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By Anirban Basu
August 18, 2017
Confidence is Key.
It’s all about inflation or the shocking lack thereof. After more than eight years of economic recovery and with the nation hurtling towards full employment, one might think that significant inflationary pressures would have become apparent by now. Indeed, life is becoming more expensive, whether in the form of rising home prices, tuition, healthcare costs, or labor. But for whatever reason, worrisome inflation has failed to manifest itself in the data, including the data scrutinized most intensely by Federal Reserve policymakers.
The Federal Reserve’s preferred measure of inflation, the core personal consumption expenditures (PCE) index, was up a miniscule 0.02 percent on a month-over-month basis in June. On a year-over-year basis, this measure is up 1.42 percent, well short of the 2 percent target established by the Federal Reserve.
This is remarkable given that U.S. unemployment stands at just 4.3 percent, a 16-year low. Employers in construction, trucking, manufacturing, leisure/hospitality, and in many other segments continue to complain about a dearth of qualified talent. According to the government’s most recent Job Opportunities and Labor Turnover Survey, America is home to 6.2 million job openings. That represents the highest number since the U.S. Labor Department began monitoring job postings in 2000. There are 7 million unemployed Americans, which means that there is almost one job for every person searching for one.
One might anticipate rampant wage inflation under such circumstances. But average hourly earnings are up just 2.5 percent on a year-over-year basis, well short of the roughly 3.5 percent rate one might expect from a solidly performing economy. True, employees are working longer hours than in prior years, translating into average wage and salary growth above 2.5 percent. Still, the overall impact on inflation has been sufficiently benign to allow the Federal Reserve to tread lightly. Interest rate increases have been sporadic and America’s central bank has only recently begun to discuss the processes by which it will ultimately shrink its balance sheet.
The lack of troublesome inflation explains far more than Federal Reserve policymaking. When inflation is low, interest rates tend to be low, including mortgage rates, rates attached to auto loans and credit cards. The result is that consumers are re-leveraging after deleveraging several years ago. The U.S. savings rate is once again below 4 percent.
Last year represented a record year for new vehicle sales in America. Home prices are rising rapidly in many communities in the context of interested buyers and dwindling inventory. Low inflation and interest rates also explain the weak performance of gold, which once stood at more than $1,900/ounce but has recently struggled to remain above $1,300/ounce.
Low interest rates in the U.S. and in many parts of the advanced world also help explain the seemingly insatiable appetite for stocks and other assets as investors scramble for yield. The result is a Dow Jones Industrial Average that surpassed the 22,000 level in early-August. The NASDAQ and S&P 500 have also routinely been setting records. Commercial real estate valuations have also been pushed higher, translating into more private construction.
Despite concerns regarding excess real estate speculation and bloated valuations, several private segments continue to manifest strength in terms of demand for construction services. At the head of the class is office construction, driven by a combination of job growth among certain office-space using categories and lofty valuations, and communications, which is being driven largely by enormous demand for data center capacity. Hotel construction has surged over the past three years.
Nonresidential Construction Spending Hampered by Public Stagnation
Nonresidential construction spending fell by 2 percent on a monthly basis in June 2017, totaling $697 billion on a seasonally adjusted, annualized basis according to data from the U.S. Census Bureau. June represents the first month during which spending has dipped below the $700 billion per year threshold since January 2016.
This weak construction spending data is largely attributable to the public sector. Public nonresidential construction spending fell 5.4 percent for the month and 9.5 percent for the year.
Coming into the year, there were high hopes for infrastructure spending in America. The notion was that after many years of a lack of attention to public works, new found energy coming from Washington D.C. would spur confidence in federal funding among state and local transportation directors as well among others who purchase construction services. Instead, public construction spending is on the decline in America. A number of categories ranging from public safety to flood control have experienced dwindling support for investment.
In the final analysis, one perspective on the performance of nonresidential construction depends heavily upon whether one is invested in conducting private or public work. While there are certainly some parts of the nation experiencing significant levels of public construction, those areas have increasingly become the exception as opposed to the rule. The more general and pervasive strength is in private segments. Based on recent readings of the architecture billings index and other key leading indicators, commercial contractors are likely to remain busy for the foreseeable future. The outlook for construction firms engaged in public work remains unclear.
The U.S. economy continues to expand and there is little reason to believe that the economy will fail to enter 2018 in decent shape absent a complete financial market selloff. Job growth continues to be brisk and has helped induce more people into the labor force. The global economy has firmed since last year, with better performances being delivered by nations like Japan, Brazil, and Russia. Several European nations have also experienced improved performance. All of this has helped to support corporate earnings.
However, one could argue that asset prices have recently risen by far more than is justified by shifting economic fundamentals. Among other things, this has translated into an S&P 500 P/E ratio approaching 25. Commercial real estate valuations have also raced higher, leading to another round of construction of hotels, office buildings, and other commercial structures. The implication is that there is some risk to the downside, particularly if inflationary pressures at last become apparent in the data and force the Federal Reserve to act with more urgency. Add in dollops of political intrigue emerging from Washington, D.C. and Pyongyang, and the message is that one should tread carefully at a time of elevated asset prices.
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