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Construction slows as Brexit fog thickens

As uncertainty weighs heavily on confidence, is the UK construction industry beginning to crumble under the strain?
September 26, 2019

The most recent figures for the IHS Markit/CIPS purchasing managers’ index (PMI) for construction caused much stir when they were released earlier this month. Rebuffing expectations of an improvement from July to 45.9, a further loss of momentum saw the index fall to 45.0 in August (50 represents the no-change threshold). Leading the descent was commercial construction, with client spending showing particular sensitivity to the uncertain trading environment and keeping a lid on private activity. With Duncan Brock, group director at the Chartered Institute of Procurement and Supply (CIPS), signalling that September’s data might make for further grim reading, it doesn’t bode well for the prospects of UK construction as a whole. Still feeling the aftermath of Carillion’s collapse more than 18 months later, the industry has managed to stumble onwards. But the thickening Brexit fog is threatening to grind things to a halt.

Slowdown masks a mixed performance

The overall slowdown picture masks a mixed performance across the different types of construction. Quarterly numbers from the Office for National Statistics (ONS) indicate that construction output fell by 1.3 per cent in the three months to June, reversing the 1.4 per cent increase seen in the first quarter of the year. This was largely driven by lower repair and maintenance activity in private housing, which saw the largest quarter-on-quarter decline since late 2009. The volume of activity was still higher than a year ago, driven by a resilient housebuilding sector. But building activity in the public housing sector far outpaced more sedate growth in private housing. Aside from residential, the rest of private construction remains relatively weak, especially in sectors that typically require high upfront initial investments – commercial and industrial output in the second quarter were down 5 per cent and 6 per cent, respectively, compared with the same period in 2018.

With the value of new construction orders dipping 13 per cent between April and June, the total is now the lowest since the first quarter of 2013. According to data compiled by trade body Builders’ Conference, the value of new contract awards in August dropped below £4bn, the first time in 19 months. While this may be a “seasonal glitch”, chief executive Neil Edwards has questioned whether this is forewarning that the UK construction bubble is about to burst. Whereas 10 to 12 companies usually record monthly new contract award totals of more than £100m, last month saw just three. This adds to warning signs from May when a slowing of new bids was recorded. Given the typical 22- to 26-week gap between the bidding stage and shovels being put in the ground, the industry could reach the point where the pipeline of new work isn’t able to keep pace with the rate at which projects are being completed.

 

The Brexit factor

Whatever you think of Brexit itself, the tortuous negotiation process has proved grim for construction. Awaiting clarity over the final outcome, customers have been sitting on their hands until the paralysis ends, curbing spending and delaying decisions on projects.

With the UK importing 30 per cent of its construction materials, the depreciation in the pound has led to higher material costs, which have been increasing since 2016. Price inflation may have eased to 2.2 per cent in July compared with the same point last year, but construction companies are still being squeezed by increased labour costs. From May to July this year, the construction sector saw average weekly earnings growth of 6.2 per cent year on year, beating even financial services. Higher costs are slicing into already wafer-thin margins.

Some 7 per cent of the UK’s construction workforce is comprised of EU27 nationals, with that proportion increasing to 28 per cent for London. Our impending departure from the EU could see a ‘Brexodus’ of EU construction workers, creating a gap in the labour force unlikely to be filled in any meaningful timeframe. But here lies a crucial example of Brexit exacerbating pre-existing industry problems rather than causing them. This skills shortage has been decades in the making. Alongside a failure to sufficiently invest in training, the perception as a “4D industry”, as described by design consultancy Arcadis – “dirty, dangerous, demeaning and depressing” – means construction has long struggled to attract domestic talent.

 

A sector already faltering

Although a convenient bogeyman for the industry’s woes, Brexit has hit a sector already under strain, with Carillion’s collapse casting a light on a whole host of fundamental issues – questionable margin discipline, an over-reliance on large capital projects and poor payment practices to name a few.

It begs the question of how much longer construction companies can afford to operate under such pressure. “As a sector, construction is very resilient,” says Philip Campbell, head of policy and public affairs at the Federation of Master Builders. “Our members have seen much worse economic conditions than these. However, margins are tight, and the majority of the sector is made up of SMEs, who are more exposed to any economic shocks”. Demonstrating its financial fragility, the construction industry holds the unenviable top spot for the highest number of new company insolvencies – 3,100 in the 12 months to 31 March.

According to Joe Brent, head of research at Liberum, “activity levels are certainly subdued. However, the key thing is that constructors manage risk properly and win work on attractive terms.” But a shrinking pool of work means increased competition and the temptation to fall back on old habits, taking on riskier jobs at uneconomic prices and further squeezing already lean margins.

 

Prospects for recovery

Edward Winterton, the UK chief executive of Bibby Financial Services, characterises the present moment as a “perfect storm”. In his view, the combination of the multiplier effect of Carillion’s collapse, declining confidence and reduced investment constitute “a heady mixture for the sector to overcome”.

As we move ever closer to 31 October, a resolution to the Brexit conundrum still remains elusive. If we were to exit the EU without a deal, the Construction Products Association expects that the level of disruption in the last quarter of 2019 would see overall output for the year drop 1.4 per cent, followed by a 5.1 per cent decline in 2020. Industrial building output would increase on account of demand for warehousing while there would be a sharper contraction in private housing and commercial demand. 

But if we were to strike an agreement with the EU, might we see a rally this year? According to Mr Brock, even with a revival of business and client confidence and inflow of new work, the construction industry is “much like a large tanker turning in a dock” – a recovery will be a drawn-out affair. For David Madden, market analyst at CMC Markets, a “staggered turnaround” is also the more likely outcome. “It won’t be zero to one hundred instantly but rather a steady increase over a few quarters as funds are put back into construction.”

 

The wider picture

Property and infrastructure consultancy Turner and Townsend has previously pointed to the emergence of a two-speed European construction market as competing economic centres lure international investment away from the UK. But while that momentum may have carried from 2018 into the beginning of the year, Continental Europe is also now seeing signs of a slowdown. Eurozone construction output declined by 0.5 per cent in the second quarter of this year, with the August PMI dipping below 50 for the first time in three years. Amid fears of a cooling economy, the German construction PMI sank to 46.3 last month, its lowest reading since June 2014. So, while the UK may be weighed down by Brexit, it is worth noting that its position is not unique – construction activity also appears to be softening elsewhere.

 

Expert's view

Reminiscent of 2008?

With the latest IHS Markit/CIPS survey indicating that business optimism among construction companies is at its lowest since December 2008, Tim Moore, economics associate at IHS Markit believes “UK construction companies are braced for a protracted slowdown”. With conditions seemingly so bleak, it begs the question: how does this compare to what we saw during the financial crisis?

We put the question to Professor Noble Francis, economics director at the Construction Products Association:

"This is a very different situation for construction compared with 2008’s recession. In 2008, there was a global financial crisis that affected the UK economy and especially impacted on speculative development in the housing and commercial offices markets. As a result, the construction industry was very badly affected, falling 17 per cent in just the space of two years.

"What we are experiencing now is subdued UK economic growth due to Brexit uncertainty. Uncertainty has its greatest effects on private construction in areas that are reliant upon high investment, particularly international investment, upfront for a long-term rate of return. This means prime residential apartments, commercial offices towers and industrial factories. It’s not all Brexit uncertainty, though. In retail construction, the shift in spending online has led to a shift in construction away from prime high-street retail and towards lower-value warehousing space. Also, the government’s long-term austerity programme has led to falls in activity in many of the public construction sectors. In addition, poor government delivery of major programmes has exacerbated lower activity in public sector construction."