Growth holds steady while tender prices continue to rise above inflation

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1 April 2015 Growth holds steady while tender prices continue to rise above inflation Tender Cost Update UK Trend towards risk aversion grows in regional locations and procurement choices become more critical Economy 2014 growth revised up to 2.8% but moderating in Q1 with GDP up just 0.3% in the quarter Commercial London Regions Occupier sentiment continues to improve as yields reach 7 year low Housing Market shows signs of stabilising at around pre-recession peak Public Gradual decline due to deficit reduction. Education and health expected to remain stable Investment Strongest ratio of investment to GDP for 14 years Inflation 0% CPI at zero as falls in energy continue to offset minor rises elsewhere Supply chain Becoming more risk averse in regional locations Workload Growth expected for consultants and contractors for the foreseeable future Unemployment 5.6% Steady fall continues with rate down to 5.6% Retail Sales 23rd consecutive month of year on year growth Mace Cost Consultancy has maintained its forecast for tender cost inflation nationally in 2015 at 4.5% with increases of 4.0% expected in 2016 and The continuing strength of demand from clients and occupiers means that tender prices are expected to increase at well above the level of general inflation as the trend towards risk sharing methods of procurement continues and competition is less intense. The forecast for London is also retained, with inflation of 5.5% expected in 2015 followed by 4% in 2016 and 3.5% in We expect demand to remain robust in the capital but price increases are forecast to moderate after nearly two years of strong growth which has increased construction costs significantly. The growth of the construction industry in London is well established and the market is stabilising, although complex or bespoke projects are still attracting a premium. We are now seeing a similar pattern developing in other regions where supply chain constraints and risk aversion has led to reduced competition, particularly for major projects, where the choice of procurement method is critical to achieving value for the client. Chris Goldthorpe, Managing Director Mace Cost Consultancy

2 Overview In the April Economic Review from the Office for National Statistics (ONS), GDP growth was revised upwards for all four quarters of 2014 to give an overall increase of 2.8%, with the fastest growth in Q4. The latest figures for Q1, however, show growth moderating to just 0.3% in the quarter but still up by 2.4% on the same period in Although services grew by 0.5% during Q1, both manufacturing and agriculture were slightly down, and construction showed a fall of 1.6%. Despite the disappointing growth recorded in Q1, GDP is now 4.0% higher than it was at its peak before the recession. Productivity continues to be a problem for the economists, with the latest figures showing that output per hour in 2014 was little changed from the year before and actually fell by 0.2% in Q4. With productivity still not up to the 2007 level, this represents the longest absence of growth in output per hour in the post-war period and is the main reason for the very low level of earnings growth in the last few years. Although many European economies are still struggling, there are signs that a recovery is underway. Germany posted strong growth at the end of 2014 and Spain also saw growth increasing throughout last year. With the Nordic countries and smaller economies such as Poland also returning to growth, together with the anticipated positive effect of the quantitative easing programme introduced by the European Central Bank (ECB), there is reason to believe that the European economy will have a positive effect on the UK in the medium term as demand increases. The minutes of the latest Bank of England Monetary Policy Committee meeting indicate that markets are now expecting the first interest rate rise in September 2016, somewhat later than previously forecast. In addition, the pace of tightening thereafter is expected to be very slow. Long term interest rates have fallen in the US and the UK and it is possible that these falls reflect the impact of the ECB s debt purchase programme. The result of the general election may have a short term effect on financial markets, particularly if the outcome is a coalition which will lead to some uncertainty. However, we anticipate that the positive trend in the economy is likely to be maintained over the next few years with the associated benefits for the construction industry. Retail sales continue to rise with the 23rd consecutive month of year on year growth, however, household expenditure has still not recovered to its pre-recession peak. This implies that there will be further increases which will be encouraged by the current low level of inflation and falling unemployment. The recent reduction in CPI to zero has been driven largely by reductions in transport, energy and food costs, most of which can be attributed to the collapse in oil prices and high harvest yields. Even if the CPI headline figure is negative for a couple of months, concerns about longer term deflation are likely to be unfounded as the effects of the oil price drop will start to reduce later this year. The rise in the value of sterling has helped to keep inflation low by reducing the cost of imports, but recent weeks have seen the Euro exchange rate flattening off and the US dollar has been strengthening for some time, both of which will add upward pressure to inflation in the medium term. 2

3 Construction output and orders The economic growth that is now established will continue to produce demand for construction and we expect output to grow steadily over the next two to three years, when it should have returned to prerecession levels. Demand for housing is expected to remain strong and should maintain the relatively high level of output. The private and infrastructure sectors are forecast to increase once the uncertainty of the general election and a new government has passed. % annual change Figure 1: New construction output New construction output The major trend that is demonstrated by the output and orders figures from the Office for National Statistics, is the flattening in the housing market. Falling orders during 2014 have been reflected in a steep fall in the rate of output growth, and although there is still some positive annual growth, output in the housing sector has now reached its pre-recession level, and further growth is likely to be limited, despite the promises of certain politicians during the election campaign Jan 2014 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan 2015 All new work Housing Infrastructure Public Private Feb Figure 2: Construction new orders New construction orders 40 In the private sector, new orders have been growing at 15% to 20% per annum for about two years which is in line with other indicators and general market sentiment (Fig.2). The output figures, however, have been disappointing, and, if the statistics are correct, would lead us to expect a significant improvement over the coming months. Growth in the construction workforce continues to be sluggish and although the latest figures for Q showed growth of 1.5% in the quarter, this was only up by 1.1% on the same period the previous year. % annual change Q Q2 Q3 Q4 Q Q2 Q3 Q4 All new work Housing Infrastructure Public Private Public sector output continues its slow decline and it is difficult to see any significant upturn over the coming years while the major political parties continue their commitment to deficit reduction. We do, however, expect to see spending on health and education projects maintained, as demanded by public sentiment. Infrastructure output, as expected, remains relatively flat, but we anticipate some improvement in the medium term as uncertainty regarding the general election falls away and major projects in the energy and transport sectors reach the construction stage. 3

4 Market view Commentators are divided when it comes to forecasting the effects of the general election on the construction market. Although there may be some investment decisions that are affected - particularly in the public sector - our experience is that economic conditions are creating a degree of confidence which is encouraging clients to progress developments in the expectation that whatever government is returned, the demand from occupiers will remain strong for the foreseeable future. The RICS Construction Market Survey for Q showed that workloads continued to grow steadily across all sectors and all parts of the UK. The private sector remains the main driver of growth with the housing and commercial sectors seeing the strongest rise in workloads. The Midlands/East Anglia region reported the strongest rise in activity for the third consecutive quarter. Despite anecdotal evidence from respondents that a degree of uncertainty is entering the market as the general election approaches, confidence in the growth outlook for the year to come remains strong and surveyors expect growth in both employment and profit margins. The April issue of the Savills Commercial Activity Report continued to reflect strong growth with a slightly higher reading than the previous month. Growth for commercial projects has now been recorded for 31 consecutive months and developers remained optimistic that activity would increase over the next three months. For the third consecutive month the strongest rise was seen in industrial/ warehouse work and positive sentiment was linked to improved client confidence, low interest rates and better economic conditions. The Construction Products Association forecast for April expects construction output to increase by 5.5% in 2015 due to growth in the private housing, commercial and infrastructure sectors. They do, however, forecast that growth will moderate in the following two years due to uncertainties around the general election, the resultant break in investment and the time lag to get projects to site. Infrastructure activity is expected to be largely unaffected by the election and strong growth is expected due to the 144bn pipeline of work under the National Infrastructure Plan which includes projects such has the 1.5bn A14 redevelopment, the 4.2bn Thames Tideway Tunnel and the 16bn Hinkley Point C nuclear power station. In the Markit/CIPS UK Construction Purchasing Managers Index for March, output was still increasing but at a more moderate rate than recent quarters. Improving order books and sustained rises in new invitations to tender underpinned a marked upturn in business confidence with 57% of respondents forecasting a rise in output over the coming year, while only 3% expected a fall, which equates to the strongest degree of construction sector optimism for over nine years. Housing remained the best performing sector, followed by commercial construction. Civil engineering output growth eased markedly and was the weakest performing category of activity. The Bank of England Agent s summary of business conditions for April noted that construction output growth had remained robust although the pace of increase had eased. Growth had remained strong across a range of sectors, especially higher education. Speculative development was still concentrated around London, with limited activity in a few other geographical areas generally restricted to distribution and warehousing. Growth in Private new house building had slowed on a year ago, reflecting a combination of factors, including skills shortages and large house builders concentrating on improving margins. Experian have reduced their forecast for construction output growth over the next three years due to a slowdown in private housing and a reassessment of likely infrastructure activity. Overall construction growth for 2015 is forecast to be 5.5%, with housing growth revised from 10% to 8%. Although infrastructure growth is forecast to be slower than previously thought, Experian notes that the sector is still expected to be the strongest performer, with output projected to rise by 28% in the three years to In the latest RICS Commercial Market Survey, results continue to show a firm upward trend in both occupier and investment conditions. Tenant demand rose across all areas of the market for the seventh quarter in succession and availability continued to fall significantly across the board. Tight market conditions are ensuring that rent expectations remain elevated, with the office and industrial sectors projected to see the firmest gains over the next three months. In the investment market enquiries continue to rise with interest from foreign investors also increasing. With all sectors experiencing a decline in the supply of property for sale, capital values are once again anticipated to post strong gains over the next three months. 4

5 Materials and labour The Department for Business, Innovation and Skills continues to report significant falls in the cost of structural steel and reinforcing bars which has not been reflected in tendered rates, providing a good indication of the demand which is enabling specialists to maintain their prices and increase margins. Bricks and ready mixed concrete prices continue to rise, indicating that supply constraints still exist and this position is likely to remain while housing output is robust. In overall terms, however, materials prices are reasonably stable and any price increases are forecast to be at relatively low levels for the foreseeable future (Fig 3). Annual increases in average weekly earnings for construction workers had crept up over 3% in November and December but fell back to 1% in January (fig.4.). It is likely that this single month s figures are not representative of the longer term trend and we anticipate that earnings in the industry will continue to rise at above the general inflation rate due to the labour shortages that are apparent in a significant number of areas. Figure 3: Materials prices Figure 4: Inflation indicators All construction materials Materials prices 3 Inflation Indicators Sand & gravel Ready mixed concrete Steel reinforcing bars Structural steel Bricks Metal doors & windows Builders woodwork Insulating materials % annual change % change - last 12 months -15 Feb-14 Apr Jun Aug Oct Dec Feb Oil prices firmed recently, on the news that US production has reduced. In addition, there is international nervousness about the armed conflict in Yemen which involves Saudi Arabia and Iran together with their respective allies. Any escalation of this conflict would create significant risks for oil supplies with subsequent spikes in prices. On other commodities markets, prices generally are weak. Steel billet prices suffered an unexpected fall in February from $480 to $295 per tonne and the market remains weak with three month contracts showing no increase on this price. Copper prices recovered somewhat during the first quarter from their January low but have shown further weakness in recent weeks and forward contracts anticipate that the price is expected to fall further in the medium term. Aluminium appears to have stabilised at around the low point reached at the start of the year and this trend seems likely to continue, at least for the short term. With general levels of inflation remaining very low and no external price pressures, we expect materials prices to remain generally stable with the only inflationary pressures coming from supply constraints where production is still to catch up with increased demand. Consumer Prices BIS Building Costs Earnings Manufactured Products Materials & Fuel Prices Average weekly earnings have now climbed above the other inflation indicators and we expect this to be the start of a gradual upward trend which will develop during the year. We expect oil prices to strengthen in the medium term and consumer price inflation to move back towards the Bank of England target of 2% by the end of this year and 2017 are likely to see inflation moving back towards longer term rates which, in turn, is expected to trigger gradual increases in interest rates. 5

6 Tender price inflation forecast Evidence from the market suggests that conditions remain good for the construction industry, with client demand increasing and available space reducing in the majority of the country. We continue to see improved levels for contractors overheads and profit, while the trend towards risk sharing methods of procurement is now well established (Table 1). We feel that the increased forecasts made last quarter are still valid for both the national average and London, however, these need to be kept under review in order to take account of external factors which may affect input prices, as any such increases are likely to be passed on to clients in the form of higher tender prices in the current market. With input cost inflation at low levels, it is increasing margins that continues to be the main driver behind any tender price increases, and the demand from a growing economy remains robust enough to generate the price increases that we are currently seeing. Increasing capacity remains a challenge for the industry and we anticipate that this situation will continue due to the time required to recruit and train people, particularly at a time when the slack in the labour market is reducing month on month. On some projects we are finding that contractors are having to add contingencies or inflation allowances to package tenders due to the difficulty in obtaining fixed prices from the supply chain and these can have a significant effect on the bottom line, particularly on major projects. In some areas, the effects of the recession have left a relatively small number of companies in some specialisms who are qualified to undertake certain projects, which reduces competition and procurement options, leading to upside risks which need to be considered on an individual basis at feasibility and design stages. The same comments apply to main contractors for major projects, particularly in regional locations, where risk aversion is leading to reduced competition. Table 1: Tender price inflation forecast Mace Sweett G&T Gleeds EC Harris T&T F&G London % +5.0% +5.0% +7.5% +7.0% % +5.2% +4.0% +6.0% +5.0% % +5.0% +3.0% +5.5% +4.3% National (excl. London) % +4.2% +4.0% +4.8% +4.6% +4.4% +4.5% % +4.5% +3.5% +4.7% +4.4% +4.4% +4.0% % +4.6% +3.5% +4.6% +4.7% +4.5% The above table gives our current tender price inflation forecast compared to a selection of other forecasts. The figures should be treated as averages and there will always be variations due to procurement methods, project type and local factors. 6

7 Mace 155 Moorgate London EC2M 6XB +44 (0) Contacts John Busby +44 (0) Chris Goldthorpe +44 (0)

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