Plumbing and Mechanical

Boom and Gloom: The Outlook for the Economy and Construction

August 21, 2002
The economy and the construction are showing a split personality. Homebuilding continues to carry on as if there was no recession last year and no slowdown this summer. Consumers skipped the recession but are looking more cautious now, while the rest of the economy is acting as if it is heading for a double dip. Each of these trends has implications for different types of construction.

Let's start with the best news. The government reported Friday that building permits, the best indicator of future home construction activity, held almost steady in July at a seasonally adjusted annual rate 1.7 million. That figure was just 0.5% below June's revised total and a strong 6% higher than a year ago. Historically, about 99% of permits are converted into actual starts, generally within a month or two.

Moreover, the strength in housing is widespread, by both type and region. Cumulatively, the number of permits issued in the first seven months of this year is about 4% higher than in the same span of 2001. Single-family permits are up 5%, 2-4-unit permits are up 9%, and larger-unit permits are of by less than 2%. Total permits in the Northeast are almost 10% higher than last year to date; in the South, 6% higher; in the Midwest, 3% higher; and in the West, 3% lower.

Homebuilders remain optimistic, according to the latest survey of their sentiment from the National Association of Home Builders as well as the harder evidence of permits. Meanwhile, the record low interest rates on 15- and 20-year mortgages are encouraging lots of refinancing and trade-up housing purchases in addition to new-home sales.

The hot housing market helps several categories of construction. New subdivisions create business for site-clearing, grading, utilities and paving contractors. The fixing up of houses before and after sale provides work for a variety of subcontractors and helps pump up retail sales for home furnishing, hardware and housewares, and landscaping businesses, which in turn generates more construction orders. And the strong level of home values, coupled with low mortgage rates, means many homeowners will refinance or at least have confidence that their wealth is rising enough to support higher spending despite a weak stock market.

In addition to housing-related purchases, consumers have continued to lay out money at car dealers. Dealers in turn have spent some of their money on new construction. New detailed information from the Census Bureau on value of construction put in place shows that automotive construction rose 26% from June 2001 to June 2002, even as total construction slumped by 3.5%.

In general, consumers have continued to spend, but has been a strong, ongoing shift away from department stores, higher-priced specialty chains and big resorts. Instead, consumers have headed for discount stores, airlines and vacations. Increasingly they have waited until very late to make their purchases of airline, theater and other entertainment tickets. These businesses have also been hit by a near-boycott of foreign visitors. As a result, theme and amusement park construction was down by 55% from June to June.

These trends appear likely to continue for several more months. Foreign travelers will remain scarce, depressing construction and the economies of areas like Orlando, Las Vegas, major national parks, and dampening activity in New York City and Washington. Shopping centers, where construction fell 18% from June to June compared to a 7% slide in general-merchandise store construction, will continue to lose ground. Auto dealerships will be vulnerable to any bouts of consumer caution. And both consumer and business spending will be set back if oil prices remain elevated. From October until July, gasoline prices remained below their year-ago levels. Now they have caught up and threaten to stay well above, drawing spending power away from other categories.

Turning to the business sector and business-related construction, it is apparent that there is a lot more nervousness about the future than there was a few months ago. Manufacturing activity crept up by only 0.1% in July according the Federal Reserve's industrial production release last Thursday. That is consistent with the still growing but weakening index of the Institute for Supply Management. Furthermore, manufacturers used only 74% of capacity in the past three months, far too little to lead them to call in the engineers and construction crews. Manufacturing construction put in place was off 46% from June 2001 to June 2002 and a revival appears unlikely before mid-2003.

Inventories have finally stopped, or slowed, their long skid. But in June, manufacturers' inventories were nearly 8% below year-before levels; wholesale inventories were 6% lower; and retailers were level with the June 2001 figure. The total business inventory/sales ratio has fallen from a range of 1.4-1.45 during the past five years to the current level of 1.36. That suggests all levels of business are keeping inventories lean and reducing their demand for warehouse and storage space. Warehouse construction fell 20% from June 2001 to June 2002 and will likely stay flat or fall more, even though the economy should keep growing modestly.

Similarly, office construction in most regions is likely to remain depressed until current vacancies are absorbed. With employment levels holding steady at best, that means new office construction won't pick up until well into 2003. Washington, DC may be the only exception--there the market has stayed strong, outside of the former dot-com corridor near Dulles Airport.

Two other categories of private construction deserve mention--health care and power plants. In June, private health care construction stood 17% higher than in the previous June, with hospitals, medical buildings, special care facilities and drug stores (part of "other commercial") all sporting double-digit growth. Private health-care spending is not showing any signs of slackening, and the doctors, drug and device companies, and other providers will continue to convert some of their higher revenue into expanded offices, clinics, labs and manufacturing plants.

At the other extreme, electric power plants are being canceled faster than they are being completed. Construction put in place fell 30% from June 2001 to June 2002, and no turnaround is likely as long as accounting and regulatory turmoil continues and demand remains weak.

Government-funded construction may be soon in the worst shape of any construction grouping, after having shown the strongest growth. Federally funding for highways and several other categories of construction are at or near all-time highs in fiscal 2002. But the federal fiscal year ends September 30, and next year is sure to be a different story. Revenue has fallen and spending priorities have shifted toward defense and domestic security. Construction dollars are likely to become scarce, led by a $3-4 billion drop in highway money. The state story is even worse, because most states must balance their budget every year. Revenues have tumbled compared to the projections made when fiscal 2002 budgets were adopted in early 2001, while outlays for unemployment relief, health care, and public safety officers have climbed. Construction has been deferred or cancelled and will continue to be.

Construction costs should remain well-behaved for the most part. Most producer prices are flat or falling and, as noted, there is capacity to spare throughout the manufacturing sector. However, the patchwork of steel quotas and tariffs announced by the Administration last spring has caused some construction steel to become pricey or scarce. And construction firms that use lots of asphalt or diesel fuel may find those prices soaring unless fears of conflict with Iraq die down.

Nevertheless, the one cost most likely to go up by large amounts is insurance of any type. A recent study by the Organization for Economic Cooperation and Development noted that insurance industry losses from the September 11 attacks are estimated to be between $30 and $58 billion. As a result, premiums for all types of insurance have increased by an average of 30% and in some cases much more, and coverage has been substantially reduced. That has choked off an undetermined number of construction and renovation projects among high-visibility projects.

In sum, the next several months will be very uneven for construction. Construction related in some way to consumer activity should remain strong, business-related construction will pick up gradually in 2003 if the economy keeps strengthening, but government-funded projects are likely to diminish once current jobs are completed.