The view at midyear: continued growth in nonresidential construction through 2020
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While slower growth is expected overall, some sectors are flashing signals of impending declines.
In spite of continued volatile conditions, the national economy performed reasonably well during the first half of the year. Economic growth is estimated at about 2.5 percent at an annualized rate, job growth was at a level that will add almost two million additional payroll positions for the year, inflation has remained under control, and the stock market showed healthy gains. Construction spending had been holding up reasonably well at a moderate growth pace, and the industry is on a path to add another 200,000 payroll positions this year.
As a result, spending on nonresidential building is expected to increase almost 4 percent this year and an additional 2.4 percent next year according to results from the AIA Consensus Construction Forecast Panel at its midyear update. These projections are largely unchanged from where they stood at the beginning of the year. Commercial construction levels—particularly for retail space—are in the midst of a broader slowdown. Industrial construction is seeing a very healthy rebound, while institutional construction remains on a late-cycle growth path. While some individual construction sectors are projected to see declines over the next 18 months, the consensus is that overall building construction activity will continue to expand.
Downside risks continue to outweigh upside opportunities
The consensus outlook that nonresidential construction activity will continue to expand reflects the underlying strength of the economy even this late in the business cycle: a strong jobs market and extraordinarily low rates of unemployment; rising wages, particularly at the lower end of the income distribution; restrained rates of inflation and resulting low interest rates throughout the economy; and a resilient stock market. Still, there is a growing list of concerns that would point to slower economic growth in the coming quarters. For example, a recent economic outlook survey by National Association of Business Economics put the odds of a national economic recession starting by the end of 2019 at only 15 percent. However, this same survey has the odds of a recession starting by mid-year 2020 rising to over a third, growing to 60 percent by the end of next year.
In fact, there are several potential threats to continued healthy growth in the broader economy as well as in the construction industry moving forward:
Tariffs and trade tensions
Probably the biggest risk to continued strength in our economy is that the imposition of (and threats of additional) tariffs will blossom into a full-blown trade war. Though that scenario seems unlikely, there will be continued uncertainty until this issue is resolved, which likely will have a dampening effect on business investment. Another complicating factor with the imposition of tariffs on imports to the U.S. is that they are thought to benefit U.S. producers. However, Deutsche Bank Global Research estimates that fully 30 percent of imports to the U.S. are part of the global supply chain of U.S. manufacturers, meaning the U.S. tariffs on imports can be detrimental to U.S. companies.
Weakening business confidence
Business confidence scores have fallen to levels last seen in the Great Recession according to the quarterly Conference Board’s CEO business confidence survey. Part of this concern is due to nervousness over trade issues, part is due to competitive international pressures that have limited pricing power for many companies, and part is due to concerns over corporate debt levels taken on during the era of cheap capital. However, pre-tax corporate profits fell in the fourth quarter of last year and again in the first quarter of this year. As a result, after growing over 5 percent in 2017 and almost 7 percent last year, business investment by U.S. companies has slowed this year.
Emerging consumer concerns
While businesses have been nervous for a while given the competitive pressures that they have been facing, consumers have been feeling quite comfortable. A low unemployment rate has allowed wages and salaries to grow at their strongest pace in over a decade, and low inflation has meant that these wage increases have not been eaten up in rising costs for things that they are purchasing. However, recently even consumers are beginning to climb on the nervousness bandwagon. Both the University of Michigan Consumer Sentiment Index and the Conference Board’s Consumer Confidence Index saw significant dips this past June. Even more disconcerting is that the expectations scores for these surveys dropped even more. Historically, consumer concern over current conditions matched with an even greater concern over future conditions has signaled impending weakness in the economy.
Limited potential for fiscal or monetary response
In response to a potential economic slowdown, there are potential federal backstops to buffer the weakness. Congress can implement fiscal measures to stimulate the economy, while the Federal Reserve Board can use monetary policy to pump more liquidity into the economy. Unfortunately, both of these options are severely limited at present. The Federal Government has been running significant annual budget deficits, with a recent report from the Congressional Budget Office estimating that the federal debt is likely to equal 78 percent of our nation’s GDP by the end of the year and is projected to reach unprecedented levels over coming decades. With this outlook, Congress is likely to have a limited appetite to further increase the federal debt to deal with a potential economic slowdown. On the monetary side, the Fed dropped short-term interest rates to near zero during the last recession to stimulate the economy. They only recently began to tighten interest rates, so now there is limited ability to begin another round of monetary easing. Additionally, the Fed has been trying to reduce its balance sheet of longer-term debt acquired during the last recession, again complicating its ability to begin a new round of debt purchases.
Mixed signals from architecture firms
In spite of these emerging concerns in the broader economy, the construction sector has largely shown continued healthy conditions. Recently, however, U.S. architecture firms have been sending off worrisome signals. After a strong January reading in the AIA’s Architecture Billings Index, there has been a period of softening. Since February, ABI readings included one fairly significant decline plus other essentially flat monthly readings. This has been the softest four-month period for the ABI since the last recession. While other indicators—project inquiries and new design contracts—have not been as worrisome, this recent volatility in the ABI has generated concern for the construction outlook.
Industrial and institutional sectors viewed as seeing strongest growth over next 18 months
The recent moderation in the pace of growth in construction activity is alternatively attributed to both supply constraints in the industry as well as to slower growth in the broader economy that is generating less need for new facilities. While there is evidence on both sides of this discussion, most analysts concentrate on the supply constraints: a serious labor shortage, unusually volatile construction commodity prices, rising land costs, and regulatory barriers that increase the cost of construction.
While there are genuine supply concerns facing the industry, they may be somewhat overblown in terms of their impact on industry activity. For example, there were 307,000 net new payroll positions added to the construction sector in 2018, accounting for fully 11.5 percent of net growth in business payrolls, just about the appropriate share of construction’s contribution to overall growth in the economy. Through the first half of 2019, there have been another 108,000 construction positions added, accounting for about 10.5 percent of overall net job growth. And while construction materials prices have been extremely volatile over the past few years, they have begun to stabilize recently, with the U.S. Department of Labor reporting that material inputs to construction have only risen about 1.5 percent overall over the past 12 months.
Given that there are also constraints to the demand for new nonresidential facilities, slower growth would be expected for the remainder of 2019 and into 2020. Commercial facilities are expected to bear the brunt of the slowdown, with overall spending for commercial buildings projected to slow to 2.5 percent this year and just 1.1 percent in 2020. In particular, retail construction is projected to see a modest decline this year and remain essentially flat next year. Hotel construction is expected to fare a bit better over the next 18 months, and office construction even better given the continued strong jobs market.
Manufacturing construction is finally expected to recover after several years of weakness. Recent declines in oil and gas prices have helped to revive the petrochemical facilities market. Institutional buildings are also expected to see fairly healthy results this year and additional moderate gains next year. Demographics continue to be generally favorable for the need for new educational facilities. The public safety sector also is projected to see healthy growth through 2020, making up for recent weakness in this sector.
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