the road ahead FOr COnStruCtiOn arcadis Market VieW, autumn 2017

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1 the road ahead FOr COnStruCtiOn arcadis ket VieW, autumn 2017

2 The Arcadis Autumn ket View For the construction sector, economic and market signals continue to be very mixed, with some signs that a slowdown in activity could be taking hold. Fundamentally, this is a situation of politically-made uncertainty, borne out from domestic partisan turmoil and a perceived lack of progress in the Brexit negotiations on the continent. Continued relative momentum in the UK s economic performance, in the face of all the uncertainty, is a clear marker of its strength in recent years. Against this backdrop, we explore the likely future construction demand profile, quantitative easing s relationship with construction, what a Brexit no deal would mean for the industry and more. Prices and costs tender PriCe ForeCast We expect a slowdown in some sectors to take hold from Q4 2017, followed by a recovery of demand in Key FaCtors shaping the direction of tender PriCes: Dampened economic growth continues to threaten end-user demand and investment levels. Does it make sense to continue to build? Downgraded productivity growth is crimping the public-sector purse. Will public investment levels be sustained? Will suppliers compete for turnover or consolidate their position? Suppliers are still affected by weak balance sheets. How fragile is the supply chain? How profitable is the supply chain? Can it practically reduce construction prices? The risk profiles of projects play an increasingly accentuated role in pricing. What can and will the supply chain accept? the arcadis tender PriCe ForeCast MoVeMent in the year to Q4 year Lower regional upper regional Lower London upper London infrastructure % 3% -1% 2% 3% % 1% -3% 1% 3% % 2% 3% 3% 5% % 3% 4% 4% 5% % 3% 4% 4% 5% Regional TPI - Upper Scenario Regional TPI - Lower Scenario London TPI - Upper Scenario London TPI - Lower Scenario Infrastructure note: these are assumptions related to the tpi forecast Brexit-related slowdown taking hold from Q into 2018, driven by uncertainty surrounding EU negotiations and adverse impacts on demand in commercial sectors. Continued growth in infrastructure output. From 2019, as negotiations conclude, uncertainty lifts and the UK s strong economic performance continues. Our London and Regional TPI forecasts only include the buildings sectors and cover all regions of the UK. They must therefore inform inflation risk allowances according to specific sectors and regions in question. We expect different sectors and sub-sectors to see different pricing conditions. Arcadis infrastructure TPI only includes infrastructure. 2

3 Input costs Labour The BCIS labour cost index provisionally rose 2.7% in the year to tember Some trades would have seen significantly higher labour cost inflation than this, such as high-end fitout. Plant The BCIS plant cost index provisionally rose 4.1% in the year to tember Materials The BCIS materials cost index provisionally rose 4.7% in the year to tember Evidence suggests that the inflationary impact due to the devaluation of sterling is washing through, and is showing itself in reduced escalation of materials cost indices. The future strength or weakness of sterling against the Euro continues to be a key focus. Projects with higher proportions of currency-linked packages will remain most vulnerable to currency volatility. Commodities Despite short-term price increases in some commodities, the broader relatively low market price levels have been a silver lining for the resource-hungry construction industry. This is particularly true in the UK, where the devaluation of sterling has significantly driven up materials costs for buyers. Coal has seen a price rebound, up almost 25% over the year. Strong heating demand and low inventories at China s ports and utilities was a major contributory factor. Coking coal is a key ingredient to the steel production process. iron ore, another key steel-making ingredient, rose 17% in Prices peaked near $95/ton ( 72/ton) during February but have since fallen due to weakening demand, record high inventories at Chinese ports, rising supply, and credit tightening in China. oil prices have been relative stable over the past year, holding at around $55/bbl ( 42/bbl). Prices are expected to see muted growth, forecast at 9% to 2021 by the IMF. aluminium prices rose almost 20% in 2017 due to strong global demand. Copper also saw a 20% rise in steel prices have been on the rise due to increasing demand, mainly driven by China. However global steel demand growth is expected to slow to 1.6 percent in 2018, according to the World Steel Association. Fabricated structural steel prices rose 10% in the year to August in the UK. Though some of these movements seem large, prices have effectively levelled off when looking at longerterm trends. There is little expectation from analysts of rapid growth in at least the next four years. However, the nature of commodity prices, influenced by a range of variable factors, means forecasts carry a high degree of uncertainty. The impact of commodity prices on the final cost of manufactured materials and components can be quite limited depending on the extent of value added. Global Commodities Prices Indices (F) (IMF) Coal, Australian Crude oil, avg, spot Aluminium Copper Iron ore Global commodity prices are expected to remain relatively flat for the foreseeable future. 3

4 Demand for construction UK Economy Forecasts show good global economic growth of 3.5% in 2017 and 3.7% in 2018, up from 3.0% in 2016, and only marginally below the average. Growth in the Eurozone is the best it has been for a decade. Notwithstanding some significant geopolitical risks, including a potential war on the Korean peninsula, the outlook is positive for increasing global momentum. In contrast, the UK economy is showing signs of slowing down compared to previous years. Despite a rise in interest rates, a vote of confidence in the UK economy, the Treasury s consensus forecast for growth is 1.6% in 2017 and 1.5% in 2018, down from 2.0% growth in The first three quarters of 2017 has shown 0.9% of growth, raising the question of whether a further 0.7% growth can be achieved in the fourth quarter. Although unemployment has fallen to a low of 4.3%, real wage growth remains in negative territory, falling -0.4% between May to y 2016 and May to y Almost two thirds of UK economic growth is driven by consumption and so a fall in real wages stokes fears that economic growth will slow because of reduced consumer spending. Consumer spending growth in the third quarter of 2017 slowed to its lowest annual rate since The health of the construction market is directly linked and very sensitive to the economy, so any uncertainty or threats to the fundamentals of economic growth can endanger the progress of projects. The UK Economy Strengths Buoyant foreign investment levels. Global trade and investment outlook. Weaknesses Vulnerable to perceived and actual progress in Brexit negotiations. Consumer spending slowing and consumer debt rising. Opportunities Global reputation. Government action. Threats Domestic political turmoil. Further consumer price inflation. Quantitative Easing (QE) and Construction in Focus Increases in interest rates in the UK and US, as well as a slowdown of asset purchases by the European Central Bank signals the end of an unprecedented period of loose monetary policy. What has the impact been on construction markets? QE has led to a quadrupling of the value of assets on the US Government balance sheet to $4.2tn; equivalent to $13,000 per person. Meanwhile, the ECB continues to purchase 30 billion of assets per month whilst the UK s QE programme remains capped at 375 billion. QE suppresses interest rates and encourages investors to seek better returns from more risky assets such as corporate bonds and infrastructure investments. Because of QE, pension funds and other long-term investors have focused more of their money into capital-intensive sectors such as infrastructure and property, whilst small-scale investors such as buy-to let landlords have benefitted from low interest rates and a sparkling housing market. Low finance costs and rising asset values are closely interlinked, not only for property markets, but also in infrastructure, where borrowing costs have become an increasingly sensitive element of project viability. Thames Tideway and the recent successful offshore wind auction have both benefitted from low-funding costs which reflect, in part, the need for investors to accept higher levels of risk to secure a reasonable income. Rising asset values whether in the commercial, residential or infrastructure sectors - have insulated construction markets from many of the negative impacts of austerity seen in the public sectors. Furthermore, rising asset values have provided a cushion for rising construction prices and costs. Without rising asset values, it will be less easy for construction firms to deliver value to their clients. This highlights the importance of construction s productivity challenge as the political focus shifts from QE and stimulus, via monetary policy, to investment in the real economy. These challenges are reflected in our tender price forecast. 4

5 Construction Demand sentiment In October, the IHS/kit CIPS Construction Purchasing Managers Index was 50.9, up from a score of 48.1 in tember. Any score below the 50 no change level indicates potential contraction in the market. The commercial building and civil engineering sectors, which together make up approximately 50% of UK construction output, were both down to a score of 49. The main causes are extended lead times for budget approvals and subdued risk appetite among clients in the commercial building sector, as well as a lack of new infrastructure projects to replace completed contracts. new orders and output 80% 74.8% 70% 60% 50% 40% 30% 20% 10% 0% -10% -20% Construction New Orders % Change Q vs Q (ONS) Public Housing Housing -9.6% 11.6% Infrastructure Public Sector -16.2% 8.2% Commerical Industrial -15.6% All New Work -7.8% All Other Work -9.0% there were some significant drops in new construction orders in major sectors including private residential, commercial and infrastructure in Q % 10% 5% 0% -5% -10% -15% Construction New Orders % Change 4 quarters to Q vs 4 quarter to Q (ONS) Public Housing -13.4% 10% Housing 5.4% Infrastructure Public Sector -5% Industrial Commerical All New Work All Other Work on a four-quarter comparison, drops in new construction orders have been more measured. -0.8% -11.2% -1.0% -4.2% The construction new order data indicates that the EU referendum in June 2016 triggered a slowdown in new order activity. It is assumed that the political and economic uncertainty that has engulfed the UK has hampered the ability of decision makers to commit to long term, big projects particularly speculative projects. However, aggregated UK construction output remains at a historical high and has seen a robust performance since the EU referendum, showing a broadly sustained flat performance and sitting 4% above the prereferendum level. However, the outlook is increasingly variable by sector. New Work New Orders: Volume Seasonally Adjusted Index (ONS) the data suggests that new construction orders have declined since the eu referendum. Volume m Construction Output: Volume Seasonally Adjusted by Sector (ONS) 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Public Residential Residential Infrastructure Public Sector Industrial Commercial Construction output remains at a historical high and 4% above the pre-referendum level. uk ConstruCtion demand outlook The Construction Products Association (CPA) Autumn forecast of construction output has been downgraded from the Summer forecast. Infrastructure spend remains critical to aggregated demand growth. year total Forecast annual Growth (%) total Forecast annual Growth excl. infrastructure (%) % -0.3% % -1.0% % 0.7% 5

6 Sectors in focus Commercial First 8 months of 2017 have seen commercial transactions fall by 6% against the long term average. Take up of space in regional office markets in H showed a 14% fall on H In London, demand in both the West End and City has defied expectations so far in 2017, with take-up above average at half year. Regionally, office investment volumes in H were 40% below H1 2016, but still 4% above the 10 year first half average. Office rents in London have held in the West End and seen only a slight decline in the City. Both markets have witnessed an increase in the level of incentives being granted to tenants. commercial new construction orders are down -11% on a 4Q to Q vs 4Q to Q basis. Our expectation is for a decline in construction demand in key commercial sectors in Residential New home registrations are broadly in line with 2016 s level. 40,343 new homes were registered during Q a marginal 1% decrease on the 40,810 registered in the same period 12 months ago. On a seasonally adjusted basis, residential transactions have been flat since mid House prices rose 4% in the year to tember. Prime Central London average prices declined 4.6% in the year to tember, the most modest fall since October Rents continue to rise, up 1-2% in the year to y. residential new construction orders increased 10% 4Q to Q vs 4Q to Q basis. Our expectation is for an increase in construction demand in the residential sector in Infrastructure Infrastructure output is expected to grow by c. 23% to In rail, the 48bn Control Period 6, as well as HS2, is expected to drive 40% growth in output to The roads sector is likely to see more muted growth of about 3% to For water, growth in large projects such as reservoirs, is expected to drive buoyant growth of 30% to The energy sector continues to grapple with issues associated with reliance on private investment. The Moorside nuclear new build plant, accounting for 10bn of pipeline, will be delayed to late 2020s. However, counterfactuals including offshore wind and smaller scale generation mean the sector still expects to see 28% output growth to Infrastructure new orders increased 5.4% on a 4Q to Q vs 4Q to Q basis. Our expectation is for an increase in construction demand in the infrastructure sector in * Sources: Savills, ONS, NHBC, HMRC, Halifax, Knight Frank, CPA 6

7 Navigating Brexit With little progress so far in the Brexit negotiations, a no deal scenario is increasingly being mooted, with Ladbrokes offering odds of 6/4 at the time of writing. What would this look like for UK construction? No Deal Scenario UK Construction Impact What can the UK construction industry do? Currency Sterling would likely devalue further against the Euro and Dollar. People Notwithstanding special arrangements, EU nationals and UK nationals would in theory no longer have residency rights. As a minimum, it is likely this would create an administrative burden. Money The UK would make no payment to the EU, reflecting badly on the UK as an entity that honours its debts but leaving cash to be invested where needed. Imports Traders will need to present goods to HMRC, creating severe congestion at ports. HMRC estimates 130,000 businesses that export to the EU would be dealing with customs for the first time. Trade The UK would cease to be a member of the single market. World Trade Organisation rules would apply. Tariffs will be imposed on goods flowing between the EU and UK. Firms would lose passporting rights, which allow them to sell services across the EU without having to obtain licenses in each individual country. The UK would be free to sign other bi-partite deals with trading partners. Regulation The UK would cease to be a member of dozens of regulatory agencies. The European Court of Justice would no longer have jurisdiction in the UK. Demand A no deal may undermine demand in some sectors, such as commercial offices. Speculative projects may be cut back in the short term. Some international organisations may move staff from the UK and reduce development requirements. Loss of access to the EIB could result in delays to housing and infrastructure investment. However, the likely further devaluation of sterling may stimulate more foreign investment. People A no deal scenario is likely to compound pre-existing concerns surrounding access to EU labour. In the short term, it may create an administrative burden. SMEs employing large numbers of EU workers may not be geared up to deal with this. Materials The cost of materials will increase due to the further devaluation of sterling. The addition of import tariffs will also have an impact, likely to average 2-3% alone. Due to significant customs queuing at borders, supply of materials, such as imported timber, is likely to be slow, delayed and constrained - which could create logistical problems on projects throughout the UK. Regulation The UK will obtain freedom to fully control standards and regulations but these will need to flex to facilitate future trade deals. In the longer term, enforcement of contract conditions will potentially be more cumbersome and expensive and enforcement will not be automatic: it will be subject to each member state s own national legal requirements and defences. For construction materials, the EU will continue to be a large market so there will be incentive to maintain parity between UK and EU standards. Rebalance supply chain Focus on UK-based businesses to limit exposure to some of the no deal risks. Minimise labour reliance For example, shifting construction to offsite or componentised methodologies where possible. This may require shifts in procurement behaviours. Develop contingency plans For example for the delay of materials deliveries. Contingency fund Set aside a portfolio-wide Brexit contingency fund to cover surprise cost increases or solve emerging problems. Review contracts Review Brexit clauses in existing contracts and quantify their impact if called. Look to include Brexit clauses in new contracts. So called Brexit Clauses are contractual provisions which trigger a change in rights/obligations as a direct result of a defined Brexit-related event. Examples of scenarios that might be covered include; changes to law or regulation that increase costs or adverse impacts on the ability to operate/deliver created by tariffs or loss of passporting rights. 7

8 Contact Will Waller ket Intelligence Lead Simon Rawlinson Head of Strategic Research and Insight Simon Light UK Client Development Director Arcadis United Kingdom Arcadis Our world is under threat from climate change and rising sea levels to rapid urbanisation and pressure on natural resource. We re here to answer these challenges at Arcadis, whether it s clean water in Sao Paolo or flood defences in New York; rail systems in Doha or community homes in Nepal. We re a team of 27,000 and each of us is playing a part. Arcadis. Improving quality of life. Disclaimer This report is based on market perceptions and research carried out by Arcadis as a design and consultancy firm for natural and built assets. It is for information and illustrative purposes only and nothing in this report should be relied upon or construed as investment or financial advice (whether regulated by the Financial Conduct Authority or otherwise) or information upon which key commercial or corporate decisions should be taken Arcadis