UK construction industry weakness accelerates

Insolvencies are expected to increase in the UK’s construction industry this year as higher interest rates, inflation and an anticipated domestic recession dampen demand for housing and new commercial projects. The construction industry will fall into a recession in 2023, with output forecast to drop 4.7% before recovering slowly in 2024 with growth of 0.6%, according to the Construction Products Association (APA).

The headwinds are well known. Most are of global origin (e.g. inflation, soaring energy
costs, supply chain pressures, tight labour markets), while Brexit has intensified existing challenges and created new ones (e.g. EU trading restrictions, materials costs, labour shortages, supply chain delays). These accumulated pressures, alongside geopolitical uncertainties and the legacy of Covid, will spark a new wave of distress, defaults and insolvencies throughout the sector. More than 6,000 insolvencies are forecast in the UK construction industry this year, according to Begbies Traynor’s Red Flag Alert data. The number of construction companies in England and Wales in ‘critical distress’ jumped to the highest level in almost six years in the final quarter of 2022. The data shows that construction companies in critical distress increased by 13% to 632, compared to the previous quarter, and by 35% compared with the same period 12 months earlier.

Global headwinds

Easing wholesale energy prices over the winter helped to soften some inflation drivers, while others remain firm (e.g. double-digit construction cost inflation, tight labour markets and wage growth). Annual UK CPI inflation rose by 10.1% in January, compared to 10.5% in December, according to the latest ONS data. While inflation fell last month, levels are still stubbornly in double-digits and fivefold ahead of the Bank of England’s (BoE) target. The Bank raised the base rate for the tenth consecutive time in February by 50 basis points, to 4.0%. The Bank has increased interest rates by 390 basis points since December 2021, marking the most aggressive monetary tightening in the UK since the 1980s, and now expects rates to peak at 4.50% in the coming months. Markets expect another 25 basis points hike next month. While there is typically a lag in the transmission of monetary policy to impact felt in the economy, the burden of higher debt servicing costs is already felt by the sector.

However, inflation pressures mask real economic activity, as price increases ensure the value of activity remains high, despite the lower overall activity. Private sector wage growth rose by the strongest rate seen outside of the pandemic period in the final quarter of last year, pushing up wages for construction companies. The construction industry is also vulnerable to industrial action over wages – both direct and indirect by strikes in other industries across developers’ supply chains. In December around 843,000 working days were lost because of labour disputes, the highest since November 2011.

Construction demand

Construction companies operate on low margins, so they are very sensitive to higher borrowing costs. Added to this, many were forced to take on more debt during the pandemic to survive and so are highly indebted at a time when input costs are increasing. At the same time, skilled labour remains scarce, and the threat of industrial action keeps upward pressure on wages. For example, there is an estimated £300m in bad debt within the construction industry, which could rise to £1bn by the start of 2024, according to Red Flag data. In this context, UK construction companies reported another downturn in business activity during January, reflecting weaker client demand and fewer new projects started in recent months, according to S&P Global.

The UK construction PMI index signalled a modest reduction in overall business activity in January, with the rate of decline the fastest since May 2020. Housebuilding and commercial activity both declined. Lower residential demand was attributed to “the wrecking ball of higher inflation and interest rates”, according to John Glen, chief economist at CIPS. In the commercial segment, which decreased during January for the first time in five months, softer demand reflects delayed decision-making on new projects.

Legacy Brexit impacts

Steep increases in construction materials costs post-Covid contribute to stalledb existing projects and deferred new projects. The cost of construction materials in the UK increased by around 60% compared to 35% in the EU over the eight years to the end of 2022, according to comparative data from the EU and the UK Department for Business, Energy & Industrial Strategy. Similarly, the cost of construction workers in the UK increased by around a third between 2015–2021. In Denmark and the Netherlands, cost increases were less than half the UK increase in the same period, according to BCIS data.

UK imports are broadly back to where they were pre-pandemic and pre-Brexit. At the same time, exports to the EU are still 34.2% lower than the average volume between 2016–2018, according to ONS data cited by Noble Francis, economics director at the Construction Products Association (CPA), in evidence provided to the UK Trade and Business Commission in late January. Francis says while the UK is not conducting complete checks on EU imports, the EU is, which partly explains the sharp fall in exports, compared to equivalent data pre-Brexit. There is also additional friction for smaller firms exporting construction products to the EU.

Francis added that small exporters “have struggled with the additional resource cost, admin, bureaucracy… [which explains why] exports of construction products to the EU are still more than one-third lower than before the lockdowns, Brexit distortions caused persistent pushing back of the deadlines and then Brexit itself”. All of which weigh on firms’ profitability.

Subcontractors are starting to react to half-empty order books for next year with a much greater focus on cost control, logistics and cash flows. As pressures trickle down from main contractors, small and highly leveraged subcontractors are at risk of insolvency. They are also often unable to absorb customer non-payments and time extension rejections to complete project delivery.

The net effect of these accumulated pressures over time – for a low-margin industry sensitive to changes in financial conditions, prices and sentiment – will be further corporate distress, defaults and insolvencies in the year ahead.

If your firm is affected by these issues, do get in touch, and let us see how we can help. We advise main contractors, subcontractors and funders to navigate the turbulent environment with advice bespoke to your circumstances.