Invest for recovery

Here we are back to work after a glorious summer, and everyone seems more optimistic. UK house prices and mortgage lending are up and retail sales have jumped. Not so many weeks back the papers were talking about “Boom Britain”. But as the BBC’s Evan Davis so succinctly tweeted: “I suspect we might be getting ahead of ourselves here guys.” Is it real, or do we all have a touch of sunstroke?

The single question I am asked most often at the moment is: “When is our order book going to start to pick up?” The construction sector desperately needs to know when serious growth will kick in. So much cost has been taken out of the industry, chasing down a reduction in output that now lies 17% below its peak, that there simply isn’t the capacity to deal with a surge in demand. And those who have been lost to the industry aren’t sitting around waiting to be rehired - they have evaporated: gone overseas or into different industries. The leaders of major businesses in the sector are scratching their heads as to why recruitment is so difficult.

But those who anticipate the pick-up correctly and resource for it will thrive. The next round in this highly competitive market will be won by those who have the resources to compete. But everyone is rightly nervous about calling the recovery too soon.

Increased confidence drives increased investment. That is why the construction industry will pick up faster than the economy as a whole

KPMG has been tracking the relationship between UK economic output (GDP) and output in the construction industry over the period stretching back to 1970. What is clear is that construction output is closely correlated to general economic growth, except that construction output over-reacts to that growth - a small upswing in GDP leads to a much larger increase in construction growth, and vice-versa. Government procurement slightly dampens the swings in private demand, but not enough to outweigh it. Ultimately construction is a sentiment-driven industry.

The latest Office for National Statistics figures have shown 0.6% growth in the economy in Q2, and the Bank of England is now forecasting GDP growth of 1.4% for 2013 and 2.5% in 2014 and 2015. These are the first positive growth forecast revisions since the financial crisis and suggest the corner has finally been turned. Construction indicators are pointing the same way, with output up in July and insolvencies at their lowest level since 2007.

Furthermore, government stimulus will have a beneficial effect for the industry driving significant growth in construction output in rail, roads and housing initially, and gas and nuclear energy in due course.

Some caution is in order. First, the recovery is likely to be slow. No previous recession has seen such long-term suppression of output. More than five years on from the previous peak, output is still 3.5% down, whereas even in the Great Depression it only took four years to recover.

Second, the recovery still looks fragile. Household spending represents about two-thirds of total GDP yet real household disposable income has been pretty much flat for six years, falling 1% between 2006 and 2012. It would have fallen further but for rising population and employment levels.

But before we talk ourselves back into recession, there is a missing piece in the analysis. The Office of Budget Responsibility forecasts real incomes flat to falling, but sees growth coming through from a reduction in the savings ratio. July’s lift in retail sales wasn’t driven by more pennies in people’s pockets, but from consumers deciding to spend more and save less. And the same psychology applies to businesses. Increased confidence drives increased investment. That is why the construction industry will pick up faster than the economy as a whole. Commercial property, which has been in the doldrums, may recover last, but when it lifts will do so quickly.

Remember construction is a sentiment-driven industry. Believe that and you will act now, because the industry’s resurgence is already under way.

Richard Threlfall is head of infrastructure, building and construction at KPMG