After two years of frenetic activity fueled by a bustling economy, the construction industry is poised for a breather. A number of headwinds are putting downward pressure on projects and profits, not least of them the broad economic slowdown and the continuing rise in the cost of money. “The underpinnings of the construction industry have been undermined, due in large measure to elevated inflation,” said Anirban Basu, chairman and CEO of Sage Policy Group (sagepolicy.com).
After serving to buoy construction activity until mid-2022, a number of positive forces have left the stage. They include government stimulus packages, ultra-low interest rates and rapid increases in the money supply spurred by the Federal Reserve. “All those fundamentals are now being inverted,” noted Basu. “Money is becoming more expensive, and inflation has helped produce much higher materials costs, more expensive workers and pricier equipment.”
Not all is doom and gloom. Some construction segments have a very good five-year outlook, according to Basu, largely because of federal stimulus packages that sent money directly to state and local governments for infrastructure. They include water and sewer, school construction and road and bridge work.
Housing Headwinds
Housing, an important component of the construction industry, has entered a period of correction. “The underlying dynamics of the housing market are changing as lower affordability spurred by higher house prices and mortgage rates is starting to significantly weigh on housing demand,” said Bernard Yaros Jr., assistant director and economist at Moody’s Analytics (economy.com). In particular, he noted, a rapid rise in house prices over the past 12 months is discouraging consumers from signing on the bottom line.
Affordability, in fact, has sunk to its lowest level since late 2007, while the 30-year fixed mortgage rate is within striking distance of its highest level in over a decade, leading to a decline in mortgage purchase applications. Meanwhile, the inventory of for-sale homes remains historically low, helping to prop up prices despite flagging demand. Consequently, existing-home sales have dropped over the past five months and are now at their slowest pace since summer 2020. New-home sales have similarly taken it on the chin.
There’s only so much the industry can do to bolster supply. “Capacity limits have delayed housing completions and contributed to a record number of housing units in the pipeline,” said Yaros. “In particular, the unemployment rate for experienced construction workers is about as low as it’s ever been.”
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The housing industry’s challenging environment shows up in a softening of numbers in economists’ forecasts. “We expect housing starts to fall by 1.8% and 2% in 2022 and 2023, respectively,” said Yaros. “This compares with a 15.1% increase in 2021. Median prices for existing single-family homes will increase 11.5% in 2022 and fall by 2.6% in 2023. This compares with an 18% increase in 2021.”
One bright spot in the housing picture: the lending environment. “Mortgage credit quality has never been better,” said Yaros. “The percent of loans delinquent and in foreclosure is at a record low. This goes to the stellar underwriting standards since the financial crisis, and borrowers’ credit scores are much higher.” While lending standards for mortgage loans are now tightening, the credit spigot is unlikely to seize up as it did during the financial crisis of 2008.
Larger Picture
The construction situation echoes that of the larger economy, which Moody’s Analytics expects to continue its deceleration over the coming 12 months. Downward pressures are being exerted by strong labor markets, intensifying wage and price pressures, monetary tightening and higher interest rates. The best measurement of such deceleration is gross domestic product, or the total amount of revenues for the nation’s goods and services. “Real GDP is expected to grow by 1.6% and 1.4% in 2022 and 2023, respectively,” noted Yaros. “That is much slower than the 5.7% increase of 2021.”
Maybe it’s unwelcome, but an economic deceleration is not a recession, which is loosely defined as an actual long-term decline in GDP. And here economists remain optimistic while holding their collective breath. Moody’s Analytics, for example, figures the odds of a recession are about even through 2023. “The U.S. labor market’s resilience dashes any worry that the economy is in immediate threat of suffering a recession,” said Yaros. “But the nation will enter 2023 being vulnerable to anything else that might go wrong. And it is not hard to imagine that something will.”
Yaros points to a number of ongoing problems that could worsen, including the pandemic (most notably in China) and what now seems like a never-ending Russian military assault in Ukraine. “Another massive supply shock would hit real incomes and consumers’ purchasing power and place even more pressure on the Federal Reserve to tighten financial conditions,” he said.
Corporate Profits
Corporate profitability is a major driver of a healthy economy. And while the picture here has been pretty bright lately, economists expect some softening ahead. “Corporate profit margins are about as wide as they’ve been since World War II,” noted Yaros. “Companies have been able to pass along rising material and labor costs to consumers. Nevertheless, unit labor costs are rising faster than productivity. If that is sustained, it will put pressure on margins. We expect corporate profits to increase 7.9% and 5.2% in 2022 and 2023, respectively. This compares with a 25% increase in 2021.”
The signs indicate that corporate confidence is taking a hit. “Business investment hit a wall in the second quarter,” noted Yaros. “Soaring inflation and interest rates have dampened business sentiment, forcing firms to pull back on spending. According to the Bureau of Economic Analysis’ preliminary estimate, real nonresidential business investment fell 0.1% at an annualized rate in the second quarter, after rising 10% in the first quarter.”
Once again, construction was part of the picture. “Structures were again the biggest drag on growth, with real structure spending declining 11.7% at an annualized rate in the second quarter, its fifth-straight quarterly decline and the largest since 2020,” said Yaros. “Real equipment spending also fell in the second quarter as businesses cut back on information processing and industrial equipment. On the positive side, investment in intellectual property continued its impressive streak with robust second-quarter growth nearly offsetting the combined declines in equipment and structure segments.”
Reports from the field tend to back up the economists’ readings. “Up until the second half of 2022, most companies had pretty positive access to capital and were taking advantage of low rates to plan ahead for equipment purchases and expansion opportunities,” said Tom Palisin, executive director of The Manufacturers’ Association, a Pennsylvania-based regional employers’ group with more than 370 member companies (mascpa.org). “Now, though, many companies are taking a second look at anything planned for 2023. Increasing interest rates and a tightening in the capital markets will certainly put a constraint on companies’ investments.”
Labor Market
The continuing worker shortage is a top-of-mind concern for construction industry. “Businesses will be very focused on labor availability as baby boomers continue to retire, and the supply of immigrant labor has yet to fully recover from severe pandemic-related disruptions,” said Yaros. “Despite a slowing economy, layoffs are low, indicating that businesses are holding on to labor because of the hiring difficulties they’ve faced during the pandemic.”
Will the labor market loosen? Not anytime soon, if reports from the field are to be believed. “I think a tight labor market’s going to be a bit of a permanent feature over the next few years,” said Palisin. “A lot of senior level people have moved on to retirement, probably a bit earlier than they thought they would. And especially in manufacturing, we don’t have the pipeline to immediately fill those roles. That’s why companies are trying to be creative, not only in higher salary rates but also in benefits and work flexibility, to keep and retain workers. A big feature of the next couple years will be a battle for talent.”
But that doesn’t mean employers are powerless. “Companies are investing more in automation for labor-intensive tasks,” said Palisin. “That should help resolve both the labor issue and supply chain problems. Also, interest rate increases intended to push down inflation will supposedly decrease demand, and that may help ease supply chain issues.”
Positive Factors
Meanwhile, some positive forces are expected to keep the economy from free fall. Chief among them is the labor market, the strength of which has been defying the common wisdom about recession and unemployment. Indeed, Moody’s Analytics forecasts the unemployment rate will average 4.1% in the final three months of 2023—not far off the 3.7% rate of late 2022.
There is also a feeling that the Fed will be proactive in lassoing runaway costs. “Inflation will steadily slow from more than 8% to a pace that is consistent with the central bank’s target by the end of 2023,” said Yaros. “This assumes an ebullient labor market will cool down, with monthly job gains decelerating to a level that is consistent with a growing labor force and stable unemployment. Wage growth should also slow to about 3.5% from its current 5% rate.”
The Fed’s favorite tool for fighting inflation, of course, is interest rate manipulation, and the construction industry will need to adjust to the effects down the road. “The purpose of increasing interest rates is to drive down demand,” said Palisin. “So we’re going to see a decrease in new orders that will impact the overall economy. Too, many of our companies have lines of credit that rely on floating interest rates. Rising rates will take a hit to the bottom line as companies decide whether to utilize those lines of credit to support their cash flow and investments.”
Preparing for 2023
How to prepare for 2023? The feeling is that companies should maintain healthy levels of liquidity to cushion against tougher times. “We are all going to need to watch our cash flow,” said Palisin. “Many of our companies are having their receivables stretch as customers take longer terms. And for companies that have been relying on their lines of credit, a rise in interest rates will affect their bottom lines.”
Basu agrees that a solid bank balance can help offset any bumps in the road ahead. “I believe the United States will enter a recession in 2023 and one that is not especially shallow,” he said. “Many construction companies have backlogs stretching through 2023, so even if the economy turns south they will remain reasonably busy. But at some point, the weakening broader economy will catch up with them. They will find it necessary to make more competitive bids, which will compromise profit margins.”
Uncertainty is the name of the game, and that makes planning difficult. “We are dealing with a kind of a two-sided coin,” said Palisin. “The positive side represents strong current orders and a continuing need for more workers, while the negative side represents inflationary pressures and global headwinds.”
Which side of the coin will show its face in 2023? Economists advise watching a few key indicators in the early months of the year. “Companies should keep an eye on what is happening with the cost of money,” said Basu. “Rising interest rates cannot be good for construction. Second, is there any emerging weakness in the labor market? Finally, any softening of consumer spending would point to a looming recession.”
Phillip M. Perry is a full time freelance business writer with over 20 years of experience in the fields of workplace psychology, employment law and marketing. His byline has appeared over 3,000 times in a variety of business publications.
