The Big Idea
The economy’s best-kept secret
Stephen Stanley | June 2, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Financial markets have focused this year on the difficult outlook for US office space. It would be natural to presume that the part of GDP that includes office construction, business investment in structures, is one of the weakest right now. But there is plenty more to this component than just the building of new office space. The desire of firms after Covid to bring their supply chains closer to home is generating a boom in construction of manufacturing and warehouse facilities. That is helping to keep overall business investment growing despite tightening monetary policy and uncertain economic prospects.
Investors and analysts across a range of markets are warning of a wave of troubles coming for US office space. It is becoming increasingly evident that the incidence of work-from-home is going to persist long past the pandemic. Offices are about half as full today as they were before Covid, which has led to some massive valuation drops for certain big office buildings, especially in the central business districts of large cities.
This has not translated into substantial economic weakness just yet. In fact, while certain property owners and their creditors are beginning to see major repercussions, it is likely to take a while for new construction to dry up. Just to use a prominent example, every day that I work in New York City, I walk by the new JP Morgan Chase headquarters building on Park Avenue in Manhattan. The project was launched in 2018, and the building is scheduled to be completed in 2025. The broad point is that the life cycle of large office construction projects tends to be measured in years rather than months or quarters. So, the stress currently spreading in the sector may not be fully reflected in new construction activity for several years, as much of the current activity derives from projects started long ago.
This helps to explain how office construction can still be rising, despite the frequent negative headlines. The nominal value of office construction sank sharply during the pandemic but recovered last year and has been up modestly so far this year (Exhibit 1). It is worth noting that the real value of activity is actually down noticeably from peak pre-pandemic levels. Still, the full fallout from the structural downshift in office space demand has barely begun to be reflected in GDP.
Exhibit 1: Office construction expenditures rebound from pandemic
Bringing supply chains home
Another major shift in the structure of the economy resulting from the travails of Covid is that global companies are seeking to create simpler, shorter supply chains. The far-flung global operations that resulted in falling costs for years suddenly became a major problem during the pandemic, when shipping restrictions resulted in widespread supply disruptions.
Many companies that sell their goods in the US have reacted by eagerly seeking to create more of a domestic operation base. The result is a boom of manufacturing and warehouse facility construction. Construction of manufacturing facilities was relatively stagnant until last year and has seen a massive run-up over the past year or so (Exhibit 2). In fact, the April reading released on Thursday was up by 105% year-over-year.
Exhibit 2: Manufacturing construction expenditures accelerate
For what it is worth, the largest part of the run-up in manufacturing construction in recent months has come in the “computer/electronic/electrical” category and likely reflects in part the focused efforts by the federal government to boost domestic semiconductor production through the CHIPS Act and other policy initiatives. That category has seen a nearly threefold rise from a year ago and accounts for just over half of overall manufacturing construction.
In addition, the logistical crunch in 2020 and 2021 has sparked a rush to beef up domestic warehouse capacity. This is a trend that started before the pandemic but has been sustained and, if anything, has accelerated over the past year or two (Exhibit 3).
Exhibit 3: Warehouse construction expenditures continue to rise
The GDP component “business investment in structures,” which includes nonresidential construction as well as oil and gas drilling, was on a substantial downtrend through 2020, 2021, and most of 2022. By the third quarter of last year, the level of real activity had fallen 25% from its end-2019 level. However, as manufacturing construction ramped up last year, the category has turned dramatically.
In the fourth quarter last year, real business investment in structures jumped at a 15.8% annualized pace, adding four tenths to real GDP growth. Considering the revisions to February and March data released on Thursday, real growth in the first quarter this year could have been even stronger, perhaps close to a 25% annualized rate, which would add half a percentage point to overall real GDP growth in the period. Given the continued growth in nonresidential construction activity in April, it looks like the category could post another double-digit annualized gain in the second quarter as well.
Quietly, the domestic building boom is boosting the economy noticeably in recent quarters, offsetting weakness seen in higher profile sectors of the economy such as housing and business equipment outlays.