As the saying goes, it is always darkest just before the storm, which neatly sums up where the nation is in the economic cycle. The economy has been weakening for more than a year, with only brief pause, and is now set to deteriorate in ways unseen since the early 1980s.
Despite recent declines in commodity prices—from oil (less than $40/barrel at press time) to corn (less than $5/bushel) to gold (below $800/ounce)—a myriad of factors suggest economic weakness will persist deep into 2009, if not beyond. Recently released revisions to the gross domestic product (GDP) indicate the economy actually contracted during the fourth quarter of 2007 and barely expanded during the first quarter of 2008. Subsequent revisions showed the economy declined enough between fall 2007 and spring 2008 to be declared a recession.
While the GDP enjoyed a nice rebound during the second quarter of 2008, most macroeconomic observers dismissed that three-month period as an aberration. More than $100 billion in tax rebate checks mailed between late April and early July boosted spending temporarily last summer, but the impact of the checks fell far short of inciting a self-sustaining expansion. By September, it was scarcely evident that a stimulus package had been implemented.
September and October can be viewed as game changers, with the financial markets becoming so unsteady and volatile during these months that the economy headed on a downward trajectory. As a result, the nation lost roughly half a million jobs during the course of those two months. The number of jobs lost on a net basis during the first 10 months of 2008 totaled nearly 1.2 million, with construction and manufacturing leading the way. If anything, monthly job losses are set to expand, particularly during the first quarter of 2009.
The reasons for the ongoing economic weakness include:
- sagging consumer confidence;
- pre-existing consumer debt caused by a decade of over-consumption;
- tight lending conditions;
- a surplus of unsold homes and an ongoing foreclosure crisis;
- declining home values;
- shattered financial markets;
- a credit crunch that ravaged the commercial paper, student loan, municipal bond, auto loan and credit card markets among others;
- rising unemployment (October’s 6.5 percent unemployment rate represented a 14-year high);
- declining employment in virtually all key sectors of the economy (with small exceptions in health care and government);
- a weakening American auto sector;
- growing skepticism regarding the ability of the $700 billion Troubled Asset Re-covery Program to advance the banking system and the economy;
- shaken small business confidence;
- declining business investment;
- falling corporate profits;
- weakening government finances at state and local levels; and
- a rapidly slowing global economy.
Shared Misery
Among the newest phenomena worth discussing is the slowing global economy. Prior to 2008, economists in various parts of the world believed that even if America’s economy stumbled, most other parts of the world economy could soldier forward with little effect.
They were wrong. America’s economic weakness has steadily enveloped much of the balance of the world. The International Monetary Fund (IMF) recently slashed its global economic forecasts in the face of a growing credit crisis that already has robbed the world of trillions of dollars in wealth and functioning financial relationships. In a recent update to its World Economic Outlook released in October 2008, the IMF said global growth would slow to 2.2 percent in 2009, down from the 3 percent forecast released one month earlier. Global growth of 3 percent or below is considered global recession, though many economists believe this cutoff point is arbitrary.
In any case, the U.S. economy is expected to contract 0.7 percent in 2009, with the European economy contracting 0.5 percent, according to the IMF. These forecasts, however, may prove wildly optimistic, especially because increasingly desperate efforts by central bankers have been unable to jumpstart the global economy.
Data regarding the performance of Japan’s economy have been particularly terrible. Revised data indicate Japan’s economic decline during the second quarter of 2008 was larger than originally estimated—contracting 3 percent instead of the original estimate of 2.4 percent.
Developing and emerging economies by contrast should continue to lead world growth, increasing 5.1 percent in 2009. This is still down from a forecast of 6.1 percent made in October. The IMF also expects sharp slowdowns in Eastern Europe as well as Russia and its neighbors.
This spells trouble for the U.S. economy and greatly complicates prospects for its recovery. Exports have been a leading source of growth in recent quarters and the only major economic element able to support expansion without direct government assistance. With the world economy now slowing and with the dollar rising sharply in response to global risk aversion and hunger for U.S. treasuries, export growth is set to slow dramatically in the year ahead. This may not result in too many lost jobs, but because U.S. exports tend to be capital intensive, this leaves the federal government as the only major source of economic growth in 2009.
The softening of export growth is hardly America’s most vexing problem. Unlike the mild and brief 2001 recession, this recession is consumer-led; therefore it will be both lengthier and deeper. Consumer spending is already collapsing, and given the pace of job loss now taking place, there is only one place for consumer spending to go absent another major stimulus package: down.
Even before October’s financial market meltdown, retailers were reeling. Sales at some of the nation’s best-known retailers fell by double-digits in September, highlighting the economy’s accelerating deterioration and raising questions regarding which chains will survive to see the early years of the next decade.
According to The New York Times, retail executives and analysts have not seen such rapid slowing in consumer spending since the nation’s last deep recession during the early 1980s. With the prominent exception of Wal-Mart and other discounters, retailers at every level of the consumer hierarchy are feeling the sting of consumer disengagement, including Nordstrom, J. C. Penney and Kohl’s, each of which recently lowered its earning projections.
Additionally, state budget shortfalls have become increasingly apparent. New York has been dealing with a $12.5 billion gap caused in large measure by the dislocations taking place within the financial industry. California recently declared a fiscal emergency regarding its $11.2 billion deficit, and expects a revenue gap of $28 billion during the next year and a half. Arizona has been staring at a $1 billion deficit even after cutting $1.9 billion from its budget enacted in June. According to the Center on Budget Policy and Priorities, the cumulative budget gap for states in 2010 will hit $100 billion.
The reasons are obvious. With rising job losses, income taxes decline. The projected rise in unemployment to 8 percent and perhaps beyond will further slash state revenues. Job losses involuntarily increase state spending. The rise in layoffs already has strained a number of state-run unemployment insurance funds, some of which have begun to run out of cash. Michigan, New York, Indiana, Ohio and South Carolina have less than three months of payments left, according to the National Employment Law Project (NELP). NELP also reports New Jersey, California, Kentucky, Missouri, Wisconsin, Rhode Island, Arkansas and North Carolina have roughly four to six months of money left.
In each of these states, contractors and other private employers can expect substantial unemployment insurance surcharges or other forms of increased liability to state government. If that weren’t enough, many publicly financed projects will be deferred or even cancelled in the fiscal years ahead absent a massive infusion of cash from the federal government to states and localities.
When Will Things Get Better?
Until banks begin to lend to Main Street, hope for a broad-based economic recovery will remain elusive. For the most part, banks continue to withhold funds from Main Street. Banks in reasonably good financial condition, such as Bank of America and PNC, have chosen to use available capital to gobble up assets at a perceived discount, including Countrywide, Merrill Lynch and National City. In other words, banks with available capital are choosing to expand market share rather than make monies available to Main Street.
The implications for commercial construction are obvious: The pipeline of new projects will be very thin going forward and many contractors will whittle away at their existing backlogs while becoming increasingly nervous as completed projects are decreasingly replaced with new ones.
The credit crunch directly impacts developers and the balance of the construction supply chain, and indirectly impacts the construction industry by weakening overall economic performance. According to Foresight Analytics LLC, construction loan delinquencies reached an estimated 9 percent among all property types during the second quarter of 2008—up from 7.2 percent during the first quarter and 2.4 percent from the prior year.
This confirms the widespread fear that America’s economic weakness would ultimately spread to the nation’s commercial construction market, further reducing cash flow to and from banks, financial system liquidity, construction job creation, associated income growth and government retail, property transfer and income tax collections.
In addition, the general increase in commercial delinquencies will result in even higher interest rates for projects that manage to secure financing, which will in turn delay the economy’s rebound, or at a minimum will render America’s construction recovery less forceful.
These considerations are showing up in a number of contexts, including in forecasts of industry performance. According to McGraw-Hill Construction, U.S. construction starts will decline 7 percent in dollar terms in 2009, with the largest losses expected to be in segments that had been motivating the highest proportions of new construction.
For instance, according to McGraw-Hill, construction starts within the electric utilities category, which expanded 55 percent in 2008 to $24 billion, will decline 30 percent to less than $17 billion in 2009. Similarly, construction starts for manufacturing buildings rose 69 percent to nearly $30 billion in 2008, but are anticipated to decline 32 percent in 2009 to $20 billion. Manufacturing structures had been a major winner in 2008 due to the start of several massive oil refinery expansion projects, but investment in new plants will be restrained by tight credit, diminished manufacturing capacity utilization and lower energy prices.
In other industries, ongoing declines in activity will persist. Construction starts of commercial buildings, multifamily housing and single-family housing are anticipated to decline in 2009 after declining in 2008. Construction starts in the single-family housing category have been in decline since 2006, and multifamily housing starts have been down since 2007.
From 2005 to 2007, when consumer spending remained brisk and artificially inflated, store construction maintained a breakneck pace, exceeding 300 million square feet each year. In 2007, among the top five markets for new store square footage were Phoenix, Dallas-Ft. Worth and Atlanta, as retailers raced to locate near a sea of new subdivisions.
But the decline in residential growth and the steep declines in consumer spending left the nation with too much retail space. Final 2008 data may reveal store closings achieved record totals in 2008, with the International Council of Shopping Centers predicting 6,500 retail store closings in 2008, up from an earlier estimate of 5,800. According to McGraw-Hill, of the top five metropolitan areas for store construction in 2007, four weakened significantly in 2008: Chicago (down 46 percent), Phoenix (down 32 percent), Dallas (down 60 percent) and New York (down 31 percent).
For 2009, store construction is projected to decline an additional 15 percent to 188 million square feet, according to McGraw-Hill.
Don’t expect residential markets to provide any meaningful support for retailers in the months ahead. The market meltdown of September and October eviscerated any emerging momentum the markets were enjoying. Buyers briefly re-engaged the market due to the availability of lower prices and elevated active inventories of unsold homes despite the credit crunch in place throughout early 2008. But with credit tightening further, job insecurity rising, and more prospective buyers unnerved and impoverished by the performance of stock markets globally, the emerging housing recovery has been snuffed out for at least a year, if not longer.
Multifamily construction prospects have been similarly dashed. Like single-family housing, multifamily housing starts peaked in 2005. Though the segment held its own in 2006 even as the single-family market descended rapidly, by 2007 the writing was clearly on the wall with starts falling by their steepest rate (13 percent) in 15 years, according to McGraw-Hill. With lenders now expecting 70 percent of condominium units to be pre-sold before providing funding, the outlook remains bleak for starts, especially in the face of sagging available demand.
According to the National Association of Realtors, sales of existing condos and co-ops were down 22 percent in August 2008 compared with the same month one year prior even though the median price of those condominiums had slid 7.2 percent. Further, the apartment market will weaken even in the face of rising demand from foreclosed households as fewer jobs are created and more people choose to live with roommates or at a family residence.
Weathering the Storm
The fact is, 2009 is shaping up to be the worst year economically in decades. By the end of the year, unemployment may exceed 8 percent and it is possible the nation will lose another 2 million to 3 million jobs. Economic weakness has infiltrated a host of commercial construction sectors, and the industry may have to wait until 2011 for a meaningful recovery in activity to begin.
The big questions for 2009 are when the credit crunch will abate, what the new administration will do to stimulate the economy and when markets will respond. That said, there might be a moment during which financial markets begin to rebound even as Main Street remains mired in recession. The disconnect between Wall Street and Main Street is a common phenomenon, and a sustained increase in stock prices likely would anticipate economic firming by up to nine months.
It’s official: The nonresidential building boom has stalled.
Nonresidential spending, which increased 12.2 percent in 2008, is only expected to increase 1.2 percent in 2009, according to Jim Haughey, chief economist for Reed Construction Data. In terms of construction starts and contract value, Robert Murray, vice president of economic affairs for McGraw-Hill Construction, forecasts declines of 12 percent and 10 percent, respectively, in the nonresidential market. Nonbuilding construction sectors aren’t expected to fare much better.
Only a handful of major construction sectors registered positive growth last year (in terms of construction starts), and it looks like few will be in the black in 2009. One bright spot is military construction, which is getting another funding boost of 18 percent in 2009 after increasing 29 percent in 2008. Infrastructure could get a boost if another stimulus bill is enacted.
Haughey notes higher education and health care could be potential bright spots as well, because these sectors will feel a delayed impact from current financial problems and avoid the dramatic declines seen in housing and retail. However, credit issues may begin to affect municipal bonds.
Even more than usual, significant differences exist in regional economic growth. In the Gulf Coast region of the United States, recession is not yet apparent. From Texas north to the Canadian border represents the part of America with the lowest unemployment rates. State economies such as South Dakota, Nebraska and Oklahoma have been protected from the economic downturn by high commodity prices that prevailed earlier this year. With the price of corn, wheat, oil and gas now down significantly from yearly highs, these state economies stand to edge toward recession. But this weakness is prospective in nature. Many states in this region continue to boast unemployment rates below 4 percent.
Mid-Atlantic states also remain in reasonably decent shape. Though parts of Virginia and Maryland have experienced the full brunt of the housing downturn, including various jurisdictions in Northern Virginia and in Prince George’s County, Md., the performance of their broader economies remains sound due in large measure to the ongoing expansion of the federal government. With the federal government likely to continue to expand during 2009, Maryland and Northern Virginia will remain among the most vibrant areas in the nation.
Recent job growth data indicate the Washington metropolitan area remains far from recession. With the Washington area at least temporarily serving as the nation’s financial capital, it is possible economic activity in the region will remain reasonably robust even as the balance of the nation slumps more deeply into recession. Through late 2008, both Maryland and Virginia could point to sub-5 percent unemployment rates.
Maryland and Virginia also will be among the first states to recover in terms of construction volumes. For 2009, a continuing resolution was passed that holds federal spending on transportation and many other construction-related accounts at 2008 levels through March 6.
One example is the Base Realignment and Closure account, which saw an 18 percent increase last year. Maryland and Northern Virginia were among the big winners in the military construction sector, with significant new activity under way at Fort Meade and Aberdeen Proving Ground in Maryland and Fort Belvoir in Virginia.
By contrast, New York, New Jersey, Pennsylvania and Delaware will not hold up as well. All four states have significant exposure to the financial services sector as well as to the global economy. As a result, each state will fully participate in this recession, including Pennsylvania, where growth in recent years has been disproportionately motivated by the expansion of the Philadelphia metropolitan area.
New England also has held up well, though there are significant variations within the region. Rhode Island continues to suffer one of the nation’s highest unemployment rates, in part due to a business climate that has not allowed the state to retain businesses the way other states have. By contrast, Massachusetts and New Hampshire will remain the star performers of the region. Connecticut’s economy is suffering deep blows due to its close affinity with New York’s financial sector.
The most vulnerable states surround the Great Lakes. Auto sales are now hovering at 1983 levels. Despite the White House’s commitment to provide automakers with a rescue plan, the industry still is poised to shrink in employment and the number of operating plants. That leaves states like Michigan, Ohio and Indiana with some of the worst economic outlooks in the nation.
The Pacific region is intensely linked to the global economy, and the southern and Sacramento regions of California remain highly vulnerable to the ongoing downturn in home prices. Washington and Oregon will hold up much better than California thanks in part to the recent conclusion of the Boeing strike, but the global nature of these state economies also leaves them vulnerable in 2009.
In the South Atlantic, weakness is most apparent in Florida and Georgia, which represent two of the nation’s most beleaguered housing markets. Because this region depends so much on population growth—particularly among retirees—to drive economic expansion, the credit crunch, loss of financial wealth among baby boomers, and the fact that so many Americans are staying put leaves this region among the most vulnerable. Moreover, several states in the South Atlantic, most prominently South Carolina, are disproportionately manufacturing intensive by American standards, and manufacturing stands to lose many jobs in 2009 as demand for a variety of products continues to slump.
The single greatest source of relief for the construction industry is the belated decline in materials prices. In hindsight, these prices reached absurd levels, but perhaps what is most absurd is that so much construction moved ahead even with input prices reaching seemingly impossible levels.
With the global economy now in recession and with speculators pulling their money out of risky assets, including commodities, materials prices have begun to decline. The trend established during the latter half of 2008 will continue well into 2009 given the expectations for muted demand.
Prices for steel, diesel fuel, copper and many other items have retreated. Ultimately, however, these declines will be replaced with increases in future years for at least two reasons. First, the global economy eventually will bounce back. Second, capacity is now being destroyed. As an example, John Mothersole, principal at Global Insight, reported in mid-October that scrap steel prices are collapsing at an unsustainable rate—approaching $300/short ton after costing more than $500/short ton earlier in 2008. Production of cement also has been slashed. The implication is that today’s deflation may contribute to tomorrow’s re-inflation.