders’ merchants looking to resume operations safely during COVID-19 restrictions.

The Government has made it clear that it considers construction to be a critical part of the UK economy and is keen to support the supply chain. Notice to proceed orders have been issued by the Department for Transport to the four main works civils contractors (MWCC) behind Phase One of HS2, providing an immediate boost to the industry. Nadhim Zahawi, Under-Secretary (BEIS) is also speaking with other government departments to identify construction projects that could be accelerated or brought forwards, noting that, “...in terms of prompting the economy to incentivise growth, infrastructure is incredibly important. Greenlighting such projects will give contractors and the rest of the supply chain confidence in a recovery and may help kick-start on-site activity”.


SUPPLY

Whilst a recovery in demand is expected to be U-shaped, some forecasters suggest that supply could be L-shaped.

At the moment, many manufacturers have reduced production capacity but are still actively supplying projects. To return to full capacity they will need to be confident that sufficient demand has returned and is sustainable. Otherwise they run the risk of having to stockpile unsold products and cut their workforce.

Some anticipate that cash-strapped suppliers will start to struggle in the coming weeks and so contractors are considering whether they can prop them up or buy stakes in such firms in order to keep them afloat and prevent potential collapse. Contractors are concerned that sites will be unable to restart because trade contractors and materials will not be there. Consequently, several main contractors are considering the possibility of buying up parts of their supply chain in order to keep schemes running.

As with previous recessions, some insolvencies are inevitable. The Government's Business Interruption Loan and Job Retention Schemes will help mitigate insolvency risk and allow many contractors to weather the storm, but if there is a failure of a significant number of sub-contractors, it will have an immediate and negative impact on projects. Any insolvencies will also lower industry capacity, reduce tendering competition and put a certain amount of upwards pressure on tender pricing.

Almost all contractors have furloughed a portion of their workforce. As more sites open will it be difficult to get these workers back on site? Fewer operative numbers will likely mean lower output and higher costs. However, countering this, a reduced on-site workforce may make recruiting skilled labour a little easier and push down labour wages

Housebuilders such as Taylor Wimpey plan to restart work on sites but say that it would take until at least June to reach 80% of normal activity levels. Full capacity isn’t expected to return until 2021. Contractors, such as Mace, appear to be working to a similar timeline. For some, on site productivity is currently is only 10-15% of pre-COVID-19 levels but many plan to ramp this up to over 50% over the coming weeks.

Tier One Contractors in the London market have mostly established plans to keep their sites open and maintain output whilst keeping their workforce safe in accordance within government guidelines. New project operating plans to increase resilience are being put in place which cover the movement of people on-site as well as providing new working practices for both management and the workforce. Measures such as enhanced cleaning, staggered working, temperature checks and no unauthorised visits have been implemented.

The CLC’s Site Operating Procedures (which require a distance of 2m to be maintained between workers where possible) will hamper productivity for as long as it’s in force. There will be some innovative and creative changes to working procedures, such as split shifts and this will help with productivity but it will take time to adapt. Larger sized welfare and loading areas will be required, adding cost to adapt existing or higher costs for new projects. In the short-term, lower productivity and changes to preliminaries will manifest themselves in programmes and tenders.

Finally, the impact of backlogs needs to be considered. If demand picks up quickly and industry capacity is diminished as a result of delays to projects and extended schedules, this could provide upward pressure on tender prices.