Construction and the Economy – An Update

Simon Raine
In early 2010 we commented on the likely effects of the Government’s fiscal policy and the turbulence in the Eurozone on the UK construction industry. At that time the Government was pinning its hopes on the effects of quantitative easing together with a reduced rate of VAT.

In early 2010 we commented on the likely effects of the Government’s fiscal policy and the turbulence in the Eurozone on the UK construction industry. At that time the Government was pinning its hopes on the effects of quantitative easing together with a reduced rate of VAT as the main weapons to combat the dramatic decline in the construction industry as well as kick-start the economy more generally. The downturn in public sector works as a result of the drastic cuts necessary to rectify the burgeoning government debt was still to be experienced by the industry and it was hoped that these measures would convince the private sector to ramp up and replace this gap in workload.

Over the intervening two years the situation has shown little improvement. Two rounds of quantitative easing pushing £275 Billion into the economy does not appear to have stimulated private sector construction. It would appear that this injection of money has helped banks improve their capital reserves and both companies and individuals to reduce their debt rather than stimulate investment in the built environment. The Euro crises has widened with the fiscally stronger Euro members, pandering to national sentiment, doing too little too late to prevent the downward spiral. Italy is close to joining Portugal, Ireland, Greece and Spain. France and Austria have had their triple A rating cut by several credit rating agencies.

Where does this leave the UK Construction industry?

Fiscal policy and construction

Whilst confidence in the British pound has looked reassuringly stable over the intervening period the strength of the pound is not a sign that the UK economy is well in these troubled times. Rather it appears to be protected by the many global problems that are no doubt holding back many other major currencies, There is an expectation that the Euro Zone will drop back into recession territory as a whole at some point in the coming 12 months.

Confidence in the UK remains fragile at best with the UK’s GDP figures for the 4th Quarter 2012 indicating a negative growth of -0.2% a worse position than expected.

The Bank of England has maintained interest rates at record low levels with no indications from the voting at the Monetary Policy Committee Meeting that this is likely to change in the near future.

With the UK economic growth shrinking the impact on the Construction can only point to further contraction in a sector that has seen little recovery over the last 24 months. With businesses being run in survival mode, commitment to any capital expenditure will continue to be a scarce commodity. The road to Public spending cuts continues with little sign of the Private sector stepping into the void.

Effect of quantitative easing

The effect of quantitative easing on the economy is difficult to measure as it is entangled with other factors that affect confidence. Whilst The Bank of England believed there was evidence of improved activity during the period in which asset purchases were taking place, other commentators were less sanguine. Perception is that much of the extra liquidity generated was used to improve balance sheets rather than stimulate the economy. Certainly the mortgage market, vital to house builders, remains particularly difficult.

One of the effects of QE is to reduce rates on gilts and bonds thus stimulating the equity market. However higher equity prices does not necessarily translate into more money in the economy thus stimulating growth. Whilst higher market capitalisation may encourage investment, reduced returns on bonds and gilts affects spending power particularly of those on pensions.

The Bank, encouraged by organisations such as the Council of Chambers of Commerce is reported to be considering a further round of easing hoping that the boost in money supply would encourage spending and help credit growth now that corporate and personal balance sheets are more robust. However historically there is little evidence that such action boosts rather than dampens corporate confidence – and sustained confidence is the key ingredient to encourage businesses to invest in bricks and mortar.

Eurozone: trade

The troubled and indebted economies of Portugal, Ireland, Greece and Spain show little hope for a quick turnaround.  With other countries queuing up to join the crisis the pressure on the on the euro continues to stifle any sign recovery in the eurozone countries.

The combination of the positive benefits of quantitative easing and the negative effect of the struggling economies within the eurozone, has not led to greater strengthening of sterling against the euro. This has helped UK manufacturers to increase exports to Europe creating one of the few bright spots for our economy. Recent months has seen a small increase in the exchange rate as markets continue to be worried about the inability of the Euro countries to deal decisively with the issue. Should this continue it will put our exporters under pressure as their goods will become less competitive and the Euro market will shrink. It is vital for both the general and construction economies in the UK that Europe demonstrates to world markets that there is a robust plan in place to deal with the euro problem.

Exchange rate history

Exchange rate history

Exchange Rate History for GBP/EUR

Source: http://www.dollars2pounds.com/

The UK sources £12 billion of construction materials from abroad whilst exporting £6 billion, a net balance of £6 billion. As 60 – 65% of both imports and exports are with the eurozone countries, the euro exchange rate is significant to both UK construction costs and the wider economy.

During the 1990s the trade gap in construction goods was around £1 Billion. From 2000 to 2007 as the Euro exchange rate improved the gap widen to £6 Billion as foreign goods became cheaper in the UK. Although the exchange rate dropped dramatically to almost parity in 2009 UK manufacturers of construction materials have not been able to increase their market share either in the UK or in the export market. Whilst there are some recent signs of improvement an increase in the exchange rate will favour importers.

Some major European suppliers with UK divisions may be at risk when internally trading as they tend to fix exchange rates for set periods of time, most continental suppliers will only fix exchange rates once orders have been secured.

Construction materials – Imports V’s Exports

Import / Exports

Source: http://www.bis.gov.uk/

Waiting for the upturn

The timing of any recovery in UK construction continues to remain uncertain although it is not all doom and gloom.

There appears to be a concerted Government effort to promote infrastructure projects following Francis Maude’s announcement last July of £22 Billion of investment in infrastructure over the next three years. Progress in energy investment, both nuclear and renewables, continues although the government decision to cut the FIT rates suddenly by 50% has not helped. HS2 is progressing and talk of an estuary airport in London is becoming louder. Whilst energy projects will be privately funded it is not clear whether the government is increasing funding to transport projects given their policy to reduce debt.

December saw the largest mortgage lending in the month for over a year at a time when confidence surrounding the Euro was at an all time low. House prices are continuing to remain fairly stable with the London and SE region still showing signs of growth. Commercial development remains almost dormant with little sign of new development outside central London.

Across the Atlantic a Bloomberg Global poll (January 2012) reported that fifty percent of the respondents said the economy in the U.S. is improving, compared with 10 percent who said so in a poll in September. The U.S. economy is expected to grow 1.8 percent this year, while the euro-region will shrink 0.5 percent according to the International Monetary Fund’s World Economic Outlook published in January 2012.

When the euro exchange rate fell in 2008-9, apart from an initial ‘blip', construction costs did not rise to compensate for the weakened UK buying power. This suggests that the basic laws of supply and demand within the construction supply chain continue to have a considerably greater effect on costs than the effect of exchange rates.

The next 12 months is likely to see the eurozone crisis come to a head which, whilst this will initially erode further confidence it will be hoped that this will become the catalyst to a foundation for recovery.

Looking forward, the construction sector is likely to lag behind any improvement in the general economy. A rise in the exchange rate could contribute to further falls in construction prices as it is likely that cuts in public capital construction projects will not be compensated by improvement in the Private element of the construction sector.