Has Construction Peaked?

On March 1st, we received word from the US Census Bureau that construction spending decreased 0.9% in March compared to February. Although this was only the first sequential decrease in the past four months, the trends in construction spending have actually been weak for several months now. The chart below shows that construction spending peaked last May at a seasonally adjusted annualized rate of about $1.324 trillion. The reading for March of this year was $1.282 trillion, or 3.2% below that peak.

Source: US Census Bureau

The weakness becomes more obvious when we look at the year-over-year changes in construction spending. In the first chart below, we show that growth in private construction spending, which usually accounts for 60%-80% of total construction spending depending on the stage of the economic cycle, has been negative for the past four months. Growth in public spending, on the other hand, has been somewhat elevated over the past year or so. The growth on the public side has limited the damage to overall construction spending.
Source: US Census Bureau
The next chart below breaks down the spending growth by residential and non-residential. It is fairly evident that spending on the residential side has dropped off quite precipitously, while spending on non-residential buildings has remained pretty solid. In fact, residential construction dropped 8.4% year-over-year in March – the sixth straight monthly decrease – to its lowest levels since December, 2016. The drop in residential construction can be attributed to a number of factors, the most influential of which are labor scarcity and weakness in demand. It is undoubtedly true that some homebuilders in various regions across the country are having trouble finding skilled laborers at reasonable wages. But the decreased affordability of new housing in the bigger issue as it is dampening demand for new homes. Affordability has decreased fairly dramatically over the past several years following several Fed interest-rate increases, steady increases in housing prices, and subdued middle-class income growth. Demand for newly constructed houses could also be negatively impacted by the relative affordability of previously-owned homes.
Source: US Census Bureau 
For the past many years, we have consistently stressed the housing market’s importance to the overall economy. In the chart below, we show that prior to the Global Financial Crisis, residential construction grew to over 57% of total construction spending in this country before falling to a low of 26% in May, 2009.   After rebounding for nine years, this ratio now appears to be inflecting lower again despite solid 2.9% GDP growth in 2018. Obviously, the economy is not nearly as dependent on residential construction as it had been. However, this analysis does show how sensitive some sectors of the economy are to rising interest rates. The argument that interest rates are still low compared to historical averages is simply not valid, and these construction figures are just one set of evidence disproving that notion.
Source: US Census Bureau
The more economic data that comes in, the more apparent it is becoming that the economy is unable to withstand significantly higher interest rates. In fact, the rate hikes we have already seen may have been enough to cause significant economic deterioration were it not for the short-term impact of the tax cuts and government spending increases. Now that the impact of the tax cuts is behind us, our sense is that the Fed’s next move is more likely to be a cut than a hike. This is especially true given the global economic weakness and the disruptions created by the trade war with China.

Following a 25% rebound in stocks, prices are no longer cheap. Economic and policy uncertainly, along with weaker earnings growth, are good reasons to temper expectations for further outsize gains.