Signs of Recession? Potential Impacts on the US Construction Market
September 2018 marks the 113th month of continued economic expansion in the US. This period of growth, which began in March 2009, has been underway for over 9 years and is the second longest cycle in our nation’s history (following the 120 months from 1991-2001). Although the economy remains strong by many measures and is sitting at or near historical peaks, there is increasing discussion about the next recession.
As an owner’s representative and construction cost consultancy, our clients come to us for advice on managing uncertainty, risks, and budget for their projects, particularly large-scale or long-term capital work that can extend five or more years. This report reviews the economic and construction indicators we are actively monitoring to anticipate and prepare for a potential economic shift. The indicators we analyzed are national level indicators, which average and smooth out regional variations.
Our analysis shows continued expansion on nearly all fronts but with growth slowing compared to previous years. Low unemployment and stock market highs, coupled with strong consumer sentiment are all positives, while the flattening yield curve, oversupply in the multi-family residential sector, and the lack of momentum in new housing starts are negative indicators. Uncertainty around the current political climate and trade conflicts also weigh on the economy.
Historically, recessions have been triggered by external events that cause panic in financial markets, such as the 2000 tech bubble burst, and the subprime mortgage crisis of 2008. David Kotok, Chief Economist with Cumberland Advisors, reported that some businesses are already delaying investments amid the uncertainty, which could result in slower economic growth.
As in all recessions, some geographic areas will be hit earlier and harder than others. Cities with markets already operating over-capacity with stretched labor pools such as San Francisco, Los Angeles, Washington DC, and Seattle may be less affected than others, given the diversity and relative strength of their economies. Cities more tied to a specific industry, or without diversified business bases may face more severe contraction.
Positive Leading Indicators
Construction Employment Remains Strong
Changes in construction employment can be examined as an indicator of economic activity. Prior to a recession, the non-residential construction sector typically sheds workers, while the rest of the construction industry slows hiring.
As of July 2018, US construction employment has reached almost 7.2 million people, only 480,000 less (6%) less than the previous peak in 2007. Growth in the nonresidential sector has been slowing down while the growth in the residential sector has been rather volatile. It is difficult to flag any warning signs from employment figures at this point but considering the volatility that exists in residential sector numbers, we will be monitoring this indicator closely.
Record-Breaking Stock Market Performance
The stock market is now experiencing the longest Bull market in history. Numerous factors have contributed to this performance including low interest rates that have lowered the cost of investment and increased corporate profits, the lack of yield in fixed income investments that has flooded equity markets with capital, and the 2017 tax reform anticipated to improve corporate profits.
S&P 500 and Dow Jones Industrial Average market indices, which represent the diversified market as a whole, remain strong but have struggled to climb past their all-time highs in January of 2018.
It is important to note that the stock market has generally acted as a pre-emptive indicator of fluctuations in the business cycle. Stock market declines have often preceded economic downturns, sometimes by more than a year. These occur when anticipation of an impending market contraction causes a rallying stock market to drop. With the speculative nature of equity investing and the growing use of options, negative indicators or signs can weaken investor confidence and have a ripple effect across the market, impacting corporate earnings and potentially triggering an economic downturn.
The yield curve mentioned earlier in this report is one of many such indicators that stock market investors watch closely. According to Derek Horstmeyer, Assistant Professor at George Mason University, “…data suggest that prices (especially equities) respond much more to an [yield curve] inversion than to an actual recession, which comes on average 12 months later”. Recent and expected interest rate hikes by the Fed and the threat of trade restrictions such as the steel tariff are factors that are already threatening consumer and investor confidence moving forward.
The stock market is currently booming and the economy looks poised for growth, but MGAC will continue to track indicators including regulatory changes, corporate earnings trends, interest rate changes, and inflation.
Neutral Leading Indicators
Input and Output Construction Cost Index Spread Remains Stable
ENR Building Cost Index (BCI) and Turner Construction Index (TCI) are two indices measuring input and output construction cost levels, respectively. The input cost index tracks the combined effect of material, labor, and equipment on construction costs, while the output index also accounts for the dynamics between market supply and demand, and bidding competitions. The spread between the two indices removes the effects of the inputs and can be used to gauge market conditions.
As the construction market expands, the spread between the two indices will widen as supply struggles to meet demand and contractors are able to charge a premium in a busy market. Conversely, the two indices tend to converge as the market cools due to lower margins among contractors as they compete for a shrinking pool of work. Additionally, in a heated construction market, labor quality suffers as a result of reduced productivity, which can perversely serve to suppress profitability in the busiest times. During a recession, the output index will fall far below the input index as contractors are willing to absorb a potential loss just to secure work.
As the market recovered from the previous recession, we can see that the output index surpassed the input index in mid-2012 and continued to spread until Q1 2016. After a period of narrowing from Q2 2016 to Q4 2017, the spread has resumed widening. We will continue to monitor these indices for a reversal of this trend.
Purchasing Managers Index (PMI) Decreasing
The Institute of Supply Management (ISM) releases The Purchasing Managers Index (PMI), based on data it gathers from hundreds of manufacturing firms across the country. Using data from five different weighted factors including new orders, production, supplier deliveries, employment, and inventory levels, the PMI provides a health gauge for the economy as it tracks changes in the supply and demand conditions for the manufacturing sector. A PMI reading over 50 percent indicates that at half of manufacturers reported improvement in business over the previous month, while under 50 means the opposite.
In July 2018, the PMI was at 58.1 percent, equivalent to a decrease of 2.1 percentage points from June. The new orders index, production index, supplier deliveries index all declined slightly from June, signaling a slowing (but still growing) economy. Furthermore, the Prices index decreased from June, indicating higher prices for raw materials for the 29th consecutive month.
Overall, the July report suggested a weakening expansion in the manufacturing sector amid slowdown in new orders, export orders, and production. According to the ISM, the American manufacturing industry is still growing, however it is growing at a slower and slower pace. This slowing growth is due to a number of factors including new demand and supply reductions based on the escalating trade restrictions, shortages of skilled labor, higher costs for raw materials due to tariffs, and challenges with transportation of materials and inventories (also related to rising commodity prices and trade restrictions).
Negative Leading Indicators
Yield Curve Flattening
The yield curve is an economic indicator that has predicted fluctuations in the economic cycle over the last several decades. Classically defined as the difference between two year and ten year debt instruments (usually Treasury bond yields), the yield curve has, over multiple economic cycles, been a reasonably reliable “canary in the coal mine” for economic activity, although a recent WSJ article worked to dispel its relevance when looked at over more than the last forty years.
Typically in periods of economic expansion, the yield curve slopes upward. This reflects the expectations of investors that future interest rates will be higher, indicative of greater levels of economic activity and central bank efforts to control price inflation. Conversely, an “inverted” yield curve is a situation in which long-term interest rates are lower than short-term interest rates, indicative of market forces predicting that central bank actions to lower future interest rates will be necessary to spur greater economic activity. An inverted yield curve has preceded every recession in the past 40 years.
Because the yield curve has inverted prior to every recession in the last 40 years, some believe it may help predict economic downturns.
The yield curve is not currently inverted but it has steadily flattened since late 2013. While U.S. Treasury yields increased across all maturities, the yield curve was as close to flat as it has been since before the economic crisis began over 10 years ago. In fact, with razor-thin margins of less than 30 basis points between the yield on the 10-year and 2-year issues and just 12 points between the 30-year issue and 10-year note, inversion seems imminent.
The current trend of rising interest rates reflects the actions of the Federal Reserve to curb unsustainable expansion. The Fed most recently raised rates in June and signaled that two additional increases are likely later this year. Recessions may result when the Fed raises rates too quickly or too high, a phenomenon called “over-tightening”, as higher rates cause significant decreases in investment and spending given the reduced affordability of debt, and potentially higher returns elsewhere. That said, we are currently in an environment of record low sustained interest rates, well below historical means. Our current, decade long period of ultra-low fixed income yields may truly mean “this time it really is different”.
MGAC will continue to follow changes in monetary policy to understand and anticipate the effects of these changes on investment, consumer spending, the construction market, and the economy.
High Lender Exposure To Multi-Family
US banks and other depository institutions have extended a steadily increasing amount of commercial real estate loans each month since February 2013. In July 2018, CRE debt reached $2.1 trillion; a record amount exceeding the previous historical peak by 24%. A large volume of these outstanding loans is secured by multi-family residential projects. Fueled by record low interest rates and challenges in other real estate sectors over the last several years, developers pumped millions of units into the market in a relentless search for yield and profitable means of deploying capital and debt. This glut in urban cores has curbed multi-family rent growth, which coupled with rising construction costs in major cities and increasingly expensive debt, may eventually lead to a significant market correction as investment yields become questionable.
According to the Fed’s July 2018 Senior Loan Officer Opinion Survey on Bank Lending Practices, current lending standards among US banks are relatively tight, especially for CRE debt. But some banks are reporting otherwise, as competition among lenders seeking yield has increased. Chandler Howard, Chief Executive of Liberty Bank in Connecticut, reported there has been “a rise in risky lending practices where “term sheets (are) coming through with interest-only transactions”, and “terms going out longer and longer, (with) some loosening in guarantees”.
Housing Market Losing Growth Momentum
The housing market is a strong reflection of consumer confidence and a leading economic indicator. Homebuilders are reluctant to break ground on new projects if they fear the economy may slow, or if rising long term rates affect home affordability suppressing demand. Homebuyers are hesitant to invest in a new house if they expect the market to slide into a recession, or if interest rates on mortgage debt rise too far.
Housing Starts Dropping
Since 1960, every recession has been preceded by a double-digit decline in housing starts. The previous recession was considered to have officially started in Dec 2007, but housing starts exhibited a declining trend since early 2006. Although the peak level of housing starts in the current cycle remains far below historical peaks, the growth momentum for housing starts already appears to be waning. Housing starts have hovered between 1.34 and 1.1 million per month since October 2016, most recently posting a 0.08% gain in July 2018 after a 12% drop from the previous month in June 2018.
Home Sales and Sales Prices Fall
Existing home sales dropped in July 2018 for the fourth consecutive month, while housing inventory, which has consistently declined for years, has been growing since January 2018. Median sales prices for new houses sold remain at historical highs and posted a 5% bump in July 2018, but for have generally slid since November 2017. The lack of growth momentum in housing starts coupled with the decline of housing sales and prices, raise a sign of caution, especially as the economy moves into the late stage of its current cycle.
Conclusion and Recommendations
The range of factors and leading indicators that we are tracking all point toward continued, but waning growth, for the near term. Reports from many of our clients and contacts within the A/E/C industry are in line with our market analysis, with many reporting strong backlogs through 2019 but uncertainty beyond that. Many contractors are reporting lower profitability due to labor shortage, project delays, and diminished productivity from the labor force employed.
Optimism has slowly turned to caution over the last year as a myriad of unpredictable factors such as tariffs and trade agreement renegotiations have generated widespread uncertainty throughout the construction industry. Effectively managing uncertainty on a project requires not only a holistic understanding of the probabilities, patterns, and limits of the factors that can impact construction, but also experience and judgement to help set appropriate allowances including escalation, contingencies, and fluctuation clauses.
Based off our current data, we are continuing the project an escalation factor of 4% per year for the next two years. Beyond that, we are forecasting escalation to flatten based on our market analysis and research indicating a reduction of construction activities across the market. We will be monitoring these factors and market conditions and update our projections accordingly.