The UK construction industry has been enjoying a late cycle recovery, driven primarily by housebuilding but increasingly by infrastructure and energy spending. Company managements I speak to have been cautiously optimistic about the outlook for their businesses1. In this context, the -2.2% decline in construction activity revealed in the ONS Q3 GDP data last week was both surprising and disappointing.
The first fall in construction output in nearly 2.5 years flies in the face of construction activity trends. A private survey from Markit/CIPS has since revealed that construction activity, whilst slowing, remains firmly in growth mode. Indeed companies remain broadly positive with 59% of survey respondents expecting growth while only 7% expect a contraction.
So, what’s going on behind the data? ONS data is known to be volatile & frequently revised. And although the data is seasonally adjusted construction is susceptible to weather disruptions. August was cooler and wetter than normal with some regions receiving triple the normal rainfall while the South East was the wettest since 1977.
There are other headwinds to contend with. A shortage of labour & skills has caused significant wage inflation pushing some projects to become unviable. Wage inflation in London has exceeded 10% with some prime contractors suffering significant losses on long term projects where sub-contractors have collapsed into administration during the downturn. The issue here is not demand but supply. A recent conversation with large UK construction company’s CEO revealed the tendering landscape has moved in favour of the prime contractors with better risk profiles on contracts and margins stabilising as cost inflation is priced in.
In the summer budget the chancellor cut social housing rents by 1% per annum until 2020, costing local councils £2.6b in lost rent and causing them to shelve plans to build over 5,400 homes. The government set out plans to build 170,000 social homes between 2012-2015 with plans for a further 165,000 by 2018, funded by private investment alongside £23b government funding. However, following the July budget announcement the table below clearly shows the dramatic slowdown in public housing activity as local authorities reconsider their plans.
On the other hand this table clearly shows the significant upturn in infrastructure activity. Infrastructure spending is reported to have the highest growth multiplier of all industries at 2.8 ie £1 of government spending on infrastruture generates £2.80 in economic benefit.
The demise of the Private Finance Initiative in 2010 brought spending on schools, hospitals and roads to an abrupt halt while the new coalition cut spending plans to arrest the budget deficit with the effect evident in the first chart. But lately there has been an overt commitment towards infrastructure spending. School frameworks have revived, Crossrail & HS2 are steaming ahead and the £4.2b Thames tideway contract was let this summer after a decade of planning.
Lately the notorious on-again/off-again £25b Hinkley new nuclear project got a green light when the Chinese came on board after much schmoozing by UK plc. Energy projects focused on renewables, particularly offshore wind, have let some sizeable projects in 2015. And Highways England has been formed in the image of the regulated utilities and a funding plan has been signed into law that will grow at a 6% per annum and allow long term planning and improvement of the UK arterial road network.
Nor should private housebuilding be overlooked. This was the sub-sector that kick-started the construction revival in 2013 when the government announced schemes to help first time buyers get on the property ladder. The financial press reports weekly the urgent need to increase housebuilding rates towards 300,000 homes per annum, more than double the current rate of 136,000, in order to keep pace with household creation.
In conclusion, while the latest official ONS construction activity data raise eyebrows and could signal a speed bump in the recent return to growth, my longer term expectations are for 3% growth per annum for the next 5 years. In such a cyclical sector, which is currently driven by inherently ‘lumpy’ infrastructure spending, we should not expect growth to come in a straight line.
1. This is no recommendation to buy or sell any particular security