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Future focus: job growth is expected to drive the economy and the construction industry in 2006.

Note: The following is adapted from a presentation the author, chief economist at the Portland Cement Association (PCA), made at C&D World, the Annual Meeting of the Construction Materials Recycling Association (CMRA) in mid-January.

While the strong economic growth rates achieved during the past three years are not expected to be duplicated, the U.S. economy is in good shape. Since the start of 2004 the United States has created 4.1 million net new jobs--an average pace of more than 170,000 per month--every month for two years. The pace of job creation is not expected to subside anytime soon. PGA expects more than 2 million net new jobs will be created during 2006 and 1.8 million in 2007. Labor markets will tighten and stronger wage gains are the likely outcome--something that has been absent from the U.S. economic landscape for sometime.

Consumer spending accounts for more than two-thirds of overall U.S. economic activity. The combination of job growth and stronger wage gains form a sturdy foundation for strong consumer spending going forward. While higher interest rates. energy prices and firmer overall prices will erode consumer affordability, PCA expects consumer spending will grow in a range of 3 percent to 3.5 percent during each of the next two years.

The favorable outlook for consumer spending is amplified by even more favorable conditions facing the investment sector of the United States. Sustained economic growth has increased the expected return on capital investments and at the same time generated strong corporate profitability. This combination, coupled with favorable interest rates, created an extremely favorable environment for U.S. investment activity. Business fixed investment grew by 8.5 percent during 2005. This favorable environment for capital investment is expected to remain in place during 2006 and 2007.

While a burgeoning trade deficit and large federal government deficit (referred to as the twin deficits) will act as an ongoing drag on overall economic growth, neither issue threatens near term economic growth. The threat posed to the U.S. economy by the twin deficits, in our view, is at least two years away.

CONSTRUCTION OUTLOOK

The U.S. construction market is expected to achieve roughly 2 percent growth during each of the next two years. While these percentage gains are modest, they are based from record 2005 activity levels. The composition of construction activity is expected to gradually shift away from residential and toward nonresidential and public construction. No pause in construction activity is anticipated as the residential sector winds down under the weight of higher mortgage rates. The expected gains in nonresidential and public construction are expected to more than offset modest declines in residential.

RESIDENTIAL CONSTRUCTION OUTLOOK

The favorable mortgage environment has been the key factor propelling growth in the residential market during the past few years. Homeownership rates, as a result, recently reached new highs. Low mortgage rates have increased affordability and increased the ability of potential first time homeowners to buy.

PCA expects modest declines will materialize in residential construction in each of the next two years. Nevertheless, PCA is growing increasingly concerned that the impending declines could be a bit more substantial particularly in 2007. From our view, it is a mistake to view the propelling factor as only the level of mortgage rates. The low rate environment has been supplemented by easy credit terms and more importantly a broad offering of high risk, low rate mortgage options. PCA believes all three factors characterizing the mortgage environment will turn less favorable in 2006 and beyond and force a mild retrenchment in residential construction. The risks, however, lie on the downside.

Mortgage Rates. While conventional 30-year mortgage rates are well below the 10-year average, they rose nearly 70 basis points since early 2005. The prospects of slightly higher inflationary expectations, increases in post-hurricane federal debt, some additional tightening by the Federal Reserve and potentially some slippage in the growth of foreign funds to U.S. capital markets all play a part in the outlook calling for sustained, albeit gradual, increases in mortgage rates. PCA expects 30-year conventional mortgage rates to stay below 6.5 percent through the first half of 2006 and accelerate in the second half ending the year at 6.8 percent.

Further modest increases are projected beyond 2006. On this front, PCA believes that the risks are on the upside. Foreign supply of capital to the United States has been an important ingredient in keeping mortgage rates low in the context of rising demand for capital. Recent reports indicate that China may diversify its holdings, reducing its exposure in U.S. T-Bills and hence its supply of capital to the United States. If this materializes, an added push to mortgage rates may materialize beginning in late 2006/2007.

Appreciation Rates. The expected increases in mortgage rates must also be considered in the context of strong home appreciation rates that materialized during the past several years. On a national basis the median home price has increased 51 percent since 2001. Rising interest rates in the context of high home prices may result in significant dollar increases in new homebuyer monthly mortgage payments.

In addition, strong appreciation rates have prompted speculation by investors. PCA believes that speculation is greatest in regions that have experienced the strongest appreciation rates, notably areas characterized by strong regional growth dynamics and resort areas. As interest rates rise, appreciation rates will ease and cool speculative buying. This could lead to the possibility of a more rapid decline in home sales in regions characterized by speculative buying.

The combination of rising mortgage rates, high home prices, the possibility of a tightening in lending standards and retraction in the growth of exotic mortgages translate into a scenario of decline in single family sales. PCA expects new home sales will decline by 4.2 percent during 2006. Even with this decline, 2006 sales would be the second strongest sales year in history. An additional decline of 5.5 percent is projected for 2007. In each year the forecast risks are on the downside.

Single family construction will face easing demand and the need for an inventory correction as inventories, measured on a month's supply basis, are well above the 10 year average. PCA projects starts will decline 5.6 percent in 2006 followed by a 7.2 percent decline in 2007. Even after these declines, starts activity will remain strong from a historical perspective.

NONRESIDENTIAL CONSTRUCTION OUTLOOK

Nonresidential construction has turned the corner and is expected to emerge as a growth leader for construction activity during 2006 and beyond. Nevertheless, the current recovery process is a bit slower than previous nonresidential recoveries. Long lags exist between improvement in the underlying fundamentals affecting expected nonresidential ROI and actual improvement in nonresidential construction. Global uncertainties, high energy prices and the initially slow strengthening in labor markets probably all play a role in stretching the lags and subduing the strength in nonresidential construction at this phase in the economic recovery.

Since 2001, each year of solid economic growth has resulted in an improvement in capacity utilization, vacancy rates and leasing rates. The expected ROI on property investments has improved considerably and will continue to improve with each additional year of economic growth.

Despite the lackluster recovery process in nonresidential construction thus far, PCA expects the recovery will gather steam during the next two years. At the heart of PCA's optimism are the ongoing the underlying conditions that affect nonresidential construction decisions. Office vacancy rates, for example, have declined nearly 300 basis points since the beginning of 2004. Unfortunately, vacancy rates remain high from a historical perspective and as a result office construction activity recorded no growth during 2005. Nevertheless, sustained economic growth has generated strong increases in office employment--now growing at an annual rate of more than 3 percent. Increases in office employment are expected to result in a 200 basis point decline in office vacancy rates in 2006 and again in 2007. With the decline in vacancy rates, leasing rates for office space will rise. The combination of lower vacancy rates and higher leasing rates raises the expected ROI for office properties and will propel the recovery in office construction.

Compared to the conditions that characterize the office construction sector, nearly all other categories that make up nonresidential are further along in the recovery process and are likely to show strong percentage growth gains in 2006 and 2007. Industrial construction, for example, grew at nearly 16 percent in 2005. Sustained gains in consumption, coupled with recent housing boom, are expected to increase retail construction. Increases in business and vacation travel, coupled with a weak dollar have led to a strong recovery in conditions affecting the hotel industry. Health care construction showed strong growth during the second half of 2005 and is expected to repeat this performance in the years ahead. Even the long depressed public utility sector is facing the need for expansion.

As long as the economy continues to record solid growth, the underlying conditions facing nonresidential construction will improve and lead to a cyclical recovery in nonresidential construction. As always with this sector, timing the recoveries for each nonresidential category remains a risk factor.

PUBLIC CONSTRUCTION OUTLOOK

The need to expand and improve public infrastructure including roads, water and sewer systems as well as public buildings characterizes every state in the country. At issue, however, is not the need to expand public infrastructure, but rather the financial ability of states to meet existing and future needs. Keep in mind, more than 90 percent of all public construction activity is performed at the state and local level--not at the federal level.

State Revenue Conditions. The combined outlook for income tax revenue and sales tax revenue yield an outlook for growth in general fund revenues of more than 7 percent annually during the 2006-2009 period. Furthermore, revenue gains at the state level are expected to be reinforced by gains at the local and municipal levels. This revenue growth is expected to play a key role in fueling growth in public construction spending.

State Expenditures Outlook. State expenditures are highly dependent on revenue conditions facing the state. Typically, an improvement or deterioration in state revenues are followed by a corresponding 12 to 18 month lag in discretionary state expenditures. This is reflective of balanced budget amendments in place in most states.

Increasingly, however, not all state expenditures arc discretionary in nature. Spending on entitlement programs such as Medicaid and public assistance are incurred regardless of the state revenues. Indeed, these expenses are often magnified during distressed economic times. Funding of these programs takes precedent over discretionary spending programs. As a result, even heavier spending cuts must be incurred among discretionary programs to insure balanced budgets.

State spending on education and Medicaid account for the lion's share of expenditures--both are forms of entitlement spending. Combined, these programs account for more than 64 percent of general fund expenditures and 53 percent of spending from all state fund sources. Medicaid expenditures are the fastest growing area of state spending. With the aging of the baby boom generation, more persons will qualify for this form of entitlement spending. Various estimates put the annual growth rate of Medicaid expenditures at 7 percent through 2020. These growth rates imply that added pressure will be placed on state budget officers to find new sources of funding for Medicaid.

PCA expects strong growth in public construction activity will materialize in 2006 and 2007. Even after taking into consideration the additional servicing of entitlement programs, PCA expects public construction will eventually grow at a rate in excess of 5 percent. Keep in mind state revenue growth has exceeded PCA expectations during the past year. The forecast risks are on the upside. The potential of even stronger than projected revenues may materialize, leading to even stronger public cement consumption.

The author is chief economist at the Portland Cement Association (PCA).
CHANGING COMPOSITION OF CONSTRUCTION
SPENDING GROWTH

2001-2005 2006-2009

Low Interest Rates, Weak Economy Rising Interest Rates, Strong Economy
* Growth Leader: Residential * Growth Leader: Nonresidential
 * Low Interest Rates * Strong Economy

Public Public
 * State Tax Revenues Hurt by * State Tax Revenues Recovery Due to
 Anemic Economic Growth Strong Economic Growth

* Growth Laggard: Nonresidential * Growth Laggard: Residential
 * Weak Economy * Rising Interest Rates

ECONOMIC OUTLOOK: REAL GDP GROWTH

REAL GDP ANNUAL GROWTH RATE

2003: 3.1%
2004: 4.4%
2005: 3.5%
2006: 3.3%
(proj.)

Note: table made from bar graph.
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Title Annotation:2006 FORECAST
Author:Sullivan, Ed
Publication:Construction & Demolition Recycling
Date:Mar 1, 2006
Words:2072
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