U.S. Construction Market 2019/2020: Current Conditions and Future Outlook
By Daniel LoBue, Tego Systems Corp. from Flooring Covering Installer Magazine Sept/Oct 2019
Background: Only final revised data published by U.S. government agencies and other data sources have been used in analyzing the U.S. economy to maintain accuracy and discipline in our deliberations. We utilize monthly data from the following U.S. government agencies: Federal Reserve Bank, the U.S. Census Bureau, the CIA World Fact Book – all of which is then cross-referenced with data from the World Bank, the International Monetary Fund (IMF), the Harvard Joint Center for Housing Studies and several other economic institutions with a solid long-term track record. We use inflation-adjusted numbers, calculated based on the official inflation data published by the U.S. Federal Reserve Bank and the U.S. Census Bureau. Currently, construction cost inflation is around 3.3% long-term compared to the U.S. inflation rate of around 2.2%. This means construction costs are increasing faster than the basket of goods included in the published standard inflation numbers. This is the only way to see the hidden indicators that things may not be as good or bad as they seem, and new trends have already developed before attracting public sentiment.
Introduction & Guiding Principles
With conflicting information and sentiment about the U.S. economy, especially the construction markets, we have been tracking economic indicators and data since 2003. The following is a condensed version of what we track and how we predict what we think will happen into the foreseeable future. We do not have a crystal ball; we have been reasonably accurate in our assessment over the last 16 years as to the state of the construction markets and economy and how things would develop. We were not perfect… we were far too optimistic about the housing sector recovery after the 2008 fall out.
After questioning why, and analyzing a great deal of data over time from the U.S. Census Bureau and publicly released economic data by various reputable institutions, talking to industry channels, and the finance sector, we strongly believe we have a logical explanation between long- and short-term trends and geopolitical events that have led to where the U.S. construction economy is and where we believe it is heading.
After closely analyzing economic indicators guided by our principles, it became obvious by the end of 2006, the U.S. Housing Market was already changing for the worse. Of course, one never knows exactly where one stands in time, but while housing permits were still being issued like lottery tickets for a Powerball Jackpot, inflation-adjusted total residential construction spending was already down 14% in 2016 compared to 2015.
We do not think that Building Permit data is a good indicator, but rather, the Housing Completion data paints a far more actual economic picture. As an example, in 2006, there were 742,000 residential building permits issued. By the end of 2007, only 547,000 were completed. Since there is a time lag in between the time a permit is issued until the building is finished, taking monthly snapshots instead of comparing data over time, is impractical. The same has been happening since 2017 as there were 1,300,000 residential permits issued but only 975,000 units were completed by the end of 2018. In 2018 and 2019, the same was true with 1,326,000 and 1,301,000 permits issued respectively and we are on track to see only 890,000 units to be completed by the end of 2019. This means that residential housing completions are down 18% from 2017, and through April 2019 (revised data), down 9% from 2018.
The U.S. Census Bureau classifies total construction into three segments: residential, non-residential and public. Residential housing is still the largest segment at 39% of the current $1.298 trillion total construction spending, followed by non-residential, 36%; and public, 25%.
Residential Housing Construction Markets
We were at approximately 2 million residential permits and houses built pre-2007. Currently, there are 1.3 million residential permits with only 890,000 completed. This raises the question: Why have we not seen the recovery to 1.5 million residential building permits and completions per year? The June 2019 Harvard Joint Center for Housing Study estimates we currently have a shortfall of approximately 260,000 permits per year not being issued to accommodate for the replacement of obsolete housing. After looking at inflation, adjusted construction costs, and actual household income growth, the answer is unfortunately clear.
There has been public debate by politicians and economists on this matter — most notably from business tycoons such as Ray Dalio, Bill Gates, Warren Buffet and others — corroborating our findings that the U.S. middle class is being thinned out, and the poor are becoming poorer as each year passes. Since 2003, we have found construction costs grew on average 2.9% and household income grew on average only 0.36% for the same period (inflation adjusted).
This is a pretty big deal considering construction cost increases are almost eight times higher compared to household income growth. After the downturn into the drawn-out recovery in 2008, which Ray Dalio calls “The Lost Decade,” we have seen a clear trend that more and more people have no choice but to purchase smaller houses. Others increasingly chose to rent to make ends meet, which results in even lower square footage homes being built.
Multi-family housing permits are today at 479,000, and single-family housing permits are at 1.3 million. In 2005, multi-family permits were 438,000 compared to 2 million single-family permits. The multi-family share went from 22% to 37% of the total residential construction segment — an increase of almost 70%. Everybody needs to live somewhere and if there is a shortfall between household income and construction cost, families on average are then forced to level down into either purchasing smaller square footage residences or renting units with considerably smaller square footage than single-family housing.
High income earners (above $200,000) have the highest Household Income Growth of all percentiles. This has a compounding effect on the other households as their inflation adjusted net income is in all reality flat. To illustrate this, from 1966 to 2016, household incomes (between $13,000 to $95,000) have seen very little real increase after adjusting for inflation. Meanwhile, households with incomes above $200,000 (5-10% of U.S. households), have shown increases considerably above inflation, year after year. All other households don’t, which is an unfortunate reality. Any person or organization involved in the residential housing market has certainly been wondering where the long-term average of 1.5 million housing completions (from the 1950s) have gone. With the ongoing disparity between faster rising construction costs compared to household income growth, property owners have held onto their homes much longer, which has been keeping resale and new construction growth at a slower pace, as well. There is a positive caveat to this, as remodel spending has gone from $218 billion in 2003 to $450 billion in 2018 with rental remodel spending growing more than three-fold from $31 billion to $101 billion in the same period, thus corroborating the ongoing shift in housing demographics. We believe these residential housing market trends will continue as there doesn’t seem to be mechanisms in place to address the long-term continuance of income and wealth disparity. These are very complex mechanisms that developed organically during the spectacular and long growth of our country’s economy.
Commercial Construction Markets
Commercial construction is enjoying the largest long-term average growth since 2003 — out pacing inflation by almost 2%. In fact, total commercial construction spending grew from $218 billion in 2003 to $463.4 billion in 2019, while residential construction stayed about the same at $500 billion, even though it has been trending negative after accounting for inflation since 2017.
Commercial construction currently breaks out into the following segments: 7%, lodging; 15%, office; 17%, shopping facilities; 8%, health care; 5%, education; 3%, recreation; 4%, transportation; 5%, communication; 21%, energy; and 15%, manufacturing. The sector is on a trajectory to exceed the residential market in the next couple of years in total U.S. dollars spent. Commercial construction will be subject to economic cycles but will continue to grow as U.S. commerce facilitates space growth demand. Adjusted for construction inflation, commercial construction has been declining since the early 2017 with the YTD decline being the largest at -3%. Normalized growth will resume after the 2020 election cycle. American business outside of recessionary cycles will continue to grow as individuals and businesses concern themselves with profit and growth. The overall U.S. economy is very strong compared to others worldwide — thanks to many contributing factors: Our exceptional rule of law providing for ease of doing business and new technologies and innovation come to market much faster than anywhere in the world.
The U.S. economy is the single largest in the world with GDP at $21+ trillion. Because of that, we also have the largest domestic market for goods and services, as well as the largest average annual wages per capita (2017, $60,558). This figure is only topped by Luxembourg with a population of only 590,000, compared to our 327 million. China, comparatively, has an average annual income of only $4,234 (2017 data, National Bureau of Statistics of China, pre-tax income assuming an 8% tax rate). There are many more comparisons that illustrate the sheer and absolute strength of our economy. California’s economy is the fifth largest in the world by itself at nearly $3 trillion (including the U.S. economy). Further, as of 2017 (last published reliable data), the U.S. had $37.4 trillion of all assets under management in the world (nearly 50% of the world’s $76.7 trillion in assets).
Looking past the political- and media-driven opinions, the U.S. economy has a singular position in the world. This won’t change for many decades. It is not practical to assume, or even to be concerned, that any other nation or alliance of nations will be able to replicate our economic model.
Public Construction Markets
Public construction has grown from $215.1 billion in 2003 to $328.7 billion in 2019. It splits up into the following segments: Highway and public road construction (25% of total public construction cost), education, administration, military, health care, parks, power, water supply, waste and conservatory, etc. Public construction is the only sector that has maintained its own in recent years, and is the only one sector growing at 4% for 2019, which is remarkable since construction inflation jumped to 5.9% YTD mostly due to material price increases and additionally imposed tariffs during 2018 and 2019.
Approximately $130 billion is spent for occupied structures. As the U.S. population grows at 0.7% per year (approximately 2.3 million people), plus as U.S. commerce continues to grow, the U.S. government must keep up with America’s population growth respectively. Hence, the government construction spending segment is less likely to be subject to economic fluctuations but will continue to grow at slow but steady pace. The federal government accounts for approximately 7% of the yearly spending and state and local governments account for 93%.
Macro Considerations and Outlook Beyond 2020
The failure of Congress and the corresponding administration’s well-meaning plan in the 90s that everybody is entitled to own their home, combined with the loose monetary policy in the early 2000s by the Federal Reserve, led both to the U.S. real estate asset bubble and subsequent burst in 2008. These events negatively affected world economies. We are of the strong opinion that if the Federal Reserve had allowed for a mild recession right after the dot-com boom in the early 2000s, then housing markets would have self-corrected and moderated, and the subsequent housing crash would have never been so severe.
The 10-year recovery, and overall growth of the economy, started to cool off at the beginning of 2017, which is a normal process of economic cycles with the construction sector seemingly affected the most. The Federal Reserve Bank has about 250 basis points to work with for Quantitative Easing (QE). We feel with our current Fed Chair and leadership, it will be done appropriately to cushion the effect for the overall slow-down of the economy, including the housing sector. Political pressures, including elevated tariffs, will continue to maintain unease and drive costs higher for goods and materials that already are offsetting some U.S. tax law benefits, which went into effect on Jan. 1, 2018.
Geopolitical uncertainties remain, including the tensions around tariffs, political tensions in the Middle East, former allies pitching against each other for better domestic and global positioning, new forming political alliances, and terrorist threats against the Western civilization. These events and the lead up to the 2020 U.S. elections have created a more volatile environment, which coincided with the recent upcycle of the U.S. economy and housing market.
Since the beginning of 2018, equity markets (all major indices) have acknowledged the current economic reality and have seesawed sideways — slightly up since then. In fact, the recent stellar performance of all major U.S. stock indices has been pushed to their all-time highs by less than 100 publicly traded companies. Other publicly traded companies are already pricing in expectation of a cooling off economy.
Currently, construction cost inflation is around 3.3% long-term compared to the U.S. inflation rate of around 2.2%. This means construction costs are increasing faster than the basket of goods included in the published standard inflation numbers.
Further, Ten-Year Treasury Yields have consistently declined since October 2018, indicating an economic slowdown. And finally, gold prices are reflecting the economic sentiment by rising from $ 1,270 in May to $1,415 per ounce at the time of this writing. Rising gold prices indicate developing economic uncertainties due to many factors. With equities trading at all-time highs, gold trading (the highest since 2014), and treasury yields declining, the stock market may be on the onset of a correction, if there is the slightest indication of a U.S. economic growth slow-down.
Many large private investment groups have started to increase their cash percentages and have reduced both equity and real estate exposure over the last six months. Everybody wants to be invested if things continue to rise the way they have, but institutional investors are increasingly becoming more cautious. The baseline of the U.S. economy is strong enough to weather a potential recession in the making. However, we do expect that the current trading (business) environment is here to stay. It will take time for the economy to adjust to all the various factors.
Therefore, we expect downward pressure on construction spending in both residential and commercial construction to continue as we do not foresee any fundamentals changing yet in their favor, and believe it will remain past the 2020 election cycle. A natural slowdown of economic growth, increased inflation, geopolitical events and uncertainties, are too many factors for the economy to simply just absorb.
Editor’s Note: A follow-up report will be published in early 2020 and include additional detailed market data. This article was prepared prior to the stock market correction caused by the implementation of import tariffs by the United States and China.