The budget gave us cause for caution, but it’s still in the context of optimism
It’s tough enough winning agreement on what happened in the past, so there’s little chance of knowing what the future will bring with any great certainty. Yet so much of our lives in the present rests on expectations of the future.
Let’s reflect on the fallout from the Budget. Ignore Brexit, consciences or lack of them. Forget about the music-hall magician’s distraction that was the sugar tax. In many ways these are sideshows. The real catalyst prompting a reappraisal of the political reputations of Iain Duncan Smith, former secretary of state for work and pensions, and Chancellor George Osborne, was one thing. The Office for Budget Responsibility (OBR) changed its expectations of the future rate of growth of productivity and created a real challenge for the Chancellor. One he now admits he flunked.
It’s easy to underestimate the importance of productivity. But read from the plethora of recent reports and you’ll regularly bump into the Nobel laureate economist Paul Krugman’s 1994 quote: 'Productivity isn’t everything, but in the long run it is almost everything.'
What may seem a small, arcane some might say, tweak in its forecast has led OBR to make a fairly significant shift in the expected future path of the UK economy. Chart 1 shows how the OBR downgraded its expectations for productivity growth. But this seemingly small change prompted an average reduction of 0.3% in the OBR’s expected GDP growth rate (see Chart 2).
Lower productivity growth means lower growth in gross domestic product (output). That in turn, all other things being equal, squeezes the money available to the government and makes the Chancellor’s job tougher.
Remember, this is just a forecast. It’s not what will happen. But it comes from the OBR, so we take it seriously as a guide to the future. And so should the whole of construction, because it has potentially huge implications.
There’s a very strong link between the growth rate of the economy and the activity in construction. If economic growth is negative or sluggish over a sustained period, construction activity falls.
Effectively construction tends to track the path of GDP in an exaggerated way, but it appears to need a ‘base load’ of economic growth to sustain the level of output. For construction to maintain growth over, say, a three-year period, history suggests the economy needs to grow by about 6% – an average of about 2% a year.
This is, of course, is all statistical and history never repeats itself exactly. But the rule of thumb appears to be that economic growth over three years of 6% makes a fall in construction unlikely, while growth under 5% over three years makes a drop in construction work likely.
This relationship is illustrated in Chart 3. It shows how sensitive construction output is to the level of GDP growth. Anything above 7% or 8% growth in the general economy over three years and the construction industry seems to race along.
Now let’s look at the change in sentiment at the OBR. In November the expectation was for three-year growth of around 7.5% over the forecast period. The view now is that it will be more like 6.5%.
That level of growth still points to increasing construction activity. But it’s far less positive, in the light of the above, than we saw in the November OBR forecasts.
Before we get too anxious, it’s worth reflecting on a fantastic quote made by the head of OBR, Robert Chote, in January, reflecting on the November Autumn Statement: ‘The lesson is that what the sofa gives, the sofa can easily take away.’
This was in response to comments that the OBR had apparently found ‘down the back of the sofa’ an extra £27 billion for the Chancellor to spend. Chote was seeking to highlight two things. First, how small the sum was in the scale of government spending. Secondly, how susceptible the figures are to relatively small, sometimes technical, changes in the forecast.
Forecasts are guides, but they do influence how people feel about the future and behave in anticipation. As well as suggesting a future, they influence confidence, which is a key factor in whether clients invest in construction.
Forecasts are, however, based on what, as far as we can tell, is happening in the real world. And in the real world it seems that growth in construction activity is easing. The Bank of England Agents have recently updated their assessment of construction activity and point to a more modest rate of growth in February than a month earlier. This continued softening of growth mirrors the earlier findings from Markit/CIPS (Chart 4).
But to finish on a more upbeat note, Chart 5 shows the effect of the RIBA Future Trends Survey latest release, which suggests a bounce back in optimism in January from a rather subdued December.
So while there’s always room for caution, the message in the data as it stands appears to be: sofa, so good.