Economic Outlook Assumptions

Posted by Bruce W. Woolpert on Mar 18, 2015


Bruce Woolpert Graniterock President & CEO

Each year, Graniterock prepares a financial plan for its business operations which begins with our Economic Assumptions. Information is gathered from various sources and then reviewed, analyzed and assembled into a set of economic assumptions for the coming year. We then develop our business plans in a fashion consistent with those assumptions. We share this information with our contractor-customers in the hope that our economic outlook may be helpful to you in formulating your own 2011 business plans.

However, it is important to issue a warning of sorts; this recession is unlike any we have seen. Since 1900 – 110 years ago, Graniterock has been through many recessions. We constantly remind ourselves that “survival” during such rough times remains the appropriate goal and that we must view your wellbeing and our wellbeing as intertwined because this indeed in how we come through this together. This is why Graniterock People remain committed more than ever to providing you with outstanding quality products and service, and to respond positively to your special needs. Please let us know how we can help.

U. S. Economy Construction employment in the United States peaked in 2006 and 2007 at 7.7 million workers and then fell by 1.7 million workers (-22%) to 6 million workers in 2009. Construction started to show problems in 2006 as housing starts began a decline from 2.073 million starts in 2005 to 1.812 million starts 2006. However, relative to historical normal-year housing start levels of 1.5 – 1.7 million units, 2006 numbers remained strong. Then came the “housing depression.” Housing starts then fell to only 554,000 units nationwide in 2009 and are expected to be “flat” in 2010 at 606,000 units.

Nationwide housing starts are not expected to show substantial improvement until 2012 when starts are expected to increase 25.4% to 1.209 million units. A nice increase, but starts will still be below normal activity levels.

Non-residential construction activity increased from $438.2 billion in 2007 to $464.3 billion in 2008, causing some to believe that this construction sector would remain strong through the recession. However, this was not to happen. As businesses cut employment, they no longer needed as much office and manufacturing space. Non-residential construction fell to $369.6 billion in 2009 and will fall further to $316.5 billion in 2010. Due to weakness in the jobs outlook, nationwide non-residential construction is not expected to show improvement until 2014.

In many recessions, residential construction has been a significant early contributing sector to a return to normal economic activity. This will not happen this time. Instead, the lack of construction activity in the United States is expected to be a drag on the economy until 2012. At the same time, reduced employment and overall pessimism about the economic outlook is hurting construction activity. If businesses were hiring, and people could be more secure in their jobs, it is likely that construction activity would improve sooner, perhaps as early as the second half of 2011.

The U.S. Economy slowed in the second quarter 2010 to a revised 1.6% annual rate of GDP growth. Most economists now predict that the economy will continue to crawl out of the current recession with growth rates about 2% in 2011. Growth would have to exceed 3 – 3.5% to start bringing down unemployment and improving consumer confidence.

Given the huge decline in output that took place in 2008 – 2009, the economy should be growing at 5 – 6% (bouncing back), not growing at less than 2%. What normally happens in an economic recovery is that government spending and tax cuts improve the economy as the dollars spent are passed through to inventory restocking of consumer goods, housing increases and business investment. The transition from government spending to the private sector is important because the private sector is so much larger. In this recession, the private sector is not picking up the ball from government spending as consumers and businesses continue to decide to stay on the sidelines.

Underlying the economic problems for the country are two major issues: (1) households are working to reduce debt and improve personal balance sheets, and (2) people are “freaked out” by uncertainty regarding government policies and actions. The second issue is causing people to put more emphasis on the first issue – improving household financial security. Historically, balance sheet adjustments have been associated with protracted, slower economic recoveries. Political uncertainty could be reduced if government did a better job communicating its goals and activities, and discontinued its anti-business rhetoric and policies. Consumer uncertainty is feeding business uncertainty which is causing businesses to postpone new investment and hiring. The Federal Reserve’s Open Market Committee minutes (August 2010) stated “A number of participants (Fed presidents from various regions of the country) reported that business contacts again indicated that their uncertainty about the fiscal and regulatory environment made them reluctant to expand capacity.” Uncertainty about tax matters, particularly the extension of the Bush Tax Cuts, is a significant source of business uncertainty, causing businesses to postpone expansion consideration. All of this uncertainty is leading many large corporations to hire outside the United States.

Over the next several months, a number of things could happen. Control of Congress could change, causing grid-lock between the White House and Congress. Gridlock would replace concern about what “could happen” with “assurance that nothing will happen.” Many business leaders and economists believe this would be an improvement over the current deepening uncertainty felt by consumers and business.

Some or all of the Bush Tax Cuts could be extended, but due to the long investment lives of most business investment, a one-year extension (which now appears to be the likely course of action by the Congress) followed by new uncertainty just a year from now will not be helpful in getting the economy moving again. Because government has dramatically increased the annual budget deficit and the total national debt, there can be little doubt that taxes must go up over the long-term for all Americans and entitlement program spending must be reduced. Because increased taxes mean lower return on invested capital, businesses are going to be more cautious than in the past about making business capital investments.

The Federal Reserve has purchased significant dollar amounts of mortgage securities and long-term Treasury Bonds. The result of these transactions is to increase the money supply and reduce interest rates. Interest rates are lowered directly because the Fed’s purchase of U. S. Treasury Bonds and Notes mean that government borrowing is not allowed to “crowd out” private lending activity. Short-term interest rates remain near zero and 10-year Treasury Notes are not expected to exceed 3% until very late in 2011, and then increase only slightly. These interest rates indicate that financial markets do not anticipate inflation anytime soon.

Households are repairing their balance sheets, which will allow consumers to spend more freely. The overhang of unsold houses is being worked off, which will help to stabilize house prices. As each of these impediments to a stronger recovery subsides, the recovery will gain increased strength.

Household Balance Sheets  From 1990 to 2007, annual household savings was flat, averaging $265 billion per year. With household incomes rising over this period, the savings rate (as a percentage of income) fell from 6.5% in 1990 to only 2% in 2007. However, during 2008, savings soared to $635 billion per year and the savings rate had returned to 6%.

 Although savings are up, household balance sheets have a long way to recover. Household net worth declined by $17 trillion from $66 trillion peak in mid-2007 to its low in this recession of $49 trillion in early 2009. Since early 2009, household net worth has rebounded by roughly $6 trillion due to stronger equity valuations.

 The ratio of net worth to after-tax personal income (i.e., how long a family could fund its income from its net worth) is now 4.9, compared with a 20-year average of 5.3. Net worth would have to recover by another $5 trillion to a level near $60 trillion to regain an average ratio of net worth to income. Most of this rise will need to come from financial assets since 65% of total family assets are held in financial holdings (bonds and stocks).

Indeed 88% of the improvement in family net worth has come from increased financial asset values with the bulk of the gain coming from higher stock prices. With housing comprising 25% of household assets and 13% of household net worth (i.e., value of the house less the mortgage), housing prices could improve family balance sheets by late 2011. Housing leverage (ratio of house values to mortgage amounts) has moderated thanks to a $600 billion improvement in the value of homes and a $300 billion decline in mortgage debt. A moderate uptrend in housing prices could accelerate improvement to household net worth. Low mortgage interest rates encourage home buying and act to push up home prices. While the inventory of unsold existing homes remains high, these homes are selling and the situation is improving. The inventory of unsold new homes is the lowest it has been in 42 years so renewed housing construction should occur as soon as the economy improves a bit more and consumer confidence improves.

Along with improvement in household balance sheets making a double-dip recession unlikely, corporate profits are only 11% below their peak in mid-2006. Profits have improved 55% between mid-2009 and mid-2010, providing businesses with an increased source of cash. Corporate profits continue to show improvement and corporations are starting spending on new equipment and software. During the recession, the cuts in business fixed investment accounted for more than half of the recessionary decline in real GDP. Modest increases in corporate spending during the first half of 2010 have been responsible for 42% of the improvement to GDP even though it accounts for only 15% of real GDP. During this recession, not only did businesses cutback on capital spending more significantly (60% greater reduction), but also the percentage of the workforce that has been laid off is double previous severe recessions. Businesses have learned that they can operate with many fewer employees. Productivity has increased dramatically. Businesses are not going to resume hiring until there is significantly more demand for their products and services. Businesses will be forced to add workers when the reduced workforce simply can’t handle the increased orders.

In summary, the economy is undergoing a gradual healing and improvement process. A double-dip recession is unlikely because households are making strong progress in repairing their household balance sheets, savings are up, and home prices have stabilized and should begin to improve. As these things are “repaired,” consumers will resume purchases of goods and services. In addition, corporate profits have greatly improved, providing companies with cash for investment. These “healing steps” are positive signs that the consumer and business are doing a good job putting problems behind them that were immediate concerns and the political actions are now becoming more important in the minds of consumers and businesses in making longer term hiring and capital investment decisions. Our assumption for the U. S. Economy is that these workout steps will continue in 2011 but that the economy could improve sooner if the political uncertainties are eliminated.

The UCLA Economic Forecast (actual 2005 - 2009 and forecast for 2010 - 2012) for the nation is:
Economic Statistics for the United States 2005 2006 2007 2008 2009 2010 2011 2012 Real GDP Growth 3.1% 2.7% 1.9% 0% -2.6% 2.8% 2.1% 2.8% Residential Const. Growth 6.3% -7.5% -18.9% -24.3% -23.2% -2.1% 8.8% 25.9% Housing Starts (millions) 2.073 1.812 1.342 0.900 0.554 0.606 0.815 1.209 Single Family (millions) 1.719 1.474 1.036 0.616 0.442 0.495 0.637 0.956 Multi-Family (millions) 0.354 0.338 0.306 0.284 0.112 0.110 0.178 0.253 Non-residential Const. Growth 1.5% 9.2% 14.1% 5.9% -20.4% -14.4% -6.4% 3.9% Construction Employment (millions) 7.3 7.7 7.6 7.2 6.0 5.6 5.4 5.5 Unemployment Rate 5.1% 4.6% 4.6% 5.8% 9.3% 9.7% 9.6% 9.1% Crude Oil Price ($/bbl) $56.6 $66.1 $72.2 $99.8 $61.8 $78.1 $83.6 $90.1 Interest Rates Prime Interest Rate 6.19% 7.98% 8.05% 5.09% 3.25% 3.24% 3.29% 5.18% U.S. Treasury 10-Year 4.29% 4.79% 4.63% 3.67% 3.26% 3.20% 2.97% 4.08% 30 Year Mortgage 5.86% 6.42% 6.33% 6.04% 5.04% 4.65% 4.45% 5.56%

California Economy Like the nation, the California economy is no longer on a downward trend but the economic recovery in California is expected to be even slower and take longer than for the nation. This is because our housing problems are much more severe. While construction employment fell by 22% nationally (from 7.7 million workers to 6 million) from 2007 to 2009, California’s construction employment dropped 33.5% from 2006 (California’s housing market was one of the first to turn down in the nation) to 2009. In 2009, there were only 36,300 housing starts (about 3,000 per month) compared with 208,900 (about 17,400 per month) in 2005. Housing activity in 2010 is expected to be only slightly improved to 46,200 homes. However, California’s housing problem, and the timing of housing’s turnaround, is not uniform across the entire State. Housing is doing better in “Coastal California” than in “Inland California.” Residential construction is expected to improve first along the coast and then take several years longer before improving inland. Coastal community housing markets will show improvement in the second half 2011 and strong improvement in 2012. Inland area residential activity is not expected to show improvement until after 2012 (some experts believe housing in the Central Valley will not show improvement until 2014 or later).

Non-residential construction fell from $18.2 billion in 2005 to $8.9 billion in 2009. While still weak, job growth is happening along the coast. Export/import related businesses, associated with the ports, are showing increased volume. High technology businesses are doing well. Because there is still considerable vacant office, warehouse and industrial space along the coastal areas, the upturn will be delayed until the second half of 2011 and then non-residential construction will show gradual improvement as a stronger hiring trend develops. Stronger improvement in coastal markets is expected to occur in 2012.

Because the inland areas are recovering slower than the nation’s economy, California’s statewide economy will be slower to recover than the nation. California’s unemployed grew by 1.3 million people during this recession. Employment growth continues to be uneven. Coastal Southern California is the only region showing positive net job formation for the first half 2010 (new jobs exceed new job entrants), the Bay Area is holding steady (new jobs equal new entrants), and job losses still dominate the inland parts of the state (not enough new jobs to fill recently vacated jobs as well as new entrants). Overall, there are not enough new jobs being created to drive the unemployment rate in the state below 10% until the end of 2012.

Economists expect construction industry employment not to recover to pre-recession levels for a very long time. UCLA believes that there are 250,000 “excess people” who previously did construction work along with 60,000 mortgage workers who also will not be needed. These people will need to find other employment. As a result of so many people looking for work, wages and benefits are expected to face downward pressure and drive renewed competition between union and non-union contractors. On the other hand, most of these “excess people” worked in residential construction which has been predominately non-union for decades.

UCLA economic outlook (actual 2005 – 2009 and projection 2010 – 2012) is:
Economic Statistics for California 2005 2006 2007 2008 2009 2010 2011 2012 Personal Income 5.7% 7.8% 5.1% 2.0% -2.5% 1.9% 3.7% 6.1% Residential Permits (thousands) 208.9 163.6 113.2 65.6 36.3 46.2 93.7 147.1 Single Family (thousands) 154.6 107.3 68.4 32.8 25.4 24.5 49.2 77.4 Multi-Family (thousands) 54.3 56.3 44.8 32.8 10.9 21.7 44.5 69.7 Non-residential Const. (billions) $18.2 $18.7 $18.9 $15.3 $ 8.9 $ 8.9 $ 9.1 $13.2 Construction Employment (thousands) 905 934 893 788 621 550 550 575 Unemployment Rate 5.4% 4.9% 5.3% 7.2% 11.4% 12.2% 11.0% 10.1%

California Construction Activity Focusing comments on Graniterock’s market area, we are already starting to see some improvement in custom home construction along the San Francisco Peninsula and in the coastal areas. In late 2011, residential construction activity should move to the high-end tract home market in these same market areas. Apartment and condominium construction are expected to increase in San Jose in 2011 due to the scarcity of rental units. Unfortunately, we should not expect to see a resumption of residential construction in Southern Santa Clara County (Gilroy), San Benito County, and Salinas. These market areas are still suffering from home foreclosures and falling home prices.

Commercial building construction, including retail, office building, and R&D building space, will escape a refinancing crisis in our market areas. Commercial building should gradually improve in San Francisco and the San Francisco Peninsula during 2011, and commercial construction activity will improve in San Jose in late 2011, driven by employment growth in those market areas. For other markets, vacant commercial space surveys indicate that current vacancy levels will support job growth for a longer adjustment period. Still, some projects may move forward supported by business-occupied (owner-occupied) expansion plans that have been held in abeyance waiting for an upward turn in the economy.

For public construction, we will see no help from the American Recovery and Reinvestment Act of 2009 in California. Approximately $2.55 billion in Recovery Act funding was made available in California for highway infrastructure projects. By March 1, 2010, 100% of California’s Recovery Act funding was obligated. The Recovery Act funded 109 Caltrans projects, amounting to approximately $1.35 billion, and 790 locally administered projects, amounting to approximately $1.1 billion. Only 3% of the ARRA’s $787 billion total spending was directed to infrastructure improvement. Congress believed that infrastructure spending would “put every construction worker back on the job” and was disappointed to learn that the stimulus bill had done little to increase hiring in the hard hit nationwide construction industry. With this disappointing experience and Washington’s emphasis now turning to reducing annual budget deficits (so as to not add to the national debt), there appears to be very little support for a new infrastructure spending bill. However, if unemployment were to worsen causing public concern that the recession is double-dipping, it seems likely that Congress may come to adopt President Obama’s October 2010 proposal for a $50 billion stimulus package for roadways, public transportation and airports.

State funding for highway construction will be helped by continued funding from Proposition 1B until it runs out in 2012. State funding sources are down compared with 2007 because the recession and higher gasoline prices led to reduced gasoline purchases (lower pump tax and sales taxes on gasoline). However, Proposition 1B bond funds will be available in 2011 to match local and federal funds to move major projects forward. There will be more and larger Caltrans projects in the San Francisco and Monterey Bay areas in 2011 than in recent years.

California recently approved its budget for 2010-11. The State Budget assumes that $5.4 billion will be provided by the federal government for general support (such as the recent grants to assist states and local government to maintain public safety and teacher jobs). In recent years, the federal government has provided only about $ 1 billion to California for such purposes. The Budget also includes shifting some payments to the next fiscal year such as delaying reimbursement to local school districts (for money already spent in 2010-11) until 2011-12. While the State Budget solution is largely smoke and mirrors, the good news is that tax revenues are starting to show improvement in California so perhaps a second round of budget cuts will not be necessary. The State provides funding for state highways as well as funding to local government for road maintenance. Overall transportation funding support, both for Caltrans and local government, increased significantly in 2009 – 10 due to Proposition 1B funding.

Proposition 1B funding will continue to be significant for state projects through 2012. However, as shown in the table below, transportation funding is expected to be 2.7% lower in 2010-11 compared with 2009-10. Transportation Funding in California Fiscal Years, $ in Billions 2008-09 2009-10 2010-11 % Change Caltrans Maintenance Projects $ 1.242 $ 1.233 $ 1.430 + 16% Caltrans Improvement Projects $ 3.340 $ 6.820 $ 7,018 + 3% Local Government Programs $ 1.807 $ 2.891 $ 2.200 - 24% Total $ 6,389 $10,944 $10,646 - 2.7%

Sources of economic data and analyses used in this report are UCLA Anderson Forecast (September 2010), Comerica Bank, Wells Fargo Bank, California Department of Transportation, and the U. S. Department of Transportation’s Federal Highway Administration.

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