Fasten your seat belts and enjoy the ride. Like airline travelers bracing for expected turbulence, contractors are preparing for a tricky operating environment in 2024. “Heretofore, construction companies in all sectors have been busy,” said Anirban Basu, chairman and CEO of Sage Policy Group. “But I think what you’ll see going forward is that some contractors will get even busier while others will see their revenues begin to fade.”
The future will be bright for those contractors aligned with megaprojects in infrastructure and computer chip manufacturing, noted Basu. The picture is cloudier for others aligned to markets such as offices, hotels and shopping malls. “We know we have many millions of square feet of distressed office inventory in this country that frustrates new construction,” he said. “Many owners of these office buildings are taking enormous losses on the value of their properties and are having to refinance their debts at a time when interest rates are high, and bankers are reluctant to expose themselves to the vagaries of commercial real estate.”
Helping all those contractors along will be a general economy that continues to grow, although at a slower pace. Consumers and businesses are both feeling fairly optimistic, unemployment remains low, capital investments are plugging along at a healthy pace, supply chains are improving, and the all-important housing market is burgeoning.
Throwing cold water on the good times, though, is a significant downer that no one can control: Higher interest rates established by the Federal Reserve to control inflation are putting a damper on business activity.
“A major issue for construction is that inflation remains problematic and interest rates are likely to stay higher for longer,” said Basu. “That impacts project financing.” He notes that the economy is still experiencing inflation pressures from energy prices, wages and consumer spending.
Housing Markets
Residential contractors should benefit from healthy prospects for the housing sector, an important driver of the overall economy. “New home sales are running at the top end of the range set in the decade preceding the pandemic,” said Bernard Yaros Jr., assistant director and economist at Moody’s Analytics. “One reason is that a lack of existing inventory is pushing buyers to consider new homes. The construction industry is stepping in to close the gap, and housing starts have exceeded expectations.”
The construction of new homes is being fueled by a cold, hard fact: There aren’t enough existing homes to meet demand. “The 3.1 months’ supply of existing homes remains well below the four to six months of inventory that is considered a balanced housing market,” noted Yaros. Strong demand caused a 10.3% increase in the median price for existing homes in 2022, and a 0.6% increase in 2023. A correction of 1.1% is expected in 2024.
For an explanation of the scarcity, look no further than the run-up in mortgage rates. The ultra-low interest rates of existing mortgages amount to a strong financial incentive for existing homeowners to stay put. “Current homeowners had refinanced their investments at 3% or 4%,” noted Bill Conerly, principal of his own consulting firm in Lake Oswego, Oregon. “Replacing what they had with better homes would require walking away from those mortgages to take on new ones at 7%. I think we’ll see this trend continue for another year, but I think we’ll also see a lot of strength in remodeling, and that will be financed probably with home equity lending or second mortgages.”
Lowered Expectations
High interest rates in general are causing economists to lower expectations for the next 12 months. “We expect real GDP to grow 1.4% in 2024,” said Yaros. That’s slower than the 2.1% increase expected when 2023 numbers are finally tallied, and below the 2%-3% considered emblematic of normal business growth. (Gross domestic product, the total value of the nation’s goods and services, is the most accepted measurement of economic growth. “Real” GDP adjusts for inflation.)
Slowing economic activity will affect the bottom line. Moody’s Analytics expects a decline of 4.5% in corporate profits for 2023 and only a modest recovery of 0.3% in 2024.
Reports from the field confirm the economists’ readings. “Our members are experiencing a business slowdown, due largely to the effect of increasing interest rates,” said Tom Palisin, executive director of The Manufacturers’ Association, a regional employers’ group based in York, Pennsylvania, with more than 370 member companies. While businesses understand the need for higher interest rates, they nevertheless hope for early relief. “If inflation does not continue to drop, interest rates will have to be increased further, which will be a big problem,” said Palisin.
So, are the Federal Reserve’s efforts paying off? There’s some good news here, as well as a sunny forecast. Moody’s Analytics expects year-over-year consumer price inflation to average 3.2% when 2023 numbers are finally tallied, down from over 6% a year earlier. Moreover, the number should continue to drop until it reaches the Fed’s target rate of 2% late in 2024. These figures represent the “core personal consumption expenditure deflator (PCED),” which strips out food and energy prices and is the Federal Reserve’s preferred measure of inflation.
Indeed, Moody’s Analytics believes the Fed will start to lower interest rates around June of 2024, although more slowly than previously anticipated because of persistent inflation and ongoing labor market tightness. Cuts of about 25 basis points per quarter are expected over the next few years until the Federal Funds Rate reaches 2.75% by the fourth quarter of 2026 and 2.5% in 2027.
Will that de-escalation of interest rates be enough to keep the nation from tipping into a recession? Moody’s Analytics believes that the nation will avoid a recession in 2024, attributing its forecast of a soft landing to resilience in labor markets and consumer confidence.
Basu, however, is among the economists taking a contrary view. “I believe the U.S. economy will be in recession by at some point in 2024,” he said. “A number of factors, including a very strong consumer and employers willing to hire more people and raise wages, have allowed the U.S. economy to retain momentum. But major structural issues suggest the economy will weaken, including those higher interest rates.”
Feeling Good
The public mood is a strong driver of the economy. And here the news is good. “Consumer confidence has been trending higher, and I think prospects are good for it to improve next year,” said Scott Hoyt, senior director of consumer economics for Moody’s Analytics. “Things should normalize as the economy continues to grow and gas prices stabilize.”
An impressive level of accumulated debt, though, is hanging like a dark cloud over the consumer landscape. “With credit card debt now above a trillion dollars with more consumers having to start paying back student loans and with evidence of slowing labor markets becoming more pervasive, there’s every reason to believe that the pace of consumer outlay growth will soften going forward,” said Basu.
For the immediate future though, consumer confidence seems secure, due primarily to the healthy job market. “The unemployment rate has been very low, bouncing around between 3.5% and 3.8% for some time,” said Hoyt. A slowdown in job growth orchestrated by the Federal Reserve’s interest rate hikes should moderate things. “We think unemployment will trend upward a bit, ending 2023 around 3.9% and 2024 around 4.2%.” (Many economists peg an unemployment rate of 3.5% to 4.5% as the “sweet spot” that balances the risks of wage escalation and economic recession.)
Low unemployment may fuel happy sentiments among citizens, but it presents employers with two practical challenges. The first is the need to raise wages to attract sufficient workers. “Wage and salary income growth has been strong, fueled by a tight labor market,” said Hoyt. “We’re expecting it to increase just a shade over 5% both for 2023 and 2024.” In 2022, the growth was a little over 8%.
Reinforcing the estimates of the economists, Palisin said his members have had to hike their compensation to remain competitive among themselves and other economic sectors. The group’s entry level hourly wages increased an eye-popping 8% to 10% in both 2022 and 2023, far higher than the historic average of 2.5% to 3%.
Problem No. 2 is a scarcity of workers. “Based on survey data, the No. 1 issue for construction firms continues to be the inadequate supply of skilled workers,” said Basu. “That’s not just a function of the fact that the U.S. economy came screaming out of the pandemic in the form of a V-shape recovery. It’s a long term, structural, demographic issue that transcends business cycles. America simply does not produce enough skilled craftspeople, and this impacts various industries, whether energy, manufacturing, logistics or, of course, construction. In the absence of very deep economic downturns, contractors will continue to be scrambling for talent and that will push wages higher.”
While employers never like having to raise wages, putting a cap on paychecks has taken a back seat to a more urgent concern: keeping valuable talent from jumping ship. “The big question now is not so much who can pay the most for entry-level and skilled jobs, but what can they do to retain these folks within their companies,” said Palisin. “Manufacturing in the U.S. over the last year has continued to hire pretty significantly, and we’re not seeing a lot of layoffs, so that tells you that many companies are hoarding talent.” Employers are fine tooling their operations in the areas of workplace flexibility, benefits and culture changes.
Keeping Watch
In the opening months of 2024, economists are advising construction companies to keep an eye on some key statistics to get an idea of how the year will turn out. “One leading indicator the construction companies should look at is the level of permits issued for various construction activities, whether they are single family homes, apartments or nonresidential,” said Basu. “Another would be the Architecture Billings Index, which reflects architect activity. If the architects and engineers are busy upstream, it means contractors will more likely be busy downstream.”
While construction companies tend to focus on materials prices, which have recently been roughly flat, Basu said that the cost of money has a much greater effect on the bottom line. “Pay close attention to what Federal Reserve policymakers are saying about inflation early in 2024, and assess how that will affect interest rates, which are already so high that they foreclose the possibility of many projects moving forward because they simply don’t pencil out anymore.”
Conerly advises keeping an eye out for two statistics that might indicate a pending downturn. One is any increase in initial claims for unemployment insurance. Another is an inversion of the yield curve, in which short-term interest rates exceed long-term ones.
Whatever the condition of the tea leaves, businesses in general will encounter a tougher operating environment in 2024, characterized by a need to finesse a tight labor market and reluctant lenders. “In the coming year we will face uncertainty about inflation and interest rates, shortages of labor, higher energy costs, a slowdown in China’s economy and recurring threats of a federal government shutdown,” said Palisin. “There are a lot of spinning plates in the air, and some of them may fall and crack.”
