Much has changed since the construction industry's year-end forecasts were released in the final months of 2007. While most were in agreement that the economy and several construction markets (with emphasis on residential building) were entering a severe down period at the end of 2007, some were more optimistic than others about when this downturn would reverse itself.

But as the first quarter of 2008 drew to a close, construction industry economists were talking about a recession. Already grim conditions facing the residential construction market are expected to worsen this year, with high inventories causing housing starts to decline 25% in 2008 from already depressed levels. By the end of 2008, the Portland Cement Association expects a 9.5- to 10-month supply of homes to be in “inventory” for sale.

PCA Chief Economist Edward Sullivan says the large number of foreclosures caused by the sub-prime crisis is a main contributor to the large inventory that will depress start activity. “Typically building accelerate start activity when the inventory supply reaches five months,” he explained. “A significant improvement in sales and inventory conditions is not expected until he second half of 2009.”

Even though buyers can get better priced homes in 2008, Sullivan adds, they must now have good credit scores and as much as a 20% down payment to qualify for loans. “With job and income gains expected to slow during the next four quarters, most potential home buyers will back away from such a major purchase until the economy is more stable,” Sullivan said.

THE PERFECT STORM

Sullivan's assessment of the current nation's economic troubles is simple: a recession in the near term is likely and it may not be mild. The labor market has softened, oil is hovering over $100 per barrel, and many expect that gasoline prices will surpass $4 per gallon by the summer. Total construction spending is expected to decline 11.8% during 2008, based on a three-quarter recession. According to PCA's scenario, housing starts are expected to decline 26.5% from 2007 levels. Weakening economic conditions are expected to result in a 7.1% decline in nonresidential construction during 2008, compared to robust 2007 levels. PCA's pessimistic construction outlook also reflects a significant moderation in public construction activity during 2008.

Unfortunately, according to Sullivan's forecast, the low point in construction activity doesn't even materialize until 20009. A recession will weaken labor markets and prolong a recovery in housing starts. He believes such a recovery to any significant degree is unlikely until 2010. Furthermore, since nonresidential construction contracts typically take 18 months to recover from the onset of better economic conditions, this sector probably will continue to decline in 2009. Given the lag between state revenue collections and fiscal budget decision, PCA expects a slowdown in public construction activity to materialize in FY2009 and continue through 2010.

Portland cement consumption is expected to decline 10% during 2008, followed by an additional 3.6% decline in 2009. This reflects a peak-to-trough decline of more than 22#. Beginning in the second half of 2009, the economy will gain strength, the residential inventory will eventually be burned off, higher than expected ROIs and easier credit terms will encourage a nonresidential recovery and state fiscal problems will begin to heal. In this context, cement consumption is expected to grow 5.2% in 2010, followed by an even stronger (6.7%) gain in 2011. Sullivan estimates that even in the context of sustained and robust growth following the current economic correction, past peak cement consumption will probably no be reached until 2013.

Residential Outlook

Already grim market conditions facing the residential construction market are expected to worsen in 2008. Significant relief from harsh conditions is not expected to materialize until late 2009. Regions that fully participated in the housing boom are now experiencing bust conditions, and the recovery in these markets could take longer.

Inventory conditions have worsened since 2006 bloated levels. During 2007 inventories increased by more than 400,000 homes and month's supply stands at 9.2 months. The sub-prime crisis is expected to worsen in 2008 due to the increased number of sub-prime resets scheduled and weaker overall economic conditions. This will increase of the amount of foreclosed properties added to inventories. While home prices are falling rapidly and helping to improve home affordability, this is expected to be offset by weaker labor market conditions and rigid lending standards. A sluggish improvement in sales activity will do little to improve the inventory condition.

Without an improvement in inventories, starts activity will continue to decline. Currently, there are roughly 2 million homes in excess supply. Typically, builders accelerate activity when supply of homes on the market approaches five months. Desired level of supply is not expected to be reached until late 2009 — despite some construction economists' expectations, and a significant improvement in starts will not happen during 2008. Indeed, PCA expects starts will decline another 25% during 2008.

Harsh residential conditions will hinder cement consumption during the next two years. Residential cement consumption accounts for roughly 30% of total consumption. Given the importance of the residential sector, it is likely that it will continue to act as a significant drag on overall cement consumption.

Nonresidential Construction Outlook

After experiencing strong growth in 2007, nonresidential construction activity is expected to experience a decline during 2008, followed by a further decline in 2009.

Nonresidential construction performed well during 2007 — growing 11% over 2006 levels. Unfortunately, the strong fundamentals supporting nonresidential construction have eroded throughout 2008. Nonresidential construction activity is closely tied to economic activity. The probability of a near-term recession suggests a significant retrenchment in nonresidential construction. This, coupled with a tightening in commercial credit standards suggest that the once robust nonresidential construction sector may face more difficult times during the next 24 months. Indeed, the strong growth rates that characterized early 2007, completely dissipated by yearend and are now recording negatives. Several factors account for PCA's pessimistic outlook for nonresidential construction.

Public Construction Outlook

Public construction accounts for roughly half of total cement consumption in the United States. More than 90% of public construction is performed at the state/local level. State fiscal conditions play an important role in the outlook for public construction. State revenue growth, and hence its overall fiscal condition, is highly dependent on job growth. A new worker added is essentially a new taxpayer addition. Until recently job growth has been fairly robust, suggesting solid growth in state revenue conditions. A near-term recession will translate into job losses during the first three quarters of 2008, followed by tepid job growth for several quarters afterwards.

This outlook suggests a significant moderation in state revenues will materialize during 2008 and 2009. Large state deficits are likely to emerge in 2008 and 2009. Indeed, according to the National Association of State Budget Officers (NASBO), 25 states expect a budget shortfall will materialize during fiscal 2009. Another four states expect shortfalls in 2010. This dire outlook is compounded by the fact that none of these projections assumed a recession during 2008. Finally, the potential shortfall in state/local revenues darkens the picture for state and local bonds. As fiscal conditions worsen, the credit rating on these bonds are likely to become downgraded — compounding the fiscal conditions at state and local level.

Shortfalls in state budgets must be viewed in the context of state spending priorities. State spending on Medicaid has increased significant over the past several years and now comprises the largest area for state spending — accounting for nearly 22% of total state spending. Commitment to these entitlement programs are expected to receive a high priority — to the detriment of other areas of spending, such as infrastructure spending. The combination of lower revenues and higher spending on entitlements suggests that even dedicated transportation trusts could be raided — to the detriment of public construction activity.

AGC inflation alert cites uneven growth for construction spending

In March, the Associated General Contractors of America's Chief Economist Ken Simonson released a report that spelled out what he called “the uneven growth…for construction spending, costs and labor.” The report goes on to point out that in 2007, the industry experienced high levels of demand in nearly every segment and region. For most of the year, materials costs rose less than they had in 2004-2006, and labor supplies were adequate.

In 2008, some nonresidential segments, including power and energy are expected to grow, according to AGC, but others such as lodging will slow or decline. In fact, the ongoing growth in some nonresidential categories in 2007 shows that this market does not necessarily follow residential. Investment in such structures jumped 15% in the fourth quarter. For 2007 as a whole, real nonresidential investment climbed 13%, following gains of 8.4% in 2006 and just 0.5% in 2005.

In contrast, real investment in private residential structures plunged 25% in the fourth quarter of 2007, the eighth consecutive drop and an even steeper decline that the 21% decrease in the third quarter. The full-year drop totaled 17%, following a fall of 4.6% in 2006 and an increase of 6.6% in 2005.

The producer price index (PPI) for concrete products climbed 8% to 10% annually in 2004-2006 as all types of construction increased and U.S. cement capacity fell far short of demand. In 2007, concrete prices rose a more moderate 3.3% as residential demand slackened, foreign supplies of cement — particularly from China — increased, and U.S. capacity began to expand. More capacity will come on line in 2008-2010, while residential demand will shrink further in 2008. Nonresidential demand will be mixed but will no grow as robustly as in 2004-2007. Although high fuel prices will push up production costs, read-mixed and concrete product suppliers will have trouble fully passing through the increases; a 2% to 4% rise appears likely, according to AGC.

PROJECTED U.S. POWDER CONSUMPTION (000 METRIC TONS)

	2006	2007	2008**	2009**	2010**	2011**
Total Cement Consumption	127,1011	114,474	102,679	99,140	104,661	111,928
Portland Cement	121,700	110,177	99,021	95,4588	100,402	107,178
Masonry Cement	5,401	4,282	3,658	3,682	4,259	4,750
Portland Share of Total	95.8%	96.2%	96.4%	96.3%	95.9%	95.8%
Cement and Clinker Imports	35,895	22,729	11,445	7,262	6,781	7,049
Import Share of Total	29.5%	21.6%	11.6%	7.6%	6.8%	6.6%
Percent Change
Total Cement Consumption	-0.7%	-9.9%	-10.3%	-3.4%	5.6%	6.9%
Portland Cement	-0.6%	-9.5%	-12.7%	-3.6%	5.2%	6.7%
Masonry Cement	-1.6%	-20.7%	-19.2%	0.7%	15.7%	11.5%
Cement and Clinker Imports	6.7%	-36.7%	-49.6%	-36.5%	4.0%	4.0%
Source: Portland Cement Association **estimated