An in-depth look at how the Federal Reserve could impact the engineering and construction industry.
The engineering and construction industry has always kept a close eye on interest rate fluctuations and the potential impact of those movements. Most assume that higher interest rates lead to reduced levels of investment in capital projects. For the past two years, business publications have been obsessively monitoring the Federal Reserve (“The Fed”) — watching every word and hanging on every sentence to see actions it may eventually take regarding the federal funds rate (a primary influence on interest rates).
The Fed recently indicated that the first rate hike in almost a decade is likely to happen this year. And while the economy is steadily recovering, it is still fragile, and Federal Reserve Board Chair Janet Yellen, indicated that the Fed would move cautiously. “Economic conditions are currently anticipated to evolve in a manner that will warrant only gradual increases in the target federal funds rate.”
Driving monetary policy are the Fed’s goals of 2% inflation and maximum employment (See Exhibits 1 and 2 for unemployment rates and inflation of personal consumption expenditures). “The Committee continues to see the risks to the outlook for economic activity and the labor as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2% over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate.”
The Fed signaled that rates might only go up one-quarter of a percentage point in 2015. Moving forward, the median projection is 1.625% for 2016 and 2.875% for 2017. Interest rates around the world — both short-term and long-term — have remained low, and right now the U.S. government can borrow for 10 years at less than 2%. It’s also interesting to note that low interest rates are not an aberration, but rather a longer-term trend. In the 1960s, interest rates were relatively low, then rose above 15% in 1981 and have been in decline ever since. Interest rates follow the rise and fall of inflation, which makes sense as investors demand higher yields when inflation is high to offset the decline in purchasing power of the dollars with which they expect to be repaid.
Impacts on E&C
So what does all of this mean for the E&C industry?
The overall economy has benefited from low borrowing costs, which in turn have led to growth in construction markets. But what happens when rates start moving in the other direction? According to a recent FMI survey, a majority of respondents believe that rate increases will have some impact on their businesses (see Exhibit 3).
While the federal funds rate is important to watch, FMI contends that small, incremental increases in the federal funds rate are not cause for concern. What matters most for the economy is the real, or inflation adjusted, interest rate. The real interest rate is the most relevant for capital investment decisions. The Fed’s ability to impact real rates of return, especially longer-term real rates, is limited at best. Except for the short term, real interest rates are determined not by the Fed, but by a wide range of economic factors, including the components of economic growth. Interest rates are only one part of the equation; the overall health of the economy is a larger driver of engineering and construction spending. In fact, it is actually worse if the Fed is not comfortable raising rates due to a fragile economy. Instead of solely focusing on the federal funds rate, keep an eye on GDP, inflation, unemployment and residential construction.
GDP is a measure of the total output (goods and services) that a country produces. A nation’s prosperity is directly linked to the amount of goods and services that it produces, and construction expenditures are a significant part of our national output (see Exhibit 4). Traditionally, our national output has averaged between 7-8% with a peak of almost 9% just before the Great Recession. Additionally, Exhibit 5 shows the historical relationship between construction spending and GDP and further forecasts continued growth through 2019. Based upon historical performance, U.S. construction spending has room to grow and could once again align with or possibly even surpass nominal GDP. This obviously assumes a healthy return to late 1990s economic activity levels.
The Fed’s policies are another primary determinant of inflation and related expectations over the longer term. The Federal Open Market Committee (FOMC) judges that inflation of 2% (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Fed’s mandate for price stability and maximum employment.
Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices (and perhaps wages), on average, are falling — a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. (federalreserve.gov) In other words, some inflation is good for an economy. When prices are increasing, consumers will “buy now” instead of later, thus increasing demand for goods and services. Stores sell more goods, and production facilities are busy. In turn, businesses increase hiring to meet demand, and a positive economic cycle is created.
Since 2010, the national unemployment rate has dropped from 9.8% to just above 5%, while construction put in place has experienced a 5% compound annual growth rate (CAGR). Exhibit 6 depicts the strong inverse correlation between national unemployment and construction put-in-place spending. A strong job market is crucial to the E&C industry. Unemployed or underemployed people do not build homes, and that acts as a drag on homebuilding as a leading indicator of certain sectors of nonresidential construction, such as retail, water and sewer and streets. Looking forward, indications of full-time, non-farm job growth can likely be translated into increased construction spending. Job formation is a leading indicator for homebuilding. A healthy employment picture also increases consumer confidence, which causes increased spending in housing and durable goods, which drives more construction activity.
While many construction firms do not work on single-family residential projects, housing is a key part of the U.S. economy and has a direct impact on many other industries, including commercial
construction, manufacturing, banking and many more. Housing starts are defined as the number of new residential construction units (single-family and multifamily) that have begun during a month. Generally, the figures are seasonally adjusted and statistically smoothed to adjust for weather-related impacts. Housing starts in the U.S. averaged 1,446,000 from 1959 until 2015, reaching an all-time high of 2,494,000 in January of 1972 and a record low of 478,000 in April of 2009. Typically, in a strong economy, people are more likely to buy new homes than existing homes and vice versa in a down economy. The data in Exhibit 7 depicts the residential construction market as a leading indicator for nonresidential construction. Historically, strong housing starts indicate demand for infrastructure, retail and office space.
It is likely that the Fed will begin to raise rates this year. Once the initial rate increase happens, periodic increases are expected. Aggressive increases are unlikely, as the Fed has indicated a cautious approach. In the short term, we expect minimal impact on the E&C industry. For many firms, improvement in the economy and increases in backlogs due to owners advancing projects to lock in lower rates will offset any negative impact stemming from modest rate increases.
In the longer term, inflation and the unemployment rate will continue to drive monetary policy. Although higher than expected inflation and lower than expected unemployment are not considered likely, these events would lead to more aggressive rate increases. While the impact to the E&C industry would not be felt immediately, a delayed effect on firms’ backlogs could be expected. The state of the economy — not the Fed — will be the ultimate determinant in the sustainable level of real returns and, thus, the growth of the E&C industry as well.
Lee Smither is a managing director for FMI Corporation’s consulting practice. He can be reached at 919.785.9243 or via email at email@example.com.
Joel Stinson is a consultant for FMI Corporation. He can be reached at 919.785.9247 or via email at firstname.lastname@example.org. Paul Trombitas is a research analyst with FMI Corporation. He can be reached at 919.785.9256 or via email at email@example.com.