After achieving a 20-year high this year, the construction industry is undoubtedly thriving. But have we reached the top of the cycle? John Crum examines the factors that have fueled growth over the last five years and the indicators that the pace of expansion will slow in 2019.
Equipment finance and leasing industry observers know 2018 has been a good year for U.S. business. And the construction industry is no exception. But before taking a closer look at this important segment, it is crucial to understand its scope.
How are contractors doing in 2018? What is the outlook for 2019?
For 2018, the answer is clear: The industry is thriving. The 2018 Wells Fargo Construction Industry Forecast, published earlier this year, provided some foresight when the industry optimism quotient hit a 20-year high. Participants in the nonresidential space felt overwhelmingly positive that 2018 would be better than 2017. This sentiment has proved accurate. Through September, on a seasonally adjusted basis, nonresidential construction is up 8.9% year over year.
In addition, nonresidential growth has been led by an 11% increase in government spending for the same period. The strongest segment from a percentage-growth basis has been water supply, up 31.1% from $11.1 billion to $14.6 billion. Highway and street outlay climbed 8.6% from $87.6 billion to $95.2 billion, and construction related to the educational sector rose 9.9% from $67.9 billion to $74.6 billion. On the industry’s residential side, business has been strong as well, with a 4.9% year-over-year increase from $536 billion to $562.3 billion. Combining both, the overall industry is up 7.2% from $1.24 trillion to $1.33 trillion — yes, that’s trillion with a ‘T’.
Looking back just five years, the overall industry is up 47.5% from $901.2 billion in September 2013. In short, the construction industry has done quite well since.
What has contributed to the construction industry’s strength? First, without using the pejorative some observers typically include at the end of this statement: It’s the economy. The U.S. economy has been growing since June 2009 and, if it continues through next summer, this could become the longest period of expansion in history. The byproduct of economic gains tends to be growth in income, leading to both higher private and public investments.
Certainly, other factors have contributed to industry growth, including previous lack of investment in public infrastructure, which caused pent up demand; historically low interest rates, which make housing and project financing affordable; investment in energy infrastructure from distribution to refining and, generally, the confidence that an extended growth stretch brings.
However, strength also presents challenges. Pick any industry, and its leaders will tell you their No. 1 challenge is hiring and retaining qualified workers. This problem is acute in the construction industry. The Great Recession forced hundreds of thousands of workers out of construction-related jobs, and many of them have not returned. Construction-related unemployment was 3.4% in July 2018, with a staggering 273,000 open positions, according to the U.S. Bureau of Labor Statistics. This is the highest number of openings in 18 years of measurement. Worker shortages lead to higher wages, which increases costs for contactors and leads to higher costs for project owners.
Increased construction activity increases price pressure on building materials. Input costs are on the rise due partly to the demand surge. Base costs for construction material have risen overall, yet other factors are affecting prices. Notably, steel and aluminum tariffs have influenced base-level costs for most materials. Rebar, beams, plates, pipe and construction equipment have seen price increases due to actual and potential tariffs. None of the building material price escalations this year reflect what will be increased demand of certain materials in response to rebuilding efforts after Hurricanes Florence and Michael.
Construction equipment availability, too, has become an issue for contractors, with many reporting long lead times for certain asset types. This development is confirmed by manufacturers’ backlogs and factory output. Tight availability has strengthened used equipment prices — for the industry, overall — and fortified underlying equipment collateral values used to secure loans and required for end-user leases. Dealers with rental fleets and rental-only companies are reporting robust utilization rates and underlying revenues.
What do observers expect in 2019? It may seem like the top of the cycle, but the year ahead is showing some signs of being another positive year. However, like calling the bottom of any market, making that judgment can be exceptionally difficult. Survey science is certainly inexact, but over time, trends can be observed and market direction can be generally anticipated.
The Architectural Billings Index, a leading indicator of nonresidential activity that measures potential projects nine to 12 months out, had a September reading of 51.1 and has been positive all year. Any reading above 50 is growth territory. The American Institute of Architects also notes a positive outlook for 2019 from member firms with signals toward slowing growth.
Similarly, the September Dodge Momentum index — another forward-looking indicator of nonresidential construction — was at 159.5, squarely in the growth zone, but down for the second-consecutive month. Dodge Analytics, producer of the index, notes that this level might represent a more sustainable level of industry growth.
For residential construction, housing starts and building permits are two key indicators. Through September, housing starts are up 3.7% year over year from 1.16 million to 1.20 million, while building permits are down year over year by 1% from 1.25 million to 1.24 million.
None of these statistics suggests the bottom will fall out of the industry, but rather that growth will moderate. Why? Construction activity has been vigorous for a sustained period. There are projects in place and plans for others carrying into 2019. Housing starts remain brisk.
Yet, there are warning signs that growth will slow. Tight employment restricts the ability of contractors to bid on new projects. Rising input costs make any construction project more expensive, whether it is a road, a commercial building, or a house. These factors — not just in construction, but across all industries — explain why there has been an additional growth regulator. Interest rates have steadily and consistently risen over the past 12 months. As of this writing (November 2018), the 10-year Treasury swap yield has increased 95 basis points, with the five-year treasury swap rate increasing 110 basis points; the 30-day LIBOR rate rose 107 basis points.
The bottom line? We are likely at a point in the construction sector cycle where the historic governors of industry growth have been activated, limiting the upside.
Opinions expressed in this article are general and not intended to provide specific advice or recommendations for any individual or association. Contact your banker, attorney, accountant or tax advisor with regard to your individual situation. The author’s opinions do not necessarily reflect those of Wells Fargo Equipment Finance or any other Wells Fargo entity.
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