A More-Challenging Year AheadWritten By: ELI LUSTGARTEN
Article Date: 02-01-2007
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Expect modest growth for construction markets as mid-cycle economy unfolds.
The 2007 domestic economy is following the mid-cycle outlook we've been projecting for six months. U.S. GDP growth has clearly slowed from the robust 5.6 percent of Q1:06 to the 2 percent level of Q3 and with similar growth likely for Q4 and the early part of 2007. Mid-cycle has arrived but the economic evidence is still on the side of continuing modest growth rather than recession. For example, as feared, the PMI did drop to 49.5 in November under the pressure of the sharp cuts in auto but rebounded to 51.4 in December 2006 with significant gains in both new orders (52.1 from 48.7 in November) and production (51.8 from 48.5 in November) to drive the PMI above the breakeven point.
Manufacturing employment has remained relatively unchanged as 2006 came to a close and price indexes have trended downward (47.5 in December from 53.5 in November, 47 in October and 61 in September), relieving some of the inflationary pressures that have troubled manufacturing since mid-2003.
We still expect volatility in the industrial economy in the first half of 2007. The weakness in housing, autos and farm equipment will carry over into the first half of 2007, and the truck sector has started its long awaited and predicted decline.
Inventories also appear to be modestly high as evidenced by the ISM customer index registering 50.5 in December, the same as November (though down from 52 in October) indicating the likelihood that inventories are above desired levels across many industrial markets, a fact consistent with our surveys of industrial and bearing distributors, and construction equipment rental companies. This suggests a possible modest inventory correction in the first half of 2007, similar to what occurred in the first half of 2005.
Our thesis remains unchanged that the overall trajectory for the industrial sector remains positive with growth across most domestic key end markets excluding consumer-related (housing, auto, light construction) and farm and truck in 1H:07 and strengthening industrial demand outside of North America, particularly in Europe. Recession is unlikely in our view unless inventories get further out of hand or money availability tightens significantly.
The construction sector still looks relatively flat in 2007. Based on data provided by the Association for General Contractors, non-residential construction appears poised to build upon the momentum of 2006 and rise a further 8 percent to 10 percent from what appears to be a stronger-than-expected low-teens growth in 2006.
Multi-unit residential construction for rentals will likely remain robust offsetting the expected decline in condominium construction. But a further decline in new single-family construction of 10 percent to 15 percent and an expected modest decline in improvements will likely keep total construction expenditures at about the same level as 2006.
- Healthcare (particularly hospitals), lodging (surge in hotel building) and energy-related construction remain the brightest areas of activity with doubledigit growth likely this year on top of strong performance in 2006.
- Expanding public works led by highway and streets and transportation should improve 8 percent to 10 percent helped by record levels of bond approvals, though down from 2006's double-digit levels.
- The slowing domestic economy will slow activity in other segments of non-residential construction, including educational (up 5 percent to 6 percent) and commercial (about flat as retail/shopping centers feel the effect of the housing decline). Other mid-single digit growth segments at best will be offices, manufacturing, and sewage and waste.
Recent housing data may show housing is stabilizing, although at levels well below their mid-2005 peaks; however, recent comments from major homebuilders about cancellation levels suggest the 6.3 months of supply of houses for sale at the end of November (down from a peak of 7.2 months in July and compared to 4.9 months in November 2005) may be materially understated, suggesting further weakness in this sector at least in the first half of 2007.
In the construction equipment sector, demand has peaked at historic highs, and the cooling that is under way in most markets will be much more pronounced in smaller and medium machines and areas that have benefited from the extra-ordinary housing bubble.
The rental sector clearly has indicated profitability is the focus in 2007 and less equipment purchases are likely. This is consistent with our November-December 2006 surveys, which show rental fleet utilization has slowed, fleet age is very young, with more than 80 percent reporting a fleet age of less than three years, and inventories are in line for 53 percent but too high for 41 percent.
The bottom line hasn't changed: 2006 was a good year for the construction equipment industry, but 2007 is likely to be much more challenging. If the Fed will cooperate and begin to cut rates sometime next year, this expansion may have legs to last to the end of the decade.
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