The direct and indirect impacts of the recent markets chaos on construction...

The direct and indirect impacts (so far) of the recent markets chaos on construction...

It's clearly early days into the government-made chaos in the financial markets but there are some impacts for the UK construction industry that we can identify (albeit quantifying them is a much greater issue).

Firstly, directly, the depreciation in Sterling will lead to further increases in construction materials inflation. It's worth keeping in mind that construction materials prices in July 2022 were already 24% higher than a year earlier and 46% higher than in January 2020, pre-pandemic. Sterling has depreciated 12% since the end of July. This will exacerbate cost inflation in the industry much further as depreciations in Sterling increase the price of imports. Clearly, the price of imported construction products (such as steel, aluminium and electrical wiring) will increase even more sharply. In addition, however, the price of many domestically made construction products will also increase further as they often use input materials and components that are imported as well as fuel and energy priced in dollars. This means that we are likely to see falls in the volume of construction spending even if the value of spending is maintained in some construction sectors.

Indirectly, the chaos in markets has led to sharp rises in expectations of interest rate rises. This will impact heavily on homeowner (mortgage and remortgage) costs at a time in which real household disposable income is falling (this year and next year). A week ago markets anticipated interest rates rising to 3%. Now, they have priced in interest rates rising to around 6%. The rise in mortgage rates means demand in the housing market (prices, transactions), and consequently, the house building sector is going to be heavily impacted. Private housing (the largest construction sector) was already expected to slow towards the end of this year and into next year but now it is likely to fall significantly.

In addition, the rise in rates for those remortgaging means that many households will be coming off low fixed-rates and finding that their mortgage payments double. Remortgaging is running around 300,000 remortgages per quarter currently. Some households may be forced sellers but the more widespread issue is for those households that will be able to service higher mortgage payments by reprioritising spending but this will mean cutting out discretionary non-essential spending (i.e. improvements spending), which implies further sharp falls in private housing repair, maintenance and improvements (rm&i), the third largest construction in which output has been falling since March already. Given that private housing rm&i output in July 2022 was still 15.5% higher than pre-pandemic, it has a long way further to fall.

Looking to other sectors likely to be affected, it is worth highlighting commercial new build towers, which have been badly affected in the last few years by economic and political uncertainty but new towers are reliant on large upfront investment for a long-term rate of return. There are projects in the pipeline set to go over the next 12 months but with accelerating costs and worsening economic prospects, it raises the question of whether we will see those projects break ground near-term or whether they will be paused and pushed back if not cancelled.

Theoretically, infrastructure, the 2nd largest construction sector, is the least affected as finance (central government/local authorities and regulated sector firms such as water companies, national highways etc.) is more stable. However, the sharp cost rises mean that with constrained finances set in November 2021's 3 year Spending Review and 5 year spending plans for regulated sectors respectively, what we will see near-term is the expected value spent but falls in volume and then, in the medium-term, projects towards the end of Spending Review and regulated sector spending plans will get pushed back into the next ones due to lack of finance whilst local authorities, which are already financially-constrained, will be cutting new projects to divert finance towards rising costs in basic repairs & maintenance.

UK construction lost 347 firms in July 2022 and 3,841 firms in the last year, the highest since the financial crisis more than a decade ago, according to the Insolvency Service despite strong construction demand, higher than pre-pandemic, and the general trend in construction insolvencies continues upwards. 59% of the construction firms that have gone under in the past year are specialist sub-contractors (2,258 firms). These specialists are highly reliant on cash flow and have suffered, and will increasingly suffer over the next few months, from sharp rises in materials cost inflation (hitting margin) and labour availability issues (delaying projects and revenue, with knock-on effects to subsequent projects). This is particularly the case for specialist contractors on fixed-price contracts signed up to 12+ months ago. 

Construction output in July 2022 was 1.4% higher than in January 2020, pre-pandemic, whilst construction materials prices were 46% higher and construction insolvencies were 31% higher with a consistent upward trend over the past 18 months. Given that these insolvencies are already occurring whilst construction activity is strong, UK construction insolvencies are only likely to rise further.

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