2017 - IS WINTER COMING?The UK construction industry will soon start to feel the trueimpact of Brexit in 2017.

With the Brexit vote having hit just as the cycle had peaked, once again the construction industry faces significant challenges. Any workload contraction will have severe consequences for an industry which has barely recovered from the 2008 crash.

In many sectors the balance of power is shifting to clients. Whether these clients continue to build, and how they choose to procure will have a significant impact on how the next phase in the cycle unfolds and how much construction prices adjust.

Early commitment to sustained investment in infrastructure and housing are the best prospects to improve confidence and ensure the stability of the industry.

At a glance

• Construction has entered a technical recession• Improving post-Brexit sentiment understates potential

slowdown in investment• High risk of price correction in the buildings sector from

2017 onwards• London construction cost inflation to reach 1% in 2016• Deflation to hit up to 6% between 2017 and 2018• Continuing growth in infrastructure to create two-speed

construction market • Major contractors are likely to become more risk averse with

high risk profile projects still facing inflationary pressure• Input costs continue to rise due to rising import and labour

costs • UK GDP growth to slow from 1.6% in 2016 to 0.7% in 2017,

partly as a result of falling investment • Consumer Price Index (CPI) inflation to rise up to 2% in 2017

and 2.4% in 2018 – driving further cost inflation• Business failure remains low but supply chain fragility on

the rise.

The Economic OutlookGrowth on the slideAt a stroke, the UK has gone from being one of the strongest economies on the OECD to an also-ran. The Treasury’s August consensus forecast for UK GDP growth gives 1.6% for 2016 and 0.7% for 2017 - a significant correction on the previous forecasts. Whilst consumer confidence has recovered, investment intentions have fallen, meaning that construction is likely to feel the impact of a slowdown faster than other parts of the economy.The Brexit result triggered significant devaluation of sterling as it plummeted to a 31-year low against the dollar. Bloomberg now rank sterling the world’s worst performing currency of 2016. One encouraging sign is the recovery of the FTSE 100 and 250 which, since the vote, have rallied to 2015 levels, although construction and property stocks continue to underperform. Purchasing Managers Index (PMI) scores have shown falls in sentiment and activity since the start of 2016. June’s construction PMI score of 46.0 marked the first dip into contraction territory since April 2013, reflecting the confidence hit during the referendum build up. The latest construction PMI score of 49.2 is certainly an improvement but was much weaker than the corresponding rebound for either manufacturing or services.

“Our revised tender price indices represent a significant reverse in price movement for the buildings sectors. Even based on our low impact scenario, London prices could be 7% lower at the end of 2017 than were forecast in early 2016.”

Economic stimulus Reacting to indicators, the Bank of England (BoE) lowered the interest rate to a historical low of 0.25% and announced £70bn for quantitative easing to divert investment into higher risk assets. The BoE claims that investment in these assets is better at stimulating real productive activity, demand and inflation.Post-referendum government rhetoric has indicated that sectors such as infrastructure could potentially benefit from proactive fiscal policy, with the public sector perhaps taking advantage of low interest rates to fund expanded programmes. However, the government does need to start making positive decisions, and must commit fully to major programmes if the desired economic impact is going to be felt.

Tender PricesPrior to the EU referendum, we predicted that prices would continue to grow by around 4% per annum until the business cycle was interrupted by an external event. External events do not come any more momentous than Brexit. Although the full impacts of Brexit have not yet been seen, we expect that contractors will react directly to changes in market momentum and confidence that we are already seeing. Building construction markets are particularly vulnerable to falling demand, although the infrastructure sector, supported by long-term investment programmes is still likely to be exposed to the impact of rising prices.

2015 2016 2017 2018

90.0

115.0

140.0

165.0

190.0

215.0

240.0

265.0

290.0

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142017

20182016

2015

Regional TPI - Upper ScenarioRegional TPI - Lower Scenario

LondonTPI - Upper ScenarioLondon TPI - Lower Scenario

Infrastructure - Upper ScenarioInfrastructure - Lower Scenario

0.5% -4.0%

0.0%

-2.0%

0.0%

1.0% -5.0%

0.0% 0.0%

-2.0%

3.0%

2.0%1.5%

3.0%4.5%

Arcadis TPI Forecast2016 to 2018

Lingering questions for industry

Post-brexit, there will continue to be a high degree of uncertainty affecting construction markets. We have developed scenarios to reflect the numerous variables currently in play that will influence supply and demand which include:

Q. What is the extent of uncertainty and how long will it last?Despite an improved set of PMI data in August, future events, like the triggering of the formal EU exit process, will determine confidence by influencing ‘go/no go’ decisions for programmes and projects.

Q. Which sectors will be hit hardest? Some sectors, such as commercial property, are likely to see greater falls in demand than others due to differing exposure to international markets or greater sensitivity to investor confidence.

Labour

Currency

Commodities

Plant

Risk Allowances

Uncertainty

Materials

Overheads and Profits

£$¥€

Scale of impact severity (red most severe)

INFLATIONARY

DEFLATIONARY

Q. How will contractors respond? Suppliers learnt hard lessons in the last downturn and will aim to avoid a race to the bottom. We anticipate contractors and sub-contractors may consolidate rather than pursue turnover at any price.

Q. Will some sectors become too risky for contractors? Any downturn could potentially increase the risk profile associated with sectors such as prime residential that are known to be challenging for contractors. This could paradoxically result in reduced rather than increased competitive pressure in these specialised sub-markets.

Q. How fragile is the supply chain? Low profitability still haunts the supply chain and balance sheets are still being rebuilt. Rising input costs, tighter lending conditions and falling new orders will increase the challenges associated with cash flow management.

Q. What pressures will be placed on prices? Although demand is likely to fall, background inflation is expected to rise. Upward pressure on labour costs, currency volatility and commodity prices, combined with market uncertainty, will all place inflationary and deflationary pressure on prices.

Q. How much is too much? Any falls in tender price growth will reach an ultimate point of resistance, at which the supply chain cannot or will not accept further deflation.

Labour

Currency

Commodities

Plant

Risk Allowances

Uncertainty

Materials

Overheads and Profits

£$¥€

Scale of impact severity (red most severe)

INFLATIONARY

DEFLATIONARY

Even though we anticipate that prices charged to clients could fall in a market correction, some input prices will continue to rise, placing a squeeze on contractor profits. This diagram highlights how inflation and deflation are expected to combine as the market re-adjusts.

“The supply chain still hasn’t repaired balance sheets and lenders are now tightening the terms on new funding deals”

Input costs

LabourAlthough construction demand is expected to level off, labour constraints are so severe that the issue will remain an inflationary factor. ONS data shows that only 3 percent of the industry’s workforce were registered unemployed at the start of 2016, compared to an overall UK figure of more than 5 percent. According to the BCIS and national wage award data, labour costs have increased by 27 percent since 2006. For the 40% of construction operatives who are self-employed, their earnings are likely to have increased much faster, particularly since 2013.

MaterialsIn June, the BEIS construction material price index increased 0.6% on the previous month, despite a year-on-year decline of 0.5%. Blocks and bricks were top risers seeing their cost increase by over four percent, while UK steel producers announced cost increases of around £150 per tonne in the first half of the year. Meanwhile, timber and flexible pipes have been amongst the biggest fallers, with plywood and pipe prices falling by 12.6% and 2.6% respectively in the first half of 2016.

The depreciation of sterling since last summer has added around 6-8% to the cost of imported materials. This is a significant risk factor on commercial and residential projects where dollar or euro denominated expenditure could contribute to 20-30% of costs. Some work packages are particularly vulnerable, for example cladding or switchgear.

PlantAccording to BCIS, plant costs fell in the year to July by 0.5% but were up by 1.3% on the month before. The main inflationary pressure on plant is the devaluation of sterling.

“Construction demand is expected to level off but labour constraints will remain severe”

The Construction MarketThe construction industry is a domestic-focused sector and reacts very sensitively to the economic cycle. This makes the health of the wider economy a key factor determining the outlook for the industry.

Prospects for industry sectors

Demand

Investment The BoE expect business investment to fall by almost 4% this year and 2% in 2017. Some markets such as London commercial property had already passed their peak and whilst few clients have publically confirmed project cancellations, there is evidence that some are revising their development plans. Arcadis’ market survey indicates that obtaining and securing finance for speculative developments has become a major challenge.

OutputONS new order data released in June for Q1 of this year shows an overall fall of 1.2%. Housing, public sector, and industrial sectors all showed year-on-year falls. ONS construction all work output figures show a year-on-year fall of 1.4% and confirmed a technical recession. New work output for Q2 showed that public housing, infrastructure and private industrial sectors were the biggest fallers, losing 22%, 10% and 8% of output respectively. Public housing output has fallen significantly to levels not seen since 2009 and 2012. Despite the double digit fall in Q2 of this year for infrastructure, the numbers still represent a relatively high level of output in the historical context, particularly as the order pipeline remains strong.

Supply

CapacityFirst tier contractor capacity remains constrained, particularly in London’s residential and commercial sectors. Contractors report that they have work secured for 18 months or longer. However, anecdotal evidence from current procurement activity in London suggests increased bidding appetite and more amenity in negotiations, probably due to anticipated demand falls.

Second tier sub-contractors also remain busy with order books of up to 12 months or more. However, some trades, such as demolition, have reported falling orders. Anecdotes from the market suggest that the second tier supply chain remain quite bullish in their bidding, reflecting high levels of confidence that may not be sustainable.

Financial HealthThe supply chain has not generally fully repaired balance sheets in aftermath of the last downturn. Growing evidence suggests lenders are tightening terms which may have an adverse impact on cash flow, debt management and business sustainability. That said, instances of business failure in construction are still relatively low.

EXPANSION

Transportation

Water and Utilities

Energy

STATIC

Private Residential

Public - Non-Residential

CONTRACTION

Industrial

Commercial (Offices)

Public Residential

Commercial (Retail)

Sectors in focus

Residential

Evidence suggests a housing market peak may have coincided with the Brexit vote. ONS figures show relatively flat output in total housebuilding, while the NHBC reported just over 40,000 new home registrations in Q2. The underlying regional numbers, however, present a mixed picture. London and Wales saw a 30% fall in registrations whilst the north east saw an increase of more than a third compared to this time last year. With a much greater focus on apartment development, the residential market has become an important source of contractor workload, and a potential fall in activity in cities like London and Manchester could have a knock-on effect in wider construction markets. However, we do not expect that the niche high-end residential sector will benefit from a price correction.Looking at the demand side, UK transactions increased by 4.9% between May and June but were 10.2% lower in June compared with the same month last year. In July, Halifax also reported a price drop of 1%, albeit still up by around 8% compared to the corresponding period in 2015. These numbers illustrate potential signs of a correction in markets.

Commercial

The sector has shown strong performance for the past three years. The spring 2016 Deloitte Crane Survey shows the total volume of office construction reached its highest level seen since the start of 2008. New supply is predicted to peak in 2018. UK-focused REIT shares fell in the first half of 2016 in anticipation of a reduction in asset values and in the aftermath of Brexit share prices fell by up to 30%. Share price recovery has been slow and many of these stocks are now rated as underperforming by analysts. According to CBRE, net asset values fell in excess of 3% in July. Very high construction prices had led to significant viability challenges for many schemes even before Brexit. With falling asset values however, viability challenges may persist even if construction prices fall. The uncertainty associated with the Brexit result has clearly had an impact on developer confidence and in particular the willingness to proceed with projects on a speculative basis. A combination of lower business confidence, falling asset values and Brexit-induced uncertainty suggests that the commercial cycle is likely to have peaked – with attention switching to delivery after 2020 rather than 2018-19.

Infrastructure

With commitment to long-term spending plans being so valuable to the industry, the infrastructure sector has been under the spotlight in the aftermath of the Brexit vote. Further delays to decisions on the London airport expansion and Hinkley Point C have triggered alarm bells. Some sectors, such as utilities, have greater certainty of workload under the regulatory cycle and whilst may be vulnerable to the effects of sterling-related import inflation for some procurement categories, they will also benefit in many cases from rising RPI.The government reshuffle has also shifted the landscape of ministerial responsibility for infrastructure, with five ministers covering important related policy areas. Furthermore, the magnitude of the Brexit negotiations will absorb government focus, potentially leaving other areas of governmentbusiness under-resourced. This was a concern highlighted by the National Audit Office’s CEO, Sir Amyas Morse, who recently suggested that the resource to meet public sector management requirements for major programmes may not be available or capable. The sector will need to renew its focus in dealing with the government to support both decision-making and delivery as national priorities.Despite some political turmoil, however, infrastructure output has generally been rising in recent years. The National Infrastructure Delivery Plan (NIDP) currently remains unchanged and outlines details of £483 billion of investment in over 600 infrastructure projects and programmes in all sectors and spread across the UK, to 2020-21 and beyond. Critically, support for major programmes, such as High Speed 2, has been reasserted by the new government.

“Brexit has clearly impacted developer confidence and speculative projects”

Making the best of a post-referendum environmentThe 2008 recession led to an economic contraction of over 6% and whilst the Brexit scenario presents major challenges, no one expects things to be as bad as the last economic downturn. Apparent headwinds make it tempting for parties to retrench their activities and revert back to approaches of the past. The danger of this is more long-term damage to industry relationships and capacity. What are the opportunities and practical steps that can be considered in the post-Brexit business environment?

Key areas of opportunity The UK remains attractive for investment In a global context, the UK still presents an excellent place to invest, even with the challenges of Brexit. Inherent structural attractions such as the strong justice system, high quality education, solid and reliable infrastructure and the English language – the language of global business make the UK an appealing market. As long as UK projects are deliverable and investable, they will attract support. Some investors have to invest in the UK and some sectors are relatively Brexit-resilient, at least in the short term.

Globalised resourceDigital solutions mean that not only can UK firms work anywhere in the world, but that people based anywhere in the world can work for UK firms. This can be levered for high quality design, analysis and reports around the clock from around the world. This could help free the sector from self-imposed constraints of the UK labour markets.

Certain sectors remain buoyantSectors such as commercial and industrial are likely to see falls in demand as a result of Brexit. However, sectors such as infrastructure and energy are likely to be less affected with increases in demand. Perversely during a time of difficulty for some, it is a time of opportunity for others and falls in demand in some sectors will ease capacity pressures in others.

“During a time of difficulty for some, it is a time of opportunity for others”

Practical steps for clients and contractors to consider• Understand the market and

build relationships. Enable faster identification and resolution of disruptions to project procurement that begin to emerge through maintaining a detailed understanding of market conditions.

• Work to maintain agility. Keep the opportunity to react to demand / supply events that emerge, including capitalising on price movements. Avoid a ‘one size fits all approach’ and recognise the effects of different drivers and influences such as joint venture partners, risk allocation or funding conditions. Maintain an exit strategy and consider continuity of procurement and/or delivery where disruptions occur.

• Consider changing procurement approaches. Clients might consider approaches focused on flexibility, collaboration, pragmatic risk allocation and balanced commercial terms. Target cost contracts, construction management or a negotiated two stage open book process are potential options. Key characteristics include incentivisation, aligned commercial objectives and continued engagement with suppliers.

• Establish strong due diligence to offset growing risks. Use comprehensive project control and due diligence regimes to assure against elevated risks such as financial fragility in the supply chain.

• Review risk allocation. Risk transfer costs are prohibitively high due to multiple risk premiums embedded in the supply chain. Pragmatic assessment of risk allocationmay help eliminate cost by reducing risk layers. This will go hand-in-hand with the collaborative development of mitigation plans to help better manage risk in a deeply uncertain environment.

• Proactively manage foreign exchange risk. Clients and suppliers should consider hedging, though the level of uncertainty will increase the costs. Deliberately fast-paced negotiation is another option, as is the pre-purchase or pre- allocation of currency. Another might be to adopt a floating currency approach to payment.

• Plan to make better use of the industry’s existing people resources. Looking well beyond the immediate impact of Brexit, contractors and their clients need to plan to create the long-term conditions to invest in skills and increased productivity. Boosting of supervision may play a role in enabling more efficient planning and execution of work.

“For those that are in a position to progress their construction plans, Brexit could be an opportunity to drive innovation, productivity and ultimately better outcomes. However, with falling prices forecast, background cost inflationary factors, potential falls in demand and a fragile supply chain, the industry once again faces a defining moment - one which could decide how bright our future is. The risks of a race to the bottom, damaged relationships and significant loss of capacity are very real and would set the industry back years once again. This explains why an early commitment by government to sustained investment in infrastructureand housing are now the best prospects to improve confidence and ensure the long-term stability of the industry.”

Contact

www.arcadis.com

@ArcadisUK

Arcadis United Kingdom

Simon RawlinsonHead of Strategic Reserach and insightE simon.rawlinson@arcadis.com

Will WallerMarket Intelligence LeadE will.waller@arcadis.com

Simon LightUK Client Development DirectorE simon.light@arcadis.com

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