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European Union economics and the disconnect between the Northern and Southern construction markets: Dasha Lukiniha, IHS (UK)

Filmed at Cemtech Europe 2015, 20-23 September, Intercontinental Hotel, Vienna, Austria.

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Thank you very much for the introduction and for an opportunity to speak here, as Keith mentioned my name is Dasha and I work for IHS, a global forecasting and analytics provider. So today I'd like to talk to you about European Union economics and the disconnect that we're seeing between the Northern and the Southern construction markets and really where the next spots spot and the weak spot are going to lie, for the construction industry, for the building materials providers and for the cement suppliers in particular.

So first I'm going to go over the link between the construction and macroeconomic recovery, and how these two follow together, and how this unfolds within the European Union in general. And then I'm going to ask a question of is the trend really uniform across the region, or are there any hotspots within the lumber market, the cement market, the construction industry, and any weak performance, where we don't expect to see much growth, within next, over the medium term really. And then I'm going to hold in on the Northern European market, as one of the stronger performance and the Southern European market as one of the ones still battling the recession.

I'm going to slightly touch upon the Eastern European market as I think in the recent events, it's becoming one of the interesting construction and macroeconomic regions to look at and to see where the risks lie within the region. And then I'm going to tie this in together and say what this means for the construction industry going forward and what this means for the cement industry in particular. So I'm going to start off with this graph that shows construction spending against GDP growth and I'm going to almost state an axiom and say that construction spending tends to follow macro economic recovery very closely.

This happens due to a variety of reasons. First of all on the residential segment, construction spending really depends on consumer spending power, on the ease with which it is easy to get a mortgage, etc and on the non-residential side on the infrastructure and structures construction, it really depends on the health and the state of the budget, on how the government is able to plan for the large scale infrastructure projects over the near-medium term.

And looking at Europe it is by no means an exception, what we've seen is construction closely followed the GDP growth, GDP being slightly less cyclical, due to the fact that it includes an aggregate of all industries within the economies. So going forward we see this length continuing and for Europe as a whole we see stable growth rates coming out within the next two years.

So we see about a 1.5% growth this year and acceleration to 2% in 2016. Photo construction spending is going to follow suit and going to increase at a 2% growth rate, this and next year. If we were to look at the construction industry by different types of segments, so if we were to break it out and to the residential segments, so the housing demand and the non residential segment, your usual more cement intensive segment of the construction sector, it is generally quite a fairly balanced recovery.

Residential construction tends to recover quicker because housing demand tends to be more elastic, than government budgets for large scale infrastructure projects. Generally speaking we are seeing a pick up in both segments especially from next year on wards, which is going to drive the cement demands upwards in terms of the operating environment for the cement suppliers and producers, we see them operating in a stable custom environment, which is is a lot Jude festival all price drops, which is going to create a favorable effect for the margins for the suppliers, as well as a relatively low inflation environment.

So all in
all if we were to look at a European region as a whole, it looks like a stable and a fairly predictable market to invest in for building materials providers and it looks like the worst is behind us. But then the question arises is the trend really uniform across the region or are we seeing larger increases in one region and really still contractions in another region and where we see the demand for the building materials coming from is it really uniform? Well the short answer to that is no and what we are in fact going to see is a larger diversion going forward.

If we look at the building activity, pre 2009 slump and post 2009 slump, and what we can see on the graph is three different regions, the Northern European region, the Southern European region and the Eastern European region, and pre 2009 the three were very closely following each other and Eastern European construction market was a little bit higher, a lot of it was due to the pent-up demand for the infrastructure construction post of the Soviet Union collapse, and as well as rapidly rising consumer spending power.

Which was increasing the residential segments. However, in 2009 things kind of went South, all three collapsed, but what we saw shortly after that was that Northern and eastern European regions were able to come back up, and they are picking on all fronts, lumber, wood, cement for construction segments, and what we saw was Southern Europe really stayed down below and we don't see that gap closing.

We haven't seen it close up to now, and we don't expect it to close anytime soon, making it in a way less attractive operational environment, and there are several reasons behind the shift. First of all Southern European countries , have been facing structural rigidities and structural problems, that were in a way hidden when the European region and the global region was going through a period of very strong growth.

However when the slump happened, when the crisis hit, these structural problems sort of there was light shed on them and in order to salvage the situation, several years at least are needed, and the exact problems that I'm talking about are high levels of public debt, that are really lowering your infrastructure spending,

that will impact the cement demand adversely. Political instability in a lot of the countries, as well as one big problem and that's plaguing, I want to say most of the countries in the South, Italy, Greece, Spain, Portugal, even France are the low productivity environment, high cost environment and making it less profitable, for example for cement suppliers to even operate their operations on an export basis, when the internal demand is low. To make this point further if we looked at construction spending as a ratio to 2007 levels, we see that Northern Europe collapsed then went back up, Eastern Europe is a little bit low right now in terms of construction spending but that's mostly due to the geopolitical crisis, Ukraine-Russia crisis that's currently plaguing the region.

Considering that Eastern Europe region is quiet heavily dominated by Russia, and all of the neighboring countries are still very closely tight to the Russian market, there's going to be sort of a knock-on effect. So weakness in Russia which is seeing relatively large contractions right now which is an IHS forecast construction to drop by about 10% this year, it will have a certain knock-on effect on the other Eastern European countries. However we do not expect this trend to continue for a very long time.

It is set to recover within the next several years. But if we look at the Southern Europe, really construction market fell to more than half of what it was pre 2007 levels. And 2015 is at the bottom and we don't see it coming back up within the next 10 years to what it was before. So really when the Southern European region including Greece and Italy, Spain, Portugal, are much less attractive destinations right now. This of course is reflected in cement consumption very closely, this map shows cement consumption variation in 2014, and we already see that most countries up North, have been seeing increases and are still increases in cement consumption, and a lot of the countries down South, most of the countries are saying contractions.

Now one interesting example of that is Spain, that is one of the perhaps exceptions in the Southern European region, it's seeing a little bit of a renaissance, as it has been one of the pioneers in structural forms, I'm going to come back to it a little bit later on. So generally speaking, if we were to hone in on the Northern European market first and its construction, as a stronger performing region, it is safe to say that it is on the path of steady growth, that the worst the contraction is behind us and that we are going to see a healthy GDP growth, healthy consumer spending levels, healthy investment sentiments coming out of the region, over the medium to medium term. Construction, both in the residential segment and on the non-residential segment, is going to see how the increases so it's going to pick up to over 3% growth from next year on wards.

But of course even within the Northern European region, we are seeing the differences in performance. For example two countries that will stay fairly muted this year, in the sense of construction spending, will be Norway and Belgium, this is going to be more brief slow down as opposed to a period for contraction for Norway it's got a lot to do with oil price job and the need to re-balance economy somewhat. And Belgium is still struggling with adverse labor market conditions and slow economic growth that it will see construction spending pick up from next year on wards. Now the three countries that I would really like to focus on and where we see most of the construction spending in the Northern region happening and proving to be attractive not just from the activity perspective but also from the operations perspective, are Germany, the United Kingdom and Ireland.

Germany has been one of the star perfomers through the entire global crisis and it was one of the countries that recovered much much quicker and going forward we continue to see strong constructions spending growth, both on the residential segment as the credit conditions are very easy and it's easy for people to get hold of mortgages, the lending conditions are very favorable. But also on the non-residential side, we will see large scale infrastructure projects going forward within the next 3-5 years. And this is a lot to do with the fact that there's a lot of pen tab demand for infrastructural renovation within the country.

Germany has under-invested in inrastructure up until now and it needs to harmonize infrastructure across the West and the East and they've made it their priority within their budgets for the next couple of years and they've already put a framework together, for large scale road work renovations, rail network development, housing schemes across Germany, so we're going to see a lot cement demand coming from those projects in particular.

We see residential segment posting a 4.2% in growth this year and a non residential segment or infrastructure segment posting an over 4% growth this year, followed by similar gains. The second country of interest, the United Kingdom has already seen a very strong pick up in construction. Of course there was Olympic games,

there was a huge rump up in activity up until that point, but it continued with strong growth even after the Olympics preparations were over. And it is due and in part to very strong economic growth to the UK labor market is perhaps one of the most flexible markets in the European region, and it makes it an attractive environment to operate in.

One of the perhaps lagging problems of the United Kingdom is that wages are growing faster than productivity but generally speaking it is, a very flexible market where it's easy to hire, it's easy to fire workers so unemployment levels are really low. United Kingdom also has a budget that's in a relatively healthy state right now and they have put together a plan for infrastructure development for the next two to five years, that's going to include again housing schemes, flood defense systems, road networks, investment strategy and we're going to see a lot of cement sales from there.

United Kingdom already sold cement sales up almost 8% last year and we continue, we expect to see similar growth this year and next year and over the near to medium term. The third country of interest, Ireland, is another interesting case. It really took a big hit through the recession, it's construction activity fell by something like 60%. It was bailed out, the Troy cart is what you know very closely, but it's made some very, very significant headway in the way of structural reforms, and it is seeing strong pickup in construction.

So we expect to see low utilization rates within the industry, within the building materials industry picking up. We're expecting to see a lot of pent up demand coming out of there, we're expecting to see more and more housing sales. Of course the only problem with it is that Ireland is already seeing a possibly another housing bubble forming and there's a need to watch over for that, because that could prove to be very adverse for the future macro economic growth of the country, but we expect cement sales as well as production up over the next few years.So all in all, it is possible to say that Northern European market will remain an attractive destination for building material providers going forward, and in a general sense the third world remains the safe place to invest in.

Now going to another site of the spectrum, Southern Europe. Southern Europe is still battling the recession, it will not see major economic growth coming out of the region over the near term and its construction spending will remain flat this year, which means that its cement consumption and cement production is likely to post, still contractions this year and possibly next year.

Of course there's some un-uniformity of performance even within the region. The worst performance, the weakest performance and as John Christoph mentioned Italy, their cement consumption has been contracting and it will continue to post flat gains over the next couple of years and because of it's structural make up, it is really facing three main problems that are constraints to both macro economic growth as well as construction growth.

So first of all Italy has a very very high level of public debt, that still continues to grow and it will of course cartel and prevent large scale infrastructure planning going ahead and it detracts any external investment that could perhaps go forward. Another problem is political instability, so that political instability is really slowing down their firm process needs, to make Italy an attractive destination. And the third problem is the cost environment, very low productivity and very rigid labor markets, are making it very difficult to hire and fire workers. The wage bargaining, the wage setting mechanism is very rigid in the sense, so even as an export destination, some countries have been able to hold on to exports, so if you have very low utility capacity utilization rates within the industry, for the lumber industry, for the cement industry,

you can re-balance and move it to an export destination. Countries such as Italy, France, Portugal are becoming less attractive as those destinations Nations due to unfavorable operating environment and what these countries are really attempting to do, is to create those reforms and to physically consolidate in order to attract that investment, and to solve the labor market issues.

Greece is a very difficult case at the moment. Their continuous political instability and their low growth constructions are really preventing any infrastructure projects going forward. I just predict a 35% probability within the next 12 months of Greece exiting the Euro, and I think it grows to 42% probability within the next 48 months, meaning that we're actually expecting that probability to increase over the longer time due to Greece being in the current state mismatched with the rest of the growth agenda in Europe.

But of course there are exceptions to these dynamics and as I mentioned before Spain is one of the interesting countries, in terms of micro economic performance, in terms of construction performance, in terms of cement production and cement demand. Spain, took one of the largest hits in construction activity, through the recession, and it was one of the pioneers that really implemented labor market reforms that really implemented fiscal consolidation, restructured its finance sector, and it's beginning to show both on the macroeconomic growth, on the construction spending growth.

Spain will post an increase of 1.5% this year followed by further acceleration in construction spending levels, and it's already seeing cement levels, cement sales, cement productions pick up. Spain in a sense is one of those countries that was able to get hold of the export market. Spain is the European Union largest cement exporters.

So cement exports grow 32% in 2014, and what we expect to see is this pick up in internal demand, in internal growth will take some of the pressure off the export markets and re-balance that towards serving the internal market more. And we expect to see pick up in utilization rates as well over the near term.

So generally, cement consumption is expected to be the strongest in the Northern European region, so this graph shows cement consumption growth over the next two years, and we see sort of flat growth in 2015, with contractions for the Eastern European region, because of the geopolitical crisis and we expect to see similar contractions in the Southern European region, followed by a very slow pick up from next year on wards.

So what this actually means for the construction industry and for the cement markets in particular, the key take way here is that it is no longer one Europe and as we thought it was going to be a temporary phenomena where Southern Europe took a larger hit but it nonetheless we expected that their construction industry was going to recover fairly quickly, it was going to converge with the Northern Europe, with the Eastern Europe, it is looking to be increasingly unlikely, but this is going to happen over the near and perhaps medium term, depending on how political instability really unfolds in the region.

So what we expect to see is that you will see a strong Northern European market region, strong growth,, strong investment climate, a lot of construction activity, infrastructure renovation and a lot of cement demand coming from there, but what we are going to see Southern region really on the other side of that spectrum and we are going to see it battling with low capacity utilization numbers and with the ability to fully implement the structural reforms needed for the sort of renaissance so to speak to a per. Few countries of North, Germany, the United Kingdom and Ireland will be very attractive, both from the operating environment as well as from the investment perspective.

Italy, Greece and Spain will still be a little bit shaky and will see a low growth rates. Eastern Europe at the moment, remains an attractive destination for building materials providers and for future growth prospects but it's a bit on the fence, with regards to current geopolitical risks that are plaguing the region.

We remain optimistic on where the activity is going to go, but there's going to be more certainty over the direction of the region over the next six to eight months. Of course there are downside micro risks and one of them being the Greek exit from the Euro that has the potential to. Southern Europe is look like game of dominoes, Greece goes down then there's a possibility that Portugal goes down after it and then you have Italy, Spain etc.

So this is unlikely to happen as it seems that the governments have been able to show themselves from that contagion, that it non the less remains a possibility over the near term. So all in all key take way here is, I'd like to leave you with a thought that we can no longer base our decisions on one Europe testament and we are going to see the gap between the Southern European region and the Northern European region and going forward over the near to medium term.

Thank you very much, if anyone has a question.

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