GOING INTO the New Year, US construction haulers will continue to operate in a very challenging market. While the economy remains slow, many fleets report that they are hauling cement and other construction materials.
The economic momentum that gathered steam during the early part of 2010 ebbed as growth transitioned from stimulus and inventory fueled to core fundamentals, such as consumer spending, investment and net exports, says Portland Cement Association Chief Economist Ed Sullivan in his year-end economic and industry outlook. As recently as last summer, he believed the nation would see a gradual and sustained recovery fed by growing confidence among business and consumers, leading to gains in spending and job creation. This scenario played out until the latter part of the year, according to Sullivan.
A slower recovery in 2010 meant nearly flat growth in the construction sector, with a 0.3% increase in cement consumption aboveverydepressed 2009 levels. Sullivan predicts 1.4% and 4.0% increases in cement demand in 2011 and 2012, respectively. The projected 5.7% gain through 2013 represents a nearly two-thirds drop from the 16.5% percent gain noted in his most recent (August) 2010-2012 cement shipment outlook.
“Future gains in construction activity are dictated by labor conditions today,” Sullivan says. “Slow job growth leads to slower home purchases and start activity; it undermines the speed at which state deficits can heal, [thereby] impacting public construction; and, implies low occupancy rates for the non-residential market.”
Cement consumption
While small percentage gains could characterize each of these segments during the next two years, he adds, substantive cement consumption volume gains are unlikely to materialize until 2013.
Slightly more optimistic is McGraw-Hill Construction's 2011 Construction Outlook, which predicts an increase of 8.0% (to $445.5 billion) in overall US construction starts for 2011, following the 2.0% decline expected for 2010.
“While the economy is still facing headwinds, the stage is being set for construction to see modest improvement in 2011 from last year's very weak activity,” says Robert Murray, vice president of economic affairs at McGraw-Hill Construction, addressing the 72nd Annual Outlook 2011 Executive Conference in Washington DC. “We're turning the corner, slowly. 2011 will be the first year of renewed growth for overall construction activity, and 2010 becomes the final year of a very lengthy and unusual construction cycle.”
PCA's economic bounceback scenario can best be described as a “synchronized recovery,” reflecting the self-sustaining momentum and interplay of marginal increases in demand, prompting job gains, feeding consumer, business and bank optimism, leading to further marginal gains in demand. The scenario reflects a gradually building private sector momentum, something essential given the winding down of the American Recovery and Reinvestment Act (ARRA) of 2009. However, this expected scenario may be out of synch with current market activity.
Economic confidence
Consumer and business confidence, key ingredients in sustaining momentum, have tapered off. Private-sector growth, as a result, has entered a period of slowdown. Furthermore, ARRA stimulus will increasingly fade as a positive for economic growth. Many companies have been able to meet incremental increases in demand without adding many full-time workers to the payroll. Thus far, this non-hiring game has worked due to strong gains in productivity. There are limits, however, to productivity growth and the ability to postpone hiring.
This point is reinforced by data showing an easing in the rate of productivity growth, as well as gains in temporary hiring. While job gains and the process of economic recovery are expected to continue, improvement may not continue at the same pace as previously expected. Indeed, economic growth will probably not become strong enough to generate more robust job gains for some time — translating into a longer than expected period of meager growth. While the fundamentals should prove strong enough to prevent a return to recession, the economy is now extremely vulnerable to even modest external shocks. PCA's Sullivan believes the potential for a double-dip recession remains high — roughly a one-in-three possibility.
Homebuilders are unlikely to significantly accelerate construction activity until two critical conditions are met: low levels in inventory of unsold new homes reflecting no higher than five months' supply and stable or rising home prices. Both conditions are necessary to ensure adequate returns on investment (ROI) for homebuilders to spur an increase in building activity. Lacking either condition, a substantive recovery in home building will not materialize in the short term.
Given this, analysis of the residential sector becomes very simple. A significant improvement in residential construction cannot begin until the foreclosure crisis is over. This is not expected until 2012. High levels of foreclosure activity increases inventory levels and depresses home prices, adversely impacting homebuilders' expected ROI. Substantive cement-consumption increases emanating from the residential construction sector require detailed foreclosure analysis, says Sullivan.
Mortgage problems
Foreclosure estimates are based on labor market conditions, home prices, number of mortgage resets, and the toxicity of mortgages open for reset. According to RealtyTrac, more than 1.3 million US households received a foreclosure notice in 2007; over 2.3 million received notices in 2008; and 2.8 million got notices during 2009. PCA expects foreclosure activity will top three million during 2010-2011.
The overall number of mortgage resets is expected to decline in 2011. To some, this could imply a reduction in foreclosures next year. Unfortunately, the types of mortgages that are due for reset are extremely toxic. This suggests a greater default rate and, as a result, foreclosure levels that are likely to match 2010 record levels.
Sullivan expects a generally flat single-family housing starts scenario for 2011. In 2009, single family starts totaled 440,000 units, rising to an estimated 476,000 units in 2010. PCA expects 2011 housing starts will reach 492,000 units. As labor market conditions slowly improve, lending standards gradually ease, foreclosures begin to subside, and new home prices stabilize, initially tepid gains are expected to materialize. Housing starts are projected to reach 690,000 units in 2012.
For comparison's sake, the Mortgage Bankers Association expects single-family starts to reach 477,000 in 2010, to hit 531,000 in 2011, and to top 763,000 in 2012. For the same three years, the National Association of Home Builders forecasts starts of 479,000, 655,000, and 970,000, respectively, while the Nation Association of Realtors comes in with projections of 489,000, 590,000, and 808,000.
Pessimistic view
Clearly, 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 Sullivan's projections for housing starts activity and cement consumption. Consensus averages for single-family starts compared to PCA projections suggests potential upside risk of additional cement consumption amounting to 1.9 million metric tons in 2011 and 3.0 million metric tons in 2012.
In assessing this potential upside risk, 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-start overbuilding occurred. Since 2007, however, substantial pent-up demand has been generated by under building. The excess building has been completely absorbed and pent-up demand for 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 housing-start recovery compared to PCA's outlook. The long-term trend of 1.6 million units should be reached in 2015, according to estimates.
There is one final factor to consider with the residential forecast. High debt, joblessness, and the large amount of foreclosures are damaging credit for many potential new home buyers. Furthermore, substantively easier standards and/or the re-emergence of a subprime credit market is unlikely to materialize anytime soon to accommodate potential buyers with damaged credit. This implies a gradually higher proportion of starts going toward rental units — a factor incorporated in the PCA forecast. A typical single-family unit consumes 19 metric tons of cement, Sullivan notes, while a multifamily unit consumes roughly nine metric tons.
Nonresidential construction is not expected to recover soon due to large declines that characterized 2009 continuing to materialize in 2010. Further, smaller declines against weak 2010 levels are expected to define 2011. No substantive recovery is expected in 2012, according to Sullivan, and all factors considered, a recovery in nonresidential construction is not expected to materialize until 2013.
Commercial market
PCA's nonresidential outlook suggests a prolonged recovery process. The timing of the nonresidential activity reflects the process in which a recovery materializes — referred to as the “transmission mechanism.” An improvement in office construction, for example, occurs only after job creation is strong enough to improve occupancy rates and reduce vacancies. Given sustained job creation and a lowering of vacancy rates, the leasing rates will first stabilize and then improve. Only when both conditions are present will expected increases materialize, igniting new interest in commercial construction activity.
Office vacancy rates currently stand near 19%. PCA believes the trigger point for stabilization in leasing rates is near the 15% vacancy rate level. This implies that roughly 890,000 office jobs will have to be created to trigger leasing rate stabilization. Since roughly one in three of all jobs created are of office variety, this implies the economy must add roughly 2.8 million jobs. That level of job creation is not expected until 2012.
Either directly or indirectly, job creation 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. PCA's slower economic growth is characterized by a slower improvement in job creation. This, in turn, stretches out the timing for a recovery in nonresidential construction.
In addition, the commercial real estate market is plagued with refinancing issues. Many commercial properties were refinanced during the easy credit era, coinciding 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. While commercial real estate leverage is improving, it remains high on a historical basis. More than $1 trillion in commercial real estate debt is coming due over the next few years, and the value of much of the collateral is still less than the loan balances. In light of difficult lending standards, PCA expects commercial property values will continue to decline through 2011. The asset price decline further hinders an improvement in ROI.
To compare, the McGraw-Hill Construction 2011 Outlook predicts that commercial building will increase 16%, following a three-year decline, which dropped contracting 62% in dollar terms. The levels of activity expected for stores, warehouses, offices, and hotels in 2011 are expected to be quite weak by historical standards. Economist Robert Murray also anticipates manufacturing building will increase 9% in dollars and 11% in square feet in 2011.
Public projects
According to Sullivan, the public construction sector outlook contains political as well as economic risks. Assumptions regarding both areas could have significant implications on the volume projections for cement consumption. Public cement consumption typically accounts for 40% to 45% of total US consumption. In light of dormant private sector cement usage, public sector consumption is expected to account for 50% to 55% of consumption during the next two years. This implies that assumptions and assessments regarding the public sector carry more importance than usual and, as a result, can be a source of larger forecast risk.
PCA believes that over the last two years, a new wave of fiscal conservatism has embraced Congress — perhaps ignited by President Obama's health care plan — giving rise to the influence of the Tea Party's conservative agenda. Still, the political push for further significant fiscal efforts to stimulate a fragile economic recovery now seems remote. Keep in mind, the political winds can change quickly, as the recent elections would indicate. If convincing evidence surfaces that the economy faces much harsher prospects than modest growth, fiscal policy initiatives could regain a place at the political table, thus upgrading the economic and cement consumption outlook.
PCA believes the current political realities translate into no new highway bill materializing until 2013. Keep in mind, there remains a window of opportunity during March-September 2011 period, during which a new highway bill could be considered and adopted. If an earlier than expected highway bill materializes, PCA's current forecast could underestimate 2012 cement consumption accrued to highway spending.
The size of the new highway bill is not expected to be as large as the $500 billion program initially discussed by the recently voted out top-ranking Rep Jim Oberstar (D-MN), chairman of the House of Representatives Transportation and Industry Committee. For this economic forecast, PCA assumes a more modest bill reflecting a significant increase (20%) over its predecessor, SAFETEA-LU. To some, this increase may seem too optimistic, says Sullivan. Funding of the new highway bill remains the key obstacle for any increase in spending. Sullivan believes the Highway Trust Fund is already broken at existing levels of funding, and there is no political will for an increase in the gasoline tax, the key source of funding for the trust.
PCA's political assumptions imply that SAFETEA-LU will be extended once again, and that the extension will be at existing nominal funding levels. In 2010, the extension did not materialize until April. This seven-month delay resulted in a shortfall of funds prompting some projects to be stopped or delayed. While some of this delay may have been captured later in the year, PCA believes one million to two million metric tons of cement consumption was lost for 2010 due to extension delays. No doubt the delay resulted in some unexpected weakness in cement consumption. Assuming 2011 extensions are not delayed, this implies a 2010 to 2011 net increase of two million to four million metric tons in SAFETEA-LU cement consumption for 2011 (no loss of one million to two million as in 2010, plus recapture of lost 2010 volume).
Unfortunately, no 2011 extension of SAFETEA-LU, which expired on December 31, materialized before Congress recessed. PCA saw a 50-50 chance that an extension will be voted on during the lame-duck session. If not, it is likely an extension will not materialize again until April 2011. PCA's current forecast assumes a lame-duck passage.
State funding
No significant changes have been incorporated regarding discretionary state highway spending. Eroding state fiscal conditions account for the entire decline in highway cement consumption that has materialized since 2006, falling by more than 12 million metric tons, or 22% of the total industry's decline in volume since the start of the downturn. PCA estimated discretionary state street/highway cement consumption at 5.5 million metric tons in 2009.
Most state budgets are bound by a “balanced-budget amendment” requiring states to balance expected revenues with expected expenditures for the fiscal year. Unfortunately, such amendments tend to de-stabilize the economy during economic downturns and focus the efforts of balancing the budget on the few areas that fit into the “discretionary spending” area.
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 entitlements and other mandatory programs that cannot be easily cut. Spending cuts, therefore, are focused on discretionary state spending, including construction programs.
Discretionary state construction spending was hit hard during 2009. PCA estimates real discretionary state highway/road spending declined 4% in 2008 and another 12% in 2009. This reduction reflects not only fewer funds available for spending, but also a shift in state spending priorities. During the 10 years preceding the economic downturn, state highway/road construction discretionary spending accounted for roughly 2.4% of total state expenditures. Cutbacks in state discretionary highway/roads spending accounted for only 2.1% in 2008 and 1.9% in 2009.
In addition to the reduction in highway/road spending, the composition of spending moved away from large and expensive projects toward resurfacing activity. This lowered cement intensity associated with state highway/road spending. PCA estimates state highway/road intensity declined 14% in 2008 and 50% in 2009. The change in the composition of state spending, coupled with outright spending cuts accounted for a decline in cement consumption of 2.7 million metric tons in 2008 and 7.1 million metric tons in 2009. Unfortunately, PCA expected state and local construction spending will act as a drag on cement consumption again in 2010, albeit smaller in comparison to 2009. Large state deficits are expected to continue in 2011, improving in 2012, and lead to small surpluses in 2013, according to Sullivan.
State discretionary spending on highways and roads is expected to decline and stabilize at 1.7% of total spending during 2010-2011, representing an extremely low commitment to local infrastructure. During the last recession, state discretionary highway spending declined from 2.5% to 2.2%. Thus far, this recession has dropped the same from 2.3% to 1.9%. PCA expects the extremely low cement intensities that materialized in 2009 will be repeated in 2010-2012. This is a continuation of 2009 state spending strategies reflecting limited commitment to large and expensive projects toward cheaper resurfacing activity, stretching scarce state transportation dollars.
The McGraw-Hill Construction forecast sees public works construction dropping 1% in 2011, given the fading benefits of the ARRA for highway and bridge construction. PCA recognizes that no significant changes have been incorporated regarding ARRA spending. Despite more than $5.6 billion spent on highways and streets, ARRA contributed little to cement consumption (an estimated 580,000 metric tons) during 2009. This reflects delays in spending activity as well as an emphasis on projects requiring short design times (shovel ready), such as resurfacing activity. This type of spending is generally associated with very low cement intensity. During 2010, ARRA spending is on pace for $11.6 billion, and PCA expects $9 billion will be spent in 2011, followed by $600 million in 2012.
The composition of projects is expected to continue to move from resurfacing to more design-intensive projects, which typically carry higher cement intensities. Indeed, PCA generally believes states that have been slow to spend ARRA dollars during 2009 are likely to make a higher commitment to “big projects” during 2010-2011. ♦
