A marked slowdown, but no projected decline for nonresidential building

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The construction market showed disappointing performance last year, but growth is expected to continue into this year and next

Construction spending last year was surprisingly weak, with current estimates suggesting that the industry eked out only a very modest increase. This year and next look to be more of the same. The American Institute of Architect’s Consensus Construction forecast panel is projecting just a 1.5% increase in spending on nonresidential buildings this year, and less than a 1% increase in 2021, according to recently released results. Once inflation in building materials and construction labor are factored in, this suggests a modest decline in actual construction activity. However, given that the current and upcoming period is expected to be the low point for this extended construction cycle, such a result would produce an extremely mild construction trough by historical standards.

As recently as last summer, construction forecasters were projecting growth of almost 4% in construction spending for nonresidential structures for 2019, with the economy humming along at a solid growth pace and producing healthy gains in business payrolls.

However, beginning in the second quarter, business investment began to decline, and the second half of the year saw the nonresidential construction market slow significantly.

A few building sectors were responsible for much of this unexpected weakness. On the commercial side, the retail and other commercial facilities market was expected to be an underperformer in 2019, but not see the double-digit percentage decline that is currently estimated. On the institutional side, the huge education construction market was projected to see its long-anticipated acceleration in construction activity. Instead, there was almost no improvement in spending levels for these facilities last year. While these sectors dramatically underperformed compared to expectations, there were a few that outperformed expectations or a least generated the expected increases. Office and hotel construction activity continued to see solid gains, and the modest growth in health care construction effectively matched projections.

Economic outlook beginning to look less volatile

Though the broader economy is expected to see slower growth this year, the number of potential trouble spots seems to be diminishing. Overall growth in GDP is estimated to have approached 2.5% last year, and is expected to drop to closer to 2% this year. Still, the prospects for a national economic recession in 2020 or 2021 have significantly diminished, as many of the downside risks have eased. The list of upside factors also has lengthened to include:

• Favorable interest rates – Generally, late in a business cycle, the economy begins to overheat, pushing up inflation and interest rates. This time, inflation remains extremely tame, and long-term rates in particular have been edging down for over a year. With recent cuts in short-term rates by the Fed, we now have a more normal yield curve for interest rates, not the inverted yield curve of last summer that was signaling a recession.
• A strengthening housing market – Lower interest rates have had a particularly positive effect on the housing market. Housing starts trended up throughout 2019, ending the year with the highest monthly figure since late 2006. While the December housing starts figure is not likely to be duplicated anytime soon, the general upward drift looks to continue into this year. Of particular significance are the recent positive trends in the production of affordable homes, a segment that has underperformed so far during this cycle.
• Employment trends – The job markets continues to remain very strong. About 2.1  million net new payroll positions were added last year, below the almost 2.5 million added in 2018 but still an extremely strong performance for this late in the business cycle.  The national unemployment rate remains extremely low, ending the year at 3.5%. All of which points to a solid foundation for consumers, so it’s no surprise that consumer sentiment scores remain very healthy.
• Trade agreements – Tariffs and trade have been one of the biggest concerns for the economic outlook in recent months, However, even this situation has seen improvement. The recently passed United States-Mexico-Canada (USMCA) trade agreement has been widely applauded, while the agreement on an initial trade deal with China lowers the temperature for the time being on that situation.

Still, there remain several downside risks to the economic outlook.

• A weakening manufacturing sector – Topping the list of concerns is that manufacturing production has been gently easing over the past year. The Purchasing Managers Index for manufacturing companies has been below the significant 50 level – indicating a monthly decline – for five straight months, suggesting that this sector will continue to trend down. Trade and tariff uncertainty have contributed to this manufacturing weakness, so there may be an easing to the slowdown in coming months.
• Declining business investment levels – Many U.S. businesses have seen increased global competition limit their ability to generate pricing power. However, a tight labor market has forced employers to raise wages, putting pressure on their ability to generate profits. Even though stock prices have remained near record levels, domestic corporate profits have been flat at best over the past year, suggesting that international operations may be generating a disproportionate share of overall corporate profits.
• International tensions – International unease continues, from the nuclear threat in North Korea, to tensions boiling over in the Middle East, to protests in Hong Kong, to discord in Great Britain over the Brexit negotiations. While most of these concerns are just simmering at present, any one of them has the potential to boil over into something more serious.
• Election year politics - Conventional wisdom has it that presidential election years are generally good years for the economy. Deficit spending is often used as a strategy to prime the economy. However, the growing federal government debt limits options on this front. Furthermore, intensely partisan politics make it unlikely that any bipartisan fiscal program – such as an infrastructure investment program – will emerge anytime soon. And finally, the Federal Reserve has limited ability to lower short-term interest rates to help boost the economy should a lift be needed, given how low they are already.  

Design trends point to modest gains in the construction outlook

Revenue trends at architecture firms underscore the recent overall weakness in the construction sector of our economy.  The AIA’s Architecture Billings Index bounced around between positive and negative monthly readings for most of the year with four negative monthly numbers, producing the worst year for revenue growth at architecture firms since 2012. However, the fourth quarter was the strongest of the year, suggesting reasonably healthy conditions for the design professions heading into 2020. Project backlogs at firms eased somewhat as the year progressed, averaging 6.5 months through the first half of the year before falling to 6.2 months in the third quarter and partially recovering to 6.3 months in the fourth.

Regionally, weak business conditions have been confined to architecture firms in the Northeast, as firms in the other three major U.S. Census regions on average reported billings growth each month during the fourth quarter. Firms specializing in the multifamily residential sector and in the commercial/industrial sector saw a healthy upturn in business conditions during the fourth quarter of last year, while institutional firms saw only modest gains over this period.

In spite of the ongoing volatility in billings at U.S. architecture firms, new design work continued to expand through most of last year. Architecture firms indicated that new project activity declined in only two months in 2019. As with billings, the fourth quarter saw the strongest growth in new work coming into firms. This end-of-year strength in new projects activity suggests that architecture firm billings should continue to grow moving into 2020.

Outlook cautious, but reasonably optimistic

With the fear of a construction downturn looming, the disappointing levels of construction activity during the second half of last year might be interpreted as the construction sector heading into an earlier and deeper recession than expected. However, recently there have been several positive trends. The overall economy has stabilized, and most forecasters have lowered their odds of a national economic recession beginning over the coming two years. Fear of escalating tariffs and an emerging trade war with China emerging have been reduced recently. The residential markets, a traditional leading indicator of nonresidential building activity, have seen some unexpected strength recently. Finally, design activity at architecture firms, historically a very accurate leading indicator of future construction activity, showed unexpected weakness earlier in 2019. However, design billings improved during the fourth quarter, and new projects coming into architecture firms saw strong growth toward the end of the year. So, while 2020 and 2021 are expected to see only very modest gains in construction spending nationally, the prospects of a more significant downturn over this period have dimmed recently.

Kermit Baker, Hon. AIA, is AIA’s Chief Economist and part of the AIA Economics and Market Research Group, which provides AIA members with insights and analysis of the economic factors that shape the business of architecture.

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