2008 Construction Forecast: Slowdown in Growth in Nonresidential Construction Market

by Craig DiLouie, Lighting Controls Association

Posted January 4, 2008

New nonresidential construction forecast added January 24, 2008

Cooling rapidly at the end of 2007 and in a precarious position at the start of 2008, the U.S. economy is not technically in a recession and, despite the gathering stormclouds, was predicted to steer clear of national recession unless the unemployment rate increased significantly. However, in December 2007, it did just that, as reported January 4, rising from 4.7% to 5.0% and leading many economists to suddenly become pessimistic.

Even before December's jump in unemployment, the present economic slowdown was still expected to impact the nonresidential building market starting in the second half of 2008 through 2009.

This special report from the Lighting Controls Association provides the latest economic data and forecasts announced late last year. A new nonresidential construction forecast was added on January 24. Total nonresidential construction spending is expected to slow to a 0.7% growth rate in 2008 and a -0.9% growth rate in 2009, according to the AIA semi-annual Consensus Construction Forecast.

U.S. ECONOMY

Real gross domestic product (GDP), or the total market value of all final goods and services produced in the U.S. in a given year, rapidly cooled in the fourth quarter after a strong second and third quarter, according to the Federal Reserve’s economic projections. Over 2007, GDP is estimated to have grown at an average rate of about 2.5%. This followed three years of solid growth—in 2004 (3.6%), 2005 (3.1%) and 2006 (2.9%)—that were more in line with the 3% average annual growth rate of the past two decades.

Growth is expected to remain sluggish in 2008 (1.8-2.5%), 2009 (2.3-2.7%) and 2010 (2.5-2.6%), according to the Fed.

Dr. Scott Anderson, senior economist for Wells Fargo, has forecasted a slowdown in 2008 to an average growth rate of 1.9% (see below).

Source: Bureau of Economic Analysis, U.S. Department of Commerce, Wells Fargo

Why is the economy slowing? The major contributors to real GDP are consumer spending, private investment, net exports and government spending.

Consumer spending has driven the economy in recent years, representing 70% of the nation’s 13+ trillion GDP.

The Consumer Confidence Index (CCI) ended the year 24 points lower than a six-year high in July, indicating that consumers are far from optimistic in their short-term outlook on business conditions, employment, inflation and stock prices.

Anderson predicts consumer spending, trending at about 2.8% in 2007, will fall to 1.8% or even as low as 1% in 2008, as shown in the below graph.

Consumers are backing off spending for several reasons, he says, including tighter credit and lending standards, declining housing and stock market wealth contributing to people feeling “poorer,” and a slowdown in payroll growth. He adds that the first half of the year is going to feel like a recession to most consumers even if one does not occur.

Tighter credit and lending standards are of course the result of the subprime mortgage crisis, which started in the fall of 2006 and became a national and international credit crisis over the next year. The bursting of the housing bubble in 2006-2007 also saw declines in national home sales and prices and, subsequently, builders slowing production to reduce inventory and allow demand for new homes to catch up with supply.

The reduction in housing spending in 2007, in fact, is credited with reducing real GDP growth by a full percentage point.

Forward-looking indicators such as homebuilder confidence and building permit issuance paint a grim picture of future construction activity. Housing starts are expected to continue to decline until the middle of 2008 and then stabilize, says Anderson, reducing the chance of a recession aftwards unless a recession occurs first and continues the decline. David Seiders, chief economist for the National Association of Home Builders, says many builders are currently “bracing themselves for the winter months when home buying traditionally slows, scaling down their inventories and repositioning themselves for the time when market conditions can support an upswing in building activity, most likely by the second half of 2008.” Nonetheless, Anderson expects housing prices to continue to decline until 2009, dampening consumer confidence and spending.

The year did have one significant bright spot, and that was exports, the benefits of a weaker dollar finally being realized. Net exports increased 7.5% in the second quarter and 19.1% in the third, and are expected to buoy a softening economy in 2008. According to The Kiplinger Letter, net exports will keep the economy from “looking feeble” in 2008, accounting for about one-half of the 1.5-2% growth in GDP it has projected for 2008, up from one-fourth in 2007.

“The big story here,” says Dr. Jim Paulsen, chief investment strategies for Wells Capital Management, “is that while housing spending has taken a full percentage point off real GDP growth, it’s been totally offset by a percentage point gained in trade. For the first time in about 15 years, export growth is adding to real GDP growth, and it will continue as the dollar continues to weaken.”

A weaker greenback helps exports but many products that Americans buy are foreign-made, including oil and food—which contributes to inflation, currently above 4% and expected to run at about 4% in the first quarter of 2008, according to Anderson.

Inflation is also receiving upward pressure from high oil prices, which had climbed to nearly $100/barrel at the end of 2007 and then hit $100/barrel in the first days of 2008. The Energy Information Administration (EIA), U.S. Department of Energy, estimated a 30% increase in residential heating oil prices during the winter of 2007-2008. According to GasPriceWatch.com, the national average price per gallon of gas was $3.03 on January 3, 2008. On December 17, 2007, The Christian Science Monitor reported that businesses were starting to pass on higher energy costs to their customers. Consumer prices rose 0.8% in November, while producer prices surged 3.2%, mostly because of energy. Oil prices to refiners are expected to remain well above $70 per barrel in 2008, according to EIA.

Meanwhile, EIA has projected electricity prices to increase marginally in 2008—average industrial end-use cost/kWh about 1.6%, commercial about 1.3% and residential about 1.7%. Electricity sales to the industrial and commercial sectors are expected to be limited by slower GDP growth. And according to EIA, “Most states that had planned to let price caps expire within the next year have either delayed those plans or changed the expiration schedule so that increases occur over a longer time frame.”

The real wild card in the economy at this point is payroll growth and its effects on the unemployment rate. The labor market recently began showing signs of weakening due to sluggish payroll growth numbers that resulted in an increase in the unemployment rate as people enter the labor force faster than new jobs are created.

Forecasting a 5.1% unemployment rate by the end of 2008, Anderson points out that a higher-than-expected unemployment rate could magnify housing and consumer spending problems (this forecast was made before the January 4 report on unemployment). “Many Americans appear to be one job loss away from mortgage default and bankruptcy,” he says, pointing out that the national household debt-to-income ratio is 130%, a historically high level. “If unemployment rates rise more than expected, banks would respond by further restricting credit, home prices would fall below current expectations of a 10% national decline, and we’d see a downward spiral in the economy.”

Part of the bad news is that developing conditions, while not technically a recession at present, may begin to show signs of “stagflation”—rising price inflation coupled with increasing unemployment, low or no growth in economic output, and eventually a recession, reminiscent of the supply shock of the late 1970s.

On December 14, former Fed Chairman Alan Greenspan told ABC’s “This Week” program, “We are beginning to get not stagflation, but the early symptoms of it,” as reported in the December 17, 2007 issue of The Christian Science Monitor. One of the problems with stagflation is it hampers Fed policy in managing the money supply—the Fed will be bound between raising interest rates to combat inflation, which restrict the money supply and contract the economy further, or lower interest rates to increase the money supply and stimulate economic growth, which could increase inflation.

U.S. CONSTRUCTION

Total construction spending declined an average 3% during Jan-Oct 2007 compared to the same period a year earlier, after increasing 5.7% in 2006 over 2005. This was the first downturn in overall construction spending since 1991.

In October 2007, the value of put-in-place construction reached $1.158 trillion, a <1% decline from the same period a year earlier.

Private residential construction declined throughout 2007, following a downward trend set in motion after the housing bubble burst after peaking at an annual rate of $696 billion in February 2006. Private residential put-in-place construction declined an average 17.7% in Jan-Oct 2007 compared to the same period in 2006.

In October 2007, private residential construction fell to an annual rate of $503.7 billion, 16% lower than the same period a year earlier.

Nonresidential construction, one of the unsung heroes of the 2007 economy, cushioned the impact of residential’s decline with strong growth—an average 15% in Jan-Oct 2007 over the same period in 2006, after increasing 12.3% in 2006 over 2005.

In October 2007, the value of nonresidential put-in-place construction reached $647 billion, a 16% increase over the same period a year earlier.

Public construction increased 12.1% Jan-Oct 2007 over the same period in 2006, up 9% from 2005. Private construction increased 17.3% Jan-Oct 2007 over the same period in 2006, up 15% from 2005.

Looking to 2008, all of the above economic developments will affect construction. The continuing problems in the residential sector will mean continuing declines in residential construction for the short term. Lower consumer spending and tighter credit will lead businesses to be conservative about fixed investment, with retail construction being most vulnerable.

What will happen in the construction industry?

One forward-looking indicator of future construction spending is the American Institute of Architects’ (AIA) Architectural Billing Index, which stayed above 50 throughout 2007 (as of November, the last reported ABI as of the writing of this whitepaper), and ended the year modestly trending upward. A score above 50 indicates an increase in billings with a 9- to 12-month lag between billings and construction spending.

Weakness in the overall U.S. economy is translating to a tempered forecast for the nonresidential construction market, however, and spending is expected to increase by a modest 0.7% in 2008 in inflation-adjusted terms, according to the AIA semi-annual Consensus Construction Forecast, a survey fo the nation's leading construction forecasters.

Led by demand for institutional projects, the growth in 2008 is expected to be at a slower pace than recent years, with commercial projects likely to see the most decrease. Also there is expected to be continued volatility in the costs of building materials.

“After ending 2007 on a high note, we are anticipating a significant slowing of nonresidential construction growth in 2008,” said AIA Chief Economist, Kermit Baker, PhD, Hon. AIA. “A slight decrease in activity is actually expected in 2009 with 2008 and 2009 projected to be the trough of the current construction cycle.”

The consensus is for a small decline of 0.9% in nonresidential activity in 2009, with institutional categories continuing to outpace commercial catgories of construction.

Click here for the full report.

“Oil prices in the $100 per barrel range are not the only construction material input that is experiencing unusual price fluctuations. Iron and steel scrap have increased more than 28% between 2006 and 2007, with construction sand/gravel/crushed stone up over 8%, selected steel products up almost 6% and fabricated structural metal increased more than 5% during the same period,” Baker added. “Conversely, gypsum products are down more 23% over the past year, with prices for insulation, plywood, aluminum and natural gas lowering a bit as well.”

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