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Four threats to construction recovery in 2011-12

09/13/2010 by Jim Haughey

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The Reed Construction Data forecast expects the economy and hence construction to avoid   a big hit from any of these threat resulting in a delayed and sluggish recovery.  Total construction spending is forecast to expand 5.3% next year and 11.4% in 2012. This will bring spending by the end of 2012 up to 87%of the spring 2007 peak level. The four structural problems in the economy will be partially blunted but mostly deferred for the future. Nonetheless, anyone of them is capable of causing an abrupt cutback in spending for an extended period.

The least threat is now from the European public debt crisis.  Unsustainable spending in Southern and Eastern Europe plus Ireland and Iceland prompted international lenders to abruptly force many countries into serious austerity programs to maintain their access to borrowing. Emergency loans from the large Northern European countries limited the scale of the necessary spending cuts. This has trimmed GDP growth in the Euro area with a modest feedback on the US. There is little risk of another round of austerity programs through 2012.  However a significant bond default or a decision in a large country not to follow the announced austerity plans could set off another round of steep rate increases for public debt and even deeper austerity plans to bring the interest rate increases to an end.

Promises of un-payable public employee pensions and benefits have created a severe fiscal crisis in some states, notably, California, New Jersey, New York and Illinois and less severe problems in many other states. This problem has been building for several decades and only hit the headlines recently when pension trust funds lost value during the recession and the number of pensioners grew quickly as people hired in the 1960’s and 1970’s began to retire.  Normally, trust fund shortfalls are funded with small annual contributions over several decades.  Many states are successfully doing this.  The base case forecast includes spending cuts in many large states to cover rising pension costs.

The risk of further damage to the construction recovery is that a number of large states will elect to cut future pension expenses by raising the retirement age or the employee pension contribution, cut the pension as a share of the final salary or cut the employer paid share of employee benefits. Calls for this type of action are now pending in the four states with the largest pension problem. This action could further cut public spending and also depress the willingness of public employees to spend as long as there is a large threat to their financial situation.

China is expected to account for more than 25% of the growth in the world economy in 2011-12. A significant cutback in Chinese economic growth, now about 9% annually, would cut US exports and set off a recession in the manufacturing industries. China’s bizarre economy makes it difficult to assess the risk of a Chinese economic slowdown. Clearly, 9% GDP growth is unsustainable long term.  This growth pace has been driven by moving surplus rural labor to Pacific coast export factories. No output is lost in rural areas so increases in factory production, now running at 15% plus annually, is a direct addition to GDP.Now there is increasing evidence that this growth model is coming to an end. Coastal factory workers are demanding and getting 20-40% salary increases because of a growing labor shortage. This is forcing low margin, low technology factories to flee to Southeast Asia in search of cheaper labor.  During the long economic boom, China over invested in fixed assets.  Too many factories, stores and apartments were built.  Managers of empty facilities are not making their loan payments.  Bad real estate loans are being covered with new capital from net export sales. This is not sustainable.  The solution is either a sharp economic cutback to avoid adding more unneeded assets or a transition to slower economic growth to absorb the asset surplus over many years.

Chinese economic managers have so far periodically let off enough steam from the overheated economy to avoid a sudden, prolonged slump in their economy.  This year they sharply raised borrowing rates and equity/down payment requirement about five months ago to slow the growth in asset investment, production and spending.  The economic growth rate did slow for several quarters but is now accelerating again.  Strong Chinese economic growth is very fragile.  The excesses of the last two decades have to be corrected soon.

The biggest risk to the economy and construction is the financial and confidence cost of the Obama agenda.  The financial aspect is easy to describe. The federal deficit has tripled and the President is asking for a large tax increase and hundreds of new fees. This reduces the capacity to make investment and major consumer purchases. The confidence aspect is more difficult to describe.  The Presidents’ class warfare approach to governing has made the small share of people with control of most of the spending in the economy very nervous.  They are uncertain of market prospects for their business and the security of their income. Uncertainty leads to caution and causes consumption, hiring and investment to by trimmed or postponed. New home buying is the best example.

The base case forecast assumes that the November election will stall the roll out of the Obama agenda and provide a boost to spending confidence.  But the election result may not be what is now generally expected.  If so, we will see another burst of public spending that is quickly more than offset by a renewed collapse in private spending.

 

Recent Comments

Jim: What does the embedded new cost of doing business do to price inflation? Do you think the supply-chain is robust enough now to pass along their "inflated" cost of debt? Will this add another layer to the PPI for construction materials in 2011, presuming recovery?
Dean Dinas -
Oct 02 8:44 PM
The economic fallout from the financial sector collapse is not something that can be laid at the feet of any one act or policy, it is cummulative of many factors. The fact is that improved property, whether it is residential, commercial, or industrial, still does not a stable value, and value is only established by transactions. With all of the un-absorbed built environment inventory (we have over-built just a little, don't you think?) that is not selling except at depressed (and depressing) prices, it will be some considerable time before someone wants to do a project and risk $10million on a project that may be worth $8million when it's finished. There will be little if any recovery in construction until those kinds of realities are reversed.
Chuck Kaplan -
Oct 17 6:15 PM



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