Inside AGC — January/February 2007

Economic Outlook — Outlook for '07: Neither Heaven nor …

By AGC Chief Economist Ken Simonson

For many nonresidential contractors, 2006 was their busiest year ever, but some contractors were caught in the downdraft of the home building collapse. Everyone had to stay atop the bucking bronco of ever-changing materials costs. What will 2007 bring for nonresidential markets, housing-related activity and materials costs?

Impact of Housing Slowdown

Several favorable signs for nonresidential spending include a record level of voter-approved bond issues that should add to the demand for roads and bridges; sewer, water (in California) levee projects; schools; and parks, conservation and recreation facilities. Private nonresidential construction will see continued expansion of manufacturing, energy and power-related, hospital, hotel and resort, and transportation facilities.

Even the residential market will have bright spots, although nationally, single-family home building is likely to keep shrinking for most, if not all, of the year. In a few regions with high population growth or booming economic activity, home building may not turn down. Meanwhile, rental housing is beginning to pick up in many markets after a long slumber.

The housing slowdown will taint some other types of construction. When a subdivision is canceled, that means less work for contractors who build the local utilities, streets, public buildings, religious structures and retail that support the housing.

A slowdown in home remodeling and sales cuts into demand for stores carrying home building materials, furniture and furnishings, appliances and consumer electronics, and yard and garden supplies. Demand dips for small office space for real estate and property insurance agents, mortgage and title companies, and other housing and home sales-related businesses. Thus, retail and office construction are not likely to be as robust as other private nonresidential segments.

Materials and Transportation Costs

Materials cost pressures have recently subsided after extreme increases in the first eight months of 2006. For the time being, there should be moderation or falling prices for gypsum products, construction plastics, lumber and oriented-strand board. Some of the highest flyers of 2006, such as steel, diesel fuel, concrete and copper, may retreat slightly in price, but they will not come close to their pre-runup levels.

Within a few months, however, construction materials costs could well be rising at a 6 to 8% annual rate again, even as overall inflation stays in the 2 to 4% range. Two factors make construction materials costs more susceptible to steeper increases than the overall rate of inflation.

First, construction requires generally fixed quantities of materials. Many materials used in construction are also in demand from other sectors, both in the United States and fast-growing economies like those of China, India and elsewhere in Asia. Yet supplies of some materials expand slowly. An example is copper, where the major mines have been subject to labor unrest or political turmoil. As a result, prices have jumped.

Second, materials must be physically delivered using a transportation network that is often stretched to its limits. Transport costs are high, and bottlenecks frequent. In addition, fuel-price spikes add to transport costs as well as the direct costs of operating equipment.

The ongoing rise in materials costs is likely to limit the number of public contracts that will be awarded. Therefore, 2007 will probably be a strong year for private, nonresidential construction, a positive but not stellar year for public projects, and a dismal year for residential work, other than rental housing and a few hot local markets.

All contractors will have to contend yet again with spikes in materials costs and occasional shortages although the drop in demand from the large residential market will keep shortages short-lived and rare, for the most part.