LIFTING THE LID ON PANDORA S BOX A CHANGE OF PACE FOR BRITISH CONSTRUCTION

LIFTING THE LID ON PANDORA S BOX A CHANGE OF PACE FOR BRITISH CONSTRUCTION

EXECUTIVE SUMMARY The UK economy continues to perform robustly though significant threats remain. Potential risk of a slowdown in tender price growth in some commercial sectors remains with falls most likely in 2018. Infrastructure tender prices to remain buoyant. Deep uncertainty continues with the trigger of Article 50. Paradoxically, the calling of a snap UK General Election is likely to create more certainty for business in the medium and potentially longer term. Exec summary Outlook for British Economy STRENGTHS Robust Performance Positive Sentiments WEAKNESSES Reliance on Consumer spending Vulnerable to negotiations progress OPPORTUNITIES Global reputation Government policies THREATS Inflation Investment outlook Global outlook

What next for prices and costs? In some sectors, we do not currently see anything other than a two-year potential slowdown in demand growth. However, since our last forecast in January, there have been some significant changes which impact our previous tender price forecast. UK economic forecasts have been significantly revised up. UK government rhetoric has switched in recent weeks to a potential softer Brexit. Snap UK general election called, paradoxically boosting business sentiment in the medium and potentially longer term. However, early indications suggest other EU member states are looking to adopt hard-line stance on areas such as trade. And the threat of a Scottish independence referendum could create further uncertainty. Arcadis Spring 2017 Tender Price Forecast We have maintained our view that the infrastructure market will remain inflationary. We have adjusted our view for the buildings markets - that there is a lower chance of a slowdown affecting building construction markets during 2017, with more risk of a slowdown in 2018 comparably. The Arcadis Tender Price Forecast - Movement to Q4 of each year Year Lower Regional Upper Regional Lower London Upper London Infrastructure 2017-1% 3% -1% 2% 3% 2018-2% 1% -3% 1% 3% 2019 2% 2% 3% 3% 5% 2020 3% 3% 4% 4% 5% 2021 3% 3% 4% 4% 5% 330.0 310.0 290.0 270.0 250.0 230.0 210.0 190.0 170.0 Regional TPI - Upper Scenario Regional TPI - Lower Scenario London TPI - Upper Scenario London TPI - Lower Scenario Infrastructure 150.0 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Note: These are assumptions related to the TPI forecast Brexit-related slowdown taking hold from Q4 2017 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.

What next for prices? Will the economic cycle support investment? Built asset value growth is slowing. Does it make sense to continue to build? Who will keep building? How many clients keep building and in which sectors, is the most critical factor. Will the public sector sustain current levels of spend? What toll will aggressive government budget deficit targets take on construction spend? How fragile is the supply chain? Despite improved business conditions, the supply chain is still affected by weak balance sheets. Can better management truly reduce costs? The current environment may present an opportunity to re-evaluate the efficiency and productivity of project delivery. Will we see a race to the bottom? Suppliers have learnt from the last downturn and will aim to avoid low-margin bidding. Important past reflections 2008 2013 This is no 2008. However, construction once again faces a foreseeable event with uncertain consequences. Based on the start of the last downturn, cautious optimism when it comes to demand and price growth levels is warranted. The scale of the impact of financial crisis took everybody by surprise and no commentators predicted tender price falls of over 20 percent. However, we simply still do not know what the future holds and so no indicator should be ignored. Certain sectors and regions saw hyper annual tender price inflation of up to 12 percent per annum for the past few years. There has been a far greater volatility in demand and price inflation at a trade level across sectors increasing the level of uncertainty for clients and contractors. Based on this, tender price movement can vary dramatically by sector and region and can surprise. Input costs The Arcadis input cost index for Q4 2016 rose 5.4 percent in the year and 1.3 percent over the quarter. Labour The BCIS labour cost index rose 2.8 percent in the year to March 2017. For the 40 percent of construction operatives who are self-employed, earnings are likely to have increased further. The main inflationary driver is the skills shortage aligned to growth affecting specific trades. The ability to import skills from the EU and beyond after 2019 could offer help mitigating the skills shortage. Plant The BCIS plant cost index rose 7.9 percent in the year to March 2017. However, values are still lower than levels seen during 2012 to 2014. Materials The BCIS materials cost index rose 5.9 percent in the year to March 2017. However, the index value is like levels seen during 2012 to 2014 inclusive after two years of falling costs. Most of the inflationary impact because of the devaluation of sterling is now in the bag, making the future strength or weakness of sterling against the euro a key focus. Materials and commodity prices are still generally at historical lows on the global markets. As a result, if and when sterling strengthens, materials cost inflation could reduce very quickly. However, if sterling weakens further or global commodity prices rise, there could be further growth in costs around the corner.

Market conditions 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. Britain had the best performing economy in the G7 last year and there is widespread optimism that this trend continues for the foreseeable future. However, growth has largely been driven by consumption rather than investment. As we await our eventual exit from the European Union, however, progress at the negotiating table will come to be a significant influencing factor on the outlook. A key bellwether of progress will be how sterling holds up as things move forward. Whether it weakens or strengthens will impact on rising costs here in the UK, as well as foreign investment levels two of the most critical levers for construction. However, it is not all about what happens in Europe. The global trend towards protectionism could take the steam out of future potential global growth, inevitably hitting the UK. As we enter the next phase of Brexit, British construction must walk a tightrope of perfectly balanced short-term flexibility and long-term commitment, with further potential volatility threatening its stability. Uncertainty and UK construction Uncertainty Not Brexit Related Brexit Related Political Economic Demand Government budget deficit targets imply reduced public investment. Tough government immigration targets pre-dating the vote for Brexit. Business rates and taxation rises create tougher trading conditions. Downward phase of economic cycle. International trade barriers could emerge holding back growth. Ability to deliver planned infrastructure programme. Viability challenges associated with high construction prices, asset values, tax and risk. A deal may be unachievable in the allowed timeframe. Scottish referendum risks UK breakup. Future migration arrangements are unknown. UK General Election. European trade barriers could emerge. UK sources of competitive advantage weakened by Brexit. Consumer spending could slow. Sterling could strengthen or weaken Key sector detail is missing which could be impactful on construction demand. E.g. whether the financial services sector obtains passporting rights could impact office demand. Sources of demand relocates to Europe.

Demand for construction When demand falls, tender prices follow suit. Therefore future demand is at the centre of our price forecast as opposed to input costs where, historically, the correlation has not always been as strong Last year new build construction output peaked, totalling circa 100bn. Following the financial crisis, it was the housing and infrastructure sectors that led the charge to recovery. 2016 s all work volume based growth rate of 2.4 percent indicates a progressive slowing of the market growth rate, from a peak of 8.1 percent in 2014 and 4.9 percent in 2015. Residential output doubled since 2010 and in some areas, such as Manchester, the sector has seen a 200 percent increase in the last seven years. Infrastructure has also rebounded while commercial sectors have seen respectable expansion despite remaining below previous cyclical peaks. However, Brexit could potentially burst the bubble. Total Quarterly UK Construction New Work Output ( m current prices) by Sector 2006-2016 30,000 25,000 Value - current prices seasonally adjusted 20,000 15,000 10,000 5,000 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Public Residential Residential Infrastructure Public Sector Industrial Commercial

The future for demand New work orders were three percent higher in 2016 than the previous year, despite signs of tailing off in the final six months. Crucially, this showed in the private residential and commercial sectors, which saw a quarterly drop in new orders at the end of 2016 of -3 and -16 percent respectively. Together these sectors make up 60 percent of total construction output. A Bank of England survey showed that business investment intentions had grown slightly at the beginning of 2017, although firms have been progressing plans to mitigate increased energy, labour and materials costs in anticipation of Brexit, rather than investing in new capacity. This means investment in technologies and business systems rather than buildings. The IHS/Markit Construction Purchasing Managers Index (PMI) score fell to 52.2 in March revealing a growth slowdown in UK construction, led by weaker housing activity. The survey also pointed to only a marginal increase in new work, which contributed to slower employment growth and a slight decline in input buying. New Order Volumes 2016 vs 2015 (ONS) % Change 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% Public Residential Residential Infrastructure Public Sector Industrial Commercial New Order Volumes Q3 2016 vs Q2 2016 (ONS) 60.0% All New Work Output forecasts The Construction Products Association (CPA), in their winter forecast pointed to a flattening of output over the next two years but also highlighted key sectoral differences. When major infrastructure projects are removed from the numbers, falls in demand of up to -1 percent are expected in the building sectors in 2017 and 2018. Our view is that the next six months of negotiations will crystallise the kind of Brexit that will be realised and its impact on investment in the UK. 50.0% 40.0% 30.0% % Change 20.0% 10.0% 0.0% -10.0% Public Residential Residential Infrastructure Public Sector Commercial Industrial All New Work -20.0% -30.0% -40.0% New Order Volumes Q4 2016 vs Q3 2016 (ONS) 30.0% 20.0% 10.0% % Change 0.0% Public Residential Residential Infrastructure Public Sector Industrial Commercial All New Work -10.0% -20.0% -30.0%

Sector focus Infrastructure The beginning of the year has excited and disappointed. However, even with some loss of pipeline, with High Speed 2 on its way, infrastructure investment levels look like they will continue at current levels. The bidding consortia for Silvertown Tunnel are both European which could be an indicator of some of the capacity challenges in the market. Housing Construction demand in the residential sector remains strong. The government s recent Housing White Paper makes it clear that housing has a place in the much-lauded industrial strategy. However, the success or failure of the strategy depends on numerous complex elements coming together, which have never before materialised. Furthermore, with Brexit negotiations as well as pending electioneering right around the corner, this is not yet the government s main priority. Commercial The commercial sector can best be described as a tentative market at present with many clients and potential occupiers maintaining a wait and see approach. Nevertheless, the sector has outperformed the expectations of many since the June referendum. Undoubtedly it is the global status of key cities like London and Manchester that have perpetuated demand levels.

Contact Simon Rawlinson Head of Strategic Research and Insight E simon.rawlinson@arcadis.com Will Waller Market Intelligence Lead E will.waller@arcadis.com Simon Light UK Client Development Director E simon.light@arcadis.com www.arcadis.com @ArcadisUK Arcadis United Kingdom