2014 Construction Economic Outlook: Expect Positive Momentum in Nonresidential Spending, But Watch Out for Speed Bumps

The U.S. economy is like a Corvette: It can launch from zero to 60 mph in 3.8 seconds and has 460 horsepower. In economic terms, this translates into a growth rate that has averaged more than 3 percent during the past 25 years and the capacity to create and support companies such as Boeing, Microsoft, Verizon, GE, Ford, Facebook, Google, Walmart, Coca-Cola, Lockheed Martin, Cargill, Wells Fargo and many more. The United States remains the global research and development giant, boasts the world’s finest higher education system, has strong demographics, and soon will be the global leader in the combined production of oil and natural gas.

Despite all that torque, the U.S. economy has been stuck at 2 percent growth for several years. Imagine a sports car with incredible get-up that constantly has to negotiate a series of speed bumps that permit it to only travel 30 miles per hour. To complete the analogy, it translates into sub-par economic growth and an unemployment rate still stuck higher than 7 percent after more than four years of economic recovery. It also translates into a nonresidential construction sector that remains immune to forceful and broad-based recovery. The value of nonresidential construction put-in-place remains 22 percent less than the October 2008 high.

The latest set of obstacles is well known. Businesses and consumers spent the past year wrestling with higher tax rates, sequestration, rising interest rates, a federal shutdown, the specter of debt default, hesitant state and local government financing, and uncertainties associated with health care reform. In October, the International Monetary Fund downgraded the U.S. growth forecast for 2013 from 1.7 percent to 1.6 percent. The upshot: 2013 will go down as yet another disappointing year for the U.S. economy.

Consumers in the Driver's Seat
Although many interest rates, including the 10-year Treasury and a variety of mortgage rates, rose substantially during the summer, it was not due to fears of inflation. Consumer prices rose just 0.2 percent in September after climbing a similarly benign 0.1 percent in August. Despite large jumps in February and June (0.7 and 0.5 percent, respectively), trend inflation remains well within the Federal Reserve’s comfort zone. Overall consumer prices as measured by the Consumer Price Index are up 1.2 percent for the past year (through September 2013), while core prices are up 1.7 percent.

Higher household net worth helps fuel economic activity as well. According to the Federal Reserve’s Flow of Funds report, U.S. household net worth expanded by $1.34 trillion during the second quarter of 2013, reaching a total of $74.8 trillion. This represented a gain of 1.8 percent from the first quarter and was driven by a combination of rising stock and home prices. In fact, in the aggregate, Americans have never been wealthier.

The combination of favorable borrowing rates and rising wealth has positioned consumer spending to be the most stable source of economic growth since the end of the recession. To that point, consumers contributed approximately half of the 2.5 percent growth observed during the second quarter.

Notably, these gains in wealth have been highly skewed toward a small share of households. In 2012, the top 10 percent of earners took home more than half of the nation’s total income—the highest level ever recorded, according to Annie Lowrey, who covers economics for The New York Times. Lowrey indicates the top 1 percent of earners absorbed more than one-fifth of the income earned by Americans last year. Wealthier households have benefited disproportionately from the boom in share prices. Only about half of all U.S. households own stock directly or through vehicles such as pension accounts. But according to Lowrey, the richest 10 percent of households own roughly 90 percent of share value, expanding their net worth and their incomes when they capture capital gains or receive dividends.

In contrast, the economy remains depressed for many wage-earning families. National unemployment rose from 7.2 percent in September to 7.3 percent in October, with more than 700,000 Americans leaving the labor force. Much of the decline in participation is attributable to the federal government shutdown, though not necessarily all. Labor force participation has been declining for quite some time, and was already at a 35-year low prior to the shutdown.

The situation is not poised to improve. Not only was the fourth quarter of 2013 impacted by the federal shutdown and the collateral damage associated with debt default fears, but consumer confidence is also in decline. Not surprisingly, these events are related. U.S. consumer sentiment deteriorated in October to its lowest reading since January, when consumers were dealing with the possibility of sequestration and the reality of higher tax rates.

This likely will undermine the achievement of retail expectations. The National Retail Federation expects sales to increase 3.9 percent to $602.1 billion in November and December. To put that expectation into context, the past decade has seen 10-year average holiday sales growth of 3.3 percent.

Predictably, online sales growth is expected to be even more impressive. Shop.org’s 2013 online holiday forecast calls for sales in November and December to expand between 13 percent and 15 percent year over year to as much as $82 billion. Last year, e-commerce sales rose 15.5 percent, according to the U.S. Department of Commerce.

Yellow Light for Housing and Job Growth
Among the drivers of these optimistic forecasts is the performance of the nation’s housing market. According to the National Association of Realtors, existing home sales are up more than 10 percent on a year-over-year basis. Total existing home sales rose 1.7 percent in August, followed by an expected 1.9 percent decline in September. New home sales, which are measured by the U.S. Census, also expanded in August from 390,000 to 421,000 on a seasonally adjusted annual rate basis.

Home prices in certain regions are climbing at pre-recession, housing boom rates. According to the October 2013 Case-Shiller index, U.S. home prices rose 1.3 percent from July to August for the 10-City and 20-City Composite. For the past 12 months, the composite indexes are up 12.8 percent, the highest annual growth rate since February 2006. In August, all 20 cities exhibited price gains on both a monthly and annual basis.

While coincident indicators remain positive, other indications suggest the housing market’s momentum has begun to wane in the face of higher mortgage rates. Between mid-May and mid-September, 30-year fixed mortgage rates rose from approximately 3.5 percent to more than 4.5 percent.

Consequently, since April, monthly rates of price gains have declined. Applications for mortgages, particularly for the purpose of refinancing, have plummeted and pending home sales have slowed. The National Association of Realtor’s pending home sales index, a forward-looking indicator based on contract signings, fell 5.6 percent in September, meaning completed sales were already set to decline for the remainder of the year.

The federal government shutdown further hampered consumer mortgage acquisition efforts, including through the lack of Internal Revenue Service documentation available to verify income, payments on tax or other federally imposed liens. This implies the housing market will slow further during the fourth quarter. The hope is momentum will be re-established by the key spring selling season. But for now, home-selling and homebuilding are potentially set to slow dramatically as 2014 approaches.

With consumers pulling back, federal outlays diminished, and the housing market’s momentum at least temporarily interrupted, job growth is also likely to slow as 2014 approaches. While recent employment growth has hardly been extraordinary, at least it has been steady. From October 2012 to October 2013, the nation added 2.33 million jobs, including 204,000 jobs in October.

However, the quality of jobs being added generally has been low. Four key low-wage segments—retail trade, leisure/hospitality, home health and temporary staffing agencies—have been jointly responsible for a majority of net new job creation in recent months. According to the U.S. Labor Department, wages and benefits rose 0.5 percent during the first and second quarters of 2013, only slightly up from the increase of 0.4 percent during the fourth quarter of 2012. For the 12 months ending in June, wages and salaries rose just 1.7 percent. Once inflation is accounted for, the level of worker compensation has barely budged in recent periods.

Long story short: Associated Builders and Contractors’ (ABC) national forecast for the next two quarters remains quite subdued.

Will Nonresidential Construction Accelerate?
For nonresidential construction to experience a dramatic upturn, there needs to be a high degree of confidence among developers, financiers and government budgeting officers. That level of confidence simply does not exist and recent events haven’t helped.

Nonresidential construction spending rose 0.2 percent in August and is up 1.3 percent compared to one year earlier. Performance reflected a broader pattern—one that has helped suppress the pace of industry recovery. On a year-over-year basis, private nonresidential construction rose 4.3 percent, largely due to segments most closely related to consumer spending, but public nonresidential construction spending has dipped nearly 2 percent.

The largest year-over-year gain in construction spending was in lodging (26.7 percent). The commercial segment also has performed well, along with power and manufacturing. But reductions in construction spending in key publicly financed segments such as public safety (–7.6 percent) and education (–5.2 percent) more than offset the impact of growing private segments.

ABC expects publicly financed segments to continue to be hamstrung by reluctant state and local government budget officials. State governments are still dealing with long-term pension and health care cost issues. Moreover, with one-third of their revenues coming from the federal government on average, many states simply lack the confidence necessary to aggressively move forward with capital budgeting, including the education and public finance categories. Some state and local governments, however, raised revenues to support capital spending by placing additional taxes on gasoline or raising fees charged for services.
This should keep spending in the transportation and highway/street categories reasonably stable.

Moreover, certain private categories are set to expand meaningfully during the year ahead, including health care (utilization will be on the rise), power (a consistently strong segment in recent years), commercial (the result of protracted periods of consumer spending growth) and lodging (hotel occupancy continues to rise). Manufacturing-related construction also is likely to rise, particularly given anticipated growth in exports next year with the strengthening of the global economy.

In fact, ABC’s most recent Construction Confidence Index indicates most contractors remain quite confident about their 2014 prospects in terms of revenues and margins. Roughly 60 percent of contractors expect their revenues to rise during the year ahead, while 82 percent expect their profit margins to rise or remain flat.

ABC’s Construction Backlog Indicator (CBI) also indicates some forward momentum. The CBI rose 3.9 percent during the second quarter of 2013 to 8.2 months, up from 7.9 months the previous quarter. However, it remained at that level through the third quarter. The Northeast, driven by recovery in finance and professional services, and the South, driven by recovery in industrial production, have experienced construction backlog expansion during the past year.

Among the states experiencing rapid construction job growth are energy-producers such as Texas, North Dakota and Louisiana. A number of communities hit hard by the downturn, including California, Arizona, Georgia and Florida, have been adding construction positions rapidly with the housing market stabilizing and household formations accelerating.

Another positive factor has been the astonishing stability of nonresidential construction materials prices. After extreme volatility for much of the past decade, including the surge in prices in late 2007 and early 2008 and the collapse thereafter, prices collectively rose only 0.6 percent between September 2012 and September 2013. For several months, ABC has been predicting greater volatility in these prices given surging stock/asset prices, the continuation of extraordinary monetary stimulus in the United States and rampant geopolitical uncertainty in much of the world.

To date, that volatility has failed to materialize. According to the most recent data, plumbing fixtures and fittings prices are up 1.7 percent over the past year, concrete prices are up 3 percent, and iron and steel prices are down 3.9 percent. Moreover, year-over-year price increases in certain categories, including gypsum and softwood lumber, have become less extreme in recent months.

For now, materials prices should remain stable, particularly if the United States deals with its debt ceiling issues with some level of finality. After only expanding an estimated 2.9 percent in 2013, the global economy is expected to accelerate to 3.6 percent next year. All things being equal, this will raise the level of demand for construction inputs, which in turn will accelerate price increases, though not to the extent experienced in 2004, 2005 and 2007.

ABC forecasts nonresidential construction spending will expand in the high single digits next year. Even slow growth ultimately unlocks construction opportunities. Ongoing recovery steadily produces lower vacancy rates (e.g., the national office vacancy rate has fallen below 16 percent), rising rents and more comfortable lenders. These and other factors push projects forward. Of course, growth eventually produces higher interest rates, and that may begin to serve as a more meaningful speed governor in late 2014 or in 2015.

The notion that construction spending will improve next year is supported by a variety of other leading indicators. The Wells Fargo 2013 Construction Executive Survey found that more than half of respondents experienced higher construction activity relative to a year ago, with 22.4 percent reporting much higher activity (in excess of 5 percent). Only 15.5 percent perceive declining construction volumes. Excavation and site-prep work has become busier during the past year, implying that many projects have been green-lighted and will be associated with ongoing construction activity next year. According to ABC’s model, next year’s growth segments include commercial construction (about 5 percent), health care (nearly 7 percent), lodging (8 percent), communications (5 percent to 6 percent) and manufacturing (3 percent to 4 percent).

The Big Picture
ABC forecasts U.S. economic growth of around 2 percent again next year (1.8 percent to 2.6 percent). Interest rates will remain supportive. In part, this reflects the recent nomination of Janet Yellen as the nation’s next Federal Reserve Chairwoman. She is an architect of round three of quantitative easing and other monetary stimulus programs, and has a reputation for being more concerned about unemployment than inflation. With inflation pressures likely to remain suppressed, accommodative monetary policy is set to stay in place throughout 2014.

That should help re-ignite the nation’s housing market, which will in turn help restore consumer confidence and allow America to possibly approach 3 percent growth by the final two quarters of next year. In fact, that pace of growth could occur earlier than that because some of the economic activity postponed during 2013’s final quarter (e.g. purchases of automobiles) likely will show up during the first half of 2014.

That said, too much economic uncertainty remains for sustained 3 percent growth next year. Part of this uncertainty stems from the ongoing implementation of health care reform, including ultimately the enforcement of the employer mandate. Budget squabbles and news emerging from abroad also could put the brakes on growth.

Anirban Basu is chief economist of Associated Builders and Contractors. For more information, visit www.abc.org.

Equity Rebound
A lackluster economic recovery hasn’t stopped U.S. equity markets from surging higher for the second consecutive year. As of Nov. 7, the Dow was up 4 percent since the onset of the third quarter and up more than 16 percent year to date. The Nasdaq Composite was up 12 percent from the start of the third quarter and nearly 24 percent year to date.

Many factors contribute to the ongoing rebound of equity markets, including the performance of the broader economy. According to the Bureau of Economic Analysis, real gross domestic product expanded at an annual rate of 2.5 percent during the second quarter of 2013—significantly better than the 1.1 percent associated with the prior quarter and the 0.14 percent performance registered during the fourth quarter of 2012. Leading the way during the second quarter was a combination of growing consumer outlays and business investment.

Corporate profits also are motivating share price appreciation. Like the economy, profits from current production rebounded during the second quarter, expanding by nearly $67 billion after falling roughly $27 billion during the first quarter of 2013. A majority of large U.S. corporations beat their earnings estimates during the second quarter. However, a materially smaller share exceeded their revenue estimates, implying that companies continue to aggressively manage costs to bolster bottom line performance. This is perfectly consistent with a soft macroeconomic environment.

Arguably, the most important equity market driver has been the continued injections of liquidity into the economy by the U.S. Federal Reserve. With the luxury of consistently low inflation, the Fed has continued to fuel economic growth through a combination of monetary policies, including ongoing purchases of U.S. treasuries and collateralized mortgage-backed securities to the tune of $85 billion per month. After hinting that the pace of purchases would slow by September, the Fed decided not to taper that month and to continue to maintain expansionary monetary policy. This money has to end up somewhere, including in stock markets.

Expert Perspectives

David Crowe
Chief Economist
National Association of Home Builders

What’s your outlook for single-family housing starts?
The single-family trend should accelerate in 2014 and 2015. The current year will likely come in at 629,000 starts, or a 17 percent improvement over 2013. As the economy improves and job creation accelerates, more households will gain the confidence and economic comfort to move forward with plans to buy a new home. The NAHB estimates about one million pent up home purchases should be released in the next two years along with the normal flow of home buying.

How is the multifamily market expected to perform?

The multifamily market has been the star of the home building show for several years. Construction will continue to rise, but at a slower rate as builders begin to catch up with the rush in demand from newly formed households. The year should finish out at 300,000 units started and next year should see a 10 percent increase to 330,000.

What will be the top five states for residential market growth?
Texas, North Dakota, Wyoming, Oklahoma and Montana have returned to normal and are back to producing homes at the same or higher level than before the boom. These are energy-producing states with robust employment and economies that were not damaged significantly.

Kermit Baker
Chief Economist
The American Institute of Architects

How would you sum up the outlook for nonresidential construction in 2014?
The housing recovery and domestic energy production should push GDP growth into the 2.5 percent range for most of 2014. Recent growth in design billings points to healthy gains in future construction levels. Following a pause in the broader construction recovery in 2013, AIA expects to see construction spending gains in excess of 7 percent. The commercial/industrial sector will continue to lead the upturn, with activity accelerating in the low double-digit range.

What sectors will see the most opportunities?
The hotel sector is projected to see a 15 percent spending increase in 2014 after growing 17 percent last year. The office and retail sectors will see strong, but not quite as robust, growth. Following gains of nearly 20 percent in 2013, more modest spending growth is expected in the manufacturing sector this year. Health care and education facilities will finally shake off their flat performance for spending gains of 8 percent and 5 percent, respectively. The public safety, religious and amusement/recreation sectors also should see reasonably healthy improvements this year.