No place like home for building a recovery

The construction industry might look sickly, but in truth it is a drag on growth, not a key driver of the economy

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A "disaster" and "woeful" were just two of the words used to describe the latest UK construction figures. KPMG's Richard Threfall branded the figures "a nightmare… We all want to wake up and find this isn't real, but sadly it is. The only way out is for fast, determined action to stimulate growth across the construction industry".

Heady stuff, indeed. At a stroke the seemingly much better UK economic news of late has been stopped dead in its tracks, and all because the Markit/Cips construction purchasing managers' index showed activity in the sector was lower than expected in September, following another terrible month in August.

But does the continuing shrinkage of the construction industry mean that the "green shoots" of recovery for the third quarter are completely illusory or is there more to it?

Regardless of how it is dressed up, construction suffering its worst period since late 2010, when the country was sitting under a mountain of snow, is bad news. The feeling of doom is even more acute because construction has become a political hot topic. The Coalition has identified the sector – rightly – as a germinator of growth and wants to relax the planning laws for developers and homeowners alike. And in his party conference address this week Ed Balls, the shadow Chancellor, said a Labour government would help first-time buyers and oversee the construction of 100,000 extra homes.

However, construction is a relatively small part of the UK economy, accounting for only about 7 per cent of activity. It suffered a horrible second quarter, shrinking by 3 per cent, according to the Office for National Statistics. But this figure, released last week, was massively uprated from an initial estimate of minus 3.9 per cent.

Tellingly, this uprating had only a marginal impact on the overall UK growth figures from the ONS, which were raised from minus 0.5 per cent to minus 0.4 per cent. This shows that construction is important but it's nowhere near as important to growth as services and government spending, which account for some 70 per cent of the UK economy. If such bad news was emanating from the retail sector – a major part of services – then it would be much more worrying for the prospects for overall GDP growth in the third quarter. Nevertheless, construction is a substantial drag on the headline GDP figures, which are hoped by policymakers and the Treasury to be much better in the third quarter.

Howard Archer, the chief economist at IHS Global Insight, said: "The extent of [construction's] recent weakness has weighed down on the UK economy and it contributed appreciably to the quarter-on-quarter GDP declines in both the second and first quarters of 2012 … contributing 0.2 percentage points to the GDP contraction in the second quarter and 0.4 percentage points to the drop in the first quarter." In effect, the construction numbers will be like a racehorse's weight handicap – something that has to be overcome before positive overall growth can be registered.

Construction continues to be a drag on the UK, not least because public spending cuts are really beginning to bite when it comes to building projects – a bulwark for growth after the bottom fell out of the residential market in 2008. And the bad news didn't end with construction. House prices – key to the consumer's feeling of wealth and financial well-being – suffered a 0.4 per cent fall in September, according to the normally trustworthy Nationwide survey. But it's difficult to lay too much store in the monthly house price figures as they tend to move about rather violently, subject to one-off factors such as the weather and even events like the Olympics. If you were to plot a graph of monthly house prices it would look like the ECG of a heart patient, blipping up and down. Three-monthly figures or even annual rates are smoother and more reliable in revealing trends in prices. But here the three-monthly figures show a market practically flatlining, apart from London, which is skewed upwards by wealthy international buyers, and Northern Ireland, which is still suffering from the bursting of its bubble.

The good news is... the absence of really bad news on house prices – there is no asset fire sale going on, repossessions are at a much lower level than you would expect in a recession, partly due to lender forebearance and the very cheap mortgages that are out there (it is even becoming easier and cheaper to remortgage, with home loans at their most available since the 2008 financial crisis). The UK also continues to defy the gloom, creating jobs rather than shedding them. As a result there is no drag on growth from the housing market, allowing Robert Gardner, Nationwide's chief economist, to pronounce: "We expect the UK economy to see a gradual recovery over the next 12 months, with house prices remaining relatively flat or declining only modestly over the same period." This is not like the early 1990s when house price falls led to a constriction of consumption and recession, in turn leading to repossessions. This time it's merely low-level economic background noise.

And regardless of the travails of construction and the limp housing market, the consensus estimate is for a return to growth in the UK in the third quarter – largely because the second quarter was so bad. Most forecasts sit in the 0.4 to 0.7 per cent growth range and if they turn out to be correct that means the palest of green shoots will be visible. But nurturing them will need construction to be less of a drag in 2013.