The Big Idea
A construction growth engine that may be stalling
Stephen Stanley | January 5, 2024
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.
A boom in construction of domestic manufacturing and warehouse facilities last year helped propel economic growth, but that boom appears to be peaking. It came last year in response to Covid-related supply chain snarls, despite well-publicized issues for office properties. But turning the page to 2024 shows that while the level of activity remains high, this GDP component seems unlikely to contribute much to growth. It’s another reason that last year’s stellar growth is going to prove difficult to match.
Financial markets and those who track the banking sector have been warning of a wave of troubles coming for office space in the US. As time passes, it has become increasingly evident that the rise in the incidence of work-from-home is going to persist long past the pandemic. Eighteen months after various lockdown restrictions were largely lifted, the Kastle data on security card swipes at downtown office buildings in 10 cities has leveled off at just over 50% of pre-Covid levels. This has led to some massive valuation drops for certain big office buildings, especially in the central business districts of large cities.
In nominal terms, office construction expenditures have been roughly flat in recent years, dipping for a while during the pandemic and then gradually recovering. Most recently, the level of nominal outlays appears to have stagnated (Exhibit 1).
Exhibit 1: Office construction expenditures slow
However, it is vital to adjust for inflation when comparing recent economic readings with pre-pandemic figures. After adjusting for inflation, the weakness in office construction can be seen clearly (Exhibit 2).
Exhibit 2: Real office construction expenditures have dropped since 2020
Even so, it is worth noting that the scale of this industry is sufficiently small that it is not likely to have a sharp direct economic impact. Real outlays have declined from a peak annualized pace of $87 billion at the beginning of the pandemic to a low of $59 billion early last year although it could, and likely will, fall further. That is a drop of close to one third, but the $28 billion fall represents one tenth of one percentage point of real GDP. If the sharp persistent drop in demand for downtown office space is going to have a meaningful impact on the US economy, it would have to come from ripple effects in the financial sector. I am optimistic that while certain developers and perhaps even some small banks with heavy lending exposure to office landlords may endure stress, the overall economy will avoid the sort of cascading dynamic that occurred on the back of the housing bust in the 2000s.
Bringing supply chains home
Turning to the sources of strength in the structures component of GDP, large international companies responded to the pandemic by trying to shorten their 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 chose to create more of a domestic operations base. The result has been a boom in manufacturing and warehouse facility construction.
The dollar value of construction of manufacturing facilities has been rising. The sector was relatively stagnant through 2021 but has seen a massive run-up over the past two years (Exhibit 3). In fact, recent readings are two and a half times larger than the pace of spending just prior to the pandemic.
Exhibit 3: Manufacturing construction expenditures jump
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 more than tripled over the past two years and currently accounts for well over half of overall manufacturing construction.
This points to another potential driver of growth in nonresidential construction going forward. If the geopolitical situation continues to deteriorate, especially relations between the US and China, there may be continued and perhaps broadening legislative efforts to encourage domestic production in key industries such as green energy.
Unlike for the office sector data, the picture for construction on manufacturing facilities is similar in nominal and real terms. Real expenditures are still up sharply over the past two years (Exhibit 4).
Exhibit 4: Real manufacturing construction expenditures rise, too
In addition to the manufacturing construction boom, 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, accelerated in 2021 and 2022. The value of warehouse construction has climbed steadily (Exhibit 5).
Exhibit 5: Warehouse construction expenditures rise
Circling back to manufacturing and warehouse expenditures, if you look closely, you may notice that the level of activity for manufacturing construction appears to be topping out, albeit at a sky-high level, and outlays for warehouse facilities have been falling since July. Logically, the adjustment to a heavier domestic production and distribution model was more likely to be a 1-time adjustment rather than a source of permanent growth. We might have hoped that the uptrend would last a little longer, but it is not altogether surprising that the growth impetus appears to be cooling.
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 nearly 20% from its 2019 peak. However, as manufacturing construction began to ramp up last year, the category turned dramatically.
In the fourth quarter of 2022, real business investment in structures bounced at a 6.5% annualized pace, adding two tenths to real GDP growth. Real growth surged to over 30% annualized in the first quarter of 2023 and 16% in the second quarter, adding 0.8 percentage points and 0.5 percentage points to real GDP growth, respectively, just at the time when economists had expected the expansion to give way to a recession. In the third quarter, the advance moderated to a still-robust 11% annualized, adding three tenths of a percentage point to real GDP growth. Unfortunately, the momentum looks like it continued to wane in the fourth quarter. I look for only a marginal gain in the just-ended quarter.
Given the recent trends in the monthly data, I have penciled in a roughly flat performance for all of 2024. The business investment in structures component of GDP, which quietly contributed significantly to last year’s economic growth, appears poised to flatten out in 2024, another reason that I expect this year’s growth path to be roughly half that of 2023.