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UK Construction Outlook – July 2017

11/07/2017


Ian Selby
Risk Underwriting Manager
28th June 2017


 

 

Introduction

The past 12 months have been characterised by increasing political and economic uncertainly. Since the surprise referendum result on 23rd June 2016, the UK has seen a sharp decline in the strength of the pound, increasing inflation and, after an expectations-beating second half of 2016, stalling economic growth in the first half of 2017. We now go into the formal Brexit negotiations with a hung parliament and increasing discord amongst politicians. The odds of another election in 2017 are now just 13 to 8.

Against this backdrop, it is the aim of this report to look at how the construction industry as a whole has performed over the past 12 months and how this performance fits into a longer term context. We will look at the short to medium term prospects across three broad areas of the market – housing, infrastructure, and commercial – focussing on the larger macroeconomic factors at play as well as strategies being pursued by the larger market players.

Note: all references used in this report are available on request.

Market Performance

Monthly data from the Markit/CIPS Survey and from the Office of National Statistics (ONS) construction sector updates show broadly similar patterns.

Figure (i) below shows the position from Jan 06 through to May 17 from Markit/CIPS. Any reading above 50 suggests expansion in the market; anything below is a retraction. The stand-out feature is undoubtedly the recessionary period between early 2008 and mid-2010, which has been more than well documented but also of note to us is a small period of retraction and negligible growth in 2012 and early 2013. This produced a period of under-performing contracts which resulted in heavy losses for a number of main contractors that came to light in 2015-16 as contracts came to final account stage.

Figure (i) – IHS Markit CIPS Construction PMI

In comparison, 2014 and 15 showed strong levels of expansion before referendum-related uncertainty was cited as the main cause for a slow-down in expansion and then, eventually, a 2-3 month hiatus in July and August 16 where the survey fell into retraction territory. However, since then, we have seen a gradual return to longer term expansionary rates with the May figure hitting 56.0, a 14 month high. This is still below the peak of 64.6 seen in January 14, but nonetheless it has been an encouraging performance against the uncertain political backdrop.

Latest ONS data to April 17 (see figure (ii) below) for construction output only goes back to April 11 but shows the same period of retraction in 2013 followed by strong growth through 2014 and 15 before a levelling out in mid-2016. ONS data can tend to be volatile at the first estimation stage, demonstrated by the Q1 2017 figure. In the initial April update this was given as growth of 0.2% but has been subsequently revised upwards to 1.1%. This is more in line with the Markit/CIPS data and tallies with what we are anecdotally hearing from policyholders.

Figure (ii) – ONS Construction Output April 2017

In aggregate, aside from a brief period in the summer of 2016, it is reasonable to suggest that output in the industry has not been overly adversely affected by the referendum result and ensuing political uncertainty.

To understand if this trend is likely to continue we need to look at the underlying fundamentals of each area of the market. 

Housing

Fundamentally there is a lack of housing in the UK market. A Government white paper from early 2017 was blunt in its assessment, saying ‘our housing market is broken’ and in need of ‘radical lasting reform’. At the heart of the problem lies a classic case of demand far outstripping supply. Although dwelling completions for the 12 months to March 17 was a post-recession peak of just over 121k, this is significantly short of the consensus requirement of 225k-275k that the white paper calls for. As per figure (iii) below, we would need to go back to the 1970’s to get to the level of building required for current demand.

Figure (iii)-New Dwelling Completions 1946-2016 ONS Q1 March 17 Housing Update

So, why is the market failing as it is? Point one must lie with the behaviour of the larger house builders. Figure (iv) below notes the turnover growth and pre-profit margins realised by the top five listed house builders compared to 2012. During the past five years they have managed to grow their top line whilst increasing pre-tax profits to oligopolistic levels. Trading updates for each suggest that growth will now be in the low single-digits for 2017. Whilst returns are so strong, there is no impetus to change the status quo. 

Figure (iv) – turnover and profit levels top 5 UK House builders 2012-16

How are they able to do this? Barriers to entry resulting from an overly cumbersome planning process means that land banks built up by the larger housebuilders extend into several years; there is a lack of strategy from local authorities to support, for example, infrastructure, local requirements, etc… putting off potential smaller developers; and existing funding for housing associations is not enough to build at the pace needed. The white paper notes these issues will be addressed by devolving power to local authorities such as ‘the northern powerhouse’, providing a clearer and more open structure to the planning process, providing a £2.3Bn Infrastructure Fund, and providing funding of £7.1Bn to housing associations to help build new homes.

The success of this plan remains to be seen. At least the issues facing the market are noted and correct but the main gist of the white paper seems to be towards trying to provide a co-ordinated approach to the market, but by putting more of the decision-making process to the local level who, based on past experience, have not delivered the level of results needed. Funds for infrastructure and housing associations are obviously welcome, but probably do not scratch the surface of the level of spending needed to provide the step-change in supply that the market needs.

That said, the Markit/CIPS survey for May specifically noted housing as the ‘key growth driver’ with the ‘recent soft patch for property prices’ not deterring housing supply. With average UK house prices having outstripped 2007 highs back in 2014 and the house price to earnings ratio not far off the 2007 peak (see figures (v) and (vi) below) I think it is difficult to argue that we will see prices increasing at the level we have seen in the past five years, but it has got to be encouraging that developers continue to build despite this. Even in the top-end of the London market, Chinese investors Wanda  International announced at the end of June that they are continuing to buy up land around the their Nine Elms site in Vauxhall with £470m paid for 10 acres earlier in June[2]. Investment incentives may be reduced from where they were a couple of years ago but there is still a clear interest in the UK market from would-be owners and investors alike.
 

    

Figure (v) – Av house price 2007-2017        Figure (vi) – House Price to Earnings 1987-2017

 

Any effects seen from Brexit on the housing market will likely to be indirect. Inflation increases leading to an increase in interest rates could have the effect of, not only increasing the prices of mortgages, but also denting confidence in the outlook for the market. Bank of England Governor Mark Carney has been vocal in trying to push down expectations of any rate hike, but nonetheless the last meeting saw their dovish stance voted through by 5 to 3 only. There has got to be the chance of a rise at some point this year if inflation continues to increase. The Markit/CIPS survey specifically notes that the experience of the supply chain during the recession means ‘it may be some time before….suppliers have more confidence to invest in their capacity’. It has been seven years now since we came out of the recession in the construction sector so it is hard to see what else can be done to put confidence back in the supply chain to invest. The recent election result certainly isn’t going to help that.

Furthermore, the narrow majority saw a significantly watered-down Queens Speech for the state opening of parliament on 21st June. Limited time was given to policies outside of the EU negotiations so it is hard to see there will be significant appetite to push through the ideas discussed in the Government white paper. I would think the most likely scenario over the next two to three years is continued gradual progress in the private housing market, helped by anything that can be done by housing associations and local authorities. With the recent Grenfell disaster, there may be renewed political impetus to be seen to be supporting this end of the market.  

Infrastructure

Following the initial political regime change post-referendum, new Chancellor Philip Hammond looked to be making positive noises with regards to increased Government spending on infrastructure projects. After some dallying from the previous Government, the £18Bn (at least) Hinckley Point project was given the go-ahead in September, followed in the October by an in principle agreement for a third runway at Heathrow, costing £17.6Bn. This is on top of the £56Bn expected cost for the HS2 line up to Birmingham (first phase) due to start in 2017. An announcement in December saw the total pipeline rise by £37Bn to £500Bn compared to March 16. £300Bn of this to be invested by 2020/21.

The improved outlook is being borne out in recent data. Seasonally adjusted data from the April ONS construction update (table 3AQ) noted quarter on quarter improvements in infrastructure spend of 1.2% and 2.3% in Q4 2016 and Q1 2017 respectively. For April, output rose 5.7% month on month. This was after declines through the first half of 2016.

So, all is now looking rosy in the world of infrastructure? Not quite. The election result looks to have tempered the Government’s ambitions for what they are going to achieve outside of the Brexit negotiations in the next parliament. The Queen’s speech on the 21st June saw only one notable addition to infrastructure: phase 2a of the HS2 rail line from Birmingham up to Crewe. This has worried market participants, prompting Lord Adonis, Chairman of the National Infrastructure Commission (NIC – a Government body set-up to oversee long term infrastructure plans), and three leading business organisations to make a statement re-iterating twelve key infrastructure projects that need addressing during the course of the next parliament. These surround the Hinkley, Heathrow and HS2 projects already noted, but also include investment in Crossrail 2, an Eastern crossing of the Thames, HS3 linking major Northern cities, new 5G broadband infrastructure, and renewable energy spending. The release is basically trying to put pressure on the Government to put in concrete plans to get these moving. Reaction so far has been limited.

Overall, the impact of Brexit on infrastructure was actually probably positive. As economic headwinds started to come to the fore the Government sensibly looked to positive fiscal stimulus to boost the economy given limited opportunities to loosen monetary policy any further, and infrastructure spend was their Plan A. In principle I am sure the Government would like to continue with this course of investment, but I think it is safe to say the chances of further project delays has now significantly increased. There are always long lead times for large projects like this, but once on the ground they can sustain supply chains for a number of years. Similar to the supply chain in housing, the increased level of uncertainty is going to make it less likely for businesses to increase capacity heavily at this time
 

Commercial

A CBRE report on the UK real estate market outlook[1] noted 2016 was likely to see investment of c.£49Bn for the year, down on the all-time highs of £69Bn in 2015. They note that there was clearly ‘hesitation’ from investors from mid-2015 onwards. This has been counteracted somewhat by the significant depreciation of the pound as well as increasing levels of Asian investors, but market sentiment still ‘points to a hold strategy’ (p13). Investment in 2017 is noted to be being supported by strong liquidity in the market from banks and private equity funds. This is in contrast to the immediate aftermath of the referendum result when a number of large property funds closed for fear of a run on the sector.

Figure (vii) – UK Investment Volumes Q1 2012 – Q3 2016, CBRE Real Estate Market Outlook

To understand the impact of Brexit on the commercial property market we need to look at the performance of sub-sectors of the economy. Here, we look at the main areas of Office and Retail, plus the smaller areas of industrials/logistics, data centres, and student accommodation. 

Office Space

The main areas of concern for falling demand surrounds the financial sector. The major banks have all been reported to be making contingency plans for moving European headquarters To Frankfurt, Madrid, Paris, Dublin, etc… CBRE predict employment growth of -0.5% for the period 2016-21. However, this has been counteracted by creative industries which are seen to be growing by 2% y/y and professional/technical at 3%. This chimes with major new projects we have been seeing completed, notably Google HQ at Kings Cross (£1Bn) and Bloomberg in the City (also £1Bn). 



Figure (viii) London Office pipeline forecast (Deloittes)

As shown in a recent Deloitte reportand corroborated by the number of cranes around the City at the moment, 2017 is looking to be a record year for new office space with 8m sq ft of space coming on the market. As per figure (viii) above, this is forecast to remain above the long term average through to 2021. Flexible working and shared office space seems to be the new trend: Blackstone have just bought a majority stake in industry pioneers The Office Group which valued the business at £500m, whilst British Land have made a ‘major play’ by starting up ‘Storey’ which offers short term office space to companies with 20-70 employees across three campuses in London.

Retail

The CBRE report notes over 3.2m sq ft of new retail space is to open in 2017. Westfield in Oxford, The Lexicon in Bracknell and the West London Westfield extension accounts for nearly all new shopping centre space at 2m sq ft, with a further 1.2m sq ft to be added to out-of-town retail parks. The major supermarkets are expected to run at similar levels to 2016, with Lidl, Aldi, M&S and Co-Op all expanding on store builds, albeit mainly with smaller stores. With the weakening consumer outlook the timing of this expansion is questionable, but shopping centre operator Intu recently reported occupancy rates of 95.8% as of March 17, marginally ahead of March 2016[1], suggesting there is no sign of a hit to them. I am sure there will be pressure to come here if the consumer market looks likely to continue to struggle during 2017 and I would think an easing off of investment would be likely.

Other

The high-street’s loss is likely to be the logistic industry’s gain. With internet sales expected to rise from 15% to 17% of total goods bought over 2017, demand for distribution and warehousing plants will continue to increase.  Anecdotal evidence from policyholders has seen strong demand throughout 2016 and 2017 for concrete flooring, mezzanine levels, new warehousing facilities, etc…. However, if trading levels with Europe do dissipate during negotiations or following the formal exit of the EU, there could be issues with over-capacity in the long term.

2016 investment in student accommodation totalled £3.0Bn. This was behind an ‘unusually high volume’ (p25) in 2015 but still ahead of all previous years. The value of a UK education seems to be holding up despite the referendum result, with the 15% fall in the value of the pound helping to support this. Expectations are similar levels to continue through 2017. 6% of students in the UK are from overseas so the market is not immune to issues over control of students; any restriction of EU (or non-EU for that matter) citizens could have a detrimental effect.

An increasing willingness of corporates to use off-site cloud-based servers is helping to fuel growth in the European data-centre market. London is leading this with 44% of the overall capacity, and this is expected to increase 8-10% in 2017. However, London’s position in Europe does depend on data protection issues being aligned during the Brexit negotiations. Any loss of London’s legal ability to hold non-UK data could lead to a large over-supply.

Overall, it is hard to argue that any one area of the commercial property market is going to be adversely affected by Brexit in the short term. The difficulties will start to come as the impact of the negotiations over aspects of the ongoing relationship become known. Trading levels, data sharing, banking arrangements, and movement of students are just a few of the ways in which construction demand is going to be affected in the medium to long term. 

Structural Concerns

Across all sectors and, indeed, the wider economy in general, two principal issues stand out as having had an immediate impact following the referendum result last year. The first is the movement of people and, in particular, workers from the EU into the UK. For example, 78% of respondents to a survey from seasonal agricultural businesses noted they’d had problems getting sufficient numbers of workers this year. The second is price levels. With the c.15% decline in sterling post-referendum result we have seen inflation rates in the wider economy increase from 0.8% in July 16 to 2.7% in May 17. We will look at the impact of these points on the constructions sector now.

Workforce

Even before the result of the referendum, a number of construction groups that we meet with had mentioned a shortage of skilled labour, especially in the London market. One contractor noted in late 2015 that they were seeing QS’s, tower-crane drivers, and project managers going to rivals for pay increases of 25%+. Indeed, figure (ix) below from the latest RICS survey[1] noted continued skills shortages going back to late 2013. It is difficult to say exactly why this has been happening, but reasons offered have included underinvestment in new staff, especially apprentices, since the 2008 recession as well as a lack of appropriate education in schools.

Figure (ix) – RICS Survey respondents reporting skills shortages by trade

It is against this back-drop that we go into formal Brexit negotiations. Research, again from RICS[1], notes that 8% of the construction workforce comes from the EU, amounting to 176,500. Anecdotal evidence has seen certain companies reliant on overseas workers for up to 50% of total staff. So far, no construction industry workers have been put on the ‘Shortage Occupations List’ of protected jobs, but the Government have continued to make noises about ensuring a continued supply of skilled labour. As can be seen from figure (ix) though, there is a requirement for all levels of skill across the industry.

With the movement of people high up on the agenda for Brexit talks we would hope to get a firm idea about what controls are going to be put in place. As of writing, the idea of national ID cards for EU citizens[2] is the main strategy. At least it looks like the existing workforce will be able to stay in the UK but future support from an immigrant workforce seems unlikely. As labour shortages increase we can expect to see further pressure from the industry to ensure a continued supply of labour.
 

Input Price Inflation

Figure (x) is taken from the IHS/Markit survey for May 17. After an initial surge post-referendum in the second half of 2016 and into Q1 of 2017, the last couple of months have seen the rate of increase slow somewhat. A seasonally adjusted reading for May of 68.4 is the lowest since October 16. Although prices are still rising, the slowing over the last two months suggests that the effects of the exchange rate drop are working through the supply chain. Stable currency levels add some support to this argument. Since the step-change drops following the referendum and the ‘flash-crash’ last year, sterling has continued to trade in the $1.25-$1.30 bracket for most of 2017. 

 

Figure (x) – Input Price Inflation IHS/Markit Survey May 17

In terms of output, latest March 17 price data from the ONS[1] noted year on year inflation of 1.7%, a decline from 2.5% in December 16 and from a recent high of 3.5% in January 16. Figure (xi) on the following page shows output inflation to have broadly followed recent increases in output. As such, we can expect to see some level of margin squeeze along-side the increasing input costs.

Figure (xi) – Construction Output Inflation Oct14-Mar17

Corporate Strategy

Taking four major UK-listed construction contractors, Kier, Balfour Beatty, Morgan Sindall, and Galliford Try, although not comparing exactly like-for-like, is there anything we can take from their respective medium to long-term strategies? An outline of these are as follows:

Kier Group – latest H1 Dec 16 interim results updated on their Vision 2020 plan. The expectation is for low margins in construction (2.5%) and services (5.0%) to continue. Cash generated will be used to help fund their property and regeneration arms. Trading for H1 has been fine with static revenues of £2Bn generating £73m on operating profit from continuing operations. Non-core assets have been sold, and focus has been on controlling costs to help improve margins. The order book remains sound at £8.9Bn, up from £8.5Bn as of their June year end. They view medium term prospects in transportation, power/utilities and mixed-use commercial & residential to all be positive.

Balfour Beatty – Dec 2016 FY revenue up to £8.53Bn (£8.23Bn) at underlying operating profit of £67m (£-106m). After multiple profit warnings in 2014, the group’s focus has remained on ‘cash in and cost out’ of £200m and £100m respectively, and have delivered ahead of expectations. Non-core assets have been sold, bringing in £334m of cash. They are now implementing ‘phase two’ of their ‘Build to Last plan to reach operating margins of 2-3% in UK construction, 1-2% in the US, and 3-5% in Support services. Their total order book is robust at £12.7Bn (£11.0Bn) giving them good revenue visibility over the coming years.

Morgan Sindall – 2016 saw continued improvements in underlying trading with revenues up 7% to £2.56Bn and operating profits up 26% to £48.8m. Construction margin of 0.7% remains buoyed by 4.3% made in Fit-Out and 3.1% in in Partnership Housing, with capital being used to fund their Urban Regen arm which contributed 25% of operating profits on just 6% of turnover. Again, cash generation and cost savings have been key as they look to hit 2% margin in construction, 2.5% in infrastructure and 3% in property services. Long term ROCE in Partnership Housing and Urban Regen are both looking to hit rates of 20%+. An overall order book of £3.6Bn (15: £2.82Bn) underpins growth prospects.

Galliford Try – performance across the group is heavily impacted by the strong performance of their Linden Homes division, a top 10 UK housebuilder, who made a 17.5% operating margin for FY 2016 on £800m revenue. Their 2021 strategy is to see continued growth in revenue here to £1.25Bn with margins expected to squeeze up to 19%-20%. This more than supports margins of 1.1% seen in the main construction arm although, similar to others, long term plans are to hit 2%. The third prong of their strategy is to nearly double units sold under their partnership homes division to 4,200. This will generate £650m revenue at margin of 6%-7% by 2021.

Overall, the main contractors are all following broadly similar strategies. Margins in construction and support services are expected to remain slim, but a focus on streamlining businesses by selling non-core assets and streamlining costs should improve cash generation for use in other parts of the business. Outlooks for all these groups are largely positive with order books improved on 12 months ago. Our overall positive outlook for housing and infrastructure in particular are supported by the strategies of the main contractors.

Summary

Despite the initial hiatus in activity following the referendum result in June last year, construction output has got back to long term growth levels, supported by continued expansion in the housing market and increased infrastructure spending from the Government. Although we head into Brexit negotiations with a large degree of uncertainty over the likely outcome, this is likely to only hit certain pockets of the construction market. Input price inflation is looking to be levelling out, and an early indication on freedom of movement for workers would be very welcome.

Probably of more concern is the current political limbo leading to a downsizing of infrastructure plans, or consumer concerns/restricted lending practises reducing the demand for new mortgages through reduced affordability. That said, the main groups have all been reducing costs and streamlining business for the past 18-24 months now, and we know from the Markit/CIPS that supply chains have been hesitant to invest heavily for some years now. It is difficult to argue the economic situation is without risk at the moment, but businesses look to be remaining cautious. In the absence of a significant uplift in claims or an external shock to the UK market a cautious but supportive outlook remains the best strategy at this time.

Ian Selby
Risk Underwriting Manager
28th June 2017
 


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