Slow employment growth, diminished government funding and continued uncertainty form the backdrop for current and future state of the construction industry, with flat consumption numbers expected for next two years.
By Steve Prokopy
Job creation is key to improving many economic indicators, and its reduction translates into a longer wait for cement and construction industry recovery, according to the latest forecast from PCA Chief Economist Edward Sullivan. Even with an economic recovery, construction levels will remain at new floor levels and lead to relatively flat cement consumption until 2014, said PCA, which revised its cement consumption forecast to increases of 1.1 percent in 2011, 0.5 percent in 2012 and 7.4 percent in 2013—roughly half of the previous forecast. According to Sullivan's report, large structural issues exist in each construction sector that will slow recovery.
“The Great Recession was construction focused. Residential, nonresidential and state discretionary construction levels collapsed,” said Sullivan. “Despite economic growth, the residential sector, for example, will continue to be plagued by a large volume of foreclosures, tight lending standards and weak new home prices. I don’t see a rebound in most of that market until 2014.” Sullivan adds that nonresidential construction will also remain low until 2013, and lack of assured federal funding will drag down the public sector until 2014 as well.
Recovery for the construction industry is tied to general economic growth and job creation, Sullivan added. Job creation will reduce, and eventually eliminate, the adverse impacts of foreclosures, tight lending standards, commercial occupancy and leasing rates, as well as the severity of state fiscal conditions. However, because the impediments to a construction recovery are so large, even if an acceleration in economic growth and job creation occurs on a sustained basis, the benefits will not materialize quickly.
The slower economic growth outlook may carry only small downside risk, but it will impact the timing of the construction recovery, Sullivan maintains. The timing of the construction and cement market recoveries has been pushed back. In PCA's previous forecast, a residential recovery was expected to begin during the second half of 2013. While the residential recovery will begin at different times depending on the region of the country, a significant residential recovery is not expected to begin until 2014. The beginning of the residential recovery accounted for much of the increase in cement consumption that was previously expected for 2013. As a result, PCA now expects relatively flat market conditions will persist through 2013.
Seeming to concur with Sullivan's expectations, McGraw-Hill Construction, part of The McGraw-Hill Companies released its 2012 Dodge Construction Outlook, which predicts that overall U.S. construction starts for 2012 will remain essentially flat. The level of construction starts in 2012 is expected to be $412 billion, following the 4 percent decline to $410 billion predicted for 2011.
“The construction industry has struggled to see recovery take hold over the past couple of years. After plunging 24 percent in 2009, new construction starts leveled off in 2010 and have hovered within a set range during 2011,” said Robert Murray, vice president of economic affairs, McGraw-Hill Construction. “The backdrop for the construction industry is the fragile U.S. economy, which continues to see slow employment growth, diminished funding from federal and state governments, and pervasive uncertainty. In 2012, the top-line numbers are not expected to show much change, but there will be variation within the major construction sectors, with some gains predicted for housing and commercial building, assuming the U.S. economy avoids recession.”
False start to growth
A year ago, the economy seemed poised for stronger, sustainable economic growth. Due largely to the European sovereign debt crisis, consumer and business confidence waned. As a result, private sector growth entered a period of slowdown. Furthermore, ARRA stimulus decreased as a positive for economic growth, forcing the Federal Reserve to enact a new round of monetary stimulus to avert the potential of a double-dip recession.
By late 2010 and early in 2011, the European debt crisis was temporarily resolved and faded from the public mind-set. This, coupled with the “payroll tax holiday” and Fed actions, led to a revival in economic activity. Real GDP, job growth and confidence recovered. Seemingly, the economy was on a sustainable path of stronger growth and job creation in excess of 200,000 a month. Once again, however, this has proven to be a false start to stronger, sustained growth. The political games played by Congress over the debt ceiling exerted adverse influence on near-term growth. The debt ceiling debate injected new uncertainty and risk onto the economic landscape. Consumers, business and bank confidence was already weak. This added a dose of risk hindered real economic activity.
Sullivan says the economic recovery from the Great Recession will be led by a strengthening in business, consumer and bank confidence. Lacking a sustained and decisive improvement on this front, private sector fundamentals such as job creation, investment and easing in lending standards will not be released in full force and commit the economy to a path of tepid improvement. Such a path suggests the continuation of a fragile economy and one that remains vulnerable to even mild economic shocks that could lead to a contraction in economic activity. This is the precarious condition the economy has been in for two years.
This first quarter of 2012 could represent a significant challenge to economic growth. The payroll tax and extended unemployment insurance benefits will expire year-end. Federal aid to the states has already expired. Furthermore, The EIA expects energy prices will rise. These conditions, and others, could result in significant first quarter weakness. Pressure could mount for additional stimulus. PCA assumes the payroll tax holiday and extended unemployment benefit will remain in place through 2012 - providing consumers with some cushion to offset rising energy and food prices. PCA also assumes unemployment insurance will be extended throughout 2012. Keep in mind, the current political realities suggest significant opposition to fiscal spending actions. Tax cuts, however, are appealing to both political extremes.
Taken together, PCA believes a synchronized recovery remains in place—reflecting the self-sustaining momentum and the interplay of marginal increases in demand, prompting job gains, feeding consumer, business and bank optimism—leading to further marginal gains in demand. While job gains and the process of economic recovery are expected to continue, it may not continue at the same pace as previously expected. The pace at which this scenario unfolds has been scaled back and suggests more moderate economic growth rates for 2011-2012.
This slower economic outlook implies a slower recovery in construction. Furthermore, there is a disconnect in timing between economic and construction recoveries explained by the existence of structural wounds generated by the construction focused recession. Despite economic growth, for example, the residential sector will continue to be plagued by a large volume of foreclosures, tight lending standards and weak new home prices. Aside from difficult access to credit markets, potential investors in commercial buildings are likely to wait until occupancy and leasing rates improve and asset prices appreciate. Finally, the impact of the stimulus is winding down and state fiscal conditions remain weak.
While the recovery process for the construction industry is expected to be long, its beginning is tied to general economic growth and job creation. Job creation will reduce, and eventually eliminate, the adverse impacts of foreclosures, tight lending standards, commercial occupancy and leasing rates as well as the severity of state fiscal conditions. Because the impediments to a construction recovery are so large, even if an acceleration in economic growth and job creation materializes on a sustained basis, the benefits will not materialize quickly. The slower economic and job creation outlook contained in the current forecast suggests a modest delay in the construction recovery.
Stage is set for residential upturn
PCA says the expected timing for a recovery in housing starts has been pushed back, since several processes must occur prior to a recovery in starts. In the context of slower job growth, the winding down of structural impediments for a housing recovery will take even more time. Keep in mind, much of the summer forecasts’ volume recovery that began in 2013 is attributed to a starts recovery that also was expected for the same year. By pushing back the housing starts recovery, much of the 2013 cement volume gains disappear.
Homebuilders are unlikely to significantly accelerate construction activity until two critical conditions are met: 1) low levels in inventory of unsold new homes reflecting no higher than five months supply, and 2) stable or rising home prices. Both conditions are likely to be required to insure an adequate ROI for homebuilders to spur an increase in building activity. Lacking either condition, a substantive recovery in home building will not materialize. A significant improvement in residential construction cannot begin until the foreclosure crisis is over. High level of foreclosure activity increases inventory levels and depresses home prices—adversely impacting homebuilders expected ROI.
Mortgage resets are expected to decline dramatically after the first quarter 2012. Unfortunately, the process from reset to foreclosure and finally to bank possession is a long process and continues well after resets have declined. This suggests that high levels of bank-possessed properties will remain on PCA’s residential forecast estimates are well below the consensus of construction economists. If the consensus is correct, there is the potential of upside risk to our projections for housing starts activity and cement consumption. Consensus averages for single family starts compared to PCA projections suggests potential upside risk of 800,000 metric tons in 2012 and nearly 2.0 million mt in 2013.
In assessing this potential upside risk, keep in mind that PCA agrees with the consensus that demographics will eventually push starts to a long-term trend level of 1.6 million to 1.8 million starts. This implies that during 2003-2006, roughly a 1.5 million-starts overbuilding materialized. Since 2007, however, substantial pent-up demand has been generated by under building. The excess building has been completely absorbed and pent-up demand of roughly 2.5 million to 3.0 million units currently exists.
The continuation of under building (below the 1.6 million-unit level) will generate even more pent-up demand. Some suggest the combination of favorable affordability levels and existence of pent-up demand will generate strong enough sales to draw down inventories in 2011 and 2012—prompting a more robust starts recovery compared to PCA’s outlook. PCA’s more pessimistic starts outlook reflects the timing of a release in housing demand—not the longer-term market potential. PCA believes the combination of modest job creation, weak consumer confidence, tight lending standards and a difficult foreclosure environment are going to take some time to become favorable enough to support more robust starts—even in the context of large pent-up demand and favorable affordability levels.
PCA’s outlook also implies larger pent-up demand balances will be ready for release in the back end of the forecast. The long-term trend of 1.6 million units is reached in 2015. There is one final wrinkle to the residential forecast. High debt, joblessness and the large amount of foreclosures will damage credit for many potential new home buyers. Furthermore, substantively easier standards and/or the re-emergence of a sub-prime credit market is unlikely to materialize anytime soon to accommodate potential homebuyers with damaged credit. This implies a gradually higher proportion of starts going toward rental units. This is incorporated in our forecast. Keep in mind, a typical single family unit consumes 19 mt of cement. In comparison, a multifamily unit consumes roughly 9 mt.
The McGraw-Hill Construction forecast sees single family housing in 2012 improving 10 percent in dollars, corresponding to a 7 percent increase in the number of units to 435,000 (McGraw-Hill Construction Dodge basis). This is still a low amount, as the excess supply of homes due to foreclosures continues to depress the market. Multifamily housing will rise 18 percent in dollars and 17 percent in units, continuing its moderate, upward trend.
Nonresidential rebound tied to labor market recovery
Several issues confront a recovery in nonresidential expected return on investments (ROIs) and construction activity, including depressed occupancy and usage rates, soft leasing rates, declining commercial asset prices and tight lending standards. Job creation, either directly or indirectly, translates into higher occupancy and leasing rates. Combined, these factors determine the expected return on investment for most commercial properties. Weak economic conditions depress expected ROIs. Only with a significant increase in jobs, will the outlook for commercial construction activity accelerate.
It will take time for these conditions to heal and give way to a nonresidential construction recovery. The speed at which the healing process begins will be largely dictated by the strength in the labor market recovery. PCA maintains the nonresidential recovery process will remain prolonged, with substantive cement volume gains materializing in 2013.
In addition, the commercial real estate market is plagued with refinancing issues. Many commercial properties were refinanced during the easy credit era. This period also ran coincident with high property value assessments. Many of these properties were refinanced on five year balloon payments, which are now coming due, and based on asset values market conditions no longer support. Many commercial property owners have been successful in restructuring their debt—to some extent reducing the same threat posed by the single family mortgage market. While commercial real estate leverage is improving, it remains high on a historical basis. Over $1 trillion in commercial real estate debt is coming due over the next few years. The value of much of the collateral is still less than the loan balances.
Finally, prospective asset appreciation adds to potential commercial property owners overall expected ROI. Unfortunately, the prospect of sustained low occupancy and leasing rates has prompted a decline in commercial real estate asset values compared to peak levels related to the housing boom. PCA expects commercial property values will continue to decline through 2011. The asset price decline further hinders an improvement in the return on investment.
Commercial building will grow 8 percent in 2012, according to the McGraw-Hill Construction outlook. Warehouses and hotels will see the largest percentage increases, but improvement for offices and stores will be modest. The institutional building market will slip an additional 2 percent in 2012, after falling 15 percent in 2011. The tough fiscal environment for states and localities will continue to dampen school construction, and the uncertain economic environment will limit growth in healthcare facilities. Manufacturing buildings will increase 4 percent, following the 35 percent gain in 2011, says McGraw-Hill Construction, as the low value of the U.S. dollar continues to support export growth.
ARRA, highway bill, state dollars make for uncertain public works
Substantial risk surrounds PCA’s forward assessment regarding highway construction. At first glance, highway spending could be facing a double-digit decline during 2012. American Recovery and Reinvestment Act (ARRA) dollars will decline significantly. An extension of the highway bill at constant nominal levels suggests fewer real dollar spending after inflation is considered. Finally, slower job creation implies a prolonged period of state governments’ fiscal duress. While ARRA spending is expected to decline in 2012, it also distorted the trends and assumptions made regarding state highway construction spending. Once the interplay between ARRA and state spending are assessed, it is likely that ARRA had much less of a stimulatory impact than even modest estimates suggest. Further, analysis implies an increase in 2012 state highway spending. Combined, these assessments reduce the adverse impact of fewer 2012 ARRA dollars on overall highway spending next year.
PCA assumes a new highway bill will be put in place for fiscal 2014 at existing levels. In the meantime, extensions fill the gap. This represents a significant departure from previous PCA assumptions one year ago, which assumed a 2013 bill at a 20 percent increase over existing levels. This assumption change results in a much less robust recovery in cement consumption volumes during the 2012-2015 horizon. Furthermore, even this more conservative assumption may represent the largest policy risk to the forecast given current political leanings.
ARRA stimulus spending is winding down. Presently, 83 percent of the dollars have been spent and 71 percent of the projects have been completed. Twenty-five states have spent 90 percent of their funds while 15 of these states have spent more than 95 percent of their funds. An estimated $5.8 billion will be spent in 2011, down 49 percent from the $11.4 billion spend in 2010. The remaining balance of ARRA funds will be released in 2012, or roughly $3.8 billion. Of this balance, PCA expects the spending to be concentrated in 13 states, accounting for 89 percent of the remaining funds.
Moving into 2012, says PCA, the bulk of the remaining stimulus spending will be in California, Texas, Florida, New York, Virginia, Ohio and Georgia, representing 61 percent of the unspent funds. Wyoming (at 99.8 percent of its stimulus dollars spent), Oklahoma (99.4) and South Dakota (99.1) have completed their highway stimulus spending, with 25 additional states having spent more than 90 percent of their funds.
Two aspects must be considered regarding state highway spending levels. PCA’s slower job creation outlook suggests a more gradual improvement in the size of state deficits compared to the last forecast projection. Small surpluses are now expected to materialize on a national basis by 2014—pushing back the timeline by roughly one year. Revenue receipts have been increasing and are determined directly, or indirectly, by employment conditions and tax rates. Aside from raising taxes and user fees, state revenue conditions are largely at the mercy of economic conditions and job creation. In the absence of politically unpopular tax hikes, large spending cuts are required to balance a budget in the context of economic distress. On the expenditure side, the bulk of state spending is entitlement and other mandatory programs, which cannot be easily cut. The spending cuts, therefore, are focused on discretionary state spending - including construction spending.
Discretionary state construction spending was hit hard during the recession. During the 10 years preceding the economic downturn, state highway/road construction discretionary spending accounted for roughly 2.4 percent of total state expenditures. Cutbacks in state discretionary highway/roads spending accounted for only 2.1 percent in 2008, 1.9 percent in 2009, and 1.8 percent in 2010. In past reports, PCA attributed these declines completely to states’ fiscal distress.
Recent data, however, has revealed that some of the decline in state discretionary spending occurred due to ARRA. In theory, ARRA highway spending was supposed to be added on top of state discretionary spending, yielding construction stimulus. Data suggests that states swapped ARRA dollars for programs that would have been funded by the state—even in the context of difficult budgetary times. According to PCA calculations, ARRA spending increased $3.2 billion in 2009 (stated in real 1996 dollars) and $3.6 billion in 2010. During these years, state discretionary spending declined $2.4 billion in 2009 and $2.0 billion in 2010. State highway spending declines sterilized roughly two thirds of the potential stimulatory construction impact posed by ARRA.
Clearly, the declines in state highway spending could be completely accrued to budgetary pressures. Spending activity year-to-date during 2011 may paint a different picture. ARRA spending declined $3.2 billion in 2011 compared to 2010 levels. While states still faced difficult fiscal conditions, state discretionary spending increased by $1.4 billion. As ARRA dollars declined, state spending increased. This implies that states recognized that federal ARRA support was on the way out and swapped planned state spending for Federal dollars. While it is likely that some of the decline in state spending was a result of harsh fiscal conditions, it also seems likely that ARRA magnified the decline.
If this analysis is correct, it has significant impact on 2012 and 2013 total highway spending projections. In previous forecasts, PCA held constant the state highway/road construction discretionary spending ratio to total state spending at 1.8 percent, or 2010 levels, until state budget surpluses materialized. This year’s data suggests the ratio is 2.0 percent, well above expectations. The increase in 2011 state discretionary highway spending was unexpected and may suggest state spending actions in 2012 and 2013 as ARRA spending continues to dissipate. PCA’s incorporates higher state highway spending into its forecast.
President Obama has proposed a jobs bill that includes additional infrastructure spending. Highway spending in this proposal roughly equals the dollar levels of the ARRA stimulus. Even if the bill were passed tomorrow, administrative lags, similar to those encountered with ARRA, would prevent any meaningful additional construction spending from materializing in 2012 or even early 2013. Likewise, the potential benefits of an infrastructure bank, also included in the Obama proposal, will take time to set up and implement, therefore, the benefits to construction may not materialize until 2013 or later. PCA has not included the Obama proposal into its forecast estimates.
McGraw-Hill Construction believes public works construction will drop a further 5 percent in 2012, after a 16 percent decline in 2011, due to spending cuts and the absence of a multiyear federal transportation bill for highway and bridge construction.
New paving takes hold?
During the five years preceding the recession, residential and nonresidential construction accounted for 56 percent of total cement consumption. Since the recession began, these sectors’ contribution to cement consumption declined to less than 48 percent. Given the weakness in the private sector during the downturn, cement consumption became increasingly dependent on the public sector, accounting for more than half of all cement consumption.
As the economy recovers, the private sectors will gradually account for a higher proportion of total cement consumption, particularly in light of political conditions hindering increased infrastructure investment. The current forecast suggests that the recovery in the private sector will be tepid. Compared to historical trends, this implies that the public sector will play a larger role in total consumption throughout the forecast horizon. No public sector is more important than highway cement consumption, accounting for roughly 70 percent of total public consumption.
Until recently, asphalt enjoyed a lower “initial bid” and, according to some, a life-cycle paving cost advantage compared to concrete. Given these cost advantages, asphalt paved roads captured roughly 94 percent of all pavements in the United States. The environment and dynamics of world economic growth that resulted in asphalt’s paving cost advantage no longer exists, says PCA. The world economy has permanently changed with the emergence of strong growth among lesser developed and transitional economies. Economic growth among these countries translates into new demand for commodities, such as oil.
Since asphalt is a byproduct of oil refining, the new global realities suggest that asphalt’s long-held paving cost advantage over concrete has not only eroded, but also has already reversed. This reversal has been amplified by changes in oil refining processes and further raising the cost of asphalt. The changes in the composition of world economic growth that have ushered in the new paving cost dynamics are just beginning. Increasingly, the longer-term global economic trends suggest that concrete will enjoy a substantial paving cost advantage over asphalt.
These new paving realities may already be taking hold. Based on recent data analysis, concrete’s share of the paving market has increased from an average 13.5 percent prior to concrete’s initial bid cost advantage (2003-2008) to an average of 15.3 percent (2009-2011). The increase in market share translates into incremental cement consumption of 337,000 mt in 2009, 232,000 mt in 2010 and 111,000 mt through the first two quarters of 2011. Keep in mind, Oman data represents a subset of the entire paving market, and as a result the volume gains associated with concrete’s enhanced ompetitive position could be even larger.