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WASHINGTON —Associated Builders and Contractors Chief Economist Anirban Basu predicts the nonresidential construction sector will remain stable for the second half of 2018, yet warns of a potential economic downturn in 2020, according to a recent mid-year economic outlook originally published in Construction Executive  magazine.

While the strong U.S. economy contributed to a positive forecast, a rapid rise in interest rates and materials prices could cause a dip in construction sector spending, especially given ongoing international trade issues.

“Contractors are becoming more and more concerned about surging materials prices—especially metals,” said Basu. “On a year-over-year basis, iron and steel prices are up 13.5 percent, which not only impacts a contractor’s margins but could potentially diminish demand for construction services overall.”

Prices for inputs to the overall U.S. construction industry expanded 2.2 percent in May, the largest monthly increase in 10 years. Prices expanded again in June by 0.8 percent and are 9.6 percent higher than at the same time one year ago, according to recently released U.S. Bureau of Labor Statistics data.

“And not only are materials getting more expensive, so are the costs of getting materials to jobsites,” said Basu. “Despite record low unemployment in the United States, an overall lack of skilled laborers in the construction sector and downstream markets contributes to the uncertainty.

“From electricians to painters to estimators, industry leaders are growing increasingly concerned about the dearth of skilled construction professionals and how human capital shortages have trickled down the supply chain,” said Basu. “This will not only contribute to increased compensation costs but also increased inflation and higher interest rates, which could potentially hinder both construction and real estate sector growth.”

The deluge of unsettling news reported in the media—terrorist assaults, indictments, chemical warfare, a burgeoning trade war and an ongoing set of inquiries that at least theoretically threatens the presidency—would appear to be enough to soften economic performance.

Plus, some business owners are experiencing anxiety about the series of tariffs the Trump administration recently implemented with the goal of protecting American jobs and domestic industries, as well as shrinking the nation’s trade deficit. Other nations countered in various ways, including China, home to the world’s second largest economy. Even more recently, the Trump administration threatened a 10 percent tariff on up to $200 billion worth of Chinese goods unless current trade practices are reformed. In turn, the Chinese government has promised a substantial response.

But to date, there’s little evidence that all this negativity has done much damage to the economy. Here’s what’s known as of spring 2018: Even with all the ups and downs, the U.S. economy has added jobs for an incredible ninety-three consecutive months. Since employment bottomed out in February 2010, the nation has added approximately 19.1 million new jobs. By May, unemployment had declined to 3.8 percent, the lowest rate in 18 years. June saw unemployment creep up to 4.0 percent as high school students and others surged into the labor force. The most recently available data indicate that there are more than 6.6 million available job openings in America, a prodigious tally that actually exceeds the total number of unemployed Americans.

The previously characterized two percent recovery is now a three percent recovery, with the difference largely coming from capital expenditures. In short, America’s economy is experiencing a level of momentum that it had not enjoyed during any prior portion of the economic expansion.

While deep division exists among people regarding who (if anyone) should receive credit for this bump in performance, the fact of the matter is that the bulk of macroeconomic indicators suggest that many business leaders are optimistic, anxious to expand their enterprises, and are stepping up both hiring and investment to chase emerging growth opportunities.

For now, the U.S. economic expansion remains firmly in place, with a combination of momentum, tax cuts, global money supply and confidence propelling the country forward.  America’s economy expanded 2.3 percent in 2017, and the International Monetary Fund forecasts 2.9 percent growth this year. During 2018’s initial quarter, the U.S. economy expanded two percent on an annualized basis, which is quite respectable by first quarter standards. The Federal Reserve Bank of Atlanta’s latest forecast suggests that 2018’s second quarter growth will be close to 4 percent on an annualized basis.

CLOUDS FORM, DARKEN

Even as the economy rolls along, clouds have begun to form on the horizon. Recent surveys indicate that many economists believe the next downturn will begin in 2020 or in 2021, which could completely reverse today’s momentum within the span of approximately two years.

Of course, they could be wrong, but their logic is largely rooted in interest rate dynamics. Inflationary pressures are building throughout the economy. Contractors are well aware of surging materials prices. Prices for inputs to the overall U.S. construction industry expanded 2.2 percent in May, the largest monthly increase in 10 years. Prices expanded again in June by 0.8 percent and are 9.6 percent higher than at the same time one year ago according to recently released U.S. Bureau of Labor Statistics data. Nonresidential construction input prices increased 0.9 percent for the month and 9.8 percent for the year.

For obvious reasons, all eyes have been on the price of metals, which are predictably increasing briskly. On a year-over-year basis, iron and steel prices are up nearly fourteen percent and steel mill product prices are up more than twelve percent. Separately, the price of softwood lumber, which is the subject of an ongoing dispute with the Canadian government, is up more than twenty-three percent compared to a year ago.

These dynamics are fraught with unforeseeable consequences. For instance, will the rise in materials prices induce diminishing demand for construction services? Will more expensive materials prices squeeze contractor margins? Moreover, if the general increase in various prices triggers rapidly rising interest rates, it presumably would truncate the ongoing economic expansion, now in its 10th year. All of this suggests that contractors should be rooting vigorously against full-blown trade wars, which would only serve to exacerbate already observable, problematic trends.

But inflationary pressures are emerging from several other sources. Recent declines in labor force participation are unnerving. With America boasting a record 6.6 million job openings, labor force participation should be rising. Though labor force participation rose in June, it had been declining steadily in prior months.  Broader trends suggest that human capital shortages will continue to worsen, and that implies faster wage growth (fine), more inflation (not so good), and higher interest rates (problematic for many, including those in real estate and construction). Average hourly earnings for all private nonfarm employees rose another five cents in June, from $26.93 to $26.98. During the last 12 months, average hourly earnings rose by 2.7 percent (72 cents).

This dynamic of rising wages, inflation and interest rates may be what ultimately undoes the current economic expansion. Higher interest rates are not good for many asset prices, including the inflated asset prices of stocks, bonds and commercial real estate.

Construction industry leaders naturally have been fixated on the dearth of electricians, HVAC professionals, roofers, painters, superintendents and estimators, but other skills shortfalls are impactful. For instance, not only are materials becoming more expensive, but so too is getting materials to the jobsite. Supply chain jobs are critical to a functioning U.S. economy, yet trucking firms are encountering a lack of adequate human capital.

The Cass Truckload Linehaul Index measures market fluctuations in per-mile truckload linehaul rates independent of certain cost components, such as fuel. June’s Index reading was 9.5 percent higher than the year-ago reading—the largest annual percentage increase to date. In short, the rising cost of trucking services impacts many goods, driving inflation higher in the broader economy.

WEATHERING THE STORM

The Federal Reserve, always on the lookout for rising inflation, recently raised its key Fed Funds rate to a range of 1.75-2 percent. The Federal Reserve also intimated that it would raise key rates not once, but possibly twice more in 2018.

Ultimately, the question comes down to whether the U.S. economic expansion cycle can weather the stormier times to come—times associated with rising costs, higher interest rates and potential trade wars comprised of tit-for-tat retaliatory tariffs. It’s important not to overestimate or underestimate the capacity of the U.S. economy to navigate turbulence.

As an example of the structural superiority of the U.S. economy along multiple dimensions, the United States recently came in first in a global ranking released each year by the IMD World Competitiveness Center. IMD defines competitiveness as “the extent to which a country is able to foster an environment in which enterprises can generate sustainable value.” Nations that can foster such an environment are more attractive both to domestic and foreign investors. This helps explain the high levels of foreign direct investment that continue to pour into America, including into U.S. commercial real estate.

IMD bases its rankings on 258 indicators ranging from trade statistics and national employment to more qualitative information such as business sentiment. The U.S. has consistently ranked among the top five nations, but this year the country raced to the top spot past Holland, Singapore and Hong Kong.
In other words, the geopolitical environment need not be perfect for the U.S. economy to progress because it is resilient, innovative, flexible and massive. Nonetheless, even giants can be slain, and it is the case that every past economic expansion cycle in American history eventually has wound to a close.

IMMEDIATE FORECAST

For now, the outlook for the U.S. nonresidential construction industry appears solid. Backlog remains elevated, with public construction finally joining the construction recovery, due in large measure to improving fiscal conditions at state and local government levels.

Recent industry surveys indicate that despite rising materials prices, increasing compensation costs and higher interest rates, construction firms expect to remain busy and in-demand for the balance of the year and beyond.

However, a growing number of construction industry leaders are concerned about their ability to maintain current profit margins in the context of rapidly rising costs and a potential inability to fully pass along cost increases to purchasers of construction services, including public sector buyers.

Construction industry leaders seeking advice on how to operate in this environment should consider this a good time to put more cash on balance sheets. While the near-term outlook remains benign, the longer-term outlook has become decidedly murkier.

Reprinted from ConstructionExec.com, July 10, 2018, a publication of Associated Builders and Contractors. Copyright 2018. All rights reserved.

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