The House Always Wins: The UK Construction and Materials Industry

The course of this year has been a challenging equity market around the world. Investors are reviewing their investment strategy in a global market surrounded by fear and uncertainty due to higher inflation, more aggressive central bank intervention leading to high-interest rates and quantitative tightening, and the ongoing Russo-Ukrainian war that puts more pressure on the prices of raw materials and the supply chain, plus the unknown implications of the recent Shanghai Covid cases and the Zero-Covid Policy implemented by the Chinese government. Investors are reviewing their portfolio risk and shifting towards higher-value investments and defensive portfolios. Stock valuations tend to look for corrections in this market environment and offer compelling opportunities when good quality companies trade in low valuation ranges.

Chart 1. Equity Returns: Construction and Material Sector

The UK construction material sector has not been an exception. It is exposed to inflation of raw materials in a country that deeply depends on the import of most of the materials needed. Nevertheless, the construction sector has proven resilience and stronger recovery from recent economic downturns in the last 10 years. The sharp decline seen during 2020 due to the Covid lockdown policy was quickly surpassed and reached historical highs by December 2021. Indeed, the FTSE 350 Construction and Material fell by 32% from 27 December 2019 to the bottom on 1 April 2020 and since then it recovered sharply to end with around a 74% increase by 29 December 2021. This tells the sector's ability to adapt to adverse economic events.

This exceptional performance in the general markets index is reflected in high Beta sensitivities within the peer group (mean: 1.24; median: 1.28) as we will show in the next section. This is a critical parameter for most portfolio managers during the current rebalancing process and needs to reduce overexposure to equities with a high systemic risk.

Table 1. Peer Group: Quick Comparison (Currency: GBP, As-Of Date: 31 Mar 2022)

A Cyclical Industry:

The risk of stagflation, the situation where the economy shows simultaneously high inflation and stagnation of economic output, is highly likely. Central bank authorities are reacting too late to control the monster of inflation after astonishing monetary expansion and fiscal stimulus. Now central banks need to put the foot on the pedal to keep control of the inflation but at the cost of a slow down in the economic growth.

The construction and construction material businesses are one of the most cyclical sectors and are deeply affected by inflation and supply chain disruption. For example, historical data of the MSCI ACWI Index for the Material Sector and FTSE 350 Construction and Materials Index compared with the UK real gross domestic product growth (annual GDP growth rate) from December 1994 illustrate the relationship.

Chart 2. Construction & Materials Equity Index and UK real GDP growth

During the financial crisis of 2007-2008, the FTSE 350 Construction and Materials Index fell by nearly 50% while the MSCI ACWI/Materials (Sector) Index collapsed by nearly 63%. The interesting thing is that the equity sector began its recovery while the economy remained in recession. This is because, during the trough, governments tend to stimulate the construction sector to reduce unemployment. We saw the same phenomenon after the Covid Lockdown was enforced in 2020 and 2021. While restaurants and pubs were forced to close, the construction sector was allowed to continue operating. If that's the case, the house always wins.

In the following post, I will comment on some of the companies in the construction materials sector listed in the peer group selection. Please, leave your comments and questions so I can incorporate them into the following article.

Regards,

Jhoan Cordoba

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